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Earnings Valuations

Earnings Based Valuation (Earnings Valuation)value the firm as a going concern. The aim is to make an intelligent projection of the ability of the firm to capture its intellectual capital, intellectual property and/or competitive advantage as 'Future Free Cash Flows' over a fixed period (a reasonable time horizon commensurate with the environment the firm operations in) plus a 'perpetuity' or terminal cash flow that captures the life cycle position of the firm.
 
Free Cash Flows are defined as those cash flows that are available to the providers of finance (debt and equity) after adjustment for Replacement Capital Investments (to replace ongoing assets), Incremental Capital Expenditure (CAPEX) and Incremental Working Capital needed to grow the firm. These cash flows are then discounted at a discounted rate represented by the WACC.
 
Weighted Average Cost of Capital (WACC) is the cost of capital funding (See WACC) weighted for the capital structure of debt and equity. The WACC is therefore a critical component of valuation and the creation of wealth, as it estimates the opportunity cost (and a premium for risk) that would be needed to given to the providers of finance (Debt and Equity). It captures this return to the investors (equity and debt holders) as a cost, as it represents a cost to the firm.
 
WACC calculations contain key elements like the 'Risk  Free Rate' on government bonds, an estimate of the Market Risk Premium (sometimes called the systematic risk), the unique or unsystematic risk of the firm (also called the Beta) and the debt interest rate adjusted for the tax shield available to debt. In Australia and New Zealand the WACC includes an adjustment for imputation credits as well. 
 
The Free Cash Flows of the firm over a reasonable time horizon plus the perpetuity value of the terminal cash flows are combined to form the 'Shareholder Value' or Earnings based value of the firm.
 
Earnings valuations are valid for going concerns that are able to justify their projection and face reasonable due diligence on the key value drivers of the firm. When this occurs an earnings based valuation is vastly superior to standard relative valuations as they;
  • Firstly capture the value of the firm based on intelligent assumptions of key value drivers. These assumptions can then be tested by a willing buyer and a willing seller to arrive at a consensus value;
  • Secondly they can be used to measure the value gap between project value and actual value achieved and measure which drivers have created or destroyed the value of the firm and why (See 4G Balanced Scorecards)
  • Thirdly they individualise the firm and capture the manner in which the firm chooses  to compete. (as against Relative Valuations which provide a relative Revenue Multiples or EBIT multiples which use the same yardstick for measuring good or bad companies). 
  • They are a key ingredient of 4G balanced scorecards that use the current and future projections of shareprice as Value Advisory Services
 Allan Rodrigues of The Business Farm specialises in earnings valuations particularly for firms and organisations operating under risk and uncertainty. He is contactable at allan.rodrigues@thebusinessfarm.com.au