Business valuation: whose earnings forecast should you use

When it comes to business valuation using the income-based methods, reliable business earnings forecast is essential. Given that all forecasts are at best educated guesses, which one should you choose to improve the accuracy of your business valuation?

Two obvious alternatives are to either adopt the financial projections created by the business management or develop your own independent forecast.

Business clients usually are highly motivated to provide the earnings forecast that backs their view of what the business is worth. For example, if the business management team is seeking equity financing, they would be very interested in developing a very optimistic earnings projection. On the other hand, if gift or estate taxes are the reason for business appraisal, the owners would likely go for the most conservative earnings forecast they can come up with.

An independent business appraiser may provide an impartial view of the company’s earnings outlook going forward. However, the appraiser usually is not nearly as familiar with the business value drivers, the industry it competes in or future prospects. An experienced management team can readily envision these factors.

The differences in the earnings forecasts that result may not seem large at first. But an earnings growth rate spread of just a few percentage points could make a big difference to your business valuation result.

Example: How business earnings forecast affects business value

As an example, consider a company with $750,000 in net cash flow earnings in the most recent year. Let’s assume that the firm’s discount rate is 27%. In one scenario, we anticipate the earnings to grow at 5% per year. A more rosy case can lead to a growth rate of 8%, just 3 percentage points higher.

Using the direct capitalization of earnings method we get the following business value results:

• Earnings growth of 5%: Business value: $3,579,545
• Earnings growth of 8%: Business value: $4,263,158

That’s a difference in business value of 19.1%.

If you are preparing your own business valuation, you likely expect another party to read the report and accept it as reasonable. If your reader does not buy the business earnings forecast as realistic then it is a good bet he or she is going to discount the whole business appraisal as being on shaky ground.

A business appraiser working for a client is responsible for the final result. If you decide to accept the business management earnings projections, you would need to state any known risks in your report.

The company may encounter significant product acceptance difficulties in the future or face a protracted regulatory compliance validation period that reduces the earnings. On the other hand, the new product may become wildly successful and bring in lots of money.

Needless to say, such different outcomes will affect the value of the business. Clearly stating these possible scenarios in your business valuation report shows the reader that your analysis is thorough and well considered.

Calculating cash flow for business valuation – manager replacement

One of the most important things you can do in a business valuation is to determine the earnings basis. Most income and market-based business valuation methods take some form of cash flow as its earnings input. Since accounting measures of business earnings usually require adjustments, calculating the earnings basis right can make a major difference to your business appraisal.

One common measure of business earnings used in private company valuations is seller’s discretionary cash flow, or SDCF for short. Here is how you can calculate this figure:

• Start with the company’s pre-tax net income
• Add back non-operating expenses and subtract non-operating income, if any
• Add back one time or extraordinary expenses
• Add back paper expenses such amortization and depreciation
• Add back interest expense
• Add back the principal owner’s total compensation
• Adjust the compensation of the remaining owners to market, known as manager replacement

Depending on how the rest of the business owners get compensated, this manager replacement adjustment can increase or decrease the available business cash flow. For example, if the business owners are relatively underpaid for their services, your SDCF figure will be reduced by the appropriate amount. The idea is that a potential business buyer will need to replace the departing business owners with professional managers who will expect to be paid adequately for their work.

On the other hand, some owners may be currently paid more than their contribution would warrant. In this case, the new business owners will likely be able to replace these functions at a lower cost. The result is higher SDCF.

Either way the manager replacement adjustment is very important. It is a very good idea to carefully review all the functions performed by current business owners and determine the associated labor costs at market levels.