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The Income Approach to Business Valuations

When a business owner begins the succession planning process or finds another need to conduct a valuation they are often surprised to learn there is more than one to determine a company’s value. Most simply think value is determined as a function of an earnings multiple, but often it’s more complex than that. Whether a valuation is needed for succession planning, merger/acquisition, partner buy-in or as part of ongoing litigation it’s essential to be aware of the various valuation methods used. Based on time, place and circumstance a valuation professional can select from one of three approaches to arrive at a value – including the income approach. This approach is generally used to determine the value of a service company (for example engineering companies or healthcare organizations) and those with an operating focus such as a grocery store or retail chain. To help clients’, prospects and others understand the income approach and when it is commonly used, DiGabriele, McNulty, Campanella & Co has provided a summary of key facts below.

What is the Income Approach?

The income approach measures the future economic benefits that the company can generate for a business owner (or investor). As part of their analysis, valuation professionals assess factors that determine expected income including data such as revenues, expenses and tax liabilities. Depending on the age of the company the analysis may focus on historical data in the categories previously mentioned. However, if a company is only a few years old more emphasis is placed on reviewing the company’s projections to determine validity. There are advantages to using this approach including its ability to be applied to companies in different industries as well as companies in different growth stages.

Income Approach Methods

When using this approach, there are two primary methods for determining a company’s value, which include:

  • Capitalization of Earnings – This method is often used to help investors determine the risks and return of purchasing a business and help identify the expected rate of return. Using this method, the value of a company is determined by calculating the net present value (NPV) of cash flows or other expected future profits. This can include profits from existing agreements or those expected from the ordinary course of business. The capitalization of earnings estimate is determined by taking a company’s expected future earnings and diving by the capitalization rate. This rate is determined by in part by the company’s perceived risks. Be aware however, that the rate for small businesses ranges from 20% to 25%.
  • Discounted Cash Flow (DCF) – This method is often used to help investors determine the attractiveness of an opportunity. It uses future cash flow projections and discounts them to arrive at a present value estimate for the company. This provides flexibility to reflect projected growth or anticipated declines and the impact on cash flows. When a company is in its early stages there may not be a lot of historical data to use for analysis or a company may be rolling out a new product which is expected to increase cash flow. This method provides the opportunity to account for such changes in the valuation process. The goal is to arrive at an expected amount to be received from the purchase of a company (adjusting for the time value of money).

Contact Us

If you require a business valuation for your company then it’s important to be aware of the various approaches and when they are commonly used.  The specifics of your situation will dictate which approach should be used to arrive at the most accurate business value possible. If you have questions about the income approach or need assistance with a business valuation, DiGabriele, McNulty, Campanella & Co can help. For additional information please call us at 973-243-2600, or click here to email us. We look forward to speaking with you soon.

 

Accounting Firm | New Jersey CPA - DiGabriele, McNulty, Campanella & Co is a New Jersey CPA Firm focused on providing forensic accounting, forensic investigation and damage calculations for litigation and other purposes. Also offer traditional tax, accounting and audit services to companies across the Tri-state region.

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