Valuing Your Business Using the Income Approach: What’s Right for my Business?

Business valuations are generally conducted using one of three approaches: 1) the asset (or cost) approach, 2) the market approach, or 3) the income approach, which is most common. Under each approach, there are several methods that can be applied. This article focuses on the income approach and its two most commonly used methods.

In most valuation reports, clients will see some application of the income approach. The two most commonly used methods are the Capitalization of Earnings / Cash Flows Method (“Cap of Earnings”) and the Discounted Cash Flows (“DCF”) method. The key distinction between the two methods is whether the valuator is using historical operations or future expectations to calculate the respective values.

Under the Cap of Earnings method, valuations are calculated using the historical cash flow stream to anticipate future returns. In order for the Cap of Earnings method to be appropriately applied to value a company, the following operating characteristics should be met:

• The business is in a mature state of its business cycle (not a startup or early stage);
• Future operations are indicative of present and past operations;
• The company is not planning any significant changes to its operations or divisions in the near term; and
• The company does not generate significant income or expenses from non-operating assets.

If any of the above-mentioned scenarios are not true, the business owner should question the use of this method in their report. Alternatively, a DCF may be a more appropriate method for valuing the company.

Under the DCF method, business forecasts are developed and projected into future years based on management’s expectations and market trends. The DCF method is more flexible than the Cap of Earnings method in that it can account for volatility in future operations, investments in growth or business lines, and future capital expenditures. However, the model is only as good as the forecasts used to develop the value. Consequently, it can be easily manipulated to achieve a specific objective or outcome. Characteristics that make a DCF method successful are the following:

• The company has management that is financially sophisticated enough to provide realistic input on forecasting future cash flows;
• The company’s financial statements and historical information are organized and classified in a way that it can be compared to other industry peers;
• The business can plan and expect, with some certainty, specific events in the near term that may impact operations and growth; and
• Industry activity can be leveraged to anticipate how achieving certain milestones can predict future growth or contraction.

Whichever method is used in the report, it is critical that the valuator is able to explain the approaches and methods applied.

Since the onset of the Covid-19 Pandemic, the valuation industry has turned to the DCF as the more applicable income approach method. However, it does not mean that the Cap of Earnings method is invalid in every case. Businesses experiencing little impact from the pandemic may find it more appropriate to use the Cap of Earnings method. Additionally, smaller businesses often do not have sophisticated financials or records to develop accurate forecasts. In such cases, adjustments should be made and / or considered to historical operations to account for the abnormalities as a result of the pandemic.

As a business owner, it is important to discuss these items ahead of time with your valuation provider in order to get a more accurate valuation of your business. Additionally, it is easy to be optimistic about the future of one’s business, but a prospective investor or buyer considers potential downturns as well. In summary, the more critical you are of your own business and expectations, the more accurate and realistic your value will be.

For any questions related to the Income Approach, or business valuation in general, please contact Bryan Setz at bsetz@vlcpa.com or 800.887.0437.