The Income Approach to Valuations

Apr 19, 2018Business, Business Valuation

The words “Business Value” or “Business Valuation” by themselves hold more than a singular definition. The complexity of business valuations, make it challenging to fully grasp what is involved in the process of valuing a company. There are three main approaches when establishing a value for a company:

  • Income
  • Asset
  • Market

The income approach evaluates the income (earnings or cash flow) a company will generate from its operations over a designated period of time. This approach is based on a fundamental valuation principle, which finds the value of a company to be equal to the present value of the future benefits of ownership. The goal of the income approach is to prove the cash generating capabilities, or earnings potential of the company being valued.
 
With the income approach, the valuation analyst will estimate future ownership benefits, cash flow and then determine a value based on a rate of return called the discount rate or capitalization rate. The discount rate is set by the valuation analyst, based on current rates of returns for US treasury bonds and the US stock market, along with professional judgment in evaluating the specific risks of the company and its industry. This rate should reflect the time value of money, inflation, and risks associated with the specific company or company interests subject to the valuation.  Think of the discount rate as the rate of return a potential buyer will desire from the investment in the company.
 
Two of the most commonly used methods within the income valuation approach include the:

  • Capitalized Returns Method
  • Discounted Future Returns Method (Cash Flows) 

CAPITALIZED RETURNS METHOD

The Capitalized Returns Method converts a level amount of benefits into a present value based on a single period or the average of several historical periods. This method may be used when a company’s future operations are not expected to change significantly from its current normalized operations or when future returns are expected to grow at a somewhat predictable rate. To apply this method, a company’s current normalized cash flow are divided by a capitalization rate to estimate value. The capitalization rate is normally a derivative of the discount rate adjusted for expected growth and is a factor used to convert a single period income stream into an indicated value. 
 

DISCOUNTED FUTURE RETURNS METHOD (CASH FLOWS)

The Discounted Future Returns Method requires specific estimates of future benefits over a specified period of time (usually five years) until a normalized level of cash flow is reached in the terminal period. Typically, management will provided the valuation appraiser with a forecast for the next five years (e.g. 2018 through 2022). A terminal period and/or terminal value is usually the present value of a future benefit stream flattened or stabilized. The Discounted Future Returns Method may be used when a company’s future operations are not likely to remain static, which allows for flexibility with margins, growth rates, and debt repayments. These benefits are then discounted back to present value. 

 
Contact Us

There are many reasons a company may want or need a business valuation, including negotiating a merger or business sale, estate and gift tax planning, considering new shareholders, attempting to resolve partner or other liability disputes, determining shareholder equity or even marital dissolution. A business valuation may also be useful for strategic planning and benchmarking purposes. Whatever purpose the valuation is fulfilling, it is vital to engage experienced professionals who will take a comprehensive view of all the company’s investments.
 
Smith Schafer works with companies, in multiple industries, to uncover the true value of their companies’ tangible and intangible assets. Click to contact Smith Schafer’s Valuation Services Group to schedule a free 30 minute consultation. We look forward to speaking with you soon.

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