Corporate Finance Manager at RSM Poland
In my previous post I brought up the topic of difficulties which result from predicting conditions under which entrepreneurs will have to operate in the future. This is indeed a key challenge when specifying the scale and directions in which a company develops, as they are the key factors influencing the ability to create value. Therefore, despite difficulties, one should neither neglect nor belittle this very process.
How to estimate a company’s potential?
We have to face similar difficulties when preparing company valuation, particularly when we apply the income-based valuation methods. These methods of determining a business’s value cannot, as a rule, take place without additional support from the financial plan, illustrating with numbers the future probable state of a company. If we prepare financial plans for next few years, we may feel rather confident when assessing their reliability. But what if we are supposed to outline a financial plan of a company’s operation for next 10 or 20 years? Most likely we won’t be able to determine accurately what the market conditions will look like and what the current state of a given company will be. Therefore, there’s no use going into detailed forecasts when considering company’s distant future. Hence my question: what should we do to illustrate the company’s potential and ability to increase its owners’ wealth?
Residual value of a company
In this case, the residual value comes in handy, including full amount of private financial gain earned by the company after the period of detailed projection. It is usually assumed that the income or cash flow will, at some point, either remain fixed or change at a constant pace. Therefore, the residual value is calculated with the application of one simple formula illustrating the sum of elements of a geometrical progression.
Those who are experienced in dealing with companies’ valuation vary in their opinions on whether to include the residual value as a constituent of the entire company’s value. Some fully accept this rule, even if the majority of company’s value is allocated in the area of residual value. However, there are also others, distrustful of the residual value, struggling to prolong the period of detailed projection and neglecting to acknowledge cash flow which could be generated after the projected period. Speaking from own experience in the field of financial modeling, in relation to company valuation, I could state as follows:
- There’s nothing wrong in including the residual value when calculating the value of a company. What is more, it is highly recommended, as most companies do not cease to exist just like that, after 10 years or so. Most of them will still operate and bring profits to their owners.
- It is crucial that the tools applied should be adjusted to the specificity of a valued company. Therefore, including the residual value will be, as a rule, correct, yet there can occur such situations where it will be necessary to waive from the application of this concept. For example in the case of special purpose vehicles realizing a developer project. If it is an entity which has a sole defined project in its wallet, it will be difficult to assume that it would be able to generate cash flow for an indefinite time frame. Valuation of such company should in fact mean to estimate the value of a realized project.
Finally I would like to notice that when estimating the residual value one must be extremely cautious. First of all, it is crucial to apply realistic assumptions concerning the growth rate of cash flow after the period of detailed projection. Although the operation of a company is not merely limited to a time horizon of few years, still, the more our projections are concerned with far future, the more difficult it becomes to base them on a solid foundation. The company’s current state, results and figures or even its present perspectives lose their significance when we assess its long-term perspectives. Even if we are dealing with a model company, operating dynamically and efficiently, still it would be difficult to accept the idea that such situation will last endlessly. History can name plenty of companies which had been successful on the market, yet weren’t able to keep up with the changes occurring around them. Gradual evolution of customers’ needs and ways of fulfilling them have turned out for these companies to be too great a challenge. Despite their initially optimistic forecasts, they were unable to come up with a new effective business model.