1. How Much is This Company Worth Today?

Let's say investors are considering an investment in your company and plan to take their money out in five years. To them, your company is worth today what it can earn during the five years, plus their share of the value of the company at the end of the five years. This is like saying, the value of a five-year 10% Canada savings bond is the interest it will earn each year plus the principal amount paid back at the end of the term. The interest is equivalent to cash flows, and the principal is equivalent to the value of the company at the end of the year. The big difference is that the cash flows and the value at the end of the term are known for certain with a savings bond, but for investments in active businesses, these are unknowns. The discounted cash flow method applies adjustments or "discounts" to account for those unknowns.

Using this method, the value is the total of the cash flows, adjusted or discounted, plus the value remaining (or residual value), also discounted.

A Simplified Example

A company is projected to have fluctuating cash flows (e.g. losses of $200,000 in the first two years, a gain of $300,000 in the third, etc.) that total $1 million over five years. How much is it worth today?

a) Discount the cash flows.

The cash flows are discounted at a rate acceptable to the investor - say 20% (see chart). This leaves a present value of $0.4 million. In other words, the calculation indicates that getting $1 million in five years is the same as having $0.4 million today, using a discount rate of 20%. (This rate is used to calculate a discount factor for each year; the first year's cash flows are only discounted for one year, by about 80%; but the fifth year's cash flow must be discounted for five years, so it's discounted by much more, about 40%.)

b) Find the residual value of the company and discount it.

The company's value at the end of the five years is calculated as being $10 million. This "residual value" is then adjusted by a discount factor (based on the 20% rate the investor finds acceptable), leaving a value of $4 million. You can think of the "residual" as an estimate of how much someone would pay to buy the whole company at the end of the investment period.

c) Add the discounted cash flow and the discounted residual value.

The cash flow value and the residual value are then added together. The estimated value of the firm using the discounted cash flow model is $0.4 million + $4 million or $4.4 million.

This example is very simplified. For a more detailed explanation, see Calculating New Tech's Discounted Cash Flow Value, based on our case example company. Further discussion can be found in the Valuation Methods tool.

2. Investors' Rate of Return

Investors want to calculate their rate of return. To do that they must compare the amount of the investment to the amount they will earn at the end of the investment period. But how can they know what they will earn in the future? Again, they must use the discounted cash flow projections to estimate the future value of their investment.

A Simplified Example

If investors had invested $500,000 and received 35% of the company's shares, how much will their return be at the end of the investment?

a) Take estimated cash flow for the final year.

The cash flow in the final year is used as a basis to decide the value of the company. Imagine that the company is projecting earnings of $500,000 in the final year.

b) Estimate the value or sale price of the company based on the cash flow.

How much will someone pay for this company in five years? Perhaps companies will be selling for 5 times or 10 times their earnings. Investors must decide what they think the market will be like and choose a multiple to multiply the cash flow by to convert it to a value for the company. Let's say the investors choose 8 times earnings. Then the value of the company when the investors will exit should be 8 times $500,000 or $4 million.

c) The value of the investors' share is calculated.

If the investors have purchased 35% of the shares of the company, they can expect to take away $1.4 million when the business is sold.

d) The investors determine their rate of return.

The investors' original investment of $500,000 is then compared to the return of $1.4 million. The return is the equivalent of a return of 23% compound interest for five years (see the table below).

3. How Much of the Company do the Investors Get?

The valuation information you get from discounted cash flow also allows you to consider the percentage of shares the investors receive in return for their investment. In the example above, the investors' share was assumed to be 35%. At that proportion, and given a value of $4 million at the end of the investment period, the investors would make $1.4 million, or 23% on the initial $500,000 investment.

If the investors feel that isn't an adequate return, then one way to increase the return is to give them a greater equity share for the same investment. So, for example, if their $500,000 investment bought them 45% of the company, instead of 35%, they would get 45% percent of the $4 million exit value — or $1.8 million. And that is equivalent to a 29% return on their investment.