What is Discounted Cash Flow

In theory, the fair value of an asset is determined by the meeting of a willing, but not anxious, buyer and a willing, but not anxious, the seller. Irrespective of what any theoretical valuation indicates, in practice business or an asset is only worth what a purchaser will pay for it. Different categories of buyers, strategic/corporate buyers versus financial buyers for example, maybe prepared to pay different prices. The value will also be dictated by the level of ownership required:

• Investment <20%
• Minority interest >20%, <50%
• Joint venture 50%
• Control >50%

A valuation is not a scientific exercise and is dependent on the quality of information available. It is a set of arguments supporting a view on value and we therefore usually express it as a range

Purpose of Valuation

The valuation exercises that we undertake are generally from the view of what a business might cost to acquire or what price it might attract upon disposal. It is extremely important therefore to keep in mind the purpose for which the valuation is intended. Valuations can also be important for the purposes of establishing fee levels in engagement letters.

Different purposes include:

• Purchase or sale of a private company
• Recommended bid for a public company
• Hostile bid for a public company
• Break-up valuation
• Leveraged buy-out
• Contribution to joint venture or merger
• Fairness opinion
• Asset transfers with a group (tax or restructuring)
• Providing of credit facilities

There are primarily three methods of valuations.

• Comparable companies analysis (compcos): shows where a company should be trading if it were fairly valued by the market
• Comparable transactions analysis (comptrans):  shows us the amount that a purchaser should be prepared to pay by reference to precedent transactions
• Discounted cash flow analysis (DCF): shows us the expected value of the business by reference to future cash flows

Other industry-specific techniques (eg takeover premium, leveraged buy-out models, break-ups, sum-of-the-parts (SOTP) valuations, liquidation values, and real options techniques) are also applied.

The suitability of each technique is dependent on the purpose of the valuation and the information available. This note discusses the Discounted Cash Flow (DCF) technique for valuing a business.

Next Steps

Now that we have understood the purpose of valuations, we move forward and introduce you to the most famous (or infamous) Discounted Cash Flow approach.  Till then, Happy Learning!

What is a discounted cash flow analysis?

Discounted cash flow analysis (DCF) shows us the expected value of the business by reference to future cash flows. Discounted cash flow analysis involves estimating the present value of the future cash flows that the business being valued is expected to generate. DCF analysis requires high quality historic and projected financial information on the business. The quality of the financial information is crucial to Discounted Cash Flow valuation – “garbage in… garbage out”.

The particular information required will depend on the nature of the company being valued but at the most basic level, detailed assumptions over the projected period are required for:

• Turnover
• Operating margins
• Interest charges
• Taxation charges
• Depreciation charges
• Capital expenditure
• Working capital movements

There is a danger of over-generalizing in preparing cash flow forecasts – i.e. assuming a constant growth rate after the first couple of years. It is important to question the forecasts and consider all cyclical, industry-specific and other general or macroeconomic influences. Rather than discounting cash flows indefinitely into the future, a terminal value, based on the company’s long-term growth rate (perpetual growth rate methodology) or a multiple of the final year’s earnings or cash flow (exit multiple methodology), is usually assumed after a period of, say, five to ten years.

The terminal value can represent a very high proportion of the overall valuation of the business (particularly in a company pursuing long-term growth and investing heavily during the forecast period).

 A Discounted Cash Flow valuation is only as accurate as of the assumptions/key sensitivities underlying it and the easiest way to establish a margin of error is to vary the principal assumptions.

In theory, the choice of discount rate or assessment of the internal rate of return will depend critically on the cost of debt and the market risk premium in the country of the target, the share price volatility of the target and the level of debt of an optimal target structure. However, a purchaser would have to consider other issues, such as its funding costs and the value of the business to it.

Steps for Applying Discounted Cash Flow (DCF) Method