Back to the Future! the Discounted Cash Flow Model in Valuation

• Publication year: 2022
• Author: Written by Jared Tonks, CPA, ABV, CFF

BACK TO THE FUTURE! THE DISCOUNTED CASH FLOW MODEL IN VALUATION

Written by Jared Tonks, CPA, ABV, CFF^*

It has been somewhat taboo throughout some California courts to use a Discounted Cash Flow model to value a business. Wait: what is the Discounted Cash Flow Model? It is a business valuation method which uses projected future earnings to determine the present value of a business.

Okay, that's still a little bit too complex. Let's break it down even further: you buy a business in the hopes that it will make money in the future. A seller will sell a business knowing he/she is giving up the money he/she will make in the future. The amount the seller is willing to take and the amount the buyer pays for the business is dependent upon how much money a business will make in the future.

Let's assume for a moment we have Company A owned by a husband and wife which they started during marriage—undisputedly community property. Due to irreconcilable differences, the parties decide to file for divorce. Company A is a very successful clothing design and wholesale business where Wife manages the day-to-day affairs. Wife desires to buy out Husband from Company A in 2022. Husband is successful in his own right as an engineer but knows he will be losing the economic benefit (income) associated with the community property business. Husband and Wife each hire a valuation expert and they both go to work.

There are three approaches to valuing Company A (or any other business):

1. The Income Approach - This is exactly what I previously described. It is based on the theory of opportunity cost (for all the econ majors out there). The principle is simple: you are giving up the opportunity to invest in a multitude of things in order to invest in the business in question. How much return (profit, earnings, etc.) would you have to receive in order to drive you to invest in Company A? For example, you are giving up the opportunity to invest in the stock market. The S&P 500 has earned an average of 12.2%¹ annually since 1926. So in order to invest in Company A, you need to make more than 12.2%. On the flip side, pursuant to the divorce, Husband is giving up the future economic benefit of ownership in Company A. What is the value of that benefit?

2. The Market Approach - This approach drives the value of most real estate appraisals. Real estate appraisers look to other similar homes nearby which have recently sold (comparables) to help them determine the value of the home they are valuing. The same applies to a business appraisal. Business appraisers try and find similar businesses which have actually sold and then compare those companies the company being valued, here Company A.

3. The Asset Approach - The last approach is the asset approach. Asset approaches are driven by the value of the underlying assets in the business. You simply add up all the assets in the business (both tangible and intangible) and subtract the liabilities. The net worth of

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the business is its value. If you simply add up the physical assets of the business and subtract the liabilities, the appraiser is assuming there is no goodwill or perhaps the business is better off being sold than held for investment. Therefore, this approach is typically used for start-up companies or asset holding companies.

For purposes of this article, I will focus on the income approach. When considering the use of the income approach, one must understand one of the primary principles underlying the income approach. Regardless of the method employed, an income approach assumes that income will be received in the future. California Family Law Courts in particular have been enamored by the Capitalization of Net Cash Flow Model (also known as the capitalized earnings or single period method). All these models have one thing in common. They use historical results to project the future earnings of a business. That is worth repeating: they use historical results to...