Whenever you value a business based on income, you need to address two questions:
- What are the business earnings likely to be in the future?
- What level of risk is associated with getting these earnings on time and in full measure?
Financial forecasts are a typical way to estimate future business income. The goal is to project earnings for some period of time. You can then discount this income stream to get your business valuation as of today.
Obviously, your results will depend on how realistic your financial forecasts are.
Many financial projections assume a constant growth rate, often based on the business historic track record. For example, a 5% revenue growth rate may be used to forecast future business sales levels.
Business financial plans also assume that some costs are fixed. This can make the business projected earnings picture look rosier every year.
This type of forecast may have serious drawbacks that can result in unrealistic business valuation results.
For one thing, constant business growth rates are rarely seen in the real world. External events beyond the business owners control affect business financial performance.
Think about the political upheavals such as 9/11 and its effect on personal safety and stability of the capital markets. Or the rise of the Web and the emergence of social networking, e-commerce and search engine marketing.
If we look back past year 2000, many of the changes affecting businesses today could hardly be foreseen.
A 5-year horizon for your financial projections is a reasonable limit to handle this level of uncertainty. Your business valuation would be more accurate because it relies on shorter period forecasts – validated by more likely near-term events.