Business Valuation Basics: Handling Maintainable Earnings
One way of valuing an economically viable business is using the going concern principle to evaluate its capacity for sustained operation. A common approach for this is the Capitalized Cash Flow Method (CMM) – a valuation method based on a business’s potential to achieve future cash flow.
The CMM is usually used for a business well-established in its industry with a famous merchandise and long-term supporting customers. Such businesses would have a relatively steady cash flow, which can then be appropriately projected. This is useful when there is no such information ready for use.
The two main elements of CMM are as follows:
(i) the rate of return adjusted in consideration of the after-tax risk,
(ii) the annual after-tax maintainable earnings. (This would be capitalised by the rate of return in (ii).)
What Are Maintainable Earnings?
They are representative of the expected average annual income achieved from the sustained operation of a business – a future figure. Hence they are presented as a point estimation or a range.
Evaluating for a fair and realistic level of maintainable earnings needs an expert level of evaluation and examination of the following:
(i) the business and its potential customers,
(ii) the opportunities and the current economic and industry conditions and opportunities, and the influence of these conditions on the business’s operations and reported performance.
The Following Considerations Are Important For Deriving An Appropriate Level Of Maintainable Earnings:
Fair and realistic level of maintaining earnings of a business is derived from its financial statements, which informs about the business’s past performance, and hence a valid point of reference for projections.
When using the statements, it is vital to first verify that the said business’s past performance is sustainable into the future, and the economic and industry conditions would not vary drastically.
In view of this, financial statements are modified in the following situations to better represent the potential of a business:
- Important changes in the competition and industry
A consolidation state of an industry or several businesses, new and expired competitors and new trends of consumer behaviour are the significant changes that will influence a business’s potential.
- Presence of non-recurring / unusual items
These items are likely the one-off litigation costs, the major and special single sale contracts, moving costs and restructuring. In their presence, the revenue and expense items would need to be modified accordingly.
This is especially for private businesses: compensations are modified for a better indication of the market value of the relevant services or products.
- Non-Arm’s Length Transactions
When these are completed at non-commercial rates, they must be modified back to commercial rates to show the market value of its basic form.
- Redundant Assets
These are the assets not required for a business operation, and hence undergo a different valuation. Hence the revenue and costs derived from these assets are ignored.
Expected Future Business Performance
Annual budgets tend to show the most accurate approximation of a business performance in the following year. As the management of a business is seasoned with relevant experience, possessing a reliable understanding of the industry, the business and the people involved, their annual budgets would reveal the prospects of the business, as well as the relevant influences of its performance. The same management’s assumptions may also surface the relevant risks, which are definitely important considerations for the valuation.
Reliable budgets are usually created from experiences and the expert knowledge and skills of making valid forecasts of a business performance. Hence checking a management’s past projections against real data helps to verify the management’s ability of making financial projections, and hence the usefulness of the budget.
The analysis on business forecasts and the thoroughness of a budgeting process should be done after grasping the intention of a forecast.
When historical data or financial statements are unable to provide sound prospective operating results, the situation calls for calculation work of a combination or average thereof.
Hence based on the objective information of a case, the most useful projections can be derived from a simple or weighted average of past financial performance.
Operative results from reports of actual data and projects are mostly used as the basis of determining a fair and realistic level of maintaining earnings. However, the same results need to be first evaluated against the current market conditions and the latest opportunities for business growth.
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