Lesson 5 – EARNINGS AND MARKET APPROACH

VALUATION Unit 1 – Earnings Approach

Overview:
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 revenue.

Learning Objectives:
After successful completion of this lesson, you should be able to:
1. Discuss the two common methods under earnings approach.
2. Illustrate how capitalizing past earnings and discounting future earnings are calculated.

Course Materials:

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 future.

Two Common Methods of Earnings Approach

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 P400,000.

Given the information above, the business value is also computed as P4

Million (P400,000/10%). Both investments have the same risks and rewards.
 2. Discounting Future Earnings – it uses average of the trend of
predicted future earnings and divided by the capitalization factor.
Therefore, it is a valuation method that estimate firm’s worth or
value based on earnings forecasts.

Three Methods for Estimating Terminal Value

a. Liquidation Value Model
b. Discounted Cash Flow Model
c. 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?
Year Earnings
1 50,000.00
2 60,000.00
3 65,000.00
4 75,000.00
5 750,000 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

Activities/Assessments:

Answer the problem:

Ciamara’s expects to generate the following earnings over the next five
years. The terminal value is P900,000. Assuming the discount rate is 12%,
what is the present value of the firm?
Year Earnings

1 50,000.00

2 60,000.00

3 65,000.00

4 75,000.00

5 900,000 Terminal Value