The prior post contained an overview of valuation methods. This one addresses the income approach in particular. The discounted cash flow (“DCF”) method is the income approach favored by most financial professionals. In this approach, the value of the business is measured by estimating the expected annual future cash flows of the business, and then applying a discount rate to the future cash flows to determine the net present value (“NPV”) of the future cash flows. The future cash flows are discounted to NPV because of the “time value of money.” Receiving $100 today is worth more than receiving $100 a year from now. Therefore, the present value of $100 in the future is less than $100.
In a DCF analysis, the future cash flows are projected out into the future using a series of assumptions about how the business will perform in the future. While DCF analysis is widely accepted, its valuation output is extremely sensitive to the assumptions that must be made. Therefore, small differences in assumptions can lead to very different valuation conclusions. DCF analyses are often attacked by undermining the assumptions made by the appraiser, rather than the DCF concept itself. That is, the opposing expert appraiser will often opine that the DCF method is valid, but the inputs were wrong. As is often said, “garbage in = garbage out.”
The formula for a DCF analysis is complicated. DCF models are typically prepared by financial experts. To understand DCF valuation, one should have a working knowledge of the following terms:
- Future Cash Flows: Projections of the amount of cash produced by a business’s operations, after paying operating expenses and capital expenditures.
- NPV or net present value: The value of all of the future cash flows discounted to today’s dollars by applying the discount rate.
- Expected annual growth: The rate the business is expected to grow.
- Discount Rate: The cost of capital (debt and equity) for the business. This rate, which acts like an interest rate on future cash flows, is used to convert them into current dollar equivalents. This is sometimes called the Weighted Average Cost of Capital or “WACC”.
- Terminal or Residual Value: The value of a business at the end of the projected period. A typical DCF analysis uses a 5-year projection period or, occasionally, a 10-year projection period.
(This is for informational purposes and is not legal advice.)