Having worked hard at building your business you are naturally interested in its value when the time comes to sell. Particularly if it's been wellmanaged with a good trading history and a loyal, profitable customer base. So how do you value your business?
A number of business valuation methods are in common usage. Here are just a few.
 Assetbased, or "book value" assessment. This method draws information from the balance sheet, so it's highly factual, looking at the here and now. But if yours is an ongoing business, assets on the balance sheet can be expected to generate profits for the foreseeable future and beyond. Therefore used on its own this method is likely to be detrimental to your interests as it ignores future cash flows. Indeed the book value method is often associated with a business that has failed, in a "fire sale" breakup valuation.
 Stock market. Great, if your business happens to be listed in a competitive, openlytraded stock market where a share price reflects demand and supply at a moment in time. It's unlikely to apply to you.
 Multiplies. There are a number of subjective "rules of thumb" based on multiples of, for example, profit, Earnings Before Interest and Tax (EBIT), Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA), even sales revenue. However, these can be seen as wild guesses and are difficult to defend objectively in front of a serious buyer.
So how do you calculate your business objectively, in a way that can be defended?
Related: Online Business Valuation Tool
Discounted Cash Flow (DCF)
The DCFmethod is as accurate as it gets, looking at your business as an ongoing moneymaking machine. Current and future profits are what really interests a potential buyer. The less risky, the better. Looked at in this way balance sheet assets, for example, fixed assets, current assets, and money in the bank, are simply a means to this profitable end.
Having established that true business value is inextricably linked to future profits, we now take a look at the key elements of the DCFmethod. We develop this explanation using the example of a mature, wellmanaged business, with a solid client base, forecast to earn $100,000 in profit every year for the next 5 years.
Download the Valuation Model (XLSX)
Forecast Period
It's typical for business owners to make planning forecasts 35 years ahead. When you come to sell however there's an additional dimension to forecasting. That's the income accruing beyond this time horizon. There's more on this below, but for now, let’s stick to a 5 year forecast period.
Adjusted Profit Explained
We need to be careful before taking the $100,000 profit figure directly from the income statement. Seller’s Discretionary Earnings (SDE) is a cash outflow of discretionary expenditure that is not part of normal business operations. For example, small business owners tend to pay themselves a salary above, or below the market rate. Equally, it could be other optional perks or fringe benefits, for example, company cars. For business valuation purposes it makes sense to adjust the profit to reflect the SDE (if any).
Now let’s feed the numbers into DCF. Below is the first version of our Business Valuation model.
Table 1. Version 1 of the Valuation Model
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 

Profit 
$100,000 
$100,000 
$100,000 
$100,000 
$100,000 
Total Profit 
$500,000 
Five years of profit at $100,000 suggests a business value of $500,000. Agreed?
But wait a minute. Is the buying power of money today the same as in 5 years time?
Intuitively (and correctly) the answer is, No. Because of the socalled "time value of money".
Inflation reduces the value of a dollar over time. There's another more subtle reason based on the concept of "opportunity cost". In other words, a buyer could have taken their money and earned guaranteed interest income, for example from government bonds. Or invested in shares of solid bluechip companies on the stock markets. Less risk, as compared with acquiring your business.
So it's clear for these reasons that $100,000 earned in 5 years is not worth the same amount today. But how is the adjustment made over the forecast period?
Say Hello to "Discounting"
Discounting is a technique that calculates the "present value" of forecast money received in the future.
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In our example, each yearly profit number is adjusted using a standard formula to bring it back to today's money. There's no need for you to be a math genius here. Just know the formula for calculating the present value of an amount received in the future as:
Present Value = Amount / (1+Discount Rate)^Period Number
So, for example, the present value of $100,000 earned in Year 5 is:
Present Value = $100,000 / (1+15%)^5 = $49,718
(Where ^ is "to the power of", or the number of times the bracketed figure is multiplied by itself, which, you will note, has the effect of dividing $100,000 by a larger figure as each year passes, so progressively reducing its value)
But wait. Why the 15% discount rate?
The Discount Rate
The discount rate chosen reflects an assessment of relative business and financial risk. An appropriate discount rate is typically derived from two factors: 1) the socalled "riskfree" rate of return (as, in theory, enjoyed with government securities), and 2) a selected risk premium for investing in a commercial business entity.
In our example, we analyze a business in terms of this Cost of (Owners) Equity.
What is Cost of Equity?
Cost of Equity is the expected return a buyer requires when putting money into a business. For mature businesses, this rate should be somewhere between 12% to 20%. The riskier the business, and the more uncertain the future, the higher the rate used.
For calibration, a startup company's Cost of Equity could exceed 100%, whilst a utility company enjoying a near monopoly in a local market may have a Cost of Equity as low as 5%.
For our example business, Cost of Equity is taken as 15%.
Let's now take another look at how this affects the valuation table:
Table 2. Version 2 of the Business Valuation Model
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 

Profit 
$100,000 
$100,000 
$100,000 
$100,000 
$100,000 
Present Value of Profit* 
$86,957 
$75,614 
$65,752 
$57,175 
$49,718 
Total Present Value of Profit 
$335,216 

