Join Jim Stice for an in-depth discussion in this video Use discounted cash flow analysis to determine a company's value, part of Finance Foundations: Business Valuation.
- Already we have forecasted our friend's online retailing business will have free cash flow of $1,000 next year, computed as $2,200 cash inflow from normal business operations minus $1,200 cash needed for capital expenditures. But a business doesn't last for just one year, hopefully. What is our forecast of free cash flow after the first year? Well, in a complete analysis, we would extend our sales forecast and financial statement forecast for several more years into the future. My brother, Jim, and I teach a case about Home Depot in which we build a spreadsheet to forecast the operating cash flows of the company for the next five years.
In this simple example for this course, let's assume that we have forecast that our friend's company's free cash flow will increase $50 in each year for the next two years. So the forecast of free cash flows for the next three years are as follows: next year, $1,000, in two years, $1,050, in three years, $1,100. Now what about beyond our three year detail forecasting horizon? Well, this gets interesting, so pay close attention. We call this forecast in the terminal year.
Now, Bill Gates of Microsoft and Warren Buffet of Berkshire Hathaway are two of the cleverest businesspeople in the United States and are the two richest people in the United States. If you were to go into partnership with Bill and Warren and give them $1 billion, they probably would have enough great business ideas in their heads that they could take that $1 billion and start an innovative business that would generate cash flows with a present value far in excess of $1 billion. Now what if you were to give them another $10 billion? Do they have enough good ideas to be able to use that additional $10 billion to generate excess profits? What if you gave them $100 billion? The point is this, eventually even Bill Gates and Warren Buffet are going to run out of innovative ideas.
At that time, any additional investment funds you give them will be used in just an average way and earn just an average return, and the present value of the cash flows from any of those investments will exactly equal the amount of the investment. To use a phrase often used in finance, all that will be left will be zero net present value projects, projects that return exactly the average required rate of return. The key thing to remember is this, you don't increase the value of your business by engaging in average zero net present value projects.
With such projects, the discounted value of future cash flows is completely offset by the initial cost of the project. Instead, you increase the value of your business by using investment funds in innovative ways that earn above normal returns. Once a business has run out of innovative ideas, growth via new projects will not increase its value because the discounted present value of new projects is exactly offset by the initial cost of the projects. So once the terminal year is reached, when it's expected that the company will have no new above average ideas, the valuation impact of any additional growth can be ignored.
For illustration purposes, we will assume that our friend will run out of innovative ideas in his online retailing business after three years. After that, free cash flow will be assumed to be a constant forever $1,100. The business will still keep growing, but all of that growth will be through average projects that barely generate enough profit to pay the interest on the money borrowed to finance those projects. These additional average projects don't generate any surplus value for us, the owners, so we can ignore them as we value our ownership in the business.
All right, now it's time to put together both our free cash flow forecast and our risk adjusted interest rate of 20%. The present value of the free cash flows for each year for the next three years is computed as follows: first, year one, $1,000, the free cash flow, divided by one plus .2, .2 is the interest rate, to the first power, one year. That's $833. Year two, $1,050, that's the forecasted free cash flow, divided by one plus .2, .2 is the interest rate, to the second power to represent two years.
That's $729. And in year three, $1,100, the free cash flow, divided by 1.2 to the third power, three representing three years. That's $637. So those are the discounted values of the free cash flows for each of the first three years. What about after that? Well, our terminal year assumption is that any additional cash flows from growth in year four, year five, and beyond will only be enough to compensate for those providing the new financing needed to pay for this growth. So from the standpoint of the existing owners, free cash flow in year four, year five, year six, and beyond is assumed to stay a constant $1,100.
Now the present value of $1,100 to be received each year forever if the interest rate is 20% is computed quite easily. It's just $1,100 divided by the interest rate, .2. That's equal to $5,500. This $5,500 number means that the one lump sum equivalent of $1,100 each year forever is $5,500 if the interest rate's 20%. But we have one more little adjustment to do. This terminal value is computed as of one year before the first cash flow, so at the beginning of year four, which of course, is the same as the end of year three.
if we want the present value of this $5,500 as of right now, it must be discounted back three more years. The DCF analysis for this online retailing business indicates a value of $5,382 computed as follows: year one, the present value, $833 as we already saw. Year two, the present value of $729. Year three cash flow has a present value of $637, and the present value of the terminal value is $3,183.
Total, $5,382. Now does anything make you nervous about this DCF valuation? Yes! It's the fact that most of the value is in the terminal value, which is far enough out in the future that we don�t' have any precise forecast for what will happen in those years. Now this is always the case with DCF valuation. The large majority of the value is out in that black box terminal year. DCF analysis, or the income approach as its known in the appraisal literature, is the technique of last resort.
It's much better to use a price multiple if at all possible. A DCF analysis is very sensitive to the assumptions about interest rates and free cash flow growth rates. My suggestion, my strong suggestion, is that you try to do any business valuation with a price multiple, taking advantage of all the market information that you can.
Make sure to check out the Stice brothers' other accounting and finance courses to understand the other economic factors that impact your business.
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- Using market, cost, and income approaches to business valuation
- Valuing homes
- Valuing companies by multiples
- Using price-to-sales ratios to value companies
- Using discounted cash-flow analysis to estimate value
- Valuing McDonald's as a case study