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FAIR VALUE
TM

Reprinted from Volume XIV, Number 2 Summer 2005

THE INCOME VALUATION APPROACH

(THE BASICS FOR ATTORNEYS AND JUDGES)

By: George B. Hawkins, ASA, CFA method, looks at the actual past results of the company as
Managing Director an indicator of its expected future results. It then
converts these earnings into an estimate of value using a
Introduction capitalization rate. This article provides examples of each
In determining the price to pay for a company, a valuation method and explain the mechanics of the
buyer of a business ultimately looks to the return he or various calculations and their implications to value.
she will receive on his or her Finally, the article examines how to determine
investment. That return might come in the appropriate income valuation method to use in
the form of annual dividends, growth in particular situations. These include:
the value of the business over time (as
eventually realized by a sale at some � Rapidly growing companies
future point in time), or some � Cyclical companies
combination of the two. The � Start-up companies
quantification of the value, in today’s � Mature companies
George Hawkins dollars, of these expected future sources � Synergistic acquisitions
of return is at the essence of business valuation and the � Companies with multiple business lines
income valuation approach. Attorneys who deal with � Contracts or joint ventures with finite lives
valuations for any reason, including for estates and gifts, � Liquidation
divorce, litigation, health care ventures and in business � Size of the company and the sophistication of
transactions should at least have a basic understanding of typical buyers and sellers
the income approach. This is required in order to � Purpose of the valuation- including equitable
intelligently critique a valuation where it is used and to distribution, health care transactions involving
ask questions of and/or cross-examine valuation experts hospitals, and bankruptcy
or examine the reasonableness of a proposed transaction
price. Valuation Methods Within the Income Approach-
This article begins with an overview of the two An Overview
primary ways of using the income valuation approach. The concept of the time value of money is at the
The first, the discounted future income method, involves core of the income valuation approach. Namely, the
forecasting a company’s “income” streams (e.g., earnings income streams or cash flows the buyer of the business
or cash flow) on a year-by-year basis, and then converting anticipates he or she will receive in the future can be
these results into their present worth today based on the translated into their present worth by taking into account
investor’s required annual rate of return for taking the their risk. This risk is expressed as the investor’s
associated risk. The second, the capitalization of earnings required rate of return, also called a discount rate.

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INCOME APPROACH (continued)
Two widely used techniques to value a with uncertainty in two ways. First, the greater the
company’s anticipated future income streams are the uncertainty, the higher the discount rate used, resulting in
discounted future income and capitalization of earnings a lower present value for the forecasted future results.
methods. Each method attacks the issue of “income” Second, since it is difficult to reliably predict beyond five
from a different vantage point. The discounted future or seven years in a forecast, many valuators will only
income method looks to the future by making annual forecast year-by-year results for that time period. Then,
forecasts of a company’s earnings and cash flows and for the final year, a simplifying assumption is made that
then uses present value techniques to convert these the final year’s earnings (or cash flow) will continue to
estimates into a value of the business today. Meanwhile, grow in the future at some assumed constant long-term,
the capitalization of income method looks to the actual annual sustainable rate of growth. Unless a company is
historic results of the company as an indicator of its expected to go out of business, most businesses have a
results in the future. This technique typically involves continuing life into the future beyond the final forecast
dividing a company’s annual historic earnings by a year. Therefore, using other techniques that will be
“capitalization rate” which incorporates risk (the discount discussed later, this continuing income stream can itself
rate) and a factor for the expected future annual growth of be “capitalized” into an estimate of value.
these earnings. The measure of “income” that is Therefore, the discounted projected future
capitalized most frequently is the after-tax income of the income method involves projecting a company’s
business, although the approach can also be used with anticipated future income streams (e.g., earnings or cash
pre-tax earnings, earnings before interest and taxes, flow) on a year-by-year basis into the future, usually for
measures of cash flow, and other measures that will be five or seven years. Each of these future annual income
discussed. streams are then discounted back to their present worth
Each of these methods will be explained in detail, today at an appropriate discount rate (required rate of
beginning with the discounted future income technique, return on investment for risk) required by a buyer. At the
followed by the capitalization method. The basics of final projection year a “terminal value” is determined that
each method will be discussed and examples of each will represents the estimated value of the sale of the company
be presented. at that time. This sale value is based on the capitalized
value of the company’s future income stream from that
Discounted Future Income Method Explained point onward. In other words, if the business were sold in
in General the final forecast year based on its earnings or cash flow,
In its purest form, valuation theory says that the this terminal value is what would be received at that point
value of any business is simply the present value of all of in time.
its anticipated future income streams. If the valuator had This terminal value (which is to be received five
a perfect crystal ball he or she could forecast a company’s or seven years hence) is then discounted back (at the
future year-by-year results into perpetuity (or for the discount rate) to its present value today. The summation
finite life of the business). Then, a discount rate (the of the present value of each of the forecasted annual
required annual rate of return for risk) could be used to income streams along with the present worth today of a
convert all of these future income streams into their future sale value of the company at the final forecast year
individual present worth today. The result would results in a fair market estimate of the company.
collectively represent the value of the business.
The reality is that no valuator has a perfect What is Meant By the Term “Income?”
crystal ball and the ability to make reasonably supported Note that the term “income” is used generically.
and reliable forecasts decreases the further out into the There are a variety of potential “income streams” that
future one looks. Why? The business, economy and the might be used to determine value in the discounted future
world in general are subject to continuing uncertainty and income method, such as a company’s net profit (after­
change, some of it partially or completely unpredictable. tax), pre-tax profit, cash flow, dividends and so forth. A
The fact that the future cannot be fully known does not more commonly used interpretation of the discounted
mean, however, that it should be ignored. Buyers and future income method involves the use of cash flow (or
sellers of businesses are always looking forward and free cash flow) as the measure of income. This technique
attempting to make sense out of chaos to determine their is called the “discounted cash flow” valuation method.
prospective future returns. Cash flow is a term that is used in many forms in the
The discounted future income approach deals investment community for different purposes so it is

