9029 / What is the income valuation approach that is used in valuing closely-held business interests?

The income approach to valuing closely-held business interests is primarily based on an estimation of future earnings capacity. The first step in the process of calculating future earnings is to obtain any financial plans prepared by the company. The next step is to project the company’s cash flow for a minimum of five years. These projections should be based on information about the recent past, including the company’s profit-and-loss statements. Company sales and income are also frequently used to predict future cash flow.

In cases where the company has an erratic history of sales and earnings, the process may become more complex. In these situations, the reason behind the irregular financial past must be determined. An important element in this analysis involves determining whether the company is operating in a cyclical industry prone to yearly swings in sales and income. If so, other industry firms can be expected to show similar cyclical behavior. Recognizing an industry cycle should provide clues to future financial performance.

If the industry is non-cyclical, firm records must be reviewed to determine the specific reasons or events that caused the erratic history. Questions to ask include:

(1)     Does the company face heavy debt and/or potentially substantial litigation costs?

(2)     Is management lacking in experience or depth?

(3)     Have products not been brought to market in a timely manner?

(4)     Has growth been too rapid?

(5)     Was expansion poorly planned?

A problem in any of these areas may signal problems in the future as well.

When predicting cash flow, the standard practice is to forecast five years into the future and discount each year’s cash flow back to present value, by using a market-indicated rate of return. Risks faced generally by the industry in which the company operates should also be factored into this equation. The fifth year value of the company must be estimated by capitalizing the fifth-year cash flow, using an appropriate rate of return that considers both company and industry risk. The fifth year value is translated into present value by using a discount rate derived from the market rate.

The sum of the discounted cash flows for five years and the present value of the capitalized fifth year results in the fair market value of the company under this valuation approach.