I 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 | ForecastedCash 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.
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