How to Use Future Earnings and Cash Flow for Asset Valuation
Although asset value provides a snapshot of a company’s current value, it doesn’t provide much insight into the company’s potential future value. Taking into account the replacement value of assets, as explained in the previous section, is one way to project the company’s future value.
Another approach is to look at the company’s ability to produce earnings and cash flow into the future. Several tools are available for measuring a company’s potential profit.
Nearly all companies use the accrual method of accounting, which requires that they recognize revenue when it’s earned rather than when they actually receive payment. The accrual method also posts expenses when they’re incurred instead of waiting until the bills are actually paid. As a result, the earnings using the accrual method differ from the cash method.
Your first approach to determine future value may be potential earnings. Take a look at the firm’s past financial performance. Next, consider how your industry knowledge could help increase sales. Mull over the firm’s reputation and customer list.
Maybe you’re considering buying an ad agency. The firm has a stable group of clients that have used the company for advertising for years. Your purchase price includes retention bonuses to motivate current key employees to stay with the company. Based on your long experience in the industry, you conclude that you can generate a 15 percent profit margin — or a 15-cent profit on every dollar in sales.
Every investment has an opportunity cost associated with it. Opportunity cost is cash you invest in the purchase that you can’t use for some other purpose. Assume you invest $500,000 in a greeting card shop instead of investing the same amount in a convenience store. The profit earned by the convenience store owner is given up — that’s the opportunity cost of investing in the greeting card shop.
Moving to cash flow
Earnings are important, but a better measure of a company’s value may be the cash flow it generates. If you decide to invest in a company, you use cash. That cash has to come from somewhere. Consider these points:
If you borrow funds, you stand to pay interest expense on the loan.
Investors that issue stock expect a return on their investment, possibly in the form of a dividend.
If you use cash from your existing company’s operations, you’ll have a tougher time meeting the cash flow needs of your business.
A business needs to recover its cash investment as soon as possible. Given these considerations, a potential buyer may look at future cash flows of the new business to determine a company’s value.
Assume you’re looking at a $600,000 investment in a bookstore. Based on your analysis, you determine that the business will generate $100,000 in cash inflow per year. The calculation you need to use is payback period:
Payback period = Initial investment / Cash inflow per period
In this case, the payback period is 6 years ($600,000 / $100,000). You can make a judgment as to whether or not 6 years is a reasonable period to recover your original cash investment.
Putting a present value on cash flows
Many analysts add a present value assumption into cash flow analysis because of inflation, which is broadly defined as a rise in the general level of prices for goods and services. In other words, today’s dollar is likely to buy you more than a dollar will buy you five years from today.
Inflation impacts the value of the cash flows you receive from the business you purchase. The cash inflows should be adjusted to their present value (the current worth of a future sum of money). You should consider the present value of the cash flows you receive, because that amount represents the current purchasing power of those dollars.
Your annual cash inflows in the prior section total $100,000 per year. Assume a 3 percent inflation rate. You’re interested in the present value of the payment received at the end of year 5. You need to multiply the cash inflow by a present value factor of 3 percent per period for 5 periods. You can find numerous versions of present value tables online.
When you find a table, the period n is 5 (five years). After you find the n value for 5, scroll over to the 3 percent column. The table should show 0.863 (depending on rounding in your table). You can multiply this present value factor by the cash inflow amount:
Present value of $100,000 at 3 percent, end of year 5 = $100,000 x 0.863 = $86,300
If you find a present value factor for all payments, you can compute the present value of all cash inflows. Use the sum of the cash inflows to judge the value of the business.