When it comes to valuing a business, the business value number you get is always in today’s dollars. In other words, all business appraisals are done in the present.
Yet the key goal of business valuation is to assess the company’s earning potential and risk going forward. In this sense, your business appraisal is always forward looking.
No two business types stretch the dimension of business earning upside and risk more than these:
A “cash cow” business which produces steady income year over year. The company does so with minimal risk but shows moderate growth.
A high growth company that promises excellent growth and great returns in the future. At present though, the business may be unprofitable.
So which business is worth more money today?
Let’s see how the well-known Discounted Cash Flow business valuation method lets you answer this question precisely.
Example: business valuation of a cash cow and a rising star
For our “cash cow” business, we have the following net cash flow forecast in the next 5 years:
- Year 1: $100,000
- Year 2: $103,000
- Year 3: $106,090
- Year 4: $109,273
- Year 5: $112,551
The earnings growth rate is an uninspiring 3% per year. However, because the company operates in a well-protected niche and stable industry, you estimate the risk to be quite low and calculate the company’s discount rate at just 15%. Beyond year 5, the long-term terminal value of the business is capitalized at $966,062.
Our “rising star” high growth company shows a very different cash flow forecast. In the first year the company is unprofitable. It breaks even in year 2 and starts producing good earnings starting in year 3.
- Year 1: ($100,000)
- Year 2: $0
- Year 3: $100,000
- Year 4: $125,000
- Year 5: $156,250
This is done at a very high earnings growth rate of 25% per year. However, this growth is achieved at considerable operational and market risk. Hence, you estimate the discount rate for this company to be around 35%.
Given the long-term growth and year 5 earnings, you determine the long-term (terminal) business value to be $1,953,125. Five years from now, the high growth business would be worth about twice as much as the company with the steady income!
Business valuation calculation: which business is worth more today?
You can calculate both scenarios using ValuAdder Discounted Cash Flow business valuation.
The value of each business is based on the respective earnings forecast, discount rate and long-term value. Remember that we are interested in what each company is worth today. The results:
Cash cow business value: $833,334.
High growth business value: $474,623.
Business value conclusion: high growth comes at a price
What this example demonstrates is that high business growth that defers business earnings may be worth less than a low-risk stable income stream.
In fact, our high growth business will have to demonstrate about twice the business earnings in year 5 to be worth the same as the “cash cow” company. Getting to that level of earnings fast may require considerable amount of additional capital and stretch the company’s ability to grow.
A strategy to maximize your business worth
Knowing this, you can combine the two extremes into a winning business value-creating strategy:
1. Develop a steady, low risk income stream first. Early positive cash flow and stability of earnings translate into superior business value.
2. Focus on high growth opportunities going forward. Their risk may be justified by higher returns at a later time.