The DCF (discounted cash flow or discounted cash flow) business valuation is the fundamental method of valuation. The value of a business is based on the cash flows it expects to generate net of its financial indebtedness.
This valuation method is based on the premise that the company is worth more by its future than by its past or present! It is the only method that can be used for a company at the creative stage or with strong development prospects.
Discounted Cash Flow Methods
The DCF method is inseparable from the realization of a business plan that tells the story of the company, justifies the assumptions of changes in sales and expenses, investments and the need for working capital. The buyer and the seller must therefore agree on a business plan.
An appraisal report often uses several methods in addition to the DCF method: the stock market comparables method or from recent transactions, the ANC’s asset method (Adjusted net assets). The DCF method is, however, the only method that can be used for a company that has prospects for a sharp increase in its result, whether at the stage of its creation or at a stage of its development.
The peculiarity of this method is to value not the assets and debts of the company but the cash flows generated from the exploitation of these assets and debts.
Which Cash Flows to Consider?
Valuation is based on free cash flow, or FTD (or free cash flow).
Free Cash Flow (FTD) = Operating Cash Flow (FTE) – Investment Cash Flow (FIT)
FTE = Gross operating surplus (GVA) – Corporate income tax – Change in working capital
Gross operating surplus (EBITDA) is the financial surplus generated by the operation, which is however only a “potential” flow. Calculated exclusively from the profit and loss account, it does not take account of customer-supplier payment discrepancies. The variation of the BFR makes it possible to pass from the potential flow to the real flow.
FTI = Acquisition of fixed assets net of disposals.
Business Value (not the value of the company!)
Enterprise value is an economic value that does not take into account the financial structure. It is equal to the sum of free cash flow (FTD) discounted at the expected rate of return by all fund providers.
The explicit horizon
The explicit horizon has duration generally between 3 and 5 years, it corresponds to the project ramp-up period. It gives rise to forecasts of annual flows based on assumptions of sales growth, changes in the margin rate, recruitment, investments, etc…. This horizon ends once the company is expected to mature. The implicit horizon then takes over.
The implicit horizon and the final value
The implicit horizon starts at the end of the explicit horizon to infinity. The present value of the cash flows generated during this horizon is called the final value.
Valuing the company from only the FTD of the explicit horizon (most often between 3 and 5 years) would of course lead to the under evaluation. The goal is for the business to continue to exist and generate cash flow beyond this horizon, but how long? As the company does not have a fixed duration, it is an indefinite project. The assumption is that the company continues to generate a stable FTD from the end of the horizon explicit to “infinity” or at least over a long period.
Valuing the implicit horizon requires firstly evaluating the long-term normative or recurrent FTD cash flow.
In order for the company to generate the GTF over the long term, it is necessary that it renews its production tool. The evaluator will seek to evaluate the average renewal investment. The amortization expense of the last year of the explicit horizon may be a good approach because the accounting rules provide for it to be calculated over the useful life, which is the period over which the company plans to operate the property.
The final value corresponds to the current value of the normative flow updated to infinity; it is determined by the formula of Gordon & Shapiro:
The final value is a discounted value that is, however, positioned at the end of the explicit horizon. A second update should therefore be performed to bring this value to the date of the initial investment.
The enterprise value (and not the enterprise value) is also referred to as the value of the economic asset equals the sum of the discounted FTDs of the explicit horizon and the discounted final value. At first glance, the term “value of economic assets” may be misleading. It is not a question of valuing fixed assets, stocks and receivables, even at their market value. The value of the economic asset is nothing other than the discounted value of the future cash flows, the explicit horizon and the terminal value.
Admittedly, investors are not going to cash in all the FTDs generated by the company, if only because the net result is distributable in dividends. However, undistributed amounts are expected to be invested at a rate of return at least equal to the discount rate and thereby increase the value of the business.
The Choice of the Discount Rate
In any net present value calculation, the discount rate reflects investors’ expectation of return, which is itself dependent on the perceived level of risk of the project. The liability relates two categories of resources, equity and financial debt. The weighted average cost of capital (WACC) represents the performance expectation of all fund providers, lenders and investors.
The calculation of the WACC includes a feature when the evaluation is performed as part of a transmission. It is easy to understand that investors express their expectation of return not on the value of the company’s equity but on the amount of their investment. We are then in the context of an iterative calculation. The value of the enterprise depends on the weighting factor used for the calculation of the WACC and in turn the weighting factor depends on the value of the enterprise. Spreadsheets easily solve this type of circular calculation (after validation of the iterative calculation key).
The value of equity or the price to be paid for the business
However, the enterprise value does not yet represent the price to be paid to acquire the equity securities. If investors buy the right to collect all of the FTDs generated by the company, they still have to repay the loans.
The net debt represents the totality of the net financial indebtedness of the possible financial surpluses, it is equal to:
+ Loans at MLT
+ Outstanding cash loans (TC)
– Surplus cash
= Net debt
When the overall financial situation is surplus, we will talk about negative net debt. It is then added to the enterprise value to give the value of equity. The value of equity represents the price to be paid for the business; it is equal to the enterprise value less the value of the net debt (or increased negative net debt).
Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
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