Valuation Basics: Understanding the Income Approach

Financial analysts consider the purpose of business valuation and the availability of variables and information to determine the appropriate valuation method. The top three business valuation approaches or methods include:

1. The asset approach
2. The income approach
3. The market approach.

Financial analysts prefer the income approach of business valuation for service providers, such as engineering and healthcare companies. The income approach also works well for businesses with ongoing operations, like the service industry, grocery store chains, prospects, etc.

The income approach does not depend on historical market transactions of similar types. It aims to value the business at the present value of its future earnings or cash flows. The process involves projecting business earnings and adjusting them for changes (if any) in the growth rates, cost structure, taxes, and other variables.

Income Approach for Business Valuation

The income approach for business valuation includes two basic variations:

1. Discounted cash flow method
2. Capitalization of earnings method.

Discounted Cash Flow Method

Professional analysts and investors use the discounted cash flow method to determine a realistic price for a business. Investors mainly use this method to buy a business or invest in a company in exchange for a share of ownership.

Project managers and financial analysts working in big companies also use this method to determine if a given project would be a good investment. They use this method even when investors want to pay more money now in anticipation of greater future gains.

This method suggests that business value equals the present value of its projected future earnings plus the present value of the terminal value.

The valuation process begins with the analysts projecting the business’ expected future cash flow over an extended period. The most commonly projected items include capital expenses, operating costs, revenue, and working capital. Analysts then discount the future cash flows to arrive at the present value. They usually apply steep discount rates ranging from 30 percent to 60 percent for start-ups.

As a rule of thumb, the younger the company, the larger the discount rate due to the greater uncertainty of its future earnings. However, this method does not work in the case of very young, pre-revenue companies.

The discount rate for risk adjustment may be the weighted average cost of capital (WACC). The idea is to find the projected future cash flows.

As per the Gordon Growth Model, companies need to obtain net cash flows for just one year and assume constant perpetual growth. Its formula is:

Business Value = First Year Cash Flows / Required Rate of Return – Growth Rate

This formula assumes that the present value is in perpetuity.

Using a variation called the multi-stage growth model, which does not assume an unchanging constant of growth, companies divide the future into two or more stages:

• The initial period of four years, for which companies need to find the net cash flows and growth rate for every year,
• The period after the initial four years, for which projection is unreliable year after year.

Analysts discount cash flows of each year separately to “time zero.” According to Investopedia, “time zero” is the initial cash flow paid in during the project’s start and is not discounted because it is not a future value but a present value. Therefore, analysts discount the cash flows of each year separately to determine their present value.

The Gordon Growth Model helps find the present value of the cash flows at the end of the previous year, also called the terminal value. They discount back the terminal value to “time zero” or its present value and add the result obtained to the present value of cash flows in the initial period.

The equation for finding the discounted cash flow is:

DCF = CF1 / (1+r) ^1 + CF2 / (1+r) ^2 + CF3 / (1+r) ^3 + CF4 / (1+r) ^4…+ CFn / (1+r) ^n

Where:

• DCF is the sum of all the future discounted cash flows that the investor expects to produce from the investment.
• CF represents the cash flow for a specific year. CF1 is the cash flow for the first year, and CF2 is the cash flow for the second year, and so on.
• R is the discount rate in decimal form. It is the target rate of return that an investor wants on the investment.

Let’s try to understand the discounted cash flow method further with an example:

Suppose your friend says he will give you $2,000 after four years and asks you how much you are willing to pay for it today. To determine how much you should offer, you must translate that $2,000 into its value today.

Suppose you had $1,100 today, and you compounded it at 13.5 percent per year; it would be equal to about $2,000 in five years, as shown below:

Future value: $1,100 × (1 + 0.135) ^5 = $2,000

Present value: $1,100 = $2000 / (1 + 0.135) ^5

On the other hand, if you had $1,400 today and compounded it at 7.7 percent per year, it would be equal to $2,000 in five years, as shown below:

Future value: $1,400 × (1+0.077) ^5 = $2,000

Present value: $1,400 = $2,000/ (1+0.077) ^5

Hence, we can say that the amount of $2,000 five years from today has worth to you now, depending on the rate of return you compound during that period. Let’s assume you have a target rate of return. You will likely get the exact maximum you should be willing to pay today for the expected return in five years.

