When you think about how much something is worth—like a car, an investment in a rental property, or even a business—there are different ways to figure that out.
One common method used by businesses and investors is called the Income Valuation Approach. This method is predicated on the basis that something is worth how much money it can generate in the future. One specific way to apply this method is called the Capitalized Cash Flow (CCF) approach.
What is an Income Valuation Approach?
An Income Valuation Approach is a generally accepted valuation methodology used to determine the value of something, like an asset such as a business, by looking at the money it can make in the future. The basic concept here is straightforward: the higher the potential earnings the asset can generate, all else equal, the more valuable this asset is.
There are two broad methodologies using an Income Approach:
- Capitalized Cash Flow approach; and
- Discounted Cash Flow Approach.
Key Concepts to Understand
- Future Cash Flows:
- Think of cash flows as the money that comes in and goes out of a business over time. In the Income Valuation Approach, we focus on the money a business expects to bring in over the years.
- DCF Method:
- The DCF Method is generally appropriate in situations where the business’s cash flows can be reasonably estimated and are expected to differ significantly from the current situation (due to for example, expansion of capacity, significant change of management and/or financial structure, cessation or sale of a portion of a business, or where the subject of the valuation has a finite life).
- Risk and Return:
- Every investment has some level of risk. The more uncertainty with respect to earning the future cash flows, the higher the risk associated with them. To account for this higher risk, investors use a higher discount rate, which lowers the present value of future cash flows.
- Growth Rates:
- If a business is expected to grow (higher revenue and profits), this growth is factored into the valuation. A business with significant growth prospects is generally considered to have higher value.
What is the Capitalized Cash Flow Approach?
The Capitalized Cash Flow approach is a valuation methodology that falls within the Income Valuation Approach umbrella. It works best when a business has steady, predictable cash flows—meaning its earnings are not volatile and do not change much from year to year, typically we see this in practice when the subject company is likely at a mature state in its life cycle. This is contrasted by a company that is a start-up and is expected to grow significantly year over year – when this is present, we used a Discounted Cash Flow (DCF) Methodology.
Here’s how you would apply the CCF method:
- Estimate Annual Cash Flow:
- Figure out how much money the business makes in a typical year, this is referred to as the annual cash flow.
- Determine the Capitalization Rate:
- Next, you need to determine and apply an appropriate capitalization rate, which reflects how risky the investment is and how much return an investor would want or expect to earn from having taken on this risk (“High risk high reward”). The capitalization rate helps convert the annual cash flow into a present value.
- Calculate the Business Value:
- To determine how much the business is worth, divide the annual cash flow by the capitalization rate. This result gives you an estimate of the business’s value.
Business Value = Annual Cash Flow / Capitalization Rate
The above does represent a very simplified explanation of the approach. In completing valuation reports and applying this approach, there are several nuances that need to be addressed depending on the tax situation, how the business has been financed, non-operational or redundant assets, etc. However, the primary pieces are what has been included above.
