The Income Approach to business valuation uses the economic principle of expectation to determine the value of a business. To do so, one estimates the future returns the business owners can expect to receive from the subject business. These returns are then matched against the risk associated with receiving them fully and on time.
The methods under the Income Approach include:
1.Discounted cash flow method:
This income-based business valuation method provides highly accurate estimate of business value based on the business earning potential. Under this method, we determine the business value by discounting the future business earnings using the so-called discount rate which captures the business risk. The use of this method requires the following three inputs:
1. Business net cash flow forecast over a pre-determined future period
2. Discount rate
3. Long-term residual business value
Our Income Statement forecast provides the net cash flow numbers five years into the future. Since the subject business is debt-free, we use the equity discount rate calculated earlier. Finally, the residual business value which represents that portion of business value past the net cash flow projection period is calculated as follows:
CF5→ is the net cash flow estimated in year 5 of our forecast.
g →is the long-term growth rate in the net cash flow.
d →is the discount rate.
R →is the residual business value.
2.Multiple of Discretionary Earnings Method:
The Multiple of Discretionary Earnings method is a variant of the direct capitalization methods under the Income Approach. Essentially, this method establishes the business value as a multiple of its earnings adjusted for the net working capital, nonoperating assets, if any; and long-term liabilities.
3.Earnings Basis Calculation:
To determine the business value using this method, we use the Seller’s Discretionary Cash Flow (SDCF) as the basic measure of the business earning power. We estimate SDCF as a weighted average of historic values obtained during the company’s income statement reconstruction.