adpapa Editor
24 July 2020
Have you ever wanted to understand how to value a business using the discounted cash flow method? Well, if you have, well this article will definitely help.
If you are looking at your property, for example you could go bottom up and try and value it based on the cost of bricks and mortar. That’s called an assets approach when applied to a company.
You could look at similar houses in the street try and work out if yours is worth something similar. That is what we call a multiples based approach using company jargon. What we’re going to do is look at a company a bit like a property from our point of view of how much money you’ll generate in the future.
Some people value properties by saying let’s just look at the rental income we can squeeze out of this thing in the future. They bring that together and come up with a number. In company valuations speak, this is called discounted cash flow method. That’s the formula we’re going to focus on here.
For a moment, let’s imagine that we have a company with a five year life. They all say that’s artificial! Well, the whole of the discounted cash flow method involves making some quite big assumptions. At the end, I’ll explain which ones you need to do more work on in practice. So how do you go about it you would say right I reckon I can forecast the cash flows for this company over the next five years.
I’ve managed to do that, so I’ve managed to forecast sales costs to get to some kind of profit. Then I turn that into cash flow and I’m comfortable that I can say over the next five years, there’s the forecast cash flows are $100,000,000, which is obviously a very simple example.
You might say well that’s easy to crack it. You write out on the board the company’s going to generate a hundred million in five years. Not so fast alright because straight away you’ve got a problem which is if you’ve got your forecasts wrong.
A hundred million in five years time worth as much as it is received in one year’s time? The answer is no, because inflation erodes the value of money over time. So you can’t just add up these hundred millions and say well the company is worth $500,000,000.
That’s the value of the income generates because use do something called discounted, hence the expression DCF or discounted cash flow. So I’ll make another assumption. You might be saying how can you make all these assumptions? Well in practice this is exactly what people need to do to apply this technique. I’m going to say that interest rates over the next five years will be 10%.
Now if you take an interest rate of 10%, what you’re going to be doing is saying well based on that 100 million received in a year’s time it’s worth a little bit more than under a million received in two years time which is worth a little bit more than hundred million receive in three years time and so on.
The reason for that is that basically if you’ve got $100,000,000 in a year’s time you could be investing it if you want to see it this way to earn interest to 10%, so it’s worth more to you than 100 million received in four or five years time because that can’t be invested.
To earn anything money has a time value. The sooner you get it, the more it’s worth. Basically what you need to do is reduce these future hundred millions back to the equivalent of today’s money. This is called discounting, and for those techies out there who want to know the little formula that you use to do this and then I’ll sort of cut in and give you the numbers.
You apply a little formula that says basically you divide it by 1 plus R to the N as in the math video however R is the interest rate and the number of periods so I’m going to divide the first year’s cashflow assuming it’s received in 12 months time by 1 divided by 1.1 then the second one divided by 1.1 squared 1.1 cubed and so on.
If you do that, you find you need to reduce rounding slightly the first year’s cash flow a little bit because 100 million in a year’s time isn’t worth quite as much as if someone gave you a $100,000,000. Now, if interest rates 10% because you shut it now you can invest it another 10%, then you need to reduce the second year’s cash flow.
I’ve rounded slightly by 0.83. What you’re effectively saying is that 100 million received one year from now isn’t worth as much a hundred million, it’s actually only worth roughly $90,000,000.
Applying this kind of principles equally means in five years that 10% is roughly 378 million not 500 million, which is what you get. So, the higher interest rates are, then the lower the value of those cash flows and the lower the value of the business overall.
If I was using this technique to value a company that could generate a hundred million five years consecutively it interest rates 10 percent I get to 378 million and then I’ll be saying something like well there’s the value of the company if it’s issued say a hundred million shares each one is worth about $3.78 now.
Some of you will be out there screaming into the ether that I’ve made lots of assumptions here – there are things missing!
Saying you know what could possibly go wrong or what haven’t I considered where are the ambiguities of the discounted cash flow method, if you like. First of all, do companies stop after five years? Not usually, they keep going. How would I deal with that in practice?
What I need to do is plug in what they call a terminal value and then discount that back and add it on the end. A terminal value would be being saying general after five years there’s no point in forecasting individual cash flows it’s bad enough forecasting for five years.
I’m not going to carry on forecasting something might happen in 15 years time so I’m just going to say I reckon the company will generate a certain lump of money for the route for its remaining life. I’ll discount that back in one go it’s called a terminal value. That’s all I’m going to say about it.
I didn’t say the discounted cash flow method was easy or pinpoint accurate. The 10% reflects a number of things ;the riskier you think this business is, the higher that number will be. The higher the value of other opportunities – if you could put your money into a bank account that paid a decent interest rate you’d want even more for investing in a risky company.
That in turn, pushes the rate up potentially as well. How easy is it going to be to get these cash flows out of the company? All these things affect that 10% and there are various models which I won’t go into today one of them is called a capital asset pricing model.
So there you have it. What you have exactly is a technique that looks quite scientific, actually done in full and gives you a number as good as anyone, however valuing companies isn’t easy there’s no foolproof scientific method.
Valuing a business using the discounted cash flow method requires you to make quite a few assumptions and it requires you to do forecasting or require you to come up with right interest rate or requires you to have adding up correctly.
However, the discounted cash flow method is nonetheless recognised as one of the sort of front running techniques used to value small businesses, larger companies or even individual shares.
