5.2 Business Valuation - Income Methods

We have reached the heart and soul of business valuation - the earnings or discounted cash flow (DCF) method.

Isn't it a bit presumptuous to say one particular method is at the core? Perhaps. But the truth is the other principal valuation methods rely on it. The asset method is based on a DCF analysis -- since a prospective purchaser has to ascertain the asset's present value. The market method also relies on DCF -- since it reflects how somebody else valued comparable assets.

The DCF method, as we have seen, first estimates cash flows in the future and then approximates their risk using a discount rate or capitalization multiplier. What a tenuous science! An estimate multiplied by an approximation. But when we guess the future -- dependent on so many human and cosmic variables -- it's the best we have.

5.2.1 - Income method (capitalization of earnings)

The most widely-used method to compute the value of a business looks at the present value of anticipated future income or cash flow generated by the business. In effect, the valuator capitalizes the company's current earnings. Like other methods for valuing financial instruments, this method relies on the discounted cash flow (DCF) model. (More 5.2.1>>)

5.2.2 - Basic DCF formulas

To understand the income method, you should have a firm grasp of the basic DCF formulas -- including the general DCF formula, the formula assuming zero growth, and the formula assuming constant growth. (More 5.2.2>>)

5.2.3 - Applying DCF formulas

To apply the DCF method, the valuator must estimate cash flows/earnings, by adjusting book earnings and making projections. Then the valuator must determine a discount (or capitalization) rate, using such methods as CAPM or weighted cost of capital. (More 5.2.3>>)

5.2.4 - Excess earnings method

The excess earnings method, sometimes known as the "formula method", is used by courts to "simplify" the valuation of closely-held businesses. Hardly a simplification, it is a hybrid that combines cost and income approaches. Earnings are separated into those derived from tangible assets and intangible assets (name, reputation, quality of personnel). (More 5.2.4>>)