5.9 Valuation methodology – income methods
Given that the income generated by a business can be expressed in many ways and given that the value of a business usually depends on its income generating potential, it is not surprising that there are several recognized income-based valuation methods.
The key to understanding income-based valuation methods is to recognize that the core value of the business is the product of two aspects of the business:
- Its income, expressed as one or more of net income, earnings before interest and tax (EBIT), earnings before interest, tax and depreciation (EBITDA), free cashflow or, in some cases, revenue. This represents the OPPORTUNITY in the business.
- A multiple or capitalization rate or discount rate. This represents the RISK in the business.
The most important issue in income-based valuation methods is to match the income, in the way it is expressed, with the appropriate multiple, cap rate, or discount rate.
The two most common income-based valuation methods are:
- The capitalized cashflow method, used mainly for mature and/or stable businesses with reasonably predictable cashflows; and
- The discounted cashflow method, used mainly for growing businesses (often requiring further, periodic investments) or those with a limited lifespan.
Refer to the sections that follow (5.10 and 5.11) for a more detailed look at the capitalized cashflow method and the discounted cashflow method.