Valuation methods are better if they consider the current and future value of a firm based on its probable performance. Changing conditions of the environment surrounding the business, and changes in the business itself, greatly reduce the value of historical data and demonstrate the usefulness of valuations which consider future performance (Lieberman, 2003). This is the theory of value used in the valuation of most financial instruments, and is the basis for cash flow and income based valuations.

The discounted cash flow method is the academically preferred method for valuing a business. However, its complexity and great need of data and best professional judgments result in its not being much used in practice (Demirakos, Strong & Walker, 2004). The discounted cash flows method calculates value using the future income a firm is expected to generate and a terminal value which represents the firm’s probable worth at the end of the income stream. These are then discounted to the present value, giving a fairly accurate proxy of the benefit the owner will receive (Jenkins, 2006). The discounted cash flow method also allows the valuer the greatest level of flexibility in examining a firm (Melloan, 2004) and explicitly includes the treatment of capital assets and recapitalization through their impact on cash flow (Lippitt & Mastracchio, 1993). A greater variety of variables may be included, thereby increasing the accuracy of the valuation. Discounted cash flow valuations are highly dependent on the valuer’s using appropriate estimation and assumptions regarding the future of the firm. The quality of the information put in to the calculations is directly reflected in the quality of the output (Harrison, 2003).

The process of calculating the value of a business can be broken into three major steps. These are calculating the projected income and cash flows for the foreseeable future; calculating the terminal value at the end of that period; and finally considering any extraneous influencing factors and making special adjustments. Each of these steps has particular facets that must be explored and appropriately accounted for. The process of conducting a discounted cash flow valuation is the same in small private businesses and their larger public counterparts, the primary difference being the availability of information.

Projecting future cash flows of a business begins with a study of its current cash generating capabilities, after adjusting its balance sheet and income statement to accurately reflect the firm’s finances. The current level of cash generation is used as a baseline for the coming year’s projections. In projecting the future cash flow of the venture the valuer needs to closely investigate the macro economic situation and the state of the industry of which the firm is a part (Harrison, 2003). Quantifying these key factors will give the valuer an idea of the firm’s maximum long-term sustainable growth rate. Attention should be given to the market which the firm serves – to evaluate whether its customer base is growing and whether the consumption rate of the customers is increasing (Feldman, 2003). The projection horizon of business analysts averages about six years, which is lower than the ten-year academic recommendation. This is explained by the inverse relationship between the length of a projection and the projection’s accuracy (Peterson, Plenborg, & Scholer, 2006). Care must be taken, however, not to project cash flows for too brief a period, because this will lead to the terminal value’s influencing the valuation too strongly (Gompers, 1998).

After projecting cash flows for a period of time, the enterprise’s terminal value must be appraised. The terminal value may be calculated in several ways. Some analysts use earnings multiples to estimate the terminal value. That practice is generally not recommended, because of the ease of application and greater accuracy of Gordon’s Growth Model – earnings divided by required return less the growth rate (Peterson, Plenborg & Scholer, 2006). In Gordon’s Growth Model a firm is assumed to grow at a constant rate forever, discounted at another constant rate. This creates a problem similar to that of the earnings capitalization method. However, because the discounted cash flow method allows the valuer to project a variable rate of cash flows for the foreseeable future, the impact of valuing earnings as a perpetuity is minimized. The terminal value may also be calculated as a salvage value – the recoverable value of the assets in the final year, taking into account the impact of taxes (Gompers, 1998). The maximum growth rate at which a firm may grow in perpetuity is generally agreed to be no higher than the combination of gross domestic product growth and inflation, the average assumption of which commonly used by analysts, is 3.1 percent (Peterson, Plenborg, Scholer, 2006).

The rate at which the firm should be depreciated is another significant variable in the discounted cash flow method, as well as in the earnings capitalization method mentioned earlier. This rate of required return should account for the risk involved in the business and the return that the owner may expect on his investment. Generally, the basis for defining the required return on an investment is the well-known Capital Asset Pricing Model (CAPM) (Ross, Westerfield & Jordan, 2008, p. 426). CAPM prices assets as a function of the overall risk of the economy less the risk-free interest rate, which gives us the market risk premium. This premium is then multiplied by a firm specific risk factor, commonly known as beta.

Calculating beta for a small private firm involves finding comparable public firm’s betas and making a judgment. Regression lines between the market price changes of these firms and the change in the market for the same period are graphed. The slope of the regression line is the firm’s beta. The different firms’ betas may then be compared, to establish a probable range for the beta of the private firm, remembering to take into account factors specific to the private firm that differ from those with which it is compared. This direct examination of a firm’s beta is necessary in the valuation process (Rhee, 2005).

Paul Gompers from Harvard Business School points out a number of factors that must be considered in the use of beta for small entrepreneurial firms (1998). The first is to try to match the period of the risk-free rate used with the period of cash flow projection for the firm. For example, if the cash flows are projected for ten years into the future the risk-free rate used should be that of a ten-year treasury bond maturing in the same year.

Gompers also stresses the importance of consistency in the calculation of market risk when using CAPM to calculate beta for multiple firms. The importance of unlevering beta to compensate for the effects of debt is also underlined. A firm’s beta is unlevered by dividing the levered beta by one plus the ratio of the market value of debt over the market value of equity. Finally, the present value of the tax shield effect of debt financing must be calculated over the periods projected and in the terminal value. Gompers proposes this be done by multiplying the tax rate by the interest rate on the debt and the amount of debt held in the period. This value is then brought back to present value.