The business valuation tool uses the discounted cash flows (DCF) method to determine the value of a business.
DCF also takes into account the forecasted cash flows, no matter if they are into or out of the business, over the next four years. Discounting these future cash flows back to the present time is the best way of accounting for business and financial risk.
It is important to consider a "terminal" cash flow value (terminal value) to add to the four individual forecasted cash flow years. This assumes the business will continue to generate steady cash flows for the next five years and bundles them together in a single estimate that is calculated as present value of ordinary annuity. The result is then discounted back in the normal way.
The estimated market value of non-operating assets (if any) is added to the calculated present value of future cash flows. That way, both the future and present amounts of earnings are taken into account.
The choice of discount rate is clearly crucial to the calculation of business value. It works in conjunction with the cost of equity and is made up of two factors. There’s the "risk-free" rate of return (as, in theory, "guaranteed" with government securities), plus a risk premium for investing in a commercial entity. The risk premium shall take into account factors such as uncertainty of profit forecast, market and economic risks, competition, and quality of customer portfolio, to name just a few.
The discount rate reflects the relative riskiness of your business compared with others, including the safe "do nothing" option. A buyer will assess your business on the basis of relative risk compared with alternative purchase options.
The business value becomes the sum of the present values of the cash flows in the forecast period, plus the discounted terminal value figure, plus the market value of non-operating assets (if any).
All private sector businesses are inherently risky. It’s a question of estimating the degree of risk for each business and applying the appropriate discount rate. Business buyers and investors will consider, either explicitly or implicitly, the cost of equity when putting money into any business. For a typical mature, established business, the cost of equity used to discount future cash flows is in the 10% to 25% range. The higher the rate chosen, the higher the expected risk, and the lower the value of future cash flows in today’s money.
Another way of presenting business valuation is to graph business value (on the vertical Y-axis) against a range of discount rates (the cost of equity on the horizontal X-axis). See the chart above.
What about Book Value?
The DCF method is based on the assumption that the business being valued is ongoing and that its assets are set in daily operations. However, there may be situations, especially with assetsloaded businesses, that the company's "book value" (i.e., assets minus liabilities, in market terms) results in a higher amount compared to what was calculated with the DCF method. Therefore, it is important to use both methods (DCF and book value) in parallel, and pick the highest resulting amount of the two methods.
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