I don't fault business buyers for being cautious when acquiring a company. However, it is not uncommon for this type of cautiousness to result in a fundamental error when using a Discounted Cash Flow (DCF) approach to value, which will significantly and inappropriately undervalue a business.
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.
As a business broker, the mistake that I see some people make is that they use poor performance assumptions for the business while using an unadjusted discount rate that is appropriate for the risk of the business. Let me give an example:
Assume that for the size, industry, and risk profile of a business that the discount rate is determined to be 18%. Assume that three years ago the business had $900,000 of Operating Free Cash Flow (OFCF), two years ago it had $950,000 of OFCF, and last year it had $1 million in OFCF. Also assume that the market and activities the business has been involved with have lead to this steady growth and absent a significant change, a similar level of growth is believed to be realistic for at least the next 2-3 years. Given this information it may be realistic to assume that next year the business will have somewhere around $1,050,000 in OFCF.
A risk-adverse buyer or business broker may say, "I like the business, and while I think $1,050,000 in OFCF for next year is a reasonable assumption, what if the business doesn't perform at that level? There are a variety of things that could go wrong with the business so rather than projecting $1,050,000 in OFCF, I'm going to use the last three year's average of $950,000 and keep that cash flow constant going forward in my projections." The problem with this is that this will put OFCF at roughly 10% lower than it is actually projected to be in the coming year, and it will likely be an even wider divide in the future if the business continues to have similar growth. However, part of the reason that an 18% discount rate was used rather than a 5% discount rate is to take into consideration the risk of lower performance. If a buyer is projecting much lower performance, than it is inappropriate to use the 18% discount rate because that would, in essence, double count the risk.
If you are going to project lower financial performance than you believe is realistic, then you need to be using a lower discount rate because you've already modeled the risk into your projections. When Warren Buffett acquires companies he analyzes the business enough that he is comfortable with its risk, and he uses conservative projections but utilizes a very low discount rate based on a "risk-free" long-term US Treasury yield (which is currently under 4%). While I would not advocate using that low of a discount rate for a small privately held company, if you are going to use projections that show lower financial performance than you expect, a lower discount rate needs to be utilized than if you are projecting more realistic performance.
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.
As a business broker, the mistake that I see some people make is that they use poor performance assumptions for the business while using an unadjusted discount rate that is appropriate for the risk of the business. Let me give an example:
Assume that for the size, industry, and risk profile of a business that the discount rate is determined to be 18%. Assume that three years ago the business had $900,000 of Operating Free Cash Flow (OFCF), two years ago it had $950,000 of OFCF, and last year it had $1 million in OFCF. Also assume that the market and activities the business has been involved with have lead to this steady growth and absent a significant change, a similar level of growth is believed to be realistic for at least the next 2-3 years. Given this information it may be realistic to assume that next year the business will have somewhere around $1,050,000 in OFCF.
A risk-adverse buyer or business broker may say, "I like the business, and while I think $1,050,000 in OFCF for next year is a reasonable assumption, what if the business doesn't perform at that level? There are a variety of things that could go wrong with the business so rather than projecting $1,050,000 in OFCF, I'm going to use the last three year's average of $950,000 and keep that cash flow constant going forward in my projections." The problem with this is that this will put OFCF at roughly 10% lower than it is actually projected to be in the coming year, and it will likely be an even wider divide in the future if the business continues to have similar growth. However, part of the reason that an 18% discount rate was used rather than a 5% discount rate is to take into consideration the risk of lower performance. If a buyer is projecting much lower performance, than it is inappropriate to use the 18% discount rate because that would, in essence, double count the risk.
If you are going to project lower financial performance than you believe is realistic, then you need to be using a lower discount rate because you've already modeled the risk into your projections. When Warren Buffett acquires companies he analyzes the business enough that he is comfortable with its risk, and he uses conservative projections but utilizes a very low discount rate based on a "risk-free" long-term US Treasury yield (which is currently under 4%). While I would not advocate using that low of a discount rate for a small privately held company, if you are going to use projections that show lower financial performance than you expect, a lower discount rate needs to be utilized than if you are projecting more realistic performance.
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