One big problem with the earnings-based methods just described is that they are based on historical performance - what happened last year. And as the oft-heard saying goes, past performance is no assurance of future results. If you were making an offer to buy a local small business, chances are that you'd base your offer on its ability to produce profits int he years ahead. Likewise, if your company were hatching plans to acquire Amalgamated Hat Rack, it would be less interested in what Amalgamated earned int he past than in what it is likely to earn in the future under new management and as an integrated unit of your enterprise.
We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method: discounted cash flow (DCF). The DCF valuation method is based on the same time-value-of-money concepts. DCF determines value by calculating the present value of a business's future cash flows, including its terminal value. Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.
For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:
1. The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow. They would use EBITDA and make some adjustment for taxes and for changes in working capital. Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.
2. Your analysts would then estimate future annual cash flows - a tricky business to be sure.
3. Next, you would estimate the terminal value. You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows). That net figure after taxes will fall into the final year's cash flow. Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:
Present value = Cash Flow / Discount Rate
Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity). This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.
4. Compute the present value of each year's cash flow.
5. Total the present values to determine the value fo the enterprise as a whole.
We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2). Our calculated value there is $4,380,100. (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)
In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business. All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager. Such determinations are best left to the experts. What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.
Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)
Present Value Cash Flows
(in $1,000, Rounded) (in $1,000)
Year 1 446.5 500
Year 2 418.5 525
Year 3 398.7 500
Year 4 381.6+2,734.8 600+4,300
Total 4,380.1
The strength of the method are numerous:
- It recognises the time value of future cash flows.
- It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
- It accounts for the buyer's cost of capital.
- It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
- It is based on real cash flows instead of accounting values.
The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.
We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method: discounted cash flow (DCF). The DCF valuation method is based on the same time-value-of-money concepts. DCF determines value by calculating the present value of a business's future cash flows, including its terminal value. Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.
For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:
1. The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow. They would use EBITDA and make some adjustment for taxes and for changes in working capital. Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.
2. Your analysts would then estimate future annual cash flows - a tricky business to be sure.
3. Next, you would estimate the terminal value. You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows). That net figure after taxes will fall into the final year's cash flow. Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:
Present value = Cash Flow / Discount Rate
Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity). This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.
4. Compute the present value of each year's cash flow.
5. Total the present values to determine the value fo the enterprise as a whole.
We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2). Our calculated value there is $4,380,100. (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)
In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business. All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager. Such determinations are best left to the experts. What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.
Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)
Present Value Cash Flows
(in $1,000, Rounded) (in $1,000)
Year 1 446.5 500
Year 2 418.5 525
Year 3 398.7 500
Year 4 381.6+2,734.8 600+4,300
Total 4,380.1
The strength of the method are numerous:
- It recognises the time value of future cash flows.
- It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
- It accounts for the buyer's cost of capital.
- It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
- It is based on real cash flows instead of accounting values.
The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.
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