Business Valuation - Income Approach

Discounted Cash Flow (DCF)

Discounted Cash Flow Formula - Income ApproachThe discounted cash flow model of the Income Approach is frequently used in finance to determine the value of a business as a going concern. The gist of this model is “to determine today’s value of all projected future cash flow of a company adjusted for risk”. When calculating the DCF for a business, the cash flow we use is either the Seller’s Discretionary Cash Flow (SDCF) also known as Seller’s Discretionary Earnings (SDE), or Earnings Before Interest Taxes Depreciation and Amortization (EBITDA).

To understand this model, you need to know these few terms: Present Value (PV), Time Value of Money, Discount Rate, Terminal/Residual Value, Seller Discretionary Earnings, EBITDA.

Key Notes:

  • Projecting the income for the first 5 years is important.
  • Do not mix up cash flow to equity and cash flow to firm.
  • Do not mix up discount rates: Weighted Average Cost of Capital and Cost of Equity.
  • Match nominal or real Cash Flow to nominal or real Discount Rates. Real rates are inflation adjusted.
  • Note that since central banks have deployed quantitative easing, the risk free rates have been distorted compared to historical.

Steps used to determine Discounted Cash Flow:

  1. Complete income statement projections 3-5 years into the future.
  2. Determine the Cash Flow (SDE or EBITDA) for each of the future years.
  3. Determine the right Discount Rate for the company (Rule of Thumb or using CAPM)
  4. Use the Discount Rate to find the Present Value of the Cash Flow for Year 1 – 5.
  5. Add up all the PV to give you Net Present Value (NPV)
  6. Find the capitalization rate and steady growth rate to calculate the Terminal Value.
  7. Add the Terminal Value to the NPV of Cash flow Year 1 – 5.
  8. The total becomes your company value using the DCF method.

Capitalization of Earnings

Capitalization of Earnings - Income ApproachThe Capitalization of Earnings method is a simplified version of an Income Approach model to estimate the future earnings of a company. The model requires the determination of a capitalization rate which is the discount rate minus the growth rate. Once the capitalization rate is determined, the earnings is divided by the cap rate to give an estimate of enterprise value.

This Income Approach model assumes that the growth rate remains steady and earnings change year on year at the same rate into perpetuity. It may be used with relatively accurate results on mature businesses with steady earnings.

Key Notes:

  • To determine the capitalization rate, extrapolate them from either publicly traded stocks or from small business sales data.
  • Understand price adjustments to account for lack of marketability of privately held companies.
  • Growth rates range between 1-5%. Global growth rate typically range in the 1-3% range or inflation rate.
  • Deciding what earnings figure to use appropriately. Use average of multi year earnings. Businesses do not sell based on a single year earnings only.

Steps to Determine Capitalization of Earnings:

  1. Determine the capitalization rate (discount rate – growth rate = capitalization rate)
  2. Determine which earnings to use (EBITDA or SDE).
  3. Determine the value of the earnings figure to use. Best approach is weighted average of min 3 years earnings.
  4. Adjust for lack of marketability.
  5. Determine the price of business.

Discretionary Earnings Multiple

The Discretionary Earnings Multiple method involves creating a table of factors affecting value and assigning each factor with a multiple and the weightage to get a weighted average earnings multiple. This Income Approach method is subjective and not uniform among different users. The multiple, weights, and even the factor itself is subjective but can be defended by the appraiser. Using this method, therefore, may result in values that differ from appraiser to appraiser.

Once a weighted average multiple is derived, this multiple is multiplied by the discretionary earnings of the company (also called normalized or adjusted earnings).

Key notes:

  • Subjective in nature but can be defended.
  • May not have uniform or closely matched valuations.
  • High potential to skew results to favour the appraiser’s intent.
  • Simple and straight forward.
  • Used by many brokers for its simplicity.

Steps to Determine Discretionary Earnings Multiple:

  1. Identify factors that affect value and assign minimum of 3 levels and match each level to a multiple.
  2. Give appropriate weight to each factor according to level of impact on business value.
  3. Multiple the selected factor multiple by the assigned weight and add them all up.
  4. Multiple the weighted average multiple by the (weighted) average discretionary earnings.
  5. Final value is the estimated enterprise value.