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How to Value Your Business – Income Approach (Part 2)

Abstract

There are three approaches that business valuations use, and this video covers the income approach. This is Part 2 of a two-part video on the income approach and this video focuses on the Discounted Cash Flow method.

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Introduction

Certified Business Valuators utilize three approaches when valuing your business. Here we do an in-depth review of the Income Approach which is focused on valuing a business based on the future anticipated economic benefits such as cash flow. This video focuses on the Discounted Cash Flow method and provides an example of a business that was valued using this method.

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Transcript

Hi, I’m Sheila Darby, a managing director here at BizWorth. Thank you for joining me for Part 2 of the Income Approach. This video should follow the video on Income Approach Part 1, so be sure to watch Part 1 before Part 2 of the Income Approach. In Part 1, we’ve already covered the capitalization of earnings method and in Part 2 we’re going straight into the discounted cash flow method, otherwise known as the Discounted Earnings Method.

So, it’s important to know that Discounted Earnings Method is the same as discounted Cash Flow Method. This method is based on the fact that the total value of a business is based on the present value of the future anticipated or the future projected earnings of a business. This could be cash flows, earnings, or another economic benefit stream, but it’s based on the present value of the projected future earnings plus the present value of a terminal value. This is the new and unique part. So, we’re going to cover this in a lot more detail, but this method does require an assumption for a terminal value. That means at a high level, if we value your business out based on projected earnings of the next 5 years or 10 years, regardless of when that projection ends, at the end of that period, whether it be 5 years, 10 years or 20 years, there is an assumption for a terminal value. All the future earnings beyond that point, unless you’re valuing a finite resource such as a particular natural resources plate or a gold mine for example that you’re going to estimate to the end of life, but this is based on the valuation of a company or business that’s projected to operate indefinitely. It’s a going concern business and that’s why terminal value is so important.

So, let’s walk through what an example looks like. So, in this particular example there is a service company. We have lots of different service companies that we’ve worked with over the years that would really fit nicely into this category. This could basically be a restaurant that’s getting ready to start a new location, it could be a hair salon business, it could be a marketing and advertising business that’s focused on SEO. We have valued a lot of service based businesses that can have cashflow similar to this. This particular company was a service based business that had been in business for about two years and based on their profile, their projected growth, their earnings, and the investments that they were going to be making:

Year 1 [you’re standing here on today’s date and a year out from today you’re anticipating that] the cash flows at the end of that period will be $10,500.

Year 2 (from the end of that year one to the next year two) the cash flows will be $40,700.

Year 3: $80,600

Year 4: a little over a $110,000

Year 5: a little bit over $150,000.

This example is using a discounted cash flow method and it’s really great to use for companies that are expecting to have fluctuations in their cash flows, they’re also great for companies that really have good forecasted earnings or forecasted cash flows. There are reliable projections that can be used for discounted cash flow analysis. It’s also really great for companies that are expected to have different growth rates so there could be a short-term expected high growth rate,  one that’s slightly different for the midterm ,and then there’s a long-term growth rate. So, there’s lots of different examples where a discounted cash flow method would be applicable, and these are just a few of them.

Another example comes to mind is for companies that have expected high capital expenditures over the next few years. They’re doing a large project, something large is coming online and then they want to project out to that period, and then they use the terminal value thereafter.

Moving on in this example, Year 1 of their projected cash flows is the year following the valuation date. To be very clear, if today’s the valuation date year 1 is a year out from now that’s going to be discounted back. For this example, we’re going to use a pre-tax discount rate of 24% and we’re also going to assume that the capitalization rate is 24%. This assumes that there’s zero future growth and that’s usually rare, but for this example we wanted to keep it simple and straight forward. So, let’s cover step one. Step one for going through this DCF method is to calculate the present value of the annual cash flows, and there’s lots of different ways that we can illustrate this so we’re going to show you two. This is the first one and this is showing all the data from top to bottom. You see that today is Year 0, so when we discount back we’re going back to today, but here’s Year 1’s cash flow, Year 2’s, Year 3’s, Year 4’s and so on. The sum of all those cash flows is $392,200 and that’s an undiscounted amount – that’s just summing up all the cash flows. Remember, we are going to assume a 24% discount rate and there’s a science to discounting. There is a mathematical formula, here it is, so for the sake of time on this video we’re just showing you what that looks like on the slide. What does the discounted cash flow look like? You can tell that the further out in time you go, the greater or the more that discount rate is impacting the cash flows.

