Company valuation by discounted cash flows: 5 key steps

We are together in each step

When carrying out a discounted cash flow of a company valuation, it must be borne in mind that a simple long-term financial projection is not enough. In order to achieve a correct and consistent valuation, certain steps must be followed.

1) Historical and strategic analysis of the company and the sector

Company valuation by discounted cash flows: 5 key steps

On the one hand, the first thing to look at is the company itself and its sector. When looking at the company, a thorough financial analysis should be carried out in which the evolution of the following factors should be observed:

  • Income statement and balance sheets: Here the most important thing is to know if the company is generating profits, what is the historical growth of the company and what levers are defining these results.
  • Evolution of the flows generated by the company: Since this valuation method is mainly based on cash flows, it is very important to know where these flows come from and whether they are sustainable over time.
  • Evolution of the company's investments: Bearing in mind that investments are the driving force for maintaining growth in sales and, in many cases, in future cash flow generations, it is very important to know what the company tends to invest in, how much it is capable of generating and the need for regular investments.

In addition to these, the development of the company's financing, the analysis of the company's financial health and the weighting of the company's current risk are other key factors that differentiate a good financial valuation from a bad one.

Once this section has been completed, it is essential to undertake a strategic and competitive analysis, which means getting to know the company and the sector perfectly.

In this case, knowledge of the sector, of the main players, key drivers that are affecting the evolution of the sector are a good way to start.

This analysis should then be followed by identifying the value chain, understanding the company's capabilities and competitive position in order to understand the company's environment, the functioning of the industry and the current situation of the company in relation to its competitors.

2) Projections of future flows

Once the guts of the company and the sector are known, the next step is to project the future flows of the company. To do this, the forecasts of the industry, the company's competitive position and that of its competitors must be projected.

Once this has been done, it is possible to have an insight into the situation that the company may face in the future, which will then be used to make financial forecasts.

These financial forecasts should be made on the three financial statements, the cash flow, the balance sheet and the income statement, with a strong emphasis on planned investments, financing and cash flow generation capacity, with this section being finished after the calculation of the final value of the investment.

In this step, it is crucial to have certain scenarios available, to be able to see how different variations in inputs may affect the company and to be able to create contingency plans that help to redesign the strategic plan in case of worse than expected situations.

Company valuation by discounted cash flows: 5 key steps

Finally, such projections should be reviewed for consistency, thus avoiding under- or over-weighting. To this end, it is important to compare these projections with historical forecasts and the historical ability to deliver on the company's strategy, among others.

3) Determining the cost of resources

Once the projections have been drawn up, it is necessary to know the profitability required by each business unit and for the company as a whole.

To do this, both the cost of debt and the required return on equity are taken into account, i.e. the weighted average cost of resources is calculated. This calculation must be carried out with great care, as a slight variation can alter the result of the final valuation.

4) Update of future flows

In this section only the expected flows and the residual present value are discounted to the corresponding weighted average cost, thus obtaining the present value of the investments.

5) Interpreting results

Once the valuation has been carried out, a benchmarking with similar companies is undertaken to see if it makes sense or if an imputation needs to be revised, or if it serves as a "sanity check".

In addition, it is also important to identify the expected value creation and the horizon over which it could continue to create value, how sustainable it is and which threats need to be monitored more closely.

A sensitivity analysis in this section usually provides a great deal of value in terms of knowing what could happen according to the different scenarios previously considered, giving greater certainty about the valuation.

Finally, it is crucial to be able to justify the strategy underlying this expected value creation and to try to guide the company's managers in maximizing this creation.

The M&A Professionals



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