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How to Value a Company Using Discounted Cash Flow
Business valuation is typically based on three major methods: the income approach, the asset approach and the market (comparable sales) approach. Among the income approaches is the discounted cash flow methodology calculating the net present value ('NPV') of future cash flows for an enterprise. As an alternative to the more abbreviated income capitalization approach, this methodology is more relevant where future operating conditions and cash flows are variable or not projected to be materially consistent with current performance levels.

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How to Value a Business

There are many ways that investors employ to value a business; multiples and financial ratios are among the most common approaches. However, to know the absolute value of a business one needs to consider an analysis of discounted cash flow of a business. DCF puts into account that the present value of money will change over time; the value of money will increase based on the earning potential of a business.

Finance professionals are using DCF analysis to determine how attractive a business opportunity is. Put simply, discounted cash flow is a business valuation approach that considers future free cash flow of a business and then discounts it to determine the present value, which is then used to estimate the absolute value of a business. One of the approaches that investors are using is to determine the value of the business' stocks. If the DCF analysis shows that the value of a business is higher than the current investment cost, then the business opportunity is considered lucrative.

What is DCF?

Discounted Cash Flow analysis values a company or a project today based on the amount of money that the company or project is projected to make in future; the idea behind this is that the business is inherently contingent on its potential to generate income for investors.

DCF analysis has a number of variations based on a number of assumptions. Investors estimate the amount of future cash flow, company's growth rate and the cost of capital. If any of these assumptions deviate from the expected course, the valuation results are affected big time. To this end, analysts are placing different price target estimates when determining the fair business value.

Forecast Period: How Far into the Future Should a Business' Cash Flow Be Projected?

When intending to buy or invest in a business, making an educated guess on the market and competitive position of a business comes in handy. This goes with the assumption that with time, the business matures into a slower growth rate.

When a business is slow growing in a low margin industry where competition is high, the forecast period should be no more than a year. When valuing a solid company that has set strong marketing channels, has regulatory advantage and brand recognition, the period should be 5 years. If a business has shown remarkable growth in the past, has a dominant market position and operated with high barriers to entry, valuation period should be 10 years.

Revenue Growth Rate

After deciding the forecast period, the next step is estimating a business' free cash flow within the forecast period. Here, revenue growth should be forecasted. Here, the investor needs to think of how the business, and the entire industry, will perform over the forecast period. Factors such as market contraction or expansion, market share numbers, emergence of new products and price changes should be considered.

A horde of guesswork is involved when forecasting revenue growth, and as such, it is important to consider different scenarios; one where the growth of a business is consistent over the forecast period and one where the growth rate reduces with time.

Estimating Free Cash Flows

Business Accounts.

In simple terms, free cash flow denotes a measure of a company's performance financially. This shows how much revenue a company has left after operation costs, net investment, taxes and working capital are deducted. This is the money that could be used to venture into new business opportunities, paying dividends, improving shareholder value, developing new products and paying debts.

To forecast free cash flows, there is need to estimate:

  • Future operation costs
  • Taxation
  • Net investment
  • Change in working capital

Future Operation Costs

Every business will incur operation costs including cost of goods sold, administrative expenses, salaries, research and development among others. Most companies will show the cost of operation on their income statements. If this does not appear, it can be calculated by subtracting the net operating profit of a company from the total revenue. Note that the net operating profit is the earning of the business before taxation and interest.

Forecasting future operating costs involves looking at the company's past operating margins; this is a figure always shown as a percentage. Operating margins are calculated by dividing the operating income by revenue or net sales.

Taxation

Most companies do not pay official corporate tax rate on operating profits. To this end, calculating the tax rate involves dividing past average annual income tax by pre-tax profits. The company's historical income statements will show this information.

Net Investment

To keep a business growing, investments in capital items such as equipment, plants and property is pertinent. Net investment is calculated by subtracting non-cash depreciation, as seen on income statement, from capital expenditure, found on statement of cash flows. Past net investment figures are used to project future net investment figures.

Change in Working Capital

Working capital refers to the amount of money a company uses to run day to day operations. As a company expands, so does the working capital needed to run it daily. The figure can be calculated by subtracting current liabilities from current assets. These details can be found on the company's balance sheet published on the company's quarterly and annual financial statements. If there is more cash tied up in a company's working capital this year than in previous years, the working capital is considered as a cost against the free cash flow.

After calculating all the figures and adding them, they can now be subtracted from the sales revenue of a company to get the free cash flow. This is used to determine how a business is doing financially and how it will perform in the years to come.

Calculating the Discount Rate

After calculating the free cash flow of a business and projecting it over the forecast period into the future, it is time to estimate the worth of these cash flows today. This can be done by calculating the discount rate, which will in turn be used to calculate the net present value of a company's cash flows. There are multiple ways of calculating discount rates; one of the most common approaches is to calculate the Weighted Average Cost of Capital (WACC) – this is a measure of cost of debt after tax and cost of equity.

Companies have two main sources of finance, debt and equity. Put simply, WACC denotes the cost incurred by the company in raising that amount. WACC is determined by multiplying cost of debt and equity with their respective weights and then adding the products together. The weight of equity or debt refers to the proportion of the company financed by either. To this end, calculating WACC requires that one first determines the proportion of the company financed by debt and what proportion is financed by equity.

Calculating a Company's Equity Fair Value

After calculating the discount rate, the fair value of a business can be calculated by entering the figures calculated above into an online calculator that gives the final value of the company to be sold, bought or invested in.

However, one can still calculate the value of a business step by step without a calculator. To get the final discounted cash flow value, the terminal value of a business needs to be determined. If, for instance, the forecast period is five years, the cash flows of a business need to be estimated after that period failure to which the business will be assumed to have ceased operations.

