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Future Earnings Valuation

April 13, 2006

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Theoretically, anyone purchasing a small business is interested only in the business's future. Therefore, a valuation based on the company's expected earnings, discounted back to arrive at their net present value (NPV), should come the closest to answering the buyer's questions about how much the business is really worth today.

That's the theory. However, in practice, valuations based on future performance of the company are the most difficult to do because they require the appraiser to make numerous estimates and projections about what's around the bend. They are also the most time-consuming methods. If inexpertly done, future earnings methods can result in a target sales price that's way off base.

Nevertheless, if you think that your most likely buyer is a larger company, it may be worth while to have your appraiser use one of these methods. If carefully done by an expert business appraiser, valuation methods based on future earnings can result in setting the highest reasonable price for your business.

Methods based on future earnings are very frequently used by larger companies in either merger or acquisition situations. The large-company acquisitions manager will understand the method behind the madness of making so many predictions about the future. Moreover, large companies are often "strategic buyers" who are likely to accept a higher price for your company in any event, provided that you can justify it. That being the case, why not set the highest asking price that you can reasonably back up with some mathematical formulas and pro forma (projected) statements?

Using the discounted cash flow method. So, how do you go about setting a price based on future earnings?

The first step is to look at your recast financial statements. Working from these, your appraiser will create projected statements that extend for five or more years into the future. Each year's free cash flow will be determined (some appraisers prefer to look at each year's earnings before interest and taxes or EBIT). These projections should not assume any major changes by the new owner, since you are trying to measure the company as it exists today; the new owner doesn't want to pay you for the value he or she hopes to add to the company!

Once you have done this, the projected free cash flow from each year is discounted back to the present, to arrive at the net present value of each year's cash flow. These NPVs are added up, to arrive at the total NPV of the company's earnings for the near future.

How do you compute NPV? The easiest way is to use a good financial calculator. If you don't have one, or don't want to take the time to learn how to use one, our Business Tools contains a simple "present value of $1" table that you can use to compute the NPV of your cash flows.

The key here is deciding which discount rate to use. The higher the rate, the lower the answer you'll get as to the value of the company. The discount rate must reflect the appraiser's best guess as to what the market rate will be for investments of a similar nature over the next five years. It should also factor in the buyer's expected cost of capital (i.e., the interest rate on an acquisition loan) and the expected inflation rate. Choosing the correct cap rate is perhaps the most difficult task the appraiser must do — and perhaps the most mysterious to the rest of us. Let's just say that expertise in this area is one of the main things you're paying your appraiser for.

The next step in using the discounted cash flows method is to determine the residual value that the company will have after the five (or more) years of your projected statements. There are a number of different ways of doing this, more or less precisely. One of the easier methods is to take the estimated cash flow from the last year you've forecasted, and assume that level of cash flow will continue indefinitely into the future. Obviously, this is a rather conservative prediction because most buyers will want the company to continue to grow after the next five years! But, at any rate, you can take the last projected year's free cash flow, divide it by the discount rate, and arrive at the company's perpetuity earnings value. This value becomes the company's residual value, which can in turn be discounted to find its NPV.

Finally, the NPV of cash flow from each of the projection years, plus the NPV of the company's residual value after these years, is added up to arrive at the present value of the business.

Let's say that after doing your best to look into the future and forecast the next five year's cash flow, you arrive at the figures in column one. Assuming a 20 percent discount rate, you come up with the following figures:

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