Valuation Approaches

The Income Approach to Business Valuation

What is the present value of the cash this business is expected to generate?

The income approach values a business on the earnings or cash flow it is expected to generate. The two methods are capitalisation of future maintainable earnings, which divides a single sustainable earnings figure by a capitalisation rate, and discounted cash flow, which forecasts cash flow year by year and discounts it to present value.

Methods

The methods under the Income Approach

Capitalisation of future maintainable earnings

A single sustainable earnings figure is divided by a capitalisation rate, which is the discount rate less sustainable long-term growth. This suits stable, mature businesses where one year of normalised earnings fairly represents the future.

Discounted cash flow

Cash flows are forecast year by year, each is discounted to present value, and a terminal value is added. This suits businesses with a forecastable change in trajectory: growth, a turnaround, a contract rolling off, or a site opening.

Detail

The discount rate, built up rather than assumed

A discount rate is not selected from a table. It is built from layers, each of which compensates for a risk the reader can recognise: a risk-free rate taken from long-dated Australian Government bond yields (Source: RBA, Statistical Tables F2 Capital Market Yields), an equity risk premium for owning a business rather than a bond, a size premium because smaller companies are riskier than listed ones, an industry risk premium for the sector's own cyclicality and regulation, and a company-specific loading for customer concentration, key person dependence, record quality and geography.

Summing those layers gives a cost of equity. Where the business is valued on invested capital, that is blended with the after-tax cost of debt to produce a weighted average cost of capital. The capitalisation rate is then the discount rate less sustainable long-term growth.

When it leads

Where the Income Approach leads

Established trading businesses with reliable earnings: medical, dental and allied health practices, accounting and legal firms, trades and services businesses, franchises, recurring-revenue software, and transport operators with genuinely contracted work.

A defensible valuation considers all three approaches, applies the ones that fit, and explains why the others were given little or no weight. A detailed report sets that reconciliation out in full.

Medical and specialist practices General practice, specialist rooms and day surgeries across the Sydney health precincts. Dental practices Single and multi-surgery practices, from suburban general dentistry to CBD specialist rooms. Accounting, advisory and law firms Fee-based professional firms where recurring work and client retention carry the value. SaaS and IT services Recurring-revenue software and managed IT businesses across the Sydney tech corridor. Aged care and disability support Home care, supported independent living and NDIS support providers across Greater Sydney. Marketing and creative agencies Digital, media and creative agencies where retainers and client tenure carry the value. Architecture and engineering consultancies Design, structural and civil consultancies working off a fee pipeline rather than a fee base. Mortgage and insurance broking Trail and renewal commission books, valued as an annuity rather than on new business written. Specialist trade contracting Electrical, plumbing, HVAC and fire services businesses with contracted maintenance work.
Questions

Income Approach questions

The income approach values a business on the earnings or cash flow it is expected to generate. A sustainable earnings figure is either divided by a capitalisation rate, or forecast year by year and discounted to present value. It is the approach that best reflects how a buyer of an established trading business actually thinks.
Capitalisation of earnings uses one sustainable earnings figure and divides it by a capitalisation rate, which suits a stable, mature business. A discounted cash flow forecasts each year separately and adds a terminal value, which suits a business whose trajectory is changing, such as one opening a site, absorbing an acquisition or facing a contract expiry.
The discount rate is built up in layers rather than selected from a table. It starts with a risk-free rate taken from long-dated Australian Government bond yields, then adds an equity risk premium, a size premium, an industry risk premium and a company-specific loading for factors such as customer concentration, key person dependence and the quality of the records.
A capitalisation rate is the discount rate less sustainable long-term growth. It converts a single year of maintainable earnings into a value, and it is the inverse of the earnings multiple, so a capitalisation rate of 25 per cent is the same as a multiple of four.
Businesses with reliable recurring earnings. On this site that includes medical, dental and aged care or disability providers, accounting, advisory and law firms, marketing and engineering consultancies, mortgage and insurance broking, SaaS and IT services, and specialist trade contracting with maintenance contracts.
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The other two approaches

Approach The Market Approach Approach The Asset Approach All industries Browse the full Sydney list
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