Earnings and

Market Valuation
Module 9: Valuation and Concepts
Lecture Content
 Earnings and Market Valuation
 Earnings Approach
o Capitalizing Past Earnings Approach
o Discounting Future Earnings Approach
 Market Approach
o Comparative Private Company Sales Data
o Guideline Public Data
o Prior Transactions Method
o Expert Opinion of Professional Practitioners/ Heuristic Pricing Rules
Method
 Illustration of the Market Value Approaches
 Advantages and Disadvantages of the Market Value Approaches
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Earnings and
Market
Valuation

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Earnings and Market Valuation
Earnings Approach is another common method of valuation and is based on the
concept that the actual value of a business lies in the ability to produce revenue,
profit and eventually wealth in the future. There are a lot of methods of
valuation under the earning value approach, but the most common two is
capitalizing past earnings and discounting future earnings. Capitalization of
Past Earnings is a method of establishing the value of a company which uses
the formula is Net Present Value (NPV) divided by Capitalization rate. To
properly apply the formula requires a strong understanding of the business
being reviewed. Discounted future earnings is a method of valuing a firm’s
value based on forecasted future earnings. The model takes earnings for each
period, as well as the firm’s terminal value, and discounts them back to the
present to arrive at a value. The model relies on several assumptions that make
it less than useful in practice, including the level of those future earnings and
terminal value, as well as the appropriate discount rate.
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Earnings and Market Valuation
Market Approach, on the other hand is behind the concept that the value of the
business can be determined by reference to reasonably comparable guideline
companies are publicly traded or because they were recently sold, and the
terms of the transaction were disclosed. The business valuation methods under
the market approach that are typically used in professional business appraisals
include comparative transaction method/comparative private company method
and use of expert opinions of professional practitioners.

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Earnings
Approach
o Capitalizing Past Earnings Approach
o Discounting Future Earnings Approach

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Earnings Approach
An earning value approach is based on the idea that a business’s value lies in its ability to produce
revenues, profits and eventually wealth in the future.
 Capitalizing Past Earning determines an expected level of cash flow for the company using a
company’s record of past earnings, normalizes them for unusual revenue or expenses, and
multiplies the expected normalized cash flows by a capitalization factor. The capitalization
factor is a reflection of what rate of return a reasonable purchaser would expect on the
investment, as well as a measure of the risk that expected earnings will not be achieved.

 Discounted Future Earnings is another earning value approach to business valuation where
instead of an average of past earnings, an average of the trend of predicted future earnings is
used and divided by the capitalization factor.

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Capitalizing Past Earnings Approach
Illustration:
Let’s take an example of a company that for the last ten years, has earned and had cash flows of about
500,000 every year. As per the predictions of the company’s earnings, the same cash flow would
continue for the foreseeable future. The expenses for the business every year is about 100,000 only.
Hence, the company makes an income of 400,000 every year.

To figure out the value of the business, an investor analyses other risk investment that have the same
kind of cash flows. The investor now recognizes a 4 million treasury bond that returns about 10%
annually, or 400,000.

From this, the investor can determine the value of the business, is around 4,000,000 [400,000/10%.
This is because it is a similar investment concerning risks and rewards. This would be a method in
determining similar investments for the value of a company.

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Capitalizing Past Earnings Approach
Limitation. There isn’t one perfect method to determine a company’s value, which is why assessing a
company’s future earnings has some drawbacks. At first, the method used to predict the future earnings
might give an inaccurate figure, which would eventually result in less than expected generated profits.

In addition to this, exceptional circumstances can occur that eventually compromises the earnings, and
affect the valuation of the investment. Further, a business that has just entered the market might lack
adequate information for finding out an accurate valuation of the company.

The buyer has to know all about the desired ROI and the acceptable risks, as the capitalization rate has
to be reflected in the risk tolerance, market characteristics of the buyer, and the expected growth factor
of the business. For instance, if a buyer is not aware of the targeted rate, he might pass on a more
suitable investment or overpay for an investment.

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Discounting Future Earnings Approach

Discounted future earnings Approach is a valuation method used to estimate a firm's

worth based on earnings forecasts. These forecasts for the discounted future earnings
method uses these forecasts earnings of a firm and the firm's estimated terminal value
at a future date, and discounts these back to the present using an appropriate discount
rate. The sum of the discounted future earnings and discounted terminal value equals
the estimated value of the firm.

