THE DISCOUNTED CASH FLOW METHOD

This is a more sophisticated valuation method and is preferred because it captures all the variables. Basically what we are doing is taking projected cash flows for a reasonable period (generally 3 to 5 years), discounting these back to the present value using a discount factor. We then determine a termination value for the cash flow beyond our forecast period, capitalize that and then discount this amount back to the present using the same discount factor. Adding the two together gives us the enterprise value. As in the Multiple of EBITDA Method, we then deduct the interest bearing debt to arrive at the shareholder value.

The discount rate is the required rate of return for a given period of time and a given perceived risk. Generally we use the nominal rate which includes inflation. A typical range is 10 to 15%, which is greater than we see from the stock market, which makes sense given the higher risk of investing in small enterprises. The capitalization rate is the discount rate less the growth rate (generally 2 to 5%).