Earning Capacity: The Critical Piece of the Puzzle

Where does the value of a business come from? First and foremost, it comes from the ability to generate earnings, its earning capacity. The value of a company that does not have earning capacity comes only from its assets.


Earning capacity isn't just net profits or cash flow. Financial statements and tax returns do not reflect economic reality. They must be adjusted to compensate for accounting principles, tax regulations, and related party dealings that accurately portray what really happened.


In addition, earning capacity is not created in one year. A company must have a history of generating earnings consistently. Trends should be analyzed and unusual or non-recurring events should be eliminated. In some cases, these events can be the accumulated effect of incremental changes, so you can't be too quick to factor them out.


Value is not created by earning capacity that is just average. A company can only create real value by exceeding intrinsic benchmarks or the earning capacity expected by industry. Depending on the valuation method used, the earning capacity of a business can be used to value the entire entity or just its intangible (goodwill) value. 

Many small businesses don't earn enough money to create value. In some cases, their earnings may not provide the owners with adequate compensation despite the fact the companies have existed for decades with excellent reputations and an established customer base. Their owners worked hard to build the businesses, but they lack one important thing-earning capacity. Without it, these small businesses have little or no goodwill value. In fact, there could even be negative goodwill.


Simply put, loyal customers and a great reputation have no value if the owners can't convert them into earnings.