With the help of the discounted cash flow equation, you can translate future cash flows into their present value. This calculation uses the compounded rate of return you are likely to receive from your investment. Analyzing the expected discounted cash flows when you want to buy a business or have someone invest in your business can help you decide which investments are worthwhile or not.

Now, let us use the discounted cash flow formula to calculate the value of a business.

Suppose you are an investor who has received the offer to purchase a 30 percent stake in a long-running business. Also, you know the owner very well, and this strong-running business having a growth rate of 4 percent per year, has been passed on for three generations.

Currently, the business produces about $700,000 per year in free cash flow. So, if you invest in the 30 percent stake in the company, you will get $210,000 per year in cash, and this amount will also grow by 4 percent every year.

So, how much should you pay to buy this 30 percent stake?

Assuming accurate growth estimates, you will get $210,000 in the current year, $218,400 in the next year, $227,136 in the year after, and so on. The 30 percent business stake is worth the amount equal to the sum of all future cash flows that you will likely get. That, too, after considering that each of those cash flows is discounted to their present value.

Assume you target a compounded rate of return to be 15 percent for this private deal offering low liquidity. You would want to purchase this business stake at a price low enough to allow you to earn this rate of return.

Let’s work on the equation for this:

DCF = $210,000 / (1+0.15) ^1 + $218,400 / (1+0.15) ^2 + $227,136 / (1+0.15) ^3 + … + CFn / (1+r) ^n

DCF is the discounted cash flow value, the sum of all the future discounted cash flows. It is also the maximum amount you should pay for the business today to get a 15 percent return per year. The numerators in the above formula represent the expected annual cash flows, which start at $210,000 for the first year and grow by 4 percent per year in perpetuity. When the denominators are divided by a 15 percent compounded rate yearly, they convert annual cash flows to their present value.

As per the table below, the discounted versions of those cash flows shrink for the first five years, even as the expected cash flows keep growing. This is because the discount rate is much higher than the growth rate.

Use Excel or any spreadsheet to carry out this pattern indefinitely.

As per the table, you expect to get $245,669 in actual cash flow during the fifth year; however, it is worth merely $122,141 to you today. In other words, if you have $121,141 today, you could grow it by 15 percent per year for the next five years and turn it into $245,669 after those five years.

As we calculate further, the discounted versions of those future cash flows will shrink each year and approach zero at some point as the discount rate of 15 percent being applied is much higher than the growth rate of the cash flows, which is 4 percent.

So, $1,909,083 is the maximum amount you need to pay to buy a 30 percent stake in the business to achieve 15 percent annual returns. Of curse, this assumes accurate estimates for the growth.

Also, the sum of the first 25 years of the discounted cash flow for this example is $1,754,484. Meaning that even if the company goes out of business after a few decades, you will still get most of the rate of return that you expect, and the company need not last forever for you to get your investment’s worth.

Capitalization of Earnings Method

Capitalization of earnings gives a broad estimate of a company’s value, depending on its future earnings. It calculates the net present value (NPV) of the company’s expected future profits or cash flows by taking its future earnings and dividing them by the capitalization rate.

The capitalization of earnings method of the income approach determines the value of a business by looking at its current cash flow, the annual rate of return, and the expected future value

The formula for business valuation is:

Business Value = Annual Future Earnings / Required Rate of Return

Let’s get a better understanding of the capitalization of the earnings method with an example.

Suppose a real estate company’s board of directors receives a takeover offer. After discussion, they determined the company’s forecasted future earnings are $25 million, with its required rate of return at 12 percent.

By using the capitalization earning method equation, $25 million / 12% = $158.33 million. Thus, the company is worth $208.33 million if the future earnings continue into perpetuity.

Income Approach of Business Valuation Summary

Companies seeking a more detailed forecast prefer the discounted cash flow method over the capitalization of earnings method. While we have discussed the business valuation methods under the income approach, experienced valuation professionals are the best judges of the approach and method most suitable for a particular business or company.

Connect with our experts to know more.