Looking to sell your business? A discounted cash flow valuation model is the preferred investor method of a more in-depth business valuation, referred to as a DCF-model. Here is how such a model model is built by investors.
What is discounted cash flow valuation?
A cash flow valuation model gives the enterprise value, discounted to today’s money terms, based on your estimated future cashflow. Deducting the company’s net debt from the enterprise value gives the equity value, i.e. the value of your shares.
A discounted cash flow valuation is forward looking. Usually 10 years of which the first 3 – 5 years is most important. A buyer or investor will therefore need to understand and access how you come to your estimated future cash flow. The detailing of your business plan, your market, your growth and organizational assumptions will be important.
Read more: How to value a business.
Understanding financial models
The cash flow valuation model is usually made in Microsoft Excel with inputs from your business plan. Investments being capex and your estimated working capital will also have to be included. This is what makes a cash flow valuation model more accurate than only using an EBITDA-multiple valuation.
It is true that a ten-year forecast used in a cash flow valuation is no more than a best estimate. The same uncertainty as with an EBITDA-multiple valuation where the size of the multiple is a proxy for future growth.
At some point, most entrepreneurs needs to support an important business decision with a valuation. This could be to estimate the merits of a tender offer or a production facility investment. A discounted cash flow valuation can be handy also in these circumstances.
Financial models are essentially just tools to help people make more informed decisions. These decisions often boil down to valuing a company, an investment project or potential business opportunities.
Cash flow valuation modelling tools
The most commonly used tool for financial modelling is Microsoft Excel. This is not to say that there isn’t a plethora of online tools that provide simple valuation services. For those tools, you purchase a subscription and you’re all set. However, because of their simplicity and because you often have no insight as to how the calculations are done their effect is limited.
But what do you need to build your own cash-flow valuation model? We’ll answer this question and look at the input required, how to project future cash-flow, how and why you discount the projected cash-flows and more.
The goal? At the end of this guide, you’re ready to start developing your own valuation model. Let’s dig in!
This guide includes a look at:
- Your business plan and why it matters for financial modelling.
- The required financial input.
- How to build your financial model.
- Long-term normalized growth.
- Gordon’s growth formula.
- How to determine the discount rate.
- How and why you should discount cash flows.
The business plan is the basis for the cashflow valuation model
The starting point for a cash flow valuation model is the business plan. We use the business plan, supported with previous years financial accounts and current budget, to estimate future revenues and expenses. That gives us the estimated annual EBITDA for the coming years, i.e. Earnings Before Interest Depreciation and Amortization. A high-level proxy for company cash flow.
Additionally, we need to estimate necessary working capital since this is an important use of the EBITDA cash flow. This can be a bit tricky but worth spending time on. Working capital impact how much free cash flow you have. Most business plans focus on activities and sales but understanding sourcing, operations, distribution and their lead-times gives working capital insight.
Spend time to understand your business plan, or the targets business plan if you’re a buyer, and to understand these operational areas as well. This is also worth about thinking of if you prepare a business plan as part of an exit preparation. Not everything needs to be included in a business plan. In depth management presentations and Q&A sessions are equally important to a buyer in exit situations.
Usually growth is forecasted and necessary investments, i.e. capex, would therefore needs to be estimated as well, further consuming some of your cash flow.
Finally, take a step back and consider if the ten-year cash flow forecast is realistic and the most relevant case. Going back to the business plan and challenge market assumptions and execution will be important to reach comfort. For a buyer, additional value may come from revenue, opex or capex synergies.
Read more: Curious about the value of your business?
What should the financial plan include?
Most companies don’t have a multi-year financial plan. They really on a business plan and a one-year budget.
If you’re a seller of a business, you need to provide enough information so that a buyer can build a 10-year financial plan. That plan is the Microsoft Excel financial forecast that we discuss, complemented with
financing ideas and tentative plans.
For startups and high growth businesses such financing plans can include estimated necessary new share issues and equity funding. For mature businesses, such financing plans can include ideas and plans for working capital financing, supplier credits and extension of payment terms.
While you can’t know what will happen in the future, you can certainly predict it by making informed estimates about possible outcomes.
