Banker Valuation’s business valuation tool uses an Asset Approach, an Income Approach, and a Market Approach in its Calculation Report. For the Income Approach, a discounted future cash flow method is used and is one of the most logical methods in business valuation.
The discounted cash flow method (DCF for short) is based on the theory where a shareholder will generate future economic benefit (cash flow) and require a specific rate of return on the investment based on certain risk characteristics (discount rate). Although we won’t discuss the formulas in detail, there are three major components:
- Base Year Cash Flow – for the Banker Valuation model, the user simply weights historical cash flows based on the most likely case scenario going forward. The weighted cash flow is the “base year”….meaning, if there was no growth expected, the business would most likely cash flow at this same amount year over year. The base year is used for the market approach (price to weighted revenue and/or price to weighted SDE or EBITDA).
- Projected Cash Flow – once the base year has been weighted, the user has the ability to project cash flows for year 1 to 4…..this could be a positive or negative growth rate. If the use believes growth will be relatively stable, inflation plus a small amount of industry growth could be used….let’s say a stable growth rate of 3.5%.
- Discount & Cap Rate – Banker Valuation uses a proprietary risk rating tool which takes into consideration the average “required rates of return” for small to mid-sized businesses and then increased / decreased based on specific risks of the subject company being valued. The model takes into consideration most of the risks that impact privately held companies…..such as financial risk, industry risk, customer concentration risk, reliance upon owner, etc.
Once the 3 primary components above are developed, the model calculates itself….discounting projected cash flows back to their present value based on the required rate of return. If the 3 components are developed correctly, the discounted cash flow method is the most accurate method available.