Valuation of a company is associated with a lot of difficulties and insecurities. It is impossible to estimate the object value of a company only by counting since the numbers are not the only factor to consider. To facilitate the business valuation process there are a number of helpful models. According to theory, the business valuation procedure should consist of several phases to provide a reliable value. These phases are business analysis, accounting, and financial analysis, forecasting and valuation itself.
Valuation of a company varies depending on which valuation model that has been applied and how input variables have been estimated. The valuation models can be commonly classified as follows:
- Asset-based Approach – The purpose of the model is to study and reevaluate the company’s assets and liabilities obtaining the substance value which also is the equity. The substance value is thus estimated as assets minus liabilities. Basically, the company’s value could be determined by looking at the Balance Sheet. Unfortunately, the values on the balance sheet cannot be used because the book value seldom is the same as the real value, except for the case of liabilities that is often accounted in real value. The problem is when following the principles of accounting, assets often are depreciated over their life expectancy and when the asset-based approach is applied the real value for these assets must be determined. In this case, the real value is equivalent to the fair market value that is the value of the asset on a free market.
- Income-based Approach – This approach constitutes estimation of the business value by calculating the present value of all the future benefit flows which the company is expected to generate. The most commonly used model using this approach is the discounted cash flow model or dcf valuation
model. It is accepted as an appropriate method by business appraisers. There are several models of income approach depending on which type of income flows that will be discounted. The common benefit flows that are usually used in the income-based approach are dividends, free cash flows, and residual income. The dividends and cash flow are two measures which refer to direct payment flow from a company to shareholders and the residual income measure has focused on the return which is derived from company’s book value and based on accrual accounting.
- Market-based Approach – The market approach determines company value by comparing one or more aspects of the subject company to similar aspects of other companies which have an established market value.
DCF Modeling for Discounted Cash Flow Valuation Purposes
Discounted cash flow valuation or DCF valuation relates to the value of an asset to the present value of expected future cash flows on that asset.
Mathematically the present value can be expressed as the following formula:
PV = ∑FV / (1 + i)ⁿ
PV = Present Value
FV = Future Value
i = discount rate reflecting the risks of the estimated future value
n = raised to the nth power, where n is the number of compounding periods
Or in this case for calculating the dcf value:
Value = [CF1 / (1+r)1] + [CF2 / (1+r)2] + … + [CFn / (1+r)n]
n = Life of the asset (year)
CF = Cash flow in period
r = Discount rate reflecting the riskiness of the estimated cash flows (WACC)
As formula shows, using the discounted cash flow valuation to determine a business value the appraiser must always make an estimation of the elements below:
- Estimation of business life expectancy
- Estimation of future income flows that a business will generate during its life expectancy
- Estimation of the discount rate in order to calculate the present value of the estimated income flows
In discounted cash flow valuation, the intrinsic value of an asset is calculated which is based on fundamentals. DCF technique perceives that markets are inefficient and make mistakes in assessing value. It also makes an assumption about how and when these inefficiencies will get corrected. The best way to represent this is by dcf modeling.
DCF modeling is simply building a valuation model using the dcf method to determine the value of a business or an asset. By simply building a dcf valuation model, you will be able to determine how attractive an investment opportunity is. This is why dcf modeling is highly regarded as one of the most useful tools to value a business or an asset.
Now that you know the formula to calculate the DCF value, below is an example of a simple DCF valuation calculation to show how the cash flow is discounted.
As shown above, we used a time period of 5 years’ worth of projected free cash flow stream. A DCF model is usually accompanied by forecasted financial statements as well as discounting the following variables which are counted as WACC (discount rate):
- EBIT (Earnings before Interest and Taxes)
- Adjusted Taxes (the applicable income tax rate applied to EBIT
- Addback Depreciation and Amortization as these are non-cash expenses
- Change in Net Working Capital needs to count for any changes in the working capital required to run a company
- CAPEX which is one of the major cash flows and needs to be deducted
In the above example, let’s just assume the values above as to only determine how the discounting works as well as calculating the terminal value. Provided with such data (in this case, a fixed flow of cash flows), and a discount rate calculated from the WACC (weighted average cost of capital). The data is then used to calculate the projected terminal value.
