What Is Discounted Cash Flow (Market Approach) Valuation?
We specialise in shareholder litigation and commercial disputes. This type of litigation frequently encounters complex concepts regarding (amongst other areas), valuation, and unsurprisingly valuation is another key area where the parties will often encounter difficulties.
There are many reasons why investors, shareholders, and owners might seek to determine the value of a private company and these can go beyond litigation and disputes we deal with.
For investors, understanding a company’s current value and future prospects is essential to determining if it’s a worthwhile investment.
Shareholders may find themselves in dispute with directors or other stakeholders over how the company is being run or other matters.
For owners and directors, having an accurate picture of the company’s valuation helps them make informed strategic decisions and can help attract outside investment, if desired.
Numerous valuation approaches exist. Many are best suited to a specific type of company or industry sector.
One approach commonly used by experts is a Discounted Cash Flow (DCF) valuation.
Like any form of financial analysis, DCF has its strengths and weaknesses.
However, it’s a versatile method and particularly effective at valuing businesses with consistent earnings and cash flow.
What Is Discounted Cash Flow (DCF) Valuation?
A Discounted Cash Flow or DCF valuation is often used to assess whether an investment is worthwhile based on forecasted future earnings.
A DCF valuation for investment purposes is often called the ‘market approach’ because an expert will make a market-based assessment of future growth.
Projected earnings and cashflows are discounted by an expert-determined rate to estimate their market value. Forecasting potential future earnings and cash flow provides an alternative to the so-called traditional method of valuation, which accounts for current, comparable values — not anticipated future growth.
Discounted Cash Flow differs from Net Present Value (NPV), although the two are connected.
NPV adds another step to the DCF method by deducting the front-end cost of an investment from the valuation.
When Is Discounted Cash Flow Valuation Used?
A market-based DCF analysis predicts the future earnings performance of an investment made today and considers projected growth when determining a company’s current value.
For investors, a DCF forecasts the future value of an investment based on current earnings and cashflows and growth projections.
An accurate DCF valuation helps investors seeking to buy a company or purchase shares perform due diligence and make an informed decision about whether or not to invest.
DCF valuations also help business owners and directors understand the projected value of their company to aid in strategic decision-making and attracting outside funding.
In a recent review of real estate investment valuation protocols, The Royal Institute of Chartered Surveyors (RICS) recommended DCF as the primary valuation approach for commercial property assets.
Discounted Cash Flow valuations are flexible yet based on real-world financial data as well as projections of growth.
Many investments are made in companies valued using a DCF approach. However, valuers and investors should agree Discounted Cash Flow is the most appropriate valuation method for the specific business and market.
Even if DCF is not the primary approach, it’s often relevant as a supporting method to offer additional analysis and data. In particular, DCF provides opportunities to identify inaccurate data in an alternative form of modelling.
Because a DCF can act as a check on other valuations, scenarios where a DCF is inappropriate are rare, at least as a supplementary analysis.
How Does Discounted Cash Flow Valuation Work?
At its foundation, Discounted Cash Flow valuation is a straightforward concept. DCF valuations work on the basis that £100 today is worth more than £100 in twelve months because it can be profitably invested.
DCF valuations are based on the principle that future earnings and cash flow projections must be discounted to current-day value to be accurate.
The method first appeared in the 1930s, expounded by the economist John Burr Williams in his book, The Theory of Investment Value.
Williams proposes that a company’s intrinsic value is equal to the present value of its future dividends and not its current earnings.
American economist Myron Gordon further developed Williams’ model in the 1960s with his own theory – the Gordon Growth Model – which, in simple terms, assumes that dividends grow as companies continue to grow.
That gives you some history behind the foundations of Discounted Cash Flow.
But how does DCF actually work?
The formula for a DCF valuation has three essential components.
- Discount rate (R)
- Cash flows (CF)
- Number of periods (N)
The discount rate — known as ‘R’ — aligns future costs to present value. This is typically based on how much the company must make to remain in operation or the business’s cost of capital.
Companies typically use the weighted average cost of capital or WACC for the discount rate. WACC takes account of the returns expected by shareholders and avoids the risk of a flawed analysis.
