What it means
The income approach is one of three standard valuation families, alongside the market approach, which compares the business to similar sales, and the asset approach, which adds up what is owned. It rests on a simple idea: a business is worth what it can earn for whoever owns it.
Everything else in the method is about estimating those earnings and pricing the risk that they fail to arrive. There are two main forms of the approach.
Capitalisation of earnings takes one normalised year of profit and divides it by a capitalisation rate, which suits stable, mature businesses with predictable trading. Discounted cash flow projects several years of cash flow and discounts each year back to a present value, which suits businesses whose growth is changing.
The word "normalised" does a lot of work here and is where most valuation errors begin. Before valuing, an analyst strips out one-off items and adjusts owner-related costs to market levels, for example replacing an owner's below-market salary with the cost of hiring a manager to do the same job.
Without that step the earnings figure either flatters the business or understates it badly. The rate applied is where most of the argument happens in a real negotiation.
A higher capitalisation rate means a higher required return and therefore a lower value, and rates rise with customer concentration, dependence on one key person and volatile trading history. Small owner-managed businesses commonly attract required returns far above those demanded of large listed companies.
The approach matters because it links price directly to performance and risk. It tells an owner that improving sustainable profit, or reducing the perceived fragility of that profit, is what raises the eventual sale price.
It also explains why two businesses reporting identical profits can sell for very different sums.
In practice
Real-world examples.
Example
An accountancy practice with normalised profit of $260,000 is valued by capitalising at 25%, giving $260,000 / 0.25 = $1,040,000. The buyer applies that relatively high rate because client relationships sit with the retiring partner. A two-year handover period is negotiated to reduce the risk and support the price.
Example
A commercial landlord values a small industrial unit by the income approach, using net rent of $96,000 a year and a market yield of 8%. The value is $96,000 / 0.08 = $1,200,000. Because property yields are widely published, this version of the approach is comparatively easy to defend.
Example
A fast-growing software company reports profit of only $600,000 last year, which capitalised at 20% would suggest a value of $3,000,000. A discounted cash flow model reflecting three years of contracted subscription growth produces $8,400,000 instead. The buyer and seller argue about growth assumptions rather than about the method itself.
Formula
Calculation
Value = Normalised annual earnings / Capitalisation rate, where the capitalisation rate is the buyer's required return net of expected growth.
Harborline Cleaning Services produces normalised annual earnings of $450,000 after adding back the owner's excess salary and removing a one-off legal settlement. A buyer requires a 20% return on this type of business, so the capitalisation rate is 0.20 and the value is $450,000 / 0.20 = $2,250,000. That is the same as applying a multiple of 1 / 0.20 = 5 times earnings. If due diligence reveals that one customer provides 40% of sales, the buyer may raise the required return to 25%, giving $450,000 / 0.25 = $1,800,000, which is a multiple of 4 times earnings. The five-percentage-point change in the rate removes $2,250,000 - $1,800,000 = $450,000 of value, exactly one year of earnings.Case study
Seen in the real world.
Northgate Coach Hire is an illustrative, fictional family business whose owner wanted to retire and expected four times last year's reported profit of $380,000, or $1,520,000. The buyer's adviser normalised the earnings first: he deducted $100,000 because the owner paid himself $60,000 against a market rate of $160,000 for a full-time manager, and added back $30,000 of one-off legal costs. Normalised earnings came to $380,000 - $100,000 + $30,000 = $310,000, and at the same multiple of four the value was $310,000 x 4 = $1,240,000, a gap of $280,000 against the owner's expectation.
Rather than accept the lower price, the owner spent 18 months acting on what the valuation had exposed. He recruited a general manager at market rate, won two new school contracts so that no single customer exceeded 20% of revenue, and put three-year agreements in place. Normalised earnings rose to $390,000 and the buyer's required return fell from 25% to 20%, producing a value of $390,000 / 0.20 = $1,950,000. The story is invented, but the mechanics of it are exactly how the income approach rewards lower risk.
Watch out
Common mistakes.
- Capitalising last year's reported profit without normalising it for owner salaries, personal expenses and one-off items.
- Confusing the capitalisation rate with the discount rate, when the capitalisation rate is the discount rate less expected long-term growth.
- Building a discounted cash flow model with a hockey-stick growth curve that the business has never achieved and cannot evidence.
Questions
People also ask.
Why does a small change in the rate move the value so much?
Because value is earnings divided by the rate, so the relationship is not linear and small rate changes produce large value swings.
Should I use capitalisation of earnings or discounted cash flow?
Use capitalisation for a stable business with steady profits, and discounted cash flow when earnings are expected to change materially over the next few years.
Does the income approach work for a loss-making business?
Not usefully on its own, because there is no positive earnings stream to capitalise, so an asset-based or market-based valuation is normally used instead.
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