Discounted Cash Flow valuations

Why probability and discount rates matter

Corporate finance services

There are various ways in which you can value a business or growth project, with popular business valuation methodologies including earnings multiples, asset-based approaches, entry costs or Discounted Cash Flow methodologies.

The Discounted Cash Flow (DCF) methodology provides a strong valuation approach, as it is applicable not only to traditional business assessments but also to growth-oriented projects. However, it requires detailed assumptions regarding future operations of the business which is not always achievable or practical in owner-managed scenarios.

This article examines how employing a probability-weighted approach in DCF can lead to a more precise valuation and minimise the risk of compounding assumptions, thereby ensuring a realistic and commercially sound outcome.

What is a Discounted Cash Flow model?

A DCF model is an income-based approach to valuation (as opposed to asset-based or market-based 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 flow levels off or flattens.

The projected cash flow and terminal value are discounted for investment risk, then combined to estimate the company’s current value. In investment scenarios, that estimate can then be used to consider investment potential; if the value arrived at is greater than the current cost of the investment, the investment opportunity is regarded as a positive one.

The calculations undertaken to determine a DCF valuation of a business are complex and require specialist knowledge in order to be applied appropriately. Our valuation e-book sets out examples that explain the process and key assumptions in more depth.

When is a discounted cash flow model used?

A discounted cash flow is primarily used for two key purposes:

Company valuations

A company valuation may be required for various specific share processes, including gifting or selling shares, the passing of a shareholder, or establishing a share price during equity raising initiatives. Additionally, valuations are necessary for acquisition scenarios and business planning purposes.

Capital budgeting decisions or project analysis

Capital budgeting is the process of identifying and evaluating projects which will generate cash flow to the company in the future. This can include capital investment in machinery (which may be a replacement for normal business operations or an expansion to increase capacity), new product launches and compliance related projects.

What are the limitations of the DCF methodology?

As with any valuation methodology, a DCF valuation is highly sensitive to the assumptions on which it is based. This then has a significant impact on decisions made by management, be it, in relation to a sale or whether a project goes ahead. It is therefore essential that assumptions and estimates are based on reality and tailored in the most appropriate way possible.

Five key common limitations of a traditional DCF model

1. Layers of assumption

The assumptions must be grounded in the reality of how the business functions within its industry. Moving from real-world to maths-world is a real skill, and translating that into appropriate assumptions that balance practicality and complexity is another entirely separate skill. However, if these are missing, the DCF will be limited.

2. Cost of capital assumption

The calculated cost of raising funds for a company/project is taken as a weighted measure of the cost of debt financing (such as interest on a loan/overdraft) and the cost of raising equity (implicit returns required by equity investors). However, simply using this weighted average cost of capital (WACC) as a discount rate without adjusting it for the risk present to the company or the proposed project may lead to significant errors when assessing the value proposition.

3. Management reaction and decisions

In reality, future cash flows and decisions are not fixed or determined at the present day, and in owner-managed businesses they are often not easy to reliably predict. Instead, future cash flows are dependent on a series of management decisions throughout the lifecycle of a business or project, which take into account recent performance and trends.

4. Terminal value

It is difficult for any business owner to reliably estimate cash flows in the near future, and even more challenging to estimate cash flows which stretch even further into the unknown. Therefore, a business valuation can be significantly affected by assumptions made about the terminal value in the DCF, which are typically subjective and quite often wrong.

5. Forecast financial performance

As mentioned above, accessing accurate forecast financial performance can be inherently challenging for owner-managed businesses. Forecasting performance is subjective by nature and may not be based upon realistic or considered assumptions. There is also the risk that, depending on the purpose that they were prepared for, expected performance is predicted on an overly cautious or overly ambitious basis.

Where should discount rates be obtained?

Over the last couple of years, discount rates in DCF valuations have faced growing scrutiny from HMRC, auditors, as well as buyer and sellers. In a way this is positive, marking a shift from DCF valuation models being solely academic, to something more people can understand and assess. Nevertheless, it also requires management teams submitting a DCF to support their discount rate with stronger evidence, making the choice of valuer more vital than ever.

Management teams that hire an academic valuer may encounter problems when submitting a DCF valuation, as they tend to rely on big company data, making broad-brush assumptions relevant to those firms, then applying it to much smaller businesses. While this may be acceptable, the valuer’s lack of practical market insights can reveal flaws to tax authorities, auditors, and other practitioners, ultimately triggering commercial and tax risks for the shareholders. We therefore advise that the costs of debt and equity are properly appraised using multiple methods and sources, and that this isn’t treated like a mechanical process for academics and analysts alone.

