Valuation of the Business:
Basic Approaches Expanded
Refer to: Chapter 4, Franchising and Buyouts
Market-Based Valuation
The market-based valuation approach relies on financial markets in estimating a firm’s value. This
method looks at the actual market prices of firms that are similar to the one being valued and have been
recently sold, or that are traded publicly on a stock exchange. For instance, as a prospective buyer, you
might find recently sold companies having growth prospects and levels of risk comparable to the firm you
wish to value. For each of these companies, you could calculate the price-to-earnings ratio, measured as
follows:
You then apply this ratio to estimate the prospective company’s value as if it had the same price-toearnings ratio as the similar firms that were recently sold.
The market-based valuation approach is not as easy as it might appear, because it is often difficult to
find even one company that provides a good comparison in every way. It is not enough simply to find a
firm in the same industry, although that might provide a rough approximation. Instead, the ideal company
is in the same or a similar type of business and has a similar growth rate, financial structure, asset
turnover ratio (sales/total assets), and profit margin (profits/sales). There is little published information
about company purchases; however, many large accounting firms have departments that can sometimes
provide information about the selling prices of comparable companies. Most major real estate companies
also have an “ICI,” (industrial, commercial, investment) department that can provide information.
As an example, assume that you are considering the purchase of the Aberdeen Company, which has
after-tax earnings (net income) of $80,000. You are interested in determining a fair price for the company
and have located three comparable firms that recently sold, on average, for six times their earnings after
taxes. That is,
Using this information, you estimate the market value of Aberdeen’s equity as follows:
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Valuation of the Business: Basic Approaches Expanded
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or
Aberdeen’s market value = 6(Aberdeen’s after-tax earnings)
Given Aberdeen’s after-tax earnings of $80,000, you estimate its equity market value (the owner’s
value) to be $480,000:
Thus, it could reasonably be argued that the market value of Aberdeen Company’s equity ownership,
a price you might be willing to pay for the firm, is about $480,000.
Earnings-Based Valuation
We now provide a different perspective, in which the value of a firm is not determined by historical or
replacement costs or by market comparables, but by future returns from the investment. That is, the
estimated value of the firm is based on its ability to produce future income or profits—thus, the name
earnings-based valuation approach.
Different procedures are used in valuing a company based on its earnings, but the underlying concept
is generally the same: (1) determine normalized earnings and (2) divide this amount by a capitalization
rate. That is,
Normalized earnings are earnings that have been adjusted for any unusual items, such as a one-time
loss in the sale of real estate or as the consequence of a fire. Also, the buyer should be certain that all
relevant expenses are included, such as a fair salary for the owner’s time.
The appropriate capitalization rate is based on the riskiness of the earnings and the expected growth
rate of these earnings in the future. The relationships are as follows:
1. The more (less) risky the business, the higher (lower) the capitalization rate to be used, and, as a
consequence, the lower (higher) the firm’s value.
2. The higher (lower) the projected growth rate in future earnings, the lower (higher) the capitalization
rate to be used and, therefore, the higher (lower) the firm’s value.
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Valuation of the Business: Basic Approaches Expanded
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In practice, the capitalization rate is determined largely by rules of thumb; that is, it is based on
conventional wisdom and the experience of the person performing the valuation. For example, some
appraisers assign capitalization rates for different types of firms as follows:
Small, well-established businesses, vulnerable to recession
Small companies requiring average executive ability but
operating in a highly competitive environment
Firms that depend on the special, often unusual, skill of one
individual or small group of managers
15 percent
25 percent
50 percent
Assume that the normalized earnings for a company are $130,000 (before deducting anything for the
owner’s salary) and that fair compensation for the owner’s time would be $50,000. Using the earningsbased valuation technique, the appraiser would capitalize the $80,000 in earnings that remains after the
owner’s salary is deducted ($130,000  $50,000). If the appraiser uses a 25 percent capitalization rate, the
firm would be valued at $320,000, calculated as follows:
Cash Flow–Based Valuation
Although not popular, a cash flow–based valuation approach in which a company is valued based on
the amount and timing of its future cash flows, makes a lot of sense. The earnings-based valuation
approach, while used more often in practice, presents a conceptual problem. It considers earnings, rather
than cash flows, as the item to be valued. From an investor’s or owner’s perspective, the value of a firm
should be based on future cash flows, not reported earnings—especially not a single year of earnings;
valuation is just too complex a process to be captured by a single earnings figure. For one thing, there are
simply too many ways to influence a firm’s earnings favourably (even when using generally accepted
accounting principles) while having no effect on future cash flows, or, even worse, reducing cash flows.
Buying a business is in one sense similar to investing in a savings account in a bank. With a savings
account, you are interested in the cash (capital) you have to put into the account and the future cash flows
you will receive in the form of interest. Similarly, when you buy a company, you should be interested in
future cash flows received relative to capital invested. In a cash flow–based valuation, a comparison is
made between the expected rate of return on investment (the interest rate promised by the bank) and the
required rate of return to determine whether the investment (savings account) is satisfactory.
Copyright © 2016 by Nelson Education Ltd.
Valuation of the Business: Basic Approaches Expanded
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Two steps are involved in measuring the present value of a company’s future cash flows:
1. Estimate the firm’s future cash flows that can be expected by the investor.
2. Decide on the investor’s required rate of return.
The first step—projecting cash flows—is no simple matter and is beyond the scope of this book.
However, anyone serious about valuing a company would be well advised to develop an understanding of
the technique or to seek assistance from someone who can help in this regard.
The second step involves selecting a discount rate to be used in bringing the firm’s future cash flows
back to their present value. This rate is not the same as the capitalization rate used for earnings. The
capitalization rate is used to convert a single-point estimate of the current or normalized earnings into
value. A required rate of return is used as a discount rate that is applicable to a stream of projected future
cash flows. The required rate of return is, therefore, the opportunity cost of the funds: An investor must
think, “If I do not make this investment (buy this company), what is the best rate of return that I could
earn on another investment having a similar level of risk?” The answer to this question provides the
appropriate discount rate to be used in valuing future cash flows.
The required rate of return also equals the existing risk-free rate in the capital markets, such as the
rate earned on short-term Canadian government securities, plus a return premium for assuming risk (risk
premium). In other words,
Required rate of return = Risk-free rate of return + Risk premium
For example, assume the current rate on Canadian treasury bills, a short-term government security, is
4 percent. If, for a given investment, such as buying a company, the risk premium is 15 percent, then the
required rate of return should be 19 percent (4 percent + 15 percent).
How the risk premium is estimated is clearly an important factor in determining the required rate of
return. Although there are no hard-and-fast rules that can be used in determining the required rate of
return, the smaller companies listed on the Toronto Stock Exchange have provided investors an average
risk premium of 15 percent. So if the rate of return on a government security is 6 percent, an investor
should expect at least a 21 percent rate of return on his or her investment (6 percent risk-free rate + 15
percent risk premium)—and even more if the firm being valued is riskier.
In fact, for most very small firms, the rate should be significantly more than 21 percent. The risk
premium—the rate above the risk-free rate—should, according to one experienced appraiser, be at least
16 percent, and possibly as much as 30 percent, depending on the riskiness of the firm being valued.
Given the required rate of return for valuing a company, an appraiser can then use the rate to calculate the
present value of the firm’s future cash flows.
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Valuation of the Business: Basic Approaches Expanded
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