Business Valuation - What is the "Income Approach"?
A common method applied to business valuation is the income approach. This approach provides a value for a business based on the expected future cash flows to be generated by the company. Two of the most common methods used under the income approach are the capitalization of earnings method and the discount cash-flow method (DCF).
Capitalization of Earnings Method
The capitalization of earnings method determines a value of a business by dividing cash flows of the company by a capitalization rate. This method is most appropriate when the company has stable cash flows which are expected to continue.
Discounted Cash-Flow Method
The discounted cash-flow method determines a value of a business by projecting the cash flows of the business into the future and present valuing them back to the valuation date. For example, cash flows may be projected out for 5 years and then each of those projected cash flows are discounted back to their present value. A terminal value is also determined by dividing the expected cash flows at the end of the projection period by a capitalization rate and discounting that value back to the date of value. The present value of the cash flows from the projection period is added to the terminal value to reach a value for the business. The discounted cash-flow method is most appropriate for start-up companies or those with cash flows that are expected to increase or decrease going forward at varying rates.
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Disclaimer: The information contained in this article is for general guidance only. The information presented should not be acted upon without the advice and guidance of a professional tax, legal, or financial adviser who is familiar with all the relevant facts.