By James F. Sandkuhler, CPA, CVA, CFE

Over the last few months we have had several discussions about the art and science of business valuation. We last reviewed the recognized approaches for valuing a business. This article will examine the income approach in more detail, and discuss methodologies used in the income approach.

To quickly review, there are three recognized approaches for valuing a business: the income approach, the market approach and the asset approach. The income approach looks to the past and future to quantify the potential financial benefits of owning the business. The market approach looks to the past, arriving at a conclusion through analysis of transactions and trading values of companies similar to the entity being valued. The cost approach looks to the present and draws a conclusion based upon the theory that the business’ value can be measured by the cost of reproducing or replacing it.

Once the valuator has decided upon the most appropriate approach or approaches (sometimes more than one approach/method will be used) to employ, a decision must be made regarding which method(s) to use within these approaches. The facts and circumstances of each business, the purpose for which the valuation is being performed, and the valuator’s judgment and expertise will all be important factors in this selection process.

As we examine methodologies under the income approach we will focus on two important concepts: the discounting of future returns and the capitalization of historical earnings. An understanding of these basic concepts is essential to understanding the income approach.

DISCOUNTED FUTURE RETURNS

Discounted future returns methods are driven by the concept of the time value of money. Suppose I owe you $100. Would you rather I pay you today or a year from now? Obviously, you’d prefer to have your money sooner rather than later. But suppose I can’t pay you today. In that event, when I retire my debt to you a year from now, you will likely demand a return on your investment. And that return will be commensurate with the risk you perceive in me as a debtor. Alternatively to accepting $100 today, you may require interest at, say, 10% one year from today. The higher the perceived risk, the higher the return you will require.

This concept is at the heart of discounted future returns methods of valuation. These methods are based upon the theory that the total value of a business today can be measured by computing the present value of projected future earnings of that business.

Obviously, these methods require the measurement of expected future returns, which involves the preparation of reasonable projections for a period of years and determination of the most appropriate definition of income or return. Income can be defined in a wide variety of ways (pre-tax, post-tax, discretionary cash flow, cash flow, etc.), discussion of which is beyond the scope of this article.

Once future returns have been defined and measured, those returns over a consecutive period of years in the future are discounted to present value today using an appropriate discount rate. As in our example above, that discount rate will be reflective of the perceived risk in the achievability of those returns.

As a prospective buyer, if you perceive a significant level of risk, you will require a higher return. In other words, you will employ a higher discount rate. The higher the discount rate, the lower the present value of the enterprise.

CAPITALIZED RETURNS

These methods are similar to discounted future returns methods in that they involve developing some estimation of future earnings or returns. They differ, however, in how those expected returns are developed.

In a nutshell, capitalized returns methods are based upon the theory that the best indication of what will happen in the future can be approximated by what has happened in the past.

The valuator analyzes a number of years (usually five or more) of historical financial results of operations for the subject company. The results are adjusted for extraordinary, non-recurring items and for income and expenses generated from non-operating related assets and liabilities. The income statements are then normalized to present a truer picture of economic reality. For instance, owners’ compensation may be normalized to reflect the value of services rendered by the owners in generating profits. Rent between related parties may be normalized to reflect fair market rental.

These normalized historical results of operations are then used as a basis for predicting future results. Based on the particular facts and circumstances and the valuator’s judgment, a straight arithmetic average may be used, or a weighted average giving higher weight to more recent history may be employed.

The resultant average earnings will then be capitalized using an appropriate capitalization rate to obtain an indication of total enterprise value. There are numerous accepted theories and philosophies for developing capitalization rates. For purposes of this discussion, capitalization rates, like discounts rates, can be viewed as a measure of risk that the anticipated future returns as measured by reference to the history of the enterprise, may or may not materialize.

Many of the methods used in valuing a business are capable of being reduced to formulas. Nevertheless, the experience of the valuator is critical in obtaining a fair result.

Next time we will explain valuation methodologies under the market and asset approaches.

Certified Valuation Analysts James Sandkuhler and Joel Charkatz, chair the Business Valuations practice at the accounting and consulting firm KAWG&F, P.A. They are currently working on a handbook entitled, BUSINESS VALUATION: The Art Behind the Science. For more information, contact them at 410-828-CPAS or email Jim at jsandkuhler@kawgf.com.