How do quality of earnings relate to value? I'd first point out that valuing a business is a surprisingly complex and nuanced process, and theoretical value can't be allowed to overshadow common sense. For example, a business that is generating Earnings Before Interest Taxes Deprecation and Amortization (EBITDA) of $200,000 may be worth $1 million if using an income-based approach to value, but if such a business has assets that could be auctioned for $1.2 million and has no debt, then, of course, it would be worth more than $1 million as long as there is a market for its assets. Nevertheless, for the majority of financially well-performing businesses, value will be impacted by three primary factors:
- The level and quality of earnings;
- Risk factors; and
- Growth prospects
A business with a higher level and/or higher quality of earnings is going to be worth more than a business that has a lower level and quality of earnings, assuming similar risk factors and growth prospects.
Following is a link to an article that describes some of the things that buyers look at during due diligence to determine the quality of earnings: Quality of Earnings: A Critical Component of Due Diligence