Discounted Future Earnings

Key Takeaways

• Discounted future earnings estimate a firm's worth by forecasting future earnings and discounting them to the present.
• A key component of this model is the discount rate, which reflects the firm's risk and affects the final valuation.
• Terminal value can be estimated using methods like liquidation value, multiples approach, or stable growth.
• Assumptions in inputs like future earnings and discount rates can significantly impact the estimated value.
• Small changes in input values can lead to significant variations in the firm's estimated worth.

What Is Discounted Future Earnings?

Discounted future earnings is a valuation method used to estimate a company's worth by forecasting its future earnings, then discounting those earnings back to the present value using an appropriate discount rate.

This method estimates a firm's value by combining its forecasted earnings and terminal value, applying a discount rate that accounts for risk and time. Given the reliance on forecasts and assumptions, this method requires careful consideration of input variables like discount rate and terminal value to yield reliable estimates.

Understanding discounted future earnings is crucial for investors and analysts as it helps make informed decisions about a company's potential profitability and investment worthiness.

How Discounted Future Earnings Valuation Works

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.

Comparing Discounted Future Earnings With 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.

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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.

Using a discount rate of 10%, the present value of the firm is $657,378.72.

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.

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