The key reason behind the accuracy of the Discounted Cash Flow business valuation method is that it lets you match the business cash flows and the risk, represented by the discount rate you use. This method works by translating these cash flows to today’s dollars by calculating the so-called present value.
Now, any seasoned business person would agree that you can make reliable cash flow forecasts only so far into the future. Typical forecasts are done for 3 to 5 years, sometimes up to 10 years. But a successful business may continue running well past the initial cash flow projection. Obviously, such a business continues to create value over and above what this projected cash flow is worth. So how do you measure it?
This depends on what your plans are for the business. If you plan to sell it once the projected cash flows have been received, then the additional value is in the proceeds you realize from the business sale.
But what if you plan to run the business indefinitely? You can continue with your business cash flow projections, but their accuracy tends to suffer the farther out they are. Can the business value be assessed without this infinite stream of cash flow projections?
Yes indeed. What you need to do is estimate how the business cash flows will change past the projection period. One simple assumption is that the cash flow will continue growing at a constant rate. You can refer to your cash flow forecast to estimate this growth rate. And the value of a constantly growing cash flow stream can be calculated by the process known as capitalization.
So, under this approach, there are two parts to what the business is worth. First, it’s the present value of the initial cash flow stream. Second, it is the long-term value of the constantly changing cash flow, known as the residual value or terminal value.
Here is the ground rule to bear in mind when using the Discounted Cash Flow business valuation method:
The shorter the cash flow projection period and the lower the discount rate, the larger the contribution of the residual value to the total business value.
So, if your business is relatively low risk and you expect to see a steadily growing cash flow, then a short-term cash flow forecast should suffice. However, if you anticipate significant changes in your business earnings, then consider doing longer-term cash flow projections in order to get an accurate estimate of business value.