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.