The income approach to carry out a business valuation of a company is based on the concept that the value of a business lies on the economic profit expected in the future and risk level to be associated with the investment. The fair market price of the business product or the company is determined in terms of the net present value given by the benefit stream with respect to the discount or capitalization rate. The benefit stream covers the most valued and almost all important sources of income interested by the concerned of the company. The discount rate is obtained from the data and statistics given by the respective public companies and gives the value of the expected returns from the company in the present market.
How is discounted cash flow or DCF calculated?
The discount rate can be defined as an economic element essential to make investors or buyers to get attracted to your business and accept the company strategies and the risk associated with it. It is used to calculate the DCF by estimating the expenditure of the business including capital and infrastructure. From the investor’s side of benefit, a discount rate is the expected rate of returns from the business for the investment. This value then serves as the basis for determining the net present value in income approach. The most common methods of calculating discount rates follow the principle that the income from the business enterprise under consideration keeps on growing at a constant rate over the specified time period. There are two important elements of discount rate:
- Rate by excluding the risk factor and taking only the expected returns from the secure investment, known as the risk-free rate
- Rate by including the compensation of risk given to the investor above the risk-free rate, as a premium depending on the investment
For the preliminary collection of data required for calculating DCF, include the revenues and expenditures over a specified number of years and estimate the profit by removing the expenditures to get the net cash flow. Apply the estimated discount rate to each year’s profit, which gives the net present value of the expected profit in the future. You can also consider taking the net present value at the end of the subject period, known as the terminal value for calculation. For DCF, you need to know three values:
- The inflation rate
- The number of years to be considered
- The accurate discount rate
What you get in the end after incorporating all three values is the discounted cash flow value.