Business valuation: value of multi-year contracts

Some businesses like secure long term contracts that ensure continued revenue streams far into the future. What is the effect of such contracts on business value?

The answer is twofold. First, the contractually guaranteed revenue stream reduces business risk. You essentially have a very good idea of what the earnings from such a contract will be and when they will be received.

Second, the expected revenue steam implies that you can prepare ahead of time. You can estimate the needed business expenses such as staffing and materials, and product production schedules, reducing uncertainly and waste. Importantly, you can optimize business operations for profitability.

Stable earnings point to higher business value

Predictable, stable earnings are always a good thing for a company. This reflects on its business value captured by a number of business valuation methods. Look, for example, at the value factors used by the Multiple of Discretionary Earnings method. Stability of earnings is at the top of the value factor list.

Planning to use the Discounted Cash Flow method in your business valuation? Then the contractually guaranteed revenues would likely lead to a much more reliable cash flow forecast and reduced discount rate. As a result, you calculate a more realistic and likely higher business value.

Cash cow businesses command higher market values

Companies with guaranteed earnings are known as cash cows. Investors and business buyers are eagerly looking for businesses like that all the time. So market demand for a company with long term customer contracts is very high. This drives up competition and increases the business market value.

In summary, business value is about risk and returns. Predictable earnings and low risk are great indicators of higher business value.

See Valuation Tour