Valuation Methods – The Income Approach
The Income Approach is one of the three approaches (along with the Market Approach and Asset Approach) used to estimate enterprise and equity value. The income approach seeks to identify the future economic benefits to be generated by an entity and to compare them with a required rate of return. This numerator/denominator relationship can be applied through a number of different methods such as:
- Discounted Cash Flows
- Capitalized Cash Flows
- Excess Cash Flows
For the purposes of this discussion, the focus will be on the discounted cash flow method and how it can be applied.
The first step in the valuation process, performed internally or externally, is to determine the future cash flows or “projections”. This will be the responsibility of the company’s management if using an external valuation specialist. The specialist should review the projections for reasonableness. The projections are typically performed for the upcoming five years. Although this is not a hard and fast rule, it is a rule of thumb that is commonly applied. Revenues and expenses should be projected forward from current results. The resulting amount should be appropriately tax affected to determine what the free cash flows of the entity will be. Other adjustments that should be considered are cash related items such as CAPEX, depreciation and amortization, to name a few.
After the free cash flows are determined, the entity’s numerator of the calculation is largely in place. Next, the denominator is the focus. The rate of return, or discount rate, for more developed companies is often determined through the Build-Up Method. CAPM is used in some circumstances, but the inherent difficulty in identifying a “beta” for the CAPM calculation causes many valuation specialists to use the Build-up Method. While this type of approach works for a company with more history, a new company or one just beginning to generate income and free cash flows poses a different challenge.
Investors seeking to assess a younger company may choose not to apply the income approach as it may not be applicable due to a lack of results on which to base projections. However, if there is a basis to work from, using the Build-up Method may not be appropriate. The rate of return for companies that are younger can vary quite a bit. Amounts from 20%-80% are often used for companies that are early-stage. The less risky and more reliable the projections, the closer the rate of return is likely to be nearer to the 20% end of this spectrum. Riskier, younger ventures with less proven results upon which to base the projections may use a discount rate closer to the 80% end of this range.
Taking the free cash flows discussed as the numerator and applying a rate of return, or discount rate, will result in the present value of future cash flows. The sum of these for the five years, based on the reasonable adjusted projections, provides one half of the value to be calculated.
Not many companies will simply end at five years. The valuation needs to also take into account the additional years of cash flows to be obtained. These cash flows can often be even more significant than the five years already detailed out. The terminal value, as this next amount is known, is generated by applying a long-term growth rate to the company’s free cash flows and discounting this total back to a present value as was done with the first five years’ projections.
When calculating the terminal value, the growth rate should consider the stage of the company and how it is likely to grow in the future. Many times, the United States GDP can be used as an estimate for this future growth. For well developed companies, exceeding this is unlikely. For earlier-stage companies, exceeding this is not uncommon.
The sum of the present values of the five year projected free cash flows and the terminal value provides the total enterprise value from the Income Approach.
- Widely recognized
- Flexible in addressing companies of many different stages and natures
- Simulates a market price even if there is no active market
- Relies on hypothetical projections
- Utilizes a discount rate with many variables in determining the appropriate figure
The Income Approach, whether ultimately relied upon or not, is important for a valuation specialist to consider in a 409A valuation. Working with a company to determine future free cash flows can be valuable in learning more about the company.
Are you ready to start your 409A valuation? Contact us, and one of our appraisers will be in touch and we can get your valuation started.
Leave a ReplyWant to join the discussion?
Feel free to contribute!