The Income Approach for Dummies
Written by: Michele Leppard
When presenting a valuation to our clients, we often get asked: “What are the differences between the varied approaches to valuation”? So here is a simple explanation of the Income Approach laid out in straightforward terms for the non-economist.
The Income Approach is one method used for the purpose of valuing a privately-held business. Valuation analysts are often needed to value a business for many reasons, including but not limited to M&A transactions, partnership disputes, matrimonial dissolution, estate matters and strategic consulting. The Income Approach converts expected future returns to the present value.
When valuing businesses, the Income Approach looks at the Discounted Cash Flow and the Capitalization of Earnings Methods. Each of these approaches focuses on the future cash flow generated.
The Income Approach should be used when the business expects to produce positive future cash flows.
Questions to consider when looking at the Income Approach:
How much cash will this business provide?
Is there a chance that I will not receive this income in the future?
How long will I receive this income?
Will it be one year? Will it be five years? Will it be forever?
How much should I pay for this investment?
There are three main tasks to address when working with the Income Approach:
Estimate the risk of not receiving the income – risk of failure (RISK)
Estimate the growth of the income (cash flow) into the future (GROWTH)
Calculate the risk adjusted value of the future income (cash flows) (DISCOUNTING)
The Risk of Failure (RISK)
If your friend came to you today, and said, “I need to borrow some money. I can pay you back $100 next month, when I get paid.” How much would you lend him today? Now your response will depend on the RISK you anticipate of not receiving the money back. Are you 20% uncertain of being repaid? Are you 100% certain of being repaid? Similarly, you need to consider the risk of not receiving the cash flow from this company, which is based on the risk-return concept.
This risk is better known to valuation analysts as the DISCOUNT rate. This is the rate of risk associated with the future income forecasted (cash flow forecast). Many times this is known as the ‘opportunity cost’ for your money.
An understanding of the various levels of risk are needed to calculate the discount rate:
Type of security (equity, debt, other)
Size Risk
Industry Risk
Company Specific Risk
Estimate the Growth of the Income into the Future (GROWTH)
When looking to the future growth of a company, an understanding of industry dynamics is essential.
A few questions that need to be asked are:
What does the market have in store for its participants?
Are there any new technologies?
Are there any inventions that will wipe out the market?
Does the company have intellectual property?
Is it a heavy fixed cost company or is it a variable cost company?
Does the company have any major problems to consider?
When using the discounted cash flow, the value of an asset is the present value of the projected cash flow, discounted at a rate that reflects the potential risk. In fact, most valuation analysts consider the income approach to be the ‘Holy Grail of Valuation.’
A simple illustration of the Income Approach
It is easy to understand the income approach when you ask yourself this question: “if you were provided cash flows into the future, how much would those cash flows be worth today? ”The answer is that an investment today is worth the sum of all the future cash flows it will produce and discounted to its present value.”
For more information on valuation our team is always available to answer your questions and schedule a gratis consultation. Call us at (973) 545-2891 or email me at Michele.Leppard@RedMapleEconomics.com.