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Methods For Valuing A Business: Part 3 – The Present Value of Future Earnings Valuation

In parts 1 & 2, I broke down the four methods of business valuations and defined the two asset based valuation methods. The final two valuation procedures fall under the category of income based valuations. For most potential buyers of your business, especially financial buyers, the value will be based on the bottom line. Most buyers usually want to buy a business based on its ability to generate income for them. The higher the income, the higher the price for the business (all other things being equal).

To determine the price for a business based on income, there are basically two ways to approach the valuation – the present value of future earnings valuation (PV) and the capitalization of current net earnings valuation (CAP). The PV approach is more complicated and requires you to use financial compounding which only accountants and MBAs love to do. The CAP approach is more straightforward and easier to use and understand. However, never forget two important points:

  • The true value of your business will be what a financially qualified buyer is willing to pay for it at a particular point in time.
  • A financially qualified buyer will most likely base a buying decision on your company’s proven ability to generate income and the likelihood that it will continue to do so.

Let’s (lightly) go over the PV approach. This method of valuation will provide a much better indication of the true value of a privately-held profitable business than the asset valuation and the market comparison approaches. The Present Value of Future Earnings Valuation method attempts to put a current value on a stream of future earnings. There will be many variables to consider, such as the time value of money, whether the future earnings are expected to increase, decrease, or remain flat, the projected inflation rate, and how far into the future one wants to project earnings. After all of these variables have been taken into consideration, you apply the compound interest formulas to determine today’s value of a future stream of earnings from the business.

The biggest problem with this approach, besides its complicated nature, is when you try to use this method with an arm’s-length buyer, you will receive a great deal of resistance. Most buyers do not want to make a valuation decision for a business based on “projected” future earnings stretching out over several years, which many owners want to show as rapidly increasing. Who can predict the future? Even if it is possible to make some learned predictions as to future income, is it reasonable to expect a buyer to pay for those earnings?

Let’s face it, running a business of any kind is risky. To continue to maintain a given earnings stream, the manager/owner of the company will have to be continually adjusting and fine-tuning the company’s business approach. A wrong move could send those attractive, historically consistent earnings right into the toilet. On the other hand, a fresh, bold approach to the business could take the company to higher levels. Most buyers, whether strategic or financial, will want to personally benefit from the opportunity for increased sales as a compensation for the risk they are taking by acquiring your business. This is not to say that you do not sell your business for as much as you can get, but being realistic about establishing a value for your business will make the selling process much smoother and faster.

Bio and ListingsCRE Blog Posts

Advisor Top BarLisa Sharp Business for Sale BrokerAbout Lisa Sharp – Based out of Pensacola, Florida, Lisa has worked in commercial real estate since 2000 and specializes in business brokerage and commercial sales and leasing. Her experience as an owner and operator, of multiple businesses, makes her especially qualified to help clients purchase and sell businesses. Click here to read her full bio, or if you would like to contact her, you can call her at 850-434-7500, or email her at [email protected] You can follow her on Twitter at @lsharpsvn.

Image Courtesy of “How Much Means Asking Price And Charge” by Stuart Miles

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