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.
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