Multiples don’t take the future into account – isn’t a Discounted Cash Flow the best way to value a business?

Valuing a business is as much of an art as it is a science.

This means that, in practice, people generally don’t rely on just one approach to build a valuation. Typically, several methods are used in conjunction with each other to 'triangulate' a competitive valuation. Applying both a multiple and evaluating the Discounted Cash Flow (DCF) are two techniques commonly used together to deliver a robust valuation that stands up to interrogation, from both the seller and the purchaser.

Comparing how DCFs and multiples work, and how they are applied in practice

A DCF valuation works based on developing detailed, near-term financial projections along with an extrapolation into the future.  The forward-looking portion of the forecast is discounted to measure its ‘current value’, which considers things like inflation, or the opportunity cost of capital being tied up. DCFs factor in the impact of possible synergies created via an acquisition and the impact that these may have on growth, hence corporate acquirers will often use a DCF.

So, we’ve established that DCFs do factor in future growth, and that the higher the growth, the greater the value of future cash flows, and the greater the valuation today. However, whilst DCFs are important, when conducted in isolation they do lack important market context.  

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Valuing a business is as much of an art as it is a science.

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Multiples, on the other hand, are all about context. A multiple is a comparative measure whereby a business’ valuation is expressed as a multiple of its profit (typically EBITDA). For example, if a business generates £10m of EBITDA and is viewed to have a 10x multiple, then the Enterprise Value is £100m. Besides profits generated, a multiple valuation considers many other factors, such as the market opportunity, quality of the management team, and timing of the transaction.  To decide on what multiple is appropriate, the valuation team will explore similar-sized M&A transactions that have taken place as well as the implied Enterprise Value of publicly listed companies that operate in the same sector. In short, it is a much broader evaluation of both company and market potential. 

Future growth is one of the key drivers of a higher multiple and, across all industries, there is a positive correlation between growth rate and valuation multiple. A simple way of demonstrating this is with the principal of payback; if a company were valued at 10x EBITDA and did not grow, it would take 10 years for the acquirer to generate the amount of profit that they have paid for. Whereas, if it is a high growth business, payback could be achieved in say three years. 

A robust valuation is always arrived at through a combination of approaches

So, whilst DCFs do mechanically factor in growth, they ignore many of the softer factors that are included in multiples-based valuations. This is why investors or acquirers typically look at both to triangulate a value. A good adviser will navigate you through the various components and thought processes that go into both valuation methods.  We will show you how to best position your business, ensuring you have the greatest chance of securing a premium valuation. 

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