Terminal Value

Gordon Growth Model is one of the popular approaches used in calculating Terminal Value. Here, terminal value is calculated by dividing the product of final company's year cash flow and 1 plus long term growth rate of cash flow by the difference between discount rate and long term cash flow growth rate.

Terminal value equals final company year cash flow by (1 plus long term growth rate of cash flow discount rate-long-term growth rate of cash flow)

Enterprise Value

To calculate the enterprise value, the present value of cash flows, for the years from now till the end of the forecast period, are divided by the discount rate and then added. The fair value of a business will be its enterprise value minus the business's debt. This completes the discounted cash flow valuation. When looking to invest in a company, an investor can divide the end results in the DCF valuation with the outstanding number of shares.

Is DCF Analysis a Good Way of Valuing a Business?

Discounted Cash Flows is a popular approach of business valuation used by investors. It is a lengthy and involving process and some investors rely on analysts and online calculators. However, even when using a calculator, an investor will still be needed to calculate the discounted rate and the weighted average cost of capital among others.

DCF as an approach of calculating the value of a company has strengths and weaknesses.

Strengths

  • DCF gives a close estimate of a company's intrinsic fair value and is considered a sound valuation approach especially when the analyst is confident on their assumptions.
  • The use of free cash flows by DCF analysts eliminates subjective policies in accounting.
  • Short-term conditions prevailing in the market and non-economic factors do not impact DCF analysis and thus the analysis stays true through the forecast period.
  • When the confidence regarding future cash flows is high, DCF comes in handy and acts as the best approach.

Weaknesses

  • There are assumptions made in DCF analysis; if there happens to be even a slight change, DCF valuation is affected greatly and the fair value of business will not be correct.
  • Compared to other valuation techniques, DCF takes more time.
  • When a company is not operating with 100 percent transparency, forecasting the future value can be very difficult.

Discounted cash flow estimates the value of a company today based on its future cash flows. It assumes that the value of a business is equal to the total cash flows accrued over a period of time. The analysis can be a handy tool to an investor when used right. Investors, however, need to consider many factors that may affect a business including profit margins and future sales growth. There are different techniques that one can employ to calculate DCF but all, when done correctly, will give the same value.

Factors Affecting Discounted Cash Flows and the Value of a Business

There is a negligible difference between two figures representing the value of a business gotten from different valuation techniques. The value of a business can be calculated by simply looking at the balance sheet, which is a financial statement highlighting the assets and liabilities of a company. There are a number of factors that would affect the final fair value of a business as expounded below.

Inventory Valuation

Depending on the technique a business uses to value and account for inventory, its value can be affected positively or negatively. The value of a business can be decreased on financial statements by use of the first-in, first-out recording method. This is so because, a business' most recent and the most costly purchases happen to be the first to be moved out of the warehouse and into the sales floor.

The reduction on the inventory value consequently lowers the profit expectations and the business in turn pays less tax. When looking to invest on such as a business, these inventory records will be confusing and will not give the accurate discounted cash flows. Large business benefit when they use this method to gain tax advantage but even smaller businesses are using the same as a tax reduction stunt.

Sales Revenue and Liquidity

Sales revenue supplies the business with the cash it needs to fund all the running costs of a business. The working capital in a business is crucial for the day-to-day expenditures and payment of short-term loans maturing in less than 12 months. Factors that affect the sales revenue of a business, be they internal or external, affect the cash in bank and the cash on hand and consequently the value of a business on financial statements. One of the factors that affect sales revenue is seasonality, which causes sales revenue to rise greatly then fall drastically. Seasonal sales revenues affect the overall operation of a business including cash flow.

Cash Management Practices

Irrespective of fluctuations in sales, a good company's cash management system ensures there is money whenever needed to finance the working capital of a business. Assets on financial statements, therefore, are in most cases determined by the business' ability to manage cash. Cash management policies that affect the value of a business on financial statements include account receivables collections and cash reserves establishment.

Cash reserves up the value of cash a business hold in the bank; this ups the company's liquidity and ensures the company is able to pay its bill even when the cash at hand goes down or when the sales revenue declines. The final valuation of a business also increases.

When the accounts receivable collections are done correctly, they decrease the time taken to collect any money owed to the business. When it appears on financial statements, it occurs as a decrease in the value of accounts receivable with an increase on cash on hand.

Internal Controls

Internal controls refer to a list of measures that have been taken to curb internal theft and fraud within the business. These controls have the potential to affect the value of cash and that of inventory on financial statements. Ineffective internal controls increase the risk of theft and fraudulent dealings within the business thereby decreasing the value of assets on financial statements.

Controls include limiting access to financial data, separation of duties, and using pre-numbered receipts. There are also inventory controls including both scheduled and random inventory counts. The efficiency of the management team also affects the value of a business.

External Factors

There are a number of external factors that affect the value of a business including;

  • The overall state of economy factoring in interest rate levels, demand and production cost among others.
  • How businesses in the same industry are being valued
  • The demand to buy the business in question
  • Prevailing competition in the market and the market position that a business holds
  • Technological disruption

The potential of a business to compete with others in the same industry including its market position, marketing strategies and brand recognition greatly affects its financial performance currently and in future. So does, the model of operation and integration of technology into the operation process. When the operation of a business is interfered with, be it in the technological aspect of the business or how records are kept, the final fair value of the business is affected.

Conclusion

There are many ways through which the value of a business can be calculated. One of the simplest ways is to multiply the number of shares a business has with the value of each share. This method makes the assumption that the value of each share is accurate. However, one of the popular and most used methods is discounted cash flows. When used correctly, the technique gives accurate figures. However, caution should be taken to ensure that the values on a company's financial records are correct.

There are online calculators that help calculate DCF requiring the user to enter the business expected annual growth, weighted average cost of capital, and the forecast period.