Estimating future returns is a difficult task. Often the starting point is past returns, perhaps adjusted for unusual and nonrecurring items that have occurred. Knowledge of the business, industry, economic conditions, and other factors must be brought to bear.
One important task is to separate the expected future returns from the business in its present form from the expected future returns under the guidance of the new owner. Often, the efforts of the new owner will be more influential in determining future success than continuing the same uses of assets already in place. Because the business valuation is usually being conducted to establish a selling price, the buyer should not pay the seller for the buyer’s anticipated improvements in the business.
Another consideration is whether to conduct the analysis on a constant dollar basis or to estimate revenue and cost increases resulting from inflation. Whichever is chosen, the discount rate should be selected in a consistent manner, as discussed in the next section.
Although discounting expected future returns is a conceptually sound approach to business valuation, it is often not used due to the practical difficulties of implementing it. We need projected returns for several years into the future, and such estimates can be highly speculative.
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