A. Christine Davis, CPA/CFF, CVA, CGMA
How to Value Your Business Using the Income Approach
Updated: May 27, 2021
As an entrepreneur, it is helpful, if not necessary, to know the estimated value of your company, even if you're not ready to sell. You've worked hard to establish your industry foothold and may intend to take on a business partner or sell somewhere down the road. Even if you don't have such plans, for the typical business owner, the business represents not only the present, but also the future. For that reason alone, it's important to not only have an idea of how much your company is worth but also a realistic basis for it.
Still, an estimated business value is not so cut and dried. A business is ultimately worth as much as a potential buyer is willing to pay. Even so, getting to an agreed-upon number may depend upon the buyer's and seller's ability to agree to a common valuation method and the assumptions used. There are three widely accepted methods of valuing a business: the asset-based approach, the income approach, and the market approach. The discussion below focuses on the income approach. It is intended to be an overview and has been simplified for illustrative purposes. Income Approach Operating companies with profitable operations, like a retail business, a restaurant or a manufacturing company, are best suited for this valuation approach. While the asset-based approach starts with your balance sheet, the income approach starts with your income statement (also known as the profit and loss statement). Your business value is determined by estimating the net income you expect to make through some future point and then recalculating that cash flow in terms of today's dollar values (also known as the present value). There are two common ways to apply this valuation approach and we'll detail each below: the discounted earnings/cash flow (DCF) and capitalization of earnings methods. Discounted Earnings/Cash Flow (DCF) This method calculates a company's expected earnings stream or cash flow over some time horizon, five years for example. Your forecasting skills will have a significant impact on the overall end value. For this reason, it's important to carefully select your assumptions. Take growth rate from year to year, for instance. Do you expect five percent growth? Or zero? Then, what discount rate will you use? What about the capitalization rate? The numbers you select will have a considerable impact on your estimated business value. The more realistic your chosen variables, the more reasonable your estimation will be. The basic steps for the DCF method are:
Obtain or prepare a forecast of net cash flows for the next five years;
Calculate your "terminal" or "residual" value. This is usually equivalent to the fifth year's forecast, which is then projected into perpetuity, then divided by a capitalization rate;
Using an appropriate discount rate, calculate the present value of the five-year forecast;
Using the capitalization rate, calculate the present value of the terminal value;
Sum up the two present values and deduct the amount of any existing interest bearing debt. The result is the estimated value of your business.
A look at an illustration can help clarify how this valuation method works. In the example below, we selected differing discount and capitalization rates; the difference between the two numbers relates to the 5% estimated annual growth that's shown. Illustration - In our example, the estimated business value is $1,669.470:
Year one of the forecast cash flows below is the year following the valuation date
After-tax discount rate is 12.71%
After-tax capitalization rate is 7.45%
There is interest-bearing debt of $371,000
1. Obtain or prepare forecast of future cash flow for the next fiveyears:
After-tax cash flow to be received at the end of: Year1 $314,051
Year5 187,154 2. Calculate the terminal value:
$2,512,129 (Year 5, $187,154 divided by 7.45%)
3. Calculate the present value of the forecast net cash flows: End of Net Cash Flow Present Value Factor (12.71%) Present Value
Year 1 $ 314,051 0.94 193 $295,814
Year2 82,743 0.83571 69,149
Year3 132,297 0.74147 98,094
Year4 132,336 0.65786 87,059
Years 187,154 0.58367 109,236
$659,352 4. Calculate the present value of the terminal value:
End of Terminal Flow Present Value Factor (12.71 %) Present Value
Year5 $2,512,129 0.54978 $ 1,381,118
5. Add both present values and deduct interest-bearing debt to arrive at the estimated business value:
PV of forecast cash flows $ 659,352
PV of terminal value 1,381,118
Deduct: Interest-bearing debt (371,000)
Value of business $1,669,470
The DCF method is suitable for business owners who expect their company to experience rapid or unpredictable growth in future years.
Capitalization of Earnings
The capitalization of earnings method is appropriate for business owners who expect a steady growth trajectory or to anticipate minimal fluctuation in earnings. This method doesn't distinguish between earnings variations in future years; instead, it assumes that profits will be steady from year to year. Once that steady earnings number is determined, it is discounted to present value by using an appropriate capitalization rate.
In theory, your estimated value under the DCF method should approximate your estimated value under the capitalization of earnings method, so long as your company's earnings are expected to grow at a constant rate. Even if you expect a steady growth rate, the DCF is more suitable if you'd rather use specific revenue or expense amounts in your forecast.