One of the most interesting concepts that we introduce to business owners at our M&A seminars is the discounted cash flow method of business valuations. Quite a few attendees are aware of the most common method of how to value their businesses – a multiple of the most recent fiscal year earnings – because lots of industries have a “rule of thumb” that uses this method.
For example, if you look at the Business Reference Guide published by the Business Brokerage Press you will see page after page of industry valuation “rules of thumb.” For example, if you look up “Auto Tire Stores,” you will see a standard rule of thumb indicating that these operations go for 1.5 to 2.75 times recast earnings plus inventory (for a definition of recasting, please follow this link). Lawn maintenance businesses go for 1.5 to 2 times recast earnings plus inventory. Publishers of newsletters typically have a rule of thumb of 1 to 2 times revenue. And so forth.
Your industry probably has some variation of this as well. These rules of thumb by and large are fairly accurate in terms of historically giving a value range for a business in a specific industry. However, it is only one valuation method, and it does not account for two things:
And it is this last issue that the discounted cash flow (DCF) method addresses. Of all the concepts we introduce at our seminars, the DCF is probably the most challenging for business owners, especially those without degrees in finance, to understand. So as we do in our seminars, we are going to present a simplified explanation of this method of valuation. Here is the official definition of DCF:
"In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)—the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question."
For those of you that love the mathematics, here is the DCF formula for your pleasure:
"The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.
Thus the discounted present value (for one cash flow in one future period) is expressed as:
DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt;
FV is the nominal value of a cash flow amount in a future period;
r is the interest rate or discount rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;
n is the time in years before the future cash flow occurs."
For those of us that are not mathematicians, what does all this mean in laymen’s terms? Essentially this: The DCF model is used by professional buyers to determine what they will pay today for the future earnings of your company. The model works this way: Your historical income statement is recast to reflect the true earnings of the company. Once this process is completed, a “base year” is forecast. This is usually the current fiscal year that you are in.
Once the base year number is established, you will then need to create what accountants call a pro forma financial statement. This is a fancy term for the building of five years of income statements, which ultimately show your recast earnings from year one of the pro forma through year five.
With me so far? This is where it gets complicated. At this point you are ready to discount the future earnings back to today’s dollars. The critical issue is the rate you will be using to discount your earnings. The discount rate is critical because the lower the discount rate, the higher your business valuation will be. Conversely, the higher the discount rate, the lower it will be. So determining what discount rate to use is vital, and the discount rate is determined by the perceived risk associated with the investment.
This is an inexact science. A risk-free investment, say a government bond, would command a very low discount rate to value. An investment in a publically held company, although riskier, is not as risky as an investment in a privately held company. In addition, your particular company may have risk factors associated with it that could impact your discount rate. Other factors that could also impact it are your historic growth rate vs. your forecasted rate. For example, if your company has been growing at a 5% rate and you are forecasting five years of growth at 25%, it is almost guaranteed that a buyer will apply a higher discount rate.
This is why, as we have stated before, it is really vital that you have professional M&A advice before approaching buyers. Certainly the DCF valuation model is not the only valuation method that buyers will use to value your business. Savvy buyers will apply several methods to accurately value your company so that they can earn the ROI (return on investment) that they need. However, they will ultimately use the method that gives them the greatest return, which means your valuation may be lower. Again, if you have a professional M&A advisor working with you, the value of your company will be determined before you go to market using the DCF and other financial models. This allows you to have an idea of the value range you should expect buyers to be in.
Of course I have over simplified the DCF process. The reality is that the method can be very complicated, as all valuation methods can become. A tremendous number of variables need to be accounted for that I cannot cover in 1,000 words or less. If you are interested in seeing the DCF model in action, as well as getting an overview of other methods used, attend a Generational Equity M&A seminar in your area. The information we provide is helpful as you begin your exit planning. To find out more, please visit our website.
Carl Doerksen is the Director of Corporate Development at Generational Equity.
© 2015 Generational Equity, LLC. All Rights Reserved.
it all started with a conference.
start your story today,
speak directly with one of our senior advisors +1-972-232-1121
The information we learn from customers helps us personalize and continually improve your experience. Here are the types of information we gather.