*Discounted at 15% discount rate 
The Total Present Value of Profit in Table 2 above is now much closer to an accurate business valuation.
Can we stop here?
Probably not. Returning to the question of how to account for income beyond Year 5, we introduce the concept of Terminal Value.
Terminal Value
Sometimes referred to as Residual Value, Terminal Value represents the stream of cash generated beyond our 5year forecast horizon. It's an assumption that steady cash flow will continue 5 more years (in theory, perpetuity shall be considered, but in reality, nobody will accept that ;). The estimate takes the Year 5 cash flow and calculates the present value of 5years ordinary annuity:
$100,000 * ((1(1/(1+15%)^5))/15%) = $335,216
Then, the math to calculate today's present value of the Terminal Value:
$335,216 / (1+ 15%)^5 = $166,661
Now add the "Terminal Value" to our valuation model:
Table 3. Version 3 of the Valuation Model
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 

Profit 
$100,000 
$100,000 
$100,000 
$100,000 
$100,000 

Present Value of Profit 
$86,957 
$75,614 
$65,752 
$57,175 
$49,718 

+ 
Total Present Value of Profit 
$335,216 

Terminal Value 
$335,216 

+ 
Present Value of Terminal Value 
$166,661 

Business Value 
$501,877 
So far, so good. A step closer to a realistic Business Valuation. Good enough?
Maybe.
 Yes, if the business has no depreciated assets, no balance sheet debt, no intention to borrow, and no need for future working capital adjustment
 Otherwise, No. We need to make a few future profit adjustments to arrive at "Free Cash Flow to Equity" (FCFE). That is, cash flows at the owner(s) disposal.
Let’s get started with some adjustments.
First Adjustment: Depreciation
Whilst business valuation doesn't directly take assets into consideration, any asset depreciation deducted in the income statement needs to be added back. That's because depreciation is an artificial, notional expense that doesn't see any actual outflow of cash from the business. It sets aside money, protecting it from corporate income tax.
Let’s assume depreciation at $20,000 per year for the forecast period:
Table 4. Version 4 of the Valuation's Financial Model
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 

Profit 
$100,000 
$100,000 
$100,000 
$100,000 
$100,000 
Depreciation 
$20,000 
$20,000 
$20,000 
$20,000 
$20,000 
Free Cash Flow to Equity (FCFE) 
$120,000 
$120,000 
$120,000 
$120,000 
$120,000 
Present Value of FCFE 
$104,348 
$90,737 
$78,902 
$68,610 
$59,661 
Total Present Value of FCFE 
$402,259 

Terminal Value 
$402,259 

Present Value of Terminal Value 
$199,994 

Business Value 
$602,253 
Notice that Free Cash Flow to Equity (FCFE) sees the depreciation row added to the profit row, which is then discounted in the normal way. The terminal value is now also taken as perpetuity of FCFE (i.e., instead of profit).
Second Adjustment: Changes in Working Capital
A company may adjust its working capital requirement. When perhaps it needs to increase inventory to meet rising demand or improve liquidity through more cashinhand. Anticipated changes in working capital become cash flows, "in" or "out", depending on the direction of change in working capital.
In our example let’s assume that the company needs to increase its inventory level to $50,000 in Year 2. Increasing inventory makes the change in working capital figure negative as money flows out of the business.
Here's the new version of our valuation sheet.
Table 5. Version 5 of the Business Valuation Model
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 

Profit 
$100,000 
$100,000 
$100,000 
$100,000 
$100,000 

Depreciation 
$20,000 
$20,000 
$20,000 
$20,000 
$20,000 

Changes in Working Capital 
$0 
$50,000 
$0 
$0 
$0 

Free Cash Flow to Equity (FCFE) 
$120,000 
$70,000 
$120,000 
$120,000 
$120,000 

Present Value of FCFE 
$104,348 
$52,930 
$78,902 
$68,610 
$59,661 

+ 
Total Present Value of FCFE 
$364,451 

Terminal Value 
$402,259 

+ 
Present Value of Terminal Value 
$199,994 

Business Value 
$564,445 
Third Adjustment: Borrowing
Borrowing means taking out loans and paying them back. This cash flow is completely under the control of business owners. Logically, loan repayments decrease the amount of Free Cash Flow to Equity, and vice versa. In our example, let’s assume that the business pays back a $150,000 debt balance during Years 1 to 3 at $50,000 each year.
Here is the final version of our valuation calculation.
Table 6. Final Version of the Business Valuation Model
Year 1 
Year 2 
Year 3 
Year 4 
Year 5 

Profit 
$100,000 
$100,000 
$100,000 
$100,000 
$100,000 

Depreciation 
$20,000 
$20,000 
$20,000 
$20,000 
$20,000 

Changes in Working Capital 
$0 
$50,000 
$0 
$0 
$0 

Loans paid back 
$0 
$50,000 
$50,000 
$50,000 
$0 

New loans taken 
$0 
$0 
$0 
$0 
$0 

Free Cash Flow to Equity (FCFE) 
$120,000 
$20,000 
$70,000 
$70,000 
$120,000 

Present Value of FCFE 
$104,348 
$15,123 
$46,026 
$40,023 
$59,661 

+ 
Total Present Value of FCFE 
$265,181 

Terminal Value 
$402,259 

+ 
Present Value of Terminal Value 
$199,994 

Business Value 
$465,175 
There you have it!
An accurate, scientificallybased, yet very practical business valuation. Taking forecast profits, adjusted appropriately to find Free Cash Flow to Equity. So you can arrive at an Asking Price that you can justify.
It doesn't involve complicated math. If you are still not sure about how the numbers were generated, go back to your calculator and recheck the example.
Video: How to value a company using Discounted Cash Flow (DCFmethod)  by MoneyWeek Investment Tutorials
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As Discounted Cash Flow uses the major drivers of business value it's an equally useful tool for a buyer to check that your Asking Price is fair. The model is robust, so any discussions during negotiation are likely to be about the input assumptions made.
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