Income Approach – Overview
The income approach is one of the three primary methods used in business valuation. This approach estimates the present value of a company’s future cash flows. The income approach is particularly relevant for companies with a stable customer base and steady revenue streams. In this article, we will discuss the income approach and illustrate its application in a hypothetical Singapore business context.
The Income Approach
The income approach involves estimating a company’s future cash flows and then discounting them to present value to determine the company’s value. This approach relies on the assumption that a company’s value is directly related to its ability to generate income in the future.
The income approach has three primary methods – the capitalized income method, the discounted cash flow method, and the excess earnings method. The capitalized income method assumes that the company’s future income will remain constant and uses a capitalization rate to estimate the company’s value. The discounted cash flow method estimates the company’s future cash flows and then discounts them to present value. The excess earnings method calculates the value of a company’s intangible assets based on its excess earnings over a defined return on assets.
Income approach – Valuation methods
This income approach valuation 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. The value here is derived from discounts on a series of expected cash flow – typically refers to the terminal (or residual) value. Theoretically, the terminal value refers to the expected cash flow in the final year of the forecasting period; hence it describes the worth of the business when its operations have stabilized. It can be derived via the capitalization of earnings method or the market approach.
This approach is suitable for companies with positive cash flows and also for startups with high-growth potential, but is not yet profitable. With the DCF method, there is greater flexibility. Hence it is generally suitable for businesses that plan to change their capital structure in a short term or have high growth.
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. Here, the expected economic benefits for a representing singe period are tuned to the present value through dividing by the capitalization rate – the discount rate after subtracting the long-term sustainable growth rate.
Sometimes known as the CCF – or capitalized cash flow – method, this is generally appropriate for established businesses, such as real estate, that have a consistent capital structure and hence predictable earnings or operating income. 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 in Singapore with stable profitability often use this valuation method.
Excess earnings method
The excess earnings method is a valuation approach that determines the value of a company’s intangible assets, such as goodwill or brand value. This method estimates the earnings generated by a company’s tangible assets, subtracts a fair return on those assets, and then calculates the value of the company’s intangible assets based on the remaining earnings, or excess earnings. The excess earnings method is commonly used in the valuation of professional service firms and other businesses with significant intangible assets.
The income approach to business valuation determines the amount of income a business can expect to generate in the future. In this approach, an equity interest become a function of two variables:
- Expected Economic Benefits
These can be in the form of the available cash flow for equity investors or equity and debt investors, or the earnings before tax.
- Discount Rate (based on the involved risks)
These can be in the form of the weighted average cost of capital (WACC) or the cost of equity.
Application in Singapore Business Context
Let’s take a hypothetical case of a technology company in Singapore that is seeking a business valuation using the income approach. The company has a stable customer base, a strong reputation in the market, and consistent revenue streams.
Using the discounted cash flow method, the business valuer estimates the company’s future cash flows based on historical financial data and industry trends. The business valuer projects the cash flows over a five-year period, with a terminal value for years six and beyond. The business valuer also assumes a discount rate of 10% to account for the time value of money and the risk associated with the company’s future cash flows.
After projecting the company’s cash flows, the valuator discounts them to present value using the discount rate. The present value of the cash flows represents the company’s enterprise value.
In this hypothetical case, let’s say the business valuer estimates the company’s enterprise value to be $50 million. The business valuer would then subtract the company’s outstanding debts and add any cash or other liquid assets to arrive at the company’s equity value.
Conclusion
The income approach is a useful method for valuing a company, particularly in the case of businesses with stable revenue streams. In the Singapore business context, the income approach can be applied to any industry, from technology to retail to manufacturing. By estimating future cash flows and discounting them to present value, the income approach can provide a realistic and accurate valuation of a company’s worth.
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