What Is an Income-Based Approach to Business Valuation?
There are several different approaches to valuing a business. This can be important for a number of reasons including the most common reason our commercial litigation team encounter- in the context of shareholder unfair prejudice petitions and investor/shareholder disputes. An income-based valuation method is one of a number of alternative approaches.
Like all valuation methods, an income-based approach has strengths and weaknesses. It’s a form of analysis better suited to certain types of business and shareholder litigation than others.
The term “income-based approach” is a broad church that covers several types of financial analysis, each with pros and cons.
Valuing a business on an income basis is frequently employed by financial and valuation experts, usually accountants or forensic accountants, working with our expert commercial litigation team to gain vital insights, and to maximise or minimise share sale or purchase criteria.
What Is an Income-Based Approach?
The income-based approach to valuation is sometimes also called the capitalisation method.
A valuation on this basis requires expert review and analysis of a company’s financial data alongside projections about future growth and earnings potential to determine a current value.
An income-based valuation uses numerous methods to estimate a company’s value based on its capacity to generate income. It’s widely used to value commercial property-based companies.
The income-based method includes Discounted Cash Flow (DCF) analysis, used by investors and managers to gauge a company’s worth.
An expert can estimate the company’s current value by forecasting future earnings or rents for property investments and discounting them by the capitalisation rate.
It will go without saying that for the valuation method to be accurate, and for it to be workable, accurate information needs to be made available transparently. In a dispute or litigious scenario this can often be difficult and it can often be necessary to consider need for pre action disclosure (also known as a PAD application) to be made, among other methods.
A DCF analysis provides an objective template to assess financial performance and business growth, helping potential investors and business owners make strategic and well-informed decisions.
The income-based approach is used extensively to ascertain value in mergers and acquisitions and subdivides into specific methods for investment analysis purposes.
Types of Income-Based Valuation Methods
Discounted Cash Flow Method (DCF)
This commonly income-based valuation method works by assessing the future cash flows of a business using forecasting techniques and discounting that data to present value. The discounting process aims to adjust for inherent risk factors or unknowns.
DCF is a flexible valuation method as it allows for variation in growth rate, margins, debt repayments, and other random factors that are not static in the future.
It also allows adjustment for one-off gains like the sale of assets, insurance policy proceeds, or ad hoc losses such as costs associated with a court case or legal settlement. This is called normalising adjustments.
Dividend Discount Model (DDM)
The Dividend Discount Model provides a framework for valuing equity investments such as stocks.
Forecasting considers future dividend payments over a set period. Then, it discounts them to their current value by applying a discount rate that considers the desired return rate from the investment.
Capitalisation of Earnings Method
This valuation method estimates future benefits from the company, usually measured as future maintainable earnings or sometimes cash flow. Predicted earnings are then capitalised using the appropriate rate for the business.
An expert valuer must understand normalised earnings with adjustments for seasonal fluctuations and non-repeating assets — among other factors — to accurately estimate the capitalisation rate.
The rate is calculated using the desired rate of return and expected growth rate.
An analyst can estimate the company’s value by dividing normalised earnings by the capitalisation rate.
Choosing the Best Valuation Method
It’s crucial for a shareholder retaining and expanding ownership, or for an ongoing exiting shareholder, to choose the best valuation method at the outset and to instruct an expert who understands the most appropriate valuation method which is appropriate and can be justified, and which is also likely to achieve the best valuation on the type of company involved.
The Discounted Cash Flow method works best for businesses with regular and predictable cash flow.
The Dividend Discount Model is better suited for companies with stocks that pay regular dividends.
Different sectors and industries prefer different valuation methods — usually dictated by unique business characteristics and the convention of past practices.
What Are the Factors That Influence Income-Based Valuation?
Numerous internal and external forces can impact income-based valuations. The most common factors include:
State of the Economy
Even healthy businesses are not immune from so-called ‘market forces’ — the cyclical highs and lows of the national economy. Depending upon the type of business, the health of international economies can also play a part.
Financial Performance
A company’s financial status heavily influences income-based valuations for obvious reasons. Low expenses and high income create bigger profits, which typically correlate with higher cash flow or earnings, resulting in a higher valuation.
