278 ENTREPRENEURSHIP
future achievement, but it is sometimes an indication. In cases of valuation for the pur-
pose of buying or selling a business, sellers rely on past performance for their valuation;
after all, their management was responsible for that performance. But in most cases the
sellers will no longer be part of management, so the context for the historical perform-
ance no longer exists. In such cases, historical earnings should not be used to predict
future performance.
Future earnings and the historical resource bases are a middle-of-the-road approach
to calculating value. They correctly identify for the future the important earnings stream
out of which dividends will be paid. Also, the firm’s future earning capacity determines
market value. However, the use of the historical resource base assumes that the relation-
ship between the firm’s capabilities and its environment will remain unchanged. This
calculation represents the value to a current owner who anticipates no major changes in
the assets of the firm, its strategy, or its competitive or macro situation. In a buy-sell sit-
uation, the buyer should not rely on this estimate because of the high probability that
the underlying resource base will be modified under new ownership.
The present and future resource bases make up the most appropriate measure of earn-
ings in both buy-sell and new venture valuations. Future earnings are the basis for future
returns which flow directly from whatever new resources and capabilities the firm’s
founders and top managers developed. Valuation is a forward-looking process, and its
calculation requires estimates of future performance.
In addition to the problem of determining which earnings to include and under what
circumstances to include them, valuation must grapple with the problem of comparable
earnings. Earnings can be stated and calculated in a number of ways: earnings before
interest, depreciation, taxes and amortization (EBIDTA), earnings after taxes (EAT),
and earnings before and after extraordinary items. Extraordinary items should be omit-
ted from earnings calculations because they represent non-normal operating situations
and one-of-a-kind events. Valuations focus on an ongoing business, not on special situ-
ations.
Both EBIDTA and EAT are earnings legitimately used in the valuation process. The
advantage of EBIDTA is that it measures the earning power and value of the business
fundamentals and underlying resources before the effects of financing and legal (tax) or-
ganization. From the viewpoint of a new venture in search of financing or in a buy-sell
situation, EBIDTA is preferred because financial and legal structures may be altered
according to the tax preferences of the owners. However, EAT is also a reasonable and
workable figure to examine. The important consideration is consistency in valuation
methods. The entrepreneur should not employ EAT for one scenario and EBIDTA for
another.Which Capitalization Factor? Determining the capitalization factor is also an exercise
in both estimation and judgment. The capitalization factor or price-earnings (P-E)
ratio is the multiple that represents the consensus among investors concerning the
growth and reliability of the firm’s earnings over time. The P-E ratio is the price an
investor is willing to pay to buy a claim on $1 worth of current earnings. Higher P-E
ratios mean that investors believe earnings will be much higher in the future; lower P-E
ratios indicate that investors do not believe earnings will increase very much.^31