Business Valuation – Income Approach
Business valuers often use the Income Approach as the primary business valuation approach. However, this approach assume that the business is profitable or expects to be profitable in the future.
Business Valuation – Income Approach Method
Per the International Valuation Standards, methods under the Income Approach are variations of the Discounted Cash Flow Method (DCF).
Under the DCF method there are two steps. Firstly, the business valuer estimates expected future cash flows. Secondly, the valuer applies a discount rate to calculate a present value for the business.
As a consequence, when valuing a business the value has to assess two key inputs:
- expected future cash flows
- discount rate
Simple! The difficulty for the valuer is establishing what the cash flows and discount rate should be.
Expected future cash flows and business value
Future cash flows are the cash flows available to debt and equity holders. The higher the expected future cash flows, the higher the business value.
Valuers often calculate the future cash flows as the expected earnings before interest and deprecation. From this earnings figure, the value then deducts working capital movements, capital expenditure and tax.
When estimating future cash flows, the valuer analyses past financial performance and future forecasts. In addition, the valuer assesses the operations and the outlook for the business and the industry. The key cash flow inputs that a valuer often considers include:
- annual and monthly revenue trend
- gross profit margin
- overhead expense trends
- working capital to revenue requirements
- capital expenditure to growth requirements.
Discount rate and business value
The discount rate is the return required by investors. The rate reflects the perceived risks attached to the future cash flows. The more risky the cash flows, the higher the discount rate. The higher the discount rate, the lower the business value.
Factors that valuers considered in estimating a discount rate include current interests rates and yields, market returns reflecting market risk and risks specific to the industry and business.
In estimating the discount rate, valuers also consider the sources of funding. Debt holders will typically require a lower return compared to equity investors. However, increasing debt can increase the risk of default. Increased default risk increased returns required by debt and equity holders.
Capitalisation of Earnings method
The Capitalisation of Earnings method is a simple abbreviation of the DCF method. The Capitalisation of Earnings Method assumes that future earnings are stable; that there is no significant growth.
Instead of projecting cash flows for multiple years, the valuer estimates a single future cash flow. The valuer assumes that that cash flow continues in perpetuity.
Income Approach summary
Business valuers often adopt the Income Approach as a primary valuation approach. The Income Approach requires the valuer to estimate future cash flows and a discount rate.
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