When you're considering having a company valuation done, there are many options available. One option to consider is the discounted cash flow business valuation, which is based on a company's income and growth. In a nutshell, it calculates the net present value that future cash flow will bring in a business.
What is a Discounted Cash Flow Business Valuation?
A discounted cash flow business valuation looks at the expected future income, or cash flow, of a company for a reasonable time period. If a company is expected to have a particular percentage of growth and a set percentage of a weighted average cost of capital for a set period of time, the expected cash flow over that time period can be calculated to show the valuation of a company based on those numbers.
How it Differs from Other Types of Valuation
There are three approaches commonly used in business appraisals, involving looking at assets, seeing what the market will bear and basing the appraisal on income. A discounted cash flow appraisal is based on an income assessment, but takes it a step farther by not only including current income but projections about future income and the effect growth has on that figure. This business valuation method estimates value based on the company's future projections.
How it's Carried Out
There are several steps in this type of company appraisal, so let's look at each one a step at a time.
- Decide how far out to forecast your valuation. The next five years of revenue and profit projects are ideal.
- Estimate the rate of revenue growth, the working capital needs and estimated capital expenses for each year. Though it's easy to base this figure off of past performance, doing so can create a figure based on false information. This involves thinking about what the company's sector will look like in a few years, how well equipment will hold up, whether supply prices remain the same or increase.
- Next, you'll need to calculate free cash flow based on the previous figures, which can be compared against current income statements, and future operating costs based on the company's prior performance.
- Finally, you'll need to calculate the discount rate. There are many different approaches to this, and it's best left in the hands of an expert to determine which one will best reflect future business performance.
Though a discounted cash flow valuation can seem complicated, it provides real benefits for your business in terms of projecting the value your business has now based on assumptions into the future. If you're considering selling your business or merging it with another, having this type of valuation performed will help you negotiate from a position of knowledge. Work your way through the process and discover where your business expectations and future are really headed.