A common way to arrive at a substantiated business valuation is the Discounted Cash Flow method (DCF method). In this article we will show you, using a numerical example, how to arrive at such a business valuation based on the DCF method.
Content:
1. What is the Discounted Cash Flow method?
2. DCF method in 4 steps
Benefits of Discounted Cash Flow 3.
1. What is the Discounted Cash Flow method?
During a business acquisition, it is important for both a buyer and a seller to know what the business in question is worth. To arrive at a substantiated business valuation, both parties often apply the DCF method. The Discounted Cash Flow method, often abbreviated to DCF, is a method for valuing businesses and is the second most commonly used method after the EBITDA multiple method. They are often used side by side to arrive at a more accurate estimate of the value of the business.
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The main premise of the DCF method is that the past only plays a limited role and the main focus is on the future earning capacity of a business. Therefore, a calculation is made of the cash flows to be expected in the future and these are discounted to the present at a certain rate (discount).
To determine that discount factor, we look at the specific characteristics of the business in question, also called value drivers. You can think of:
- The extent to which the business depends on its owner.
- The predictability of revenue.
- Presence of a strong management team
- Distribution of revenue across customers
- Innovativeness of the business
- Market entry barriers
A risk profile is created based on the above value drivers. The higher the risk for the buyer, the higher his return requirement will be. And a higher return requirement in turn translates into a higher discount and thus a lower business valuation.
2. DCF method in 4 steps
To arrive at a business valuation based on the DCF method, the following four steps are followed:
Even though the DCF method looks to the future, the analysis begins with a look at the past. To predict the future, it is necessary to determine where the business's strengths lie. Consider the following questions:
- What is the future earning power based on?
- Does the business have a distinctive product?
- Does it have exclusive deals with large customers or suppliers?
- Does it produce cheaper than the competition?
- Is the business more innovative than its industry peers?
Every company has its own mix of distinctive and value drivers. To present the most realistic picture of the company's past, the financial statements are normalized. That is, corrected for incidental or non-market items. Think of a DGA with a management fee higher than a usual executive salary. Or incidental consulting costs related to the business transfer.
These are examples of cost items that unfairly depress the bottom line and thus give an inaccurate picture of earning power. Balance sheet items will also be looked at in this way. Are there hidden reserves that depress equity? Are there debt relationships with shareholders that need to be repaid? Correcting all such items will produce normalized financial statements, which will serve as the basis for further calculations.
Step #2: Forecast future cash flows.
Now that the past has been mapped out, we can determine the future cash flows. Of course, this is not a matter of simply extrapolating the historical data. A business is always evolving and therefore future cash flows will look different than in the past.
The basis for determining the future cash flow is the business plan. Market expectations and strategic choices made all affect cash flows. Think about investments in new or machinery to be replaced, entering a new market or divesting a business activity.
You incorporate all consequences of the business strategy and market developments into a cash flow statement for the next three to five years. For each year, incoming cash flows are offset against outgoing cash flows, leaving out financing costs and dividend payments. In this way, it becomes clear how many "free cash flows" remain to repay loans, pay interest and reward shareholders for their efforts. In doing so, it is common to create three scenarios: a worst case, a best case and normal case.
Step #3: Determining the discount rate
Once the future cash flows are set up, then you calculate the net present value of these based on the WACC; the Weighted Average Cost of Capital. This is a discount rate based on a weighted average of both the return requirement on equity and the cost of debt.
You weight both assets in proportion to their share in total assets. You express the WACC as a percentage. The higher the WACC, the higher the return requirement and the cost of debt capital, the lower the value of the company.
The one component of the WACC, the cost of debt capital, is easy to determine. In the case of a bank loan, it is the interest rate charged by the bank. However, the required return on equity is less straightforward to determine because it is based on the risk profile of the business. After all, the higher the risk, the higher the required return.
Return on equity
When determining the return requirement, the return on government bonds is often taken as a starting point. This return is assumed to always be achievable with an investment. Let's set this at 3%. Investing in listed equities is a lot riskier and therefore requires a higher return. Historical figures show that in the long run a return of 8% is realistic. The risk premium of equities over bonds is therefore 5%.
Investing in an individual business - because that's what a buyer ends up doing - is much riskier than investing in publicly traded shares. The mere fact that the shares of a limited liability company are not freely tradable leads to higher risk. An additional risk premium of 7% for investing in a BV compared to listed shares is quite defensible. This brings the minimum required return on equity to 15%.
But then we are not there yet. Every business and every industry has its own risks. At the company level, for example, it is the dependence on the owner, the quality of the management, the innovativeness or the spread of activities. At the industry level, it is, for example, entry barriers, upcoming laws and regulations or the opportunities and threats of the Internet.
All these factors can justify a risk premium or discount and thus a higher or lower return requirement, respectively. Percentages between 15 and 25 are common. Private equity parties often even charge a return requirement on equity of 30%.
Example of a WACC (discount rate)
From the determination of the company's risk profile comes a return requirement on equity of 20%. The equity to debt ratio is 65/35 and the business has taken out a bank loan at 5.5%. The corporate tax rate is 25%.
The determination of the WACC then looks like this: (20% x 65%) + (5.5% x (1-0.25) x 35%) = 14.4
Step #4: Determine the enterprise value
Now that the future free cash flows and the discount rate have been determined, we can release these figures to the Discounted Cash Flow formula. It looks like this:
Free cash flow year 1 + free cash flow year 2 + ... + free cash flow year n / (1 + WACC)1 + (1 + WACC)2 + ..... + (1 + WACC)n
Suppose the WACC is 14.4% and we have a forecast period of four years, in which we have determined the free cash flows as follows: 200,000, 75,000, 300,000 and 225,000. We call the period after the projected years (four in this case) the residual period. The cash flow in this residual period is assumed to be constant and we set it at 150,000 in this example. A valuation then proceeds as follows:
200,000 + 75,000 + 300,000 + 225,000 + 150,000 euros / 1,144 1,144 2 1,144 3 1,1444 1,1444x0,144 = 1,172,000 euros
As mentioned, in practice, three scenarios are often set up. The DCF calculation can be applied to each of these scenarios. In principle, the worst case scenario will yield the lowest business valuation, because here the free cash flows are the lowest. However, the probability of achieving this scenario is a lot higher than the best case scenario. Hence, the bad case scenario has a lower risk profile and therefore a lower return requirement on equity. This in turn has an upward effect on the value.
3. Advantages of Discounted Cash Flow
The DCF method not only gives insight into the value, but also shows how the value of the company is affected. This can be done by turning two knobs: ensure that the earning capacity increases and thus the future cash flows, or ensure that you lower the risk profile and thus the discount rate. In addition, the DCF method offers several distinct advantages:
- It assumes the future situation and only that is relevant for a buyer
- The method is based on cash flows and not on (manipulable) profit figures.
- For buyers, a DCF calculation is valuable because banks attach great importance to future cash flows when granting loans
The main advantage is that based on a DCF report, a meaningful discussion about the value of a business can be held. Buyer and seller can talk to each other: why are sales estimated at one million euros next year, while they were seven tons last year? Are there contracts behind this? Why are costs falling by 10% in the coming years? If the value is determined based on a rule of thumb, such as "five times the net profit," such a substantive discussion is not possible. Then it quickly becomes horse-trading.
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