Income Approach

What is the Income Approach?

The income approach is an umbrella term for all income-based valuation methods. In practice, DCF and straight capitalization of earnings, are the most common. This definition and method assumes that the value of a business is directly related to its ability to generate income.

The income approach is also used in commercial real estate appraisals, a subject which is not covered in this article.

When is the Income Approach Method Used?

The income approach is one of the most commonly used methods of business valuation. It may be preferred for businesses with a track record of earnings. However, because it can be based on a projection of future cash flows, it is also useful for valuing businesses that are not yet profitable.

Some examples include:

• Business sales & acquisitions
• Capital investments
• Legal & litigation matters
• Mergers & restructurings

For businesses with significant assets relative to revenues, the asset approach may be used instead of, or in combination with the income approach. If there are many similar and comparable businesses in the market, the simpler but accurate market approach may be used instead. It may also be used in combination with this method.

Nielsen Valuation Texas can assist in most situations requiring this valuation method, but we respectfully decline to perform start-up valuations.

Key Methods Under the Income Approach

Business valuation firms use a variety of methods, all of which fall under what is known as the income approach to valuation. The two most common are the capitalization of earnings or cash flows and the discounted cash flow (DCF) method.

However, as we will show, the income valuation approach methods widely used in the industry often fail to reveal the true value of the business due to risky projections, predetermined formulas, and standardized tables of capitalization rates.

Discounted Cash Flow (DCF) Method

Many business valuators and venture capitalists use the Discounted Cash Flow (DCF) method to estimate the fair market value of a business. It is based on projected future cash flows, which are then discounted by a discount rate to calculate their present value.

A terminal value is used to represent the value of the business in perpetuity.

The result of this method can vary widely depending on the inputs and between different appraisers. Various assumptions are required, and the slightest miscalculation can lead to huge differences in the value of the business.

This method is widely used by business valuators, but we believe it is too speculative to use in most cases. The exception is the valuation of start-ups.

Straight Capitalization of Earnings or Cash Flows

Straight Capitalization of earnings or cash flows is the simplest of the income approaches. It is based on adjusted earnings for a single period and is therefore called the single period capitalization method.

It is similar to the DCF method, but instead of using a detailed projection of future cash flows, it uses an annual net cash flow as a baseline, combined with a sustainable growth rate and the company’s estimated risk.

It uses a multiple of next year’s projected cash flow. The multiple is positively correlated with expected growth and negatively correlated with risk.

This method works best for companies with stable earnings and is less speculative than the DCF method.

How the Income Approach Should be Applied

At Nielsen Valuation Texas, we pride ourselves on ensuring that our business valuations represent the true value of the business in question.

This means taking into account the financial history of the business and its risk factors, while emphasizing considerations relevant to real-world transactions. In doing so, we ensure that the valuation is fully compliant with Internal Revenue Service (IRS) Revenue Ruling 59-60.

Here are some examples:

Never Use Standardized Tables of Capitalization Rates

The income approach is often used with standardized cap rate tables. While convenient, such an income approach valuation fails to capture the unique risks, opportunities and nuances of the businesses being valued.

At Nielsen Valuation Texas, we never use standardized tables of capitalization rates in our income approach valuations. Instead, we consider the nature of the business, the risks involved, and the irregularity or stability of earnings. This is perfectly in line with IRS RR 59-60, which also states that:

”No standard tables of capitalization rates applicable to closely held corporations can be formulated.”

Do Not Use a Predetermined Income Approach Formula

While the use of a pre-determined income approach formula may speed up the valuation process, it often leads to a false sense of security in estimating the value of a business.

They oversimplify the complexities of business value. IRS Ruling 59-60 is also clear on this point:

“Valuations cannot be made on the basis of a prescribed formula.”

Therefore, the results of an income approach calculator or similar online service will be highly misleading without prior evaluation of the inputs.

At Nielsen Valuation Texas, we always evaluate each business in detail, looking at the context and specific conditions, the history of the business, its growth, stability, diversity of operations, its dependence on its owners, and more. When necessary, we conduct interviews and visit the business to complete our valuation.

Take Historical Earnings into Account When Possible

The income approach model often emphasizes expected future income as the basis for valuation. However, a common mistake is to neglect or undervalue past and current performance while overestimating future potential, resulting in unrealistic projections.

Revenue Ruling 59-60 states:

“Prior earnings records usually are the most reliable guide as to the future expectancy, but resort to arbitrary five-or-ten-year averages without regard to current trends or future prospects will not produce a realistic valuation.”

At Nielsen Valuation Texas, we always consider prior years’ results. We also consider the stability of earnings, long-term and recent trends, and current company issues or potential that may affect future earnings.

Use Studies of Marketability Discount Rates Carefully

Marketability discount rates, also called discounts for lack of marketability, are percentage reductions applied to the valuation of a business or asset to reflect the difficulty of selling it quickly at fair market value.

While academic studies on the subject can be useful in some contexts, in most cases they lack real-world applicability.

At Nielsen Valuation Texas, we base our conclusions on observed transactional behavior and market dynamics rather than theoretical compilations.

Always Make Normalizing Adjustments First

Finally, it is essential to normalize the income statement before performing any calculations for an income approach appraisal in order to get a realistic valuation.

Let us look at how to do this:

Normalizing Adjustments Are Essential

Before calculating the value of a company using the income approach method, it is essential to begin with normalization adjustments.

This means that the company’s income statement should be normalized for nonrecurring, unusual, and discretionary items.

Without this “preparation” of the underlying data, the calculations will be wrong, and the valuation will be misleading. And often it is not just a percentage difference up or down. Without normalizing the income statement, the calculated value of the company will be many times higher than its fair market value – or a fraction of it.

Here are a few examples:

• Sale of an asset: An asset that is no longer in use is sold. The gain on the sale should be eliminated from income.
• Legal settlements: A gain or loss resulting from a one-time legal settlement should be eliminated from the income statement before applying the income approach.
• Restructuring costs: Restructurings are necessary but are infrequent or one-time costs and should be normalized out of the income statement.
• Life insurance proceeds: Non-recurring insurance payouts should be excluded from the calculations.
• Discretionary items: Expenses that benefit the owner privately and that would not be present in a public company should be excluded from the calculation. Examples include personal living expenses, lavish automobiles or private travel.