Published by NACVA QuickRead
This article examines two alternative approaches to the Discounted Cash Flow (DCF) Method when seeking to capture the majority of total value within the horizon. A closer look is given to the Residual Enterprise Income (REI) Method as well as the Abnormal Enterprise Income Growth Method (AGR) in comparison to the DCF Method, and a determination is made as to which method is most effective.
The Discounted Cash Flow (DCF) Method is a standard Income Approach when valuing a healthcare business as a going concern. However, one of the common pitfalls in the DCF Method is the disproportionate amount of the enterprise value indication produced beyond the projection horizon (i.e. terminal or continuing value), often times well over 50 percent of total value. Valuation is meant to capture the future payoffs based on what we know now, so why not root as much of the value as possible based on the accounting numbers of the business that we know today? Why rely so much on terminal value that is derived from beyond the projection horizon, when a majority of the total value can be captured within the horizon? Which leads to the next question: how can the majority of the total value be captured within the horizon? The answer lies in two alternative approaches to the DCF Method: the Residual Enterprise Income (REI) Method and the Abnormal Enterprise Income Growth (AGR) Method. Both of these methods are rooted in accounting-based valuation methodology. A comparison of the three methods will show how more of the value can be captured within the projection horizon based on real, present accounting numbers.
“Why rely so much on terminal value that is derived from beyond the projection horizon, when a majority of the total value can be captured within the horizon?”
