The Income Approach – Income-Based Valuation

The Income Approach in Brief

What is the income approach? It encompasses a range of valuation methods based on a company’s income. The two most common methods of this approach are straight capitalization of earnings and DCF valuations.

All income approach valuation methods assume that a business’ value is based on its capability to earn money.

This approach is also commonly used in the valuation of commercial real estate, which we will not discuss in this guide.

Two Key Income Approach Valuation Methods

A range of methods within the income approach are used by appraisers, the two most common being DCF – Discounted Cash Flow – and straight capitalization of earnings or cash flows.

A common mistake made by many appraisers is relying on pre-determined formulas or standardized tables of capitalization rates, and making assumptions that are too far-fetched. This leads to an incorrect valuation of the business.

Later, we will demonstrate how this approach should be used to arrive at a value that reflects market valuations.

How to do an Income Approach Valuation in Practice

At Nielsen Valuation Group, we believe in providing business valuations that demonstrate the true value of a company, as opposed to purely theoretical calculations.

Our goal is to deliver a credible valuation using real transactions as a model. The financial history and risk factors of the business are important to the valuation. All of our business valuations are in full compliance with the Internal Revenue Service (IRS) Revenue Ruling 59-60.

What does this mean in practice? Let us present a few examples:

We Always Normalize the Income Statements First!

One of the biggest mistakes when using the income approach to value is to take the income statements at face value. This leads to incorrect valuations because it is essential to normalize the income statements before making any calculations.

For example, unusual, non-recurring or discretionary items must be removed as they should not be part of the valuation.

What may look like a detail on paper can have a far-reaching impact on the final valuation. You risk overvaluing or undervaluing the business, depending on whether the omitted normalization is a revenue or an expense.

Here are a few examples:

• Assets sold: A company decides to sell ten of its twenty cars. This income is not related to the business and should not be part of the valuation.
• Restructuring costs: Necessary restructuring costs can be excluded from the calculation because they are infrequent and aim to improve operations.
• Discretionary items: If the owner has benefited personally at the expense of the business, such expenses must be normalized from the income statement. Examples include, but are not limited to, personal travel, luxury cars, or personal living expenses.
• Life insurance proceeds: These are one-time payments that should not be included in a business valuation.

We Never Apply a Predetermined Income Approach Formula

Predefined formulas allow for quick assessments. But they are virtually useless for producing credible estimates.

Unfortunately, too many business valuators use formulas to speed up the process. However, this gives a misleading feeling of safety. and an oversimplification of a complex matter.

IRS Revenue Ruling 59-60 makes this clear:

“Valuations cannot be made on the basis of a prescribed formula.”

If you use an online business valuation calculator or buy a cheap valuation service, it will use a prescribed formula. As a result, you will receive an incorrect valuation.

At Nielsen Valuation Group, we pride ourselves on always scrutinizing each business in detail to understand its true qualities, risks, and track record. Among other things, this means analyzing its growth, earnings stability, ownership dependence, and diversity of operations.

We also offer to conduct interviews and site visits, or a full due diligence, to make the valuation complete and nuanced.

We Do Not Use Standardized Tables of Capitalization Rates

Valuers often use standardized tables of capitalization rates when doing an income approach appraisal. They are quick and convenient. However, they do not take into account the unique circumstances of each business. Risks and opportunities must be analyzed for each business being valued – a process that cannot be simplified with a cap rate table.

The IRS is clear on this:

”No standard tables of capitalization rates applicable to closely held corporations can be formulated.”

At Nielsen Valuation Group, we never use such standardized tables. Instead, we look at the business in question. We look at things like actual risks, earnings stability, and what is happening in the business. All our valuations are IRS RR 59-60 compliant.

Historical Earnings Are Important – We Use Them Whenever Possible

While the income valuation approach often uses anticipated future income in its calculations, we find that many appraisers underestimate the importance of examining current and past performance. This leads to an unrealistic emphasis on future projections. In other words, speculation.

Let us again refer to the IRS Revenue Ruling:

“Prior earnings records usually are the most reliable guide as to the future expectancy, but resort to arbitrary five-or-ten-year averages without regard to current trends or future prospects will not produce a realistic valuation.”

For us at Nielsen Valuation Group, prior year earnings are very important, but not just in absolute terms. Earnings trends and stability are also important to consider, as well as specific events or risks within the company that are likely to affect the long-term trend.

Be Careful with Marketability Discount Rates Studies

Discounts for lack of marketability – or marketability discount rates as they are also called – are applied to valuations of businesses or assets that are not likely to sell quickly at fair market value.

An example is the sale of a distressed business or the sale of assets during a business liquidation. In such a situation, it is a buyer’s market and the seller must be willing to accept a lower price.

Academic studies on the matter may be useful in some situations, but they are often useless in real-world situations.

In contrast, all the valuations we perform at Nielsen Valuation Group are based on conclusions drawn from market dynamics and real transactional behavior, instead of theoretical anthologies.