Factually, there is no such thing as the future, singular, only futures plural, but there is only one past.
This may help explain why most valuations are based on the future maintainable earnings (FME) methodology with a reliance on historical trading results. The past is often considered to be the only reliable source of information about the multiple futures that may lie ahead for a business.
In theory, the discounted cash flow method (DCF) is the preferred method to value a business because it attempts to assess the timing and quantum of future cash flows. Fundamentally, the value of any asset is the present value of its future cash flows. Then why is there a bias towards FME if DCF is considered to be the preferred method? Some typical reasons given are:
- The business does not prepare budgets
- Lack of reliable information about the future
- Difficulty in estimating future earnings
Predicting earnings for a DCF is no less precise than using the average of prior year’s trading results under FME, either method is obviously subject to uncertainties. Just because a business has made a profit in the past, does necessarily mean that level of profit will continue every year in the future.
The valuation of a business should always consider the DCF method and provide reasons why it has not been used. The DCF method may be more appropriate than the FME method under the following circumstances:
- Recently established business
- Recent and/or expected changes (internal and external)
- Cyclical business
- Business operates in a disruptive industry
- Growing business
Next time you have to consider the value of a business in a property settlement ask yourself if the value takes into account the multiple futures of the business.
If you would like to know more about our Shadow Expert service or how we could help an existing client, please feel free to contact John at de Blonk Smith Young on (07) 3221 4465.