Fundamentals of Business Valuation: The Income Approach
- Chad Hudson
Jan 4, 2024
How much is your business worth? This question lies at the heart of many business decisions — and a lot is riding on the answer.
Perhaps you’re planning to gift a share of the business to a loved one or you’re creating an employee stock ownership plan (ESOP). You could be exploring your options for exiting the business altogether. Or maybe you’re embroiled in a marital divorce or shareholder dispute.
Whatever your situation, achieving your desired outcome is a little bit easier when you come to the table with a professional business valuation — one that uses the valuation approach that best fits your business, your industry, and the reasons driving you to understand what your business is worth in the first place.
Which Valuation Approach Fits?
There are three primary valuation approaches. You might think of them as three philosophies of how to value a business. The market approach uses comparable transactions in the marketplace; the asset approach focuses on what a company owns; and the income approach is interested in what the company earns. Within these three approaches, there are numerous methods (such as capitalization of cash flow and discounted cash flow, described below) that valuation professionals can use to determine value.
In many cases, valuators use multiple approaches and methods to arrive at the final conclusion of value. In fact, valuators’ professional standards require them to consider all three approaches in every valuation they perform, and you can expect a professionally prepared valuation report to explain all three approaches and the various methods within each approach.
By understanding how each approach works and when it is typically used, you will be better prepared to use the valuation report to make wise business decisions. This article gives you a high-level view of the income approach, which is the primary approach used in most business valuations.
How Income-Based Valuation Works
When using the income approach, valuators attempt to answer the question of how much annual, ongoing economic benefit the business can reasonably expect to produce in the future. This approach considers the risks associated with the investment, the timing of the anticipated benefits, and expected growth.
The formula for this approach is:
Value = Benefit ¸ Required Rate of Return
The numerator (benefit) is often expressed as cash flows or net income, while the denominator (required rate of return) is typically expressed as either a capitalization rate or a discount rate.
Much research and analysis go into this seemingly simple formula. But at the end of the day, what business owners need to know is that, in general, value tends to be inversely correlated with risk.
The most commonly used income-based methods are:
- Capitalization of cash flow/earnings. When a business has steady earnings or a discernible trend that can reasonably be expected to continue into the future, a valuator will use that historical trend as one input in the calculation of what the business will earn in the future. Due to its use of actual net cash flow or net income, this method is most appropriate for mature companies with an established operating history.
- Discounted cash flow. With this method, valuators use projections of the company’s future financial results (such as pro forma financial statements prepared by management) as opposed to historical or current financial results. Valuators then apply a discount rate to convert those future anticipated cash flows into present value. This method is typically used with companies that are expected to experience varying levels of growth.
Challenges in Using the Income Approach
Due to its focus on recurring cash flows, the income approach is commonly used when valuing operating entities. However, applying this approach in small and mid-sized businesses (SMBs) can be challenging.
For one thing, SMBs’ financial statements often paint a less-than-accurate picture of the financial health of the company, requiring valuators to adjust, or “normalize,” them to reflect appropriate income and expenses. For example, if you’re paying yourself a below-market salary, or if your company is paying below-market rent for warehouse space (perhaps because you own the warehouse through a separate entity), a valuator would make adjustments to reflect market rates.
For an Accurate Valuation, Seek Specialized Skills
Achieving an accurate and supportable valuation requires specialized skills and depth of experience. Given how much is riding on the value of your business or ownership interest, it pays to turn to a credentialed professional, such as a Certified Valuation Analyst (CVA) or someone who is Accredited in Business Valuation (ABV).
If it’s time for a valuation, talk with your CRI advisor. We’ll explain which valuation approach is optimal for your situation and help you understand the reasoning behind the numbers so you can get the insights and information you need.