If you are valuing a business using the income based methods, creating a viable earnings forecast is essential. Your business valuation result depends on your ability to accurately predict the income stream and assess business risk going forward, not an easy task.
What do you value – Business highfliers or cash cows?
No one has a crystal ball in business. Any number of circumstances can affect business prospects and have a material impact on its earnings. On the other hand, some companies operate in a protected niche mitigating uncertainty and ensuring the profits for the foreseeable future. These are the famous cash cow businesses, an investor’s dream come true.
So while an earnings forecast can be credible for a cash cow business, the same approach may fail when estimating future earnings for a high tech start-up.
What options are out there to create a reliable set of earnings forecasts for a company? The answer is, unsurprisingly, it depends.
Linear regression model for cash cow businesses
For the cash cow business that you expect to continue running much the same as in the past, an excellent earnings forecast model is the well-known linear regression. Under the assumption that historic trends accurately predict the future, you essentially project business revenues and expenses based on the company’s historic track record.
Visualize plotting the revenues and expenses on an X – Y chart. Draw a straight line through the historic data set into the future to read off the anticipated numbers. This is the linear regression model in a nutshell.
But what happens with the new businesses without a reliable history of earnings? Or a company undergoing significant changes such as new investment or change of business strategy? In such cases historic trends may be either non-existent or plain misleading.
Sales driven earnings forecast models
Time to roll up the sleeves and get to work developing a more realistic earnings forecast model. Most such models are sales driven. Based on the management’s plan and knowledge of the business and its industry, you create a revenue forecast.
Let’s say the company is expected to generate a certain level of sales in the next year, then continue to grow the sales level at 5% per year. Don’t forget to check the industry sector growth trends so as to stay within a realistic range of possible growth rates.
The business expenses, both cost of goods and fixed expenses can then be forecast as a percentage of revenues. This gives you the gross profit and net income forecast. You can use the same approach in order to estimate the future needs for current and fixed assets investment such as working capital, property, plant, and equipment, and financial capital.
Uncertain business prospects – creating best case, worst case earnings forecasts
The situation may get really interesting if you anticipate several likely outcomes for the company. Let’s say there is a possibility of substantial regulatory compliance outlays that may become a drag on business earnings. Or a government agency approval needed to enable the company’s new product sales.
You can create several what-if earnings forecast scenarios to capture each potential future outcome. Early approval creates the opportunity to generate high level of sales early on. Your earnings forecast should reflect this scenario. Higher business earnings in early years are sure to translate into higher business valuation result using the discounted cash flow method.
Conversely, delays in product introduction or pricing pressures from competition are likely to depress the earnings forecast. Re-run your discounted cash flow valuation with this cash flow stream to see how the business value changes.
Business valuation as a strategic value building tool
Having several business valuation results for each anticipated scenario gives you a range of values for the business. Remember that the discounted cash flow valuation gives you the present value, or what the business is worth today. You have translated future expectations into a set of numbers relevant right now.
Such what-if valuation analysis is extremely helpful if the business management must make critical decisions on their strategy. Don’t like the numbers? Now is the time to review your business strategy and make value enhancing changes.
Then re-run your business valuation to see the difference.