So, Year 1 there’s less of a difference: $10,500 vs $8,468, but because of the time value of money and risks over time build the discount rate impacts the cash flows greater and greater. Which makes sense if you’re projecting your company to make $10,000 next year versus $10,000 five years from now, there is the time value of money of those cash flows, but also the risk associated with those cash flows. So, the sum of the discounted cash flows is $175,000 approximately versus the $392,000. This is the difference in time value of money and the risks that are accounted for. Here’s another way to illustrate your cash flows: Year 1, Year 2, Year 3 -all the cash flows are laid out, but just to show you visually, to take all those cash flows into the future projected anticipated amounts, discounting back to today, here is the discounted amount ($175,049). Another great example is if you were to win the lottery and just for the time value of money and for the risk of the government not paying you in the future, you decide to take a lump sum amount. Well, if you had won $392,200, the sum of all the cash flows, if you wanted to take that payout today that could be something like a $175,000 if a 24% discount rate was used. So, there are two different ways to lay this out. I know we’re all visual learners and we learn differently so we wanted to lay this out two different ways.

Let’s move on to Step 2. Step 2 is calculating the present value of the terminal value. Remember, we had a projection of cash flows out for five years, but the company does not stop operating in five years. The company is a going concern – it’s going to continue to operate indefinitely into the future. So, how do you put a value on that? Well, that’s through the terminal value. You look at the benefits stream in the last year. So, if you go back to Year 5, you see that there was a $150,300 that was projected and you had a terminal growth rate of 0% in this example. So, in this example the terminal benefit stream is $150,300 because there’s zero growth, but if there was a 3% growth this would basically grow by 3%. So, it’d be something slightly higher than $150,000. Now you need to calculate a terminal discount rate and know the terminal growth rate. We’ve stated what we already know here. This is used, the discount rate and the growth rate is used, to calculate the capitalization rate. The capitalization rate is 24%. If the growth rate had been 3% it would be 24% – 3% but here, there’s 0% growth rate. So, the capitalization rate matches the discount rate, but that usually is not the case. So, here the terminal value in the last year is $626,250. To do the math, that’s $150,300 divided by the 24% discount rate and now you need to discount that back to today’s value. So, discounting that back we’re applying the discount rate in period five and you’re going to get a value of $213,619. Again, what is this amount? This is all the future years beyond Year 5 that the company will generate, discounting back that amount (the $626,250) that you’re going to earn for all future benefits, discounting back today is $213,619.

Step 3 is to add both the present value of the future discounted cash flows to the present value of the terminal value. If you take those two amounts, $175,000 and add it to the $213,619, you will get the total indication of value for that company which is approximately $388,000 or if you’re rounding $389,000, so that is the indicated value equity value for this particular company.

I hope you found these examples helpful. I know we covered a lot in these videos. Part 1, you saw the introduction of what the income approach was and you saw a quick example of the capitalization of earnings method. In Part 2, you saw the example of the discounted cash flow method or otherwise known as the discounted cash earnings method. I hope you found these videos helpful. Valuing businesses can be complex and overwhelming. There are three generally accepted approaches: the asset, the income and the market, but within each one of those approaches there are many different methods that can be used to value a business based on the circumstances and the specifics of your particular business. Please reach out if you have any questions. If you go to our web site, www.BizWorth.com, you can schedule an appointment to meet with me or one of our advisors to talk about your business valuation. Even if you’re not sure it’s the right time for a business valuation, hop on a free consultation and let’s talk through that. We’re always happy to help business owners so feel free to reach out. If you like our content and would like to see more, visit our blog or follow us on Facebook, LinkedIn, and YouTube. Thanks so much.

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