Growth Prospect
Companies growing steadily or quickly well in established sectors tend to produce forecasts of favourable future earnings or cash flows, leading to higher valuations.
The Selected Discount Rate
The chosen discount rate is hugely influential. A higher discount rate results in a reduced assessed value of prospective earnings or cash flow and, hence, a lower valuation.
What Are the Pros and Cons of an Income-Based Valuation Approach?
Pros
An income-based approach to business valuations is objective. It is also quantitative at its core, meaning less reliance on subjectivity and interpretation. It’s easy to see why financial professionals and accountants often favour this method.
An income-based approach looks to the future. For a company seeking to attract investors, strong sector performance is hugely beneficial to an emerging business or startup. The income-based valuation process takes account of anticipated growth and prospects.
A critical element of an income-based valuation is that it considers that ‘time is money.’ £100 today is worth more than £100 a year from now because it can be profitably invested.
This concept is called ‘the time value of money’ or TVM. It’s a core financial principle relied on by economists and financial professionals.
Cons
The biggest drawback of the income-based approach to valuing a business is using assumptions such as the discount rate. The result is only ever an estimate and can distort the final analysis, resulting in an over or undervaluation.
This can lead to financial decisions that may be imprudent or missed investment opportunities.
The income-based approach to valuations is like baking a cake; a surprisingly small change to one ingredient can hugely impact the final result.
Consequently, one could describe this approach as sensitive — some might say overly sensitive — which isn’t always beneficial. Minor adjustments produce significant variations and can skew decision-making.
The income-based approach to valuations doesn’t suit businesses with erratic or unpredictable cash flow patterns. Forecasting future earnings using this method has questionable accuracy.
The accuracy and availability of a company’s financial data are also crucial to a successful income-based valuation. Access to a company’s data — and its reliability — will influence the choice of valuation method and could determine whether an income-based approach is viable.
Finally, the income-based approach does not factor in intangible elements like brand reputation, business goodwill, and intellectual property like trademarks or patents.
Depending on the type of business, intangible factors can hugely influence a company’s value. However, they remain outside the parameters of an income-based valuation.
Valuation of shares is incredibly delicate and subtle, especially in the context of a dispute where anything and everything is likely to be contentious or questioned to varying extents. The impact of getting this right or wrong can be significant. As a result there is now growing and significant case law that touches on valuation in the context of s.994-996 companies act 2006 unfair prejudice petitions. The methodology and time at which any valuation should take place can be critical factors in either establishing greater or lesser value for remaining or exiting shareholders.
FAQs
Why is the Income-Based Approach Considered the Most Difficult Valuation Approach?
The income-based approach is considered the most challenging valuation approach because the values used are estimates first and foremost. Therefore, assumptions must be valid and underpinned by accurate data.
The second flaw of this method is that minor adjustments can disproportionately affect the valuation results, again highlighting the inherent weakness of using forecasting and estimates.
What Is the International Valuation Standards Council?
The International Standards Valuation Council (IVSC) is a global standard-setter for valuations. This not-for-profit organisation establishes and maintains standards on valuations, especially in the context of third-party stakeholders and investors.
Expert valuers employ various approaches and models during a valuation, and IVSC criteria may be a part of this process.
Conclusion
The income-based approach to business valuation has long played a crucial part in company strategy and decision-making for owners and investors.
There are numerous drivers to evaluate financial performance and growth prospects; income-based valuations are often the tool of choice to do this and help make informed decisions.
However, income-based valuations are both sophisticated and sensitive and require an experienced lawyers and experts to select the appropriate method based on the type of company, the reliability of data, and what is standard practice for that industry.
If you find yourself in a legal situation where you need to value a company accurately, contact Helix Law’s specialist commercial litigation team. Our team have dealt with (and are dealing with) unfair prejudice petitions involving all levels of companies; from those with turnover and assets of hundreds of thousands of pounds, to those with assets of tens of millions. We understand the court process and how to position you to maximise your position, and value. We understand how to create and use leverage to your advantage. We act for clients nationally and internationally. If you are involved in a commercial dispute or fear you might be, we are happy to assist you. You will find us approachable but direct, clear and transparent regarding costs, and above all else; incredibly effective.
