How Much Is My Business Worth? 2 Methods for Using the Valuation Income Approach

Comps valuation

IF you are an entrepreneur, you may wonder how you can accurately assess your company’s value. You are not alone in this. In the United States, there are about 26.5 million businesses. Most of these are small businesses. Nearly 99.7% of all of these companies employee fewer than 500 people. In fact, there are about 21 million companies in the country who list no employees at all. There are three methods most companies use to determine their actual value. You have the valuation income approach, the asset approach and the market approach.

The valuation income approach deals primarily with how much money the business is expected to make. This type of valuation is best suited for manufacturing companies, retail businesses or restaurants who have a definite cash flow. Basically, in this kind of business valuation analysis, you take the amount of money that the company is expected to take in and then calculate the actual earnings based on the current value of the dollar.

There are two ways to measure a company’s worth using the valuation income approach. The first is often referred to as the discounted cash flow or DCF. The second is the capitalization of earnings approach. The DCF approach is the kind of business appraisal valuation that relies on an estimation of the company’s earnings over a period of time, say five years. A person’s ability to accurately estimate how much the company will bring in is very crucial to this kind of analysis. This also needs to take into consideration any expenses that will occur during the same time period.

  1. Draw up your forecast for what you think the company will make over the time frame.
  2. Determine the terminal value, which is the value of the company during the last year of the analysis. As most of these analyses look at a company over five years, it will be the value of the business at the end of the fifth year.
  3. Determine the five year forecast value by using the correct discount rate.
  4. Determine the present value of the terminal value (the value at the end of the fifth year). This will be done with the appropriate capitalization rate.
  5. Take the two present day values and subtract any debt that has been incurred. The results will be the value of the business.

This is the better valuation income approach for companies that are expected to experience a large or rabid growth over the time period. The other way the valuation income approach is measured is by looking at the capitalization of earnings method. Businesses who expect to experience a more steady or subtle slope line growth are better served by using this method. The business valuation report from this method does not differentiate the earnings from year to year but assumes a stable and steady growth rate. After you have determined what your earnings will be, you use the appropriate discount rate to find the current value. That number represents the value of the company.

If you run both methods on your company, you should theoretically arrive at the same number. That will be the case if your company’s earnings rise at a predictable and steady rate over the time period you have set. Again, most companies do this for a five year interval. There are some drawbacks to that as most people assume their company will have a lifespan that exceeds five years.

Both methods do require you to have decent skills in forecasting how much your profits will be in the future. For many new companies the DCF is the more suitable valuation income approach to use when soliciting investments in the venture.

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