When appraising a new or growing business, valuators often turn to the discounted cash flow (DCF) method. This technique, which derives value from a company’s ability to generate cash flow in the future, allows for significant flexibility in assumptions about growth. So, it also can be useful when valuing struggling companies that are in a state of flux. Here’s more on this method — and how growth factors into it.
The DCF method in a nutshell
A closer look at growth and the terminal value
When applying the discounted cash flow method, valuators assume that the company’s cash flows will eventually stabilize at a growth rate that’s sustainable over the long haul. Usually, this long-term growth rate is more conservative than the growth rate assumptions made during the discrete discounting period.
The rate of inflation is a good starting point for the long-term growth rate. But some businesses also may be able to sustain a reasonable amount of real growth over the long term. Other businesses, including those that rely on wasting assets such as minerals or coal supplies, may grow at a rate that’s below inflation.
Valuators often estimate terminal value using the capitalization of earnings method. This technique assumes that cash flows in the final year of the discrete discounting period will grow at the long-term growth rate into perpetuity. Long-term growth also factors into capitalization rates that are used in this method. So, small changes in the long-term growth rate can have a big impact on a company’s terminal value.
The DCF method falls under the income approach, one of the three broad approaches to valuing a business. Under this method, a valuator generally projects a company’s cash flows over a discrete period of time, and then, at the end of that period, he or she assumes the company’s cash flows will stabilize and estimates a terminal (or residual) value. Next, the cash flows during the discrete period and the terminal value are discounted to their present values. Finally, the sum of those present values equals the company’s value.
Growth comes into play when a valuator (or management) projects future cash flows. It also factors into the determination of the proper discount rate. For example, growing businesses are generally more risky and would typically call for a higher discount rate.
Valuators consider several qualitative factors when assessing growth. Examples include the quality of management, capacity to form partnerships and marketing abilities.
A valuator also should assess the potential growth from the company’s existing assets. Relevant factors include overall industry growth, the company’s market share and the growth of assets in previous periods.
Of course, a company could also develop new assets. If the development of new assets is a significant part of a company’s business plan, a valuator must take into account both the potential growth from such assets and the costs and risks related to achieving that growth.
In addition, a valuator must assess the likelihood of acquisitions and the amount of growth that will result. A valuator will look at the company’s history of acquisitions and the level of acquisition activity in the industry, as well as the company’s projected financial ability to successfully carry out acquisitions.
Valuators consider quantitative growth factors, too. Historical data is particularly valuable if the company has been functioning under consistent business conditions — and expects to continue to do so in the future. In such a situation, any recent trends upward or downward in cash flow are insightful, unless they’re caused by a temporary change in operations, such as a short-term plant closure. Such trends require more in-depth analysis before a valuator can assume they’ll continue.
If management projections are available, they also will be considered. These projections can provide a valuator useful insight on the economic forces influencing the business’s growth. Management projections are especially important in two scenarios: 1) when the company is relatively new and lacking in historical financial data, and 2) when the company has recently undergone, or is expected to undergo, a material change. Examples of material changes include the introduction of a new product line or service offering and the closure of a facility. When such events occur, historical data usually becomes less relevant because it reflects substantially different circumstances.
Management projections can’t be accepted on their face, however. Valuators must question the assumptions and consider the purposes for which the projections were originally prepared. For example, projections may be more reliable if they’re prepared in the ordinary course of business than if they’re prepared for litigation.
Temper the growth
Because growth influences both cash flow projections and the determination of the appropriate discount rate, valuators (and attorneys) must stay vigilant to ensure the effects of growth aren’t exaggerated. If growth, including any of the qualitative and quantitative factors, is incorporated into cash flows and the discount rate without being appropriately tempered to account for such double consideration, a valuator risks significantly over- or undervaluing the business.