- Earnings-based valuation
Definition
In this method, the price of the company is assessed as the economic value that the entity generates, regardless of the amount of its assets.
With this technique, the earnings will be multiplied by industry’s average price to earnings ratio to estimate the total value of the company. Industry average price to earnings ratio shows the price that investors are willing to pay in average for shares relative to the income that is generated by companies in that industry. Therefore, multiplying company’s earnings by this average ratio could be an acceptable method to evaluate the business.
Stakeholders’ Perspective
- Investors are willing to receive specific amount of return on their investment over time. So, investors may use this method to know how much the value of the company will be, compare it against their required return on investment, and determine their ownership percentage for their investment.
Illustration:
If earnings are projected to be $10,000 in year 5 and price to earnings multiple is 10, the company is worth $100,000 in 5 years. An investor who is investing $20,000 today and expects10% over the period of 5 years will therefore require [20,000*(1+10%) ^5] or $32,210.20 in the end of year 5. Investors will then need to invest by 20,000 for 32% of the business.
Concerns and Ambiguities
Three questions need to be answered:
- a) Earnings of which duration should be used (past or future, or both)? With current management, or under a new management / strategic direction?
- b) How to determine the effect of accounting practices and assumptions on the earnings?
- c) Which earning (before or after) taxes and interests to be used.
Similar to asset-based evaluation, there is no definite answer to any of the abovementioned questions.
As first step, historical earnings may be used. There will, however, be three matters to consider. First) it should be noted that past performances may not be a truthful indication of future returns (or losses). Nonetheless, past earnings can be used as a guideline and data point. To use future earnings, income and expenses need to be examined, their trends (year over year or percentage of income) may be determined, and projected to calculate the future earnings. Second) accounting practices may affect earnings to a great extent, especially for private companies that may not follow financial reporting standards and disclosures mandatory for public entities. Third) the impact of one-time or non-recurring accounting events (such as losses of operation as a result of an earthquake or fire, or costs of reorganization or lawsuit settlement) should be determined and isolated. And finally) either EBIT (earnings before interest and taxes) or final net earnings can be used for calculation. But it should be noted that the right multiplier is to be used. If valuation will be based on EBIT, then the price to EBIT multiplier should be used to determine the price, and if valuation is based on earnings, then price to earnings multiplier should be the benchmark. However, to study the earnings before financing costs (interests of loans), EBIT would be preferred to investors. It is because they can isolate the earnings, as an indicator of how business performs, from effects of financing (interest) and taxation.
Notes:
Earnings-based evaluation would be more appropriate than asset-based evaluation for high-tech or IT companies with substantial intangible assets and products. However, considering that accounting practices and assumptions may have significant impact on the amount of historical earnings, this method should be used with extra care and expertise. In addition, past trends may not continue in the future, especially in a turnaround scenario, when investors plan to change the management team and company’s strategic direction.
3- Cash Flow-based valuation
Definition
In this method, valuation is based on the net present value of future cash flow regardless of company’s earnings or assets. Cash-based appraisal would be more preferred than earning-based assessment, especially in turnaround cases when investors plan to change the strategic direction and the management team. In addition, cash flow is less prone to wild swings due to changes in accounting practices.
Stakeholders’ Perspective
- Similar to earnings-based approach, in this method investors can determine the ownership percentage for their investment by deciding their desired return on investment and benchmarking it against the net present value of forecasted cash flow to reach at their ownership percentage.
- This method is especially useful to the entrepreneurs. Regardless of the earnings, they can calculate the projected (direct and indirect) cash flow. Cash flows include
- I) Reduction in cash outflow: business-related expenses are tax-free, and would have been taxed otherwise. Therefore, reduced amount of tax, will have an upward impact on the amount of cash to the entrepreneur. (Details of tax benefits to entrepreneurs is out of the scope of this article).
- II) Increase in cash inflow: entrepreneurs may collect salary and/or dividends.
III) Capital gain/ Return of capital: which will materialize in an IPO exit, or else when the business is acquired.
Founders will then be able to manage their expectations on how much salary and/or dividend they would like to collect in the end. Like investors, founders may determine how much return they would be willing to have on their investment, which includes their time as well as money.
Illustration:
Mrs. E decides to start a business with prospects to sell it at the end of year 5.
She can now expense her car lease, fuel, and a part of her mortgage and hydro bills on her business, because she has a home office and uses her car for marketing and meetings. Business-related expenses amount to $10,000, and tax on those expenses amounts to $2,500 (assuming 25% of tax), which she shouldn’t pay because they are now expensed on her business. Now she has $2,500 more in her pocket.
IF she expects to receive salaries, she will need to generate earnings through either financing her business (bank loan or investors), through operations (providing services or products), or through investment (purchasing a real estate, land or other assets). Salaries will increase her cash inflow.
In the end of year 5, she may generate income through selling her business, or an IPO exit. This will also increase her cash inflow.
Mrs. E may calculate the net present value of the cash flows to decide how many hours she is willing to spend on the new business, and whether she is willing to invest in the business. But the most important decision would be, whether she is willing to start the business, or prefers to remain employed. Also, if she plans to start the business, what strategic direction she should take to be able to sell the business in the end of year 5.
Please note that the above-mentioned example is extremely simplified is merely for further clarification of the three streams of cash flow, and how an entrepreneur may use this approach to assess his risk tolerance. Further details are out of the scope of this article.
Conclusion:
Evaluating a business is not a simple task. Information is not readily available, many assumptions are made, and different perspectives and methods may be used to make an educated guess. However, even the best estimates based on all available information and reasonable assumptions is not reliable enough in many cases.
However, a clear understanding of different techniques, what each means, how the calculations are conducted, and how different stakeholders should use each number as a guideline would definitely help entrepreneurs to a great extent.
Entrepreneurs who understand prospect buyers and investors’ perspectives, will have a more realistic view of the value of their company and will be better prepared to negotiate for a deal that is fair to them and of value to the investors or new partners. In addition, with this knowledge, founders will be able to evaluate the financial returns of their startup and therefore manage their expectations and devise a more efficient and effective operation and strategic plan.