What’s My Business Worth – Part 2

I wrote a couple weeks ago (see here) about one way of calculating the value of your business. I’ll share in this blog another method that valuation practitioners use to assess the value of a business with an example.

Discounted Cash Flow

To paraphrase Warren Buffett, “the value of a business is the cash flows a business will produce over its lifetime, discounted back to the current date using an appropriate rate”. Typically, you will use this method if the company has recently undergone significant changes such as completing a major expansion, introducing a new product or will be profitable in the near future. Below is a sample discounted cash flow analysis prepared by valuation firm Evans & Evans for Cipher Pharmaceuticals in September 2023.

 Step 1: Projections for EBITDA

 In any discounted cash flow, you always have to start by making projections of what the future revenue and costs will be for roughly 5 years. To do this, you have to speak with management and see their forecasts, analyze industry growth trends as well as look at how well the company has grown in the past. By doing this you will have your projected EBITDA for the next few years. After the last year you add a terminal year that usually grows at GDP. This is to account for the terminal value of the business which is the value of the business beyond the projection period.

Step 2: Taxes, Capex and Working Capital

 Once you have your projected EBITDA numbers for the next few years, you need to deduct income taxes at the current rate, capital expenditures and working capital for the business. The capital expenditures should take into account any amount that is required to sustain the current run rate of the business as well as any amount that needs to be invested to expand the business. Each capital expenditure will then be net of a tax shield because you can claim CCA on these amounts as they are capital additions.

Your working capital deductions is the amount needed to sustain business operations. Working capital consist of accounts receivables, inventory and accounts payable. If the business has to make large inventory purchases such as a retailer to purchase clothing, these will be deducted as working capital in the valuation.

Step 3: Free Cash Flows and Present Value

After deducting everything in Step 2 from your EBITDA, you are left with the free cash flows of the business remaining. These amounts need to be present valued back to the current date to account for the time value of money. Because the free cash flow amount 3 or 5 years from now is not in your pocket today, it must be discounted back.

The rate we use is called a discount rate. This is just essentially the rate that would attract an investor into an investment. If you look on the example below, I highligt the discount rate in the model.

When it comes to the terminal value, we must capitalize the amount using a capitalization multiple. This is just your discount rate less usually the GDP rate and then take the inverse of that number to arrive at your capitalization rate.

Step 4: Enterprise Value to Equity Value

Once the present value of the cash flows and terminal values are summed up, we add the present value of existing tax shield (Current UCC balances) to arrive at your Enterprise Value. From this amount certain adjustments are made like adding cash and marketable securities, deducting interest bearing debt and any preferred stock outstanding, adding or deducting any working capital surplus or deficiency and adding the present value of any non-capital loss carryforwards.

For the Cipher example, they just went from summing the present value of the cash flows right into determining the equity value.

Summing Up

There is a lot more nuance that goes into a discounted cash flow. This was just a general overview of what it looks like. In the valuation example I used there are also pages and pages of notes and calculations that backs up what goes into the numbers, but for simplicity sake I thought it would get too messy to include it.

 If you are interested in seeing what goes into a full blown valuation report, I will attach the PDF here. It starts on page 55 and goes until the end of the document.

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