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What is the Discounted Cash Flow Valuation Method?

By Generational Equity

01/26/2015

One of the most interesting concepts that we introduce to business owners at our M&A seminars is the discounted cash flow method of business valuations. Quite a few attendees are aware of the most common method of how to value their businesses – a multiple of the most recent fiscal year earnings – because lots of industries have a “rule of thumb” that uses this method.

For example, if you look at the Business Reference Guide published by the Business Brokerage Press you will see page after page of industry valuation “rules of thumb.” For example, if you look up “Auto Tire Stores,” you will see a standard rule of thumb indicating that these operations go for 1.5 to 2.75 times recast earnings plus inventory (for a definition of recasting, please follow this link). Lawn maintenance businesses go for 1.5 to 2 times recast earnings plus inventory. Publishers of newsletters typically have a rule of thumb of 1 to 2 times revenue. And so forth.

Your industry probably has some variation of this as well. These rules of thumb by and large are fairly accurate in terms of historically giving a value range for a business in a specific industry. However, it is only one valuation method, and it does not account for two things:

  1. Any unique features of your company that may command a premium (or conversely any negative issues it faces that may require a discount)
  2. The future cash flow your company will generate

And it is this last issue that the discounted cash flow (DCF) method addresses. Of all the concepts we introduce at our seminars, the DCF is probably the most challenging for business owners, especially those without degrees in finance, to understand. So as we do in our seminars, we are going to present a simplified explanation of this method of valuation. Here is the official definition of DCF:

"In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)—the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question."

For those of you that love the mathematics, here is the DCF formula for your pleasure:

"The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.

Thus the discounted present value (for one cash flow in one future period) is expressed as:

where

  • DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt;

  • FV is the nominal value of a cash flow amount in a future period;

  • r is the interest rate or discount rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;

  • n is the time in years before the future cash flow occurs."

For those of us that are not mathematicians, what does all this mean in laymen’s terms? Essentially this: The DCF model is used by professional buyers to determine what they will pay today for the future earnings of your company. The model works this way: Your historical income statement is recast to reflect the true earnings of the company. Once this process is completed, a “base year” is forecast. This is usually the current fiscal year that you are in.

Once the base year number is established, you will then need to create what accountants call a pro forma financial statement. This is a fancy term for the building of five years of income statements, which ultimately show your recast earnings from year one of the pro forma through year five.

With me so far? This is where it gets complicated. At this point you are ready to discount the future earnings back to today’s dollars. The critical issue is the rate you will be using to discount your earnings. The discount rate is critical because the lower the discount rate, the higher your business valuation will be. Conversely, the higher the discount rate, the lower it will be. So determining what discount rate to use is vital, and the discount rate is determined by the perceived risk associated with the investment.

The Discount Rate is Key

This is an inexact science. A risk-free investment, say a government bond, would command a very low discount rate to value. An investment in a publicly held company, although riskier, is not as risky as an investment in a privately held company. In addition, your particular company may have risk factors associated with it that could impact your discount rate. Other factors that could also impact it are your historic growth rate vs. your forecasted rate. For example, if your company has been growing at a 5% rate and you are forecasting five years of growth at 25%, it is almost guaranteed that a buyer will apply a higher discount rate.

This is why, as we have stated before, it is really vital that you have professional M&A advice before approaching buyers. Certainly the DCF valuation model is not the only valuation method that buyers will use to value your business. Savvy buyers will apply several methods to accurately value your company so that they can earn the ROI (return on investment) that they need. However, they will ultimately use the method that gives them the greatest return, which means your valuation may be lower. Again, if you have a professional M&A advisory firm working with you, the value of your company will be determined before you go to market using the DCF and other financial models. This allows you to have an idea of the value range you should expect buyers to be in.

Of course I have over simplified the DCF process. The reality is that the method can be very complicated, as all valuation methods can become. A tremendous number of variables need to be accounted for that I cannot cover in 1,000 words or less. If you are interested in seeing the DCF model in action, as well as getting an overview of other methods used, attend a Generational Equity M&A seminar in your area. The information we provide is helpful as you begin your exit planning. To find out more, please visit our website.

Carl Doerksen is the Director of Corporate Development at Generational Equity.

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