DCF method (discounted cash flow) in german practice

Company valuation by discounting surpluses in Germany

The DCF (discounted cash flow) method is, in addition to the capitalized earnings method according to IDW S1, an important method in german practice for the valuation of companies and shares in Germany. It determines the enterprise value by discounting the future surpluses (cash flow) to the company owners on a valuation date, which are determined within the framework of long-term corporate planning. Cash flow is defined as the balance of cash inflows and outflows in a given year.

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Time horizon and approaches in german practice

Corporate planning in Germany is usually divided into several planning phases, usually a detailed planning phase of three to five years and a more distant planning phase. There are various methods with different approaches for the DCF method:

• In the net approach (so-called equity method), only the net payments to the equity providers are considered, i.e. it is assumed that all surpluses are distributed and the claims of the debt providers have already been satisfied. The cash flows calculated in this way are discounted by a risk-adjusted return, which is determined using a capital market model, in order to obtain the present value of the german company.
• Under the gross approach (so-called entity method), the cash flows accruing to both equity and debt providers are first determined and discounted. The share of debt capital is then deducted from the total value of the company determined in this way to obtain the enterprise value. The discount rate is based on a company's average cost of capital, which is determined on an individual basis in Germany.
• In a variation, the adjusted present value (APV) method, the value-determining characteristics of a company are broken down and discounted and valued separately using different interest rates.

Difficulties for the german practice arise from the fact that cash flow and discount rate are essentially based on forecasts.

Differentiation from other methods of business valuation in Germany

The income capitalization approach is predominant in Germany. As with the DCF method, the focus is on the future of the company. However, the discounted cash flow method is based on earnings instead of discounted cash flow. The discounted cash flow method, which has Anglo-American roots, has so far been used predominantly for larger companies, while most medium-sized and small GmbHs and partnerships in Germany tend to be valued on the basis of the capitalized earnings value using an IDW S1 expert opinion.

Also widespread is the so-called simplified capitalized earnings value method, which is used in particular on the occasion of a business valuation for inheritance and gift tax. In many cases, however, the simplified capitalized earnings value method leads to less meaningful results than the DCF method.

The same applies to the net asset value method or the liquidity value method. Both methods only consider the sum of the individual assets of the german company. For most valuation situations and most companies, no realistic market value can be determined in this way.