At Price Bailey we have access to discount rates from at least two databases at any one time and readily apply our own judgement and experience to interpret them.

A key weakness of the academic DCF approach is its failure to interpret data convincingly or present arguments that would satisfy a critical audience, such as HMRC, buyers or sellers, or even judges. Too often, discount rates are poorly justified, with valuers relying only on the removal of outliers and generic size adjustments, without deeper analysis. This becomes a significant issue if the valuation report is intended to support a decision or manage risk effectively.

A solution to the limitations: the probability-weighted Discounted Cash Flow model

A probability-weighted DCF model involves evaluating multiple scenarios, usually base, worst, and best cases that factor in elements like inflation, rates of growth or decline, and customer concentration risk, with each scenario assigned a specific probability. Management options are then assessed and incorporated into the model and the DCF is calculated. This provides a more realistic intrinsic value calculation which helps to deal with some of the issues surrounding a normal DCF model.

As discussed above, the cost of capital assumption is an important estimate in determining the value of a company or project. Too high and the future cash flows are discounted too heavily and result in a low (or negative) project value. Too low and the future cash flows are not discounted appropriately and results in an artificially high valuation.

While the impact of different scenarios occurring can be understood by adjusting the discount rate applied, it is far easier to make informed judgements on the probability of success and adjusting accordingly.

Understanding the detail of the various possible scenarios and weighting these on a probability basis allows us to consider the risks and different pathways without applying arbitrary assumptions to the whole calculation.

In reality, managers are provided with decisions further down the line which can change future cash flows, known as “real options”. These real options give managers the right (but not obligation) to make decisions about projects, such as:

Timing options: Delaying projects until more information is obtained or more clarity is gained around demand.
Expansion options: Following a successful project launch, additional investment may be made to increase production.
Abandonment options: Projects expected to result in loss can be abandoned with any costs incurred to date considered as sunk costs.
Flexibility options: Managers may increase or decrease price or production in line with demand among other factors.

This degree of optionality is not used in a traditional DCF model, despite its clear practical real-life applications, but in probability weighted DCF models, these considerations are factored into the probability-weighted pathways.

Finally, terminal value is typically determined by either a Gordon growth model, or (more commonly in the owner-manager world) a multiple of earnings approach. The multiple used is intentionally conservative, representing the uncertainty of future earnings and reflecting the likelihood that current valuation multiples might not persist over the long-term. If possible, using a cyclically adjusted average is better (e.g. the average take from across one economic cycle). However, a probability weighted DCF can take this one step further, applying the probability to the terminal value and reducing the reliance on just one or two assumptions for the final valuation.

One particularly interesting application of a probability-weighted method is applying different probabilities to costs and revenue, reflecting contracts and knowledge about future prices, but not sales. However, it is important to be aware that overcomplicating a probability weighted DCF essentially leads to a Monte Carlo simulation, a mathematical technique which weights thousands of simulations to create a probability distribution of outcomes. Whilst these can be useful tools for valuations where multiple scenarios exist (i.e. growth shares), it’s always good to start here rather than accidentally end up with one.

A practitioner’s view

Archaeologists have discovered Samarian stone tablets from nearly 2000 years ago containing cash flow projections with costs of capital.

These days, many owner-managed businesses often do not benefit from stable cash flows, therefore when conducting a valuation, it is worth considering alternative valuation methodologies to DCF initially. If DCF must be used, it is often applied using a probability-weighted DCF, particularly for early-stage businesses where there is high expected volatility and a lot of hope value.

This makes sense, given that within a business there are a number of potential scenarios that could play out, and valuing on the basis of only one potential pathway leaves room for a lot of error and potentially missed value. Therefore, utilisation of this technique provides a more sensible and realistic view of the future, opening up the opportunity to discuss true value whilst also providing investors or shareholders with the confidence to know that the key risks have been understood and incorporated.

Closing thoughts

Understanding and applying Discounted Cash Flow analysis can feel complex, yet it continues to be one of the most reliable ways to uncover the true value of a business and make confident, forward-looking decisions. Grounding strategy in robust financial modelling can help businesses to move ahead with clarity, whether they’re seeking growth, investment or a sale.

If you’d like expert guidance tailored to your situation, fill in the contact form below to speak to one of our Corporate Finance advisers today.

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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