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Module 5 - Valuation Concepts and Methods

Earnings and Market
Intended Learning Outcomes
At the end of the lesson the students are expected to be able to:
1. Discuss the two common methods under earnings approach.
2. Illustrate how capitalizing past earnings and discounting
future earnings are calculated.
3. Enumerate the methods under market approach.
4. Illustrate the market value approaches.
Introduction: Earnings Approach
In this lesson, other business valuation methods will be
discussed like Earnings Approach. This will tackle how to value a
company based on its earnings or ability to earn or produce
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
Two Common Methods of Earnings
1.Capitalizing Past Earnings Approach – it 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. 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 the
expected earnings will not be achieved.
• The estimate here is found by taking the future earnings of the company and dividing
them by capitalization rate – income valuation approach which shows the value of a
company by analyzing the annual rate of return, the current cash flow and the expected
value of the business.
• Illustration. Cecilia Company has earned and had a cash flows of about P500,000 every
year. The same cash flow would continue for the forseeable future as a prediction of
company’s earnings. The expenses for the business every year is about P100,000 only
which leads to P400,000 income 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 P4 Million Treasury Bond that returns about 10% annually or
• Given the information above, the business value is also computed as P4 Million
(P400,000/10%). Both investments have the same risks and rewards.
Two Common Methods of Earnings
2.Discounting Future Earnings – it uses average of the trend of
predicted future earnings and divided by the capitalization Therefore,
it is a valuation method that estimate firm’s worth or value based on
earnings forecasts.
• Three Methods for Estimating Terminal Value
1.Liquidation Value Model
2.Discounted Cash Flow Model
3.Stable Growth Model
• Illustration. 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?
750,000 Terminal Value
• Using a discount rate of 10%, the present value of the firm is
• P657,378.72. Computed as follows:
• P50,000 x (1/1.10)^1 + P60,000 x (1/1.10)^2 + P65,000 x
(1/1.10)^3 + P70,000 x (1/10)^4 + P750,000 x (1/1.10)^5
= P657,378.72
Market Approach
• The idea behind the market approach is that the value of the
business can be determined by reference to reasonably comparable
guideline companies for which transaction values are known.
• Market-based valuation methods are routinely used by business
owners, buyers, and their professional advisors to determine the
business worth. It offers the view of business market value that is
both easy to grasp and straightforward to apply. The idea is to
compare the business with other similar businesses that have
actually been sold. It could provide quick pricing estimate or selling
price. Its mechanic involves finding a price multiple of the benchmark
such as price to earnings ratio, price to book value and etc.
Approaches under Market Value
1.Empirical/Statistical – this involves the following:
• A. Comparative private company sale data – formerly known as comparative transaction
method. This involves finding out previous transactions like merger and acquisitions of
comparable companies. Transactions should come from the same industry. Some of the
sources are Institute of Business Appraisers (IBA), BIZCOMPSR, Pratt’s StatsTM, Done
DealTM, Mid Market CompsTM, MergerstatR.
• B. Guideline Public Company Data – involves identifying a comparable company and
obtaining the stock price for the company’s listed securities. The source usually is coming
from Securities and Exchange Commission (SEC).
• C. Prior Transactions Method – involves looking up historical transactions in securities of
the business undervaluation such as historical stock quote from a listed stock
2.Heuristic Pricing Model – uses the opinion of experts who are usually the professional
The best professional group that is doing this is the business intermediaries or brokers.
s of Market
Sample Problem in Market Approach
• Price should be matched to the appropriate parameted based on providers of
capital and the numerator will be paid with the money given in the denominator.
For example, in Price/EBIT, price is the market value of invested capital (MVIC),
since the earnings before interest payments and taxes will be paid to both the
debt and equity holders. In price/net income, price is the market value of equity
(MVEq) only, since net income is after interest payment to debt holders and
represents amount potentially available to shareholders.
• MVIC – is usually the numerator paired with Revenues, EBITDA, EBIT, Debt-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 shares to shareholders and bondholders, hence the
sources are equity and debt.
• MVEq – is the numerator paired with Pre-tax Income, Net Income and Net Cash
Flow and Book Value of Equity. It is defined as the mount of money invested or
raised by issuing securities to shareholders only – hence equity alone.
• Illustration. You are to evaluate Lung Company’s current value
and assigned to find out the reasonable minimum price the
company can issue for 20% shareholdings. A comparable
company has been identified – Heart Company which is very
similar with Lung Company and that was priced or valued at
P150 Million taken as a whole (MVIC). The following are the
relevant financial information of the two companies:
In million Php Heart Company Lung Company
Gross Revenue 100 80
Net Sales 90 75
Net Cash Flows 15 10
EBITDA 17 14
Gross Profit 60 49
Book Value of Total Assets 100 90 Book Value of Equity 80 60
Net Income 15 10
Compute for the Value or the Price of Lung Company using the following
• a. Gross Revenue
1.Net Income