BUSINESS VALUATION 101: The Income Approach to Value a Business
Updated: Mar 10, 2021
To read about the Three Main Approaches to Value a Business click here.
The income valuation approach bases the value of a business on its ability to generate future economic benefits. This valuation approach estimates the value of a closely-held business by converting business’s future expected cash flows or earnings into a single present value. Future earnings, such as net cash flow after taxes, are projected and then capitalized or discounted to perform the valuation. .
Two main calculation methods are usually utilized within the income approach, the Discounted Cash Flow Method and the Capitalization of Cash Flows Method.
The Discounted Cash Flow Method, within the income approach, requires estimating the future cash flow streams of the business and discounting them by the discount rate. The discount rate represents the total rate of return that an investor would demand on the purchase of an investment considering the value of money and level of associated business and economic risk.
The Discounted Cash Flow method is typically used when future expected cash flows or growth rates are expected to vary over a certain period of time. The typical steps in applying the Discounted Cash Flow Method include projecting the company’s future financial performance for each year over a certain forecast period (usually five years); estimating the value of the business at the end the forecast period when the business is expected to grow at a set growth rate in perpetuity (the terminal value); determining the appropriate discount rate which incorporates a risk-free rate of return and the perceived level of risk for the business being valued; and discounting the estimated future earnings and the terminal value to the present using the calculated discount rate.
Interestingly, the Discounted Cash Flow method is a meaningful method when trying to estimate the future performance of a business affected by the COVID-19 pandemic as the business stabilizes and returns to a “normal” level of operations and profitability over time.
While this method is a theoretically valid approach, it relies on the ability of the valuation expert and the company’s management to forecast earnings or cash flows with reasonable accuracy and assess the risk associated with those earnings or cash flows. As with any forecast, there is an element of uncertainty involved.
The Capitalization of Cash Flows Method within the income approach is most appropriate when a company’s historical earnings can reasonably be considered indicative of its future operations, and is best applied when valuing mature and well-established companies with steady earnings. Within this method, a company’s future economic benefits for a representative single period are converted into value through division by a capitalization rate. Capitalization Rate for a company is equal to the discount rate described under the Discounted Cash Flow Method above less the long-term annually compounded sustainable growth rate of the subject company.
In light of the COVID-19 economic impact business valuation experts may find it challenging to justify the use of stable earnings projections and steady long-term growth rate going forward. Thus, this method currently appears to be less relevant than the Discounted Cash Flow method when estimating the value of a business affected by COVID-19.
To read more the Three Main Approaches to Value a Business click here.
AICPA, ASA, CICBV, NACVA and IBA (2017). International Glossary of Business Valuation Terms. Retrieved from: ttps://s3.amazonaws.com/web.nacva.com/TL-Website/PDF/Glossary.pdf
Internal Revenue Service (1959). IRS Revenue Ruling 59-60. Valuation of Non-Traded Assets. See a Link to Full Text (PDF)
Aswath Damodaran (2018). The Dark Side of Valuation. Pearson Education.