Business Valuation – A Discounted Cash Flow Perspective
Discounting of Revenues and Expenses
Business valuation involves the study of many aspects of a business, including anticipated revenues and expenses. Because cash flows extend over time, a discounted cash flow cash discount processing (DCF) model can be a helpful tool. A discounted cash flow analysis for a business valuation requires the analyst to consider two components: (i) a projection of ongoing revenues and expenses of the foreseeable future; and, (ii) a determination of the discount rate to be used.
Ongoing Revenues and Expenses
Projecting a business’ expected ongoing revenues and expenses requires expertise in the business’ specific field. For example, a DCF analysis for purchasing an office tower requires input from commercial real estate specialists. Similarly, a DCF analysis of a proposed mine requires the involvement of geologists.
Selecting the discount rate requires us to consider two components: (i) the cost of capital; and, (ii) the risk premium associated with the stream of projected net revenues.
Capital is a productive asset that commands a rate of return. If a business purchase is financed by debt, the cost of capital simply equals the carrying charges on the finance loan. If the business purchase is financed by the owner’s equity, the relevant cost of capital would be the “opportunity cost” of the capital – the net income that the same capital would generate if committed to its next-best alternative.
The choice of discount rate must consider not only the owner’s cost of capital, but also the risk of the business investment. Some types of investment are more risky than others. In the case of a riskier business, it is appropriate to include a higher discount rate.
Sample DCF Model for Business Valuation