Income Approach to Business Valuation
In income approach of business valuation, a business is valued at the present value of its future earnings or cash flows. Future earnings/cash flows are determined by projecting the business’s earnings/cash flows and adjusting them for changes in growth rate, cost structure and taxes, etc. The present value is determined using a discount rate which reflects the required rate of return of the investor.
Income approach is a powerful and effective approach because unlike market approach i.e. relative valuation, it doesn’t rely on any past similar transactions. However, since value is very sensitive to estimates of growth rate and required rate of return, these inputs must be sound.
Income approach has two main variants: (a) discounted cash flows approach and (b) capitalization of earnings.
Discounted Cash Flow
Under the discounted cash flow method, the first step to determine the projected future cash flows. The simplest approach, called Gordon Growth Model, works out net future cash flows for just one year and assumes a constant perpetual growth.
| Business Value = | Cash Flows during First Year |
| Required Rate of Return – Growth Rate |
The above equation is based on the formula for present value of a perpetuity.
Another approach, called multi-stage growth model, divides future into two or more stages: (a) initial period of say 5 years, for which net cash flows and growth rate for each year can be determined and (b) period after the initial period for which year by year projection is unreliable. Under this method, cash flows of each year in the initial period is discounted separately to time 0. The present value of the cash flows at the end of the last year (which is called terminal value) is determined using the Gordon Growth Model. The terminal value is discounted back to time 0 and added to the present value of cash flows in the initial period.
Capitalization of Earnings
Under the capitalization of earnings method, value of a business is determined by discounting its future earnings.
| Business Value = | Annual Future Earnings |
| Required Rate of Return |
Under the capitalization of earnings approach, no growth in cash flows is considered.
Example
Stonewall, Inc. is company engaged in real estate management. In December 2016, the company’s board of directors has received a takeover offer. In discussing the offer, they have requested a presentation by the company’s CFO.
The company’s net cash flows for the recently closed financial year are $19 million. The CFO has worked out that company’s expected net cash flows in the first five years (2017-2021) shall be $20 million, $22 million, $25 million, $30 million and $35 million. From sixth year onwards, he believes that it is better to assume a 5% growth rate. He also estimates that the company’s cost of equity is 12%. His presentation shows the following calculation of the company’s value:
| Year | Net CF | Discount Factor @ 12% | Present Value |
| 2017 | 20 | 0.8929 | 17.86 |
| 2018 | 22 | 0.7972 | 17.54 |
| 2019 | 25 | 0.7118 | 17.79 |
| 2020 | 30 | 0.6355 | 19.07 |
| 2021 | 35 | 0.5674 | 19.86 |
| 92.12 | |||
| Terminal Value | 36.75 | 14.2857 | 525.00 |
| Company Value | 617.12 |
He goes on to explain that the terminal value is calculated by finding the net cash flows in 2022 by applying the 5% growth rate to cash flows in 2012 and then discounting $36.75 million to time 0 using the formula for present value of perpetuity.
One of the director, Mark, questions the company’s ability to precisely forecast net cash flows even in the initial period of 5 years and suggests that the company should use assume a constant growth rate of 5% to calculate value. He comes up with company value using the Gordon Growth Model as follows:
| Company Value = $19 million × | 1 + 5% | = $285 million |
| 12% – 5% |
Another director, Mary, questions the use of net cash flows and growth rate assumption. She suggests that the value should be determined based on the expected earnings and an appropriate capitalization rate (which she claims is 10% as obtained from a popular valuation database). She is also against incorporating any growth rate assumption.
The CFO informs the board the earnings for earnings for the most recent year were $25 million and are expected to be $24 million next year. After some quick number-crunching, he tells the board that based on the approach suggested by Mary, value amounts to $240 [= $24 million ÷ 10%]. However, he says he sticks to his stance that the valuation arrived by him using the multi-stage discounted cash flows approach is the most reliable.
by Obaidullah Jan, ACA, CFA and last modified on