7.7 Income Statement-Based Valuations

INCOME STATEMENT-BASED VALUATIONS

Valuing a business can also be approached through its income statement by estimating how much earnings it will generate in the future. This method known as earnings capitalization translates anticipated earnings into present value by applying a required rate of return, or capitalization rate. To apply this technique, two key inputs are required: an estimate of future earnings and an appropriate capitalization rate.

1. Estimating Earnings

Capitalizing earnings starts with projecting how much income the business will generate. This typically involves analyzing accounting earnings better known as the “bottom line” on the income statement. With this approach, two key challenges arise including timing issues and  reporting issues.

Timing Issues: Valuation looks to the future, but our best evidence often comes from past performance.

Equal weighting can be refined if certain years are more representative than others. For instance, the most recent year might be given extra weight if it’s more indicative of current operations.

Reporting Issue:  Even “net income” can be subjective, as it’s shaped by accounting choices. Methods of inventory valuation (FIFO vs. LIFO), depreciation (straight-line vs. accelerated), and bad debt provisioning all influence reported earnings. Though GAAP requires consistency within a company over time, changes in accounting methods do occur, and differences between companies may distort comparisons.

For example, MSFT changed its useful lives for servers and network equipment from four to six years in 2023, reducing the depreciation expense recognized in 2023 and 2024. Adjustments may be needed to ensure comparability across time.

2. Choosing a Capitalization Rate

Once normalized earnings are estimated, we apply a capitalization (cap) rate, the rate of return an investor requires to justify the investment, reflecting the risk that the earnings may not materialize as expected.

The basic formula is:

Value = Earnings/Capitalization Rate

In general, the higher the risk, the higher the required rate of return, which leads to a lower valuation. Conversely, companies with stable, predictable earnings can justify lower cap rates and higher valuations. While industry guidelines and market benchmarks can provide helpful starting points, the selected capitalization rate should reflect the specific risk profile of the business and prevailing economic conditions.

3.  The Price-Earnings (P/E) Ratio

The P/E ratio measures how much investors are willing to pay for each dollar of a company’s earnings. It is calculated by dividing a company’s stock price by its earnings per share (EPS), and it reflects investor perceptions of risk, growth potential, and overall market sentiment.

Importantly, stock prices often fluctuate for reasons unrelated to business fundamentals. Emotional reactions—such as fear during downturns or euphoria during booms—can distort market valuations. For example, it is common for the price of a typical publicly traded stock to swing as much as 30 to 50% within a single year, even though the company’s actual financial condition remains stable.

This volatility highlights the importance of fundamental valuation techniques, such as analyzing earnings, cash flows, and capitalization rates. These tools help investors (and lawyers evaluating financial claims or investments) distinguish between true value and market hype.

Limitations of Income Statement-Based Valuations

Just as balance sheet–based valuation methods are often incomplete because they overlook a business’s earning potential, income statement–based approaches such as earnings capitalization or applying price-to-earnings (P/E) ratios, also have notable limitations.

When capitalizing earnings, the method depends heavily on accounting-based earnings which are influenced by rules and conventions that may not reflect true economic performance. Additionally, this approach focuses on estimated earnings without considering how those earnings will actually be used, whether distributed to shareholders as dividends or reinvested in the business.

Valuation, ultimately, is about estimating the future stream of payments that investors expect to receive. For P/E ratios to serve as a reliable valuation tool, two key assumptions must hold:

1. The P/E ratio must be based on expected future average earnings, not just historical results.
2. It must assume that all earnings will be distributed to shareholders as dividends, rather than retained by the company.

Because these assumptions are often unrealistic, income statement–based valuation methods can provide an incomplete picture of value. This leads to the use of a more comprehensive approach, cash flow–based valuation, which focuses directly on the future cash available to investors, regardless of accounting conventions.

Summary

Income statement–based valuation methods, such as earnings capitalization and the use of price-to-earnings ratios, offer valuable tools for estimating a business’s worth based on its expected profitability. These approaches emphasize forward-looking analysis while grounding valuation in historical financial data, adjusted through techniques like normalized earnings and investor-required capitalization rates. However, their effectiveness depends on the accuracy of earnings estimates, the relevance of accounting policies, and the rationality of market sentiment. While useful, these methods have limitations particularly in assuming earnings accurately reflect economic reality and will be fully distributed to shareholders. As such, income-based valuation should be applied thoughtfully, often in combination with other approaches, to arrive at a more complete and reliable assessment of business value.