Earning method - Bases of Valuation
The business is valued according to the net stream of income it is expected to create over its lifetime.
Determination of maintainable earnings
a) The first step in arriving at earning based valuation is for estimate the future maintainable earnings and if the situation during the future is expected to be same to those in the past, it is then prudent to face the forecast on the historical figures. Conditions do change however and like as changes in revenue and cost. Hence, a detailed examination of profits of the most current loss and profit account will be essential to estimate the effects of the changes. Though the information known will depend upon the nature of the business the common principles to bear in mind must comprise the trend of sales and gross profit.
b) Analysis of sales and gross profit percentage along with:
i) Customer type
ii) Geographical areas
iii) Departments
iv) Product lines
c) Costs as a percentage of total sales.
d) Necessity of expenditure in the business e.g. excessive remuneration on expenses charged.
e) Unusual fluctuations in the ratios.
f) Inclusion of all costs.
g) Effects of external situation like recession or inflation.
Though, there is several type of arriving at the value based on the earnings valuation as:
- Price earnings ratio valuation
- Earnings yield valuation
- Super profits valuation