How To Value A Business: Income Approach

Income Approach—The Income Approach derives an indication of value based on the sum of the present value of expected economic benefits associated with the company. Under the Income Approach, the appraiser may select a multi-period discounted future income method or a single period capitalization method. 

The capitalization method estimates the fair market value of a company by converting the future income stream into value by applying a capitalization rate incorporating a required rate of return for risk assumed by an investor, along with a factor for future growth in the earnings stream being capitalized. This results in a value based on the present value of the future economic benefits that the buyer will receive through earnings, dividends, or cash flow. The capitalization method uses a single period proxy of future earnings to determine the present value of the asset. This method is usually employed when a company is expected to experience steady financial performance for the foreseeable future and when growth is expected to remain fairly constant.

Multi-period discounted future income methods involve discounting a projected possible future income stream on a year-by-year basis back to a present value using an appropriate discount rate that reflects the required rate of return on the investment (compensating for risk). For the final year of the projection period, the income stream that represents the expected income stream in perpetuity is capitalized to arrive at a “terminal value,” which is then discounted back to a present value (at the same discount rate) and added to the present value of the prior years’ income streams to arrive at the indication of fair market value.

This multi-period method is most commonly used when the company is expected to experience a period of abnormal growth or when the growth rate for the near-term is anticipated to be significantly different from the long-term rate of growth. This is predicated upon the ability to create a reasonable forecast of the company’s income stream for the forecast period. If these conditions are satisfied, the multi-period discounted future income method may more reliably capture the value impacts of cyclicality or abnormal short-term factors impacting the company’s results than a capitalization method.

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