The DCF method: what does it involve?

In a company acquisition, it is important for both the buyer and the seller to know what the company in question is worth. A business valuation can also be important in disputes and tax matters. The DCF method is a commonly used method for calculating the value of a company. DCF stands for Discounted Cash Flow. The DCF method focuses primarily on what a company can earn in the future. The past plays only a limited role. Below, we will discuss what this popular method entails and what steps it consists of.

How does a DCF valuation work?

Although it does not play a major role in a DCF valuation, you do start by looking at the past. To paint as realistic a picture as possible, the year-end accounts are normalised. This means that they are adjusted for incidental or non-market-related items. These are items that make the result appear more negative or more positive than it actually is, creating a false impression of profitability. The balance sheet items are examined in the same way. The normalised financial statements form the basis for further calculations.

The next step is to map out future cash flows. This is often done for a period of five years. The future incoming cash flows are then settled with the outgoing cash flows, which yields the free cash flow. This is converted into cash using a required rate of return. Finally, you can use the required rate of return and the future cash flows to complete the formula for the DCF method. The result of this formula reflects the valuation of the company based on future cash flows.

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Advantages of the discounted cash flow method

Applying the discounted cash flow method has the following advantages:

Because this method takes the future into account, it provides the most accurate picture of a company’s value.
It is a flexible method that can be adapted to different companies.
The method can play a supporting role in investment decisions.
The DCF method shows how a company is performing, making it possible to identify areas for improvement.
It is a useful tool for strategic planning. Future cash flows are mapped out, which makes it easier to make decisions about future investments.

Two side notes about the discounted cash flow method:

It is important to use reliable starting points for future cash flows. Only then can you gain a good understanding of the value of the company.
Applying the DCF valuation method is quite time-consuming. It is therefore wise to outsource this task to a party with extensive experience in this matter.

Example: discounted cash flow valuation in practice

The DCF method is a useful way to determine the actual value of a company. The example below shows how to carry out a discounted cash flow valuation.

Suppose a technology company expects free cash flows of €300,000, €400,000 and €500,000 in the next three years. Starting in year 4, stable annual growth of 3% is assumed. The discount rate (required rate of return) is 9%. Each cash flow is converted into cash separately, as is the calculated end value from year 4 onwards. This end value is determined on the basis of: €500,000 × (1 + 0.03) / (0.09 – 0.03) = €8,583,333.

This end value is then converted to present value, resulting in approximately €6,644,000. Together with the present value of the cash flows in the first three years (approx. €1,003,000), the total discounted cash flow valuation of the company amounts to approximately €7,647,000.

By carrying out a DCF valuation, future cash flows are translated into their current value, giving you a solid basis for negotiations in the event of a sale, investment or acquisition. BrightOrange is more than happy to apply this method to your situation.

What other methods are there besides the DCF method?

Besides the DCF method, there are a few other ways to figure out how much a company is worth. Depending on the situation and what the goal is, you decide which method works best. This could even be a mix of a couple of methods. For example, there are multiple methods like EBITDA and EBIT. These help you figure out how much a company is worth based on the price paid for similar companies. Multiple methods are quick and easy to apply, but this also makes them less accurate. Another disadvantage is that it can be difficult to find transaction prices for other companies. These are not always publicly accessible.

Another method is the intrinsic value calculation. This is simply the difference between a company’s assets and liabilities, or its own equity. The downside of this method is that it doesn’t take future income into account. The profitability method pays more attention to this. With this method, the current value of the expected profit is determined.

Business valuation by BrightOrange

At BrightOrange, we have years of experience in business valuation, including the DCF method. Feel free to contact us for more information. We can support you when acquiring or selling a company and are happy to help you close a successful deal. Rely on our specialists.