What Is Discounted Future Earnings?
Discounted future earnings is a valuation method used to estimate a firm's worth based on earnings forecasts. The discounted future earnings method uses these forecasts for the earnings of a firm and the firm's estimated terminal value at a future date, and discounts these back to the present using an appropriate discount rate. The sum of the discounted future earnings and discounted terminal value equals the estimated value of the firm.
- Discounted future earnings is a method of valuing a firm's value based on forecasted future earnings.
- The model takes earnings for each period, as well as the firm's terminal value, and discounts them back to the present to arrive at a value.
- The model relies on several assumptions that make it less than useful in practice, including the level of those future earnings and terminal value, as well as the appropriate discount rate.
Understanding Discounted Future Earnings
As with any estimate based on forecasts, the estimated value of the firm using the discounted future earnings method is only as good as the inputs – the future earnings, terminal value, and the discount rate. While these may be based on rigorous research and analysis, the problem is that even small changes in the inputs can give rise to widely differing estimated values.
The discount rate used in this method is one of the most critical inputs. It can either be based on the firm's weighted average cost of capital or it can be estimated on the basis of a risk premium added to the risk-free interest rate. The greater the perceived risk of the firm, the higher the discount rate that should be used.
The terminal value of a firm also needs to be estimated using one of several methods. There are three primary methods for estimating terminal value:
- The first is known as the liquidation value model. This method requires figuring the asset's earning power with an appropriate discount rate, then adjusting for the estimated value of outstanding debt.
- The multiples approach uses the approximate sales revenues of a firm during the last year of a discounted cash flow model, then uses a multiple of that figure to arrive at the terminal value. For example, a firm with a projected $200 million in sales and a multiple of 3 would have a value of $600 million in the terminal year. There is no discounting in this version.
- The last method is the stable growth model. Unlike the liquidation values model, stable growth does not assume that the firm will be liquidated after the terminal year. Instead, it assumes that cash flows are reinvested and that the firm can grow at a constant rate in perpetuity.
Discounted Future Earnings vs. Discounted Cash Flows
The discounted earnings model is similar to the discounted cash flows (DCF) model, which does not include a terminal value for the firm (see the formula below). In addition the DCF model uses cash flows rather than earnings, which can differ. Finally, earnings forecasts are trickier to ascertain, especially far out into the future, than cash flows which can be more stable or even known in advance.
Example of Discounted Future Earnings
For example, consider a firm that expects to generate the following earnings stream over the next five years. The terminal value in Year 5 is based on a multiple of 10 times that year's earnings.
|Year 5||$750,000 (terminal value)|
What if the discount rate is changed to 12%? In this case, the present value of the firm is $608.796.61
What if the terminal value is based on 11 times Year 5 earnings? In that case, at a discount rate of 10% and a terminal value of $825,000, the present value of the firm would be $703,947.82.
Thus, small changes in the underlying inputs can lead to a significant difference in estimated firm value.
The main limitation of discounting future earnings is that it requires making many assumptions. For one, an investor or analyst would have to correctly estimate the future earnings streams from an investment. The future, of course, would be based on a variety of factors that could easily change, such as market demand, the status of the economy, unforeseen obstacles, and more. Estimating future earnings too high could result in choosing an investment that might not pay off in the future, hurting profits. Estimating them too low, making an investment appear costly, could result in missed opportunities. Choosing a discount rate for the model is also a key assumption and would have to be estimated correctly for the model to be worthwhile.