Corporate valuation using the discounted cash flow method

 

 

There are many different methods to choose from when it comes to valuing a business, and these methods are often based on different assumptions and logic. In most cases, it would be most profitable for an investor to use the discounted cash flow method (DCF).

It’s not always easy to fully assess the profitability of a company as accounting practices in many countries allow for tricks that can alter a company’s reported annual result. Similarly, when preparing to sell a business, it’s common for companies to inflate annual profits and budget for a turnover increase in the upcoming years. The purpose of this is to win over the future investor and reassure him about his acquisition plans.

By using the discounted cash flow method, you allow for the value of the company’s future performance to be estimated on the basis of the after-tax free cash flow. One of the objectives of the discounted cash flow method is to give the buyer a clearer overview of the return and the future profits of the business. So, by using this method, the business is valued as being worth what it will bring in. In contrast, the net accounting assets method will show the current business value. The discounted cash flow process is almost only suitable for established businesses that have been making steady, growing profits for several years, for start-ups and for companies looking to raise funds to launch new activity.

This particular choice allows for a specific view of the company’s cash flow fluctuations and thus reduces the consequences of so-called non-cash accounting transactions, such as depreciation, provisions, etc.

In line with the recommendations of the Federal Tax Administration in Switzerland, it’s suggested that a detailed budget should be created for the coming years (between 4 and 10 years). If short-term investments are planned, the budget should integrate the entire life cycle of these investments in order to understand the impact of their expenditure on the company’s cash flow.

The discounted cumulative cash flow over several years will help to better understand the future value of the business, leading to a different assessment of share value.

The investor will see the value of the money generated by the acquisition and not the accounting benefits, which will focus on optimizing the profitability and taxation of the company. This should reassure him as he will understand that his acquisition will produce a cash surplus and therefore a more secure return on investment.

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