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## Discounted Cash Flow or DCF Method

The discounted cash flow method allows you to value a business based on projected future cash flows. Of course, money that you expect a business to produce in the future is worth less than money today. We have created a calculator that you can use to perform the calculations discussed below. The calculator allows you to assume that you will receive a lump sum at the end (e.g. you plan to sell the business), to assume that there is a steady income stream for a period of time, a growing income stream for a period of time, or a perpetual stream of income at the end (with or without growth).

### Discount Rate

The most common way to calculate how much future cash flows are worth is to discount the cash flows using a discount rate that is derived by adding two components. The first component is the risk free rate, which is the rat of return that a buyer could achieve by investing the money in an essentially risk free investment (In the U.S. a treasury bond with a maturity similar to the time frame being projected is often used). The second component is a discount for risk. Typical discount rates for risk might be:

- 20-30% For businesses with annual sales over $20,000,000 and some barriers to entry.
- 25-35% For businesses with sales between $10,000,000 and $20,000,000 and some barriers to entry.
- 30-50% For businesses with sales under $10,000,000 and low barriers to entry.

There is overlap in the ranges because other factors can increase or decrease the risk premium, including customer concentration, volatility of earnings history, reliance on key employees, and threat of litigation.

### Future Cash Flows

Once a discount rate is determined, future cash flows are projected. The cash flows are generally projected for 3 to 5 years in the future. Cash flows after the period forecast are assumed to grow at a terminal rate. The terminal rate is generally far lower than the rate of growth used during the forecast period because as businesses mature they tend to grow more slowly and after the initial period of growth the boost from synergies with an acquiring company and new management has taken place.

### Weighted Average Cost of Capital

An alternative way to determine the discount rate is to use the Weighted Average Cost of Capital. Using this method you determine the average return demanded for all of the capital used in the business and use that as the discount rate. For example, suppose we have a business that we are buying for $10,000,000 and we are financing as follows:

Amount | Source | Rate |

1,000,000 | Note from Seller | 5% |

5,000,000 | Bank Loan | 9% |

4,000,000 | Equity Investment | 35% |

The weighted average cost of capital would be:

10% (percentage financed at Seller Note Rate) times 5% (amount Financed at Seller Note rate)

plus 50% (percentage financed at Bank Loan rate) of the amount financed times 9% (percentage financed at Bank Loan rate)

plus 40% (percentage financed at Equity rate) of the amount financed times 35% (percentage financed at Equity rate)

0.05 X 0.1 + 0.09 X 0.5 + 0.35 X 0.4 = 19% Weighted Average Cost of Capital

### Forecasting Future Cash Flows

Once we have determined a discount rate we need to forecast future cash flows. Most buyers will argue that past cash flows are the best predictor of future cash flow, they want to buy something that has been proven, not pay for potential. In fact, one argument that we hear from buyers is that if they manage to increase revenues or profits it will be because of their hard work. Of course, there is an element of truth to the argument that future increases in cash flow are the result of the new owner's efforts but there are a number of places where future cash flows can be argued to be the result of the acquisition.

#### Synergies and Economies of Scale

When a business is acquired it may be able to buy materials in bulk and reduce costs. Many functions, such as payroll, accounting, information technology, and facilities management can be consolidated yielding cost savings. In some cases, locations can be closed.

#### New Products and Services

If the company being sold has developed or acquired new products that are not yet producing revenue then an argument can be made that the revenue from those products should be adjusted for. However, in high technology industries such as software a buyer will not accept that argument unless the new technology goes above and beyond the normal R & D needed to stay current and competitive.

#### New Customers and Contracts

If there are major new customers, especially with signed contracts, that will materially change the financial performance of the company that can be a reason to base the sale on future projections instead of past performance.

#### Increased Investment

If the company being acquired has made major investments that will improve its financial performance then future cash flow projections should be used. For example, if new machinery has just been installed that will allow a manufacturer to make twice as many widgets an hour, the widget manufacturer can argue that future cash flows will be far higher than past cash flows. Buyers will sometimes counter that argument with the argument that becoming more productive is a normal part of doing business. All widget manufacturers are becoming more productive, they will claim, and prices will fall as a result of the industry's increased productivity. Be prepared to demonstrate that your investment really is extraordinary and will pay off with increased cash flows if you are arguing that you deserve to be paid for a past investment.

### Adjusting Future Cash Flows to Present Value

Once you have forecast future cash flows you discount them back to what they are worth today using the following formula:

For each period (usually we use annual numbers)

PV = FV/(1+r)^{n}

Where PV is the present value, FV is the future value, r is the discount rate, and n is the number of periods.

After the last period that has been forecast, we need the value of the enterprise. Some buyers, such as private equity groups that plan to flip the company in three to five years may forecast a terminal value (what they think they will be able to sell the company for at that point) but we prefer to assume that the business will then become a perpetuity (or a growing perpetuity where growth is assumed to approximate the historical growth rate of the industry)

For the final value - the perpetuity that we assume at the end the formula changes a bit to

PV = (PP/r)/(1+r)^{n}

Where PP is the perpetuity payment.

Or if the perpetuity is growing we can include the growth rate by adjusting the formula as follows:

PV = (PP/r-g)/(1+r)^{n}

Where g is the growth rate of the perpetuity.

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