Module in FM 2-Financial Analysis and Reporting

Module 5
Valuation: Earnings Based Approaches

INTRODUCTION

Getting the valuation of your business is very important throughout your company’s
lifetime. The reason for getting a business valuation can range from estate planning, partner
buy-in, going through a merger, selling off the company and even divorce. Regardless of the
reason, it is very important to understand how business valuations are conducted.

Based on the variables and information available, a valuation expert can select one of
three kinds of business valuation approaches to identify the value of the business. One such
approach is the earnings based approach. This is normally used to value service-oriented
companies, such as healthcare or engineering companies along with businesses that have
ongoing operations such as the service industry, grocery store chains, prospects, and
others.

THE EARNINGS BASED APPROACH TO VALUATION

Sometimes referred to as the “income capitalization approach”, is a type of real estate

appraisal method that allows investors to estimate the value of a property based on the
income the property generates. In the earnings based approach of business valuation, a
business is valued at the present value of its future earnings or cash flows. These cash flows
or future earnings are determined by projecting the earnings of the business and then
adjusting them for changes in growth rates, taxes, cost structure, and others.

EARNINGS-BASED APPROACH METHODS

The earnings based approach valuation has three main methods, namely the
capitalization of earnings, capitalization of cash flow and discounted cash flows method.

1. Capitalization Of Earning Method

Capitalization of earnings is a method used to determine the value of a company by

calculating the net present value (NPV) of expected future profits or cash flows. This
estimate is figured out by taking the entity’s future earnings and dividing them by the
capitalization rate.

Basically, it is an income approach with a business valuation formula that determines

what a company is worth by looking at the expected future value, the annual rate of return,
and the current cash flow. So, under this method, the value of the business is determined
by discounting its future earnings. Just to be clear, under this approach, there is no growth
in cash flows.
2. Capitalization of Cash Flow Method

The Capitalization of Cash Flow method values a business based on an expected cash
flow stream, capitalized by a risk-adjusted rate of return. This single-period capitalization
approach is most appropriate when a company’s current or historical level of operations is
believed to be representative of future operations and the company is expected to grow at a
relatively stable and modest rate.

The steps taken in applying the Capitalization of Cash Flow method include determining a
sustainable earnings base (ex. benefit stream), making the necessary adjustments to
convert projected earnings into projected cash flow (adjusting for capital expenditures,
depreciation, changes in net working capital and changes in interest-bearing debt),
developing an appropriate capitalization rate, and applying the capitalization rate to the cash
flow base to arrive at a conclusion of the fair market value the company

3. Discounted Cash Flow Method (Formula)

The Discounted Cash Flow (DCF) method is the third kind of earnings based approach
that many companies use for their business valuation. The theory behind this method is that
the total value of a business is the present value of its projected future earnings plus the
present value of the terminal value. In this process, the expected cash flow of the business
over a period of time in the future is projected first.

After that, each discrete cash flow is discounted to a present value at a rate that reflects
the risk of receiving that amount at the time anticipated in the projection. And the best way
to represent these projections, items such as capital expenses, operating costs, revenue,
and working capital are forecasted.

These projections are then used to figure out the net cash flow generated by the
business discounted to present value using an appropriate risk-adjusted discount rate, often
the weighted average cost of capital or WACC. Under the discounted cash flow method, the
first step is to find the projected future cash flows.

The discounted cash flow methodology requires assumptions, but the formula can be
broken down to three basic elements:

1. Projected future cash flows

2. Discount rate
3. Terminal value

 Projected Future Cash Flows

Discrete cash flows are forecasted for as many periods as necessary until a stabilized
earnings stream could be anticipated (commonly in the range of 3-10 years). Ideally,
projections will be sourced from management, but if management projections are not
available, a competent valuation professional may choose to develop a forecast based on
historical performance, industry data, and discussions with management. It is important
to test the reasonableness of the projections by comparing historical and projected
performance as well as expectations based on the subject company’s history and the
industry in which it operates.
  Discount Rate

A discount rate is used to convert future cash flows to present value as of the
valuation date. Factors to consider include, but are not limited to business risk, supplier
and/or customer concentrations, market and industry risk, size of the company, financial
leverage, capital structure, among others.

 Terminal Value

The terminal value captures the value of the company into perpetuity. It uses a
terminal growth rate, the discount rate, and the final year cash flow to arrive at a value,
which is discounted and added to the discrete cash flow projections.

PROS AND CONS OF THE EARNINGS BASED APPROACH

The Earnings Based Approach is one of the most often used valuation methods. There
are numerous reasons why valuators prefer this method over others.

Pros
First, consider the flexibility in using the Earnings Based Approach, particularly
with a DCF. A DCF has many moving parts, including the components of free cash
flow, the discount rate, and the terminal value. This allows the valuator to use their
best judgment and the facts of the case to pinpoint their estimation of the value of
the company being valued.

Second, the Earnings Based Approach uses free cash flow as a base for both
methods. Free cash flow is generally seen as the most accurate way to measure cash
flow available to shareholders after deductions for taxes, capital expenses, working
capital, etc.

Cons
There are two notable cons of the Earnings Based Approach.

First, the projections used in a DCF must be backed up by historical performance

and sound reasoning or explanation from the management team as to why the
projected cash flows are feasible. Value can easily be overinflated when using a DCF,
as the inputs are very sensitive.

Second, no one has a crystal ball. A DCF is done using projections of how a
company may perform based on the information today. The valuator must be aware
of this reality and choose an appropriate discount rate accordingly.
REFERENCES:

Saari, R. S. (March 2017). An Explanation of Income Approach to Valuation – Capitalization

of Cash Flow Method. Marcum Accountants and Advisers. Retrieved April 23,2023, from
https://www.marcumllp.com/insights/an-explanation-of-income-approach-to-valuation-
capitalization-of-cash-flow-method

Understand the Income Approach in a Business Valuation. Mercer Capital. (2021) Retrieved
April 23, 2023, from https://mercercapital.com/article/understanding-the-income-approach-
in-a-business-valuation/