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INCOME APPROACH (continued)
important to be specific about its definition. In this valuation is to examine the present worth of expected
context, we will use the term cash flow or free cash flow cash flows. Since depreciation and amortization do not
interchangeably. represent real cash outlays
A company’s net they are added back to
income does not necessarily Table A
reported net income. Adding
represent the hard dollars that Free Cash Flow Defined
back depreciation is not a free
can actually be returned to its Net Income (or Net Profit)
ride, however, because
shareholders in the form of + Depreciation and Amortization businesses must periodically
cash distributions or = Gross Cash Flow replace aging assets, as well
dividends. Businesses often - Capital Expenditures as buy new ones, to remain
must reinvest a portion of the - Incremental Working Capital Needs competitive, expand and
earnings to fund continuing + or - Net New Long Term Borrowings (Not Included If exploit opportunities. This is
needs for capital Valuation is on an Invested Capital Basis- why capital expenditures are
Explained Later)
expenditures (to replace a deduction in Table A
aging and worn out = Free Cash Flow towards estimating actual free
equipment, modernize, and cash flow.
expand), repay the principal
on bank and other loans, and support the investment in Example of the Discounted Future Income Method
working capital (such as higher levels of accounts Tables B and C contain simplified examples of
receivable and inventory) that comes as a result of the use of the discounted future income method. In the
growth. “Free cash flow” is an income measure that example “free cash flow” is used as the income measure
seeks to quantify the actual cash returns to the buyer that for valuation purposes.
the business might actually be able to pay after taking Revenues, expenses and earnings for a fictional
these other demands on resources into account and is company are forecast each year for five years, followed
defined as shown in Table A. by the final sixth year, as shown in Table B. The
In the above definition, depreciation and individual techniques for preparing these forecasts are not
amortization expenses are added back because they are shown, as this is a subject all by itself. A well-prepared
accounting charges to earnings that are non-cash in valuation report would detail the forecast assumptions so
nature. These charges are meant to provide an accounting that they could be scrutinized.
measure of the wasting of a company’s asset base (such From the company’s net profit is then subtracted
as machinery and equipment and real estate), over their those various items discussed previously which represent
economic useful life. Remember that the goal of a a call on the company’s cash, i.e., capital expenditures,

TABLE B- EXAMPLE OF THE DISCOUNTED CASH FLOW METHOD- FORECASTED INCOME STATEMENT

DISCOUNTED CASH FLOW VALUATION METHOD Terminal

VALUATION MODEL Actual Forecast Forecast Forecast Forecast Forecast Forecast
Results Year Year Year Year Year Year
Base Year 1 2 3 4 5 6

2004 2005 2006 2007 2008 2009 2010

Percentage Annual Growth Rate 15% 12% 10% 8% 5% 5%

Equals: Revenues $14,000,000 $16,100,000 $18,032,000 $19,835,200 $21,422,016 $22,493,117 $23,617,773

