How to use the discounted cash flow (DCF) model for business valuations

Accounting, Business, Corporate Finance, Investment, Strategy

There are a number of reasons for valuing your business, and while preparing a business for sale maybe the most common, it is certainly not the only one.

For example, a business valuation may be needed for a number of specific share processes – such as gifting or selling shares, on the death of a shareholder, or to help determine a share price as part of an equity raising share issue – as well as acquisition or for business planning purposes.

And just as there are a number of reasons for valuing a company, so there are a number of methods used to reach that valuation. These include:

  • Earnings multiples – which use a price-earnings (P/E) ratio (representing the value of a business divided by its profits after tax) multiplied by current profits to achieve a current valuation.
  • Asset-based – the value of assets as stated in the accounts, adjusted to reflect current market rates or bad debts (but not taking into account future earnings).
  • Entry cost – a valuation reflecting the costs involved in setting up a business from scratch, such as buying assets, recruiting and training staff, developing products, and building up a customer base.
  • Discounted cash flow (DCF) – valuing the business on the basis of a longer-term cash flow forecast and a residual business value, then using a discount rate to determine the value of the business in the current market.

Particular methods may be more suited to valuing different types of business, or businesses at different stages of development. For example, DCF valuations are generally appropriate for cash-generating, stable, established businesses with good long-term prospects.

How does the discounted cash flow approach work?

Discounted cash flow (DCF) is an income-based approach to valuation (as opposed to asset-based or marketing approaches), and is a comparatively technical method which draws heavily on long-term assumptions and predictions about business conditions.

The approach is based on the theory that the value of a business is equal to the current value of its projected future benefits, which includes the present value of its ‘terminal’ worth. That terminal value doesn’t assume the end of the business, but represents a point in time when the projected cash flows level off or flatten.

The projected cash flow totals and the terminal value are then multiplied by an annual discounted rate (which encompasses the risks of investing in the specific company being valued), to arrive at an estimate of a current value. In investment sectors, that estimate can then be used to consider the prospects of investment potential; if the value arrived at through DCF is greater than the current cost of the investment, the investment opportunity is regarded as a positive one.

The calculations to determine a DCF valuation of a business are complex, but investment sites such as Investopedia and einvesting for beginners set out examples that explain the process in more depth.

 

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What are the risks of this approach?

These sites and others also highlight some of the limitations of the DCF approach. For example, the growth rate assumed for the length of the cashflow forecast must be justified by the firm’s operating performance, and companies’ growth rates can change, sometimes dramatically, from year to year, or even decade to decade. Small changes in inputs, particularly early on in the forecast process, can result in large changes in the estimated value of a company.

However, the DCF approach to business valuation is now widely used and accepted as one of the key valuation methods. To ensure the most accurate method of evaluating your business, you should consider carrying out the valuation process using various approaches – such as an income-based approach, an asset-based approach, and a marketing approach – and then reconcile these valuations to arrive at the most accurate figure.

A practitioner’s view

Our Strategic Corporate Finance team regularly conduct formal and informal valuations on large and small companies around the world. We often have to value businesses using a DCF and, When doing so, it is essential we have strong forecasting capabilities – we’ve used these models in mining and energy projects globally because the whole industry is setup for long-term thinking and contracts. Without this a DCF can end up being unnecessary layers of assumptions upon assumptions,

Our growth capital team help early-stage disrupters raise funds. Problems can arise when the management teams put together forecasts and then hope that they can use a DCF to justify a really high valuation. Investors don’t work in this way – they would see this approach as assumptions on top of assumptions. There has to be some comparability with other businesses, there has to be certainty in the forecasts and the discount rate used has to be sensible. All of this then needs to result in the right internal rate of return (IRR) for the investor themselves. This thinking is normally missing from management teams of early-stage businesses.

More recently, we and some of our peers are seeing ‘probability weighted’ DCFs emerge which is a better approach for management teams who feel the need to use a DCF as the primary valuation methodology.

This post was written by Chand Chudasama, one of Price Bailey’s Strategic Corporate Finance Directors. If you would like to know more then please contact Chand using the form below.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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