Definition:

Business Valuation is the process of determining how much a business is worth

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.

What might such capitalization rates be? In a Management Issues paper discussing "How Much
Is Your Business Worth?", Grant Thornton LLP suggests:

"Well established businesses with a history of strong earnings and good market share might often
trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating and
volatile market tend to trade at much higher capitalization rates, say 25% to 50%."

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.

What might such capitalization rates be? In a Management Issues paper discussing "How Much
Is Your Business Worth?", Grant Thornton LLP suggests:
"Well established businesses with a history of strong earnings and good market share might often
trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating and
volatile market tend to trade at much higher capitalization rates, say 25% to 50%."

Discounted Cash Flow

Discounted cash flow is a complicated method that projects future earnings. It is used to estimate
the future cash flows of your company, excluding capital expenditures and increases in working
capital, or the money needed to run the business.

Definition:

Liquidation Value of Assets

The liquidation value of an asset is its value if liquidated (sold) quickly to raise needed cash.
Liquidation value is usually significantly less than the value if the asset were sold at fair market
value.

Liquidation Value of a Business

The liquidation value of a business is the price that can be obtained for a business that is, or will
soon be, ceasing operations. Because there is no longer a customer base, there is no value in
"goodwill," and the value of assets is lower because the business must be sold quickly.
Liquidation value applies in a Chapter 7 (liquidation) bankruptcy.

Liquidation value can vary based on whether the business liquidation is forced (over a short
period of time, with assets being sold off quickly to satisfy creditors) or orderly (more strategic,
over a longer time period, to gain the maximum from each asset).

A liquidation valuation may be included in a business valuation report to show the lowest
possible valuation of the business and its assets.

Definition:

Multiples of Earnings
The earnings (income) of a business are used to value a business. In most cases, EBIT (earnings
before interest and taxes) is the measure used. Buyers use rules of thumb to value businesses
based on multiples of business earnings. For example, a buyer might pay 3 or 4 times earnings if
a business has market leadership and a strong management.

Earnings Normalized
In many cases, earnings are normalized or adjusted to take out income taxes, non-recurring
income and expenses, non-operating income and expenses, depreciation and amortization,
interest expense or interest income, owner compensation.

Also Known As: Price/Earnings Ratio

Question: What are the Reasons for Creating a Business Valuation? Why Value a Business?
Answer:

Certainly every business owner considers getting a business valuation at the time he or she
decides to sell the business, but every business needs to have an up-to-date business valuation on
hand at all times. Here are some reasons a business valuation should be done at least once a year:

 Something could happen to you (the business owner) and having a business valuation
would help your family deal with the potential sale or dissolution of the business.
 You may find an opportunity to sell or merge which needs to be decided quickly. Having
an up to date business valuation allows you to take advantage of opportunities.
 You may want to take on a new partner or LLC member, and you need to know the value
of your business to determine the buy-in price.
 You may be reaching retirement and you need to know the value of your business in
order to construct an exit strategy.
 You may want to expand or build new facilities, and taking your business valuation to the
bank will help them make the decision to lend money.
 You may need to separate from partners or shareholders, and you need to know the value
to determine how to divide up the business.
 You may be dealing with a divorce or other family issue, and you need to know the value
of the business as one piece in the discussion.

As you can see, things change, and there are many reasons why having an up-to-date business
valuation can help you plan and deal with emergencies.

Answer:

Certainly every business owner considers getting a business valuation at the time he or she
decides to sell the business, but every business needs to have an up-to-date business valuation on
hand at all times. Here are some reasons a business valuation should be done at least once a year:

 Something could happen to you (the business owner) and having a business valuation
would help your family deal with the potential sale or dissolution of the business.
 You may find an opportunity to sell or merge which needs to be decided quickly. Having
an up to date business valuation allows you to take advantage of opportunities.
 You may want to take on a new partner or LLC member, and you need to know the value
of your business to determine the buy-in price.
 You may be reaching retirement and you need to know the value of your business in
order to construct an exit strategy.
 You may want to expand or build new facilities, and taking your business valuation to the
bank will help them make the decision to lend money.
 You may need to separate from partners or shareholders, and you need to know the value
to determine how to divide up the business.
 You may be dealing with a divorce or other family issue, and you need to know the value
of the business as one piece in the discussion.
As you can see, things change, and there are many reasons why having an up-to-date business
valuation can help you plan and deal with emergencies.

