Valuing a Business: Discounted Cash Flow and the Internal Rate of Return
Valuing a business can often be a subjective process, and there are no hard and fast rules. When asked how to value a business, many people would probably first think of a multiple of its net profits, or perhaps it's asset (book) value, both of which look at the historical performance of the company. However, sometimes it is more appropriate to consider the future potential of the company, and this article examines ways in which businesses can be valued 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).
Discounted cash flow and net present value
Put simply, discounted cash flow calculates a company's current value by estimating the amount of money it will make in the future. To take into account that money received today is worth more than money received in the future, this income is then discounted at a rate that takes into account its 'time value'. The selection of this discount rate is problematic as it is an expression of the risk and uncertainty of actually receiving the projected income together with many other factors, such as the rate of inflation and the opportunity cost of investing the money elsewhere. The value that an investor arrives at for this income stream is known as the net present value (NPV), and 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.
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