Understanding Your Company's Finances
Business owners have multiple different options when looking to find the value of their business. The Discounted Cash Flow Analysis is a way to determine the value of your company by looking inward at your company’s finances. Unlike the other valuation methods the discounted cash flow analysis does not require financial information from other comparable companies. This type of analysis is perfect for private companies competing with other private companies. This is because most private companies’ financial information is practically impossible to find. Therefore, discounted cash flow analysis is a perfect tool for businesses to determine the valuation of their company without the burden of uncovering outside information.
Previously, we talked about the multiple different types of business valuation methods and the pros and cons of each method. Our past article lays out what type of method may be useful for your specific business. This article is going to lay out how to calculate the valuation of your company using a discounted cash flow analysis. Discounted cash flow analysis translates future cash flows that you are likely to receive into their present value to you today. This is based on the compounded rate of return you are reasonably expected to achieve with your money today.
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Once you have the equation for discounted cash flow analysis, you can start plugging in your own information. First, DCF stands for discounted cash flow and it is what you will solve for when determining your business’ valuation. Next, CF stands for cash flow. It is the amount of money coming in and out of the company. The n represents the period of time. In the equation the 1 and 2 represent the first and second year. A business owner can use as many projections as they want in this type of analysis. Business owners can project, 5 years, 10 years or more. Finally, the r stands for the discount rate. This is the target rate of return that you want on an investment.
It is common to use the weighted average cost of capital for r in the equation. The weighted average cost of capital (WACC) is the rate a company pays to finance its assets. WACC includes the average cost of a company’s working capital for taxes. The WACC takes into account the average rate of return that a business’s stock and bondholders expect. Furthermore, it can include bonds, long-term debt, or common and preferred stock.
Using Discounted Cash Flow Analysis to Determine the Fair Value of Your Business
Once you have gathered all the relevant information, you can start to calculate the discounted cash flow. In this article, we are going to walk through a real-life example of business valuation using the discounted cash flow formula. However, we have changed the name of the business to protect their privacy. We are going to calculate the fair value of a private business called Carrie’s Cupcakes. Carrie owns Carrie’s Cupcakes and is looking to sell her business in the next few years. However, Carrie is unaware of how much her business is worth. Carrie wants to know how much her business is worth now to strategize how to negotiate the sale of her business. This article shows how Carrie can calculate the value of her business using internal information pertaining to her business.
Carrie’s Cupcakes brings in $500,000 per year in free cash flows. Carrie's Cupcakes is also growing at a steady rate of 5% per year. To calculate the business’s cash flow or CF, you would multiple 500,000 x 0.05 to get 5% of 500,000. This gives you $25,000 so next you would add $25,000 to $500,000 giving you $525,000 which is the value of CF2. Next, to calculate CF3you solve for 5% of $525,000 and add that to the 525,000. This gives you $551,250 for CF3. These steps can be repeated for as far out as you would like to calculate. However, we are going to stick to calculating three years out. Once you have calculated the cash flow you can start to calculate the fair value of your business. Here is what the calculations should look like:
Carrie’s Cupcakes is a private business with low liquidity, therefore we are going to go with a target compounded rate of return of 15% per year. Now, all we need to do is plug this into the DCF equation.
In this example, Carrie’s Cupcakes’ value would be $1,194,214 over a three year period. As a business owner looking to plan for the future, this valuation is helpful when looking at selling, merging, or just strategizing. This information can turn any inexperienced business owner into a knowledgeable negotiator and strategist in no time. There are also some free websites that can help you calculate these equations yourself. Once you have the data needed you can just plug those numbers in and calculate the value of your business. At the bottom of this article, we have linked these sources for you.
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