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Multiple of Earnings

See Also:
Normalized Earnings
Adjusted EBITDA
EBITDA Definition
Valuation Methods
Business Valuation Purposes
EBITDA Valuation

Multiple of Earnings

Multiple of earnings is one way to value a business. It involves multiplying a company’s profits by a certain number to end up with a value. “Multiple of earnings” multiplies the “earnings” (or income or profit) of a year, or average of years, in order to come up with a figure representing the company’s worth in a sale.

In most cases, EBIT (Earnings Before Interest and Taxation) is the amount used for this first earning’s number. However, for companies ranging from several million dollars to several hundred million dollars, the “multiple of earnings” is often equivalent to the multiple of EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortization) instead of EBIT.

Determining what number the current profits are multiplied by depends on the stability of the business. For example, a company that’s very well-established, with a strong hold on the market, that can operate under or with an entirely new team might bring in a multiple of 8 to 10 times current profits. On the other end of the spectrum, a small, individualized business that relies solely on one service provider might acquire a multiple of 1 times current profits. In reality, most businesses are sold for a multiple of 3 to 5 times the current profits.

Using Multiple of Earnings for Business Valuation

There are many different methods for business valuation; however, the central method calculates multiple of earnings. You should consider some of the following questions before evaluating a company:

Is a seller using pre-tax earnings or post-tax earnings?

If you’re the buyer, remember to include your tax rate not the seller’s. If you are the one selling, pick which year of earnings to base the valuation on. Many sellers will use the current year’s earnings even if the second half has not occurred yet. Simply multiply the first half of the earnings to project through the year.

Do you use past profits or projected future earnings?

Most appraisers recommend using the profits from the last three years to establish more credibility in the sale; however, you can weight the more recent years more heavily, if the profits are increasing each year, to suggest projected income.

Are the current earnings an anomaly or are they consistent?

Many owners will sell after a spike in profits, but you should evaluate the business risk by looking at a more thorough review of a business’s earning history.

What’s the business’s climate?

How established is the business? Can it run without the current staff or leadership team? Are there competitors moving in that have yet to affect the company’s earnings? Is the economy growing or shrinking? What is the impact of new technologies on the industry?

(Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

There are many factors to consider when evaluating a company, and many aspects to include when determining the “true” value. Looking at the profits solely will not give you the full picture of a company’s worth.

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Multiple of earnings

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Multiple of earnings

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Normalized Earnings

See Also:
Key Performance Indicators (KPI’s)
Collection Effectiveness Index (CEI)
How Does a CFO Bring Value to a Company?
Multiple of Earnings
Continuous Accounting: The New Age of Accounting
Budgeting 101: Creating Successful Budgets

Normalized Earnings

Normalized Earnings are adjustments made to the income statement in preparation to show potential buyers of the company. When making these adjustments, eliminate expenses not usually incurred for the production of the business. To show a more realistic return on investment, the normalized expenses should not appear on the future buyer’s income statement.

Different Types of Normalized Earnings

There are multiple types of special expenses that are unusual on a typical income statement. For now, let’s categorize them into two types of normalized earnings – Type A and Type B.

Type A: Non-Recurring Gains and/or Losses

The goal of “normalizing earnings” is to provide prospective buyers a typical income statement so they know what to expect. Expenses such as a lawsuit, non-operating assets, and other abnormal items that occur once are considered expenses you can eliminate when normalizing earnings.

Type B: Discretionary Expenses

Do not record certain expenses at fair market value price. Adjust these expenses so the buyer of a company does not assume these expenses incur regularly. If you include these expenses, then as the current company owners, you should specify that these expenses or earnings are not generating/generated by business. Examples include vacation homes, car rentals, startup costs, and unreasonably high bonuses.

(If you want to learn how to measure your company’s key performance indicators for free, then get it here!)

Normalized Earnings Example

For example, Laura Johnson is the CEO and founder of X company, and now wants to sell it. Her current business generated over $2 million last year, according to her income statement.

Normalized Earnings

Type A: Laura experienced a lawsuit and lost $250,000. Because this was one-time event, remove the lawsuit expense for adjustment purposes.

Type B: Laura’s sales team had a sales contest to boost revenue for the year 15%. As a result, two salespeople gained extremely high bonuses totaling to a $100,000 additional salary.

By normalizing these earnings, EBITDA increases by $350,000, earnings that the buyer can potentially make without those extra costs.

Normalized Earnings

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Normalized Earnings

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Rule of 72 Definition

Rule of 72 Definition

The rule of 72 definition is an approximation tool used to determine the amount of time it will take for money to double on the earnings of compound interest. The Rule of 72 is also used to calculate the rate of return necessary to double an investment in a specific amount of years.

