Business Valuation Methods: Part 2

2. Earning Value Approaches

These business valuation methods are predicated on the idea that a business’s true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning.

With this approach, a valuator 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.

The 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.

Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.

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. Whether the business involves plumbing or management consulting, will existing customers automatically expect that a new owner delivers the same degree of service and professionalism?

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. Note that this can be mitigated in many cases, such as when a trusted family member (who may already be familiar with the client list) takes over the business.