Michael B. Lehner, CPA/ABV, CFE, ASA
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MLehner@zbtcpa.com
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Avoid common pitfalls when applying the income approach in business valuation

Avoid common pitfalls when applying the income approach in business valuation

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Valuing a business using projected earnings is a complex undertaking. Here are some common pitfalls that novice or untrained valuators tend to make when using the income approach — and experienced business valuation experts have learned to steer clear of.

Mismatching earnings and discount rates

Under the income approach, anticipated economic benefits are converted into a single present value. In other words, the value of a business interest is a function of a:

  1. Projected earnings stream, and
  2. Discount rate based on the risk of the investment.

Economic benefits can take many forms. Examples include earnings before tax; cash flow available to equity investors; and cash flow available to equity and debt investors. Likewise, discount rates can take many forms. Examples include the cost of equity or the weighted average cost of capital (WACC).

Errors may occur when the subject company’s projected earnings are matched to the incorrect discount rate. For example, equity cash flows should be matched with the cost of equity, not the WACC. The cost of equity will be higher than the WACC. So, if equity cash flows are discounted using the WACC, the business interest is likely to be overvalued. In addition, pretax earnings streams shouldn’t be discounted using an after-tax cost of capital (and vice versa).

Adjusting (or not adjusting) historical earnings

The underlying assumptions for most earnings projections are based, to some extent, on historical earnings. Projections based on past performance sometimes need to be adjusted, for example, to reflect standard industry accounting practices, for nonrecurring income or losses, or for related-party transactions. But the appropriate adjustments vary depending on the degree of control that the business interest possesses. For instance, adjustments for compensation or rent paid to related parties may not necessarily be appropriate when valuing a minority interest that lacks control to change these payments.

Adjustments also may be needed to align the subject company’s earnings stream with the earnings streams generated by comparable public companies used to derive the discount rate. Errors typically occur when the person valuing the business interest 1) fails to consider control issues, or 2) overlooks adjustments needed to reflect how much earnings a hypothetical buyer would expect the business to generate in the future.

 Making unrealistic assumptions

Typically, the income approach is based on the assumption that the subject company’s earnings will grow indefinitely. At some point, however, the company’s existing assets (such as a factory or piece of equipment) will be fully utilized, and the company will need to purchase additional assets to meet its earnings projections.

A common assumption is that annual depreciation expense will approximate the need to update fixed assets. This might not necessarily be true when the company is operating near or at its capacity limit.

The same principle applies to other fixed costs, such as managerial salaries and rent expense. At some point, all costs are at least step-variable (that is, they increase in steps, rather than on a per-unit basis). Management also may need to take on additional debt to achieve its projected earnings, which could alter the company’s capital structure.

Likewise, when valuing a high-growth business, such as a start-up venture or a high-tech firm, management may expect to grow at 10% (or higher) each year. But no business can realistically expand at such a pace forever. Competitors and substitute products are likely to enter the marketplace and eventually slow down the pace of growth.

So, before discounting projected earnings, an expert needs to take a step back and evaluate whether projections seem reasonable over the long run. Oversimplified projections can lead to valuation errors.

Hire a business valuation expert

These pitfalls highlight the perils of do-it-yourself business valuations and the importance of hiring a credentialed business valuation expert. The pitfalls may also trigger questions as attorneys and business owners review valuation reports prepared by the opposing side in litigation.

 

Sidebar: Two methods, one valuation approach

Two popular methods that fall under the income approach are capitalization of earnings and discounted cash flow (DCF). Which is appropriate when valuing a particular business?

Under the capitalization of earnings method, economic benefits for a representative single period are converted to present value through division by a capitalization rate. The cap rate equals the discount rate minus a long-term sustainable growth rate. This method is generally most appropriate for mature businesses with predictable earnings and consistent capital structures.

Conversely, the DCF method derives value by discounting a series of expected cash flows. The “cash flow” at the end of the projection period is known as the terminal (or residual) value. Terminal value is typically calculated using the market approach or the capitalization of earnings method. It represents how much the company could be sold for at the end of the projection period, when the company’s operations have, in theory, stabilized.

DCF models are generally more flexible than the capitalization of earnings method. For example, the DCF method is well suited for high growth companies and those that expect to alter their capital structure over the short run.

Michael Lehner


This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.