What is the income approach to business valuation?

CBV Institute’s glossary defines the income approach as a general manner of estimating the value of an asset, business or investment using one or more methods that convert expected economic income into a present amount. BDC lists income-based approaches under its earnings-based methods. This page explains what the approach looks at and where the named sources say it is used. It does not give a value, a rate or a range.

What the approach measures

The glossary defines economic income as monetary inflows or outflows from business activities, and gives cash flows, EBITDA and net income as examples. BDC quotes a chartered business valuator who says valuation is usually forward-looking: a buyer is not buying what the business earned in the past but what it will earn in the future, and historic results provide guidance but are not necessarily indicative of future results.

Two of the methods inside it

In the glossary, the capitalization of economic income method converts expected economic income for a representative single period into value by dividing by a capitalization rate. The discounted economic income method calculates the present value of expected economic income using a discount rate. The glossary places other methods within the income approach too, such as the cost savings method for intangible assets. BDC says capitalized cash flow is used when cash flow is expected to remain stable in future years, and discounted cash flow when cash flow is expected to fluctuate substantially, such as when a company is growing rapidly. For each in turn, see how the capitalized cash flow method values a business and how a discounted cash flow valuation works.

Where the sources point to it

BDC says earnings-based approaches are commonly used for businesses that generate reasonable profits and whose value is greater than that of their net assets alone. The CRA’s Information Circular 89-3, dated August 25, 1989, which outlines the valuation principles the CRA generally follows for closely-held corporations for income tax purposes, calls the earnings and asset value methods the two most generally accepted bases for determining value, and says the earnings method is of primary concern when valuing shares of operating companies that manufacture or market products or services. BDC adds that a valuator chooses the method, or combination of methods, best suited to the type of business and the information available.

What to ask the valuator

Ask which earnings were used and how they were adjusted. The glossary defines normalized earnings as economic income adjusted for extraordinary, nonrecurring, noneconomic or other unusual items, in order to eliminate anomalies and facilitate comparisons. Ask also what forecast the work rests on, and whether the valuator tested how reasonable the projections are, which BDC says a valuator may do.