Values the company from a potential investor’s point of view (i.e. , how profitable it will be in future).
Business appraisers create forecasts based on historical financial documents and expectations of future business conditions.
Since investors expect different returns on their investment based on the risk associated, the appraiser must consider this.
As the name of the approach suggests, the Income Approach determines what a business is worth based on its expected future earnings. This type of analysis is used in a variety of different applications such as: determining the value of publicly traded stock, bonds, real estate and other financial instruments. One reason that the Income Approach is so often used is that it can be applied in virtually all situations. Regardless of whether a business is a start-up, successful and profitable or in financial distress, the Income Approach can be used to model virtually any type of business.
The Income Approach is based on three primary factors:
Expected future earnings
Expected long-term growth in earnings
A discount rate (in other words, the rate of return an investor expects based on risk)
This approach is perhaps the most technically complex of the three valuation approaches and requires the appraiser to possess a thorough understanding of both the subject company and the underlying theory of the Income Approach.
Determining the Appropriate Earnings Stream and Growth Rate
The appraiser may use one of two Income Approach methods: the Multiple Period Discount Method (MPDM) or the Single Period Capitalization Method (SPCM). The MPDM is most appropriate when the subject company is in its growth stage—that is, earnings continue to change significantly from year to year. Under the MPDM, the appraiser forecasts out an appropriate earnings stream for multiple periods. The SPCM differs in that it is primarily appropriate for companies with stable earnings—that is, companies whose earnings remain similar over a period of several years. In these cases, the appraiser uses the next year’s earnings stream capitalized.
Expected future earnings can be defined in a multitude of different ways. Common earnings streams include net income after tax, net income before taxes, cash flow to equity, cash flow to invested capital, earnings before interest, earnings before interest depreciation and amortization and many others. Depending on the characteristics of the subject company, some earnings streams may be better at describing the financial benefits that the company is capable of producing.
One of the first tasks that a business appraiser must complete is to determine an appropriate earnings stream with which to develop the Income Approach. Some of the factors that our appraisers consider are the size and age of the business, the existing and forecasted capital structure, the purpose of the valuation and the interest to be valued.
Once an appropriate earnings stream has been selected, the appraiser must then develop a forecast based on company- and industry-specific conditions. Some of the factors that our business appraisers consider when developing forecasts are management projects/plans, the state of the economy, the state of the industry and historical trends. This is often the most time-consuming stage in the valuation process since there are many factors that must be thoroughly researched and examined. For example, the company’s income statements and balance sheets must be analyzed for revenue and earnings growth, and change in working capital, debt and capital expenditures, respectively.
Another factor that must be considered is a long-term growth rate. This is the rate at which the Company’s earnings will grow into perpetuity. It essentially assumes that the Company will always continue operations in the future. There are two primary factors that are considered in developing this rate: expected inflation and expected growth in their industry and the economy.
Investors’ Required Rate of Return:
A discount rate is used to determine what an investor would require in return for assuming the risks of ownership. For example, if an investor is considering an investment in a new ‘start-up’ company, they would likely require a much higher return (to match their risk) than if the company had demonstrated many years of stable and predictable earnings. Another factor that investors consider is what rates of returns they could get elsewhere, such as investing in government Treasury bills (T-bills) or in publicly traded stock.
The following is a simplified example of the Income Approach:
The forecast below is forecasted net cash flow to equity. To arrive at forecasted net cash flow to equity, our appraisers would first need to forecast the company’s income statement and balance sheets. As can be seen in the chart below, the sample company’s forecasted net cash flow to equity grows at a dramatically slower rate after 2014. This is when the company is forecasted to reach its long-term rate of growth.
The next step would be to develop the required rate of return that investors would demand for taking ownership in the company. If we turn this rate of return into a multiplier, it is then possible to demonstrate how much a dollar of earnings received in the future would be worth to an investor today.
Assuming a 30% rate of return, the chart below demonstrates that a dollar of this earnings stream in 2010 is worth only $0.77 to an investor today. This chart also means that an investor would be willing to pay only $0.06 today in return for $1 of earnings in 2020.
The next chart describes the value of the company when you multiply the discount factor against forecasted net cash flow to equity for each year. This chart illustrates what the company’s forecasted earnings in each particular year would be worth to an investor today. For example, in 2010 the company is forecasted to produce $1 in earnings. As illustrated by the chart below, $1 in earnings in 2010 is only worth $0.77 to an investor today.
The sum of all present values, as shown in the chart above, would be the indicated value of the business. It is important to note that this forecast stops in 2020.
One of the assumptions of the discounted cash flow model (an Income Approach method) is that the company would continue into perpetuity. How then, would it be possible to add up an infinite number of present values?
The answer can be determined by using what is known as the Gordon Growth Model. This model is used to calculate the value of all future earnings once the company has reached its long-term growth rate (in this case, 3.5%). In this example, we would divide the company’s forecasted earnings in 2020 by the capitalization rate (which is the discount rate minus the long-term rate of growth), to determine the ‘terminal value’ of the company as of 2019. From there, our appraisers would apply the appropriate discount factor to determine the value of the business today.
