Business valuation methods under the income approach feature prominently in professional business appraisals. These business valuation techniques work because you can determine your business value accurately based on two important factors: business earnings and risk.
There are three key assumptions that help make your income-based business valuations highly relevant and accurate:
- Business people have alternative investment opportunities.
- All business investments have different earning potential and risk profiles.
- Business value depends on the amount, timing and risk of earnings received from each investment.
Company value is affected by available alternatives
Business people have more investment opportunities than resources available. Ask a seasoned business broker and you will hear about a number of businesses for sale. Venture capitalists may receive thousands of business plans each year. While each business is unique, there are many business owners and buyers active in the market place.
Hence, each business must compete for the limited investment capital by demonstrating attractive earnings while minimizing the risk. This investment capital takes the form of business owners’ investment in their own business.
Business value depends on each firm’s risk and return profile
No two businesses ever look the same. A young company has different earnings growth prospects than an established firm. Companies in the same industry may differ in the ways they do business, the levels of capital investment, and the value of their customer base.
The Discounted Cash Flow business valuation enables you to compare these different businesses by calculating the so-called Present Value. This establishes the business value of each firm based on the risk and return that the business can produce.
Business value is affected by the amount and timing of business earnings
The risk of realizing these earnings in full measure and in the time frame you expect also differs from company to company. The Discounted Cash Flow business valuation shows its true strength here. It adjusts for the timing and amounts of your cash flows directly.
Discount rate to capture business risk
In addition, the discount rate captures your company’s risk. The Discounted Cash Flow math works to put greater weight on the more recent business cash flow projections. This improves the accuracy of this business valuation method because more immediate income forecasts tend to be more accurate.
What this means is that, by using the income-based business valuation methods, we can determine the business value of each company based on its unique investment profile.