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The basic concept of business value is that the future benefits (returns) of owning a company must be adjusted (discounted) for the risks associated with owning the company. The sales or earnings of a company are typically used to represent the benefits (returns). Multiples and rates are used to represent the risks. The basic formula of business value is – Value = Returns/Risks. This article will address how to quantify the returns of a business.

Earning Capacity
There are many benefits to owning a business (financial and non-financial). Non-financial benefits like: being your own boss, controlling your own destiny, prestige, etc. are impossible to quantify, so valuation focuses on the financial rewards. The returns from a company are generally measured by its ability to generate earnings (earning capacity). The value of a company that does not have earning capacity comes primarily from its tangible assets.

Earning capacity is not just the net profits from financial statements and tax returns. Net profits must be adjusted to compensate for accounting principles, tax regulations, and related party dealings that do not accurately portray what really happened. Cash flow is considered a purer form of earnings because it is not affected by accounting principles and tax regulations. For these reasons cash flow is the preferred measure of earning capacity for valuation purposes.

The earnings of a small, owner-operated company must do two things. First it must provide adequate compensation to the owner for the services he or she renders to the company. Any remaining cash flow or earnings represent the earning capacity of the company.

Many small businesses don’t earn enough to provide the owner with adequate compensation. Some of these companies have existed for decades, have established customer bases, and have excellent reputations. Their owners have worked hard to build the company to its current state, but they lack one important thing – earning capacity. Without it these small companies have little or no goodwill value. Essentially these companies have only been providing a job for the owner. Intangible assets like loyal, repeat customers and a great reputation have little value if the owners can’t convert them into earning capacity.

Earning capacity is not created in one year. A company must build a history of generating earnings consistently. Trends should be analyzed and unusual or non-recurring events should be eliminated. These events can sometimes be the accumulated effect of incremental changes, so don’t be too quick to factor them out. The earning capacity of a business can be used to value the entire entity or just its intangible (goodwill) value depending on the valuation method used. A three to five year period is often used to analyze earning capacity. A straight or weighted average of earnings over the period is often used in the valuation formula.

Past vs. Future Performance
Since the value of a company is based on future benefits, it would seem reasonable to use projections of future performance as the basis for a valuation. Using projections pose a number of practical problems. First, most small companies don’t normally prepare projections. It is impractical to prepare formal projections for a valuation. Doing quick and dirty projections to save time and money creates a valuation based on questionable earnings, so why bother? Second, projections tend to be unrealistic because they make assumptions that may not occur or have different outcomes. Because there are no good ways to estimate future results, assumptions are often based on arbitrary changes to prior year numbers. Finally, since every number is created from assumptions, it is subject to question or manipulation.

Past performance may not reflect future results, but at least it is based on actual numbers that can be traced back to financial statements or tax returns. Historical data can be adjusted to reflect expected changes in future performance. These adjustments should be limited to results expected from actions that were already implemented, are ongoing, or imminent.  One of the goals of a valuation is to be able to explain and justify the results. Data from past performance is much easier to justify than projected data.

Conclusion
A key component in the business valuation formula is the expected returns from a company. Those returns are quantified by determining the earning capacity of the company. The next step to complete the equation is to quantify the risks associated with owning the company.