If you plan to value a business using methods under the income approach, the discounted cash flow technique us likely to be high on the list.
Using this venerable business valuation method requires that you forecast the business earnings over some future period, usually measured in years. In addition, you would also need to assess the business risk and calculate the discount rate. Finally, you would compute the residual value, also known as the terminal value of the company, based on your expectation of earnings growth.
The Financial Accounting Standards Board (FASB) has issued interesting recommendations on the use of the discounted cash flow valuation in its Concept Statement No 7.
Business valuation problem: earnings forecast uncertainty
The basic idea is that any cash flow projection you create is at best speculative. After all, who knows whether the company will really win the customer acceptance it anticipates or how the competitors will react to the introduction of a new product line. Overall market conditions could suddenly deteriorate limiting the customers ability to buy the company’s products or services. All this could fall outside the management’s expectations and significantly change the actual earnings for the business.
Given this uncertainty, FASB has suggested a somewhat different approach to business valuation. Instead of a single cash flow projection, they recommend that you create a number of possible cash flow forecasts.
Use multiple cash flow forecasts to improve your valuation
Each forecast can be assigned a probability of occurrence. Let’s say, you foresee a possible best case scenario where the firm lands a number of major customer contracts. You can create a cash flow forecast that reflects this outcome. On the other hand, unexpected problems may crimp the earnings going forward. You capture this situation by creating an alternative worst case cash flow projection.
To round out your analysis, you may put together yet another earnings forecast that is somewhere in the middle of these two extremes.
You then assign a probability to each scenario. For example, the best case gets a weight of 30 percent, worst case 20 percent and the middle or most likely case 50 percent.
Finally, you calculate the business value as the weighted average of the above scenarios, using the risk free rate as the discount rate. Usually, the yield of long-term US Treasuries is selected for the risk free rate.
While this approach to business valuation has some merits, most business appraisers prefer to capture the company risk directly and calculate the discount rate based on the full assessment of the subject business risk profile.
Match earnings forecast and discount rate to increase valuation accuracy
One way you can combine both methodologies for a highly effective business appraisal is to use the multiple cash flow projections each with its own discount rate. The idea here is that each outcome is associated with its unique business risk. This should be reflected in the scenario specific discount rate.
If you use the build-up model for discount rate calculation, one element that is likely to vary a lot is the company specific risk premium. This makes sense – in each possible outcome the company management can make decisions that change such factors as the capital structure, customer concentration, and earnings stability.
The result is a different level or risk and different discount rate. These key inputs will in turn affect your business value calculation.