In our last discussion we provided a broad overview of the valuation process. One of the crucial steps in this process is “determining the value” of a company (or a partial interest in the company). In order to determine a value, valuation analysts have three valuation approaches and several valuation methodologies available to them. This article addresses one of those valuation approaches: the income approach, plus the specific methodologies within that approach.
This is one of the more commonly used approaches in valuation. The International Glossary of Business Valuation Terms defines the income approach as a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that convert anticipated economic benefits into a single amount.
There are two primary methodologies within the income approach: the capitalization of earnings method (COE) and the discounted cash flow method (DCF). In general, the COE method utilizes historical information to determine a value, while the DCF method employs forecasted or projected future cash flow expectations to determine a value.
The COE method is defined by the Glossary as a method within the income approach whereby economic benefits for a representative single period are converted to a value through division by a capitalization rate. Thus the COE method requires the development of a single period economic benefit and a capitalization rate. This method is often utilized in situations where earnings are stable and are expected to grow at a steady rate into the future.
In the DCF method, the present value of future expected net cash flows is calculated using a discount rate. Thus a DCF requires the development of projected expected net cash flows and a discount rate. This method is somewhat the opposite of the COE method in that it utilizes several periods of fluctuating earnings before a stabilized period, instead of just a single earnings period.
Both of these income approach methods require the determination of an earnings measure, either for a single period or for several future periods. The earnings measure selected by the valuation analyst can be any number of earnings measures. In many cases cash flow is considered the preferred earnings measure for the application of an income approach methodology. This is because cash flow is the best representation of the return an equity holder or invested capital holder (debt or equity) can expect from their investment in the business.
Equity cash flows differ slightly from invested capital cash flows. The difference is the treatment of cash flows to fund debt service. Equity cash flows are calculated after debt service payments (principal and interest) and/or inflows (borrowings). This is because, in most cases, debt holders have a preferred claim to cash flow over equity holders.
In addition to identifying an earnings stream for either a single period or for several periods into the future, both of the income approaches require identification of the risk associated with obtaining the earnings stream. This measure of risk is referred to as either a capitalization rate or a discount rate. These rates convert the earnings into values. Capitalization rates are used in conjunction with a single period earnings measure to determine value, while discount rates are used to present value future expected net cash flows back to a single present value.
While the income approach is the most common method used in valuing a business, it is not the only method to consider. In our next communication, we will look at the market approach and the various methodologies associated with it.
For more questions about the valuation process or how to determine the value of your business, call Jason Thompson at (317) 608-6694 or email [email protected].