Business Valuation: The Income Approach
Keep reading to learn all about the income approach business valuation formula.
Getting the valuation of your business is very important throughout your company’s lifetime. The reason for getting a business valuation can range from estate planning, partner buy-in, going through a merger, selling off the company and even divorce. Regardless of the reason, it is very important to understand how business valuations are conducted.
Based on the variables and information available, a valuation expert can select one of three kinds of business valuation approaches to identify the value of the business. One such approach is the income approach. This is normally used to value service-oriented companies, such as healthcare or engineering companies along with businesses that have ongoing operations such as the service industry, grocery store chains, prospects, and others.
Keep reading to learn all about the income approach business valuation formula.
Business Valuation Income Approach
In the income approach of business valuation, a business is valued at the present value of its future earnings or cash flows. These cash flows or future earnings are determined by projecting the earnings of the business and then adjusting them for changes in growth rates, taxes, cost structure, and others.
Income Approach Methods
The income approach business valuation has two main methods, namely the capitalization of earnings and discounted cash flows approach. Both have been explained in detail below.
1. Capitalization of Earning Method
Capitalization of earnings is a method used to determine the value of a company by calculating the net present value (NPV) of expected future profits or cash flows. This estimate is figured out by taking the entity’s future earnings and dividing them by the capitalization rate.
Basically, it is an income approach with a business valuation formula that determines what a company is worth by looking at the expected future value, the annual rate of return, and the current cash flow. So, under this method, the value of the business is determined by discounting its future earnings. Here is the income approach business valuation formula for this method:
Business Value = Annual Future Earnings/Required Rate of Return
Just to be clear, under this approach, there is no growth in cash flows. Below is an example to understand this method better.
Let us assume that there is a company named Best Services Ltd and it is engaged in real estate management. In 2019, the company’s board of directors got a takeover offer. They discussed the offer and they eventually requested a presentation by the CFO of the company. The forecasted future earnings of the company was $19 million, with a required rate of return of the company at 12%.
With the equation of the capitalization of earnings methods, this $19 million / 12%= $158.33 million. Thus the company would be worth $158.33 million if the future earnings continued into perpetuity.
2. Discounted Cash Flow Method (formula)
The Discounted Cash Flow (DCF) method is the second kind of income approach that many companies use for their business valuation. The theory behind this method is that the total value of a business is the present value of its projected future earnings plus the present value of the terminal value. In this process, the expected cash flow of the business over a period of time in the future is projected first.
After that, each discrete cash flow is discounted to a present value at a rate that reflects the risk of receiving that amount at the time anticipated in the projection. And the best way to represent these projections, items such as capital expenses, operating costs, revenue, and working capital are forecasted.
These projections are then used to figure out the net cash flow generated by the business discounted to present value using an appropriate risk-adjusted discount rate, often the weighted average cost of capital or WACC. Under the discounted cash flow method, the first step is to find the projected future cash flows.
To make this method a bit more simple, there is a way called the Gordon Growth Model where the net cash flows are obtained for just one year and constant perpetual growth is assumed. The formula for this is:
Business Value = Cash Flows during First Year/ Required Rate of Return – Growth Rate
The above equation is based on the formula for the present value of a perpetuity. But this is just one approach. There is another approach called the multi-stage growth model. In this model, the future is divided into two or more stages:
- The initial period of say 4 years, for which the net cash flows and growth rate for every year can be found; and
- The period after the initial period for which year by year the projection is unreliable.
How to do a Discounted Cash Flow (DCF) Analysis?
The DCF method is utilized by professional analysts and investors at investment banks. It is used for determining the amount of money that should be paid for a business. To be clear, this method is not only used for when the company is being bought or for funding the company in exchange for its shares. It can also be used by project managers and financial analysts in huge companies to find if a given project would be a good investment.
As a matter of fact, this method can be used for any situation where you want to pay more money now in anticipation of huge gains in the future. To put simply, discounted cash flows analysis is based on the principle that an investment is now worth an amount equal to the sum of all the future cash flows that it would produce. And each of these cash flows will be discounted to their present value.
Here is the equation for finding the DCF:
DCF = CF1/(1+r)^1 + CF2/(1+r)^2 + … + CFn/(1+r)^n
Let us break this down:
- DCF is the sum of all the future discounted cash flows that the investment is expected to produce. This is basically the value that we are solving for.
- CF is the overall cash flow for a given year. CF1 is for the first year and the CF2 is for the second year, and so on.
- r is the discount rate in the decimal form. Basically, it is the target rate of return that you want on the investment.
Let us look at an example of this.
Let’s say your best friend gave you $1,500 after three years, and asked you how much you are willing to pay for that eventual reward today. How much would you offer? To answer this question, you will have to translate that $1,500 into its value today.
