In my Deal Note from October 22, I discussed the ‘Comps’ valuation method. In the conclusion of that Deal Note, I noted that Discounted Cash Flow (DCF) is a more reliable valuation method. In today’s Deal Note, I explain why.
The DCF method has been Alderman & Company’s #1 valuation tool for more than 21 years. There’s a handful of key elements to a DCF: the free cash flows (based on projections), the discount rate (Weighted Average Cost of Capital), and the terminal value (perpetual growth or an exit multiple).
In our recent Aviation Week Webinar, I covered how a common mistake by sellers is providing unsupported projections. The most important component of a DCF valuation is having cash flow projections that can be supported and defended during buyer due diligence. Projections drive valuations, so ensuring they’re reliable is paramount to the accuracy of a DCF valuation and to predicting buyer behavior.
The discount rate is the element of the DCF that accounts for the time value of money. The value of a dollar today is not what it was 10 years ago, and the discount rate helps account for that. Additionally, the rate accounts for the expected returns for a company in the same industry and business segment as the potential seller. While the discount rate impacts valuations, its impact pales in comparison to the importance of projections.
Traditionally, DCFs are built on projections of 4-6 years into the future, but your company hopefully has value well beyond 6 years. The terminal value calculation accounts for the value of the company beyond the projected period. While many practitioners use exit multiples to estimate a terminal value, Alderman & Company has found over the past two decades that the terminal value calculation is a better predictor of value.
There are many components to an accurate valuation, but the DCF has proven our firm to be the most reliable tool for predicting buyer behavior over the past 21 years.
Have a great day everyone.