UncategorizedAugust 4, 20200Valuation Methodologies: The Capitalisation of Earnings methodology

When undertaking a business valuation, valuers are guided by common market practice and the valuation methodologies recommended in the ASIC Regulatory Guide 111.

There are a number of valuation methods which can be used to value a business and some of the more common methods include:

  1. The discounted cash flow method (Income-based Approach)
  2. The capitalisation of future maintainable earnings methods (Income-based Approach)
  3. Asset based methods (Asset-based Approach)
  4. Industry specific rules of thumb (Market-based Approach)

Each of these methods is appropriate in certain circumstances and often, more than one approach is applied at least as a secondary cross-check to a primary method. The choice of methods depends on factors such as the nature of the business being valued, the return on the assets employed in the business, the valuation methodologies usually applied to value such businesses and the availability of the required information.

The selection of an appropriate valuation method to estimate fair market value should be guided by the actual practices adopted by potential acquirers of the business involved.

In the discussion which follows, we outline the Capitalisation of Earnings methodology.

Capitalisation of Earnings methodology: Explained

The capitalisation of earnings method is a commonly used valuation methodology that involves determining a future maintainable earnings figure for a business and multiplying that figure by an appropriate capitalisation multiple. This methodology is generally considered a short form of a discounted cash flow, where a single representative earnings figure is capitalised, rather than a stream of individual cash flows being discounted. The capitalisation of earnings methodology typically involves the determination of:

  1. A level of Future Maintainable Earnings;
  2. An appropriate capitalisation rate or multiple;
  3. Surplus assets and liabilities; and
  4. Net borrowings.

Determining Future Maintainable Earnings:

The Future Maintainable Earnings figure is typically determined by a valuer having regard to historical financial performance and is intended to be earnings which the business can be reasonably expected to achieve.

In determining the appropriate future maintainable earnings figure, a valuer should however consider historical transactions which have involved:

  • Expenses associated with the capital structure and financing costs of the business;
  • Non-arms-length revenue or expenses;
  • Revenue or expenses generated or associated with, redundant assets or assets which are not core to the operations of the business;
  • Owner-related expenses; and
  • Non-recurring, one-off expenses.

Appropriate capitalisation rate or multiple

A multiple can be applied to any of the following measures of earnings:

Revenue – most commonly used for businesses that do not make a positive EBITDA or as a cross-check of a valuation conclusion derived using another method.
EBITDA – most appropriate where depreciation distorts earnings, for example, in a business that has a significant level of depreciating assets but little ongoing capital expenditure requirement.
EBITA – in most costs, EBITA will be more reliable than EBITDA as it takes account of the capital intensity of the business.
EBIT – whilst commonly used in practice, multiples of EBITA can be more reliable as it removes the impact of amortisation which is a non-cash accounting entry that does not reflect a need for future capital investment (unlike depreciation).
NPAT – relevant in valuing businesses where interest is a major part of the overall earnings of the group (e.g. financial services business such as banks).

Multiples of EBITDA, EBITA and EBIT are commonly used to value whole businesses for acquisition purposes where gearing is in the control of the acquirer. In contrast, NPAT (or P/E) multiples are often used for valuing minority interests in a company.

The multiple selected to apply to maintainable earnings reflects expectations about future growth, risk and the time value of money all wrapped up in a single number.

Surplus assets and liabilities

Every business valued under the capitalisation of future maintainable earnings method should be assessed for surplus assets and liabilities. Surplus assets are those assets that are not essential for the operation of the business and will typically include property, non-core investments, excess working capital and loans to private businesses or related parties.

When undertaking this exercise, the impact of surplus assets and liabilities should be considered at two levels:

Level 1

Where the entity as a whole is being valued, the value of the surplus assets and liabilities should be added/deducted from the capitalisation of future maintainable earnings calculation to determine the entity value.

If the valuation is for the business assets, surplus asset or liability value is only relevant if the assets or liabilities to be included in the class of assets, form part of the valuation.

Level 2

Consideration also needs to be given to whether the surplus assets or liabilities have created holding costs for the business. Where these holding costs are identified, they should be quantified and adjusted out of the calculation of Future Maintainable Earnings.

Conclusion: When to use the Capitalisation of Earnings methodology

The capitalisation of earnings method is widely used in practice. It is particularly appropriate for valuing companies with a relatively stable historical earnings pattern which is expected to continue. This method is less appropriate for valuing companies or assets if:

  • There are no suitable listed company transaction benchmarks for comparison;
  • The asset has a limited life (such as a contract, patent, royalty stream);
  • Future earnings or cash flow are expected to be volatile; or
  • There are negative earnings, or the earnings of a business are insufficient to justify a value exceeding the value of the underlying net assets.

For any specific or general business valuation queries, please get in touch with one of our qualified and experienced experts.

 

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