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1. Free Cash Flow Business Valuation Method
The Free Cash Flow business valuation method is the most widely accepted valuation method, particularly for evaluating an on-going concern. The method is based on measuring the business opportunities in the future and its projected cash flows. Both are crucial to the investors and shareholders.
The Formula
Where:
FC = Free Cash Flow in Year i
n = The Forecast Period in Years
r = Discount Rate
RV = Residual Value in Year n
ADJ = Adjustments: Surplus assets less Debts
Operating Steps
Step 1
Enter the Discount Rate. This rate is based on the free risk interest rate in the market (e.g. government bonds) with a Market Risk Premium which grow as much as the risk which is involved in the business, or as much as the uncertainty in the business, its products and markets.
If you are not familiar with selecting the right discount rate, it is recommended to use 12-15% rate for a low risk business and 25-40% for a high-risk business.
Professionals use the Weighted Average Cost of Capital (WACC) calculated by the following formula:
Where:
T = Marginal Tax Rate
CD = Cost of Debt (The average interest rate on the company’s debt)
CE = Risk Free Interest + (Beta * Market Risk Premium)
Beta = Risk factor of the business compared to the average risk in its industry. A Beta that is lower than 1 means that the business is less risky than similar businesses in its industry and vice versa.
Step 2
Enter the Price/Earnings factor. The factor should be selected according to the average Price/Earnings factor of public companies that belong to the same industry that your business belongs to. This data can be accessed every day from the financial section in almost every daily newspaper.
Step 3
Enter the amount of Surplus Assets (assets that the business can sell without hurting its current operations) and the amount of Debt Value (short and long term debts that the business owes).
Step 4
View the Company Value in three residual value methods. These methods are explained below.
Note the company value is calculated based on the accumulated discounted cash flow during the plan period, added with the discounted residual value and the surplus assets, less the debt value.
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