The cash flow approach to valuing a business looks at future cash flows of the business and discounts them to determine the value present value of the business.

Adjust for Non-Cash Item

You get cash from either the statement of cash flows in the operating cash flows section, or from the income statement by removing non-cash items. The problem with removing non-cash items like amortization is that you lose the anticipated costs that they represent. You’ve got to be aware of this when you are using this method and take it in to account. For example, you could add on a capital asset replacement cost when forecasting future cash flows to compensate for the loss of amortization.

Find a Discount Factor

A discount factor is like an interest rate. If there was no risk, the discount factor would be the same as an interest rate. But it’s more difficult to find the discount rate for a business because there is varying amounts of risk. The method of finding a discount factor is outside the scope of this post, but for reference, you can look at Investopedia for a general introduction to finding this.

Simplified Method – Average Cash Flows

You can just average the out the annual cash flows and divide it by a discount factor. This method assumes the value of the business is can be represented from one cash flow.

Advanced Method – Yearly Cash Flows

The cash flow method of valuing a business involves forecasting cash flows and determining the present value of those cash flows. An investor might use this method when looking at a startup because he can use the forecasted cash flow statements. This method is risky because it is not usually realistic to expect to predict annual cash flows in the future because there is so much uncertainty. You should never go out any further than 5 years because after 5 years the predictions are generally worthless.

More:
5 Ways to Value a Private Business

Tags: business valuation, cash flow, cash flow approach
Categories: Lesson, Bachelor of Commerce, Entrepreneurship, Business
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