Valuing the Firm and Present Value

The value of any firm (when sold) is basically the expected future stream of profits. If profits are expected to be 0, then the value of the business is 0, though the assets might be sold for something (buildings, equipment, inventories, receivables, securities and other investments, etc.).

This may sound strange, since we might think that the businesses assets (buildings, cars, patents, people) might drive the value if the business was sold. Indeed, these assets might be worth a lot, but the core value of the “business” is its capacity to earn positive profits (or positive cash flows). If the business makes and sells a worthless product, then its value will be zero (but the buildings and the tools and the other assets might have some value). Profit (or positive cash flow) potential is the driver of the worth of the business—whether a for profit business, or a not-for-profit one.

The factors driving profits like brands and loyalty, product quality, locations, strength of competition, patents, efficiency advantages, and other things are of course important—but their importance is captured in expected future profits. There are two steps in calculating how much that future stream is worth today.

1. Calculating future profit. The basic need here is to calculate for recent (and future ) years how much cash the business is able to throw off to the owners. Essentially, it is profit plus depreciation (depreciation is an expense, but not a use of cash, so we add it back). Sometimes the interest expense is also added back, if the firm’s debt is going to be paid off at the sale. We can calculate this for the last few years. And, forecasts need to be made of profit going forward for usually 5 years. A calculation is also made of the rate of growth of profits after that point. This stream of Cash flows (CF) looks like:

Sum CF = CF 1 + CF 2 + CF3 + CF4 + CF 5 + ….. + CF infinity

2. Even if these forecasts are accurate, the business is not worth this much today. One adjustment needs to be made. The problem is the “time value of money”. If I asked you whether you would prefer a dollar received today, with a dollar to be received a year from today, I expect you’d prefer to get it today rather than wait. Everyone would. If you had the dollar today you could invest it and have more than a dollar by next year. There are also risks of never getting it. So you’d prefer today. This is the time value of money. A dollar received today has more value than a dollar received a year from now. And, by extension, a dollar received a year from now is worth more than a dollar received 2 years from now. So, if we look at the equation, we are trying to add apples and oranges— dollars received at different points in the future are not worth the same amount. ‘

What to do about it? We must put all profits in this stream into a common value of money. We could put it all in terms of 2015 dollars, or in terms of 2020 dollars. However, the convention is always to put them all in terms of “present year dollars”. We do this since the sale is now, and the alternatives for the buyer are being considered now. We do this by a process called “discounting” the future stream of CFs to put them all in terms of present value of money.

So, lets take CF1 (a year from now) as an example. Assume CF1=$200,000. How much is 200,000 received a year from now worth today? Well, lets say that if I had money now I could invest it and get 5% return in a year. So, if I calculated   200,000 = 190,476 . This means that if I had                                                                                       1.05

190,476 today I could invest it at 5% and have exactly 200,000 a year from now. The present value of 200,000 received a year from now is worth 190,476 if discounted at 5%. The present value of the CF2 = 300,000 would be = 300, 000 = 300,000 = 272,109                                                                                                                        (1+.05)²          1.1025

 

If I had 272,109 today I could invest it at 5% and have exactly 300,000 2 years from now.

So, the idea is to discount the entire stream of cash flows back to present value . This sum gives us the present value of the stream of future profits. You can see that future profits don’t weigh as heavily as profits in the very near term. If the discount rate is high, the future values are worth very little. Tables can ease the calculation process. You will learn more about this in finance.

Basically, the value of a business (at least one who’s stock is not traded on the exchanges) is the present value of the stream of future profits minus the debt the business owes. This kind of method is used for valuing non profits, as well as for profits. These valuations are done (1) when someone wants to make an offer to buy, or (2) the firms pension plan contains share of company stock, and they are required to value the firm every year as part of the oversight of the pension plan.