Business value of earnings upside
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.