By Troy L. Harmon, CFA, CVA, Chief Investment Officer, Henssler Financial
When asked the value of an asset, a financial analyst would usually work to determine the cash flows that asset might generate. Cash flows are the figures investors are most concerned with. When it comes to companies or real estate, the answer can be found by looking at historical financial results and projecting those results into the future. We call this process an income-based valuation. Depending on the company’s growth experience, the analyst uses multiple years of future cash flows or just cash flows of the next year. If a company’s growth is excessive; for instance, greater than the level of economic growth within the overall economy, the analyst will project out several years into the future. If the growth matches or comes close to overall economic growth, the analyst will use the projection of cash flow for the following year in what is called a capitalization of income.
In theory, the projection of cash flows includes a figure that expects the business to grow at a steady rate forever. That is a rather bold assumption, especially when you consider changes in technology and consumer tastes over a long period of time. Everybody knows the automobile killed the horse-drawn wagon industry and Facebook destroyed Myspace, so what makes us so bold as to think anything will live in perpetuity? Without the ability to accurately foretell the future, any analyst is left with the assumption that the business they are striving to value should continue in business for a considerable period, even forever. If financial conditions within the company should change, those assumptions also change and values fall accordingly.
When the company has a history of growth, that “forever” projection—the assumption that steady and stable growth at levels near the overall economy continues for a long time—is pushed even further out into the future. This can make the assumption even less accurate. However, the growth that occurs in the interim is the more sensitive issue. The assumption of short-term growth affects the value calculation and minor changes of 1% can make a difference of up to 50% or more in the derived value of a business.
This might make you reconsider the accuracy of the value calculated, but this method is still the best assumption in the opinion of most financial analysts. However, when you ask an accountant, you might get a very different opinion. Most accountants prefer to derive value from previous transactions, but that method is flawed and often very difficult, especially if the business has never sold an ownership stake. The accountant’s second preference is market transactions of a similar business. Although many businesses are sold on a regular basis, finding one that is in the same industry, of a similar size and in similar geographic location makes finding a reasonable comparison very difficult. Add in the difference in management and growth potential and the task becomes impossible. Only after these two methods are exhausted would the accountant agree that an income-based valuation is proper, but as you can see, the flaws are many.
As a financial analyst and business valuation analyst, I believe the best methodology for valuing a business is the income-based method, it is widely used and is the basis for the values in the stock market, as analysts provide opinions on the values of publicly traded companies and these opinions drive market prices. However, just in thinking about the historical retail dominance of Sears, Roebuck & Company and their current financial condition, things change over time. Forever is a long time! H
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