
One common mistake I see is when people utilize a Discounted Cash Flow (DCF) approach. In a DCF approach you project the likely future cash flow of the business and then discount it back to the present at a rate that is commensurate with the risk of the investment. The theory is that the value of a business should be equal to the present value of all future cash flow. But what does "cash flow" mean? Is it Net Income, Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), Seller Discretionary Cash Flow? Unless adjusting other assumptions a Discounted Cash Flow approach should use Operating Free Cash Flow (OFCF), which is EBITDA minus taxes and capital expenditures and adjusted for changes in net working capital (if the net working capital from the beginning of the year to the end of the year increases, then that would result in a decrease in OFCF).
What some people will notice is that OFCF is cash flow that is before paying interest expense. Yet, isn't interest a real expense? Why isn't that included when using a DCF approach? The reason is that interest expense is already taken into consideration in the discount rate.
The discount rate should be the Weighted Average Cost of Capital (WACC). So, for example, if a business was worth $10 million, and $5 million of equity capital was going to be used, $5 million of debt capital, and the expected return on equity by investors was 20%, and the after tax cost of debt was 5%, then the WACC would be 12.5% (i.e. 50% equity capital X 20% and 50% debt capital X 5%). Because the WACC already includes the interest as a cost of capital, it will naturally be taken into consideration when discounting the OFCF of the business. If you included interest as an expense in your projections then you would be double counting the cost of debt capital which would significantly and inappropriately lower the value of the business.