The earning value approach is primarily based on the ability of an enterprise to create earnings. Mostly, the historic financial performance is used to calculate the equity value. But one could also take the projected earnings into account. However, this is often felt as a bit too troublesome. This requires some additional thinking and work. Basing equity value on the last years’ financials is preferred. Perhaps a bit quick and dirty. But the outcome might be sufficiently precise. So, if accuracy is not a prerequisite, then one could get away with the earning value.
Sometimes, the last years’ financial performance is fundamental. But valuation experts sometimes take earlier years into account, whether or not weighted. Many different approaches can be found in practice.
So, let us look at our case from the WACC discounted cash flow article. BriWiFra generated a net income in the past year 0 of 346. We want to make our valuation exercise an easy job. So, we do not want to look into the future. And therefore, we assume this 346 is a typical income for BrWiFra for the next years to come.
What can this tell us? An investor might get this 346 as a yearly dividend out of BriWiFra. So he is probably willing to defer todays’ consumption and interchange his cash in future cash returns. But what is he willing to pay for that!?
Publicly listed companies normally are traded at P/E ratios between 10 and 25. In which P/E is the price/earnings ratio: the value of its equity divided by the net income. Should we apply such a P/E ratio for BriWiFra? This would not be wise to do so. First of all, BriWiFra is a SME. At least tiny compared to publicly traded companies. These generally serve diversified markets with different products. So we can assume an additional risk due to the small size of the company.
Next to that, the company is controlled by Brian. He is the one and only director annex shareholder. So, we may assume a lack of control, compared to larger publicly listed firms. Furthermore, the marketability of BriWiFra’s shares is obstructed by market imperfections and transaction costs. It is not difficult to understand that these will cause additional discounts on the equity value of BriWiFra.
Let us assume that an average buyer of BriWiFra’s stock will require a 20% rate of return on his investment. Then the P/E ratio will be 5. The earning value of equity will then be 1731. And this is a bit less than the valuation outcome using the WACC method, i.e. 1965.
The earning value method appears to be a bit quick and dirty. But yet, it rapidly gives a rough estimation. And if we would assume that an investor would require a 21.8% return on his investment, which is the levered Reql, we then would calculate an earning value of 1588.
Earning Value adjustments
So, in some cases, is might be practicable to use the earning value method. This instead of an elaborate Discounted Cash Flow method. With the aim to avoid time and money consuming processes. Being content with a rough estimate, which satisfies the need of a proximate starting point in price negations.
If you are willing to spend some more time by looking into the cost and capital structure, you can make some additional adjustments to end up with an more justifiable valuation outcome.
First, let us look at the cost structure. More than often, operational costs in accounting reports are not conform market conditions. This applies for intercompany charges, shareholders’ remuneration, et cetera. This requires adjustments to normative cost levels. Which is, of course, a disputable exercise. But annoying or not, one should not avoid doing this.
So, Brian is a humble person. He grants himself a modest salary of €100,000. While €160,000 would be more normative for comparable situations. Besides, the firm is housed in Brian’s own premises, which he rents out to BriWiFra at a yearly rent of €180,000. This, while normative square meter prices would allow a yearly rent of €220,000. So, in total, the operating income should be adjusted with an amount of €100,000. Thus, resulting in an after tax adjustment of (1-f) * €100,000 is €75,000.
The normalized net profit would then (and now in €/1000) be 75 less: i.e. 271. The equity value, applying the required rate of return of 20%, would then be 1356.
Yet, we have not finished our earning value appraisal task. Because, next to this, we should adjust the earning value for a deviated capital structure. Therefore, we examine the debt ratio, which is the total of liabilities divided by the total of assets.
In the balance sheet from the Assets Based value article, we find a total of liabilities of 1532. The total of assets is 2763. The actual debt ratio of BriWiFra is 55.4%.
Let us assume that a normative debt ratio for BriWiFra’s type of business is 70%. Then it appears that BrWiFra is under-levered. The firm can then attract an imaginary additional debt at an amount of 14.6% * the total assets value, i.e. 403.
This amount might immediately be paid to the shareholders as an up front dividend. However, that would result in an (imaginary) additional cost of debt to the company.
Let us assume that BriWiFra would be able to attract debt at an interest rate of 5%. Then this would increase the debt service at an amount of 5% * 403 is 20. Fortunately, this additional interest is tax deductible. So this will only squeeze the net profit with (1-f) * 20 is 15.
So now, the net profit would be 271 minus 15 is 256. Admittedly less. But now we can add the 403 to the equity value.
Adjusted earning value
The adjusted earning value is then 1683 according to
|Net income initial||346|
|Cost normalisations after tax||-75|
|Additional cost of debt after tax||-15|
|Net income adjusted||256|
|Earning value ex dividend||1280|
|Earning value improved||1683|
Earning value conclusions
So, here we end up with an adjusted earning value of 1683. This is considerably less than the equity value based on the WACC method, i.e. 1965.
Any comparison of valuation outcomes is certainly very tricky. But perhaps some words about this.
The big plus in the earning value method versus the WACC discounted cash flow method is that we adjusted the profitability, due to the non-conformity of costs. Which we similarly should have done is making financial forecasts of BriWiFra, on which we founded our WACC valuation.
The big minus in the earning value method versus the WACC discounted cash flow method is the neglecting of any future growth (at a rate of 3,3%). While growth has a substantial impact on value.
So, this is a bit of reasoning behind different valuation outcomes. But certainly not more than that! And above all: comparing apples to oranges. But, that could be OK if you equally like eating them!