Occasionally business owners need to conduct a business valuation to ascertain the value of their company.
This may be for various reasons such as planning to sell the company, going through a merger, partner buy-in, estate planning and even divorce. Regardless of the reason, it’s important to understand how valuations are conducted and the different approaches used when determining the value of a company. Depending on several variables a valuation professional can select from one of three approaches to identify value – this includes the income approach. This approach is typically used to value service oriented companies (engineering or healthcare) and those with an operating focus such as grocery store chains, To help clients, prospects and others understand the income approach, Hanson & Co has provided a brief summary below.
What is the Income Approach?
The income approach measures the future economic benefits that the company can generate for a business owner (or investor). As part of their analysis, valuation professionals assess factors that determine expected income including data such as revenues, expenses and tax liabilities. Depending on the age of the company the analysis will focus on historical data in the categories previously mentioned. However, if a company is only a few years old more emphasis is placed on reviewing the company’s projections to determine validity. There are advantages to using this approach including its ability to be applied to companies in different industries as well as companies in different growth stages.
Income Approach Methods
When using this approach, there are two primary methods for determining a company’s value, which include:
Capitalization of Earnings – This method is often used to help investors determine the risks and return of purchasing a business and help identify the expected rate of return. Using this method, the value of a company is determined by calculating the net present value (NPV) of cash flows or other expected future profits. This can include profits from existing agreements or those expected from the ordinary course of business. The capitalization of earnings estimate is determined by taking a company’s expected future earnings and diving by the capitalization rate. This rate is determined by in part by the company’s perceived risks. Be aware however, that the rate for small businesses ranges from 20% to 25%.
Discounted Cash Flow (DCF) – This method is often used to help investors determine the attractiveness of an opportunity. It uses future cash flow projections and discounts them to arrive at a present value estimate for the company. This provides flexibility to reflect projected growth or anticipated declines and the impact on cash flows. When a company is in its early stages there may not be a lot of historical data to use for analysis or a company may be rolling out a new product which is expected to increase cash flow. This method provides the opportunity to account for such changes in the valuation process. The goal is to arrive at an expected amount to be received from the purchase of a company (adjusting for the time value of money).
There are several methods for determining the value of a business. It is not uncommon for the method used to depend on a number of factors including purpose of the valuation, company type and industry served. If you are thinking about selling your company or need a valuation for other reasons, Hanson & Co, can help! For additional information call us at (303) 388-1010, or click here to contact us. We look forward to speaking with you soon.