What is Discounted Cash Flow vs. Earnings Multiplier?
What is Discounted Cash Flow (DCF)?
So, what is discounted cash flow? Think of the DCF method as a way to predict how much money your business will make in the future and then figuring out what that future money is worth today. Imagine you’re expecting to receive a certain amount of money every year for the next few years. DCF helps you calculate the value of that future money in today’s terms, considering that having money now is worth more than getting the same amount later (because of factors like inflation and earning interest).
How does Discounted Cash Flow work?
Step 1: Forecast Future Cash Flows - Estimate how much cash the business will generate in the future. For example, let's say a business is expected to make $50,000 each year for the next 5 years.
Step 2: Choose a Discount Rate - This rate reflects the risk and potential return of the investment. Think of it like an interest rate. Let's use 10% for our example.
Step 3: Calculate the Present Value - Use a formula to find out how much each future cash flow is worth in today's dollars. This involves dividing the future cash flow by (1 + discount rate) raised to the power of the number of years in the future the cash flow is.
Example:
Year 1: $50,000 / (1 + 0.10)^1 = $45,454.55
Year 2: $50,000 / (1 + 0.10)^2 = $41,322.31
Year 3: $50,000 / (1 + 0.10)^3 = $37,565.74
Year 4: $50,000 / (1 + 0.10)^4 = $34,150.68
Year 5: $50,000 / (1 + 0.10)^5 = $31,046.07
Step 4: Sum the Present Values - Add up all the present values to get the total value of the business today.
Total Value = $45,454.55 + $41,322.31 + $37,565.74 + $34,150.68 + $31,046.07 = $189,539.35
How do you choose a Discount Rate?
Choosing a discount rate is one of the trickiest parts of the DCF method. Here are a few ways to approach it:
1. Cost of Capital: This includes the cost of debt (interest rate on loans) and the cost of equity (expected return for investors). You combine these to get the Weighted Average Cost of Capital (WACC). For example, if a business has a 6% cost of debt and an 8% cost of equity, with a 40% debt and 60% equity structure, the WACC might be around 7%.
2. Industry Benchmarks: Look at average discount rates used in your industry. Financial databases and industry reports often provide this information. For example, if similar businesses typically use a 10% discount rate, that can be a good starting point.
3. Risk Assessment: Consider the specific risks associated with the business. Higher risks might warrant a higher discount rate. If a business operates in a volatile market, you might choose a higher discount rate to reflect that risk.
Now, what is the Earnings Multiplier?
The Earnings Multiplier method is simpler. It involves multiplying the business's current earnings by a number (the multiplier) to estimate its value. The multiplier is based on what similar businesses are selling for in the market.
How does the Earnings Multiplier Works?
Step 1: Determine the Earnings - Find out how much money the business makes before interest, taxes, depreciation, and amortization (EBITDA). Let's say a business has an EBITDA of $100,000.
Step 2: Choose a Multiplier - The multiplier depends on factors like the industry, market conditions, and the business's growth potential. For example, if similar businesses have sold for 4 times their EBITDA, the multiplier is 4.
Step 3: Calculate the Business Value - Multiply the EBITDA by the multiplier.
Example:
Business Value = $100,000 (EBITDA) * 4 (Multiplier) = $400,000
Comparing DCF and Earnings Multiplier
Discounted Cash Flow (DCF) Method:
Pros:
- Takes into account future earnings.
- Considers the time value of money.
- Provides a detailed financial picture.
- Many buyers find this method more accurate and reliable.
Cons:
- More complex and time-consuming.
- Requires accurate future cash flow predictions.
- Sensitive to changes in the discount rate.
Earnings Multiplier Method:
Pros:
- Simpler and quicker to calculate.
- Easy to understand and apply.
- Based on actual market data.
Cons:
- Doesn’t consider future earnings.
- Multiplier can vary widely.
- Doesn’t account for the time value of money.
- Can be overly simplistic, inaccurate and many buyers don't trust this method.
Let’s compare these methods using an example. Imagine you're looking to buy a local bakery.
1. DCF Method:
- Predicted future cash flows for 5 years: $50,000 per year
- Discount rate: 10%
- Present value of future cash flows: $189,539.35
2. Earnings Multiplier Method:
- Current EBITDA: $100,000
- Market multiplier: 4
- Business value: $400,000
Which one do you choose? It depends on your confidence in future cash flow predictions and the importance you place on the time value of money. Many buyers prefer the DCF method for its detailed picture of future earnings, while the Earnings Multiplier method provides a quick market-based estimate.
