This may be obvious to the professional appraiser, but many business people often wonder – why are business earnings forecasts such an essential part of business valuation? Shouldn’t a business be valued on its historic financial performance record?
Why do a business valuation?
Think about a typical situation in which a business needs to be valued – a business sale. An established business would undoubtedly have a solid track record of financial performance. Even if the receipts come from the proverbial shoe box, the company’s CPAs work hard to assemble detailed financial records to file taxes. So the business owners can turn either to their bookkeeper or accountant to get a copy of the income statements and balance sheets dating back a few years.
Business value is in its future earnings
The business buyer can glean quite a bit from the historic financials. But a business is never bought for its historic earnings. If you are buying a business, you are after the future earnings you can expect to get.
This expectation is key – the business buyers do not benefit from past earnings – only from the future ones. The expected money is not in the bank yet, so the business buyer needs to estimate what the business can produce going forward.
As you can see, the business buyer is really interested in what the business will bring in the future. Hence, the need to forecast business earnings.
Business risk – the second key to business valuation
Since any forecast is uncertain, you also need to estimate business risk. In business appraiser’s terms, your business valuation begins with forecasting business earnings and assessing the company’s risk in the form of discount and capitalization rates.
Take a close look at the workings of the venerable discounted cash flow method. This esteemed income-based valuation technique lets you calculate the business value directly from the earnings forecast and the discount rate. That’s right, the expected future business earnings and risk estimate are the inputs that drive the business valuation result here.
When in doubt, run what-if business valuation scenarios
Sure, no one has a crystal ball, so all future expected earnings are an educated guess at best. If you have doubts about the accuracy of a given earnings forecast, take a look at the underlying assumptions. What may seem a reasonable income stream under one set of assumptions may appear unfounded if the assumption set is changed.
Professional business appraisers have a trick up their sleeve when dealing with particularly challenging business valuation situations. If a single earnings forecast seems questionable, the business appraiser generates several, one for each set of assumptions.
Imagine a business that needs a government approval to launch a new product line, such as a medical equipment manufacturer. If the government agency, for example the Food and Drug Administration, grants the approval early on, the company can enter the market and quickly ramp up its revenues with the cutting edge products.
If, on the other hand, the FDA drags its feet over the approval, the company’s product introduction stalls, and the revenue outlook may look less promising.
You can’t tell for sure which scenario will prevail, so you cover your bases by creating two distinct earnings forecasts. You then use each forecast numbers to calculate what the business is worth today, in present day dollars.
You can further express your opinion of business value by assigning the weights to each business valuation result and calculating an average based on the two expected outcomes. This weighted average number represents your current thinking about the business value.