TVM

• Much of finance is based on the notion that a dollar today is worth more than a dollar tomorrow if not invested -- this is also known as the "bird in the hand" theory. However, if you can invest the dollar at a certain rate of interest which is above inflation, the dollar will be worth more in the future. This concept is referred to as the time value of money -- or TVM -- concept, and it is the basis for business valuation as well.
  
  

Discounted Cash Flows

• In order to apply the TVM concept to business valuation, you must first develop a way to estimate or project free cash flows in the future. Free cash flows are calculated by finding the difference between future cash outflows and future cash inflows. Analysts look at historical trends in cash flows, future expenditures and expected earnings in order to arrive at a net free cash flows number.
  
  

Net Cash Flows

• As the name implies, the free cash flow method of business valuation focuses on net free cash flows. It uses projections and forecasting methods in order to determine these cash flows. The most rudimentary way to forecast free cash flows from the company's historical financial statements is by using the formula net income plus depreciation minus capital expenditures.
  
  

Developing Projections

• In order to develop projections, you must first obtain projected financial statements. Net income is determined by looking at the bottom of the income statement. Depreciation expense is also on the income statement. Capital expenditures can be found in the investments section of the cash flow statement. For instance, if net income is $100,000, depreciation expense is $10,000 and capital expenditures are $30,000, the free cash flows for the year are $100,000 plus $10,000 minus $30,000 or $80,000. Over time these net cash flows are used to find the net present value of cash flows, which is the value of the business.