Rule of 72 Explained

The rule of 72 is essentially an estimation for determining the amount of years or the doubling time of an investment. This is done by taking the interest available on the investment and dividing it by 72. Rule of 72 investing is usually fairly accurate. It is even more accurate with lower interest rates than it is for higher ones. Use he rule of 72 for compound interest situations. If the investment earns a simple interest at the end of the investment term, then this rule is not a very good indicator. The rule of 72 is most useful if an investor cannot perform an exponential function and simply needs to do simple math for an estimate of an investment.

A lower compound interest rate means that the investment will take longer to double. Whereas, a higher interest rate means that the investment will be doubled quicker. Thus, a higher interest rate and a lower doubling time are necessary for an investment to grow faster. Usually, a riskier investment will yield a higher interest rate and a higher return in less time. If you are planning on saving or investing your funds, then it is important for you to compare different interest rates so that you can maximize the value of your investment in the shortest amount of time. Since the rate of returns for investments vary with time, use the Rule of 72 as a quick tool. But do not use it as a full solution for analyzing the future value of investments.

Rule of 72 Formula

The rule of 72 formula is as follows:

Doubling Time (# years) = 72/Interest Rate

Rule of 72 Example

What is the doubling time for an investment with a compound interest rate of 8%? A person using the rule of 72 equation would find the doubling time equal to 9 years. Calculate this by taking 72 and dividing it by 8. By performing this the investor can tell that it will take approximately 9 years to double the principal. It is fairly accurate as the exponential function yields an actual doubling time of 9.006 years. If you want to calculate the interest rate necessary to double your funds for a specific number of years, then divide 72 by the doubling time (# years).

 

Rule of 72 Definition

 

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Rule of 72

The rule of 72 is an approximation tool used to determine the amount of time it will take for money to double on the earnings of compound interest.

Rule of 72 Explained

The rule of 72 is essentially an estimation for determining the amount of years or the doubling time of an investment. Do this by taking the interest available on the investment. Then divide it by 72. This type of investing is usually fairly accurate, it is more accurate with lower interest rates than it is for higher ones. It is normally used solely for compound interest situations and is not a very good indicator if the investment earns a simple interest at the end of the investment term. This rule is most useful if an investor cannot perform an exponential function and simply needs to do simple math for an estimate of an investment.

Rule of 72 Formula

Use the following rule of 72 formula:

Doubling Time (# years) = 72/Interest Rate

Example

What is the doubling time for an investment with a compound interest rate of 8%? A person using the rule of 72 equation would find the doubling time equal to 9 years. Calculate it by dividing 8 by 72. By performing this, the investor can tell that it will take approximately 9 years to double the principal. It is fairly accurate as the exponential function yields an actual doubling time of 9.006 years.

rule of 72

See Also:
Investment Banks
NPV vs Payback Method
Internal Rate of Return Method
Weighted Average Cost of Capital (WACC)
Effective Rate of Interest Calculation

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Return on Capital Employed (ROCE)

See Also:
Return on Asset Analysis
Return on Equity Analysis
Financial Ratios
Return on Invested Capital (ROIC)
Current Ratio Analysis

Return on Capital Employed (ROCE) Definition

The return on capital employed ratio is used as a measurement between earnings, and the amount invested into a project or company.

Return on Capital Employed (ROCE) Meaning

The return on capital employed is very similar to the return on assets (ROA), but is slightly different in that it incorporates financing. Because of this the ROCE calculation is more meaningful than the ROA. The ROCE is generally used to find out how efficient and profitable a company is from year to year. As it is a percentage a company can locate problems or areas of improvement with the fluctuation of this ratio from year to year.

Return on Capital Employed (ROCE) Equation

The return on capital employed equation is as follows:

ROCE = EBIT or NI/(Total Assets – Current Liabilities)

Note: The earnings before interest and taxes, known as the operating income, is normally used, but people can also use the Net Income if they would like to incorporate the net interest and taxes into the ROCE formula.

Return on Capital Employed (ROCE) Example

Tim found that the ROCE last year is 16%. He would like to compare this number to the current ROCE. He begins by finding the following numbers in the Balance Sheet as well as the Income Statement:

Net Income = $50,000
Total Assets = $360,000
Current Liabilities = $35,000

ROCE = $50,000/($360,000 – $35,000) = 15%

Note: The drop in this number means that Tim’s company is not as efficient as it used to be or that it decreased it current liabilities.

return on capital employed

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Proforma Earnings

See Also:
Pro-Forma Financial Statements
Retained Earnings
EBITDA
Operating Income (EBIT)
Financial Ratios

Proforma Earnings Definition

Pro forma earnings are a company’s earnings that exclude rare, extraordinary, or nonrecurring items. Companies may incur expenses that do not reflect typical operating expenses. These expenses, which must be disclosed in financial statements in accordance with GAAP standards, can impact a company’s financial performance in a given accounting period. Proforma earnings exclude these extraordinary expenses in order to provide a clearer picture of the company’s financial performance. You can also call proforma earnings core earnings, operating earnings, or ongoing earnings.

