Business Valuation Income Approach
There are three conceptually distinct methodologies that can be applied when performing business valuations or asset appraisals: (a) the income approach, (b) the market approach, and (c) the cost approach.
The income approach quantifies the present value of anticipated future income generated by a business or an asset. Forecasts of future income require analyses of variables that influence income, such as revenues, expenses and taxes. The income approach is unique in its ability to account for the specific contribution to the overall value of various factors of production. There are several commonly accepted methods under the income approach.
Income Approach Methods:
Capitalization of Earnings Method
Capitalization of earnings is a method of determining the value of an organization by calculating the net present value (NPV) of expected future profits or cash flows. The capitalization of earnings estimate is determined by taking the entity’s future earnings and dividing them by the capitalization rate. This is an income-valuation approach that determines the value of a business by looking at the current cash flow, the annual rate of return and the expected value of the business.
Discounted Cash Flow DCF Method
The Discounted Cash Flow (DCF) method is an income-oriented approach. It is based on the theory that the total value of a business is the present value of its projected future earnings, plus the present value of the terminal value. The DCF method first projects the cash flow the business is expected to produce in the future, over a discrete period of time. Then, each discrete cash flow is discounted to a present value at a rate that reflects the risk of receiving that amount at the time anticipated in the projection. To better reflect these projections, items such as revenue, operating costs, capital expenses and working capital are forecasted. These projections were used to determine the net cash flow generated by the business, which was then discounted to the present value, using an appropriate risk-adjusted discount rate often the weighted average cost of capital, or WACC
Excess Earnings Method
The excess earnings method combines the income and asset based approaches to arrive at a value of a closely held business. Its theoretical premise is that the total estimated value of a business is the sum of the values of the adjusted net assets (as determined by the adjusted net assets method) and the value of the intangible assets. The determination of the value of the intangible assets of the business is made by capitalizing the earnings of the business that exceed a “reasonable” return on the adjusted (identified) net assets of the business.