{"id":6210,"date":"2022-03-23T16:15:42","date_gmt":"2022-03-23T16:15:42","guid":{"rendered":"https:\/\/intelekbusinessvaluations.com\/en-au\/?p=6210"},"modified":"2022-11-28T23:01:51","modified_gmt":"2022-11-28T23:01:51","slug":"income-approach","status":"publish","type":"post","link":"https:\/\/intelekbusinessvaluations.com\/en-au\/business-valuations\/income-approach\/","title":{"rendered":"Income Approach"},"content":{"rendered":"

The income approach is one the most used methods to estimate the value of a business. Within this approach, there are two main methods, the\u00a0discounted cash flow<\/strong><\/a>\u00a0method and capitalization of\u00a0cash flows<\/strong><\/a>\u00a0method.<\/p>\n

In this post, we will take a closer look into how this approach works and what it means.<\/p>\n

What is the Income Approach?<\/h2>\n

 <\/p>\n

\u00a0<\/strong>The income approach refers to estimating the value of a business by converting a future expected stream of earnings into a single value in the present (today) using a discount rate. This discount rate represents the rate of return that an investor\/buyer would require based on the risks he or she is incurring when acquiring a business.<\/p>\n

Examples of rate of return include buying a house, where you may be expecting a 5% return yearly. Also, generally speaking, small, privately held businesses have higher risks and require a higher return, often between 10-30%.<\/p>\n

Income Approach Valuation<\/h2>\n

\u00a0<\/strong><\/p>\n

In simple terms, the income approach derives the value of a business based on expected generated\u00a0cash flows<\/strong><\/a>\u00a0from the operation of the business, and uses a discount rate that represents your required return from investing in the business. Two of the most common methods are the capitalization of cash flows method and the discounted cash flow<\/strong>\u00a0<\/a>method.<\/p>\n

Capitalization of\u00a0Cash Flow<\/a>\u00a0Method<\/h2>\n

\u00a0<\/strong><\/p>\n

The capitalization of\u00a0cash flow<\/strong><\/a>\u00a0method takes a single expected future maintainable stream of earnings, based on the assumption that the stream of earnings\u00a0grows at a flat rate into perpetuity.\u00a0<\/strong>A discount rate (risk assessment) is used to convert it into a single current value.<\/p>\n

This method is used when one can reasonably expect steady earnings from a business into the future (e.g., if we have a business that has historically produced steady earnings without high volatility, we can then say that it\u2019s reasonable to expect the same results into the future).<\/p>\n

An example would be a small car wash business that has been operating for ten years, and each year the business consistently generates the same\u00a0cash flows<\/strong><\/a>, (revenue minus expenses) within a 5-10% difference. This provides confidence to the valuer that the historical financial results are the most probable outcome when looking into the future. The discount rate is then applied to arrive at the value.<\/p>\n

Value = earnings\/discount rate<\/p>\n

\"Income<\/p>\n

Discounted Cash Flow<\/a>\u00a0Method<\/h2>\n

\u00a0<\/strong><\/p>\n

The\u00a0discounted cash flow<\/strong><\/a>\u00a0method or\u00a0cash flow<\/strong><\/a>\u00a0method has more flexibility to its assumptions. Here, we work under the premise that the expected earnings may differ in the near future from the expectations into perpetuity.<\/p>\n

Consequently, we have two different stages of calculation in this method:<\/p>\n

we calculate the present value of the expected stream of earnings in a projected period of three-five years (this is the timeframe most commonly used, although it can be more or less) and then use a discount rate<\/p>\n

    \n
  1. we estimate the present value of the expected stream of earnings post the projected period (identified in Stage 1) into perpetuity, again then applying a discount rate<\/li>\n<\/ol>\n

    Finally, we sum stages 1 and 2 to calculate the business value.<\/p>\n

    As an example, if you had an expansion plan to acquire three more pizza restaurant franchises over the next five-year period and then stop, well, your\u00a0cash flows<\/strong><\/a>\u2014being new revenue and expenses from the newly acquired pizza franchises over the next five years\u2014would be different to a) your historical financials, and b) what it will look like after your expansion plan is complete.<\/p>\n

    So, in that example, the valuation practitioner would use a discounted cash flow<\/strong><\/a>\u00a0method to accurately capture the expansion plan (change in\u00a0cash flows<\/strong><\/a>) as well as the expected\u00a0cash flows<\/strong><\/a>\u00a0into perpetuity.<\/p>\n

    This is the simple explanation, and it gets a lot more technical and complex, which is why contracting the right valuation practitioner is key when valuing your business.<\/p>\n","protected":false},"excerpt":{"rendered":"

    The income approach is one the most used methods to estimate the value of a business. Within this approach, there are two main methods, the\u00a0discounted cash flow\u00a0method and capitalization of\u00a0cash flows\u00a0method. In this post, we will take a closer look into how this approach works and what it means. What is the Income Approach?   […]<\/p>\n","protected":false},"author":1,"featured_media":6230,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[35],"tags":[36,105,104,103,106,107],"yoast_head":"\nIncome Approach - Intelek Business Valuations Australia<\/title>\n<meta name=\"description\" content=\"The income approach is one the most used methods to estimate the value of a business. Within this approach, there are... 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