Discounted cash flow is a widely used income approach method of valuation.
What does it mean to discount?
A discount is a deduction made to a sales price or value. With that being said, how is a deduction to value a valuation method?
Here’s a brief look at how it works.
A potential buyer of a company is purchasing future economic benefit or cash flow – in other words, a return on his or her investment.
The discount rate is just that, the rate of return the buyer expects to earn on the future cash flow he or she is anticipating receiving.
Application of the discount rate to the projected future cash flows yields a value that is indicative of the present value of the future cash flow to the buyer.
The discount rate must be compatible with overall market conditions and the risk to the buyer of the investment (the company) at the date of valuation.
The factors that are considered and assessed in the discount rate start with
- A risk-free rate of return
- Risk of the market
- Risk of the size of the company
- Risk of the particular company
The valuation analyst must be supplied with reliable projections of future cash flow. Use of this method is contingent on the projected cash flow for the company, so the accuracy of these projections is vital to the accuracy of the calculated or concluded value.
It is also important for the analyst to consider that the projections must dictate what the anticipated cash flow will be for the future owner (the buyer), which may be different than what the past owner received. Therefore, adjustments may be necessary.
The discounted cash flow is a method of valuation that can be used for all transactions, but it is most frequently used in merger and acquisition transactions.
It is also a very effective method as it can readily be used to value entire companies (controlling interests) or very small company interests (noncontrolling interests).
Although a very reliable and popular method, there are many models and factors to consider. Proper assessment of the purpose of your valuation should be considered before use of this method.