Perhaps the greatest advantage of the renowned Discounted Cash Flow business valuation method is its flexibility. You can choose any stream of business income and discount it to determine the business value today. However, to get accurate business valuation results, you need to match your earnings and the discount rate carefully.
Net cash flow and build-up discount rate formula
Most business appraisal experts recommend the net cash flow as the earnings basis for use with the Discounted Cash Flow method. The widely accepted rationale is this:
The discount rate, which captures your business risk, is typically derived from the public capital markets. The investors in these markets generally obtain the economic benefits equivalent to the net cash flow. Hence, the use of net cash flow to ensure that the earnings basis and discount rate are matched.
That said, you can make an adjustment to the discount rate and then use it to discount a different income stream, such as the seller’s discretionary earnings.
In this case the discount rate will need to account for the additional opportunity cost of owning and operating the business. This cost is not included in the Build-Up cost of capital formula directly – since typical investors do not work in their portfolio businesses.
Once matched, the two sets of income streams and discount rates should provide you with comparable results.
Discretionary earnings and capitalization rate that match well
In comparison, the Multiple of Discretionary Earnings, a widely used direct-capitalization method, uses the seller’s discretionary cash flow as the earnings basis. The capitalization rate is developed from the 14 business financial and operational factors you specify.
This cap rate is matched specifically to the seller’s discretionary cash flow as the earnings basis. An important difference from the net cash flow is that SDCF includes the single owner-operator compensation and non-recurring business expenses as addbacks.