Earnings-based business valuation methods value your company by its ability to be profitable in the future. It is best to use earnings-based valuation methods for a company that is stable and profitable. There are two main approaches:
Capitalization of Earnings
The Capitalization of Earnings method assumes the calculations for a single time period will continue and calculates future profitability based on cash flow, annual ROI, and expected value.
Capitalization of earnings is determined by calculating the NPV (Net present value) of the expected future cash flows or profits. The estimate here is found by taking the future earnings of the company and dividing them by a cap rate.
In short, this is an income-valuation approach that lets us know the value of a company by analyzing the annual rate of return, the current cash flow and the expected value of the business.
Disadvantages of Capitalization of Earnings Method
There isn’t one perfect method to determine a company’s value, which is why assessing a company’s future earnings has some drawbacks. At first, the method used to predict the future earnings might give an inaccurate figure, which would eventually result in less than expected generated profits.
In addition to this, exceptional circumstances can occur that eventually compromises the earnings, and affect the valuation of the investment. Further, a business that has just entered the market might lack adequate information for finding out an accurate valuation of the company.
The buyer has to know all about the desired ROI and the acceptable risks, as the capitalization rate has to be reflected in the risk tolerance, market characteristics of the buyer, and the expected growth factor of the business. For instance, if a buyer is not aware of the targeted rate, he might pass on a more suitable investment or overpay for an investment.
Multiple of Earnings
The Multiple of Earnings method, like Capitalization of Earnings, values a business by its future profitability. However, this method calculates a company’s worth by assigning a multiplier to its current revenue. The appropriate multiplier varies widely depending on the specific industry, current market trends, and economic climate.
Valuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty is directly tied to the identity of the business owner.
Any valuation of a service-oriented sole proprietorship needs to involve an estimate of the percentage of business that might be lost under a change of ownership.