Explain the discounted cash flow approach for valuing a business.

Fin434 m5a2 discussion – valuation

The discounted cash flow (DCF) approach for valuing a business is an analytical method employed to estimate what the value of a company would be if it were to liquidate all its assets and pay off any existing liabilities. This method focuses on estimating future cash flows expected from the underlying business, and then discounts those cash flows by utilizing a discount rate that reflects the risk associated with investing in them.

An important driver to the final valuation in this model is revenue growth. Specifically, higher revenue growth translates into higher future cash flows being generated, thus consequently increasing the value of the company since more money will be available for distribution either as dividends or reinvested back into operations. The second driver is profit margin which impacts both profitability and therefore capital gains produced, thereby affecting shareholder wealth generation through increased returns from investments made.

The third driver is operating costs which need to be reduced for profits to increase; high operating costs can eat away at potential earnings created through revenues, so it’s important that those are kept under control where possible. Finally, interest rates have an influence on how much money companies have access to by way of debt financing; as such changes in interest rates directly affect overall corporate borrowing capability and capacity for additional investments done using borrowed funds should situation arise favorable enough make viable alternative funding source.[Vasiliev 2013].