Income Approach Valuation | Finding Business Worth Easy
Income approach valuation is a must when you decide to sell your business quickly in California, it is an emotional process. As you navigate the excitement of cashing out on your hard-working investment, there are also a lot of things that go into valuing your company. You can value an enterprise in various ways, but we’ll focus on the income approach today. This method involves an analysis of your company’s future earnings, and we walk you through it in the article below.
Income Approach Business Valuation Example
The income approach to business valuation is when a company’s present value of cash flows (or future earnings) determines its value. The cash flows represent the future earnings projections of the enterprise. When a business broker calculates the business value of a business in California, it must adjust these future cash flows for taxes, growth rates, cost structure, and other factors.
The income approach is an effective indicator because it does not assess historical business transactions within the market. Although future growth rates and return on investment can be volatile, the projections must be as accurate as possible.
Income Approach to Business Valuation
There are three different methods for the income approach: capitalization of earnings. discounted cash flows approach, and multiples of earnings. We highlight the key differences between the two below.
Capitalization of Earnings Method
The capitalization of earnings analyzes a company’s value by evaluating the net present value of future cash flows or profits. Its simple formula divides the company’s future earnings by the capitalization rate. The goal of this method is to determine if the company is worth pursuing from the acquirer’s perspective and to maximize the business value from the business seller’s perspective. It does this based on its current cash flow, its annual rate of return, and its projected future value.
- (Yearly Future Earnings/Required Rate of Return) = Business Value
This approach assumes there is no growth in cash flows. For example, a wholesale-distribution business is up for sale in California, and buyers want to determine its worth. When the business intermediary gives the presentation, he highlights that the company’s projected future earnings are $220 thousand, including a required rate of return at 10%. With the capitalization of earnings formula, the company’s value is:
- ($220 thousand/10%) = $2.2 million
Based on this formula, the California-based distribution company is worth $2.2 million if its future cash flow continues to produce the projected amount.
Discounted Cash Flow Method
The discounted cash flow method is slightly more detailed than the capitalization of the earning method. This method calculates the value of a business by evaluating the present value of future earnings, in addition to the terminal value’s present value. In this formula, the company’s expected cash flow is the first thing projected. Here are strategies to improve cash flow.
From there, each cash flow gets discounted into a present value, based on a rate related to the risk. This figure represents how risky it is to receive that cash flow amount at the given time projection. The most effective way to form these projects is through items like working capital, operating costs, capital expenses, and revenue.
The risk-driven discount rate helps us understand the business’s discounted cash flow to the present. The percentage is usually referred to as the WACC, weighted average cost of capital.
The most straightforward formula to calculate this is the Gordon Growth Model. This equation net cash flows for a single year with perpetual growth. Below is the formula:
- Valuation = (Cash Flows in the first year) / (Required Rate of Return – Growth Rate)
Looking to Value & Sell Your Business| Hire a Business Broker
Valuing and Selling a business in California is a massive project with a lot of moving parts. When you are a business owner and looking to retire now or in the near future, it is completely normal to be emotionally invested in the company. A certified business intermediary helps you stay on track by identifying specific milestones and navigating you through the selling process.
These certified brokers also help you maximize the value of your business before selling. They sit on a vast knowledge of the income approach to valuation of a business and determine what’s it worth, maximize value, and get it well-prepared for acquisition.
So, what else does a good business broker do when it comes to selling a business in California?
- Assembles the documents needed to perform a business evaluation and sell the company.
- Vet, inform and interview potential buyers. A business intermediary understands the critical characteristics to look for in a buyer.
- The checklist for due diligence and closing the sale. The overarching objective for the seller is to receive a buying offer via the broker. Once this goal is achieved, the business broker will partner with the buyer and seller to ensure the agreement is officially accepted by both sides.
Selling a business in California can be an emotional process. Determining the value of the business, its assets, and operations is also a critical task.
To ensure you are getting the most out of your company, you must partner with a professional to guide you through the process. Your business has come a long way, so make sure you maximize the value of your business before selling it successfully in California.
It is currently the perfect storm to value and sell your business in California. With the great resignation that started during the pandemic and the trend to continue till 2023, there are no shortages of experienced and well-financed buyers looking for the next opportunity to grab.