Using the income approach to value a business can seem straightforward on paper. The process seems simple: estimate future earnings and then apply a risk-based discount rate to calculate present value. Unfortunately, it is much more complex than this and one little misstep can significantly divert numbers and can lead to values that don’t hold up in planning negotiations or litigation. Experienced valuation professionals know how to avoid these common pitfalls listed below.
1. Mismatching Earnings & Discount Rates
The subject company’s “earnings” can take many forms. Examples include earnings before tax, cash flow available to equity investors, and cash flow available to equity and debt investors. Likewise, discount rates can take many forms. Examples include the cost of equity or the weighted average cost of capital (WACC). The WACC blends the cost of equity with the cost of debt, based on assumptions about the company’s capital structure.
Errors may happen when the subject company’s projected earnings are matched to the incorrect discount rate. For example, equity cash flows should be matched with the cost of equity, not the WACC. The cost of equity will be higher than the WACC. So, if equity cash flows are discounted using the WACC, the business interest will likely be overvalued. In addition, pre-tax earnings streams shouldn’t be discounted using an after-tax cost of capital (or vice versa).
2. Adjusting (Or Not Adjusting) Historical Earnings
The underlying assumptions for most earnings projections are based, to some extent, on historical earnings. When valuing a business using the income approach, projections based on past performance may need to be adjusted for various reasons, such as:
- To reflect standard industry accounting practices,
- For nonrecurring income or losses, or
- For related-party transactions.
The appropriate adjustments may vary depending on the degree of control that the business interest possesses. For instance, adjustments for compensation or rent paid to related parties may not necessarily be appropriate when valuing a business interest that lacks the control to change these payments. Adjustments may also be needed to align the subject company’s earnings with those generated by comparable public companies used to derive the discount rate.
Errors typically occur when the person valuing the business interest 1) fails to consider control issues, or 2) overlooks adjustments needed to reflect how much earnings a hypothetical buyer would expect the business to generate in the future.
3. Making Unrealistic Assumptions
Typically, the income approach assumes that the subject company’s earnings will grow indefinitely. At some point, however, the company’s existing assets (such as a factory or piece of equipment) will be at full capacity, and the company will need to purchase additional assets to meet its earnings projections.
Another common assumption is that annual depreciation expense will approximate the need to update fixed assets. This might not necessarily be true when the company is operating near or at its capacity limit. Management also may need to take on additional debt to achieve its projected earnings, which could alter the company’s capital structure.
Likewise, when valuing a high-growth business, such as a start-up venture or a high-tech firm, management may expect to grow at 10% (or higher) each year. But no business can realistically expand at such a pace forever. Competitors and substitute products are likely to enter the marketplace and eventually slow down the pace of growth.
So, before discounting projected earnings, an experienced valuation pro will evaluate whether management’s projections seem reasonable over the long run. Oversimplified projections can lead to valuation errors.
Qualifications Count
These pitfalls show why business valuation isn’t a do-it-yourself exercise. Hiring a credentialed valuation expert can mean the difference between a report that withstands scrutiny and one that unravels under cross-examination — or leads to misguided business decisions when using the income approach. Contact us to discuss how our valuation pros can help you get it right.