The discounted cash flow method is perhaps the most versatile valuation method under the income approach. Professional business appraisers, venture capitalists, bankers and entrepreneurs use this method to value all kinds of businesses and professional practices. Just about any business with a solid expectation of future earnings can be valued by this powerful technique. You can use this valuation for a business of any size in any industry.
The method calculates the so-called present value of future cash flows that are projected over a finite period of time. But business people and investors can envision what the company is likely to do only so far into the future. Beyond a certain point uncertainty reigns.
To handle this common situation, the discounted cash flow method uses an additional calculation. This is often referred to as the terminal value. The idea is that after the yearly earnings forecast is discounted, the company still has some residual value if the goal is to keep running the business. The terminal value uses the capitalizing calculation, dividing the last projected business earnings by the cap rate.
In other words, the discounted cash flow method works like this: first, calculate the present value of future earnings that you can forecast with reasonable accuracy. Next, assume that the business will keep running and its earnings will grow at some constant rate year over year.
In this case, you can use the capitalization calculation to estimate what the terminal or residual value of the business is. Now add the present value of the forecast business earnings and the terminal value, appropriately discounted, and you have the total business value as of today.
Terminal cap rate – the biggest source of mistakes
Pay special attention to the capitalization rate you use. The cap rate is the difference between the discount rate and the expected earnings growth rate over the long term. The key point here is that the earnings growth rate must be sustainable and should not exceed the discount rate. Otherwise the cap rate can become either too small or even negative making the terminal value calculation useless.
To do a sanity check on your earnings growth rate, compare how quickly the earnings grow in your industry sector. Take a look at a few well established competitors to see how well they are doing. Chances are this will reveal what earnings growth rates are sustainable.