Methods of Valuing a Business

Methods of Valuing a Business

Following from last months article, where we looked at asset based and comparative based methods of valuing a company we are now going to discus valuing a business on the basis of expected future income and profits. This is known as an investment approach to valuation and it use tools commonly known as Discounted Cash Flow (DCF), Net Present Value (NPV) and Internal Rate of Return (IRR) To produce a DCF the investor needs to make assumptions about the amount of income generated in the future and the timings of that income. This income is then discounted at a rate that takes into account the Œtime value¹ of money which is based on the principle that a pound received today is worth more than a pound received next year.

The selection of this discount rate is problematic as it is an expression of the risk and uncertainty of actually receiving the projected income and many other factors such as the rate of inflation and the opportunity cost of investing the money elsewhere. By using a DCF an investor can arrive at a value for the income stream. This value is sometimes called the Net Present Value (NPV). This can be defined as showing the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return. One popular discount rate can be the long-term cost of capital. When applying a (NPV) calculation as a method to value a business a purchaser might assume sales of £100,000 per year for 5 years. Please refer to the cashflow diagram......

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© 2004 Chris St Cartmail (Editor) His revised publication ŒHow to Buy or Sell a Private Company¹ is available free to subscribers.