In Summary
- This valuation method converts a company’s expected future economic benefits (cash flows or earnings) into a single present-day value by discounting them back to the present, making it ideal for operating entities with consistent earnings, predictable income streams, or significant intangible assets (like IP or brand reputation).
- The income approach uses capitalization of earnings (a single-period method that divides current-year earnings by a capitalization rate) for mature businesses with stable performance, and discounted cash flow (a multi-period method that projects and discounts cash flows over several years) for companies with expected growth, decline, or fluctuating earnings.
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How is the value of a business determined? Depending on the type of business, several variables need to be analyzed. This may include assets, liabilities, geographical location, current market conditions, etc. While it seems straightforward, valuations are complex and require the use of established models to arrive at an estimated value. There are three primary approaches, including the asset approach, market approach, and income approach. These three vary in how value is calculated and are typically used in specific situations. One method, the income approach, concerns a company’s future earning potential based on the analysis of expected cash flows and earnings. To help clients, prospects, and others, Hanson & Co has summarized the key details below.
What is the income approach to business valuations?
The income approach to valuation is often used in real estate, but it can also be used to determine a business’s value based on expected cash flows or future earnings. Instead of examining the business’s asset value or market comparisons, this approach focuses on its ability to generate income.
How does it compare to other valuation methods?
While the income approach is concerned with the future earning potential of a business, converting expected cash flows into present-day value, the market approach and asset-based approach view valuation differently. The market approach involves comparing businesses to other, similar companies in the market that have recently sold. An asset-based approach tallies the assets of a company and subtracts liabilities to derive a value.
These three valuation methods are the most common, but others may also be used, including the cost approach or option pricing models. The cost approach looks at the cost a business would incur to recreate its assets, while the option pricing model determines the fair value of options, or rights to buy or sell assets.
When is the income approach to valuation used?
Businesses can consider a few different factors when deciding whether the income approach is appropriate.
First, the company should have consistent earnings with a consistent and predictable income stream. Businesses anticipating significant future growth can also benefit from this approach based on income forecasts. It’s also a great fit for organizations with more intangible than tangible assets (intellectual property, close customer relationships, and strong brand reputation). The income approach can also value intangible assets in a way that tangible asset value cannot.
A few different scenarios may be suitable for an income approach to valuation. Businesses may use it before a sale to determine a fair selling price. Other companies may use it during a merger or acquisition to determine the target company’s value. If a business plans to expand products, services, or locations, it may use income valuation to quantify the potential financial impact of a big change.
Using the income approach to valuation can help one understand other investment opportunities or current business performance. Business owners can also use it to determine value for estate planning purposes to understand gift tax implications better.
Who benefits from this type of valuation?
The income approach can benefit many different stakeholders, including investors, lenders, tax authorities, courts, and, of course, the business owners themselves.
Investors can use this approach to assess potential investments based on the expected returns of a business in a given period. Lenders can use this similarly to determine loan terms based on a business’s creditworthiness. Courts may use the income approach to resolve business valuation disputes during shareholder disagreements or divorce proceedings, and tax authorities can use it to determine a business’s value for tax reasons.
While this can be useful, it’s typically not used alone. Other valuation methods, including the market and asset-based approaches, can be used with the income approach to provide a more comprehensive picture of the business.
Methods used with the income approach
The methods used under the income approach are generally part of one of two categories: single-period and multi-period.
- Single-Period Methods – This method looks at a single point in time, generally the current period. It may be appropriate for businesses expected to have consistent earnings and cash flow in the future. One method under this category is capitalization of earnings, which takes the current year’s earnings divided by a capitalization rate (cap rate) to determine the business value. Another is free cash flow to the firm, which looks at cash flows available to all investors and is capitalized. Cap rates are return rates used to convert income in a single period into business value. Calculating cap rates requires an understanding of risks, market conditions, industry and company specifics, and analysis of comparable companies.
- Multi-Period Methods—Multiple-period valuation methods evaluate and forecast business performance over future periods, which can often lead to more accurate valuations for businesses with expected growth, decline, or seasonality in their earnings. One common method under this category is discounted cash flow (DCF), which projects future cash flows for multiple periods using discount rates and terminal values.
Discount rates are used to determine what money in the future is worth today, adjusting for factors such as inflation and risk. Other variables businesses may want to consider include the risk levels associated with the business, how much the business is reliant on certain customers or suppliers, overall market and industry conditions, company size, the amount of debt the business is carrying, and how finances are structured.
What shouldn’t be included in an income-based valuation?
For income-based valuations to be more reliable, no matter the category, businesses should make some normalizing adjustments to remove any abnormal behavior that might swing the valuation in an irregular direction. These can include one-time unusual costs, including significant gains from asset sales, one-off legal settlements, or expenses associated with restructuring that is not anticipated to occur again.
Contact Us
Business valuations can be complicated and require different methods, including the income approach. For this reason, it is important to work with a qualified valuation professional. If you have questions about the information outlined above or need assistance with a business valuation, Hanson & CO can help. For additional information, call 303-388-1010 or click here to contact us. We look forward to speaking with you soon.