Preparing a discounted cash flow analysis
Discounted cash flows
Calculating the sum of future discounted cash flows is seen as the gold standard to determine how much an investment is worth. It’s also likely to be the evidence that your auditors will want to see to confirm that the value of an investment on the balance sheet does not need to be impaired. Put simply, discounted cash flow (DCF) analysis rests on the principle that an investment now is worth an amount equal to the sum of all the future cash flows it will produce, with each of those cash flows being discounted to their present value.
Example. Your company has a 25% stake in another company. It provides your company with about £100,000 per year in cash and it has historically had an average annual growth rate of 3%. If we use a discount factor of 12% then the DCF over the next five year period will be:
DCF=£100,000/(1+12%)+(£103,000(1+12%)2+(£106,090x1/(1+12%)3+(£109,273/(1+12%)4+(£112,551/(1+12%)5 = £380,219 (see The next step ). Tip. Thankfully, Excel has a built in “NPV” formula you can use to calculate the DCF. The formula is: =NPV(discount rate, year 1 cash flow, year 2 cash flow, year 3 cash flow, etc.).
Step 1. Create financial projections
As our example shows, in order to perform a valuation using the DCF method, you first need to forecast the investment’s future financial performance. This should be a cash flow forecast rather than a profit and loss, so you’ll need to add back non-cash items like depreciation but include the full cost of new assets.
Tip. The forecast should usually be done for the next five (or sometimes ten) years.
Step 2. Calculating the discount factor
Rather than using the rate of inflation, you should use a discount rate that reflects the riskiness of the investment. This is usually the company’s weighted average cost of capital (WACC) and reflects its gearing - the mix of debt and equity. For example, if 80% of your company’s capital is equity, it pays 9% interest on its loans and the shareholders’ required rate of return on their equity is 13%, your company’s WACC is:
| Loans | 20% of 9% = | 1.8% |
| Equity | 80% of 13% = | 10.4% |
| WACC | 12.2% |
Tip 1. While the cost of debt usually corresponds with the interest rate on loans, the cost of equity is trickier to work out. A simple way to do it is to start with the interest rate for a risk-free investment, e.g. government bonds, and mark it up by the return required to compensate for the risk of holding shares in a private company. For example, if the return on government securities is 2% and your risk premium is 11% (say 6% equity risk premium and 5% extra as it’s a private company) then the equity cost of capital is 2% + 11% = 13%. Tip 2. You can find the equity risk premium for quoted shares (which is the expected return on the UK stock market) by searching online.
Step 3. Compare DCF with carrying value
Once you’ve calculated the DCF, compare it with the carrying value of the investment on your balance sheet. If the DCF is higher, then this proves to the auditors that no impairment is needed.
For a DCF example, visit http://tipsandadvice-financialcontroller.co.uk/download (FC 12.06.02).
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