Discounted Future Earnings

What Is Discounted Future Earnings?

Discounted future earnings is a valuation method used to estimate a firm's worth in view of earnings figures. The discounted future earnings method involves these conjectures for the earnings of a firm and the firm's estimated terminal value sometime not too far off, and discounts these back to the current utilizing a suitable discount rate. The sum of the discounted future earnings and discounted terminal value equals the estimated value of the firm.

Grasping Discounted Future Earnings

Similarly as with any estimate in view of conjectures, the estimated value of the firm utilizing the discounted future earnings method is just comparable to the data sources - the future earnings, terminal value, and the discount rate. While these might be founded on thorough research and analysis, the problem is that even small changes in the data sources can lead to widely varying estimated values.

The discount rate utilized in this method is quite possibly of the most critical info. It can either be founded on the firm's weighted average cost of capital or it very well may 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 ought to be utilized.

The terminal value of a firm likewise should be estimated utilizing one of several methods. There are three primary methods for assessing terminal value:

1. The first is known as the liquidation value model. This method requires calculating the resource's earning power with a proper discount rate, then adjusting for the estimated value of outstanding debt.
2. The multiples approach utilizes the surmised sales revenues of a firm during the last year of a discounted cash flow model, then utilizes a numerous of that figure to show up at the terminal value. For instance, a firm with a projected $200 million in sales and a numerous of 3 would have a value of $600 million in the terminal year. There is no discounting in this rendition.
3. The last method is the stable growth model. Dissimilar to the liquidation values model, stable growth doesn't assume that the firm will be liquidated after the terminal year. All things being equal, it assumes that cash flows are reinvested and that the firm can develop at a steady rate in perpetuity.

Discounted Future Earnings versus Discounted Cash Flows

The discounted earnings model is like the discounted cash flows (DCF) model, which does exclude a terminal value for the firm (see the formula below). Moreover the DCF model purposes cash flows instead of earnings, which can vary. At last, earnings estimates are trickier to discover, particularly far out into the future, than cash flows which can be more stable or even known in advance.

Illustration of Discounted Future Earnings

For instance, consider a firm that hopes to generate the following earnings stream throughout the next five years. The terminal value in Year 5 depends on a different of 10 times that year's earnings.

Imagine a scenario in which the discount rate is changed to 12%. In this case, the current value of the firm is $608.796.61

Imagine a scenario in which the terminal value depends on 11 times Year 5 earnings. In that case, at a discount rate of 10% and a terminal value of $825,000, the current value of the firm would be $703,947.82.

In this way, small changes in the underlying data sources can lead to a huge difference in estimated firm value.

The fundamental limitation of discounting future earnings is that it requires making numerous assumptions. For one's purposes, an investor or analyst would need to accurately estimate the future earnings streams from an investment. The future, of course, would be founded on various factors that could undoubtedly change, for example, market demand, the situation with the economy, unexpected snags, and then some. Assessing future earnings too high could bring about picking an investment that probably won't pay off from now on, harming profits. Assessing them too low, causing an investment to seem costly, could bring about botched opportunities. Picking a discount rate for the model is likewise a key assumption and would need to be estimated accurately for the model to be worthwhile.

Highlights

• The model takes earnings for every period, as well as the firm's terminal value, and discounts them back to the present to show up at a value.
• The model depends on several assumptions that make it not exactly helpful in practice, including the level of those future earnings and terminal value, as well as the fitting discount rate.
• Discounted future earnings is a method of esteeming a firm's value in view of estimated future earnings.