By Richard Loth (Contact | Biography)

The price/earnings ratio (P/E) is the best known of the investment valuation indicators. The P/E
ratio has its imperfections, but it is nevertheless the most widely reported and used valuation by
investment professionals and the investing public. The financial reporting of both companies and
investment research services use a basic earnings per share (EPS) figure divided into the current
stock price to calculate the P/E multiple (i.e. how many times a stock is trading (its price) per
each dollar of EPS).

It's not surprising that estimated EPS figures are often very optimistic during bull markets, while
reflecting pessimism during bear markets. Also, as a matter of historical record, it's no secret that
the accuracy of stock analyst earnings estimates should be looked at skeptically by investors.
Nevertheless, analyst estimates and opinions based on forward-looking projections of a
company's earnings do play a role in Wall Street's stock-pricing considerations.

Historically, the average P/E ratio for the broad market has been around 15, although it can
fluctuate significantly depending on economic and market conditions. The ratio will also vary
widely among different companies and industries.

Formula:

Components:

The dollar amount in the numerator is the closing stock price for Zimmer Holdings as of
December 31, 2005 as reported in the financial press or over the Internet in online quotes. In the
denominator, the EPS figure is calculated by dividing the company's reported net earnings
(income statement) by the weighted average number of common shares outstanding (income
statement) to obtain the $2.96 EPS figure. By simply dividing, the equation gives us the P/E ratio
that indicates (as of Zimmer Holdings' 2005 fiscal yearend) its stock (at $67.44) was trading at
22.8-times the company's basic net earnings of $2.96 per share. This means that investors would
be paying $22.80 for every dollar of Zimmer Holdings' earnings.

Variations:
The basic formula for calculating the P/E ratio is fairly standard. There is never a problem with
the numerator - an investor can obtain a current closing stock price from various sources, and
they'll all generate the same dollar figure, which, of course, is a per-share number.
However, there are a number of variations in the numbers used for the EPS figure in the
denominator. The most commonly used EPS dollar figures include the following:

 Basic earnings per share - based on the past 12 months as of the most recent reported
quarterly net income. In investment research materials, this period is often identified as
trailing twelve months (TTM). As noted previously, diluted earnings per share could also
be used, but this is not a common practice. The term "trailing P/E" is used to identify a
P/E ratio calculated on this basis.
 Estimated basic earnings per share - based on a forward 12-month projection as of the
most recent quarter. This EPS calculation is not a "hard number", but rather an estimate
generated by investment research analysts. The term, estimated P/E ratio, is used to
identify a P/E ratio calculated on this basis.
 The Value Line Investment Survey's combination approach - This well-known and
respected independent stock research firm has popularized a P/E ratio that uses six
months of actual trailing EPS and six months of forward, or estimated, EPS as its
earnings per share component in this ratio.
 Cash Earnings Per Share - Some businesses will report cash earnings per share, which
uses operating cash flow instead of net income to calculate EPS.
 Other Earnings Per Share - Often referred to as "headline EPS", "whisper numbers",
and "pro forma", these other earnings per shares metrics are all based on assumptions due
to special circumstances. While the intention here is to highlight the impact of some
particular operating aspect of a company that is not part of its conventional financial
reporting, investors should remember that the reliability of these forms of EPS is
questionable.

Commentary:
A stock with a high P/E ratio suggests that investors are expecting higher earnings growth in the
future compared to the overall market, as investors are paying more for today's earnings in
anticipation of future earnings growth. Hence, as a generalization, stocks with this characteristic
are considered to be growth stocks. Conversely, a stock with a low P/E ratio suggests that
investors have more modest expectations for its future growth compared to the market as a
whole.

The growth investor views high P/E ratio stocks as attractive buys and low P/E stocks as flawed,
unattractive prospects. Value investors are not inclined to buy growth stocks at what they
consider to be overpriced values, preferring instead to buy what they see as underappreciated and
undervalued stocks, at a bargain price, which, over time, will hopefully perform well.

Note: Though this indicator gets a lot of investor attention, there is an important problem that
arises with this valuation indicator and investors should avoid basing an investment decision
solely on this measure. The ratio's denominator (earnings per share) is based on accounting
conventions related to a determination of earnings that is susceptible to assumptions,
interpretations and management manipulation. This means that the quality of the P/E ratio is only
as good as the quality of the underlying earnings number.