As with any estimate based on forecasts, the estimated value of the firm using the
discounted future earnings method is only as good as the inputs - the future earnings,
terminal value, and the discount rate. While these may be based on rigorous research
and analysis, the problem is that even small changes in the Inputs can give rise to
widely differing estimated values.

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Discounting Future Earnings Approach
The terminal value of a firm also needs to be estimated using one of several methods
estimating terminal value:
• The first is known as the liquidation value model. This method requires figuring
the asset's earning power with an appropriate discount rate, then adjusting for the
estimated value of outstanding debt.
• The multiples approach uses the approximate sales revenues of a firm during the
last year of a discounted cash flow model, then uses a multiple of that figure to
arrive at the terminal value. For example, a firm with a projected Php200 Million in
sales and a multiple of 3 would have a value of Php600 Million in the terminal
year. There is no discounting in this version.
• The last method is the stable growth model. Unlike the liquidation values model,
stable growth does not assume that the firm will be liquidated after the terminal
year. Instead, it assumes that cash flows are reinvested and that the firm can grow
at a constant rate in perpetuity.
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Discounting Future Earnings Approach
Illustration:
For example, consider a firm that expects to generate the following earnings stream over the next five
years. The terminal value in Year 5 is based on a multiple of 10 times that year’s earnings. What is the
present value of the firm?

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Discounting Future Earnings Approach

Situation 1:

Using a discount rate of 10%, the present value of the firm is Php657,378.72.

Computed as follows:

Php50,000 x (1/1.10)^1 + Php 60,000 x (1/1.10)^2 + Php65,000 x (1/1.10)^3

+ Php70,000 x (1/1.10)^4 + Php 750,000 x (1/1.10)^5 = 657,378.72

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Discounting Future Earnings Approach

Situation 2:

What if the discount rate is changed to 12%? In this case, the present value of the firm
is Php 608,796.61

Computed as follows:

Php 50,000 x (1/1.12)^1 + Php 60,000 x (1/1.12)^2 + Php 65,000 x (1/1.12)^3

+ Php 70,000 x (1/1.12)^4 + Php 750,000 x (1/1.12)^5 = 608,796.61

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Discounting Future Earnings Approach

Situation 3:

What if the terminal value is based on 11 times Year 5 earnings? In that case, at a
discount rate of 10% and a terminal value of Php 825,000, the present value of the
firm would be Php 703,947.82.

Computed as follows:

Php 50,000 x (1/1.10)^1 + Php 60,000 x (1/1.10)^2 + Php 65,000 x (1/1.10)^3

+ Php 70,000 x (1/1.10)^4 + Php 825,000 x (1/1.10)^5 = 703,947.82

Thus, small changes in the underlying inputs can lead to a significant difference in
estimated firm value. 15
Discounting Future Earnings Approach
Limitation. The main limitation of discounting future earnings is that it requires
making many assumptions. For one, an investor or analyst would have to correctly
estimate the future earnings streams from an investment. The future, of course, would
be based on a variety of factors that could easily change, such as market demand, the
status of the economy, unforeseen obstacles, and more. Estimating future earnings too
high could result in choosing an investment that might not pay off in the future,
hurting profits. Estimating them too low, making an investment appear costly, could
result in missed opportunities. Choosing a discount rate for the model is also a key
assumption and would have to be estimated correctly for the model to be worthwhile.

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Market
Approach
Market Approach
Market-based business valuation methods are routinely used by business owners, buyers and their
professional advisors to determine the business worth. This is especially so when a business sale
transaction is planned. After all, if you plan to buy or sell your business, it is a good idea to check
what the market thinks about the selling price of similar businesses.

The market approach offers the view of business market value that is both easy to grasp and
straightforward to apply. The idea is to compare your business to similar businesses that have actually
sold.

If the comparison is relevant, you can gain valuable insights about the business would fetch in the
marketplace. You can use the business valuation methods to get a quick sanity check pricing estimate
or as a compelling market evidence of the likely business selling price.

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Market Approach
All business valuation methods under the market approach fall within one or more
of the following categories. It is either based on statistics/empirical and/or
heuristics and/or combination of these methods.

