If you are valuing a company that is going through a period of rapid growth, the Discounted Cash Flow business valuation method should be high on your list of choices. Using this key income-based business valuation method, you can get very accurate results. This is because the discounted cash flow business valuation lets you capture the company’s growth rate and associated business risk directly.
Discounted cash flow method calls for three types of inputs:
- A stream of projected business earnings, such as your business net cash flow, usually on an annual basis.
- Discount rate representing the business risk.
- Long-term business value, often called its terminal value.
Business terminal value estimation
If you take a look at the terminal value formula, you may notice that the denominator is the difference between the discount rate and the long-term growth rate in business cash flows. This is the so-called capitalization rate or cap rate for short.
Handling negative terminal values
For some high-growth companies, the terminal value can become negative. This happens if the business cash flow growth rate exceeds the discount rate. So how do you handle such situations?
In such cases, you can estimate the terminal value as the expected gain from a future business sale. Here is one way to this:
Step 1. Project your business revenue or discretionary cash flow several years into the future. Take the values from the final year of your projections. For example, if you do projections for 5 years, use the numbers from year 5.
Step 2. Use the market-based valuation, such as ValuAdder Market Comps to estimate the current value of the business, based on the projected revenue or cash flow from Step 1.
Step 3. Factor in the effects of inflation by indexing the business value from Step 2. You can use the ValuAdder Future Value calculation to do so.
Step 4. Subtract the expected business sale transaction costs from the business future fair market value determined in Step 3.
Step 5. Use the value from Step 4 as the long-term terminal value input in your Discounted Cash Flow business valuation.More on Valuation