The income approach is one the most used methods to estimate the value of a business. Within this approach, there are two main methods, the discounted cash flow method and capitalization of cash flows method.
In this post, we will take a closer look into how this approach works and what it means.
What is the Income Approach?
The income approach refers to estimating the value of a business by converting a future expected stream of earnings into a single value in the present (today) using a discount rate. This discount rate represents the rate of return that an investor/buyer would require based on the risks he or she is incurring when acquiring a business.
Examples of rate of return include buying a house, where you may be expecting a 5% return yearly. Also, generally speaking, small, privately held businesses have higher risks and require a higher return, often between 10-30%.
Income Approach Valuation
In simple terms, the income approach derives the value of a business based on expected generated cash flows from the operation of the business, and uses a discount rate that represents your required return from investing in the business. Two of the most common methods are the capitalization of cash flows method and the discounted cash flow method.
Capitalization of Cash Flow Method
The capitalization of cash flow method takes a single expected future maintainable stream of earnings, based on the assumption that the stream of earnings grows at a flat rate into perpetuity. A discount rate (risk assessment) is used to convert it into a single current value.
This method is used when one can reasonably expect steady earnings from a business into the future (e.g., if we have a business that has historically produced steady earnings without high volatility, we can then say that it’s reasonable to expect the same results into the future).
An example would be a small car wash business that has been operating for ten years, and each year the business consistently generates the same cash flows, (revenue minus expenses) within a 5-10% difference. This provides confidence to the valuer that the historical financial results are the most probable outcome when looking into the future. The discount rate is then applied to arrive at the value.
Value = earnings/discount rate
Discounted Cash Flow Method
The discounted cash flow method or cash flow method has more flexibility to its assumptions. Here, we work under the premise that the expected earnings may differ in the near future from the expectations into perpetuity.
Consequently, we have two different stages of calculation in this method:
we calculate the present value of the expected stream of earnings in a projected period of three-five years (this is the timeframe most commonly used, although it can be more or less) and then use a discount rate
- we estimate the present value of the expected stream of earnings post the projected period (identified in Stage 1) into perpetuity, again then applying a discount rate
Finally, we sum stages 1 and 2 to calculate the business value.
As an example, if you had an expansion plan to acquire three more pizza restaurant franchises over the next five-year period and then stop, well, your cash flows—being new revenue and expenses from the newly acquired pizza franchises over the next five years—would be different to a) your historical financials, and b) what it will look like after your expansion plan is complete.
So, in that example, the valuation practitioner would use a discounted cash flow method to accurately capture the expansion plan (change in cash flows) as well as the expected cash flows into perpetuity.
This is the simple explanation, and it gets a lot more technical and complex, which is why contracting the right valuation practitioner is key when valuing your business.