To calculate this, the first thing we have to determine is what the after- tax cash flow will be each year. Although business valuation is all about the cash flow to a Buyer in the future, normally we assume the business is going to run in a similar way as in the past. So we would generally take the last 3 years, maybe using some kind of weighting so that last year gets more emphasis than 3 years ago. This cash flow would then be projected into the future and discounted back to a present value based on an expected rate of return call a ‘discount rate’. Determining the discount rate is complicated and beyond the scope of this book but in general, for small/medium businesses, it ends up being mid-20s (i.e. 22% ish). This is generally the return an equity investor would expect on their investment or the cost of equity. One way to visualise this is that it is similar to your home loan where the bank will give you £500K today for a cash flow of £2,000 per month for 30 years which is really £760K in total because of interest but the value today is £500K. The good news for many people with glazed eyes at this point is that we don't tend to use this much in practice in the small/medium business arena as it is too difficult for all parties to get their heads around. But we like to explain it as it focuses the mind that the science part of the business valuation is a function of the business's ability to generate cash flow for a Buyer applied against an expected ROI/Risk factor. Market Method Using a Multiple - The Market Method is the one that is generally used for profitable businesses when we work in the small/medium (under £50M) business arena. The basic premise is that we are comparing other, similar businesses that have sold based on some metric.
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