• Empirical / Statistical Approach

o Comparative private company sale data
o Guideline public company data.
o Prior transactions method

• Heuristic Pricing Model which uses expert opinions of professional

practitioners.

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Comparative Private Company Sales Data
This is an empirical approach. This is formerly known as comparative transaction method. Other literature
called this as guideline transaction method or comparative business sales data.

This method involves fending out prior transactions (i.e. mergers and acquisitions, divesture, etc.) of
comparable companies. Such a transaction might represent either a minority perspective or a majority
perspective. Transactions data can be obtained by finding out the exact industry of the business under
consideration using the established industry classification methods such as SIC and NAICS valuation
databases for historical valuation evidence. A number of publications collect and disseminate information on
transactions. Most publications make their databases accessible on the internet for free on a per-use basis or
annual subscription access. Among the most widely used are:
• Institute of Business Appraisers (IBA)
• BIZCOMPS®
• Pratt’s Stats™
• Done Deal™
• Mid Market Comps™ (ValueSource)
• Mergerstat®

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Guideline Public Data
The guideline public company method involves identifying a comparable company and
obtaining the stock price for the company's listed securities. Publicly listed companies
(PLCs) are required to file their financial statement electronically with the Securities and
Exchange Commission (SEC). These filing are public information and are available on
the SEC website at https://www.sec.gov.ph. Information are also available in Philippine
Stock Exchange website at https://pse.com.ph.

In most cases, the stock prices are obtained from a public market represent a minority
stake. The advantage of this method lies in the availability of a large set of recent data.
However, it might not be very appropriate in valuing early-stage and/or small businesses.
In using public company data to value private companies, proper adjustments must be
made to the benchmarks being used on account of size, growth potential, capital
structure, business life cycle (i.e. early stage or maturity), etc.

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Prior Transactions Method
The prior transaction method involves looking up historical transactions in
securities of the business undervaluation. The valuation might be for minority
stake such a historical stock quote from a listed stock exchange or it might be for
a majority stake such as merger and acquisition transactions involving the
business. Additional considerations in selecting prior transactions as a benchmark
include the time line of the transaction, the economic situation at the time of the
transaction, etc.

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Expert Opinion of Professional Practitioners/ Heuristic
Pricing Rules Method

The above approaches are all empirical and maybe used by the company analyst.
Company may also consult and use the expert opinion of professional
practitioners which uses Heuristic pricing rules method. In this method, you use
business pricing formulas that are developed based on the expert opinion of
professionals involved in business sales. The best known professional group that
does this is the business intermediaries that broker business sale transactions in
specific industries. Their knowledge of the market place and direct exposure to
transactions puts these experts in an excellent position to estimate the likely
business selling price.

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Illustration of the
MarketValue
Approaches

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Illustration of the Market Value Approaches
You are a valuation advisor at HCB Capital. You are advising a large technology
company on the potential acquisition of HBB Inc., a relatively small enterprise which
engages in health-tracking hardware and software. The company was founded in
2011. The co-founders sold a 20% stake in 2014 for Php2.5 Million when the
company’s sales were Php3 Million. The company’s revenue for the last twelve
months (annual) stands at Php20 Million, its EBITDA is Php8 Million and net income
for the same period is Php5 million. The company’s debt is valued at Php10 Million.

There are five comparable companies whose shares are publicly-traded. Their P/E
ratios at 25, 22, 18, 12 and 20. They all represent less than 25% of the total share
capital of each company.

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Illustration of the Market Value Approaches
You have identified three transactions which closely resemble the one under
consideration:
A. Annual Sales of Php50 Million, EV/net income of 12 and EV/EBITDA of 17, the
transaction represents 70% stake.
B. Annual Sales of Php10 Million, EV/net income of 20 and EV/EBITDA of 15, the
transaction represents 20% stake.
C. Annual Sales of Php25 Million, EV/net income of 18 and EV/EBITDA of 16, the
transaction represents 51% stake.

