09 Nov, 2017
Company Valuation Methods. Income Statement-Based Methods. (Part 3)
Unlike the balance sheet-based methods, these methods are based on the company’s income statement. They seek to determine the company’s value through the size of its earnings, sales or other indicators. Thus, for example, it is a common practice to perform quick valuations of cement companies by multiplying their annual production capacity (or sales) in metric tons by a ratio (multiple). It is also common to value car parking lots by multiplying the number of parking spaces by a multiple and to value insurance companies by multiplying annual premiums by a multiple. This category includes the methods based on the PER: according to this method, the shares' price is a multiple of the earnings.
Table 4. Alfa Inc. Income Statement (Million Euro)
Sales | 300 |
Cost of sales | -136 |
General expenses | -120 |
Interest expenses | -4 |
Earnings before tax | 40 |
Tax (35%) | -14 |
Net income | 26 |
1. Value of Earnings. PER
According to this method, the equity’s value is obtained by multiplying the annual net income by a ratio called PER (price earnings ratio), that is:
Equity value = PER x earnings
2. Value of the Dividends
Dividends are the part of the earnings effectively paid out to the shareholder and, in most cases, are the only regular flow received by shareholders. According to this method, a share’s value is the net present value of the dividends that we expect to obtain from it.
In the perpetuity case, that is, a company from which we expect constant dividends every year, this value can be expressed as follows:
Equity value = DPS / Ke, where: DPS = dividend per share distributed by the company in the last year; Ke = required return to equity.
If, on the other hand, the dividend is expected to grow indefinitely at a constant annual rate g, the above formula becomes the following:
Equity value = DPS1 / (Ke — g), where DPS1 is the dividends per share for the next year.
Empirical evidence shows that the companies that pay more dividends (as a percentage of their earnings) do not obtain a growth in their share price as a result. This is because when a company distributes more dividends, normally it reduces its growth because it distributes the money to its shareholders instead of plowing it back into new investments.
3. Sales Multiples
This valuation method, which is used in some industries with a certain frequency, consists of calculating a company’s value by multiplying its sales by a number. For example, a pharmacy is often valued by multiplying its annual sales by 2 or another number, depending on the market situation. It is also a common practice to value a soft drink bottling plant by multiplying its annual sales in liters by 500 or another number, depending on the market situation.
4. Other Multiples
In addition to the PER and the price/sales ratio, some of the frequently used multiples are:
— Value of the company / earnings before interest and taxes (EBIT).
— Value of the company / earnings before interest, taxes, depreciation and amortization
(EBITDA).
— Value of the company / operating cash flow.
— Value of the equity / book value.
Obviously, in order to value a company using multiples, multiples of comparable companies must be used.
Other parts of the article «Company Valuation Methods» (Part 1), (Part 2), and (Part 4), (Part 5), (Part 6), (Part 7), (Part 8)
Read also: DD Check List, Mandate F. A. Q.