When Should an Income Approach be Used to Value a Business?

There are three generally accepted approaches for valuations – market, income, and cost. The framework for these methods are provided in the International Valuation Standards (“IVS”). In this article, we will take a close look at when the income approach should be used to value a business.

The Definition

IVS 40.1 defines the Income Approach as follows:

The income approach provides an indication of value by converting future cash flow to a single current value. Under the income approach, the value of an asset is determined by reference to the value of income, cash flow or cost savings generated by the asset.

The income approach is therefore forward looking in that it looks towards a business’s future cash flow generating ability. IVS 40.2 then follows on to provide guidance on when the approach can be used:

Purpose of Income Approach

The income approach should be applied and afforded significant weight under the following circumstances:

  1. the income-producing ability of the asset is the critical element affecting value from a participant perspective, and/or
  2. reasonable projections of the amount and timing of future income are available for the subject asset, but there are few, if any, relevant market comparables.

In most situations, the purpose of a business is to return profits to shareholders. As such, the income approach is a viable method for calculating the value of a business. The income approach also becomes very useful where there is no publicly available information in the market which could be used to estimate the value of the business.

Application of Income Approach

Examples of when an Income Approach would be suitable to value your business include where there is:

  • Profitability in the business in that it is not loss making and has cash inflows which are larger than cash outflows.
  • Certainty of future revenue streams from secured contracts or there is a known demand for products/services such that a reliable cash flow forecast can be created.
  • Consistency in earnings manifesting reliability of the business’s future maintainable earnings.
  • Lack of industry data available with regards to historical sales for similar businesses for comparison.

Find Out More

Groves & Partners are expert business valuers with significant experience in applying the income approach to value a business.

Our team of business valuers include Chartered Accountants, Registered Business Valuers and Certified Minority Interest Valuers. To find out more about our business valuation services please phone us on 1300 892 717 (+61 2 7208 7970) or email info@groves.com.au.

Written by Abhay Singh