Whatever the limitations of the P/E ratio, the investment community makes extensive use of this
valuation metric. It will appear in most stock quote presentations on an updated basis, i.e., the
latest 12-months earnings (based on the most recent reported quarter) divided by the current
stock price. Investors considering a stock purchase should then compare this current P/E ratio
against the stock's long-term (three to five years) historical record. This information is readily
available in Value Line or S&P stock reports, as well as from most financial websites, such as
Yahoo!Finance and MarketWatch.

It's also worthwhile to look at the current P/E ratio for the overall market (S&P 500), the
company's industry segment, and two or three direct competitor companies. This comparative
exercise can help investors evaluate the P/E of their prospective stock purchase as being in a
high, low or moderate price range.

Investment Valuation Ratios: Dividend Yield

By Richard Loth (Contact | Biography)

A stock's dividend yield is expressed as an annual percentage and is calculated as the company's
annual cash dividend per share divided by the current price of the stock. The dividend yield is
found in the stock quotes of dividend-paying companies. Investors should note that stock quotes
record the per share dollar amount of a company's latest quarterly declared dividend. This
quarterly dollar amount is annualized and compared to the current stock price to generate the per
annum dividend yield, which represents an expected return.

Income investors value a dividend-paying stock, while growth investors have little interest in
dividends, preferring to capture large capital gains. Whatever your investing style, it is a matter
of historical record that dividend-paying stocks have performed better than non-paying-dividend
stocks over the long term.

Formula:

Components:

Zimmer Holdings does not pay a dividend, so the $1.00 dividend per share amount is being used
for illustration purposes. In the company's stock quote the latest quarterly dividend would be
recorded as $0.25 (per share) and the share price as $67.44 as of yearend 2005. On this basis, the
stock would have a dividend yield of 1.48%.

Variations:
None

Commentary:
A stock's dividend yield depends on the nature of a company's business, its posture in the
marketplace (value or growth oriented), its earnings and cash flow, and its dividend policy. For
example, steady, mature businesses, such as utilities and banks, are generally good dividend
payers. REIT stocks, with their relatively stable inflow of rental payments, are also recognized
for their attractive dividend yields. If you're an income investor, a stock's dividend yield might
well be the only valuation measurement that matters to you. On the other hand, if you're in the
growth stock camp, dividend yield (or the lack of one) will be meaningless.

Return on shareholder’s investment/Return

on equity
Return on shareholders’ investment ratio is a measure of overall profitability of the business
and is computed by dividing the net income after interest and tax by average stockholders’
equity. It is also known as return on equity (ROE) ratio and return on net worth ratio. The ratio is
usually expressed in percentage.

Formula:

The numerator consists of net income after interest and tax because it is the amount of income
available for common and preference stockholders. The denominator is the average of
stockholders’ equity (preference and common stock). The information about net income after
interest and tax is normally available from income statement and the information about
preference and common stock is available from balance sheet.

Note for students: Analysts usually prefer to use the average stockholders’ equity as
denominator. The students can use the closing figure of stockholders’ equity if the opening
figure is not given in the question.

Example:
The following data has been extracted from the income statement and balance sheet of PQR
limited:

Data extracted from Income statement:

Net operating income $ 450,000
Interest expenses 65,000
————
Net income before tax 385,000
Income tax (30%) 55,500
————
Net income 329,500
————

2011 2012
Data extracted from balance sheet:
Preferred stock $100 par, 9% $ 800,000 $ 800,000
Common stock, $12 par 1,200,000 1,200,000
Additional paid in capital 50,000 50,000
———— ————
Total paid-in capital 2,050,000 2,050,000
Retained earnings 500,000 350,000
———— ————
Total stockholders’ equity 2,550,000 2,400,000
———— ————

Required: Compute return on shareholders’ investment/Return on equity ratio

Solution:

= (329,500 / 2,475,000*) × 100

= 13.31%

*Average stockholders’ equity:

=(2,400,000 + 2,550,000) / 2

= 2,475,000

The return on shareholders’ investment or return on equity (ROE) ratio of PQR limited is
13.31%. It means for every $100 invested by shareholders’, the company earns $13.31 after
interest and tax.
Significance and Interpretation:
Return on equity (ROE) is widely used to measure the overall profitability of the company from
preference and common stockholders’ view point. The ratio also indicates the efficiency of the
management in using the resources of the business.

Higher ratio means high return on shareholders’ investment. Investors always search for the
highest return on their investment and a company that has higher ROE ratio than others in the
industry attracts more investors.

