Cash Flow Method of Valuing a Business
April 2023
The discounted cash flow or “DCF” method to valuing a business is widely used in the business valuation industry and is an acceptable method under the American Society of Appraisers’ Business Valuation Standards. It involves projecting cash flows (typically five to ten years out) and discounting those cash flows to present value at an interest rate(s) that considers the riskiness of the cash flows. The value calculated by the DCF method is reasonable if the inputs are in turn reasonable. Aggressive projections will produce an aggressive value unless the interest rate(s) used are adjusted accordingly. Likewise, conservative projections will likely produce a conservative value unless the interest rate(s) used are adjusted accordingly. So, care needs to be taken to match the projections to the interest rates used, as well as the purpose of the valuation. Although the DCF method to value a business is generally accepted by business valuation professionals as a valid method to value a business, it has also been criticized.
The advantages of using the DCF method to value a business include: 1) It is relatively easy to understand and apply; 2) Since cash flows under the method are discounted to present value at long-term interest rates it produces a value that is fairly independent of current market conditions; 3) It considers expected changes in cash flow such as one-time large capital expenditures; 4) It can be readily used in “what-if” scenarios and value sensitivity analyses; and 5) It can readily be used to assess the viability of specific projects.
The disadvantages of using the DCF method to value a business include: 1) It is only as accurate as the projections utilized and may give a false sense of precision; 2) Since it produces a value that is fairly independent of current market conditions it may produce a value that is not appropriate for the purpose of the valuation; 3) It’s not a good method to value start-up businesses when cash flows are difficult to project; and 4) It may falsely assume constant growth at the end of the projection period.
Overall, the DCF method will likely
continue to be used to value businesses,
despite its drawbacks. Its
use, and inputs, should be matched to
the purpose of the valuation.
Relevant Court Cases
-
Upsilon Chapter, Inc. v. Greek Housing Services, Inc.,
Superior Court of Pennsylvania,
Docket No. 388 MDA 2021
filed March 27, 2023
-
Simon Ogus v. SportTechie, Inc. et al.,
Court of Chancery of Delaware,
Docket No. 2018-0869-LWW,
decided April 3, 2023
Recent Business Valuation Articles
-
“Company Valuation Using the DCF Method and
CAPM: You Shouldn‘t Trust the Result,”
by Dr. Werner Gleibner and Endre Kamaras,
dated March 22, 2023
-
“Every Cloud Has a Silver Lining:
Analysis of Liquidation Likelihood for Negative
Book Value Firms,”
by Rong Huang, John Shon, Yuxuan Wang and Sha Zhao,
dated March 27, 2023
Recent Engagements
- Valuation of non-voting member interests of an
investment holding company on a minority interest basis
for gift tax reporting and sale purposes.
- Valuation of the common stock of a specialty marketing
firm on a controlling interest basis for estate
tax reporting purposes.
- Valuation of a block of stock of a niche manufacturers
representative company on a minority interest basis for
charitable donation/income tax reporting purposes.
- Valuation of the common stock of a specialty contracting
company on a 100% controlling interest basis
for planning purposes.
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