In this example, we have one prior transaction from the same company when 20%
ownership interest in the company was valued at Php2.5 million. This translates to total
equity value of at least Php12.5 Million [Php2.5 Million / 20% = Php12.5 Million]

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Advantages and
Disadvantages
of the Market
Value
Approaches

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Advantages and Disadvantages of the
Market Value Approaches
The market approach is favorable since it is easy to apply and makes use of real-world
transactions to derive a value. If a business is worth what someone is willing to pay for it,
than the market approach is the most appropriate methodology to determine that value.

However, the major challenge with the market approach is finding sufficient private
company market data to reach a valid valuation conclusion. Many closely-held businesses
do not have a suitable public company counterpart, and statistics on private market
companies and sales transactions can be difficult to find, be from questionable or unreliable
sources or can often need adjustment to be comparable to the subject company. However,
for companies in which good comparable market information exists, this approach can
provide the most reasonable estimate of value.

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Advantages and Disadvantages of the
Market Value Approaches
A key difference between the various market-based business valuation methods is how
these pricing multiples are determined. Each method has a number of advantages and
disadvantages.

Comparative private company sales data method

Advantages:
• Comparison data includes sales of small businesses that are quite similar to the small
business being valued.
• Availability of good sources of private business sales data.

Disadvantages:
• Insufficient market evidence in some industries.
• Requires careful data selection analysis and consistent data reporting standards.
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Advantages and Disadvantages of the
Market Value Approaches
Guideline public method

Advantages:
• Plenty of transaction data available from the public capital markets.
• Business sale data reporting is generally consistent and reliable.
• Business financial reporting data are readily available.

Disadvantages:
• Comparison to small businesses may not be relevant.
• Data generally involves sales .of non-controlling business owner ship interest,
not the, entire company.
• Data requires adjustment for lack of marketability of private company
ownership interest.
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Advantages and Disadvantages of the
Market Value Approaches

Prior Transactions method

Advantages:
• If data is available, this is already a good basis of valuation.

Disadvantages:
• Data is not always available.

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Advantages and Disadvantages of the
Market Value Approaches
Heuristic pricing rules method

Advantages:
• Pricing multiples based on the expert opinion of active market participants,
from the trenches.
• Pricing formulas are often relied upon both by practitioners and their client
business owners and buyers when pricing a deal.

Disadvantages:
• Pricing multiples may not be backed by rigorous statistical data analysis.
• Non-brokered business sale transaction data may not be included.

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Basic
Implementation/
Calculation Premise
of MarketValue
Approach

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Basic Implementation/ Calculation
Premise of Market Value Approach
Sales of businesses which closely resemble the business being valued are most
commonly used to estimate the pricing multiples. Statistical analysis of such actual
business sale data is used to establish the business valuation market comps.

Generally, these value measures are ratios, known as pricing multiples, of the
estimated selling price to a known financial performance characteristic. The most
popular multiples are:
 Selling price divided by business gross revenue
 Selling price divided by business net sales
 Selling price divided by cash flow, such as seller’s discretionary cash flow or
net cash flow
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Basic Implementation/ Calculation
Premise of Market Value Approach
Other common valuation multiples that are also used to rely on well-known
accounting measures, for example:
• Selling price divided by EBITDA, EBIT or net income.
• Selling price divided by gross profit
• Selling price divided by book value of business assets
• Selling price divided by market value of total business assets or fixed assets
such as furniture, fixtures and equipment.
• Selling price divided by the value of owner’s equity.

For example, to estimate the business selling price you can take the business
revenue and multiply it by the selling price to business revenue pricing multiple.

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Basic Implementation/ Calculation
Premise of Market Value Approach
Basic formula as follows:

Value = (Price/Parameter) Comparable Company x Parameter Subject Company

(For invested capital multiples, debt should be subtracted)

Where:

Price is the price measure of the guidelines company or the selling price of the company where we
are comparing the company under valuation.

Parameter is the financial statement parameter that scales the value of the company.

Price/Parameter is actually the pricing multiple formula to be used as the factor for the company
being evaluated or we called here as subject company.

The second part of the pricing multiple is .the denominator, the financial statement parameter that scales the
value of the company.
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Basic Implementation/ Calculation
Premise of Market Value Approach
MVIC is usually the numerator paired with Revenues, EBITDA, EBIT, free net
income, Debt-Net Cash Flows, Assets, Tangible book value of invested capital.
Market Value of Invested Capital is defined as the amount of money invested or
raised by issuing securities to shareholders and bondholders. Simply stated, the
sources are both from equity and debt.

