The income approach is based on the philosophy that the value of a company is determined by its future earnings. It reflects the forward-looking view of investors and values a company based on the present value of its expected cash flows.
The returns are discounted. The discount rate reflects not only the time preference for money, but also the specific risk of the investment. It represents the expected return that investors demand to compensate for the risk of future cash flows and determine present value.
There are different models within the income value method. These models differ in terms of the cash flows that are discounted. They also vary in terms of the discount rate used.
Simplified income method
Approach : This method assumes consistent, constant cash flows and is ideal for companies with a stable earnings situation.
What is discounted : A representative, normalized annual net profit.
How to discount : With a capitalization rate that reflects the company’s risk and the market’s expectations of return.
Example : Annual surplus of 120,000 discounted with a capitalization interest rate of 10% results in an income value of 1,200,000.
Discounted Cash Flow (DCF)
Approach : The DCF approach predicts future cash flows, which may vary, making it suitable for companies whose earnings change over time.
What is being discounted : Estimated future cash flows over a specific forecast period.
How to discount Using the Weighted Average Cost of Capital (WACC), which reflects the average cost of capital employed.
Example : Cash flows of 50,000, 70,000, 90,000 and 110,000 over four years with a WACC of 8% result in a present value of approximately 269,000.
Residual value method
Approach : This model is applied when forecasting future cash flows up to a certain point in time and assuming a permanent value thereafter.
What is discounted : The cash flows for an explicit forecast period plus a residual value applied after this period.
How to discount : Here too, the WACC is often used to discount both the cash flows and the residual value to today’s value.
Example : Cash flows of 100,000 annually for 5 years and a residual value of 500,000 discounted with a WACC of 8% give a total value of approximately 700,000.
Multi-period dividend discounting
Approach : This approach is suitable for companies whose dividends vary over time, especially for listed companies.
What is being discounted : Projected dividend payments, which may change over different periods.
How to discount : Using the cost of equity, usually calculated using the Capital Asset Pricing Model (CAPM) to reflect the risk of the stock.
Example : Dividends of 1.00, 1.20, 1.40 over three years and an expected constant dividend of 1.50 thereafter, with a cost of equity of 5%, result in a value per share of approximately 27.00.
Earned value methods compared to other methods
The income method focuses on future cash flow and is therefore future-oriented. It is particularly valuable when it comes to assessing the growth potential and sustainable profitability of a company.
In contrast to this is the intrinsic value method , which measures the value of a company based on its current assets minus liabilities. This method is often relevant when valuing asset-intensive companies or in liquidation scenarios.
The comparative value method , on the other hand, uses market data to determine the company’s value and draws comparisons to similar companies that have recently been sold. This method depends heavily on the availability and comparability of market data. (Here NIMBO offers a company valuation calculator , which is based on current market data for respective countries).
The real options method looks at a company from the perspective of future strategic options and is particularly applicable in industries with high uncertainty and rapid change.
Finally, the liquidation value approach estimates the amount that owners would receive in the event of a business dissolution. This approach is often used when companies are facing closure and has a strong focus on the present.
Each of these methods offers a different perspective on the value of a company and can be chosen depending on the specific context and objective of the valuation.
The income value method in an international context
The application of the income approach and its models is influenced by local valuation practices and regulatory frameworks. A look at the practices in different countries shows how diverse these approaches can be:
In Germany, the simplified income method is a preferred method that is particularly used in the valuation of medium-sized companies. This approach is supported by the standards of the Institute of Public Accountants. Similar valuation methodologies are used in Italy , Spain and Poland , with local GAAP and European Union guidelines influencing specific valuation practices. The DCF method is also widespread in these countries, especially among larger, internationally operating companies.
In Switzerland and the Netherlands , with their highly internationally oriented economies, the DCF approach, which is familiar to international investors and is in line with IFRS, often dominates. In Sweden and Norway there is also a strong preference for the DCF, due to the transparency of the Nordic markets and the dominance of IFRS.
The UK follows similar valuation standards to the US, with a strong bias towards the DCF approach. This is facilitated by a market-oriented perspective and the availability of detailed financial information.
In the United States and Canada , DCF is the dominant method, supported by the preference for shareholder value and mature capital markets. US GAAP and Canadian GAAP provide a firm framework for cash flow forecasting and valuation.
Africa and Middle East
In South Africa , the income approach is also used, although the specific choice of model depends on the size and sector of the company. Due to the economic dynamism and volatility in some African markets, the simplified income approach may be appropriate to mitigate valuation risk here.
In the United Arab Emirates , where the real estate market plays a major role, the simplified income method is particularly common in real estate valuation, while in the corporate sector the DCF is preferred to appeal to international investors.
In Australia , with a developed capital market and a strong focus on international investors, the DCF is the dominant method, supported by the application of IFRS.
In summary, in developed markets with strong international exposure and easily accessible financial information, DCF is the dominant method. In markets that are characterized by a stronger focus on medium-sized businesses and local investments, the simplified income method is used more frequently. The specific models used in each country reflect the needs of local and international investors and depend on the respective regulatory and market conditions.