The Art of Business Valuation

CHAPTER 8Income Approaches

The income approach is the workhorse of the valuation profession. In the income approach, the estimated cash flow is divided by a capitalization rate in the capitalization of earnings method, or discount rate in the discounted cash flow method to estimate the value.¹ These are the two primary income methods.

The two primary income methods will be reviewed back and forth in steps throughout the chapter. This is because many of the steps have similarities and build on one another. We start with a discussion of some critical issues about the income method that only applies to very small businesses. Then we will look at estimating cash flows under the two approaches including tax affecting and other adjustments. Subsequently we will estimate a discount rate and follow with the further adjustments to estimate a capitalization rate. Next we will complete the capitalization of earnings estimate and then discuss a few variations of that method. Finally, we will complete the discounted cash flow estimate to determine the appraisal.

A complete calculation including estimating the cash flow, calculating the discount or capitalization rate, and then completing the estimates is shown in Figure 8.3 on p. 163 for the capitalization of earnings and in Figure 8.15 on p. 213 for the discounted cash flows method. Refer back to these frequently. In fact, if this material is new to you, it may be easiest to go to the website and review the related Excel files including ...