Earnings based theories start with the assumption that a business’s value is created by its ability to generate earnings. Earnings based theories may use industry data, such as ratios and multiples of earnings, to compare earnings of the firm being evaluated with actual prices of firms in the public market. Earnings based theories derive a firm’s value from its earnings stream, They have been criticized because of the vagaries of what that constitutes (Pricer & Johnson, 1997). Earnings based models are the ones most used in the valuation process, even against the recommendations of the financial literature (Lippitt & Mastrachio, 1993).
Industry valuation benchmarks and the available market prices of comparable firms are used to compare the sales value of similar firms in the market with the firm under evaluation. Reliance on this method varies between industries, with some industries relying on it much more exclusively than others (Demirakos, Strong & Walker, 2004). Some industries use specific benchmarks, which assume that the value of a business is closely related to market share and that profit margins across the industry are relatively stable. Examples of such industries are the nursing home industry, which uses a price-per-bed rate, and cable TV companies, which utilize a price-per-subscriber rate (IPEV Board, 2008).
Available market prices of similar firms are often used as starting points. In these methods the firm under evaluation is examined for its primary financial ratios, capital structure, industry and customer profiles, among other characteristics, and is then compared against similar public firms who are listed on the market (IPEV Board, 2008). The market-listed prices are then adjusted for the differences between public firms and smaller private firms, by extracting the appropriate discounts which may include liquidity, size and age discounts.
The holding period value theory applies a multiple of earnings taken from similar firms in the industry and market to the evaluated firm’s earnings for the year the firm’s owner intends to exit (Pricer & Johnson, 1997). This amount is then discounted to the present value using a required rate of return on the capital the entrepreneur has invested. This method is good for entrepreneurs who are planning an exit in the foreseeable future, but there are significant difficulties associated with finding an appropriate multiple. Furthermore, most entrepreneurs do not know when they will exit the firm, nor have such advanced notice and foresight.
Evaluating a firm using earnings multiples is a common method for finding its value. Some of these multiples include: finding a gross revenue multiplier, by looking for predominant industry ratios of market price to sales revenue; profit margin to capitalization rates which may be applied to revenue; enterprise value over earnings before interest and taxes; and enterprise value over earnings before interest, taxes, depreciation and amortization (Siegel & Gavron, 1994). Methods using multiples are suitable for businesses that have established operations and are operating with a consistent stream of earnings (IPEV Board, 2008). The multiple used should be generated by examining comparable firms’ risk profiles, earnings levels, and growth. They should be comparable in both the type of business and the period of valuation.
Finally, the most common earnings based valuation method is the earnings capitalization method (Lippitt & Mastrachio, 1993). The earnings capitalization method uses historical earnings data or current annual earnings to establish a probable future level of earnings. This level of earnings is assumed to remain stable or grow at a constant rate for an infinite period. As such it can be valued as a perpetuity by dividing the annual income by a required rate of return less the constant growth rate (Pricer & Johnson, 1997). If the assumptions of stable earnings and continuous growth are valid, the valuation obtained by this method should be the same as that obtained with the academically accepted and more theoretically sound cash flow and income based valuations. Specifics for calculating a firm’s required rate of return and various applicable discounts and premiums are explored more fully in the discussion of discounted cash flow.
The earnings capitalization method assumes that earnings in the future will reflect historical earnings and will remain constant in future periods. However, there are some changes that may readily be predicted. These need to be accounted for, including changes in working capital, changes in the capital structure, long-term debt, depreciation levels and capital expenditures required for replacing assets (Lippitt & Mastrachio, 1993). The argument against using earnings based approaches in valuing firms is similar to the argument against using technical analysis in evaluating stock prices and movements on the open market. The past is not necessarily a good predictor of the future.