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Earnings Approach > Business Valuation | Phasecorp Business Consulting Group in Chicago and Suburbs |
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| | | The buyer of an existing business is essentially purchasing its future income. The earnings approach is more refined because it considers the future income potential of the business.
There are three versions of the earnings approach. - Variation 1: Excess Earnings Method
This method combines both the value of the firm's existing assets (over its liabilities) and an estimate of its future earnings potential to determine a business's selling price. One advantage of this technique is that it offers an estimate of goodwill. Goodwill is an intangible asset that often creates problems in a business sale. In fact, the most common method of valuing a business is to compute its tangible net worth and then to add an often arbitrary adjustment for goodwill. In essence, goodwill is the difference between an established, successful business and one that has yet to prove itself. It is based on the company’s reputation and its ability to attract customers. A buyer should not accept blindly the seller's arbitrary adjustment for goodwill because it is likely to be inflated.
The excess earnings method provides a more consistent and realistic approach for determining the value of goodwill. It measures goodwill by the amount of profit the business earns above the average firm in the same industry. It also assumes that the owner is entitled to a reasonable return on the firm's adjusted tangible net worth... - Step 1:
Compute adjusted tangible net worth.
Using the previous method of valuation, the buyer should compute the firm's adjusted tangible net worth.
Total tangible assets (adjusted for market value) minus total liabilities yields adjusted tangible net worth.
- Step 2:
Calculate the opportunity costs of investing in the business.
Opportunity Costs represent the cost of forgoing a choice. If the buyer chooses to purchase the assets of a business, he cannot invest his money elsewhere. So, the opportunity cost of the purchase would be the amount the buyer could earn by investing the same amount in a similar risk investment.
There are three principal components in the rate of return used to value a business: (1) the basic, risk free return, (2) an inflation premium, and (3) the risk allowance for investing in the particular business. The basic, risk free return and the inflation premium are reflected in investments like U. S. Treasury bonds. To determine the appropriate rate of return for investing in a business, the buyer must add to this base rate a factor reflecting the risk involved in purchasing the company. The greater the risk, the higher the rate of return. A normal-risk business typically indicates a 25 percent rate of return.
The second part of the buyer’s opportunity cost is the salary she could earn working for someone else.
- Step 3:
Project net earnings. The buyer must estimate the company's net earnings for the upcoming year before subtracting the owner's salary. Averages can be misleading, so the buyer must be sure to investigate the trend of net earnings. Have they risen steadily over the past five years, dropped significantly remained relatively constant, or fluctuated wildly? The more erratic your earnings are, the more they will be discounted. Past income statements provide useful guidelines for estimating earnings.
- Step 4:
Compute extra earning power. A company’s extra earning power is the difference between forecasted earnings (step 3) and total opportunity costs (step 2). Most small businesses that are for sale do not have extra earning power (i.e., excess earnings). They show marginal or no profits.
- Step 5:
Estimate the value of intangibles. The owner can use the extra earning power of the business to estimate the value of its intangible assets- that is, goodwill. Multiplying the extra earning power by a years of profit figure yields an estimate of the intangible assets’ value. The years of profit figure for a normal risk business ranges from three to four. A very high-risk business may have a years of profit figure of 1, while a well-established firm might use a figure of 7.
- Step 6:
Determine the value of the business. To determine the value of the business, the buyer simply adds the adjusted tangible net worth (step 1) and the value of the intangibles (step 5).
Both the buyer and seller should consider the tax implications of transferring goodwill. The amount the seller receives for goodwill is taxed as ordinary income. The buyer cannot count this amount as a deduction because goodwill is a capital asset that cannot be depreciated or amortized for tax purposes. Instead, the buyer would prefer to pay the seller for signing a covenant not to compete because its value is fully tax deductible.
The success of this approach depends on the accuracy of the buyer's estimates of net earnings and risk. But, it does offer a systematic method for assigning a value to goodwill.
- Variation 1: Excess Earnings Method
Another earnings approach capitalizes expected net profits to determine the value of a business. The buyer should prepare his own pro forma income statement and should ask the seller to prepare one also. Use a five year weighted average of past sales (with the greatest weights assigned to the most recent years) to estimate sales for the upcoming year. Once again, the buyer must evaluate the risk involved in purchasing the business to determine the appropriate rate of return on the investment. The greater the risk involved, the higher the return the buyer requires. Risk determination is always somewhat subjective, but it is necessary for proper evaluation. The capitalized earnings approach divides estimated net earnings (after subtracting the owner's reasonable salary) by the rate of return that reflects the risk level. For example, the capitalized value (assuming a reasonable salary of $25,000) would be:
net earnings ( after deducting owner's salary)
______________________________________________
rate of return 25%
Clearly, firms with lower risk factors are more valuable. Most normal risk businesses use a rate of return factor ranging from 25 percent to 33 percent. The lowest risk factor most buyers would accept for any business ranges from 15 to 20 percent.
- Variation 3: Discounted Future Earnings Approach.
This variation of the earnings approach assumes that a dollar earned in the future is worth less than that same dollar today. Therefore, using this approach, the buyer estimates the company's net income for several years into the future and then discounts these future earnings back to their present value. The resulting present value is an estimate of the company's worth. The reduced value of future dollars has nothing to do with inflation. Instead, present value represents the cost of the buyer giving up the opportunity to earn a reasonable rate of return by receiving income in the future instead of today. To illustrate the importance of the time value of money, consider two $1 million sweepstake winners. Rob wins $1 million in a sweepstakes, but he receives it in $50,000 installments over 20 years. If Rob invested every installment at 15 percent interest, he would have accumulated $5,890,505.98 at the end of 20 years. Lisa wins $1 million in another sweepstakes, but she collects her winnings in a lump sum. If Lisa invested her $1 million today at 15 percent. She would have accumulated $16,366,537.39 at the end of twenty years. The difference in their wealth is the result of the time value of money.
The discounted future earnings approach involves five steps.
- Step 1:
Project future earnings for five years into the future.
One way is to assume that earnings will grow by a constant amount over the next five years. Perhaps a better method is to develop three forecasts-an optimistic, a pessimistic, and a most likely for each year and then find a weighted average using the formula.
The buyer must remember that the farther into the future he forecasts, the less reliable are his estimates .
- Step 2:
Discount these future earnings at the appropriate present value rate.
The rate the buyer selects should reflect the rate he could earn on a similar risk investment.
- Step 3:
Estimate the income stream beyond five years.
One technique suggests multiplying the fifth year income by 1/rate of return.
- Step 4:
Discount the income estimate beyond five years using the present value factor for the sixth year.
- Step 5:
Compute the total value.
The primary advantage of this technique is that it values a business solely on the basis of its future earning potential, but its reliability depends on making forecasts of future earnings and on choosing a realistic present value rate. The discounted cash flow technique is especially well-suited for valuing service businesses (whose asset bases are often small) and for companies experiencing high growth rates. |
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