Business Valuations Based on Discounted Cash Flow
Business valuations based on discounted cash flow use the projections of your next few years of cash flow to determine how much money your business or potential investment will be worth. It allows you to see how much cash flow the business would see over the next few years, helping you to decide if your business is worth selling or if this investment is right for you. You can also use business valuations based on discounted cash flows to make budgeting decisions, allowing you to see how these decisions could impact your business.
What are business valuations based on discounted cash flow?
Discounted cash flow is a valuation method that estimates the value of a business based on its expected future cash flows. The method is used by analysts to determine the value of an investment based on how much money the investment can generate in the future.
Discounted cash flow business valuations help investors determine if the business is a good investment opportunity. The valuations also help business owners and managers make decisions about their expenditures or budgets.
Discounted cash flow finds the present value of expected future cash flows using a discount rate.
How to use discounted cash flow for business valuations
Discounted cash flow can be used for business valuations, following three steps. We have outlined the steps for calculating discounted cash flow for business valuations below:
Step 1 – forecast your cash
To start, you need to forecast the expected cash flow from your business. You can do this by taking your current cash flow and projecting it over a period of years. The expected cash flow projections will be based on your current projections and previous cash flow. A financial adviser can help you with this projection if needed.
Step 2 – select a discount rate
Next, you will choose a discount rate, usually based on the cost of financing the investment or the opportunity cost. As the money today will be worth less than the money in the future, we need to apply a discount rate for an accurate view of your cash flow. A business valuer can help you select the right discount value to increase the accuracy of your discounted cash flow.
Step 3 – discount the cash flows
Finally, the forecasted cash flows are discounted back to the present day. You can do this with a manual calculation, financial calculator, or a spreadsheet. Using a business valuer is best here, as they will do all of the calculations for you and show you the value of your business or potential investment based on your discounted cash flow.
Example of discounted cash flow
Say you have a discount rate of 10% and an investment opportunity that would produce $100 a year for the next three years. You will need to calculate the value today (the present value) of this stream of future cash flows. Money in the future is worth less than money today, so you will reduce the present value of each of these cash flows by your 10% discount rate.
The first year’s cash flow would be worth 490.91, the second year worth $82.64, and the third year $75.13. You can add these three years together to see your discounted cash flow of $248.68. When you have the discounted cash flow, you can determine if this is the right investment for you.
What are the benefits of using discounted cash flow for business valuations?
Discounted cash flow business valuations come with several benefits, including adjustable scenarios and the application of a variety of projects. Each benefit is detailed below for you:
It offers an investment evaluation
A business valuation based on discounted cash flow allows investors and companies to evaluate their investments before parting with any cash. They can see if the investment is worthwhile based on the projections without needing to have a deep understanding of the industry.
It is applicable to a variety of projects
You can apply your discounted cash flow business valuation to a variety of projects. Doing so allows you to estimate the cash flow before proceeding with a project or making adjustments to it. Potential investors and business owners can use the discounted cash flow to see the success of any project before starting the project, offering some protection for their assets.
It is adjustable
You can adjust the projections of discounted cash flow business valuations, allowing you to see how the business value could be changed based on different scenarios. Should you want to play ‘what if’ to see how your company might be impacted by market changes, a discounted cash flow valuation is a good way to do this.
Not only does this help potential investors see how your business might react to different scenarios, but it also allows owners to see how their current business model would react to different changes, allowing them to use the valuation for projection purposes and adjustments.
What are the drawbacks of using discounted cash flow for business valuations?
There are a few drawbacks to using discounted cash flow as a business valuation, which are worth considering. Discounted cash flow does not consider economic changes and relies on estimates, which can be problematic. We have outlined the drawbacks below:
It should not be used in isolation
While discounted cash flow business evaluations can be helpful, they are not best when used in isolation. This is because it does not reflect the true nature of your business, making it difficult for potential investors and buyers to determine if your business is a wide choice for them. Instead of using discounted cash flow as the only business valuation method, we recommend using it in conjunction with two or three other business valuation models for a more accurate understanding of your business’s value.
It involves estimates
Discounted cash flow business valuations involve estimates, which can make it tricky to see the true valuation of your business. While the estimates are helpful, we recommend using valuations that are based on another factor, too, that allows you to ensure the business is the right investment for you.
As discounted cash flow relies on estimates and not actual figures, you need to take care that the numbers you enter are accurate to provide a correct estimate that can be used by investors.
It does not consider unforeseen economic changes
Future cash flows can be impacted by a variety of factors, including market demand, the economy, competition, technology, and unforeseen opportunities or threats. It is difficult to consider and quantify these when calculating discounted cash flow, making business valuations based on discounted cash flow unreliable at times. Ideally, you want a valuation that considers unforeseen economic changes to offer a realistic valuation of your business.
Get in touch with a business valuation expert near you
Business valuations based on discounted cash flow don’t always show you the full picture of a business’s success. However, it is a good way to provide an evaluation for your investment and is easy to adjust to a variety of projects. A business valuation expert can help you use this method, as can others, to see the true value of your business.
We have business valuation experts across Australia, and you can get in touch with them by following the details below:
- Get in touch with our business valuation experts in Brisbane
- Get in touch with our business valuation experts in Sydney
- Get in touch with our business valuation experts in Melbourne
- Get in touch with our business valuation experts in Perth
- Get in touch with our business valuation experts in Adelaide
- Get in touch with our business valuation experts on the Gold Coast
- Get in touch with our business valuation experts on the Sunshine Coast
