Income Approach Valuations | Cash Flow Method | KS MO AR (2024)

Use Cash Flow to Determine the Fair Market Value of a Company

Key Takeaways:

• The value of a business is related to the present value of all future cash flows that the business is reasonably expected to produce.
• The income approach is generally the most appropriate approach to business valuation for an operating company with positive cash flows.
• The income approach is a way of determining the value of a business by converting anticipated economic performance into a present value.

The value of a business can be estimated in several ways, and an experienced valuation professional will consider a broad range of a company’s characteristics to determine which approaches will yield a realistic valuation.

Typically, a combination of approaches is used in a business valuation, but certain approaches are preferred for certain types of businesses. For a mature or growing operating company with positive cash flows, the income approach is the go-to method.

What is the Income Approach in Valuation?

The income approach is one out of three approaches:

• asset
• income
• market

Generally, the income and market approaches will produce valuation ranges within a reasonable range of each other, and are sometimes used in combination as an effective way to calculate tangible and intangible value.

The income approach is a way of determining the value of a business by converting anticipated economic performance into a present value.

See Also

Lesson 3 - Assumptions of the Income Approach (The Income Approach to Value)Calculating GDP With the Income Approach

Put another way, the value of a business is related to the present value of all future cash flows that the business is reasonably expected to produce. Therefore, estimates of future cash flows, and an appropriate discount rate, are key components of the income approach.

As part of the income approach, capitalization of cash flow method is applied when a company’s growth and earnings have stabilized. This method can be applied to a mature company that is not going through a growth cycle, and for which operations are expected to continue in the future as they have in the past.

This method is a preferred method for most business appraisers and business brokers given its simplicity. However, small changes to the inputs can lead to a wide disparity in value. Business appraisers need to support the inputs substantially, given many risk and growth factors.

Normalizing Adjustments

Normalizing adjustments are part of the business valuation process for nearly every company. These are adjustments that are made to ensure that the final valuation reflects “normal” operating performance, absent the unusual non-recurring income and expenses that most companies have from time to time. These may include a one-time gain from the sale of an asset, an insurance settlement or restructuring costs. Normalization adjustments may also be made to owner/officer compensation to bring it in line with comparable companies.

In the case of an operating company with stable cash flow, in order to develop a reliable valuation the benefit stream (cash flow) would need to be adjusted for considerations such as:

• Income and expenses from non-operating assets or liabilities
• Nonrecurring income and expenses
• Discretionary expenses determined unnecessary for the operations of the business

Further adjustments to the discount rate would need to be made for risk considerations, including:

• Concentrations of revenue from one customer
• Supplier dependence
• Key manager or employee dependence
• Product or service obsolescence

Adjustments also would be needed for growth considerations, such as:

• Economic growth or shrinkage
• Changes in regional and local markets
• Industry growth
• Inflation and price increases

Discounted Cash Flow

The discounted future cash flow method is applied when a company’s future operations are expected to differ from the past. Possible situations are:

• The company is adding a new product or service line, and it will be rolled out in the next year.
• The company is entering a new market and expanding its footprint.
• The company is adding a new manufacturing line or adding a new shift to meet demand from customers.
• The company is undergoing a strategic initiative that will reduce operational expenses.

Management must be willing and able to provide projections to the business appraiser in order to apply this method.

Pros & Cons to the Income Approach

As with all approaches to business valuation, the income approach has some drawbacks as well as advantages.On the pro side, the income approach:

• Values the cash flow generated by the company’s operations
• Generally substantiates the indication of value using the market approach
• Incorporates risk and growth expectations
• Is appropriate for most stable operating businesses at all stages of the business life cycle

On the con side, the income approach requires management’s input on cash flow, risk and growth, which can be subjective. It also requires adjustments to cash flow to normalize the benefit stream. Moreover, income estimates for a five-year period can be considered speculative and difficult to authenticate.

But even with these considerations, the income approach remains the most appropriate approach to business valuation for an operating company with positive cash flows.

If you are considering a business valuation for your operating company, contact an Adams Brown business valuation advisor.