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:

Mid-year convention factor for discounted cash flow valuation

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:

Year Expected Cash Flow
Year 1 $953,770
Year 2 $1,012,310
Year 3 1,070,850
Year 4 1,129,400
Year 5 $1,187,940

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

$3,915,542

Business value adjusted for the mid-year convention

$4,464,405

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.

Business Valuation by Discounting its Cash Flow

See an example of valuing a business based on its earning power and risk.

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