What Is the Discounted Cash Flow Approach?
Discounted cash flow sounds difficult, but it’s really not. Furthermore, this approach has a lot of similarities to using a multiple of earnings approach. In fact, I see multiple of earnings as kind of a shortcut to discounted cash flow.
The discounted cash flow approach is based on a concept of the value of all future earnings discounted back at the risk these earnings might not materialize.
I personally use this approach to value large public companies that I invest in on the stock market. But I would be cautious as a potential buyer in using this approach to value a small company. There are so many risks that you need to consider beyond those of buying stock in a large public company, and it is difficult to discount them all into your valuation. For example, it is very easy to underestimate the risk involved and choose a discount rate that is too low. Hence, I would prefer to get a buyer to use this valuation approach if I am selling a business to him or her.
Among the factors you need to include in your discount rate are the time value of money, down cycles in the economy, the fact that you are making an equity and not a debt investment, the small size of the company, and the relative lack of liquidity of the investment—and all of this is before you even get into the specific risk factors of the individual situation!
Related: Business Valuation Basics
A discounted cash flow approach can get complex when done properly, and the more complex it is, the more likely you can make a mistake—potentially a big and costly mistake, which is another reason I prefer a multiple of earnings approach. Even when I value large public companies using a discounted cash flow approach, I always do a “reality check” on multiple of earnings—if it seems too high, I don’t buy; if it seems too low, I don’t sell.
How to Calculate Discounted Cash Flow
You estimate the cash the business will earn this year, and then estimate the growth rate for the next 5 to 10 years. But remember, the larger the business grows, the more difficult it is to sustain the growth rate. After, let’s say, 10 years, I would just plug in what is called “terminal” growth rate, usually using 2 percent to approximate inflation, assuming that at some point the business becomes mature and growth slows. The use of a terminal growth rate may seem sloppy or conservative, but in valuing a small business with an appropriately high discount rate, the value of cash flows 11-plus years out is going to be worth very little today.
Then, you have the difficult job of assigning an appropriate discount rate. You could start with a base rate from the 10-year U.S. Treasury Bill, and then start adding from there. Next, you add a premium for an equity investment instead of debt, a small company versus a large one, and the lack of relative liquidity in a small company.
But the real differential is in valuing one small company to another. What are the chances the company will be earning the cash flows you are projecting 10 years out? What are the chances the company will even exist?
I know you probably want me to stick my neck out and give you some rough discount rates, so here goes!
- For an incredibly stable and secure small business with a product that will never go out of favor, with a very strong and defensible product line, I might use a discount rate as low as 10 percent. But that’s for an almost textbook-perfect, exceptionally low-risk small business.
- For a small business with average risk, I might use a discount rate around 13 percent.
- For a small business with a high risk, the rate would be much higher.
These are very rough rules of thumb and every situation is different. Also remember, I would tend to first consider using a multiple of earnings approach for valuing a small business.
Takeaways You Can Use
- In theory, the discounted cash flow approach is ideal.
- Generally a multiple of earnings approach is less complex, more common, and less likely to lead to a questionable valuation.
- It’s easy to underestimate risk and choose a too low discount rate.