MVEq is usually the numerator paired with Pre-tax Income, Net Income and Net
Cash Flow and Book value of equity. Market Value of Equity is defined as the
amount of money invested or raised by issuing securities to shareholders only.
Simply stated, the sources is from equity only.

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Basic Implementation/ Calculation
Premise of Market Value Approach
To illustrate the calculation of value of the company using market approach which uses pricing multiples are
as follows:

You are an analyst of a private company, Heart Company and has been assigned to do the current valuation of
the company and what is the reasonable minimum price the company can issue for 20% shareholdings. A
comparable company, Heinz Company, has been identified recently to be very similar with your company
which have been priced/valued at Php150 Million taken as a whole (MVIC). The following are the relevant
financial information of the two companies:

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Basic Implementation/ Calculation
Premise of Market Value Approach
Compute for the value or the price of Heart Company i.e., MVIC and MVEq using the following
parameters:
a. Gross Revenue
b. Net Income

Likewise, the same parameters that will be reasonable minimum price they can issue shares for a
20% shareholdings.

Answers are computed as follows:

1. Gross Revenue
a) MVIC
Value = (Price/Parameter) Comparable Company x Parameter Subject Company
Value = (Price/Parameter) Heinz Company x Parameter Heart Company
MVIC = Php150 Million / Php100 Million x Php80 Million
MVIC = Php120 Million

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Basic Implementation/ Calculation
Premise of Market Value Approach
b) MVEq
MVEq = MVIC – debt
MVEq = Php120 Million – (Book Value of Assets Php90 Million – Book Value of Equity
Php60 Million)
MVEq = Php90 Million

c) Minimum issue price for 20% shareholdings

Minimum issue price for 20% = MVEq x 20%
Minimum issue price for 20% = Php90 Million x 20%
Minimum issue price for 20% = Php18 Million

Note: This started with MVIC as numerator in the pricing multiple formula since the
parameter is Gross Revenue. This excludes the effect of interest or gross of interest or
interest have not been deducted which means the source of capital includes debt.

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Basic Implementation/ Calculation
Premise of Market Value Approach
2. Net Income
a) MVEq
Value = (Price/Parameter) Comparable Company x Parameter Subject Company
MVEq = [(MVIC – Debt)/Parameter)] Heinz Company x Parameter Heart Company
MVEq =( Php150 Million – Php20 Million) Php15 Million x Php10 Million
MVIC = Php86.67 or 87 Million (rounded off)

b) MVIC
MVIC = MVEq + debt
MVEq = Php87 Million + (Book Value of Assets Php90 Million – Book Value of Equity
Php60 Million)
MVIC = Php117 Million

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Basic Implementation/ Calculation
Premise of Market Value Approach
c) Minimum issue price for 20% shareholdings
Minimum issue price for 20% = MVEq x 20%
Minimum issue price for 20% = Php87 Million x 20%
Minimum issue price for 20% = Php17.4 Million

Note: This started with MVEq as numerator in the pricing multiple formula since the
parameter is Net Income, as this include the interest effect or interest have been deducted
which means the source of capital from debt is excluded.

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Summary

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Summary
 Two of the most commonly used valuation techniques are Earnings Approach
and Market Value Approach.
 Earnings Approach is another common method of valuation and is based on the
concept that the actual value of a business lies in the ability to produce revenue,
profit and eventually wealth in the future.
 Market Approach on the other hand is behind the concept that the value of the
business can be determined by reference to reasonably comparable guideline
companies for which transaction values are known.
 Earnings Approach has two methods: Capitalizing Past Earnings and Discounted
Future Earnings.

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Summary
 Market Approach has 2 methods: empirical/statistical and heuristics.
 Empirical/ Statistical approaches composed of 3 methods dependent on the
sources of comparable data: Comparative private company sale data, Guideline
public company data and Prior transactions method.
 Heuristics uses Heuristic Pricing Model which uses expert opinions of
professional practitioners.
 To calculate value or price of a company, in simple terms, uses pricing multiple
derived from a particular financial ratio of the company or average of similar
companies where the subject company is being compared.

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End of
Discussion 46