Spotlight on Discounted Cash Flow
Spotlight on Discounted Cash Flow
As businesses pivot to market changes during the pandemic, valuation experts are increasingly likely to turn to the discounted cash flow method to estimate value. This method is advantageous in times of economic uncertainty because it provides flexibility if management expects short-term fluctuations in growth, revenue and expenses, leverage, working capital needs, and capital expenditures.
The International Glossary of Business Valuation Terms defines discounted cash flow as “a method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate.” This method entails the following three basic inputs.
1. Cash Flow Projections
When applying the discounted cash flow method, the first step is to project the company’s cash flows over a discrete period of, say, five or seven years. There are no prescribed rules for determining the duration of the discrete projection period. Its length is largely determined by the volatility of the subject company’s cash flows and discount rate. The end of the discrete projection period may coincide with stabilized business operations or a sale of the company.
When projecting cash flows, the expert considers several factors, including:
- The past financial performance of the business or of similar companies,
- Prevailing economic and industry conditions,
- Anticipated costs,
- Working capital needs, and
- An expected growth rate.
Often, experts rely on projections that management has prepared in the ordinary course of business. Many courts find such projections to be the most reliable predictors of future cash flows, given management’s intimate knowledge of the business, the industry and the market. But courts may be skeptical of, and may even reject, management projections prepared outside of the ordinary course of business — particularly if the likelihood of litigation creates an incentive to manipulate the results.
2. Terminal Value
Terminal (or residual) value is the value as of the end of the discrete projection period in a discounted cash flow model. This amount represents how much the business could theoretically be sold for after that period. (In reality, the company probably won’t be sold at that time.) The terminal value also must be discounted to its present value using the discount rate.
Terminal value is typically estimated using the capitalization of earnings method. Here, the expert computes cash flow for a single representative future period and then divides that amount by a capitalization rate. The theory is that cash flows eventually stabilize once a business matures. In many cases, terminal value represents a large chunk of the cash flows that are discounted to present value under the discounted cash flow method.
3. Discount Rate
Once expected cash flows have been projected — including the cash flows for the discrete projection period and the terminal value — the expert adjusts them to present value using a discount rate that’s based on the risk of the investment. If the expert projects equity cash flows, they’re discounted using the cost of equity. Conversely, if the expert projects cash flows to both equity and debt investors, they’re discounted using the weighted average cost of capital.
The discount rate — though based on market rates of return — does require a certain level of subjective judgment. Small variations in the discount rate can have a major effect on the expert’s conclusion.
Sidebar: Court Considers COVID-19 Effect on Cash Flow Projections
The discounted cash flow method was used to value a business in a recent bankruptcy proceeding that would determine the amount of the main creditor’s secured and unsecured claims. The U.S. Bankruptcy Court specifically addressed the impact of the COVID-19 pandemic on business valuations in this case.
In re Kinser Group LLC involved a debtor who bought two hotels in a college town in 2017. At the time, there were approximately 1,000 hotel rooms in the city, but that number had grown to about 2,900 by late 2020, when the debtor filed for bankruptcy.
The hotels’ performance was adversely affected by increased competition in the city’s hotel market. The situation worsened during the pandemic, as many students returned home for online education and most sporting events and other college gatherings were canceled.
In determining the value of the hotels, the court rejected much of the testimony by the creditor’s valuation expert. It found the expert’s cash flow projections — which assumed the hotels’ occupancy rates would stabilize in three years — to be overly optimistic. The court determined that “post-COVID-19 stabilization” isn’t likely to occur for either hotel until four or five years after the valuation date.
The expert also valued the hotels under the assumption that they would be sold on the valuation date. The court disagreed, noting that the debtor’s reorganization plan called for it to retain and operate the hotels.
The discounted cash flow method is often difficult for laypeople to understand. An experienced business valuation expert can help you determine whether this method is appropriate for your situation and, if so, how it works and the reasoning behind the underlying assumptions.