Business valuation and time value of money
Ask any seasoned business appraiser and you will hear that business value is about future expectations. Business people invest in companies because they expect returns on their investment. Business historic performance is only interesting in so far as it enables you to estimate future returns.
Opportunity cost – making your best investment bet
Financial gurus refer to this concept as the ‘time value of money’. Given a bit of cash in hand today, you are looking to increase your holding by some future date. There are a number of alternatives in a properly functioning market. So you look around for the best bet to place your money on.
Business value is about future returns
The reason a business is worth anything, is that you can expect to receive more later than you invest today. For example, if you invest $100 today and expect to get $110 by year end, your return, expressed as a percentage or interest, is 10% annually.
Thus you figure on getting $10 on top of your investment in a year. In business valuation language, this is Net Present Value, i.e. the total return minus the initial investment.
You can take this idea a step further and calculate the Net Present Value (NPV) for a business investment project of any complexity over any time period. This is especially useful if the expected cash flow is lumpy and spread over a long time. You can compare investment projects and select the one with the highest NPV value.
Internal rate of return and hurdle rate: justifying your investment
Another technique used by professional investors is to calculate the so-called internal rate of return (IRR). It is the interest rate that sets the discounted or present value of the business cash flows equal to your investment. In simple terms, the internal rate of return is precisely what you need to justify your investment in the business.
Professional investors such as venture capitalists have an IRR in mind when screening proposed business investments, called the hurdle rate.
What your business investment is worth today: Present Value
Discounting future business cash flows to the present time is the foundation of any serious business appraisal. Whether you use the internal rate of return or the net present value in your selection, you have a consistent, reliable framework to compare business investment project side by side. Should you continue investing in a business, or do you spot an opportunity for higher returns making divestment attractive? You can use the discounted cash flow calculations to make well informed, rational decisions.