One of the central business valuation techniques under the income approach is the discounted cash flow method. It lets you calculate the business value based on three fundamentals:
- Business earnings forecast, usually annual cash flows.
- Discount rate which captures business risk.
- Long-term business value, known as the terminal value.
The standard discounting valuation formula assumes that the business cash flows occur at the end of each year. However, a business may generate a smooth income stream throughout the year.
Mid-year convention adjustment
The typical way to handle such situations is to discount the cash flows as if they occurred in the middle of the year. This calls for just one simple adjustment to your discounted cash flow valuation result, multiplication by this factor:
where D is the firm’s discount rate. You can calculate the equity discount rate by using the Build-Up model. If the company is financed by both debt and equity capital, use the weighted average cost of capital (WACC) iterative procedure.
Example: Comparing discounted cash flow valuations with and without the mid-year convention.
Consider a company with the following cash flow forecast:
||Expected Cash Flow
Let us assume that the firm’s discount rate is 30%. The estimated long-term earnings growth rate is 5.53% which gives us the business terminal value of $5,124,129.
With these inputs prepared, we next calculate the present value of the business using the standard discounting and then adjusting the result for the mid-year convention as follows:
Business value, standard discounted cash flow method
Business value adjusted for the mid-year convention
The mid-year convention result gives the business value that is 14% higher than the standard discounting valuation.
The difference grows as the discount rate increases. This makes sense – the more risky the business, the greater the importance of receiving the cash flows as early as possible.
See an example of valuing a business based on its earning power and risk.
It is a standing joke in the business appraisal profession: the business valuation is out of date the moment it is delivered to the client.
Business valuation has an expiration date
In fact, a key assumption for any business valuation is the date on which it is done. Why is the date so important? Here are a few key reasons:
- Business earnings prospects and the risk it faces change over time, sometimes very significantly.
- The industry sector can undergo changes that directly affect the value of firms competing in it. Major factors are industry consolidation, new government regulations, new and disruptive technologies.
- Investor expectations of return and perception of risk vary over time.
- Investor appetite for acquisitions can change. This in turn affects the market value of businesses. If you pay attention to the public capital markets, you will see how valuation multiples change as investors respond to market conditions.
- Access to capital for firms of certain size or in a specific market can have a great effect on their value.
Whether you conduct a business valuation for a client or assess the value of your own company, the business earnings outlook and risk evaluation are critical to your business appraisal result.
Refresh your business valuation as key assumptions change
Since none of us have a crystal ball, regularly repeated business valuation is essential. It helps you review your earlier assumptions and see what the company is worth at any given time.
Such a review will usually help you identify critical changes in these valuation parameters:
When the market uncertainty is especially high, you may want to consider a number of scenarios, each with its own assessment of business earnings outlook and risk. You can then use these scenarios as inputs into your business valuation calculations.
An average of the results, or a range of business values you calculate give you a well considered estimate of what the business is worth – and how business value has changed over time.
Business valuation tools that help you stay current
To make the task of business value reassessment easier, ValuAdder business valuation software is continuously updated to reflect the latest changes in the market:
The valuation multiples in the Market Comps Tool reflect the current values of companies similar to yours.
The discount and capitalization rates let you capture business risk that accurately reflects the current market trends.
How to Create a Business Appraisal