Ideally you have a financial plan as part of your growth planning. In particularly if you plan to growth fast year-on-year. Such a financial plan should contain a cash flow projection for the coming years. Annual estimated sales, expenses, investments and potential capital requirements shall be included. It should be revised annually to take deviations, new ideas or business opportunities into account.
Essentially, your financial plan should be in continuous development in the same way as a 12-month rolling budget. Working capital management and free cash flow is often key for successful rapid sales and delivery growth.
Required financial input for a cash flow valuation model
Once you have your business plan, your capex planning and your financial plan, you have the foundation to build a cash-flow valuation model.
Cost is not cash flow, but expenses is
Cash-flow and profit are two very important, but different financial parameters. Profit does not tell you how much cash you end up with at the end of the year. Why? Profits include accounting costs such as depreciations of assets on your balance sheet.
Financial professionals look at expenses, cash paid, and not cost when assessing cash flow.
Cash flow starts with your profit and loss statement. EBITDA is a common proxy for operational cash flow and excludes cost items such as depreciations. You will also need to deduct your working capital, your investments and non-operational expenses such as interest, amortization and tax. They are all cash flow items.
Free cash flow is the net cash flow before any financing. This is where wealth is built. This is the cash flow you shall keep track on. Free cash flow is what you build a cash flow valuation model upon.
In a valuation exercise, we’re only interested in cash flow.
Avoid hockey-stick assumptions
When you start projecting future sales and expenses, focusing mostly on sales growth in percentages is a common mistake. Why? Because it’s easy to build in hockey-stick assumptions in your cash flow valuation model. This happens when your sales continue to grow at a faster rate than your expenses and need for working capital. This is not realistic and can be seen in ever-expanding gross margins and EBITDA margins.
Always make a check row of your gross margin and your EBITDA margin in your Microsoft Excel sheet.
Be mindful that many components of your indirect expenses grow in incremental steps. Office rents is one such example.
Consider this. Your company may have an after-sales customer service organization that has surplus capacity. This gives you the incentive to increase your sales force because you will be able to create sales growth without adding more to the after-sales organization. However, this is only true to a certain point, after which you will need to invest. Be wary not to create hockey-stick projections, where margins are ever-increasing because any outside analyst will disregard them as unserious.
Include interest expenses and taxes paid
The next part you will want to add to your cash flow valuation model is interest expenses and taxes paid. This can be done relatively simply, especially if your company is stable and not expanding aggressively through debt-financed investments.
In any case, interest expenses are items which, if modelled correctly, should be linked to the cash-flow analysis.
Model the relationship between the interest-bearing debt, interest expenses and the appropriate debt amortizations over time, as a control check. These items consumes liquidity in your company., in particularly if financing expansion with debt.
Don’t neglect your working capital
Working capital is the net sum between your receivables and payables, plus your stock, inventories and work in progress.
You tie a lot of working capital to your operations if you have long lead-times between the purchase of materials and components and the final payment of the finished product. Lean production may solve your stock and inventory levels, but you also need fast processes and distribution. Capital is locked in operations until you get paid with money at the bank.
When you build a cash flow valuation model you need to estimate the working capital change between the years. Receivables and payables terms of payment may not change but stock, inventories and lead times is always a moving target unless utterly managed.
Assume you have 10 MUSD in working capital year 0, last year. If working capital is assumed to increase with 1.5 MUSD year 1 then it’s 1.5 MUSD that is the negative cash flow effect for that year.
Working capital understanding and management can be a difficult area involving financial understanding but also your operational processes and contractual terms. Neglecting your working capital is destinated to be a growing drain on your cash flow. Not spending time on considering the behind’s of working capital when making a cash flow valuation model gives the wrong value.
It’s not uncommon for fast growing and profitable businesses to come into sever liquidity problems because cash flow is shrinking. Not keeping an eye on lead times, contractual terms, stock and inventories, i.e. the working capital, is a big challenge to growing businesses.
Buyers and professional investors spend a lot of time trying to understand your working capital need. In particular if you’re a growing business. Valuation upsides as cash flow improvement potentials, can often be found in how working capital.
Building your cash flow valuation model
Let’s review the main components of the cash flow valuation model again: Sales, gross margin, indirect expenses, interest and tax paid.
On the balance sheet, you need to focus on tangible assets, receivables and cash, equity, interest-bearing debt and payables to build your complete cash flow valuation model.
