Discounted future earnings is a method of valuation used to estimate a firm's worth. The discounted future earnings method uses 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.
Breaking Down 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.
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 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.