Some sectors have conventional models such as a percentage of sales, a multiple of revenue or a price per customer or agreement, but they are all surrogates for an underlying valuation method which is based on ongoing profitability at the current level. There are, in fact, some very good reasons why these models are used, not least of all because everyone can easily understand them. Secondly, it does represent a variation on a more sophisticated valuation technique based on future earnings.
These methods are often referred as The Market Value and Rule of Thumb methods and could be used as a cross check to discounted cash flow valuation models in certain industries or circumstances. They should not be used as a primary valuation method as they do not take into account the firm’s earnings/cashflows.
Most owners think of valuation as a multiple of their earnings. Let’s go back to basic valuation theory to see why this conventional approach has gained so much use.
How is the valuation of an investment determined?
It is simply the present value of a future stream of earnings. Thus if I invest $100 at 10% interest per annum, I would expect to receive $110 in one years’ time. Thus, working backwards, $110 in one years’ time is worth $100 today if the interest (discount) rate used is 10%. Thus any business can be valued simply by taking its future earnings stream and discounting those back to arrive at what the business is worth today. Of course, we still have to determine the future earnings stream and we need to establish the discount rate. The discount rate is a reflection of the risk in the deal. Thus a higher risk would reflect either greater uncertainty about the external environment or a higher fear about the ability of the business to sustain its current performance into the future.
Earnings Based Valuation methods take into account the firm’s future earnings/ free cashflows.
Capitalisation of future maintainable earnings methodologies include:
The PER can be applied in two ways:
The PER is applied to an estimate of earnings after tax. The value derived using a PER is a valuation of the ordinary shareholders’ interest. This is described as an equity value.
Valuations based on EBITDA, EBITA or EBIT multiples calculate the Enterprise Value of the firm before factoring in the way it is funded. The Enterprise Value is typically adjusted for the following items to calculate an Equity Value.
To further explain the difference between Enterprise Value and Equity Value consider the following example of somebody’s house:
Sectors often have established valuation norms based on earnings multiples.
These can vary with economic cycles reflecting likely growth or depression trends. Multiples applied to mature industries with little likelihood of growth are generally lower than multiples applied to growth sectors. Firms which have experienced higher than average historical growth will usually command a higher multiple on the basis that future growth is also expected to continue at higher than average rates i.e. history is often used as a prediction of the future.
Most valuations adjust the Net Profit forecasts to improve comparability between similar businesses. Thus interest and taxes are added back to reflect differing debt/equity ratios and different tax situations. Often depreciation and amortisation are added back to reflect the differing ages of underlying assets and the variations in write-off methods. The final number, whether it be EBIT (earning before interest and taxes) or EBITDA (earning before interest, taxes, depreciation and amortization) may still be adjusted to bring the owner’s salary and perks into line with an arms’ length cost. In the end, what you are trying to find out is the cash surplus generating power of the business.
The earnings used in your valuation need not be the actual historical earnings. Earnings should be adjusted for abnormal, extraordinary and nonrecurring items to determine a normal level of earnings. If the entrepreneur can show highly probable growth with achievable revenue and profit targets, future earnings might be used to calculate a market valuation. However, it is important to avoid double counting growth by using future earnings and applying a “growth multiple”.
The problem of using the Capitalisation of Future Maintainable Earnings as the valuation method is that you need to arrive at a single number for the earnings component. As I will demonstrate later in this chapter, the key to an increased valuation is to progressively lift the profit earned in successive future periods. This method does not allow for such adjustments and therefore can seriously misinform the potential buyer about profit potential.
In a seminar for the Law Society, Tony Frankham stated “the methodology and value ultimately chosen will be a matter of judgement” and spoke of “considerable uncertainty” in the absence of a reliable database of market EBIT or EBITDA multipliers. Another ex-President and Life Member of ICANZ, John Hagen, confirmed in another seminar that a 10% variation from the mid-point of the range was not unreasonable. Market experience proves that price can vary significantly from value depending upon the motivations and negotiating skills of the parties.
Source: https://www.clythbiz.con.nz/view_news.cfm?key=88 Accessed 12th February 2006.
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