In business, cash is king. It stands to reason that the primary function of a business is to generate desired returns for its owners. Unsuprisingly, business value is defined by its earning capacity. The greater the returns, given an acceptable level of risk, the higher the business value.
No other business valuation method captures this idea better than the discounted cash flow technique. To use the method, you provide a cash flow forecast over some period of time in the future. The business risk is represented by the discount rate. Given that information, you can calculate what the company is worth today.
It should come as no surprise that your business value depends upon the cash flow forecast. While cash flow projection models abound, a simple way to start for a stable company is to look at the historic income trends.
This is a reasonable plan if you expect the business to continue running much the same as in the recent past. The model that fits this description is called linear regression. Essentially, you predict the business income and expenses based on their history. The math of the linear regression model combines the historic information as data points on a graph and draws a straight line into the future.
This works fairly well if you do not anticipate major changes in the business. You expect the customers to remain loyal and continue buying the company’s products. The prices should track their historic trajectory. You expect the suppliers to continue operating within existing contracts without sudden price hikes. Key expenses such as labor, energy, rental, and shipping costs should stay under control.
But what if you expect changes that affect the company’s prospects in the near future? The historic trends may no longer be a reliable guide. As a result, your discounted cash flow valuation may well produce misleading results. The problem is not with the method, it is your assumptions about business earnings and risk that may be out of line.
Consider a business buyer who is looking to purchase a business that has been losing money recently. The buyer may feel the company has potential that is not being realized under the current ownership. This makes the company an attractive acquisition target.
The buyer may need to make some changes to the business to tap the potential. This calls for a fresh earnings forecast that translates these changes into actual financial returns. Note that the business as usual paradigm does not apply here. The whole point is that the company turns a new page in order to achieve success.
The buyer’s cash flow forecast model departs from historic trends and represents a positive change expected following the business sale. Careful planning and review are key to provide the buyer with the justification of the business purchase and correct valuation.
In each situation you face, you can depend upon the discounted cash flow method to produce a precise business value result. The key challenge is coming up with the realistic assumptions and reliable cash flow forecast. If there is one situation where the old adage of ‘garbage in, garbage out’ rings true, this is it.