How does the Discounted Cash Flow (DCF) method for business valuation work?
At the to take over or to sell It is important for a company to have the right valuation To determine. The Discounted Cash Flow (DCF) method is a popular and widely used technique for estimating a company's value. In this article, we explain what the DCF method is, when it's used, and the key aspects involved. We'll also provide a step-by-step explanation with an example to clarify how the DCF method works.
What is the DCF method?
1. Estimate future cash flows
The Discounted Cash Flow (DCF) method determines a company's value by calculating expected future cash flows. These expected cash flows are discounted to their present value, providing an accurate picture of the company's current value.
2. Time value and risk
The DCF method adjusts expected cash flows for the time value of money and the risk of future returns. This means that future payments are worth less than current payments, depending on the risk and the timeframe.
3. Value based on future payouts
The DCF method posits that a company's value is equal to the total future cash flows it can distribute to its shareholders, discounted to the present. This makes the method powerful for assessing a company's true value.
4. Alternative to other methods
The DCF method is often used as an alternative to the Adjusted Present Value (APV) method. It provides an in-depth analysis of a company's financial situation and is particularly useful for companies with reliable cash flow forecasts.
Why use the Discounted Cash Flow method?
Using the Discounted Cash Flow (DCF) method offers significant advantages in determining a company's value. This method is valuable because it establishes intrinsic value by projecting future cash flows and discounting them back to their present value, providing a more realistic picture of financial health.
Realistic financial picture
: The DCF method takes into account both the time value of money and the risk of future income, resulting in a detailed and more realistic financial overview.
Flexibility for different scenarios
: The ability to calculate different scenarios and assumptions makes the DCF method suitable for a wide range of companies, from start-ups to established companies, and offers scope for modelling specific circumstances.
Dependence on assumptions
: While the DCF method is powerful, it's important to realize that the outcome depends heavily on the assumptions made. Unrealistic forecasts can significantly distort the value, requiring careful consideration when choosing assumptions.
Essential Technique for Deep Appreciation
: The DCF method remains an indispensable technique for obtaining a sound and in-depth business valuation, especially for companies with reliable cash flow forecasts, as it provides a detailed insight into the company's long-term finances.
Step-by-step plan for the Discounted Cash Flow method?
The DCF calculation consists of the following steps:
1. Projection of future cash flows
Estimate the future cash flows the company will generate, typically over a five- to ten-year period. These cash flows include all income and expenses, such as operating income, expenses, capital expenditures, and changes in working capital.
2. Determination of the return requirement
Select an appropriate required return to bring future cash flows to their present value. This required return reflects the investor's desired return, taking into account the risk of the future cash flows. The Weighted Average Cost of Capital (WACC) is often used, which indicates the average cost of capital (both equity and debt) for the company.
3. Calculation of the present (cash) value
Bring the future cash flows to the present by discounting them using the chosen required rate of return. This yields the present value of the cash flows.
4. Terminal value
At the end of the projection period, the terminal value is calculated, which reflects the value of the cash flows after the projection period. This value is also regressed on the present and added to the current value of the projected cash flows.
5. Sum of the values
The total value of the enterprise is the sum of the present value of the projected cash flows and the present value of the terminal value.
Example of the Discounted Cash Flow method
Let's put the Discounted Cash Flow method into practice with an example. We'll walk through the steps using specific figures.
Step 1: Expected cash flows
Suppose a company expects to generate the following free cash flows over the next five years:
- Year 1: €100,000
- Year 2: €120,000
- Year 3: €140,000
- Year 4: €160,000
- Year 5: €180,000
Step 2: Return requirement and terminal value
We use a required rate of return (discount rate or WACC) of 15% per year. At the end of year 5, we estimate the terminal value of the company. We assume that future cash flows after year 5 grow at a constant growth rate of 2%.
Step 3: Calculation of the present value of the cash flows
The formula for calculating the present value (PV) of a cash flow is: PV = FCF / (1+r)n, where:
- PV = present value of the cash flow
- FCF = free cash flow in that year
- r = yield requirement (15%)
- n = the year in which the cash flow takes place
The present (cash) value of the annual cash flows is:
- Year 1: €100,000 / (1 + 0.15) = €86,957
- Year 2: €120,000 / (1 + 0.15)² = €90,737
- Year 3: €140,000 / (1 + 0.15)³ = €92,052
- Year 4: €160,000 / (1 + 0.15)⁴ = €91,481
- Year 5: €180,000 / (1 + 0.15)⁵ = €89,492
Step 4: Calculation of the terminal value
- FCFyear 5 where the cash flow in year 5
- g = constant growth rate after year 5 (2%)
- r = required yield (15%)
Step 5: Total value of the company
Conclusion
Tips for Effectively Using the Discounted Cash Flow Method
The Discounted Cash Flow (DCF) method is a powerful tool for business valuation, but its use requires care and thorough preparation. Here are some important tips:
Be careful with the assumptions
: The DCF method relies heavily on assumptions about future cash flows and the discount rate. Ensure these assumptions are realistic and well-substantiated, as unrealistic forecasts can distort the final valuation.
Use reliable cash flow forecasts
: For accurate valuation, it's essential to use reliable and well-substantiated cash flow forecasts. Companies with stable cash flows are better suited to the DCF method, as fluctuating cash flows can complicate valuation.
Take risks into account
: Adjust the discount rate based on the company's risk. A higher risk assessment requires a higher discount rate to ensure future cash flows are accurately valued in line with market conditions and uncertainties.
Be careful with the terminal value
: The terminal value can represent a significant portion of the final value. Ensure that the assumed growth rate for the terminal value is realistic and conservative to avoid overestimating the valuation.
Hire an experienced Registered Valuator
: A Registered Valuator has the right knowledge and expertise to provide a reliable and independent valuation of your company. This is crucial for obtaining a fair and professional valuation.
Why choose Match Plan?
At Match Plan, we employ five of the approximately 300 certified Registered Valuators (RV) in the Netherlands, who are among the top professionals in their field. With over 30 years of experience in business valuation, we understand the complexities of the factors that influence a company's value. Our experts support you with:
- Choosing the right valuation method for your business.
- Collecting the necessary data and documents for an accurate valuation.
- Conducting a thorough financial and strategic analysis.
- Drawing up a clear and detailed valuation report.
Contact us and discover how we can help you with a reliable and objective valuation of your company.
Do you want to know?
what your company
is worth?
Simply leave your details for a no-obligation introductory meeting with one of our Registered Valuators.
Take the test!
Related blogs
No obligation Advice
Over 30 years of experience
Please feel free to contact us
advisors for an introduction.
✔ Business sale
✔ Company takeover
✔ Acquisition financing
✔ Independent assessment