Earnings-based valuation models estimate the value of a company by focusing on its expected future earnings or profits. These models aim to determine the present value of the company's anticipated earnings stream. Here are two commonly used earnings-based valuation models:
1. Price/Earnings (P/E) Ratio Model: The price/earnings (P/E) ratio model is a straightforward valuation method that compares the market price of a company's stock to its earnings per share (EPS). The P/E ratio represents the multiple that investors are willing to pay for each dollar of the company's earnings. The formula for the P/E ratio is:
P/E Ratio = Market Price per Share / Earnings per Share (EPS)
To estimate the value of the company using the P/E ratio model, you multiply the company's expected future EPS by the estimated P/E ratio. For example, if a company is expected to have an EPS of $2 and the P/E ratio for similar companies is 15, the estimated value of the company would be $2 x 15 = $30 per share.
It's important to note that the P/E ratio varies across industries and companies, depending on factors such as growth prospects, risk, and market conditions. Therefore, it is crucial to compare the P/E ratio of the company being valued to its industry peers or historical averages for a more accurate assessment.
2. Discounted Earnings (DE) Model: The discounted earnings (DE) model, also known as the discounted cash flow to earnings (DCF/E) model, is a more comprehensive earnings-based valuation approach. It takes into account the expected future earnings of the company and discounts them to their present value to account for the time value of money.
The DE model involves the following steps:
a. Estimate Future Earnings: Project the company's future earnings over a specific period, typically 5-10 years. These projections can be based on historical financial data, industry trends, growth rates, and other relevant factors.
b. Determine the Terminal Value: Estimate the value of the company's earnings beyond the projection period, often by applying a terminal growth rate. This represents the value of the company's earnings in perpetuity.
c. Apply Discount Rate: Determine an appropriate discount rate, also known as the company's cost of capital, which reflects the risk associated with the company's earnings stream. The discount rate accounts for the time value of money and the riskiness of the cash flows.
d. Calculate Present Value: Discount the projected future earnings and the terminal value to their present value using the discount rate. Then sum up the present values to determine the total estimated value of the company.
The DE model provides a more detailed analysis of a company's earnings stream, considering both the near-term projections and the long-term sustainability of earnings. However, it requires accurate earnings forecasts and relies on the selection of appropriate discount rates and growth assumptions, which can introduce uncertainty into the valuation.
It's worth mentioning that these are simplified examples of earnings-based valuation models, and variations or adjustments may be required based on specific circumstances and industry dynamics. Additionally, professional judgment and sensitivity analysis are essential when using earnings-based valuation models to account for different scenarios and risks.
