Valuing your business is one of the most important steps in creating a successful exit. However, creating an accurate valuation can be challenging and confusing for many business owners, even experienced ones. How is valuation calculated? What valuation method is best? Who can provide me with an accurate valuation? These are just a few of the questions business owners commonly ask themselves when seeking a valuation.

In this article, we focus on one such common question: Does future value matter in business valuation? That is, does the expected future value of your company influence its current value? To answer this question, we will discuss several topics, including:

• Is future value a business valuation model?
• How future value is incorporated into business valuation models
• Future considerations that impact current SDE valuations
• Limitations of using future value in calculating business value

Related Article: What Info Do You Need for an Accurate Business Valuation?

Is Future Value a Business Valuation Model?

The idea of the future value of a business factoring into the current value makes sense intuitively. After all, a buyer will care more about how much the business will be worth after they buy it than right now when it is still under your ownership. They will be more concerned about the value of the business tomorrow, next week, next month, and next year (and maybe even the next decade). 

This is because the income and value of the business now, while it is under your ownership, doesn’t matter much to them if it tanks when they take over ownership. They want to know how much they can expect to earn from the business in the future when it is under their ownership. 

As such, many business owners wonder if “future value” is an established valuation model. The short answer is no, future value is not a business valuation model on its own. That being said, the future value—or more specifically, the expected future value—of a business weighs heavily into almost all business valuation methods. 

We say expected future value because we really don’t know exactly how much a business will earn or how much it will be worth in the future. (That is, unless you have a magic crystal ball that can predict the future. But if you had one of those, you probably wouldn’t need to start, buy, or sell a business at all!) 

Lastly, the current income and value are often quite related to the expected future value of a business. You can generally extrapolate future performance based on current trends.

How Future Value Is Incorporated into Business Valuation Models

The expected future value of a business can be incorporated into a valuation in many ways. Remember, all valuations are simply an estimate of the total value of the company, and as such they are prone to error. 

Stock prices

Perhaps the most commonly visible way that future value is incorporated into a company’s current valuation is with the rise and fall of a publicly traded company’s stock price. While stock prices are somewhat tied to practical factors like the financial performance or managerial competence of a business, these factors do not tell the whole story. 

In fact, stock prices rise and fall largely based on people’s beliefs about how valuable the stock, and thus the company, will be in the future. This explains why some companies that have never turned a profit can be extremely valuable. In these situations, stock owners believe that the company has the potential to be hugely profitable in the future, even if it isn’t right now. 

Consider another situation: A pharmaceutical company releases information highlighting great results for a phase three clinical trial for a new drug. Instantaneously, the stock price, and thus the value of the company, shoots up. Sales, revenue, and profits have stayed exactly the same, yet the company is instantaneously more valuable because people believe (reasonably so) that the positive trial results will lead to approval of the drug, and thus greater sales and profits in the future. 

The market-based nature of stocks provides a clear, real-time window into how expected future performance and value shape current valuations.

Future earnings

When it comes to valuing privately owned businesses, the discounted cash flow valuation method clearly illustrates the power of future value in estimating current value. 

When using this method, the first step is to estimate the future earnings of the business. How much revenue is reasonable to expect the business to generate next year or the year after that and so on?

Of course, estimating future revenue is difficult. We will almost always be off by a little bit. But we must do our best and arrive at a reasonable estimate that we can explain and defend when talking with prospective buyers. 

At the same time, we must estimate the future expenses that the business will incur. Again, we can only do our best to come up with a reasonable estimate. Once we estimate both the expected revenues and expenses, we can determine the expected profits for the next several years. 

Discounted cash flow

The next step is to determine the value of future earnings in today’s terms, or the net present value. Given that $100,000 in three years is worth less to us than $100,000 today, we must discount these future earnings to calculate their value to us today. 

When discounting future earnings, the outcome will depend significantly on the discount rate you use. Again, choosing a rate is very much an estimation. Whatever rate you (or your business Advisor) choose will need to be reasonable and defensible. 

While discounted cash flow is one of the clearest examples of how future factors play into current valuations, it is by no means the only one. Indeed, there are many other ways to value a business, all of which consider the future. The most commonly used method for valuing privately owned online businesses is the SDE multiple method.

Below, we take a look at the SDE multiple method as well as how it incorporates future factors into the valuation process. 

Future Considerations That Impact Current SDE Valuations

Before we look at how the future plays into SDE multiple method valuation calculations, we must understand how the valuation method works. 

SDE multiple method

The SDE (seller’s discretionary earnings) multiple method of valuation states that the value of a business equals the SDE times a number, called the multiple. Or:

Business value = SDE x the multiple

Simple, right? Well, not really. First, you must calculate SDE. SDE is a number that captures the true money-generating capacity of the business, or the total benefit that the owner derives from the business. 

To calculate SDE, start with the income and add back all allowable expenses or income, including (but not limited to):

• Interest
• Taxes
• Depreciation
• Amortization
• Owner’s salary
• One-time expenses or income

Now that we have an idea of SDE, what about the multiple? How is that calculated? In reality, the multiple encompasses many tangible and intangible factors beyond income that impact the value of a company. This is important to our discussion in this article because many future-focused factors are weighed into the multiple. 

Company growth trends

As with the discounted cash flow valuation method, the expected future revenue and income of your business impact its current value. One of the best ways to get a sense of the future earnings of a business is to look at past and current growth trends. 

A business that is growing strongly is considered more valuable than a business that is stagnant or in decline, all other things being equal. This is because businesses that are growing, as well as those with a history of growth, are much more likely to continue to grow into the future compared to a business that has not been growing.

Near-term opportunities

Past and current growth are not the only factors that impact expected future earnings. If you can identify and outline specific near-term growth opportunities, it could help to boost the expected future earnings. This is true both for expected revenue growth and cost declines. 

For example, let’s say you are selling an Amazon FBA business. As you prepare the business for sale, you recognize that you have been spending $10,000 per year on ads that have had zero positive impact on revenue and growth. You cut this spending immediately as you list your business, with the expectation that this cost savings will translate into an additional $10,000 per year in profit. 

Now, this profit hasn’t been realized yet, but both you and an astute buyer can have a reasonable expectation that it will come to fruition in the future. This increased expected future earnings could raise the value of the business today.

Market and industry growth trends

The growth trends of your business alone don’t tell the whole story of expected future earnings. If your industry is growing rapidly, your business is likely to benefit from the tailwinds. The opposite is also true. Thus, past and current market and industry growth trends can influence the expected future earnings of your business, influencing the current value. 

Risk

While business and industry growth bodes well for future earnings, risk does the opposite. All businesses entail some risk, but the more risk there is related to the future performance and earnings of a business, the less valuable it will be today. For this reason, stable, consistent businesses are generally more attractive, and thus valuable, than high-risk businesses, all else being equal.

Limitations of Using Future Value in Calculating Business Value

While future earnings and value play an important role in calculating the current value of a business, there are limitations. For one, it is impossible to really know what the future earnings and performance will be. All attempts at calculating future earnings are just educated guesses based on current and past data. 

When valuing your business, it is important to create estimations and forward-looking projections that are reasonable and defensible. Any educated buyer will see through overinflated figures, damaging your credibility.

Given the complex and nuanced nature of creating an accurate business valuation, many business owners choose to work with an experienced business Advisor. Your Advisor will help you create a fair and defensible valuation, setting you up for a successful exit.