Valuation: Cash Flow Discounting-Based Methods: 2. Income Statement-Based Methods

Strategic Finance

Unlike the balance sheet-based methods, these methods are based on the company’s income statement. They seek to determine the company’s value through the size of its earnings, sales or other indicators. Thus, for example, it is a common practice to perform quick valuations of cement companies by multiplying their annual production capacity (or sales) in metric tons by a ratio (multiple). It is also common to value car parking lots by multiplying the number of parking spaces by a multiple and to value insurance companies by multiplying annual premiums by a multiple. This category includes the methods based on the PER: according to this method, the shares’ price is a multiple of the earnings.

Value of Earnings (PER)

According to this method, the equity’s value is obtained by multiplying the annual net income by a ratio called PER [price earnings ratio), that is:

Equity value = PER x earnings


PER (price earnings ratio) of a share indicates the multiple of the earnings per share that is paid on the stock market. On other occasions, the PER takes as its reference the forecast earnings per share for the next year, or the mean earnings per share for the last few years. The PER is the benchmark used predominantly by the stock markets. Note that the PER is a parameter that relates a market item (share price) with a purely accounting item (earnings).

Sometimes, the relative PER is also used, which is simply the company’s PER divided by the country’s PER.

Value of the Dividends

Dividends are the part of the earnings effectively paid out to the shareholder and, in most cases, are the only regular flow received by shareholders.”* According to this method, a share’s value is the net present value of the dividends that we expect to obtain from it. In the perpetuity case, that is, a company from which we expect constant dividends eveiy year, this value can be expressed as follows:

Equity value = DPS / Ke


Where: DPS = dividend per share distributed by the company in the last year; Ke = required return to equity. If, on the other hand, the dividend is expected to grow indefinitely at a constant annual rate g, the above formula becomes the following:

Equity value = DPSi / (Ke – g)


Where DPSi is the dividends per share for the next year. Empirical evidence shows that the companies that pay more dividends (as a percentage of their earnings) do not obtain a growth in their share price as a result. This is because when a company distributes more dividends, normally it reduces its growth because it distributes the money to its shareholders instead of plowing it back into new investments.

Sales Multiples

This valuation method, which is used in some industries with a certain frequency, consists of calculating a company’s value by multiplying its sales by a number. For example, a pharmacy is often valued by multiplying its annual sales (in dollars) by 2 or another number, depending on the market situation. It is also a common practice to value a soft drink bottling plant by multiplying its annual sales in liters by 500 or another number, depending on the market situation.

In order to analyze this method’s consistency. Smith Barney analyzed the relationship between the price/sales ratio and the return on equity. The study was carried out in large corporations (capitalization in excess of 150 million dollars) in 22 countries. He divided the companies into five groups depending on their price/sales ratio: group 1 consisted of the companies with the lowest ratio, and group 5 contained the companies with the highest price/sales ratio. The mean return of each group of companies is shown in the following table:

The price/sales ratio can be broken down into a further two ratios:

 Price/sales = (price/earnings) x (earnings/sales)


The first ratio (price/earnings) is the PER and the second (earnings/sales) is normally known as return on sales.


Other Multiples

In addition to the PER and the price/sales ratio, some of the frequently used multiples are:


– Value of the company / earnings before interest and taxes (EBIT)

– Value of the company / earnings before interest, taxes, depreciation and amortization (EBITDA)

– Value of the company / operating cash flow

– Value of the equity / book value

Obviously, in order to value a company using multiples, multiples of comparable companies must be used.



The main advantage of EV/EBITDA over the PE ratio is that it is unaffected by a company’s capital structure. It compares the value of a business, free of debt, to earnings before interest

If a business has debt, then a buyer of that business (which is what a potential ordinary shareholder is) clearly needs to take account of that in valuing the business. EV includes the cost of paying off debt. EBITDA measures profits before interest and before the non-cash costs of depreciation and amortization

The first advantage of EV/EBITDA is that it is not affected by the capital structure of a company, in accordance with capital structure irrelevance. This is something that it shares with EV/EBIT and EV/EBITA

EV/EBITDA also strips out the effect of depreciation and amortisation. These are non-cash items, and it is ultimately cash flows that matter to investors.


ev ebitda





Value Multiple by Sector

Value Multiple by Sector







– Standard& Poors, Valuation Consultants, LLC

– Fernandez, Pablo, `Company Valuation Methods, The Most Common Errors in Valuations`, Johanning, Lutz, `Risk Management ` class notes, Kellogg, Northwestern U.

– Istanbul Technical University, “business valuation” Seminar Series, Cem Sari, 2011

Please, feel free to comment or share your thoughts.