How is a Business Valued? (Pt. 3)

The Income Approach: What Can This Business Actually Earn?

In Part One, we looked at what a business owns and owes. In Part Two, we looked at what buyers have paid for similar businesses.

The income approach gets to a question most owners care about: What is the money this business can produce worth today?

The work is figuring out how much the business can reasonably earn, whether those earnings can continue, and what could get in the way.

Start With the Earnings. Then Ask Questions.

An owner tells me the business does $2 million a year. Fine. How much is left after paying everyone and keeping the business running?

Revenue gives me a sense of size. It does not tell me what the business is worth.

Even reported profit needs a closer look. Is the owner paying himself appropriately for the work he does? Is rent paid to a family member reasonable? Did an unusual expense depress an otherwise normal year?

An underpaid owner can make a business look more profitable than it really is. Someone still has to do that work, and a buyer may have to pay someone to do it.

Adjustments also need to hold up. A one-time settlement expense may deserve an adjustment. A recurring operating cost does not disappear simply because the owner would prefer to add it back.

I need to arrive at earnings the business can reasonably sustain—and explain how I got there.

Where Did the Cash Go?

A business can report a healthy profit and still leave its owner wondering where the money went.

Customers have not paid. Inventory is sitting on shelves. Equipment needs replacing.

Those demands on cash have to be accounted for in the valuation. The same applies to growth. If the forecast calls for more sales, what will it take to produce them? More employees, equipment, or inventory?

I want to see those costs in the forecast too.

Turning Earnings Into Value

For a business with reasonably stable earnings, I may use capitalization of earnings. I apply a capitalization rate to a representative level of annual earnings or cash flow.

When substantial changes are expected, a discounted cash flow analysis may be more useful. That involves projecting future cash flows and calculating what they are worth today, including the business’s value beyond the forecast period.

Either way, the assumptions have to make sense. A detailed spreadsheet can make a forecast look convincing. I still need to know why sales will increase, whether the margins are realistic, and whether the business can deliver.

Risk Is the Biggest Driver of Value

Once sustainable earnings are established, risk is the single biggest determinant of what those earnings are worth. How confident can we be that the money will keep coming in?

Two businesses may each earn $300,000 a year. One has a broad customer base, capable management, and consistent results. The other depends on one major customer and an owner who handles every important relationship.

A buyer will pay more for earnings they can depend on.

I need to understand what happens if the owner leaves, a key employee quits, or the largest customer goes elsewhere. Can the business absorb rising costs? Is demand holding up? Does debt leave it little room for a bad year?

These questions affect the return an investor requires. Greater uncertainty means a higher required return and a lower value.

In a simplified example, $300,000 of annual earnings capitalized at 20% produces a value of $1.5 million. At 30%, the value is $1 million. Same earnings. A $500,000 difference in value.

That is why the rate needs support. It has to reflect the risks of the particular business and match the earnings being valued. Selecting it is one of the most consequential judgments in the valuation.

Putting It Together

The asset, market, and income approaches give me different ways to examine the business. I consider which are appropriate and what each result tells me.

If they produce different values, I need to understand why. Taking an average does not resolve the underlying questions.

A credible valuation connects the numbers to the business: how it earns its money, what it takes to keep earning it, and how dependable those earnings are.

That is the work behind the conclusion.

Need a Business Valued?

At Forensics CPA Tax, PLLC, I prepare business valuations for owners, attorneys, and courts, including divorce matters and partnership disputes.

If you need to understand what a business is worth—and have that conclusion explained and supported—call 914-727-6075 to discuss your matter.

Angel Alicea, MBA, CPA

Court-Appointed Financial Expert

Forensics CPA Tax, PLLC