Overview of Income-Based Approaches
Income based approaches value a business based upon the past, current, or expected future cash flows of the business and the risk that the business will not produce the desired return. Estimating and valuing flows of income is done through a process called capitalization. Capitalizing the income streams will produce a so-called present value. Risk is incorporated into this valuation through a discounting process. An applicable valuation formula will discount the present value of cash flows based upon the probability that the firm will not achieve the desired cash flows in the future. The discount rate uses many factors relevant to the individual firm that make the firm’s projections more or less likely. Below are multiple income-based valuation approaches.
Issues with Income-Based Valuation Methods Generally
Income-based valuation approaches depend on a number of criteria in valuing a firm, such as a capitalization rate, risk-related discount factors, and the projection of future cash flows. Capitalization rates are often determined from historical transactions, the market rate of return, and other indefinite factors. Discount factors are based largely upon the perception of risk and the identification of possible risk factors. Various methods, such as the build-up method and CAPM, take into consideration the systemic risk associated with investing in a firm. These methods, however, often do little to account for the firm-specific risk. The projection of future cash flows is very imprecise and rarely accurate due to the tenuous nature of startup operations. The usefulness of these projections is further distorted when they are discounted to present value.