There are many reasons for a client to need to determine the value of a company. Revenue Ruling 59-60 is the impetus for all business valuations (appraisals).  There are three approaches that are utilized to value a business. The three approaches are the Asset-Based Approach, Income Approach and the Market Approach. Underneath each approach there are many business valuation methods that can be used to determine the value of a company. The Discounted Cash Flow is generally considered the preferred methodology for all cash flow-generating assets.  As with all valuation models, there are subjective assumptions that need to be made. This required years of experience to determine he reasonableness of the various assumptions being made by the business valuation expert.

Let me begin by providing some basic definitions.

Discounted Cash Flow

The discounted cash flow is the measurement to determine future cash flows that, at its net present value, will represent the value of a company.

Terminal Value

The terminal value is the value of the business after the explicit of forecast period.[1] The terminal value is critically important as it often represents a substantial portion of the total value of an entity.[2]

Forecasting Future Operations

It is the responsibility of management to prepare a forecast/projection for the company. However, companies with revenues less than 50 million, do not have the in-house expertise to prepare the forecasts/projections. It is therefore incumbent upon the business valuation expert to prepare the forecast/projection with management acknowledging various assumptions as the process proceeds.

The forecast/projection consists or estimating future revenues, operating costs, changes in capital expenditures, depreciation expense and changes in net working capital. When the cash flows have been determined, the net present value of the future cash flows, as prepared by the business valuation expert, need to be determined. This is the main focus of this article.

I will begin with the discounted cash flow and net present value as presented in a business valuation report.

Incorrect Present Value Factor

The following table shows the entire discounted cash flow table and calculation. I have highlighted the incorrect present value factor in blue and the errors this has created in yellow.

Exhibit 1

The Present Value Factor for the terminal year is 0.3669.  Doing the math for this forecast period indicates that the experts used the final fifth year period plus one. The business valuation literature specifically states in its ”Common Error” section that using a N+1 periods[3], which is what the experts used, is incorrect. The impact of this error trickles down to the final value of the business, which is incorrect. This indicates a Fair Market Value of $9,544,994.

Corrected Present Value Factor

After correcting for the N+1 error, the Present Value Factor would be 0.4402. This would indicate a corrected Fair Market Value of $10,726,962.  See the corrected discounted cash flow below. The following Exhibit 2 states at the Net Cash Flows as all of the numbers preceding line are the same.

Exhibit 2

Changes Resulting From Incorrect Net Present Value Factor in Terminal Year

On the surface, the difference between the two Present Value Factors seems nonconsequential and really, not worth the time and effort for discussion. However, the difference in the two present value factors has a tremendous impact on the Fair Market Value of the business. The difference between the two Present Value Factors is 0.0734. The original incorrect Fair Market Value is $9,544,994 and the corrected FMV is $10,726,962, a change in Fair Market Value is $1,181,968 or 11.02%.

Exhibit 3

Number of Errors

The following table indicates the number of math errors, highlighted in blue and yellow in exhibit 1 & 2, created by the incorrect net present value factor.

Exhibit 4


In all the above formulas, the terminal value is then discounted back to a present value at the present value discount rate for n period, the same number of periods for which the final increment of the discrete projection period was discounted. This is because the terminal value is the value at the beginning of the time immediately following the discrete projection period.[4]

This type of report and others I have worked on were prepared by experienced business valuation professional with many years of experience, holding many highly regarded business valuation credentials. As an attorney, it is incumbent on you to vet your business valuation expert.

Business Valuation: Terminal Value N+1
Deposition or Trial Questions for Attorneys

Questions: Verify that the expert believes that they have the correct value of the business.

Answer: Should be yes.

Question: Ask how the different attributes of the discount rate was determined.

Answer: They should cite different data sources depending on the approach used.

Question: Ask what specific items were considered for the company specific risk and how the final risk rate was determined.

Answer: There is no empirical data for this.  The rate is subjective but they should have some information available on how it was determined.

Question: Ask if they used an mid-year or full year convention to calculate the net present value factors.

Mid-Year Convention: They should use a period of .5 for the first forecast period. 1.5 for the second forecast period.  2.5 for the third forecast period, etc. They should be able to provide information and reasoning for each item.

Full Year Convention: They should use one for the first year, 2 for the second year, etc.

Question: Ask how the present value factors are calculated for each year.  You want to determine if the terminal year is the same as the last period prior to the terminal year.  If they are not the same, there may be a significant error in the total value.

[1] Hitchner, James R. “Financial Valuation: Applications and Models”, Third Edition, © 2011, John Wiley & Sons, Inc. p.148.

[2] Hitchner, James R. “Financial Valuation: Applications and Models”, Third Edition, © 2011, John Wiley & Sons, Inc. p.151.

[3] N is the number of years for the forecast, excluding the terminal year.

[4] Pratt, Shannon P. Niculita, Alina V., “Valuing a Business: The Analysis and Appraisal of loosely Held Companies”, Fifth Edition, McGraw Hill, © 2008, p. 254.