What It Means
Discounted Cash Flow method determines the business value by considering these inputs:
- A stream of expected economic benefits, such as the net cash flows.
- A discount rate which establishes the required rate of return on investment.
- An expected gain from the disposition of the business at the conclusion of the ownership period, or the long-term (terminal) value.
The objective of the method is to determine what the expected economic benefits stream is worth in present day dollars, given the risks associated with owning and operating the small business. Because of the method’s solid financial theory foundation, it is favored by seasoned investors and business valuation professionals.
Business appraisers and economists sometimes use the formal name Discounted Future Economic Income when referring to the Discounted Cash Flow business valuation method.
The reason is that this method is quite flexible with the choice of the income measures that can be used as its input. Key to the method’s accuracy, though, is a careful match between the income measure, known as the earnings basis, and the discount rate.