Calaveras Analysis

A NOTE ON BUSINESS VALUATION

Four Equivalent Discounted Cash Flow Approaches

This note and accompanying numerical example summarize four alternative ways to estimate the value a company or division. Applied correctly, each should yield the same estimated value.

Why learn four equivalent ways to do the same thing? Because depending on the information available and the particular circumstances of the valuation, some approaches may be infeasible, or one approach may be much easier to apply and may yield a more reliable estimate of value than the others. In addition, you need to be able to communicate with people who may be using any of these four techniques. Creative use and adaptation of these approaches to fit particular circumstances is an important skill.

The four approaches differ according to the cash flows discounted and the discount rate applied. Each, however, adheres to the same fundamental principle: the discount rate should reflect the risk of the cash flows to be discounted.

Another important similarity is that all of the approaches ignore expected distress and bankruptcy costs of leverage. For this reason the values estimated, especially for highly levered transactions, should always be considered upper limits.

Table 1 below illustrates each valuation approach and offers evidence that they all yield the same result – at least when valuing perpetuities. (Some would call this proof by example. I prefer to think of it by its more formal name, “finite induction.”)

I. Entity Valuation: (Also known as “free cash flow valuation, total firm valuation, or total enterprise [TEV] valuation.”) Discount free cash flows at the appropriate weighted-average cost of capital.

This is the most common valuation method, useful when no major changes in capital structure are contemplated. The method is difficult to apply when the firm’s debt-to-equity ratio is projected to change over time because, as evidenced in Table 1, the WACC changes as the...