It’s highly recommended you build your model with the flexibility to easily change e.g. growth parameters, interest rates, investment plans, dividend payments, drivers of receivables and payables. It’s common to collect these parameters on a separate assumptions sheet in your Microsoft Excel file.
Perhaps you’ll encounter a unique project or growth opportunity and you want to quickly incorporate it into your financial projections. Or your bank will ask you for a sensitivity analyses around key components. It’s always good to be flexible.
Pro tip: Make sure you link your profit and loss statement, balance sheet and cash-flow statement together with Microsoft Excel formulas so that you always have a full financial statement. It makes it easy to check if you’ve included everything – the balance has to make sense. Any changes in sales, expenses or investments will also automatically update your cash flow forecast, and also for the coming years.
Financial model vs cash-flow valuation model
You have the basic financial model and you already have almost all the input/output you need to develop your cash-flow valuation model. What’s the difference? For valuation purposes, we are interested in a very specific cash-flow concept which is called “Free Cash-Flow” (FCF).
FCF represents the cash generated in a company and available to all stakeholders providing capital to a company. These stakeholders include shareholders, debt providers and other investors.
From our diagram above, FCF is easily deduced. From EBITDA, you deduct taxes paid, net change in working capital and investments.
Since FCF is not financed, you do not deduct interest expenses, as these are part of the funds available for debt holders.
Long-term normalized growth and Gordon’s growth formula
We are looking to use a cash-flow valuation model to derive to the value of our company, in today’s money terms. But most often, there is no point in trying to guestimate specific developments beyond ten years from now, or 3 – 5 years for startups or companies in fast changing markets.
Instead, a typical cash-flow valuation will include a long-term normalized growth rate for all key components beyond five years. How do you do that?
Like this. This final period is called “year 6” or “year n”. In this year, it’s very important not to overstate sales growth, to retain profit margins at a reasonable and sustainable level. This is because this final period will be the basis for calculating the perpetuity value or “terminal value”. The terminal value is then discounted to a net present value along with the yearly free cash-flows of year 1-5. It basically considers the fact that your company will not cease to exist after year 5.
The most common method for deriving to the terminal value is Gordon’s growth formula. In year six the terminal value is calculated as follows:
Terminal Value= FCFF year 6 x (1 + long term growth rate) / (discount rate less long term growth rate)
We can also illustrate above terminal value formula in numbers: Terminal Value = 100 USD x (1 + 2%) / (10% less 2%) = 1,275 USD
Immediately, it becomes apparent that given the nature of the formula, the terminal value of 100 USD free cash-flow becomes rather significant. The value obviously has to be discounted to a net present value of today, but still, terminal value is an important element.
How to determine the appropriate discount rate
In the formula used above, one item stands out. Discount rate. This is the rate we use to discount the values of future free cash-flows to a net present value of today.
The discount rate is the cost of capital for the one making the cash flow valuation modelling. Be it a buyer of a business, an investor or you as a founder and owner.
The most typical discount factor used in a cash-flow valuation model is the Weighted Average Cost of Capital, short WACC. The WACC is not one specific rate applicable to all companies in all industries. It fluctuates over time to reflect the economic climate. It varies depending on whether your company is publicly listed or privately held. It’s also impacted by the debt-to-equity ratio in your specific company.
The WACC is calculated as follows:
E = Market value of equity
D = Market value of debt
V = E + D
Re = Cost of equity = (Market risk premium x Beta-koefficient) + Risk free rate + Unsystematic risk factors
Rd = Cost of debt
T = Corporate tax rate
Some of these components can be found as indications in publicly available, annually updated equity research papers. This includes generally used market risk premiums, commonly used risk free rate and a common small stock premium (for small listed companies).
Read more: Investors financial return requirements.
How advisors will do, and what you can do instead
It’s up to every investor to decide his or her’s own WACC. His or her’s cost of capital.
Financial advisors usually advise you to align with other similar investors looking at similar investments. They help you calculate a WACC based on current and similar stock market prices and argue that the specific WACC is the current cost of capital. That is correct for a cumulative financial market but it’s certainly so that investors are free to assume what ever cost of capital they may. As long as you have a positive return on your investment.
Some investors see less risk than others and can accept lower cost of capital. Some like to deliberately set a high cost of capital to play down the value of a specific asset.
