Discounted Cashflow

It can be difficult to accurately place a value on a potential investment. A common mistake is to estimate using historical data such as previous profits or assets owned, when in actuality it is far more useful to try and work out the future potential of the company. This is known as the investment approach to valuation:

  • Discounted cash flow (DCF) is an estimate of the amount of money a company will make in the future, taking into account that money earned today is worth more than money potentially earned in the future, resulting in a discounted rate reflecting the uncertainty and risk involved
  • Net present value (NPV) is the value derived from discounting future cash flow back to the present by a percentage representing the minimum desired rate of return
  • Long-term cost of capital is a popular rate used when discounting. The level of risk is also a large factor in determining discount rate – for example, purchasing a foreign business in a different market sector would result in a much higher discount rate than a local business in the same market
  • Terminal value (the amount expected to be received when the business is sold) is often also considered. However, only private equity investors usually expect to sell the business within five years – most purchasers see an acquisition as a long-term investment
  • Internal rate of return (IRR) is the flip side of NPV and is used to work out a break-even rate of return. It is possible to find out which level of discount rate will result in a positive or negative NPV. A business attempting to assimilate a supplier may be happy with an IRR of 15%, whereas a venture capitalist financing a startup could want an IRR of 35-50% in order for the risk to be worthwhile
  • These techniques are best used as a comparison between different potential investments than as a way of deciding whether to invest at all

Hat-tip to Robert Moore from Business Data International Limited

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