If the discount rate is inaccurate, it can severely impact the validity of the valuation.
Estimating the cost of capital requires adding up equity and debt funding costs, weighted based on the company’s capital structure. The combined cost is the weighted average cost of capital (WACC).
Cash flow (CF) is based on revenues or dividends. It includes income generated from selling products or services or cash raised by selling an asset.
The number of periods (N) represents the total length of time (typically in quarters or years) cash flows are expected to continue. Ten years is often a ‘go-to’ number as this is the average lifespan of a company.
Many expert valuers assess many of the factors involved in Discounted Cash Flow almost intuitively, but using accurate data where available is required for due diligence.
The essential difference between a more traditional valuation approach and DCF is that expert predictions are made and used to forecast the future.
What Are the Pros and Cons of Discounted Cash Flow Valuation?
The main advantage of a Discounted Cash Flow valuation for investors is that it offers a reasonably reliable indicator of the likely return on their money — particularly for companies with reliable cash flows and earnings.
DCF is a versatile analysis model applicable to various capital projects and investments. It’s flexible enough to cover different scenarios and performance.
For company owners with a small company that they’re hoping to grow, DCF valuations can aid strategic planning, attract outside funding and promote steady bottom-line growth.
If a company has a track record of consistent performance, business valuers have more confidence in predicting growing cash flows or earnings.
Discounted Cash Flow can also be used to sense-check other forms of analysis. There’s rarely a valuation scenario where DCF isn’t relevant on some level — even if it’s not the primary valuation method.
The main drawback of DCF is that it forecasts future cash flows and earnings — it’s never a guarantee.
DCF doesn’t rely on real-world data alone and requires a degree of subjectivity. Consequently, the resulting valuation can only ever be an estimate.
Determining a reasonably accurate discount rate requires a valuation expert. Even then, it remains a forecast, not a guarantee.
Many unforeseeable internal and external factors can impact future cash flows. Some examples include:
- Strength of the economy
- Misconduct or departure of a key stakeholder or employee
- Unforeseeable opportunities or threats to the company — such as COVID-19
For complex projects or companies with irregular cash flow or earnings, DCF is typically not the best choice for analysis. Without historical data, estimates used in the valuation may not be sufficiently accurate and could prove misleading.
Estimates of future cash flows or earnings that are too high can lead to a poor return on investment — or an outright loss.
Earnings forecasts that are too low have the opposite effect, skewing the picture to show an investment that’s too expensive and a possible missed opportunity.
DCF is valuable in many scenarios, but caution should be exercised in relying on it exclusively when making a decision to invest.
How Do You Calculate DCF?
Discounted cash flow valuations use a mathematical formula that forecasts cash flow and earnings over a fixed period. A discount rate — often based on comparable investment opportunities — is applied to account for the time value of money. In essence, this produces the DCF.
If the DCF is higher than the cost of the proposed investment, prospects are favourable and profitable returns should result.
What Is the International Valuation Standards Council?
The International Valuation Standards Council (IVSC) is a not-for-profit organisation that establishes and promotes global valuation standards in the public interest.
Most valuations are conducted by experts, usually appropriately qualified accountants with relevant experience. These professionals use a variety of tools, including IVSC guidelines.
Discounted Cash Flow is a valuation methodology that accounts for potential future growth. It can be an excellent tool to evaluate a potential sale or investment in a private company — especially one with regular earnings and cash flow. In a shareholder dispute we can use DCF and/or other valuation models and tools, working with an expert to position our client in the most favourable way as either buyer or seller.
For company owners and directors, an accurate DCF valuation can aid in strategic business planning and attracting outside funding.
Valuations are frequently required when shareholders or other stakeholders in a private company find themselves in a dispute over how the business is operated or other matters.
If you are a shareholder in a dispute, contact the expert Commercial Litigation Team at Helix Law. We work with investors and shareholders nationally and internationally in litigation and disputes involving this type of issue.
We aim to respond to all queries within an hour and can offer specialised advice and guidance on favourably resolving your dispute.
Helix Law has decades of experience working with highly regarded accountants and valuation experts if a DCF or other valuation approach is required.