The Income Approach is a common way to determine the value of a business. The focus is placed on the Company's earnings potential and not that of comparable companies. The various methods of the income approach require the conversion of a cash flow stream into the present single amount, at an appropriate rate, which would meet the requirements of a potential investor.
There are three common methods generally accepted in the income approach:
1. Discounted Cash Flow (DCF) Method
2. Capitalization of Earnings (Cash Flow) Method
3. Multi-Stage Growth Method
This method Is based on the theory that the total value of a business is the present value of its projected future earnings, plus the present value of the terminal value—a projection of the business's value at the end of a specified forecast period. This method requires that a terminal-value (sale price) assumption be made. The amounts of projected earnings and the sale price are discounted to the present using an appropriate discount rate, rather than a capitalization rate. This method may be used when a company expects a change in future capital expenditures (or revenue and expenses), anticipates high near-term growth rates to normalize at lower levels in the long term, and/or has a reliable income projection. Exploring different valuation methods provides a more comprehensive understanding of a company's worth.
The Discounted Cash Flow methodology evolves into a capitalization of earnings (i.e., cash flow) method when the expected future income streams are constant (i.e. a single period stream of benefits). The capitalization of earnings method is simply the procedure of converting a single period stream of future benefits into a value, factoring in long-term growth expectations. The difference is in where the long‐term growth rate is recognized and applied.
In the discounting process, the growth is included in the future stream of earnings. In the capitalization process, long‐term growth is recognized and applied through the capitalization rate.
The multi-stage growth method assumes that the short to mid-term growth of the company will differ from the long-term anticipated growth of the company. The company's future cash flow is projected at the industry’s forecasted growth rate as provided by Dun & Bradstreet’s First Research Reports.