The income approach to business valuation

History-based methods

They take known performance in a current or recent period. Then in simple formulas, they compute "a value". The formulas will fall into the following methods

These methods are easy to use and re-use. Their limitation is in knowing the multiplier, weighting, or capitalisation rate to use. In choosing a "generally accepted" multiplier, the chosen method relegates itself to a market approach to business valuation.

Projection-based methods

The weakness is in projecting future cash flows because obviously, nobody knows the future with any certainty. That uncertainty is dealt with by applying appropriate discounts for risk to the sum of forecasted cash flows.

All of those methods rely on not only an uncertain projection of future numbers, but a calculation within a calculation to determine the discount rate to be applied. The discount rate is an expression of perceived risk in the business. It will consider industry and peer performance-comparisons. Buyers will secretly consider the effects of changes to the capital structure, opportunities for synergy, and their own smarts in mitigating risk in their hands.

It is far from perfect, but like democracy, it is one of the best systems available for business valuers, despite its imperfections.

Having said that, buyers and investors prefer the projection-based methods. They give results for justifying holding or acquiring assets.

While history based models are easy for small and medium size business valuations, they are lazy options often used to abuse one or other side of the negotiating table. Often, it results in sellers being short-changed in the fight over price. But their acceptance by sellers as something which "looks about right" makes for a thriving community of arbitrage-seeking business buyers.