Managing a successful business requires discipline, vision, clarity, and consistency. Attention needs to be focused on serving the needs of customers, employees, as well as continually improving product and service deliveries. In fact, most entrepreneurs enjoy this part of being an owner and enjoy the challenge. It’s not uncommon however that businesses undergo a required business valuation. This may arise for various reasons including: the company is for sale, estate planning purposes, shareholder agreements are being created or changed and are part of ongoing litigation. Whatever the reason for the valuation, most business owners are unfamiliar with how they are conducted, and the various methods used to determine value. Generally, there are three accepted methods that can be used when conducting a business valuation. They include the income approach, the asset approach, and the market approach. Since we have covered the market and asset approach in previous blog posts, the focus of this article will be on the income approach.
What is the Income Approach?
When the earnings capacity of the company is a factor to be considered in a business valuation, the income approach is used. In simple terms, performing an income-based valuation involves looking at an organization’s financial history to make projections about their future profits and thus determine its value. A general way of determining the value of a business or business ownership interest is using one or more methods that convert anticipated economic benefits into a present single amount.
Income Approach Methods
When using this approach the two primary methods for determining a company’s value, include:
The Discounted Cash Flow Method
The discounted cash flow method arrives at a valuation based on projected cash flows by discounting them at the date of the valuation. The key to this method is to choose a suitable discount rate. When using this method, it is important to identify the cash flow streams from the company, a discount rate that reflects the risk tolerance of the investor as well as the long-term value of the business. This approach is quite versatile and can account for significant variation in a company’s growth expectations over a period of several years.
The Capitalization of Cash Flow Method
This method arrives at a valuation by dividing the total cash flow stream of a business by its capitalization rate. The capitalization of cash flow method is considered easier to perform than the discounted cash flow method but it assumes that the rate of growth for the company in question will be stable from one year to the next.
Unfortunately, many companies are unable to make this assumption because economic and market fluctuations impact demand and expected growth. For this reason it is often recommended to use the Discounted Cash Flow Method when growth rates cannot be predicted or have historically been erratic. This method is more theoretically sound in valuing a profitable business where the investor’s intent is to provide for a return on investment over and above a reasonable amount of compensation and future benefit streams or earnings are likely to be level or growing at a steady rate.
Business valuations can be complex and are more complicated than many Chicago business owners expect. A valuation professional needs to carefully select the right method to arrive at a fair and representative value of the business being examined. If you are interested in learning more about the income approach to valuations or need assistance with a valuation for your Chicago business, Selden Fox can help. For additional information please call us at 630-954-1400 or click here to contact us. We look forward to speaking with you soon.
John T. Wojcik, CPA, MST, CVA