Value is a forward-looking proposition based on the Principle of Expected Benefits. When we use the Income Approach, benefits are measured by cash flow to equity or some other measure.
When companies are undergoing change due to external factors like a recession or internal ones like innovation, it can be impossible as of the valuation date to reliably quantify the impact, timing, and magnitude of the changes.
I have valued the shares of an ESOP owned company for many years. The company, which makes test instruments, has been growing slowly but is very profitable. During the recession, management went through a comprehensive strategic planning process that led them to make many changes, none of whose benefits can yet be quantified. Here is what I wrote in my report (with company-specific details omitted):
Looking forward, the Company has undertaken three promising initiatives that could, if successfully implemented, increase revenue, profit, cash flow and equity value:
- The development of a new, patented product line currently in field-testing which could be brought to market late in 2010 or early the following year. At present, however, pricing and potential revenue are not established.
- The launch of a second-generation product, which will have higher profit margins than its predecessor.
- The introduction of an improved product (probably in 2011) and lease financing alternatives to reinforce its dominant market position and to counter a new competitor’s product and aggressive pricing in the U.S. market.
It has also undertaken three internal initiatives to protect and improve its competitive position:
- Increased outlays to protect products by patent.
- A new sales manager and a partly incentive-based sales compensation system.
Two external developments also suggest higher revenue potential:
- The worldwide economic recovery, particularly in East Asia.
- The possibility that the U.S. government will mandate increased [demand for the Company’s services].
Finally, the Company has filed a lawsuit for legal malpractice regarding its loss of a patent opportunity that could result in a multi-million dollar settlement or verdict benefit in several years.
The timing and magnitude of the economic benefit of each of these opportunities cannot be quantified appropriately at present. I have therefore not included any of their outcomes in my financial forecast, but I have reduced the risk level assessment and the discount rate for future cash flows to assign some benefit to them.
As you can see, I recited all the changes, but could not yet measure their benefits, although they certainly created upside potential (not included in my forecast). I lowered the discount rate (the company-specific risk premium) to reflect them.
I hope this helps you when you come across similar situations!