In today’s frothy buying atmosphere, it’s not uncommon to see unicorn startups valued at 100x revenue. While the majority of middle market owners recognize these multiples aren’t realistic, it’s still seductive to read about companies in your industry that were acquired for a high premium and think: that could be me.
In the world of middle-market deals, sophisticated buyers generally value companies more rationally, turning to a range of methods to determine what they’ll pay for a company. As a seller, you want these valuations to work to your advantage so you can secure the best price.
The most popular valuation methods measure very different aspects of your business, though each have shortcomings. One method stands out as being particularly out of touch: discounted cash flow, or DCF.
The DCF approach shows your company’s intrinsic value, which is equal to the sum of your future cash flows. A potential buyer then applies a “discount rate” equal to the time value of money (it is assumed that money is worth more in the present than in the future), as well as the uncertainty of future cash flows — the greater the uncertainty, the higher the discount rate.
Falling Out of Favor
DCF is seen as a reliable way to measure the true value of all aspects of a business without having to factor in short-term influences, like taxes. Sellers with high-growth companies appreciate this because it shows strong potential future cash flows, aiding in their asking price.
But many finance experts say the DCF method is not realistic because it’s impossible to estimate future cash flows beyond the first couple of years. For those reasons, DCF is losing ground as a valuation tool among buyers, and has been for some time.
“It’s not dead yet, but fortunately the number of people who are becoming aware that the DCF method is an intellectual scam is growing,” says Arturo Cifuentes, an adjunct professor of business at Columbia University.
“DCF attempts to use one parameter — the discount rate — to manage two different things, the value of money over time and uncertainty in cash flows,” Cifuentes explains. “It does not work.”
For the most part, experts agree.
Another giant challenge with DCF is its overreliance on the company’s terminal value, which is used alongside the discount rate. The terminal value, which assumes a company will generate free cash flows forever, captures the long-term cash flow value of a business at the end of the typical projection period of five or ten years. Depending on the circumstance, the terminal value can comprise 50% to 75% of the value in a DCF analysis. But not every company — or any company, really — will last forever.
“The DCF is more reliant on the terminal value and less reliant on the value of the near-term cash flows that you can predict with greater certainty. You may have a good idea of what your cash flow will be for the current year and the following year, but beyond that, your ability to project earnings and cash flow diminishes rapidly,” says Scott Stone, Principal at Butler Snow Advisory, a strategic advisory firm based in Birmingham, Ala.
Another problem: The discount rate is a static analysis that doesn’t account for a changing, global world in which interest rates, risk premiums, and risk free rates are constantly in motion.
What’s Next for DCF?
For sellers, the DCF model still has some runway. An advisor may recommend using DCF to show buyers how your revenue will grow over time and can help you create a forecast of future earnings, taking into account sales growth, profit margins, capital expenditures, working capital and more, adjusted for the discount rate.
But Aswath Damodaran, who teaches finance at the Stern School of Business at NYU and writes frequently about the myths of this valuation method, says sellers should use DCF with caution. “DCF models are less analytical devices and more sales tools, backing up a recommendation to buy.”
If you are using the DCF, the more specific you can be, the better. “Documenting how your business will generate future cash flows will put you in a much stronger position than a business owner who simply relies on industry average multiples and past trends,” says Butler Snow Advisory’s Stone. “And if you can explain and defend the intrinsic value of your company you’ll be able to quickly assess if a proposed purchase price is reasonable or not.”