The Discounted Cash Flow Model

Discounted Cash Flow valuation is the core tool in valuing a company used by Investment Bankers and Equity Analysts. The cost approach to valuation fails to capture many of the intangible assets for small business whereby reputation, managerial expertise, and other items do not show up on the balance sheet.  The use of price multiples is not applicable in most cases because of the large variations of types of businesses, limited data, and the uniqueness of the business at hand.  

The income approach is the dominant approach in business valuation.  The discounted cash flow method captures the driving principle of a valuation: value is the present worth of future benefits.  Value today equals cash flow discounted at the cost of capital. Discounted cash flow is the most commonly used method of valuation in corporate finance today.  It arrives at an estimate of what one would pay today for a series of future economic streams.

The cost of capital is also known as the discount rate.  It is the expected rate of return for similar investments.  Discounting is, in effect, the exact opposite of compounding.  To find the discount rate, take an expected payment at a point in time and compound the value backwards at the expected rate of return.  The present values of each increment (year) add up to provide the current valuation.

Capitalization Concept

A capitalization concept is used in the final year.  In capitalizing, the expected future income is converted into a value.  Instead of projecting returns into perpetuity, choose a final year (called a Terminal Year) and capitalize that year’s cash flows by a factor (the discount rate less the expected long-term growth rate).  Then, compute the net present value of that income stream and add it to the other years to obtain the current valuation.

The theory behind this capitalization policy is that most businesses are expected to have an indefinite life.  But it’s not realistic to forecast into perpetuity.  Therefore, specific forecasts are made for a reasonable period of time, normally six years, and the last year becomes the cash flow which is capitalized.  This value is called the “terminal value” and is often the largest portion of the valuation.  A steady growth rate is normally achieved within five years, and five to six years is a common approach before we capitalize and compute the terminal value.

In the basic approach to valuation known as the discounted cash flow model, the first step is to estimate free cash flows.  Free cash flows consist of net operating profit, and then the noncash expenses of depreciation and amortization are added back.  Discretionary expenses, such as profit sharing costs, are also added back.  Next, the valuator discounts these cash flows to reflect the amount that a buyer is willing to pay in current dollars for the future cash flows.

The Build-Up Model

The valuation involves what is known as the “Build-Up Model” to determine the discount rate, the rate at which the return is projected.  The discount rate is a market rate.  It is the rate of return required to induce an investor or buyer to commit funds to the investment, given its risk level.  This method incorporates the following components:

  • Risk Free Rate

  • Equity Size Premium

  • Size Premium

  • Specific Company Risk Premium

The discount rate arrived at as a result of these computations is the rate at which the Net Present Value of the cash flows is discounted to current year values.  A final step is the capitalization rate.  This is the discount rate, less the long-term expected growth rate.  This percentage is used to convert anticipated economic benefits of a single period (Year 6 or terminal value), into a single value.  The Net Present Value of all 5 years’ Free Cash Flow and the Terminal Value are the valuation of the company.  

An investor will require a return that is at least the same as the return that could be earned on other investments of similar risk levels.  This amount becomes the cost of capital, otherwise known as the discount rate.

The average cost of financing is referred to as the weighted average cost of capital.  This is the discount rate for valuing the business cash flows since the present value of the cash flows at this rate is the price that provides a required return.

The discount rate arrived at as a result of these computations is the rate at which the Net Present Value of the cash flows is discounted to current year values.

Because of the extraordinary complexity in estimating the cost of capital for small, privately-held businesses, venture capital companies often use a discount rate in the 30% - 40% range, or greater, for the cost of equity capital for the start-ups in which they invest.