Archive for August, 2015

Do you expect a company to grow its earnings rapidly in the future? Then consider using the discounted cash flow method to capture the value of this upside.

This valuation method lets you calculate business value using both the explicit earnings forecast as well as the measure of long-term earnings growth you expect. The sum of the discounted earnings along with the so-called residual or terminal value is the overall value of the firm.

The nice feature of this method is that you can incorporate the earnings forecast over an arbitrary time period going forward. This could come from your proforma financials that you generate based on your business plan.

In addition, you can capture the long term business outlook as its residual value. This element of the discounted cash flow calculation requires that you estimate the earnings growth rate past the forecast period.

It is important that you get this growth rate right. Underestimate it, and the company value will fall well below its true potential. Overestimate it, and your valuation results will be way over the top.

Just how sensitive is your valuation likely to be to this earnings growth assumption? Let’s take a look at an example. Consider a small company with the following cash flow forecast:

Forecast Year 1 Year 2 Year 3 Year 4 Year 5
Expected Cash Flow $95,376 $101,231 $107,085 $112,939 $118,793

Further, let’s assume the discount rate is 27%. We will run two calculations of business value assuming the long term growth rates to be:

  • 1. Worst Case: 5%
  • 2. Best Case: 15%

In other words, we expect the company to generate exactly the same earnings over the first five years with the same level of business risk exposure. Thereafter, the company earnings are expected to increase 5% annually in the worst case, and 15% per year in the best case.

The residual value of the company, i.e. what the firm is worth at the end of year 5 in the forecast, is also different for each case:

  • Residual Firm Value, Worst Case: $552,801
  • Residual Firm Value, Best Case: $1,087,344

Here are the valuation results calculated for each case:

  • Worst Case Value: $436,831
  • Best Case Value: $598,625

As you can see, the difference is considerable. The assumption of much better 15% cash flow growth over the long haul makes the company about 37% more valuable.

It goes without saying that a company’s prospects are affected by the industry it competes in. To be credible, your business appraisal should include a discussion of the industry outlook. This may be more important than the overview of general economic conditions.

The value of a company differs depending on whether it has a strong competitive position in a robust industry or competes in a shrinking industry sector, regardless of how well the overall economy is doing.

A properly prepared business valuation should analyze the industry sector and its growth prospects, along with the company’s ability to compete successfully. Some factors that you would consider here are:

  • Industry sector growth prospects
  • Consolidation trends
  • Financial strength of the firm
  • Management team
  • Product competitive position
  • Customer following
  • Employee skill and motivation

Your business valuation report should outline clearly the industry conditions and the company’s position in it, so that your readers will see the reasoning behind your value conclusions.

This, of course, requires that your business valuation analysis include a well considered review of the industry and the place the company occupies. This is groundwork that underlies your selections of business valuation methods to perform the actual number crunching.

For your business appraisal to be convincing, the logic behind the financial numbers and method choices should be based on sound analysis of the industry sector factors.