Podcast Transcript

For this episode we will be discussing two different valuation methods. We will break up the episode into two parts, in part A we will look at the Discounted Cash Flow Model and in part B we will look at how to calculate the Liquidation Value of a business.

In this episode we will look at the Discounted Cash Flow method, we will be applying many of the topics we have discussed in previous episodes such as; Discount Rates, Cash Flow and Growth, so if you have not already listened to those episodes I would recommend you go back now and have a listen.

The Discounted Cash-Flow Method is one of the most popular and widely used valuation techniques. It is basically the addition of all future free cash flows which have been discounted annually by the Discount Rate, which we discussed in episode 5 of the podcast. This will give us the present value of all the future free cash flows generated by the business. The sum of these free cash flow figures is the company’s Intrinsic Value. We discussed Free Cash Flow in further detail in episode 7 of the podcast.

The Discounted Cash Flow formula comprises two parts; the first part is used to calculate the Intrinsic Value of a business during what is generally referred to as the High Growth Period, where the company may have higher but potentially inconsistent free cash flow growth rates. This period is usually calculated to no more than 10 years. The second part is used for the Terminal or Stable Growth Period of the company. This is generally a more conservative estimate of a consistent rate of growth that can be expected for the remaining life of the company. A stable growth rate at or just above inflation is usually acceptable, between 2% – 5%. We discuss growth and how to calculate it in more detail in episode 8 of the podcast.

So, to start, we need to decide on how much Free Cash Flow the business is able to produce over the expected life of the company. We begin by using the latest calculated Free Cash Flow figure as a good basis to project out the likely future Free Cash Flow the business is expected to generate. To do this, we need to decide on an appropriate rate of growth. We can look at past performance and project that forward, making sure we account for the past and present economic environment and also what phase the business was in. For example, has the business been rapidly expanding for the last five years or has it just returned a subdued rate of growth that is more inclined to larger businesses. Also, has the economy been progressing strongly providing a good economic environment for the business to thrive. Each of these factors, plus many more, will have a great impact on the historical and future growth rate of a business, so it is important to have a firm grasp in understanding the business.

Now that we have decided on a rate of growth, we need to consider how long is reasonable to expect this growth rate to continue. I would suggest no longer than 10 years, assuming the high growth rate is greater than 2% – 5%. Let’s say we calculated that the business can be expected to grow at a rate of 10% a year for the next 10 years. We now increase the current Free Cash Flow by 10% each year for the next 10 years. If for example, we had a Free Cash Flow figure of $1.00, we would increase this in year one by 10% to $1.10, then in year two by another 10% to $1.21 and so forth until in year 10 we have $2.59, which is the projected Free Cash Flow the business is expected to produce in 10 years time. These calculated Free Cash Flow figures are what we call the High Growth Period for the company and are the first part of the Discounted Cash Flow Model.

We are now required to find the present value of these future Free Cash Flow figures. This is because $1.00 received in 10 years time is worth less than a dollar received today due to inflation and opportunity costs. So, to account for this and to not overvalue the business, we need to discount each future Free Cash Flow figure to a present value. We will use a 12% discount rate, as described in episode 5 of the podcast, this 12% rate accounts for inflation, opportunity costs and investment risk.

So next year we project to receive $1.10 in Free Cash Flow, if we are to discount this by dividing the $1.10 of Free Cash Flow by 1 plus the 12% Discount Rate to the power of 1, where the power of 1 stands for the number of years into the future, we will have a present value of $0.98. For year two we calculated a future Free Cash Flow of $1.21, applying the same formula of; $1.21 divided by 1 plus the 12% Discount Rate to the power of 2, as it is now two years into the future, we get a present value of $0.96. We continue this for each of the ten years. In year 10 the present value of the $2.59 Free Cash Flow is worth only $0.84 today. Another way to look at it is to assume you invested $0.84 into a savings account that will pay 12% a year for 10 years, this $0.84 will grow to $2.59 in 10 years time. This is why we are willing to pay $0.84 today to receive $2.59 in ten years time because we will be receiving 12% a year for our investment.

The sum of all these present Free Cash Flow figures is $9.07 which is the Intrinsic Value of the business, provided it will only be in business for the next 10 years. Given the majority of companies intend to remain in business well past 10 years, we need to find out what the remaining value of the business is in these subsequent years. This is where the second part of the growth calculation comes into play. To do this, we assume the business will continue into perpetuity, meaning that it’s going to remain in operation forever. This may seem like a big assumption and result in overvaluing the business, but due to the way the Discounted Cash Flow formula works, by discounting all the future Free Cash Flows into a present value, after a few decades, the present value of the Free Cash Flows become insignificant to the overall Intrinsic Value of the company. As an example, we will continue with the business which produced $1.00 of Free Cash Flow and subsequently grew by 10% a year for the next 10 years. We will assume that after 10 years this business was to grow into perpetuity at 3% a year. In this scenario, the business Intrinsic Value is $18.63, so an additional $9.56 of value has been added to the remaining life of the business past the initial 10 year period. Let’s say, rather than assuming the business will survive forever it was to only last for 50 years, in this case the business will be worth $18.29. So there is only an additional $0.34 added to the business Intrinsic Value, or 1.8%, for all the Cash Flows the business is expected to produce from year 51 into perpetuity, pretty insignificant. Lets now assume that the business will only survive for 30 years, in this scenario the business will be worth $16.84. This is a difference of $1.79 in intrinsic value between the 30 year business and the business that will continue into perpetuity. Or in other words, 90.4% of the intrinsic value of the business comes from the next 30 years of operation, with the remaining 9.6% coming from year 31 into perpetuity.

I hope this example illustrates that, although it may seem like an over optimistic assumption for the business to continue indefinitely, in terms of valuation, it has little effect on the intrinsic value of a business.

Now, back to the second part of the Discounted Cash Flow model which is to calculate the terminal value of the business. To calculate the present value of the business into perpetuity, we take the $2.59 of Free Cash Flow the business will have produced in year 10 and grow this by 3%. This will result in $2.67, which is the Free Cash Flow the business is expected to produce in 11 years time. From here, we use a similar formula to the one used to calculate the high growth period, but this time we will calculate the present value of Free Cash Flows into perpetuity. We start with $2.67 and divide that by the 12% discount rate minus the 3% perpetual growth, then multiply this by 1 plus the 12% discount rate to the power of 11, with 11 being the number of years. This results in a present value of $9.56 for all the future free cash flows expected from year 11 onwards. If we add the $9.07 calculated from the high growth period to this value, it will result in an intrinsic value of $18.63.

It would likely be difficult to follow along with these formulas just by listening to the podcast, so I have a link in the show notes to some written examples of the Discounted Cash Flow formula CLICK HERE. You can also download my free eBook, “How to Value a Business” which works through two real world examples on how to calculate the intrinsic value of a business using the Discounted Cash Flow model.

Thanks for listening in and I look forward to speaking with you in Part B of the Valuation Methods podcast where we will look at how to calculate a business’s Liquidation Value.