POC 2: Discounted Cash Flow & Firm Valuation

Valuation methodologies are rooted in the concept of discounted cash flow. Any excursion in finance and firm value would be incomplete without an exploration of this basic financial concept. All TVP concepts and methods are grounded in discounted cash flow (DCF).

All the assets, liabilities, equity, and operations of a business firm are employed to create value in the firm, which is measured by the firm’s current and future cash flows. The future cash flows must be discounted to their net present values. This requires accurate prediction of future cash flows and discounting them to the present value using an appropriate discount rate.

A couple of formulas explain the concept:

• Present Value of cash received in the future is:           PV = FV_n / (1 + i)ⁿ  where FV_n is the nominal sum to be received in the future, where n is the number of years in the future.           FV in year n is discounted to the PV, by dividing FV by a discount rate   of (1 – i)ⁿ  where

           1 = dollar in future, i is the discount rate and n is the number of periods (years) of discounting.                                                        

For a series of cash flows in future years, each year has a different discounted value. Cash flows in future years are discounted more heavily because each year has an additional year of discounting.

• The NPV of cash flows for a series of years is:

            NPV = ∑_n¹ {[ FCF] / (1 + i)^n-1 ]}  

The discount rate, “i”, is the uncertainty that the future cash flows will not materialize (risk) and expected return. These risks include market risk, industry risk, and unique company risks.

The math is important, but the implications are more so:

• ` The larger the discount rate, the lower the NPV of the FCF.

• Small and medium-sized companies have large discount rates that can approach or exceed .25, or 25%.

• In practice, the FCF are projected for 5 years, with year 5 being treated as a perpetuity the value of which is discount to year 1.

• All income approaches to Business Valuation have their roots in NPV of DCF, including EBITDA x Multiples.

• NPV of DCF Methodology can be expensive, which is why small and medium size business owners hesitate to engage a fully developed opinion of value by a professional valuation firm.

• Understanding the NPV of DCF valuation process can be quite useful to a proper conceptualization of the value of a business.