Its solid financial foundation, flexibility in valuing established companies and startups, businesses with steady earnings and rapidly changing profits make this method an excellent choice for appraising all types of businesses.
Earnings and risk define business value
Best of all, the discounted cash flow method lets you focus on the unique value-creating attributes of each business and show clearly the key relationship among these fundamentals:
- Business value
- Business earnings prospects
- Business risk
How business value depends on your assumptions: what-if valuation scenarios
You can create business earnings forecasts of arbitrary length, usually measured in years. Each forecast is your vision of a possible business outcome. And each outcome is associated with a certain level of business risk, captured by the discount rate. The discounted cash flow method lets you determine the business value in present day dollars for each earnings and risk scenario.
To increase the accuracy of your business valuation, consider using a number of such scenarios. For example, construct earnings forecasts and assess company risk for:
- Base case, or most likely outcome you expect going foreward.
- Best case, when the business conditions are most favorable.
- Worst case, in case the business encounters unexpected difficulties.
You can then calculate business value as a weighted average of the valuation results you get for each scenario. The weights represent the probabilities, in your judgment, of each scenario actually occurring.
Discounted cash flow valuation as a decision making tool
The power of the discounted cash flow method is that it enables you to translate expected business performance into value. This creates a number of opportunities:
- Selecting the best financial and operational plan from a number of candidates.
- Defining contingency plans.
- Verifying and refining assumptions to see how the value of the business is impacted.
- Selecting the best business investment opportunity from a number of alternatives.
In this sense, you can use the discounted cash flow method as a powerful planning tool as well as a highly effective business valuation technique.