Understanding the Income Approach
Forecasting Errors
One of the common pitfalls in applying the income approach is committing forecasting errors. To understand the impact of this error, this article discusses the importance of the income approach in business valuations and areas that require careful evaluation.
One of the common pitfalls in applying the income approach is committing forecasting errors. To understand the impact of this error, let us first discuss the importance of the income approach in business valuations.
Unlike the asset-based approaches, which primarily focus on the value of a company’s tangible assets, the income approach considers the earning potential of the business. This is particularly relevant for service-oriented businesses or those with significant intangible assets. The income approach is forward-looking, considering the expected future cash flow generated by the business. This reflects the inherent value of the business in terms of its ability to generate profits over time. By evaluating future income streams, the income approach captures market expectations and investor sentiment regarding the company’s performance and growth potential. By considering the entirety of the business’s income-generating capabilities, including both operational earnings and non-operational income streams, the income approach provides a comprehensive view of the business’s value.
The income approach integrates three critical components: projected cash flow, risk, and growth.
- Cash Flows represent the actual or projected earnings generated by the business over a specific period. These cash flows can be either distributable cash flows available to investors (such as dividends for equity investors or net income for all stakeholders) or cash flows available for the business to reinvest in its operations (such as retained earnings for growth). The income approach evaluates these cash flows to determine the present value of the business.
- Risk (i.e., Discount Rate) refers to the uncertainty associated with achieving the projected cash flows. Several factors contribute to this risk, including: market conditions, competition, operational risks, financial risks, and macroeconomic factors. Valuation methods under the income approach typically incorporate a risk adjustment to discount future cash flows to their present value, reflecting the level of risk associated with the business’s operations.
- Growth represents the expected increase in future cash flows generated by the business. This growth can stem from factors such as expanding market opportunities, introducing new products or services, increasing market share, or improving operational efficiency. Evaluating the growth potential of the business is essential for estimating future cash flows and determining its value under the income approach.
If an assumption does not impact one of these three components, then there is no impact to the operating value of the subject entity.
Forecasting errors are split into two classes: internal and external factors.
Internal Factors: One of the primary pitfalls in applying the income approach is the tendency to rely on overly optimistic financial projections. Businesses may forecast aggressive growth rates or inflated revenue figures without considering realistic market conditions or operational constraints. We typically see this from owners looking to sell their interests to boost any potential proceeds.
As a reminder, the income approach is a forward-looking approach, considering expected earnings of the business into perpetuity. As such, it is imperative to consider sustainable growth when applying this methodology.
Management may also provide overly pessimistic projections, especially when the party is in a divorce proceeding. By presenting pessimistic projections, the owner might aim to reduce the perceived value of the business. In divorce settlements, the value of marital assets, including businesses, often plays a significant role in determining equitable distribution. Pessimistic projections can potentially lower the valuation of the business, thereby reducing the financial settlement paid to the other party.
External Factors: Forecasting errors often occur when businesses fail to account for external factors such as changes in industry regulations, economic downturns, or shifts in consumer preferences; all of which can introduce uncertainties that impact future cash flows, making accurate forecasting challenging.
An example of external influences would be retail stores and the growth of e-commerce platforms. Companies relying on brick-and-mortar sales may overlook the increasing shift towards online shopping preferences among consumers. Forecasts should analyze e-commerce penetration rates and consumer adoption trends to gauge the potential impact on future revenue streams and market competitiveness.
One method to help mitigate these forecasting errors is to develop sensitivity analyses, whereby critical assumptions, or variables, such as growth rates, discount rates, and profit margins, are tested for their impacts on the indication of value. Additionally, management may develop multiple scenarios based on different assumptions and outcomes.
Incorporating sensitivity analyses enhances the credibility and transparency of the valuation process by demonstrating thorough analysis and consideration of several factors affecting the business’s future performance.
Steven Williams, CPA, ABV, CFF, CVA, has a decade of public accounting experience, including business valuation procedures and reporting, tax return preparation, audit procedures and reporting, and financial statement preparation. He currently specializes in the preparation of detailed and summary valuation reports to assist clients in estate and gift tax reporting, business and corporate planning, marital dissolution, and litigation support, focusing on serving small privately-held businesses and their owners.
