In today’s dynamic corporate world, there are many circumstances when estimating the value of a business or its related assets is required. Therefore, as a beginning step, it is quite useful for any business owner or high-level manager to understand the logic of how the fair market value of a business is estimated, and what are the key variables impacting it.
Value from a business is generally derived from the future disposable earnings/cash flows that the business generates, once all operating expenses and commitments to third parties have been covered. In other words, value is proportional to the prospective free cash flows the business is expected to produce, which means the higher the expected available cash flow, the higher the value.
Please note that we are referring to future cash flows; although the historic performance of the business is undoubtedly one of the factors to consider when estimating future behavior, there are other important aspects to consider as historical results are not enough indication of the future.
Overall, there are two basic approaches to estimate the value of a business. If the company is operating and is expected to continue doing so, then the most appropriate method to use will be the “Income approach”, which is based on the future earnings of the business. On the contrary, if the company will not continue to operate, or profitability is not foreseen in the future, then the “Asset approach” will be a suitable method to estimate the market value of the assets the company owns.
In this article, we will go over the basics of the Income approach, as our objective is to explain what the key variables are impacting business value for operations expected to continue.
There are two basic process steps to estimate the value of a business using the “Income approach”:
1) Forecasting the future earnings, 2) determining the appropriate rate to reflect the risks associated with the earnings of the business.
1. Forecasting the future earnings/cash flows: Basically, we need to project the most likely cash flows that will be available from the business after having covered all expenses and commitments (including debt and taxes) with third parties. Thus, we forecast revenues, operating expenses, financial inflows/outflows, and investments needed to support the operation.
When projecting all those future streams, not only the history of the business is considered, but also, other qualitative and quantitative factors from the overall economy expected performance, the industry-specific dynamics, the company business plan and its competitive position in the market, among others.
2. Determining the appropriate rate to reflect the risks associated with the earnings of the business: The value of the same nominal amount of money changes over time. Having a hundred dollars today is not the same than to have the same amount in 2 years from now. The intuitive notion of how money value changes, may be understood from the purchasing power fluctuations over time (inflation), which is a concept that most people are familiar with.
In business valuation, there are other factors (not only inflation) that affect how the nominal value of the money changes over time, such as the macro-economical risks of the country, the cost of accessing credit, the risks inherent to the specific industry, the strengths, and weaknesses of the company being valued, and a few others. All those risks are considered when bringing the expected future earnings into present value. The pace at which such future benefits are brought into the present value is called the discount rate, as future earnings value is “discounted” into the present.
To illustrate, let´s contrast the value of two very similar businesses competing in the same market, company A and company B. Both produce earnings of $1.0 million per year and are expected to grow at 5% on an annual basis. Company A has established multi-year contracts with all key its clients, has a well-diversified customer-based, and has established some penalty fees if they default to meet expected purchases in the next five years.
In contrast, Company B has not signed any contract with customers, but rather sells on a spot basis. Naturally, even if the earnings of both companies are equivalent, the risks associated with company B (uncertainty of revenues) are higher, so the discount rate used when estimating value should be higher for Company B. Just for the sake of this example, let´s assume that the appropriate discount rate for Company A should be 10%, while for Company B 18%. Refer to the example below to compare the value for both companies.
In conclusion, all actions that increase disposable earnings and all tactics implemented to mitigate the risks associated with achieving those profits will positively impact the value of the company.
About the writer:
Mónica Hernández is a business valuator at FY Canada and assists clients in improving their performances through negotiation and strategic planning. Due to her training and experience, Mónica also works with Mergers & Acquisitions and Corporate Finance.