The income approach to business valuation determines the amount of income a business can expect to generate in the future. Under the income approach, there are two commonly used valuation methods.
Discounted cash flow method: This method determines the present value of a business’s future cash flow. The business’ cash-flow forecast is adjusted (or discounted) according to the risk involved in purchasing the business. This approach works best for newer businesses with high-growth potential, but is not yet profitable.
Capitalization of earnings method: The capitalization of earnings method also calculates a business’ future profitability, taking into account the business’ cash flow, yearly return on investment (or ROI), and its expected value. But where the discounted cash flow method accounts for more fluctuations in a business’ financial future, the capitalization method assumes that calculations for a single period of time will continue in the future. So, established businesses with stable profitability often use this valuation approach.
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