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Income Approach

Income Approach to Business Valuation

The purpose of the income approach to business valuation is to calculate future cash flows then calculate the present value of those future cash flows by using a discount rate. Business Valuation Resources defines discounted cash flow as “a method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate.” The goal of this business valuation approach is to enable a business buyer to make an informed investment decision and better understand what the projected income is worth at present time.

The key concept to keep in mind here is the time value of money, which, in essence, is the notion that money you have now is worth more than the identical sum in the future due to its potential earning capacity. The future projected cash flows are “discounted” to account for the time value of money, the required rate of return, and the amount of risk involved for the given investment. Future cash flow of the business is the main driver of value using the income approach to business valuation. A key component with the cash flow calculation is to ask if the projections are reliable and predictable. If they are reliable and predictable, then the cash flow can be relied upon in the valuation.

Individuals may shy away from using this approach as they may think it is complicated at first glance, especially when compared to the market approach or asset approach to business valuation. However, when broken down into steps, the discounted cash flow calculation is quite simple.

How is it calculated: This is a multi-step process. The steps are below:

  1. Project future business earnings (typically 5 or more years into the future) or cash flows.
  2. Determine discount rate.
  3. Assign a terminal value.
  4. Discount the future business earnings or cash flows to present value by inputting the variables into a DCF calculator or excel model. The calculated value is the net present value.

When to use it: Best used for turnarounds and startups where the prior historical financials are not as relevant. Additionally, best for individuals that plan on being “investors” in the business instead of directly operating the business.

Pros

Cons

Example Business Case for Calculating Business Valuation Using the Income Approach

Example Business – Gabriel & Associates Accounting Firm

It helps to see an example business valuation using the income approach. In this example scenario, Gabriel, the owner of an accounting firm, has decided to sell his business. The business has been open for three years and is operating fine. However, Gabriel has decided to pursue other business opportunities that will require his time and management expertise. Therefore, Gabriel has listed his accounting firm for sale.

William, a potential business buyer, comes across the business for sale list of Gabriel’s accounting firm. As an accountant by training, William is always interested in purchasing other accounting firms as an investor, so he decides to conduct a business valuation for himself. As he would like to deep dive into the underlying financials and future projections of the shop for himself, he elects to focus on the income approach for valuing the business.

In order to calculate the business valuation using the income approach, he will need to follow the below steps:

Step 1

Forecast future cash flows (earnings) over the next five years

Step 2

Determine a discount rate

Step 3

Assign a terminal value

Step 3

Using the input data, discount the future cash flows to present value to arrive at the calculated business valuation

Calculating the Valuation

Step 1 (project future cash flows)

William requests that the business owner, Gabriel, put together projections for the business covering the next five years. William then focuses on the calculation of the EBITDA of the business as it has been shown to be the most reliable cash flow metric to use for small businesses with roughly $500,000 or more in EBITDA. In order to do this calculation, adjustments to the near-term projected profit and loss statement must be made. These adjustments include removing non-operating or non-recurring expenses from the business. Examples of these expenses include Gabriel’s personal vehicle costs which are on the company’s profit and loss statement as expenses. Once the EBITDA projections are calculated, William can move on to step two.

Step 2 (determining a discount rate)

Now William needs to decide on a discount rate. The discount rate is used to determine the present value of future cash flows. Since a dollar in the future is worth less than a dollar today, it is discounted. Hence the term discount rate.

For larger businesses, the discount rate is usually calculated by using something called WACC (Weighted Average Cost of Capital). For small business valuation It is not possible to calculate WACC because small, privately owned businesses do not have market capitalization. However, there are ways to approach this for small business transactions. The starting point is to understand that discount rate (return) is a reflection of risk the buyer is willing to take. In essence, it will be a reflection of the risk-free rate of return plus the risk premium for investing in a small business entity.

There are many ways to calculate the discount rate. For this example, William utilizes a large online database of the cost of capital for small businesses. The database shows that the cost of capital for the accounting firm is 12.5%.

Step 3

William will need to assign a terminal value for the business. The terminal value represents the cash flow received by the business owner after the projected period. There are a number of ways to calculate the terminal value, including, among others, the perpetuity, market, and asset methods.

For this example, William decides to use the market/comparables method to business valuation. As a rule of thumb, accounting firms typically sell for roughly 1x revenue. Below is the terminal value calculation assuming that William sells the accounting firm at the end of year 5.

Step 4 (calculation)

With all of the inputs in hand, William can now calculate the valuation of Gabriel’s business using the income approach. It should be noted that the cash flow in this calculation is unlevered (without taking out a loan) for sake of simplicity. For business buyers that plan on using debt to acquire a business then the levered cash flow, which is the cash flow an owner/investor will receive after debt payments are fulfilled, would be used. Below is the calculation for this example case:

As the calculation shows, the estimated valuation using the income approach would be $4,025,766 in this example.

Summary

Hopefully the above example is useful in illustrating the income valuation method for small business valuation. At first glance, this valuation method can seem more complicated that the other primary valuation methods. However, taking a step-by-step approach to the valuation process helps to simplify the calculation. The income valuation approach can be a very powerful tool for investors looking to determine the valuation of small businesses they are looking to acquire. Complexity can be added to the calculations in order to factor in additional information.

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