Income/Cash Flow Approach

There are two commonly used methods in the income approach.

Capitalization of Earnings Method

In the capitalization of earnings method, a benchmark earnings total is used in conjunction with a multiple. This benchmark earnings total could be any of the following:

  • Gross revenues;
  • Net revenues;
  • Net profit before taxes;
  • Net profit after taxes;
  • EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization);
  • EBIT (Earnings before Interest and Taxes); or
  • SDCF (Shareholder Discretionary Cash Flow).

The multiple is the inverse of the capitalization rate, which is made up of different risk factors attributed to the business. When you multiply this earnings total by the multiple, you get a valuation based on the historical earnings of the business.

This method provides a look at the last three years of the earnings of the business. It puts a greater weight on values closer to the current year. The strength of this method is that the numbers are real, they cannot be changed. The values can be explained and a potential buyer can effectively analyze them to either repeat or improve upon past success or avoid past mistakes going forward.

The weakness with this method is the numbers may fluctuate due to outside factors that are beyond the control of the company. The consistency of a company cannot be counted on if new management were to take over the company.

Discounted Future Earnings Method

In the discounted future earnings method, an earnings stream is projected out for three years and a terminal value calculation is utilized to handle all years past the third year of a projection.

This method provides a look at the future three years of the projected earnings of the business then uses a terminal value to predict years past those three. It puts a greater weight on values closer to the current year. The strength in this method is that it provides a realistic projection based on current performance and predicted economic growth of the industry.

The weakness with this method is that the values used are estimates. They are based on projected economic outlook and, as with all estimates, may change due to unforeseen circumstances that cannot be predicted. The projections can also be skewed if the current year was abnormal when compared to past performance of the company.