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  • Writer's pictureEric Williams

This error can significantly undervalue a business

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, the theory is that the value of a business should be equal to the present value of all projected future cash flow, when using a discount rate that's appropriate for the risk of the business. As a business broker, the mistake I see some buyers make is that they try to model in risk by using overly conservative growth projections, but then they also use a high discount rate, which is, in essence, double counting risk.

Here's 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-averse 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 the cash flow flat 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. Yet, the reason an 18% discount rate was used rather than, for example, a 5% discount rate is to take into consideration the risk of lower performance.

If you are going to project lower financial performance than you believe is realistic, then you also need to use a lower discount rate because you've already accounted for risk in your projections. For example, when Warren Buffett acquires companies he analyzes the business enough that he is comfortable with its risk, and he uses conservative projections but he then utilizes a very low discount rate based on the "risk-free" long-term US Treasury yield. That is too low of a discount rate for a small privately held business, but the principle still applies.


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