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In an academic setting, a discounted cash flow model sounds like a completely reasonable form of valuing a business.  You project out the anticipated cash flows for 5-10 years, use a discount rate and look at what those future cash flows are in present day dollars. 

The formula for this is usually given something like this:

PV = CF₁ / (1+k) + CF₂ / (1+k)² + … [TCF / (k – g)] / (1+k)^n-1

So, what’s wrong with that?  Not much if you’re looking at bond or an annuity, but everything is wrong if you’re using it to value a company.  Let me explain:

About the farthest that businesses project into the future with any degree of certainty is two or three years.  The business environment is simply changing too fast to predict out much further.  It also assumes that cash flows will be constant or at a pre-defined growth rate in the future.  Anyone who owns or runs a business knows that while it is important to budget, reality never works out like we plan. Plus, most businesses experience ups and downs in the earnings.  Finally, it assumes that the growth rate and discount rate selected will hold in perpetuity, making it extremely sensitive to small changes as reality unfolds over time.

So, if you’re still with me, let’s look at how buyers actually buy businesses.  They won’t buy without potential, but they don’t pay for it.  Buyers buy businesses based on what has actually happened to cash flows in the last three years, not what the seller says might happen 10 years from now.

Why am I warning you about the discounted cash flow model?  Because it is being used by academic types (either standalone or in conjunction with other methods) to value businesses and sets seller expectations WAY too high.  The seller gets their hopes up that maybe their business really will sell for that much and when reality sets in they are disappointed and deflated. 

Don’t set yourself up to be disappointed.  Have your business valued by an experienced business broker who has to live with the results they give you.  Value it too low?  They are leaving money on the table along with you.  Value it too high?  They are working for free because offers won’t come.  Value it correctly?  Everyone wins.  Our interests are aligned.

There ARE instances where a discounted cash flow method is appropriate, but not for the average small business looking to establish a reasonable selling price.  Most buyers are looking at a multiple of historical earnings and the feasibility of leveraging the deal.  As a mentor of mine once said, “if it can’t service the debt and put food on the table, it won’t sell.”

When you’re ready to find out what your business is worth to potential buyers, contact us.