Business Valuation Blog | Understanding Buying / Selling a Company

When you're considering having a business appraisal completed, there are different options available. One option to consider is the discounted cash flow analysis, which is based on a company's income and growth by calculating the net present value that future cash flows will bring into a business.

How does a Discounted Cash Flow Analysis work in the Context of my Company’s Appraisal?

A discounted cash flow analysis looks at the expected future income, or cash flow, of a company over a reasonable time period. If your company is expected to have a particular percentage of growth based on a certain percentage of the business’ weighted average cost of capital (WACC) for a set period of time, the expected cash flow over that time period can be calculated. In essence, the estimated value of a company will rely on those forecast numbers to drive the appraisal. WACC is a recognized variable in every business based on the company’s debt and equity structure.

How Discounted Cash Flow Differs from Other Types of Valuation Methods

There are three approaches commonly used in business appraisals, (1) which involves strictly reviewing current assets; (2) a market driven approach; and (3) basing the appraisal on income. A discounted cash flow approach is based on an income assessment, however, taking it a step further, by not only including current income but projections about future income and the effect growth has on that figure. It often produces one of the higher value estimates for business valuations as it looks at what the company will do in the future, typically seen as a best-case scenario.

The Valuation Process Explained

The steps involved in this type of business appraisal include (1) Deciding how far out to forecast your valuation, (2) estimating the rate of revenue growth by calculating profits after taxes, working capital needs and estimated expenses, (3) calculating free cash flow based on previous figures, which can then be compared against current income statements and future operating costs based on the company's prior performance, and (4) calculating the discount rate.

Though it is acceptable to appraise your business off of past performance, doing so may not take into account potential changes to your company and future external economic effects. Some factors that help to better understand these are thinking about what the company's sector and its future development are as a whole, how well your own assets will hold up, and whether supply and demand pricing will remain the same.

There are different approaches to completing this analysis, and it is best left in the hands of an experienced appraiser to determine which one will best reflect future business performance.

In summary, a discounted cash flow valuation can seem overwhelming however, the results can provide benefits for your business in terms of projecting and recording market value today and in the years ahead. Working your way through this process will assist in discovering where your business’ future is headed.

How to determine what a business is worth is a question many business owner have.  Appraisers must calculate the estimated future income of the business. Having an estimation of future earnings can affect everything from company hiring patterns to a business merger or sale. Business valuation firms typically use either capitalization of earnings or discounted cash flow to calculate an income-based company valuation. Learn what each of these methods means and when to use it. 

Understanding Capitalization of Earnings in Business Appraisals 

If a business is lucky enough to have steady income and growth, appraisers can use the more simplified capitalization of earnings method to calculate estimated future incomes. Appraisers typically use this method for established companies that have had stable levels of income and growth over the long term. For example, a hair salon or grocery store that has a stable population and sells a regular amount of product (or services) per month can use capitalization to project the earnings five years down the road.

Where income, growth, or sector variables are not stable, capitalization does not work as well. Since fuel prices vary constantly, this method wouldn't work as well for a gas station in the same stable community. 

Capitalization does not account for variables of time, so there is an element of risk in relying on data gleaned from straight evaluation without taking markets into account. 

Discounted Cash Flow: What is Means and When to Use it in Business Appraisals 

Discounted cash flow (DCF) refers to the net value in the present that a projected future cash flow will bring a business. While this type of business valuation method can be useful for determining how much return on investment a business will yield, it is not useful in all circumstances. 

To effectively calculate the future cash flow of a business, you must have some way of determining how much business will grow over a set period of time and how much capital the business needs to operate for that time period. Given this information, it would not make sense to use discounted cash flow to calculate the future income of a new business. It would make more sense to use this company valuation method to figure out the expected future cash flow of a business that has been around for a while, has set patters of seasonal growth, and has capital expenses an appraiser can easily determine. 

To determine the value of a company using discounted cash flow, an appraiser typically picks a valuation forecast time period (say, five years), and the company estimates revenue growth rate and capital expenses for each year, and thinks abut the company's sector performances in the future. Taking this information together, an appraiser can calculate a baseline figure that reflects the company's value in the future. 

In terms of how to determine what a business is worth, discounted cash flow provides real benefits to company owners who want to sell their business (or are contemplating a merger) and generate an asking point that accounts for a projected future value of the business. 

Ultimately, both of these methods can determine a working value for the company, and both are best utilized by a business valuation firm that understand the needs and challenges of your company and your sector. A business appraiser will examine income-based valuations together with other forecasts to put together a comprehensive business valuation.

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.

1. Decide how far out to forecast your valuation. The next five years of revenue and profit projects are ideal.
2. 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.
3. 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. 
4. 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.