Business Valuation for Transition – Income Approach

Preface: “Science has not yet mastered prophecy. We predict too much for the next year and yet far too little for the next 10.” –Neil Armstrong

Business Valuation for Transition – Income Approach

Further to the prophecy attribute of business valuation, we further consider the income approach to business valuation. This approach is a multi-factor approach that converts expected future economic benefits into a business valuation estimate based on historical financial precedents. Although a host of methods and valuation models are available for the income approach to valuation, often they include either a capitalization of normalized earnings and free cash or discounted cash flows. The Treasury Method of capitalizing excess earnings is a less frequently applied income approach to valuation.

For the income approach to accurately represent a reasonable estimate of business value with the capitalization method, a valuation analyst must first normalize and perhaps appropriately weight the “historical” earnings of a business. This can include normalized owner’s compensation, normalized rents, normalized wages, depreciation normalization, normalization of extraordinary gains or losses, and discretionary items including charitable contributions, travel, etc.

Weighted earnings approaches to income normalization typically represent a more moderate estimate of cash flows and smoothed effect on capitalized earnings. For instance, a valuation estimate that includes consideration of only one year of earnings is usually subject to extreme variables in value. Typically valuations of successful businesses will look at five (5) years of weighted earnings, providing a more realistic expectation of future estimated income and cash flows.

Additionally, there is much more than simply capitalizing weighted earnings or discounting expected future cash flows or earnings for a realistic estimate of value with the income method. When valuing a business for purposes of equity percentages, a valuation analyst always analyzes the working capital and cashflows. For instance, analyzing only the balance sheet with an asset approach valuation omits the dividends and return on investment equation of an investment grade asset.

Analyzing only the income statement omits the free cashflows required for debt service and working capital needs including cash overdraft concerns. A small business with say substantial cash overdrafts during seasonal inventory peaks or sales troughs will also require a valuator to analyze more than annual normalized earnings. An example would include a business needing 70% of current earnings cash flows to finance the balance sheet build and debt service (risks with cash overdrafts), then after taxes are paid there will be minimal distributions to finance any indebtedness on an equity interest purchased. A novice buyer who omits appropriate valuation analysis in such will achieve the proverbial coal miner’s lyrics “You shovel sixteen tons, and what do you get? Another day older and deeper in debt”.

Novice approaches to valuation including simple multiples of earnings for goodwill and rules of thumb on equity valuation will ultimately result in variable failures of expectations for the impulsive. If the impulsive is a seller, missed expectations can lead to a bargain for the buyer and a forfeited upside on a realistic ROI. Often in that instance, the concerns are less problematic because the seller never realizes what is forfeited in value, while the buyer reaps substantial ROI. More concerning for a buyer, it is much more problematic when expectations fail – missed payments on debt-financed acquisition costs or cash flow shortages. When combined with personal guarantees the stakes are high. The definition of bankruptcy is as real and unchanged (as of today) as it was in the days of the Charles Dickens novels.

To summarize: As in any profession, retaining the expertise of a highly skilled and trusted advisor, say valuation analyst in this regard, is not just good advice. It is sage advice. Listening to the prepared testimony (prophecy) of an experienced valuation analyst’s opinion is highly advised for any transition plan. If you or a fellow business friend are planning or preparing to plan a transition of your business whether, in whole or in part, you are advised to retain the services of a trusted (unbiased and objective) valuation analyst. Beginning a business transition with the right expectations (i.e. a great valuation prophecy) will make the pathway easier and smoother for all parties.

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