Earnings Multiple (Value-to-Earnings) Ratio:
A ratio is determined by dividing the firm’s value by its earnings that can be compared to representative ratios of recently-sold similar firms.
Normalized Earnings: Earnings that have been adjusted for unusual items, such as fire damage, and all relevant expenses, such as a fair salary for the owner’s time
Type of Firm ####Earnings Multiple
Small, well-established firms, vulnerable to recession ####7
Small firms requiring average executive ability but operating in a highly competitive environment ####4
Firms that depend on the special, often unusual, skill of one individual or a small group of managers#### 2
Risk and Growth in Determining a Firm’s Value:
Risk and Growth are Key Factors Affecting the Earnings Multiple and Firm Value
The more (less) risky the business, the lower (higher) the appropriate earnings multiple and, as a consequence, the lower (higher) the firm’s value.
The higher (lower) the projected growth rate in future earnings, the higher (lower) the appropriate earnings multiple and, therefore, the higher (lower) the firm’s value.
Cash Flow-Based Valuation
Determination of the value of a business by estimating the amount and timing of its future cash flows
Step 1. Project the firm’s expected future cash flows.
Step 2. Estimate the investors’ and owners’ required rate of return on their investment in the business.
Step 3. Using the required rate of return as the discount rate, calculate the present value of the firm’s expected future cash flows, which equals the value of the firm.
http://www.andrews.edu/~schwab/sbm-appb.ppt#8
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