We receive and store any information you enter on our Web site or give us in any other way. We do not sell or rent your personal information to others without your consent. We use the information we collect only for the purposes sending promotional information, enhancing the operation of our site, serving advertisements, for statistical purposes and to administer our systems. We DO NOT use third parties to provide customer service, to serve site content, to serve the advertisements you see on our site, to conduct surveys, to help administer promotional emails, or to administer drawings or contests, but reserve the right to do so in the future without advance notice.
By submitting my name electronically and clicking the “submit” button, I understand that I am providing Generational Group, Inc., Generational Equity, LLC, Generational Capital Markets, LLC, DealForce LLC, their affiliates, representatives, contractors, etc. (“Generational Group”) my telephone number, which may include a number that is wireless and/or a number that is on a national, state, or other Do Not Call registry or list. I hereby consent and agree to receive telephone calls including any autodialed and/or pre-recorded telemarketing calls and/or text messages (telemarketing) from or on behalf of Generational Group at the telephone number provided. I further consent and agree that telephone calls may be made using automated technology such as an automatic telephone dialing system, artificial or prerecorded voice, or SMS text messaging. Consent is not a condition of purchase. I further warrant and represent that any telephone number provided is not on any state or national Do Not Call Registry and that by agreeing to these terms and conditions that if any number provided is on any such registry, I hereby consent and agree to receive telemarking calls and/or communications including any phone calls, text messages, URLs, links, emails, etc. to the telephone number(s) and/or any e-mail addresses provided. I understand that by entering my name in the electronic form provided, that I am signing my name as equally as if it was my handwritten signature and that it is my intent to provide an “electronic signature” as that term is defined in state and federal law, as well as industry practices for e-commerce.
For reasons such as improving personalization of our service, we might receive information about you from other sources and add it to our account information.
Generational Group may license the use of its intellectual property including but not limited to its name, likeness, and logo for the use of affiliated offices. Such affiliated offices may not be owned, controlled, managed, supervised or staffed by employees, officers, or agents of Generational Group. Affiliated offices may be independently owned and operated. For more information about a particular office, please contact Generational Group at its office in Dallas, Texas.
This page may contain other proprietary notices and copyright information, the terms of which must be observed and followed.
Information on this web site may contain technical inaccuracies or typographical errors. Information may be changed or updated without notice. Generational Group may also make improvements and/or changes in the products and/or the programs described in this information at any time without notice.
Generational Group does not want to receive confidential or proprietary information from you through our web site. Please note that any information or material sent to Generational Group will be deemed NOT to be confidential. By sending Generational Group any information or material, you grant Generational Group an unrestricted, irrevocable license to use, reproduce, display, perform, modify, transmit and distribute those materials or information, and you also agree that Generational Group is free to use any ideas, concepts, know-how or techniques that you send us for any purpose.
Our computer system protects personal information using advanced firewall technology.
Information Generational Group publishes on the World Wide Web may contain references or cross references to other products, programs and services that are not announced or available in your country. Such references do not imply that Generational Group intends to announce such products, programs or services in your country. Consult a Generational Group representative for information regarding the products, programs and services which may be available to you.
Generational Group makes no representations whatsoever about any other web site which you may access through this one. When you access a non-Generational Group web site, please understand that it is independent from Generational Group, and that Generational Group has no control over the content on that web site. In addition, a link to a non-Generational Group web site does not mean that Generational Group endorses or accepts any responsibility for the content, or the use, of such web site. It is up to you to take precautions to ensure that whatever you select for your use is free of such items as viruses, worms, Trojan horses and other items of a destructive nature.
IN NO EVENT WILL Generational Group BE LIABLE TO ANY PARTY OR ANY DIRECT, INDIRECT, SPECIAL OR OTHER CONSEQUENTIAL DAMAGES FOR ANY USE OF THIS WEBSITE, OR ON ANY OTHER HYPERLINKED WEBSITE, INCLUDING, WITHOUT LIMITATION, ANY LOST PROFITS, BUSINESS INTERRUPTION, LOSS OF PROGRAMS OR OTHER DATA ON YOUR INFORMATION HANDLING SYSTEM OR OTHERWISE, EVEN IF WE ARE EXPRESSLY ADVISED OF THE POSSIBILITY OF SUCH DAMAGES.
Furthermore, all information contained within this website is the property of Generational Group.
Success, you have been added to our list.