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The Income Approach Made Simple

The Income Approach Made Simple

Determining the market value of a company with publicly traded stock is pretty easy. Multiply the stock price by the number of shares outstanding and you have the company’s worth or total market value. Have you ever wondered how to determine the value of a small business? This is an important question to answer if you are looking to buy or sell a private business. 

In the early 1900s, it was common to determine the value of a business by the lifestyle of the owner. If John the blacksmith wore nice clothes and lived in a big house, then you would have paid a large amount for his business. Negotiation skills often played a big part in how much one would pay for a business. As you can imagine, many businesses were over or under-valued.

Today, there are several approaches to valuing a business to determine a fair market value:

  1. The Market Approach
  2. The Asset or Cost Approach
  3. The Income Approach

Business valuation specialists, like Peak Business Valuation, use a combination of approaches to properly appraise a business. Today we will focus on how to use the income approach to value a business. There are two methods to using the income approach, the Discounted Earnings Method, and the Capitalization of Earnings Method. So, we will provide an overview of each method and examine their pros and cons.

The Income Approach

First, the income approach values a business based on the earnings it produces. What remains after you pay your expenses? The profitability of a business is a strong indicator of how much money will be lining the pockets of its owner. Because each business is different it is necessary to use different approaches. Let’s take a closer look at The Discounted Earnings Method and The Capitalization of Earnings Method.

Discounted Earnings Method

The Discounted Earnings Method looks at three different components to determine the value of a business:

Earnings – The amount of money left over after all expenses are paid

Terminal Value – The value of the business at the end of the forecast period

Discount Rate – The rate that expresses the risk of the investment

This method projects earnings into the future and derives what the income is worth today. The earnings for each period projected is reduced based on a selected discount rate.

Once you have determined the discounted earnings for each of the five years, you add them up. After this, add this amount to the terminal value. Then you have the value of the business. Let’s examine the benefits and disadvantages of the Discounted Earnings Method.

Benefits:

  1. Great for non-constant or rapid growth companies, like many tech startups
  2. Very detailed
  3. Scenarios can be built-in, like the best case, the average case, and worst-case scenario

Disadvantages:

  1. Relies on projections and assumptions. The further into the future you project, the more likely you are to make a mistake
  2. Can become complex
  3. Determining a discount rate that represents the risk of the earnings is difficult. It requires the expertise of the valuation expert, like Peak Business Valuation – a top business appraiser

The Capitalization of Earnings Method

This method is like the Discounted Earnings Method in that it takes projected earnings to determine the value of the business. It differs from the Discounted Earnings Method by projecting earnings over a much shorter period of time. This is often to the end of the current year. The Projected Earnings are then divided by a Capitalization Rate to determine the value of the business. 

 Value of the Business = The projected earnings stream / The capitalization rate 

The Capitalization of Earnings Method gives a clear picture of what the business is worth today and does not rely on assumptions like the Discounted Earnings Method does. As such, it is often more applicable to small, privately-held businesses with stable revenues. Here are some benefits and disadvantages to this method:

Benefits:

  1. Based on historical performance rather than assumptions
  2. Provides a value of what the company is worth today 
  3. A great method for businesses with stable earnings

Disadvantages:

  1. Not suitable for companies with volatile earnings or rapid growth
  2. New businesses may not have enough historical data to determine

The income approach is one of three commonly used methods to value a business. Peak Business Valuation uses a combination of several methods when providing a valuation. Each of these methods requires expertise to fairly represent the business. So don’t leave the value of your business up to negotiation skills. We are happy to answer any questions you may have! Please reach out via email or by scheduling your free consultation below.

 

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