Growth and value go hand-in-hand. Companies with high growth rates are appealing because they have potential to get bigger, increase sales, and earn greater profits in the future. If you want to value a business that is growing rapidly, you have to make some assumptions about the growth rate.
Two companies in the same industry, and with the same annual sales could have substantially different values based on their projected growth rates. For example, if Jack's Medical Supply Shop is expected to grow at a rate of 20% for each of the next five years and Mary's Medical Supply Shop is only expected to grow at a rate of 10% for each of the next five years, then Jack's Medical Supply Shop would have a higher company valuation than Mary's Medical Supply Shop.
What is the Best Way to Value a Growth Company?
Business valuations can be done using a number of different methods and each method may produce a different business valuation. Valuation methods may vary by industry. They may be different for a planned acquisition as opposed to a forced liquidation. Mature companies can not be valued in the same way as growth companies. The preferred method for the valuation of a company that is growing rapidly is to discount the expected future earnings of the company.
What is the Discounted future Earnings Method?
The discounted future earnings method is an income approach to valuation. It attempts to determine the value of a business today based on the projected income it will earn in the future. An overly-optimistic multiple may result in an unrealistically-high valuation and a low multiple may fail to recognize a company's true worth.
Typically, a business appraiser will work with future earnings provided by the company for the next least five years. Too short of a time frame may not provide an adequate amount of data to make an accurate appraisal. In this model, the discount rate is the key to determining the present value of a company. If future earnings are projected for each of the next five years, each year's projected earnings are discounted and then those figures are added together to come up with a company valuation.
Business appraisals using the discounted future earnings method are only as good as the accuracy of the future earnings projections and discount rate. If assumptions are slightly off, the appraised amount may not reflect the true value.
Predicting the Future is Hard
When you value a business based of future earnings, you are essentially trying to predict the future. Business valuation specialists take a logical and orderly approach to estimating future growth. They can look back on historical growth, study industry trends, and factor in contracts and relationships that will lead to future growth. However, no one knows if a natural disaster will occur or if some other force will disrupt a company's growth. The best approach when you value a business that is growing rapidly is often the conservative approach.