Projections…The Backbone of Business Valuation

Aug 10 2015

 

5053259_mI was recently asked by a lender client of ours to revise a previous valuation report, but NOT use projections in the valuation.  This was not only an odd request, but a first.  Although I understand the client’s reservations and willingness to be conservative for underwriting purposes, projections are ultimately the “backbone” of business valuation.  Let’s look at two examples of how projections are used:

Capitalization of Earnings – In the “Cap E” model, we are capitalizing one year of earnings by a capitalization rate (required rate of return less long-term growth rate).  This method is typically used when earnings are difficult to project or when there is little to no “trend”.  This “earnings” base, let’s call it earnings before interest, taxes, depreciation and amortization (EBITDA) is essentially a projection.  The analyst weights historical performance and then uses a long term growth rate to arrive at a reasonable projection going forward.  This projection is then capitalized ultimately resulting in the value of the business as shown below:

Tax Return Tax Return Tax Return Projected  
  2012 2013 2014 2015
EBITDA $200,000 $185,000 $318,000 $276,000
Weight 25% 25% 25% 25%
Weighted Average $249,750
Add Growth Rate 3%
Projection Going Forward $257,243
Cap Rate 22%
Estimated Value $1,169,284

 

Discounted Future Earnings – Many people are scared off by the DFE approach as it is “projection based”.  As shown above, all valuations are projection based, but yes, the DFE approach is slightly different….. instead of capitalizing one year of projections, we are now projecting out and discounting multiple years (typically 3-5) back to present value.  This can be a daunting task; however, it is not uncommon and when done correctly, can be the most accurate measure of value.  As shown below, the DFE approach is typically used when there is a obvious trend, or when past performance is not a good indicator of future performance:

Year Projected

Cash flow

  Present Value Factor   Present Value of Future Cash Flow
1st Year $220,341 x 0.84138 = $185,391
2nd Year $253,393 x 0.70792 = $179,382
3rd Year $273,664 x 0.59563 = $163,003
4th Year $287,347 x 0.50115 = $144,005
5th Year $295,968 x 0.42166 = $124,798
Terminal Value (a) $1,923,060 x 0.42166 = $810,881
(a) Terminal Value = 5th year cash flow x sustainable growth/by cap rate
Value of Invested Capital (Public/As If Freely Traded, controlling basis) $1,607,462
Less: Interest Bearing Debt $0
Equity Value (Public/As If Freely Traded, controlling basis)  $1,607,462

As shown above, both methods utilize projections when estimating a value.  The Cap E approach focuses on past performance to arrive at a reasonable cash flow going forward with a fixed growth rate to capitalize.  The DFE approach utilizes past performance to help develop a forward looking projection, but discounts cash flows back to the present time.  Both are so similar that if you use a fixed growth rate in the DFE approach, you arrive at the same value in a Cap E approach.