For instance, if you had $1,000 today and compounded it at 14.5% per year, it would be equal to about $1,500 in three years, as below:
Future value: $1000 * (1+0.145)^3 = $1500
Present Value: $1000 = $1500/(1+0.145)^3
On the other hand, if you had $1,200 today and compounded it at just 7.7% per year, this would be equal to $1,500 in three years, as below:
Future Value: $1200 * (1+0.077)^3 = $1500
Present Value: $1200 = $1500/(1+0.077)^3
So the amount of $1,500 three years from now has a worth to you today depending on the rate of return compounded during that period. If you have a target rate of return in mind, you will be able to get the exact maximum that you should be willing to pay today for the expected return in 3 years.
Basically, this is what the DCF equation does. It translates the future cash flows that you will likely receive from an investment into their present value today. Obviously, this would be based on the compounded rate of return you could reasonably achieve with your money today. When you are about to buy a whole business or have someone invest in your business, analyzing the expected discounted cash flows can help you decide which investments are worthwhile and which ones are not.
Discounted Cash Flow Method (DCF) – Case Study
Calculating the sum of the future DCF is the gold standard to find how much an investment is worth. With this clear, let us use the DCF formula to get the value of a business. Let us say that you are an investor who is being offered a deal to purchase a 20% stake in a business that has been in the market for a very long time. And in this case, you also know the owner very well.
This business has been passed down for 4 generations and is still going strong. It has a growth rate of about 3% per year. At the moment, it produces about $500,000 per year in free cash flow. So, if you agree to invest into the 20% stake of the company, it will give you $100,000 per year in cash. And this would also keep growing by 3% every year.
Now this brings up a very big question: How much should you pay?
In the current year, the business will give you about $100,000. The next year, it will give you $103,000 and the year after, you will get $106,090 and so on (this is obviously assuming that the growth estimates are accurate). The stake in the business is worth an amount of money that is equal to the sum of all future cash flows that it will produce for you. That is with each of those cash flows being discounted to their present value.
Furthermore, as this is a private business deal with low liquidity, let us say that your target compounded rate of return is 15% per year. If this is a rate of return that you know you can achieve on the investment, you would only want to purchase this business stake if you can get it for a low enough price that it would give you at least that rate of return. Hence, 15% becomes the compounded discount rate that you apply to all future cash flows.
So, let us work on the equation for this:
DCF = $100,000/(1+0.15)^1 + $103,000/(1+0.15)^2 + $106,090/(1+0.15)^3 + … + CFn/(1+r)^n
DCF is the value we are solving for, which is the sum of all the future discounted cash flows and is the maximum amount that you should pay for the business today if you want to get a 15% annualized return. The numerators represent the expected annual cash flows, which in this case start at $100,000 for the first year and grow by 3% per year into perpetuity. The denominators convert those annual cash flows into their present value as we divided them by a compounded 15% annually.
As a visual representation of this scenario, here is a table for the first five years that shows even as the actual expected cash flows will keep growing, the discounted version of those cash flows will shrink over time since the discount rate is much higher than the growth rate:
|Year||Actual Cash Flow||Discounted Cash Flow|
You can use Excel or any other kind of spreadsheet program to carry out that pattern indefinitely. Here is the chart for the first 25 years:
In this chart, the dark blue lines represent the actual cash flows that you will get each year for the next 25 years (that is if the business grows as expected at 3% per year). As you go into infinity, the sum of all the cash flows will also be infinite. The light blue lines represent the discounted versions of those cash flows.
For instance, during the fifth year, you are expected to get $112,551 in actual cash flows. But it would have a worth of just $55,958 to you today. This is because if you had $55,958 today, you could grow it by 15% per year for the next 5 years in a row, and you will have turned it into $112,551 after those five years.
Since the discount rate of 15% that we are applying here is much higher than the growth rate of the cash flows which is 3%, the discounted versions of those future cash flows will shrink and shrink each year and approach zero. Hence, even though the sum of all the future cash flows (dark blue lines) is infinite, the sum of all discounted cash flows (light blue lines) is just $837,286, even though the company lasts forever.
And this is the main answer to the original question. Basically, $837,286 is the maximum amount that you need to pay for the stake in the business, that is if you want to achieve 15% annual returns, assuming that the estimates for the growth are accurate. Plus the sum of the first 25 years of the DCF for this example is $784,286. In other words, even if the company goes out of business a few decades from now, you will get most of the rate of return that you had expected. This means that the company would not have to last forever for you to get your money’s worth.
With this said, you now know all about how the income approach is used for business valuation. With all that we’ve explained about this business valuation method, you can decide whether the income approach is right for your company. Keep in mind that there are other business valuation methods as well. Find out more here.
And while you are doing this, remember to keep track of all your company shares in one place. And to do this, Eqvista is your best bet for a cap table on the market. Check out the app here and learn more. Also, if you are thinking about selling your company or need a valuation for other reasons, Eqvista can help!