Another way of looking at the valuation of an investment is the discounted cashflow model (DCF) which calculates a Net Present Value (NPV) based on the following formula.
Each cash inflow/outflow (value) is discounted back to its present value (PV).
Then they are summed. Therefore NPV is the sum of all terms , where i – the time of the cashflow rate – the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.)
Looking at the equation above, one can see that the DCF model has two elements:
Thus any business can be valued by taking its future earnings stream and discounting those back to arrive at what the business is worth today. However, this method does present some challenges:
How do we select an appropriate discount rate and how long should you forecast the cashflow?
How do we accurately forecast Free Cashflows for a number of years into the future?
It is important to realise that these factors do not operate independently but are intrinsically linked to each other. The discount rate should represent the risks associated with generating the expected earnings of the firm. Thus, the consistency of the future cash flow streams will affect the discount rate which is applied to the valuation.
The discount rate is a reflection of the risk in the deal. Thus a higher risk would reflect either greater uncertainty about the external environment or a higher fear about the ability of the business to sustain its current performance into the future.
You can try this formula within Microsoft Excel. Just use the NPV formula with some simple numbers until you understand how it works and then you can try modeling your future profits using different discount rates.
Where there is no clear method which is being implemented to determine valuation and where the parties are ignorant of the underlying logic, the seller is at the mercy of advisors and brokers who may not know any better. This also leaves the smart buyer in a position to seek out bargains.
Let us take a moment to look at some basic calculations which will demonstrate the use of DCF and the impact of increasing the discount rate.
Typically an investment in the public stock market should anticipate a return of 12 – 15%, so let us use 15% as a discount rate for a very reliable business. A 25% rate would be a rate for a riskier business and 50% rate could be used for a high risk business.
For arguments’ sake, let us assume that a business was generating a positive cash surplus each year of $1 million. We can use a set of increasing discount rates to reflect increased uncertainty about the future earnings of the business.
The scenario set out in the table below would never occur realistically as discount rates of 25% or 50% would never be applied to consistent, low risk cashflows.
However, this scenario can be used to illustrate the severe effect a higher discount rate has on a firm’s valuation.
The most appropriate method of valuation for a high growth potential venture is the DCF method as it best reflects the future pattern of increasing revenue and profits and allows the user to apply a risk factor to the projections.
Now that we have seen how this works, we can use this knowledge to focus our attention on those parts of the business which will have the greatest influence on its valuation.
The two major factors in the formula which we can work on are: Risk (the discount rate); and Profitability (the projected values).
The initial point of attention should be on the risk profile of the business. We can increase the value of the business by reducing the discount rate. Since the discount rate reflects uncertainties surrounding the future cash surpluses of the business, obviously the more certain future cash surpluses are, the lower the risk associated with the business and the higher the current valuation. The first task of the business owner is to provide much more certainty around future earnings.
A business which is generating Earnings Before Interest and Tax (EBIT) of $1,000,000 could be worth anything from $2 million to $6 million, depending on the level of perceived risk of future profits. In my mind, it would be worth a great deal of money to the seller to improve the certainties around the future profit.
The discount multiple is often a judgment call on the part of the buyer. The buyer will argue that a lower multiple should apply because of factors which either limit the future income generating power of the business or increase the volatility of the future earnings.
Factors which reflect higher risk are:
Factors which represent lower buyer risk and result in higher multiples are:
However, these are also only indicators of how the business is expected to perform. If profits are expected to decline this is reflected in a lower NPV for two reasons:
If, on the other hand, profits are expected to increase, this would increase the NPV of the firm.
Smart Company is the leading online publication in Australia for free news, information and resources catering to Australia’s entrepreneurs, small and medium business owners and business managers.
