The discounted cash flow method is the fundamental valuation method to assess the present value of future cash flows, recognising the time value of money and risk.  The value of an investment is equal to the present value of the future cash flows arising from the investment, discounted at the investor’s required rate of return.

This method requires a formal business model and discounts free cash flows after excluding depreciation and allowing for expenditure on capital items.  As a prerequisite, it requires long term forecasts.  This approach is particularly suitable where the future performance of a company is likely to be significantly different from its past performance or where cash flows are expected to fluctuate substantially over time, due to major capital expenditure or for other reasons.

This method is a proxy for the discounted cash flow method.  It requires an assessment of the maintainable earnings of the company, together with the determination of a rate of return relative to the particular business for the purpose of capitalising the maintainable earnings amount.  This approach is normally applied when valuing large or controlling interests in a company.

The capitalisation of earnings approach is most readily applied when the historic earnings pattern of a business is sufficiently stable that it can be used to predict future earnings, or where other factors such as available forecasts or other indicators of likely future results are considered sufficiently reliable to allow reasonable estimates of future earnings to be made.

This method requires an assessment of a maintainable dividend, together with the determination of a dividend yield appropriate to that company for the purpose of capitalising the maintainable dividend.  This approach is normally applied when valuing small or minority shareholdings.

This method requires an assessment of the realisable value of a company’s assets and liabilities, together with expenses (including taxation) that may be incurred.  Some net asset methods of valuation assume that a company will be liquidated, and therefore include additional costs and the assessment of a profit required by a purchaser.  Other net asset methods of valuation assume that the business will continue as a going concern.  The distinction will depend on the particular circumstances.

Industry rules of thumb are sometimes used in particular industries.  These rules of thumb may offer a secondary market-based approach to test values determined according to a capitalised earnings or discounted cash flow method, or, in certain instances, they may provide a primary valuation method.  As such, industry rules of thumb must be considered where appropriate.

The Multiple of Discretionary Earnings Method overcomes to some extent the shortcomings of the more traditional ‘rules of thumb’. The method is also known as the EBPIDT approach.  The method eliminates the need to assess a market salary for the owner operators.  This method has practicality that buyers and sellers of small to midsize businesses can understand.

Buyers often think in terms of lifestyle and income to support their families. They look at the total discretionary earnings to see if it is sufficient to pay all the operating expenses of the business, carry the debt structure required by the buyer and/or operate the business, and provide a liveable wage.  This methodology is seldom used as a primary valuation approach but is often used to test the integrity of a primary earnings based approach.