Surprised? Then consider a typical situation calling for a business valuation – a company put up for sale. Business owners are proud to discuss the past track record of the business and especially how much money they were able to make.
Business value is in your dreams
Investors and buyers look at the company from a different perspective. For them the question is about the expected future earnings. Historic track record is useful to the business investor only as a guide to help with the income forecast. The money anticipated to land in the bank is why the business buyers are even interested in acquiring a company.
Business value is in the eyes of the beholder
Think the past earnings are a reliable guideline for future income expectations? Not necessarily. Consider a Silicon Valley classic case of a technology start-up being acquired by a Fortune 500 public company. Odds are the real reason behind the acquisition is to get access to the cutting edge technology and top engineering talent. It’s an asset sale, basically.
Once the Fortune 500 company completes the acquisition, things swing into gear. The start-up is transformed into a brand new business unit and changed beyond recognition.
Business value – reaching for the stars
If you think about it, the forecast of future earnings made by the Fortune 500 acquirer is beyond the reach of the start-up acting alone. The public company has at its disposal the market access, established distribution infrastructure, customer loyalty, capital, and economies of scale the start-up could only dream of.
The link between business value today and future earnings
So far, so good. But how do you figure out what the business is worth today with all those future earnings looming nicely on the horizon? In fact, the business valuation toolbox has just the valuation method to do the trick. The discounted cash flow technique lets you establish the connection between the future earnings forecast and what the business is worth in present day dollars, right now.
The discounting magic needs one more key input from you – the discount rate. This number represents the risk associated with the business. Remember, the money has not yet landed in your bank account. The expectation of income could disappoint if the company falls upon hard times and hits unexpected difficulties down the road.
The discount rate essentially captures the risks inherent in future expectations – not getting the money when you expect it, falling under the rosy earnings forecast, or perhaps not getting a penny at all.
Business valuation and risk assessment – leave no stone unturned
Number crunching with the discounted cash flow valuation method could prove addictive and, somewhat disconcertingly, misleading. This happens when you omit some key anticipated business risks while creating your earnings forecast. Start-ups like to think of themselves as poised to dominate the world. A pile of money is just around the corner.
Then the reality sets in. It turns out the competition is not sleeping after all, and production delays are a real setback. Customers may be skittish about adopting new products from an obscure young company. Or the market becomes dominated by a few well funded competitors.
So the takeaway is this – you can run your business valuation based on future income expectations. Just make sure your forecast captures the business risks your company is likely to face.