An Introduction to the Discounted Cash Flow Analysis

The Discounted Cash Flow (DCF) business valuation model is a powerful valuation tool grounded in a simple concept: the value of any given business is equal to the sum of all future cash flows of that business, discounted to reflect their value today. The basic equation looks like this:

For example, let’s say you’re looking to purchase a Florida-based manufacturer of niche industrial products. For the sake of simplicity, we’ll assume the factory will be productive for only two more years and will have no terminal value. (The builders chose a rather shortsighted location on the precipice of a sinkhole.) Cash flow for year one is projected to be $1,000 and it will grow by 3% to $1,030 the following year. The proper discount rate is determined to be 6%. The formula for the appropriate DCF model would look like this:

This raises the question of where the formula’s inputs came from. Here’s where the DCF business valuation technique breaks down. A discounted cash flow valuation is only as good as the assumptions that create the valuation’s inputs. In the above example, we made assumptions about discount rate, cash flows, lifespan, and growth rate. If any of these prove off-target, the end result can be misleading. As the saying goes: garbage in, garbage out.

Below we look at how to make better assumptions for valuing private companies. We’ll also look at the limitations that come with DCF valuations.

Cash Flow Estimation

You’ll find it hard to know where you’re going if you don’t know where you’re coming from. Unfortunately, the history of a private company is almost always more obscure than that of a publicly traded company. There are a few reasons for this. Often:

• Private firms are younger than their public counterparts. There is less of a track record you can use to build your pro formas.
• Private firms don’t face the same accounting and information sharing requirements from regulatory agencies and exchanges as public firms.
• Private firms’ financials might not account for the true cost of running the business. For example, an entrepreneur that founded a private business might work for a below-market wage prior to the sale of the company.

These points all underscore the added care one must take with a private company DCF valuation. With young companies, an investor must realize his cash flow predictions will rely more heavily on assumption and less on history. When examining the financials, he will have to be careful to make sure the accounting is acceptable for the purposes of the analysis.

And the idiosyncrasies of a small private company must be included in the estimations. What if the founder will leave after the sale? Does her current salary reflect the true cost of replacing her?

Discount Rate Estimation

The discount rate is the rate of return the investor requires from this investment. If he perceives the investment relatively risky, he will require a higher discount rate.

When valuing public companies it’s assumed the investor is properly diversified. This eliminates some of the risk of the investment. With a private company no such assumption can be made. For example, the investor might be a private equity fund specializing in a specific sector and making an investment in that sector.

Discount rates should also typically be higher for a private firm than a public firm because of a difference in expected longevity. With public companies, there’s an assumption that the business will continue indefinitely. Smaller private companies with a key founder involved in operations have a shorter expected lifespan.

Control Premium & Illiquidity Discount

There are a couple other key items that should be taken into account for a DCF valuation of a private firm. One increases its value, the other decreases it.

The premium derives from control and the value that control can realize. Unlike most purchases of shares in publicly traded firms, the purchase of a private company often comes with a great deal of control over the company. If the business is poorly run and the investor believes he can improve financial performance by exercising their power to change management, there will be a significant control premium.

The transaction costs to buy and sell shares in a public firm are virtually nil; the resources and time required to buy and sell a private company are significant. The DCF valuation should account for these costs. This illiquidity discount is widely attributed for the 20 to 30% price discount sales of private companies exhibit relative to sales of public companies with comparable financial performance.

Limitations of DCF Valuations

DCF valuations can be a powerful tool if used properly but also have serious limitations. We discussed above the difficulty of properly estimating cash flows from a private company. Estimating a trustworthy discount rate is not an easy matter either.

These issues are compounded because tiny changes to the inputs of a DCF valuation can have big effects. Discounted cash flow models often assume a business will operate for a long or infinite period of time.  A tiny change in the growth rates of cash flows or discount rate can cause a huge swing in value.

Let’s go back to our example. Say the sinkhole next to the widget factory stops expanding. We now assume the factory can operate as a going concern forever with a constant growth rate. In this case, we would use an infinite period constant growth rate DCF model.

If we expect growth of 3% and use a discount rate of 6% we get a value of $34,333. If we expect growth of 4% and use a discount rate of 5% we get a value of $103,000. Some small changes in our growth and discount rates estimates cause the DCF value to triple.

Axial has created a free Discounted Cash Flow Valuation Excel template. Find out the valuation of your business: