How do income approach methods work?

In very simplified terms, the income approach is about

  • estimate future profits
  • discounting these profits
  • adding up the discounted profits

This gives the current value of the company according to the Income Approach. The discount rate takes into account the timing of the income in the future and the specific risk of the investment.

Different approaches to the income approach

There are different models within the Income Approach. These models differ in terms of the cash flows that are discounted. They also vary in terms of the discount rate used.




earnings value methods


simplified earnings value method

Discounted Cash Flow (DCF) method

residual value method

Multi-period dividend discounting



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 Income Appraisal Method











Earnings after interest and taxes (E) 500.000
capitalization rate (i) 10%


The yield value W E is calculated as:



W E =

E
i
=

500,000
0.10
 = 5,000,000


Where E is the profit after taxes and interest and i is the capitalization rate.


Advantages and disadvantages of this method


  • Simple application, easy to understand and implement


  • Forward-looking, focuses on the company's future earnings and profits, which is important for investors who want to evaluate future returns.


  • Common practice in the SME sector, as they have less complex corporate structures.


  • Accepted by tax authorities: This method is often accepted by tax authorities in Germany, for example, when it comes to valuation for tax purposes.


  • Well suited for companies in stable markets


  • A simple assumption is made about future earnings; the complexity of a company and its market environment cannot always be fully reflected.


  • Risks of the company or possible market fluctuations are neglected


  • For companies with highly fluctuating or rapidly growing earnings, this method is too rigid and inaccurate.


  • Miscalculations in earnings forecasts and the discount rate can lead to incorrect results.

Discounted Cash Flow (DCF) method

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 Discounted Cash Flow (DCF) method


Free Cash Flow (FCF) for the next 3 years















forecast year 1 forecast year 2 forecast year 3
Free Cash Flow (FCF) 300.000 330.000 360.000

Calculation of Discounted Cash Flows and Terminal Value


Discount rate (r) = 10%


Terminal growth rate (g) = 2%




DCF 1 =

FCF 1
(1 + r) 1
=

300,000
1.10
 = 272,727



DCF 2 =

FCF 2
(1 + r) 2
=

330,000
(1.10)2
 =

330,000
1.21
 = 272,727



DCF 3 =

FCF 3
(1 + r) 3
=

360,000
(1.10)3
 =

360,000
1.33
 = 270,676


Calculation of the terminal value (TV)


The terminal value is calculated as:



TV =

FCF 3 Γ— (1 + g)
r – g
=

360,000 Γ— 1.02
0.10 – 0.02
 = 4,590,000


The terminal value is then also discounted:



DCF TV =

4,590,000
(1 + r) 3
=

4,590,000
1.33
 = 3,451,128


Total Business Value (EV)



EV = Total DCF + DCF TV = 272.727 + 272.727 + 270.676 + 3,451.128 = 4,267.258


Calculation of Equity Value


The equity value is calculated by subtracting net debt from the business value:



Equity value = EV – debt + cash


Suppose the company has 500,000 in debt and 200,000 in cash:



Equity value = 4,267,258 – 500,000 + 200,000 = 3,967,258


The equity value is therefore 3,967,258.


Advantages and disadvantages of this method


  • If the assumptions are realistic, the DCF method offers a relatively objective and well-founded business valuation.


  • Taking future revenue streams into account is particularly useful for high-growth companies.


  • Focused on long-term (future) developments


  • The assumption of an unlimited lifespan of companies is hardly realistic.


  • Valuation is based on assumptions rather than facts and is therefore uncertain.


  • The calculation is complicated and requires many assumptions; small changes in the assumptions (e.g. growth rates, discount rates) can lead to significant differences in the result.


  • Not suitable for companies with fluctuating cash flow

Residual value method

Approach : This method focuses on residual profit , which is profits less the cost of equity. It directly calculates the equity value by adding the current book value of equity and the discounted future residual earnings.

What is discounted : The cash flows for an explicit forecast period and additionally the residual value applied for the subsequent 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 Residual Value Method



Example calculation: Business valuation using the residual value method

Example calculation: Company valuation using the residual value method


assumptions



  • Discount rate (π‘Ÿβ‚‘): 8%

  • Initial book value of equity (𝐡₀): €1,000,000

  • Net result in the first year (𝑁𝐼₁): €150,000

  • Forecast period: 3 years

  • Growth rate (𝑔): 2%


calculations


1. Projected net results and book values





















Year 1 year 2 year 3
net result (𝑁𝐼) 150.000 € 153.000 € 156.060 €
book value of equity (𝐡) 1.150.000 € 1.303.000 € 1.459.060 €

2. Calculation of residual profits















Year 1 year 2 year 3
residual profit (𝑅𝐼) 70.000 € 61.000 € 51.820 €

3. Present value of residual profits





















Year 1 year 2 year 3
present value factor 1.08 1.1664 1.259712
present value of the residual profit 64.815 € 52.293 € 41.145 €

4. Calculation of the terminal value



  • Growing residual profit in year 4: 𝑅𝐼₄ = 𝑅𝐼₃ Γ— (1 + 𝑔) = €51,820 Γ— 1.02 = €52,856

  • Terminal value at the end of year 3: TV = 𝑅𝐼₄ / (π‘Ÿβ‚‘ – 𝑔) = 52,856 € / (0.08 – 0.02) = 880,940 €

  • Present value of the terminal value: PV(TV) = €880,940 / 1.259712 = €699,632


5. Total value of the company



  • Sum of the present values of the residual profits: €64,815 + €52,293 + €41,145 = €158,253

  • Total present value of residual profits including terminal value: €158,253 + €699,632 = €857,885

  • Enterprise value (𝑉₀): 𝐡₀ + total present value of residual profits = €1,000,000 + €857,885 = €1,857,885


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 29.00.

Example Multi-Period Dividend Discounting




Multi-year dividend discounting

Example: Multi-year dividend discounting


Dividend forecast for the next 3 years























Year Dividend (in €)
Year 1 1.00
year 2 1.20
year 3 1.40
From year 4 (constant dividend) 1.50

Calculation of discounted dividends


Cost of equity (r) = 5% or 0.05




D 1 =

Dividend 1
(1 + r) 1
=

1,00
1.05
 = 0,952 €



D 2 =

Dividend 2
(1 + r) 2
=

1,20
(1.05)2
 =

1,20
1.1025
 = 1,088 €



D 3 =

Dividend 3
(1 + r) 3
=

1,40
(1.05)3
 =

1,40
1.157625
 = 1,209 €


Calculation of the terminal value (from year 4)


The terminal value (TV) is calculated using the Gordon Growth formula:



TV =

Dividend 4
r
=

1,50
0.05
 = 30,00 €


The terminal value must also be discounted:



Discounted terminal value =

TV
(1 + r) 3
=

30,00
1.157625
 = 25,91 €


Total share value (sum of discounted dividends)



Stock value = D 1 + D 2 + D 3 + Discounted terminal value



Share value = 0.952 + 1.088 + 1.209 + 25.91 = €29.16


The calculated share value is therefore €29.16.


Advantages and disadvantages of this method


  • simplicity and clarity


  • A procedure recognized in the financial world


  • Offers a systematic and theoretically sound approach


  • Provides valuable insights for investors who want to focus on stable companies


  • Depending on assumptions about future dividends and the discount rate


  • Other value-enhancing factors that are not reflected in the dividend, such as high customer loyalty, unique intellectual property rights and know-how, are not taken into account.

Income 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 Earned Income Methods 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:

Europe

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.

North America

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.

Oceania

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.

Overview of the most important methods for company valuation