Should Business Owners Value Their Business on Past or Future Earnings?

Selling a business is exciting, whether you’re a serial entrepreneur or a first-time business owner.

However, knowing how to value your business for sale can be difficult once you decide to sell. You know how much time and effort you’ve put into growing it, have (hopefully) earned top profits over the years, and can see the potential growth for a new buyer.

While the balance sheet is a good place to start, the book value (market value) generally boils down to what someone is willing to pay for it.

How can you decide on a number that feels like fair market value to you and represents what someone might pay for it?

You can start by determining whether you should value your business based on past or future earnings.

Any potential buyer will perform their due diligence to decide if your business is worth what you say it is. But, your chosen method can significantly impact your business's perceived value and your approach to selling it. The good news is that there is a way to determine which is best for your business.

What Is Past Versus Future Earnings Valuing?

Valuing a business based on past earnings involves analyzing historical financial data from previous years, such as revenue, profit, expenses, and cash flow. Because this method relies on actual performance, it’s more straightforward and less theoretical.

Conversely, valuing a business based on future earnings requires projecting its financial performance. This involves forecasting future revenue, profit margins, and growth rates and considering factors like market trends, economic conditions, and business strategies.

Some factors that impact the decision to use past versus future earnings can include the following:

Business Size

The size of your business will significantly impact the valuation method you choose.

Small businesses typically have streamlined operations and financial structures. Their unique characteristics, such as a focused customer base and specialized market position, can lead to more dynamic earnings patterns. While this can present challenges in projecting future revenues, it also allows for great adaptability to market changes. Lenders and investors may consider these factors when assessing the financial outlook of small businesses.

As a result, small businesses tend to use methods of valuation that rely on historical financial data.

Businesses in the lower middle market, typically those with annual revenues between $5 million and $50 million, often employ a hybrid approach to valuation. These companies have generally established a stable operational foundation, yet still possess significant growth potential. As a result, their valuation methods frequently incorporate both historical data and future projections.

On the other hand, large companies are typically more predictable, with stable cash flows and diversified operations. And because they are less affected by market fluctuations, forecasting future earnings is more reliable. Consequently, business valuation methods that consider future earnings projections, such as the discounted cash flow method (DCF), can be more suitable.

Financial Stability and Predictability

A company's financial stability refers to its ability to maintain consistent revenue, manage expenses effectively, and generate profit over time. Stable businesses are less risky and more attractive to buyers and investors.

Financial stability and predictability reduce the overall risk associated with the business. Buyers and investors are more confident in valuations based on stable and predictable earnings, indicating a lower likelihood of unexpected financial distress.

Business Growth Trajectory

Business growth trajectory refers to a company’s growth pattern over time. Some businesses experience massive growth quickly, while others grow slowly over time, and some feel like they’re barely inching along. This speed of growth impacts how you value a business.

If a company is growing rapidly, its future earnings might be much higher than its past earnings. On the other hand, if a company is stable or growing slowly, past earnings might be a better indicator of its value.

Businesses expanding quickly often have rising sales, increasing market share, and new opportunities that could significantly change their balance sheet. For these companies, future earnings will likely be much higher than past performance would suggest.

Stable or slow-growing companies have more predictable earnings based on past performance. Although these businesses may have fewer new opportunities for rapid expansion, their past earnings provide a reliable basis for valuation.

There are certain situations where future earnings might be a more relevant basis for valuation:

• New Products or Services: If a company is launching new products or services that are expected to generate significant revenue, future earnings should be considered
• Entering New Markets: When a business is expanding into new markets, future earnings are important
• Recent Investments: Companies that have recently invested heavily in technology, equipment, or infrastructure may see a big boost in future earnings
• Industry Changes: If the industry is undergoing significant changes, such as new regulations or technological advancements, future earnings can give a better idea of the company's potential

Some industries rely heavily on future earnings for valuation because their growth potential is so significant. Examples of these industries include:

• Technology Startups: With little to no past earnings, their future earning potential can be enormous due to innovative products and high market demand
• Biotechnology Firms: These companies spend years in the development phase with very little revenue but have massive potential if approved for the market
• Renewable Energy Companies: As the world shifts towards cleaner energy, renewable energy companies have tremendous growth potential
• E-commerce: Online retail businesses can scale quickly, which means their future earnings potential can far exceed their past performance

Valuation Methods Based on Past Earnings

There are several valuation methods you can use to determine the value of a business based on past earnings:

Asset-Based Valuation

This method calculates the value of a company by adding its tangible and intangible assets and subtracting liabilities. It provides a clear picture of the company's net worth, but may only partially capture future growth potential.

Income-Based Valuation

This approach, often referred to as capitalization of earnings or historical earnings (HE), provides a straightforward way to estimate the value based on the business’s past performance and its ability to continue generating profits in the future.

It divides the capitalization rate (or cap rate), the highest rate of return investors would expect from the business, by the highest earnings before interest and taxes (EBIT) to determine a sale price.

Market-Based Valuation

Market-based valuation compares the business to similar companies that have sold recently. It uses industry multipliers and transaction data to estimate the business's value.

Valuation Methods Based on Future Earnings

If you plan to use future earnings for your company valuation, the following methods are commonly used:

Discounted Cash Flow (DCF) Analysis

DCF involves projecting future cash flows—all revenues minus operating expenses, taxes, and changes in working capital—over the next five to ten years and discounting them to their present value.

It then determines the terminal value, the business’s value beyond the forecasted five to ten years. This method considers the time value of money and provides a detailed picture of future profitability. However, it requires accurate forecasting and an appropriate discount rate.

Comparable Company Analysis

This method compares your business to similar businesses in the same industry, focusing on future growth potential and earnings projections. It involves analyzing market multiples such as price-to-earnings ratios.

Hybrid Valuation Approaches

A balanced approach to valuation often involves hybrid methods that combine past and future earnings. One common approach is calculating a weighted average of past and future earnings, blending historical performance with future projections.

This method provides a more comprehensive view of the business's value, considering both stability and growth potential.

How to Choose the Best Valuation Method for You

Choosing the best way to value your business can feel overwhelming, but it doesn't have to be.

Here are a few key factors to consider:

Industry Benchmarks and Norms

Every industry has its own standard practices for business valuation. Knowing these benchmarks helps guide your choice. For example, tech companies often look at future earnings because they usually grow fast and have lots of potential. On the other hand, manufacturing firms might rely more on past performance since their growth tends to be steadier and more predictable.

Economic and Market Conditions

The overall economic environment and market conditions also play a big role in determining the value of your business. If the market is booming, future earnings look more promising and would be a better indicator of value. But if the economy is in a downturn, past earnings provide a safer, more reliable benchmark.

Company-Specific Risks and Opportunities

Every business is unique, with its own set of risks and opportunities. These should be carefully considered during the valuation process. Consider factors like your competitive position, regulatory issues, and current market trends, as they can significantly impact your business's value.

When to Use Professional Valuations

You can use a valuation calculator to estimate the value of the business. Or, engage a professional business broker or valuation expert who can provide an in-depth and accurate valuation.

Professionals bring expertise, objectivity, and a deep understanding of market trends and valuation techniques. They can also add credibility and facilitate smoother negotiations with potential buyers. Visit BizQuest's Broker Directory to find a professional to help you value your business for sale.