The income approach to business valuation relies on estimating the future economic benefits that will accrue to the owners of the company. These future cash flows are either capitalized (capitalization of cash flow method) or discounted back to present value (discounted cash flow method) using a capitalization/discount rate that takes into consideration the risks inherent in those cash flows including projection risk, operational risk, and financial risk.
The income approach typically involves an analysis of a company’s historical financial results in order to develop expectations about the company’s future operations or to judge the reasonableness of management’s projections. Sometimes companies have little or no financial history, so more emphasis is placed on analyzing the company’s projections than its historical performance. Other companies have stable and mature operations, making the past activity of these companies potentially indicative of future results. As a result, a detailed historical financial analysis is important when valuing companies with at least a few years of operating history.
As discussed above, there are two common methods used to value a business under the income approach – the capitalization of cash flow method and the discounted cash flow method.
Capitalization of Cash Flow Method – The capitalization of cash flow method converts a single projected cash flow stream into an indication of a company’s value by dividing an annual cash flow stream by a capitalization rate. The estimated cash flow stream that is capitalized must be expected to grow at no more than a modest rate into perpetuity if this method is to be appropriately applied (if more aggressive or uneven growth is expected, the discounted cash flow method should be used instead). The capitalization rate is calculated by taking the company’s discount rate and reducing it by the long-term expected growth rate for the Company. Because the capitalization of cash flow method uses a single period cash flow stream that is expected to grow at a constant rate over time, it is generally applied to companies with stable operations and/or modest growth expectations.
Discounted Cash Flow Method – The discounted cash flow method converts future expected cash flows into a present value amount by discounting them back to the valuation date at an appropriate discount rate. The discounted cash flow method is built on a company’s projections, which provides the method with significant flexibility in reflecting the impact of future growth/decline in cash flows on a company’s value that is not afforded in the capitalization of cash flow method. For instance, a company in the early stages of development may not have historical results of operations that are indicative of future performance or an established company may be adding a new product line that is expected to materially increase revenue and cash flow going forward. The discounted cash flow method allows for consideration of these future changes in cash flow in determining the value of a company.
When choosing whether to apply the capitalization of cash flow or discounted cash flow method when valuing a company, the method is dependent on the historical performance of the company and the expectations for its future. The capitalization of cash flow method is generally a simpler approach to apply, but the company being valued must be expecting relatively constant and steady growth in the future. The discounted cash flow method allows for much more flexibility in incorporating future growth expectations, but it is a more complex analysis. At the end of the day, it is important that the characteristics of the company being valued drive the valuation methodology applied, not the other way around.