“The value of a privately held business is based on its expected future earnings.” That is the basic idea behind most of the valuation methodology that business appraisers rely on, however, we all have our favorite ways of figuring out exactly what the future holds for any going concern.
One of the most commonly used methods involves using a weighted average of the last several historical years’ results and relying on that as a proxy for the future. For many businesses over the past number of years, that method was adequate. Unfortunately, the economy and how businesses interact with it changed early on in the year 2020 with the advent of the global reaction to COVID-19.
As of this writing, it is my opinion that the past may not be the best indicator of the future for the majority of businesses now operating. That means that appraisers may need to use a different method to predict the future, and that prediction may include some volatility over the next few years, making the Discounted Cash Flow (DCF) method sound like it may be the most appropriate income-based method to use, at least for a while.
The key to using the DCF method lies in the determination of the forecast income streams, as business appraisers need to be able to identify what the expected future earnings are for the specific business being appraised.
Some valuation experts prefer to not create their own projections and instead insist that management provide projections for their use. If this is the method you choose to use, keep the following thoughts in mind:
- Management usually does not know how to create a reasonable projection. Watch out for the hockey stick method.
- Once you rely on management’s projection in your report, you have basically endorsed management’s projections and they now represent your opinion.
For those of us who prefer to create our own projections, there are several other thoughts to keep in mind:
- Not all businesses are always five years out from their point of stability, so always projecting out five years is not necessarily reasonable.
- Not all expenses will always grow at the same rate as revenues. For example, a market value rent expense from a third-party lease will often include year over year increases, but those increases will not always match the expected revenue growth year over year.
- Watch for expected operational changes that may affect large numbers like Cost of Goods Sold. If a manufacturer has begun outsourcing certain products, what will be the impact of COGS going forward and the into the long-term?
- One other item I see missed fairly often, is projected labor costs. If revenues are expected to increase significantly, will the Company need to hire additional help? If so, at what cost? Will payroll taxes also be affected?
Applying the DCF method involves the time value of money concept, so also consider which version makes more sense for the subject business, using the end-of-year or the mid-year present value convention? The first one assumes each year’s income is received in one lump sum at the end of the year, while the other assumes the business generates that income throughout the entire year. The first one will arrive at a lower indication of value, while the second one will illustrate the reduction in risk achieved by a business that does not have to wait 365 days to cash any checks.
Overall, I quite enjoy using the DCF method as it gives me more control over the assumptions that go into determining my final conclusion of value. If you have any questions about predicting the future or even just setting up the method for use in Microsoft Excel, feel free to contact me.