To start our new series we looked at events which can initiate a business valuation and the methods available to value a company. In this article we would like to outline the main points of income-based methods. We will also mention aspects supporting the selection of these most common methods as well as the challenges involved.
Essence of income-based methods
The main criterion for income-based methods is that the value of the company is determined based on its ability to generate income. The key point of this ownership approach is that the company is worth as much as the money it is capable of generating in the future. The money produced in this way, i.e. the dividend, is the owner’s income. The primary aim of profit-oriented companies is to maximise the shareholder’s wealth, namely, to generate the highest possible income for them.
How can future incomes be determined?
There are basically two methods to determine future cash flows.
- According to the first method, future cash flows are determined by averaging past incomes, more precisely, past incomes are adjusted for the effects of non-recurring and one-off incomes and expenses.
- The other approach is the discounted cash-flow method, in short, the DCF method. Basically, this means that future cash flows are determined based on detailed financial plans for the future.
Present value and risks included
Given that we are working with future cash flows, but we want to determine the current value of the company, we need to determine future cash flows at their present value.
The present value shows how much future incomes are worth just now. Determining future cash flows at present value is also known as discounting. The present value is determined from future cash flows by using a “discount factor”. Among other things, general expectations regarding inflation, investment in the given company and the risks involved in the relevant sector are reflected in the discount factor.
What are the advantages of income-based methods?
Income-based methods have the following advantages:
- The starting point is the performance of the company.
- Internal information, data and the corporate strategy are also considered.
- The DCF method is built on future expectations and trends, so not only past data is considered to determine the value of a business.
- The impact of inflation is also taken into account.
- For future cash flows, acquirers consider their own expectations or the potential synergy effects in the business plan too.
What are the pitfalls of these methods?
There are some drawbacks when calculating future cash flows and determining the right discount factor.
- Both drafting the financial plan for the cash flows and determining the discount factor are time-consuming tasks.
- As this is a complex process it requires special expertise, which generally means involving experts, and comes at a cost.
- Given that future business plans are based on assumptions and that the risks related to the company and the industry are estimated, the final result itself encompasses a number of uncertainties.
- Due to these uncertainties and the many individual assessments, it is questionable to what extent these results are accepted by external users.
Despite the uncertainties and difficulties, income-based methods are the most thorough and probably the best-known business valuation methods, which are frequently used to determine the purchase price of a company during an acquisition.
If you have questions about business valuations, please contact our financial consulting experts!
