Under the Discounted Cash Flow (DCF) method, a detailed future cash flow statement is derived for a three to six year period (known as the “Explicit Period”). The free cash flow from each year is discounted to a net present value, using an appropriate discount rate. To this net present value figure is also added what is called the Terminal Value, which is the net present value of cash flows beyond the Explicit Period, using assumptions of a more generalized and conservative growth rate.
Perhaps the above is not so simple as using multiples; there are also a number of pitfalls:
- Are cash flow projections credible? Most small to medium-sized companies have great difficulty creating visibility on cash flows three to six months into the future, let alone four to seven years into the future.
- There is a certain subjectivity in determining discount rates. Ultimately, it reflects the degree of risk associated with the company being valued, as perceived by the valuator.
The need for judgment
Numerous examples of the need for judgment were given in the discussion on Comparables Valuation. This is equally true for DCF valuation. Which of the Multiples and DCF methods should be used? It depends on the circumstances. As stated by the American Society of Appraisers “The selection of and reliance on appropriate methods and procedures depends on the judgment and experience of the appraiser and not on any prescribed formula. One or more approaches may not be relevant to a particular situation, and more than one method under an approach may be relevant.”
Valuation is a perfect illustration of the principle that “a little knowledge can be dangerous.” Our staff have performed over a thousand valuations. When you choose an advisor, choose one that knows the pitfalls, and knows how to deal with them.