Question

Present an argument explaining the benefits of the earnings-based valuation method.

• Explain how this valuation approach may generate accurate results.
• Evaluate the inherent challenges associated with earnings-based valuation.
• Provide suggestions for how analysts may overcome such challenges.

Answer 1

Under the income approach, the valuation is based on the economic benefit stream (typically a form of net income or cash flows) produced by the business. This benefit stream is either capitalized or discounted to a present value, and this amount becomes the foundation for the valuation of the company.

1)The major positive of the income approach is that it utilizes in the valuation calculation the benefit streams produced by an enterprise. Since a business’s value is commonly considered to be the present value of its future earnings or cash flows, these methods emphasize the elements that are generally valued by the investor in a business.

2)  The capitalization of earnings methods takes a single economic benefit (usually net income or cash flow for the most recent period or an average of activity from the previous three to five periods) and divides it by a capitalization rate, which represents the required rate of return necessary to earn that return given the risks of investing in the business. So , analyst can take stable period average for better results.

3) One significant downside to the income approach is the degree of estimation involved in the calculations. The forecasting of future benefit streams and determination of a capitalization or discount rate often involve a high degree of professional judgment, which can subject the valuation to debate from other parties.

4) The capitalization of earnings method is best used for stable or mature business where the benefit stream is expected to grow at a consistent rate into the future. So analysts should use it in similar environment.