Preference dividends

Preferred stock (also called preferred shares, preference shares or simply preferreds) is a stock which
may have any combination of features not possessed by common stock including properties of both an
equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e.
higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of
the assets of the company)[1] and may have priority over common stock in the payment of dividends and
upon liquidation. Terms of the preferred stock are described in the articles of association.

Preference in dividends

In general, preferred stock has preference in dividend payments. The preference does not assure
the payment of dividends, but the company must pay the stated dividends on preferred stock
before paying any dividends on common stock.[2]

Preferred stock may be cumulative or noncumulative. A cumulative preferred requires that if a

company fails to pay a dividend (or any amount below the stated rate), it must make up for it at a
later time. Dividends accumulate with each passed dividend period (which may be quarterly,
semi-annually or annually). When a dividend is not paid in time, it has "passed"; all passed
dividends on a cumulative stock make up a dividend in arrears. A stock without this feature is
known as a noncumulative, or straight,[3] preferred stock; any dividends passed are lost if not
declared.  ^ Kieso, Weygandt & Warfield 2007, p. 739.

Advantages and Disadvantages of Preference Shares

Preference shares are hybrid financing instruments having several benefits and disadvantages for
using them as a source of capital. Benefits are in the form of absence of legal obligation to pay
dividend, improves borrowing capacity, saves dilution in control of existing shareholders and no
charge on assets. Major disadvantage is that it is a costly source of finance and has preferential
rights everywhere.

Preference shares are used by big corporate as a long term source of funding their projects. They
are known as hybrid financing instruments because they share attributes of both equity and debt.
It is important to analyze the benefits and disadvantages affixed with using preference shares as a
medium of financing.
BENEFITS OF PREFERENCE SHARE

There are several benefits of a preference share from the point of view of a company which are
discussed below:

No Legal Obligation for Dividend Payment: There is no compulsion of payment of preference

dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a
fixed liability like the interest on the debt which has to be paid in all circumstances.

Improves Borrowing Capacity: Preference shares become a part of net worth and therefore
reduces debt to equity ratio. This is how the overall borrowing capacity of the company
increases.

No dilution in control: Issue of preference share does not lead to dilution in control of existing
equity

shareholders because the voting rights are not attached to issue of preference share capital. The
preference shareholders invest their capital with fixed dividend percentage but they do not get
control rights with them.

No Charge on Assets: While taking a term loan security needs to be given to the financial
institution in the form of primary security and collateral security. There are no such requirements
and therefore the company gets the required money and the assets also remain free of any kind of
charge on them.

DISADVANTAGES OF PREFERENCE SHARES

Costly Source of Finance: Preference shares are considered a very costly source of finance
which is apparently seen when they are compared with debt as a source of finance. The interest
on debt is a tax deductible expense whereas the dividend of preference shares is paid out of the
divisible profits of the company i.e. profit after taxes and all other expenses. For example the
dividend on preference share is 9% and interest rate on debt is 10% with prevailing tax rate of
50%. The effective cost of preference is same i.e. 9% but that of the debt is 5% {10% * (1-
50%)}. The tax shield is the main element which makes all the difference. In no tax regime, the
preference share would be comparable to debt but such a scenario is just an imagination.

Skipping Dividend Disregard Market Image: Skipping of dividend payment may not harm the
company legally but it would always create a dent on the image of the company. While applying
for some kind of debt or any other kind of finance, the lender would have this as a major
concern. Under such a situation, counting skipping of dividend as an advantage is just a fancy.
Practically, a company cannot afford to take such a risk.

Preference in Claims: Preference shareholders enjoy similar situation like that of an equity
shareholders but still gets a preference in both payment of their fixed dividend and claim on
assets at the time of liquidation.
Definition of 'Asset-Based Approach'

A type of business valuation that focuses on a company's net asset value, or the fair-market value of
its total assets minus its total liabilities. The asset-based approach basically asks what it would cost to
recreate the business. There is some room for interpretation in the asset approach in terms of deciding
which of the company's assets and liabilities to include in the valuation, and how to measure the
worth of each.

Investopedia explains 'Asset-Based Approach'

The asset-based approach, also called the asset approach, is one of three main approaches used to
value businesses; the other two are the market approach, which looks at what similar businesses are
worth, and the income approach, which estimates how much money the business might generate in
the future. Each approach will produce different values, and one will be more appropriate than the
others given the type of company being sold.