A company’s earnings are a key measure of its financial performance. Creditors and investors examine a company’s earnings to evaluate its financial performance when deciding whether or not to lend to or invest in the company. Compare current period earnings to prior period earnings of the same company to gauge progress over time. Or compare current period earnings to industry peers and competitors to assess the company’s competitive position in the marketplace.

Earnings According to the SEC and GAAP

The SEC requires publicly traded companies to report net income and operating income in financial statements prepared according to GAAP regulations and procedural standards. The investing public scrutinizes these measures of financial performance. However, some businesspeople often consider these income measures to be inaccurate to some degree.

GAAP standards require businesses to include rare, extraordinary, or nonrecurring items in their financial statements. But company executives believe that including these rare, extraordinary, and nonrecurring items in the financial statements obscures the true picture of the company’s financial performance. Therefore, some companies prefer to publish pro forma earnings in their financial statements along with their SEC-required GAAP-standardized earnings.

Proforma Earnings – Explanation

These pro forma earnings, or hypothetical earnings that exclude items deemed rare, extraordinary, or nonrecurring by the individuals preparing the pro forma financial statements, are considered to provide a clearer and more accurate picture of the company’s financial performance for the relevant accounting period. For example, when prepared in accordance with GAAP regulations, a company may show a loss for a given accounting period. However, during that same period, a company can show a profit in its pro forma earnings.

If you want to increase the value of your organization, then click here to download the Know Your Economics Worksheet.

Proforma Earnings

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Proforma Earnings

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Price Earnings Ratio Analysis

See Also:
Earnings per Share (EPS)
Price to Book Value Ratio
Price to Sales Ratio
Return on Equity Analysis
Preferred Stocks (Preferred Share)
Action Plan

Price Earnings Ratio Analysis Definition

Price earnings ratio (P/E ratio), defined easily as an indicator of how much investors pay for a share compared to the earnings a company generates per share, is as important in stock trading as it is in equity financing markets. It tells investors how expensive a stock is. Therefore, the higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings.

Price Earnings Ratio Analysis Meaning

Price earnings ratio, meaning an indicator to measure a company’s market performance, is one of the many financial ratios used to evaluate an equity investments in private or public markets alike. Companies with high P/E ratios are more likely to be considered risky investments than those with low P/E ratios because a high P/E ratio means high expectations for a company’s potential earnings growth. Since P/E ratio varies from industries to industries, it is more valuable to comparing P/E ratios of companies within the same industry or against a company’s historical P/E ratios.


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Price Earnings Ratio Formula

Two main price earnings ratio formulas exist:

Price earnings ratio = Market price per share ÷ Earnings per share

Or

Price earnings ratio = Average total common stock ÷ Net Income

But one is more suited to public and one to private equity markets. When the market price or earnings per share are not evident, as with the sale of a private corporation, the second option is a simpler choice.

Price Earnings Ratio Calculation

Price earnings ratio calculations are, at their core, a basic division problem.

For example, assume $20 in market price per share and $5 in earnings per share.

Price earnings ratio = 20 / 5 = 4

This means that investors pay $4 for every dollar of earnings that a company generates.

Price Earnings Ratio Analysis Example

After years of working, Barbara has become a professional investor. Barbara makes an effort to diversify her portfolio across all types of investment: stocks, bonds, real estate, angel investment, and more. To Barbara, the most important aspect of investment is knowing what to expect. She likes to get her hands dirty in her work: she skips the web and is her own price earnings ratio calculator.

Barbara has decided to sit down and evaluate her stocks. First, she prepares her tools, a warm cup of coffee, and her mindset. She then begins to look through her public stock portfolio as a whole. Satisfied with her efforts, Barbara digs deeper into the performance of her portfolio companies. She wants to know the price earnings ratio of s&p 500 stocks which she owns. Her average results are listed below:

$20 in average market price per share and $5 in average earnings per share.

Average price earnings ratio = $20 / $5 = $4

Barbara’s price earnings ratio analysis yields the prior results. She then moves on to evaluating her price earnings ratio history for her stocks as an angel investor. Her work sheds light on the following results:

$20 in average total common stock and $5 in average net income.

Average price earnings ratio = $20 / $5 = $4

Conclusion

Price earnings ratio, Dow Jones and small boutique alike, is an equation that gives an important evaluation of the performance of a company an investor has owner’s equity in. In conclusion, Barbara is happy that she can make a living using her natural skills and talents.

Price Earnings Ratio Analysis

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Price Earnings Ratio Analysis

Resources

For statistical information about industry financial ratios, please click the following website: www.bizstats.com and www.valueline.com.

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