A low WACC gives a low discount effect of future cash flows, i.e. a high present value of a future cash flow. A high WACC gives a high discounting factor and hence a low present value of a future cash flow.
Market value of equity
Market value of equity is the total equity value of a business, also known as the market capitalization. I.e. the calculated enterprise value of a company less it’s net debt position.
Market value of debt
The simplest way to come to the market value of a companies debt is to sum the outstanding debt with all future interest payments that shall be made before the debt is fully amortized. Think of it as a pre-payment of a fixed interest loan where the bank would request you to repay the loan plus all the interest payment you should have paid should you not have pre-paid the loan.
The Cost of Debt
The Cost of Debt is simply the interest rate which the company pays on interest-bearing debt. If you are the owner of the company, you probably know the exact terms of the company’s debt agreement with the bank. Otherwise, the cost of debt can be derived from the credit rating of the company.
The Cost of Equity
The Cost of Equity is slightly more tricky. It represents the return required by equity investors. Deriving the Cost of Equity follows the Capital Asset Pricing Model (CAPM), on which there are plenty of research that you could read.
The Market Risk Premium
The market risk premium as well as ranges of various unsystematic risk factors, such as small stock premiums, can be found in annual equity research published publicly by e.g. PWC and Duff & Phelps. The Beta-factor is more elusive.
The Beta-koefficient is a way to compare your specific company’s annual share returns to overall general market returns. If your company generally has less stable returns than the general market, your beta-koefficient should be higher, e.g. 1.2 or 1.3 relative the market. Bloomberg derives raw historical betas, which can be used as indicators.
The risk free rate
The risk free rate is supposed to represent the return you would achieve if your investment yielded exactly what you expected. A widely used proxy for a risk free return rate is the YTM of the 20-year US treasury bond. In a European context, we tend to use the 10 or 20 year government bond. The reason for using a long state-controlled bond is that in theory, if they are held to maturity, the risk of default during this period is considered negligible.
Unsystematic risk factors
Unsystematic risk factors include small stock premiums. This represents that a smaller company with less income and fewer products inherently is more risky to invest in than larger corporations. Another factor is the lack of capital access, indicating that privately held companies have fewer funding avenues to use than publicly traded entities.
Discounting cash-flows – how and why
We use the WACC to discount our estimated, future and annual free cash-flows to a certain valuation date. The simple reason why this is done is because our financial projections represent nominal values. That means that the EBITDA in 2024 is expressed in 2024 monetary values.
We are considering today to sell or buy or finance a company, which means that we need to bring back the values to today monetary terms. We use the WACC as discount factor because it includes the inherent risk associated with future cash-flows.
Below you’ll find a simple example of how we use the Gordon’s growth formula and the WACC to discount future free cash-flows to our chosen valuation date:
The sum of our discounted free cash-flows represents our enterprise value, not our equity value.
Why? In layman terms because a buyer buy’s the entire company including all it’s debt, not only the shares. The equity value, i.e. what a buyer will pay you as the shareholder, is the enterprise value less the compan’s net debt. Net debt is the company debt and any future non-funded pension obligations less cash at the bank.
Financial professionals sometimes uses the term “debt and cash free basis” when referring to the value of the shares.
Final remark: Simple vs. complex cash-flow modelling
In this article, we’ve touched on the basics of how to develop a financial forecast for your company. We have discussed the concept of free cash-flow and why it’s used in a cash-flow valuation.
A financial projection model can be relatively simplistic, similar to above table. It can also include endless complexities.
Consider this example: you can forecast a car manufacturer’s financials simply by using previous years’ EBITDA and increasing it by X% annually, assuming steady state regarding new models, investments etc. You could also model the revenues to allow you to make assumptions on the average price per car and the number of cars produced. Or you could go even further to include price declination on specific models to reflect life-cycles. The same goes for cost development.
A financial projection can become incredibly detailed but there are many positive things to be said about cash flow valuation modelling.
A cash flow valuation model can be used to create an in-depth understanding of the many drivers of economic value in a company. Similar to that of a business plan where the actual process to produce the business plan is often where the insight and value is created.
Does a complex financial projection provide a significantly higher degree of certainty? Or does Occam’s razor apply – the simplest of equations should always be preferred?
That’s up for you to decide.