# The Discounted Cash Flow

Whether you want to sell your online business, take over another business or just examine your situation: Knowing the enterprise value of a company is interesting at any time. The Discounted Cash Flow method (DCF) is one of the most widely used methods for this purpose.

The DCF is praised for looking not only at a company's historical performance, but rather at its future free cash flows. And that is exactly what the buyer is concerned with with a purchase.

### Future cash flow determines the market value of your online business

A simple way to determine the value of an online business is on the basis of the so-called intrinsic value. This is the total of all the company's assets, minus the debts that exist. However, it is more interesting to look at the future, rather than the current book value. What earnings is the online store capable of generating in the future? You calculate that value using the DCF method. With this, you value the future cash flows and discount them (convert them to the current value, also called the 'Net Present Value') by calculating what costs you have to incur to actually earn those cash flows.

The reasoning behind this is that "present money" has more value than "future money". In doing so, consider whether you would rather have 200 euros in your pocket right now, or whether you would not receive that 200 euros for another year, with all the intervening risks. In other words, the future 200 euros right now has less value than the current 200 euros in your pocket. How much less, that depends on several (partly assumed) risk factors that we will explain further on this page.

(The difference between the economic value (calculated with the DCF) and the intrinsic value, by the way, is called "goodwill.")

### Establishing Value

To calculate enterprise value using the Discounted Cash Flow method, we assume three elements (Time, Money and Uncertainty) reflected in two variables: The expected annual free cash flows & The cost of capital employed.

### 1.The expected annual free cash flows.

Cash flow refers to the difference between all incoming and outgoing cash flows in a given period. The free cash flow is then the total that remains, or what an online store has in deficits, after all necessary investments have been made to ensure continuity. Free cash flow, in other words, represents the ability to repay and is the basis for the economic value of a business.

There are three different cash flows:

- The operating cash flow
- The cash flow from investments
- The financing cash flow

A valuation is made on the basis of a company's operation and thus on the basis of the operating cash flow. The cash flow generated by investments (for example, real estate or shares in another company) is valued separately and added to the calculated economic value of the operation.

In formulaic form, the calculation of free cash flow can be shown as follows:

### 2. The cost of capital employed

To understand the value in use, the future cash flows must be set against the cost to "discount" this. You do this by calculating the average cost of invested capital. This invested capital consists of the sum of equity and debt capital.

The cost of debt capital is fairly easy to calculate: that is the average interest you pay on short-term and long-term debt.

The cost of equity (also called the 'return requirement') is calculated using the risk-free interest rate ('Rf'), plus a risk premium for investing ('Rm') and any additional premium for investing in a small firm ('Rs'), the so-called 'small firm premium' (used by us as 'online business premium') and any firm-specific risk factor ('Ru').

The return requirement thus looks, for example, as follows: 2% (risk-free interest rate) + 5.5% (historical return shares) + 12.5% (online business premium) + 11% (specific risk factor for the online business in question) = 31%. Suppose that you, as the new owner of an online business, demand a return of, for example, this 31%, then all businesses with a lower return fall off in your search.

#### Cost of total capital

Once the cost of equity and debt are known, they must be converted to the cost of total capital. To do this, first calculate the ratio of equity to debt. Suppose an online store is financed with 15% debt, then calculate the average cost rate as follows (assuming the above-mentioned return requirement of 31% and average debt cost of 6%)

(31% *0.85) + (6% * 0.15)/100 = 27.25%

### Calculate your online business value

Now to determine the market value of future cash flows, set the plan period and divide each year's expected cash flows (cash flow) by the average cost of capital. This then looks like this in formula form:

Suppose we assume a plan period of 3 years and based on the growing annuity model (Damodaran) a shortened residual period of 2 years and the expected free cash flow is €40,000 in year 1, €38,000 in year 2 and €41,000 in year 3. Then for each year we divide the free cash flow by the average cost of capital taken above (27.25%) to the power of 1 for year 1, to the power of 2 for year 2 etc and then we add up the results for each year of the plan period. So the value of this online business based on the DCF methodology comes out to +/- €102,750.

Please note: You may not add up the value of any existing stock. Inventory is considered an asset with which the free cash flows are realized. Bank balances may be added to the value. Loans can still be deducted from the value.

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