A business that is considered to be economically viable is generally valued on a going concern approach implying that the business will continue to operate into the future. One of the more common techniques used to assign value under the going concern approach is the Capitalized Cash Flow Methodology. This methodology is typically adopted for mature businesses with relatively stable earnings that can be reasonably estimated into perpetuity and/or when a reasonable forecast of cash flows is not available.
Two principal components of the capitalized cash flow methodology are:
(a) the annual after-tax maintainable earnings; and,
(b) the after-tax risk adjusted rate of return. The maintainable earnings after-tax is "capitalized" by this rate of return.
The focus of this article is to provide insight into what comprises maintainable earnings and to explain how the level of maintainable earnings is evaluated and computed.
Maintainable earnings equates to the prospective average annual income expected to be produced from the operating activities of the business. In other words, maintainable earnings represent the best estimate of the expected future discretionary income from operations of the business. Maintainable earnings can be expressed as a point estimate or as a reasonable range of values.
Assessing an objective and reasonable maintainable earnings level requires professional judgment and analysis of:
(a) the business and its prospects; and,
(b) the prevailing and prospective economic and industry conditions and how these conditions affect the entity's operations and reported results.
In arriving at a reasonable estimate of maintainable earnings the following factors may be considered:
Historic Operating Results
Historic operating results, if available, are often the starting point in estimating a reasoned maintainable earnings level. The results of operations from previous periods provide an objective benchmark upon which future operating levels may be estimated; however, it is important to obtain reasonable assurance that past performance is indicative of future periods and that the business conditions have not materially changed. There are many common situations in which historic results may have to be adjusted to reflect the prospective operations of the business. For example:
- significant changes to the competitive landscape and industry. The consolidation of the industry, arrival or exit of competitors or changes in consumer behavior can have a material impact on the prospective operating results of a business;
- revenue and expense items have to be adjusted for non-recurring and/or unusual items to reflect potential operating results on a go-forward basis. Such items may include one-time litigation costs, large and unusual single sale contracts, moving expenses, and restructuring charges;
- in owner managed and privately held businesses, compensation expenses often require adjustment to reflect the market value for services rendered;
- non-arm's length transactions consummated at non-commercial rates must be adjusted to commercial terms to reflect the market value of the underlying transaction; and,
- income or expenses derived from redundant assets (those assets considered unnecessary to the day to day operations of the business) are excluded as these assets are valued separate and apart from the ongoing core operations.
Prospective Operating Results
Management frequently prepares an annual budget representing their best estimate of the operating results for the upcoming year. A well formulated budget provides insight into management's expectations and may reveal business trends or factors that should be considered in assessing maintainable earnings. That is because management often has significant insight into the industry, the business and its participants and has a wealth of knowledge about the business that can only be developed through experience. In this capacity, management's assumptions may highlight risks and opportunities that are important to the valuation analysis.
When reviewing financial projections, and the rigour of the company's budgeting process, it is important to understand the purpose of the projection. Useful budgets are clear of bias and are prepared by individuals with the ability and knowledge to accurately anticipate future performance. Reviewing and testing the historical forecasting abilities of management versus actual results is one technique that can assist in establishing the reliability of financial projections.
In situations where historical or prospective cash flows are not, in isolation, a reasonable estimate of prospective operating results, it may be necessary to use a combination or average thereof. Depending on the particular facts of the case, a simple or weighted average of past and prospective operating results may provide the best estimate of projected cash flows.
It is most often the case that reported and projected operating results provide a foundation upon which a reasonable estimate of maintainable earnings can be predicated, but these results must be analyzed in the context of prevailing and prospective market conditions and business developments.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.