- Asset based approach
- Market based approach
- Income based approach
This blog will focus on the income based approach due to its wide application. But, keep in mind, a thorough valuation will include all three approaches even though the weight given to each may differ in arriving at the final opinion of value.
Income Based Business Valuation
The benefits of owning a business are normally based on the estimated future benefits and form the basis of the business value. Two income based approaches often used to estimate the future benefits are Capitalized Returns and Discounted Future Returns. If historic returns are indicative of the future benefits, then capitalizing those historic returns is a good approach. However, the future returns are often expected to differ from the historic returns. If so, using a discount of the future returns is more appropriate in such cases.
Returns = Earnings or Cash Flow?
As discussed above, the returns to be Capitalized or Discounted can be either earnings or cash flow. Earnings are usually easier for the Court to understand. They can be used if there is a consistent relationship between earnings and cash flow. If not, then cash flow should be used. Notably, the calculation needed to arrive at cash flow depends on reliable financial data. (See earlier Blog “How Good is That Business Valuation”).
Either approach and either method of measuring returns can be appropriate depending on the circumstances. It is most important to understand the choices made by the business appraiser and why those choices were made. Relying on only one approach, using an inappropriate return method, or capitalizing when you should be discounting can produce questionable results.
Steve Walker is a certified public account whose practice focuses on the financial end of family law matters. His practice is located in North Texas serving clients in Collin, Dallas and Denton Counties.