Learn about the discounted cash flow valuation method from the industry experts at Investment Business Brokers.
Discounted Cash Flow Valuation
What is the Discounted Cash Flow Valuation?
The discounted cash flow (DCF) is a business valuation method used to estimate the value of an investment based on its expected future cash flows. The DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.
Since the discounted cash flow valuation is based on the estimated future performance of a company. It remains highly sensitive to the assumptions that are made.
Steps to Build the Discounted Cash Flow Analysis
The discounted cash flow valuation is a detailed technical analysis about a company’s expected future performance based on specific drivers such as revenue growth and current market conditions. The process to accurately build the financial models for the valuation takes deep knowledge of corporate finance concepts. There are linear steps to build the models that are displayed below.
- Gathering 3 years of historic financial statements for a company.
- Normalizing the financials to accurately reflect discretionary earnings or EBITDA.
- Determining assumptions for revenue growth, cost of goods sold, operating expenses, interest, tax, depreciation and capital expenditures for a 5 year pro forma period.
- Projecting out the three financial statements (income statement, balance sheet, and statement of cash flows) based on the assumptions from step 3.
- Establishing a terminal value.
- Discounting the future cash flow and terminal value to net present value.
- Sum the present value of future cash flow and terminal value.
- Make adjustments for debt/equity.
Sample provided by Investment Business Brokers
Discounted Cash Flow Review
The DCF valuation can be advantageous or disadvantageous depending on the situation it is used for. A financial analyst with more confidence in the assumptions being made is better for the DCF. On the flip side, this can create a major pitfall is if the assumptions are incorrect.
Benefits of the Discounted Cash Flow Valuation
Extremely Detailed: The DCF requires specific data inputs that have to be carefully evaluated to accurately price companies. There are many variables that contribute to the entire valuation process.
Includes Future Expectations of the Business: A valuation based on future performance is positive for a seller whose business is experiencing growth because it will give them a higher valuation. The DCF is good for M&A transactions as the buyers can predict what the future for both companies will look like after the deal.
Ability to Evaluate Scenarios: Due to the variety of assumptions included in a DCF, analysts are able to show different scenarios about possible future outcomes for the business. Sometimes a sensitivity analysis can be performed to better understand risks.
Disadvantages of the Discounted Cash Flow Valuation
Prone to Errors: Due to the complexity of the analysis, these valuations can miscalculate the true value of a business.
Highly Sensitive to Assumptions: Slight variations in assumptions can cause sizeable changes in the concluded valuation.
Doesn’t Account for Competitors: The DCF is an independent analysis where relative comparable companies are not considered. This means the method leaves out important information about what other companies are selling for, which buyers will consider.
Business Valuation: Investment Business Brokers Can Help
It is always in your best interest to consult an industry professional such as a valuation analyst, business broker or M&A advisor to ensure you know how to value your business accurately. If you need a business broker in Texas, Investment Business Brokers can help.
IIf you have any other questions about how a DCF works or want to know what the discounted cash flow of your business is, contact us and we are happy to share our knowledge with you.
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