Business Valuations – How About a Discount?Posted by Celeste
How do investors value a business that they are about to buy into? One way that is often used is the discounted cash flow method. This method takes into account the money that your business has the potential to make (but may not yet be making) but also acknowledges the risk being borne by the investor.
A potential investor will first think about how long they expect to be invested in your business before they cash out – this will determine the forecast period.
Free Cash Flow
With this period in mind, they will then create a free cash flow projection. This projection will show how much “free cash” your company is predicted to have on hand each year after operating expenses, taxes, and investment in things like equipment are taken into consideration. The free cash flow in the final year of the forecast period will be a large part of determining the Net Present Value of your company.
The next step to be taken is for the investors to come up with a discount rate for the investment. This rate will address the risk that he investors are taking on with the investment. This rate also takes into account the loss of the use of this money. Assuming that a dollar right now is worth more than the promise of a dollar a few years from now, the investor requires a meaningful discount on the shares they are buying.
This method of valuation relies heavily on the forecasted cash flow of a company that should be part of your business plan. Business planning for the purposes of courting investment should have a strong financial projection component and clearly show what assumptions have been made.
Have you ever courted investors with your business plan? What method did you or the investors use to value your company?