The income approach to business valuation

For the most part, operating companies and businesses are best served using an income approach to business valuation. There are many models and methods which fall under this grouping. For the most part they fall into one of two categories, either based on

  •   historic income statement items, or
  •   expected or projected future cash flow

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

  • simple multiplier formulas
  • weighted average multipliers
  • capitalised owner benefit

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. That is dealth with using appropriate discounts for risk.

  • discounted cash flow,
  • adjusted present value
  • discounted dividend flow, and
  • internal rate of return regression
  • forward-looking multiple models

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 which get abused. That results in sellers being short-changed at the negotiating table. But their acceptance by sellers as something which "looks about right" makes for a thriving community of arbitrage-seeking business buyers.


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Business Valuations

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