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

Abstract

There are three approaches that business valuations use, and this video covers the income approach. This is Part 1 of a two-part video on the income approach. This video focuses on when to use the income approach and how to use it. Part 1 focuses on the Capitalization of Earnings 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 provides a way of determining an indication of value of a business using one or more methods that convert anticipated economic benefits into a present single amount. Part 1 focuses on the Capitalization of Earnings 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 today’s video on how to value a business. We’re looking at the income approach. This is part one of a two-part video on the income approach.

As a reminder, there are three generally accepted valuation approaches to valuing a business. The first is the asset approach. We covered this approach in a previous video. The second is the income approach. And the third is the market approach. And today’s video, Part 1 and Part 2 are both going to be focused on the income approach.

So what exactly is the income approach? The income approach is focused on valuing a business based on the future anticipated economic benefits such as cash flow. So, future anticipated cash flows generated from your business and it’s focused on those future benefits discounting back to a present value – a single amount for your business.

So, when do you want to use this approach? There are lots of good examples as to when this approach is preferred. However, as a certified professional valuator, we consider every approach every time. So, we’re going to look at the asset approach, the income approach and the market approach every time, and one or more of those approaches may be applicable to your particular business. So, for a business using the income approach, we’re particularly looking at businesses that are profitable. So, if your business is profitable, the income approach is a great valuation approach. If your company has been generating losses for the last year or last several years, the income approach may not be a very insightful method. Valuations for tax returns and for the IRS; again, the income approach is very insightful. Some of the helpful things about the income approach is that it’s very specific to your company, and so we look at the earning capacity of your company. We look at the growth potential of your company. We look at any large capital expenditures of your company. So, it’s very specific to your company in the future earning capacity of your company and we’ll cover the approach and the methods in more detail in these videos.

Now that we’ve decided that the income approach is appropriate for your business, how do we go about using it? Well, if you think of an auto mechanic, he may have lots of different tool chests and in each one of those toolboxes, he’s going to have lots of tools. Well, you can consider the approaches to valuing your business, the three different approaches: the asset, the income, and the market as different toolboxes, and the tools that we have in each one of those boxes are the different methods that we use. In the income approach, there are many different methods we can use, but in this video, we’re going to focus on two particular methods. We’re going to focus on the capitalization of earnings method (sometimes that’s referred to as the capitalization of cash flows method) and the second is the discounted earnings method (otherwise known as the discounted cash flow method or DCF). In this Part 1 video, we’re going to cover the capitalization of earnings and in the Part 2 method, we’re going to cover the discounted cash flow method.

The capitalization of earnings method: what exactly is it? Well, again, it’s focused on the future estimated benefits or the future estimated cash flows of your business. We’re looking at what’s being generated from your business, and then the cash flow is going to be capitalized using an appropriate capitalization rate. Again, this is all specific to your business. The important thing to know about the capitalization of earnings method at a high level is that this is a particularly useful method to use within the income approach for businesses that may be considered to be in a fairly steady state. That means they’re earning roughly the same economic benefits or cash flows a year in and a year out. There may be a marginal growth increase or a decline year over year, but they’re somewhat in steady state.

What would be a great example? Let’s talk about a manufacturing business that BizWorth looked at several years ago, and I myself worked on this particular case and it was a very good manufacturing business. The business itself generated several million dollars in revenues, but on average, the five-year weighted average of this particular manufacturing company was $591,000. After doing the analysis on the appropriate rate for this type of business, it was determined that the appropriate weight, was 21.32%. We could probably have a multi-part video on just the high level basics on what it is to take an appropriate discount rate or capitalization rate, but for the sake of not diving too much into discount rates, we’re going to assume that it is 21.32% for this particular manufacturing company. We’re also, to keep things simple, going to assume 0% growth. On average, the way we determine growth rates are: we look at the company, we look at the historical growth of the company, we look at the industry in which the company operates, we look at the economic conditions (both short term, mid-term and long term), and there’s lots of resources that we pull upon for those growth rates.

How we valued this particular company (we’ll call this company generically APC company, it was really a longstanding manufacturing business that was well-diversified, had lots of different clients and very good earnings history over the years) and how we went about the math was the capitalization of earnings indicated value. Again, the five year average on an after-tax basis was $591,000. We took that appropriate rate of return for this particular business, which was 21.32%, and we used that to divide into the $591,000 and came up with an indication of value of roughly $2,772,045 for this particular manufacturing business. The math is fairly straightforward. The science in and the art of it comes into understanding all the different methods which are appropriate for this given business. This business had been in business for many years, their historical after-tax earnings and cash flows were relatively at a steady state, their capital expenditures were fairly at a predictable state, and depreciation was at a steady state. The calculation of earnings method was a great method to use for this particular company and the math is very straightforward. It’s taking the capitalization of earnings (in this case, it’s the after-tax basis of earnings) and dividing it by the appropriate rate, which here was 21.32%.

I hope you found this example helpful. I hope it will help you when you’re considering all the different appropriate methods that might be appropriate for your company and understanding what those are, but the valuation of a company is complex. If you’re trying to use a valuation for negotiations, for estate planning, for family law matters or business litigation, you’re going to want to have a certified professional because your valuation will have a tremendous amount of credibility. 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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