As you can see, the cash flows have less present value the more in the future they are. This is what we call as time value of money. It is a concept where the money at present is worth more than the same amount in the future due to its potential earning capacity. Basically, provided that money can grow due to interest, any amount of money is worth more the sooner it is earned back. Another way of calling the time value of money is present discounted value.
To know how to calculate the discount rate (WACC), we have a WACC Calculator | Discount Rate Estimation Model Template for you to use. It is a very useful tool when building a DCF Model to discount future cash flows to firm to their present value. Now, after discounting the projected cash flows, the terminal value is then calculated.
Estimating Terminal Value
Terminal value is the estimated value of a business after the forecasted time period. It is a very important part of the financial model since it makes up the total value of a business and most often used in multi-stage discounted cash flow analysis which acts as a limit to the cash flow projections to a viable period. Basically, forecasting the cash flow beyond the terminal period will be impractical and exposed to certain risks limiting its validity and precision.
There are two methods to calculate the terminal value
- Perpetual Growth (by Analysts) – is much preferred used due to the logic behind it which is to assume the business continuous stream of Free Cash Flow (FCF) at a normalized state in perpetuity.
- Exit Multiple (by Industry) – is to assume the business will be sold based on a price of a market multiple i.e. EV/EBITDA) based on the present observed comparable trading multiples of the same business models.
Perpetual Growth Method
The Perpetual Growth method only considers the value of the free cash flows with a constant rate of growth in perpetuity. It is a widely used and standard formula when calculating the terminal value but, it is more of a theoretical concept which is difficult to explain and substantiate. It is also biased toward overestimating the terminal value since it assumes that the business or company will continue to grow at a constant rate forever which is not always the case in reality. Nevertheless, calculating the terminal value via the perpetual growth method is still popular due to the challenge of estimating as the projections stretch further into the future. Therefore, investors or users assume that cash flows will grow at a constant rate in perpetuity.
To calculate the terminal value via the Perpetual Growth method, the following formula is used:
TV = [ FCFn x ( 1 + g ) ] ÷ ( WACC – g )
TV = terminal value
FCF = free cash flow
g = growth rate of FCF
WACC = weighted average cost of capital
The Exit or Terminal Multiple method accounts for when a business is assumed to be sold at the end of the projection period. Compared to the perpetual growth method, the exit multiple approach is easier to understand and explain which makes it popular for financial modelers, investment bankers, and other related users, when conducting a valuation and calculating for the terminal value of a business or company. Theoretically, it is not very accurate since it utilizes market multiples which might not be applicable for certain specific companies. Basically, one needs to be careful when using the exit multiple approach since multiples change over time. A frequently used terminal multiple is the Enterprise Value/EBITDA or EV/EBITDA.
To calculate the terminal value via the Exit Multiple approach, the following formula is used:
Terminal Value (TV) = Financial Metric (EBITDA) x EV/EBITDA Multiple (i.e. 5x)
Both approaches have their own advantages and disadvantages. It all depends on the assumptions and what will fit better to calculate the value of business appropriately. To help you build a model with a calculation of the terminal value in different approaches, you can refer to our financial model template here: Terminal Value Model Templates.
Valuation of a Company using DCF Valuation Model Templates
Though the process of calculating the value of a company using the dcf method sounds simple, it is more than that. It would still require the appraiser to have reasonable know-how to build a valuation model that will be helpful in determining the value of an entity. For users who want to build their own DCF model, you can simply take advantage of ready-made valuation model templates using the dcf valuation method.
You can use the DCF model templates to serve as a base and a foundation for your model. This is so that you don’t have to spend a lot of time creating a dcf model from scratch. You also don’t have to spend high fees to ask a professional to build a completely new valuation model for you. If you are looking to acquire discounted cash flow model templates, you can download the templates here: DCF MODEL.
These models are made by expert financial modelers so you don’t have to worry about lacking the know-how to apply in your model. These model templates using the dcf valuation method are widely used by users from different countries such as USA, UK, Germany, France, Switzerland, and many more that are looking for assistance from expert financial modelers.