Cost of Goods Sold (Depreciation- New Assets) $0 ($67,163) ($136,341) ($207,594) ($421,944) ($457,669) ($581,499)
Cost of Goods Sold (Depreciation- Existing Assets) ($492,000) ($409,743) ($295,638) ($245,083) ($211,390) ($172,024) ($172,024)
Cost of Goods Sold ($7,000,000) ($8,533,000) ($9,556,960) ($10,512,656) ($11,353,668) ($11,921,352) ($12,517,420)
Gross Profit $6,508,000 $7,090,094 $8,043,061 $8,869,867 $9,435,014 $9,942,072 $10,346,830

Operating Expenses:
Fixed or Semi-Fixed Expenses $1,393,996 $1,203,213 $1,251,510 $1,301,869 $1,354,379 $1,755,709 $1,823,212
Variable Expenses $3,669,000 $4,310,827 $4,828,126 $5,310,938 $5,735,814 $6,022,606 $6,323,735
Depreciation- Existing Assets $130,755 $94,481 $46,898 $36,728 $28,065 $18,824 $0
Total Operating Costs $5,193,751 $5,608,521 $6,126,534 $6,649,535 $7,118,258 $7,797,139 $8,146,947

Operating Profit $1,314,249 $1,481,573 $1,916,527 $2,220,332 $2,316,756 $2,144,933 $2,199,883

Interest Expense ($112,000) ($128,800) ($144,256) ($158,682) ($171,376) ($179,945) ($188,942)
Pre-Tax Profit $1,202,249 $1,352,773 $1,772,271 $2,061,650 $2,145,380 $1,964,988 $2,010,941
Income Taxes ($480,900) ($541,109) ($708,908) ($824,660) ($858,152) ($785,995) ($804,376)
Net Profit $721,349 $811,664 $1,063,363 $1,236,990 $1,287,228 $1,178,993 $1,206,565

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INCOME APPROACH (continued)
TABLE C- CALCULATING FREE CASH FLOW AND THE RESULTING ESTIMATE OF VALUE

VALUATION OF FREE CASH FLOW Terminal

DISCOUNTED CASH FLOW VALUATION METHOD Forecast Forecast Forecast Forecast Forecast Forecast
Year Year Year Year Year Year
1 2 3 4 5 6
2005 2006 2007 2008 2009 2010

Net Profit (From Table B) $811,664 $1,063,363 $1,236,991 $1,287,230 $1,178,997 $1,206,568
Plus (Minus):
Depreciation- Existing (From Table )B $504,224 $342,536 $281,811 $239,455 $190,848 $172,024
Depreciation- New (From Table B) $67,163 $136,341 $207,594 $421,944 $457,669 $581,499
Capital Expenditures ($470,000) ($484,100) ($498,623) ($1,500,000) ($250,000) ($866,552)
Additional Working Capital Needs ($211,050) ($194,166) ($181,222) ($159,475) ($107,646) ($113,028)
Net Borrowings (Repayments) of Long-Term Debt ($250,000) ($250,000) ($250,000) $1,250,000 ($315,000) ($315,000)
Equals: Free Cash Flow $452,001 $613,974 $796,552 $1,539,154 $1,154,868 $665,512
Times: Present Value Factor (Mid-Period) at Selected Discount Rate 0.9054 0.7421 0.6083 0.4986 0.4087

Present Value of Each Annual Cash Flow at Valuation Date $409,223 $455,628 $484,523 $767,402 $471,969

FINAL COMPUTATION OF VALUE: Terminal Value Cash Flow (Year 6) $665,512

Divided By Cap Rate (See Below for How Calculated): 17.00%
Total Present Value of Cash Flows, Years 1 Through 5 $2,588,744 Equals: Terminal Value (Sale Value, End of Year 5, $3,914,777
Plus: Present Value of Proceeds of Company Sale at End of Year 5 $1,448,464 Based on Cash Flow Forecasted for Year 6)
Times: Present Value Factor Based on Discount Rate 0.3700
EQUALS: VALUE BY DISCOUNTED CASH FLOW METHOD $4,037,208
Equals: Present Value of Proceeds of Future Sale $1,448,464
Discount Rate (all equity) 22.00%
Capitalization Rate Calculation:

Discount Rate 22.00%

Less: Long Term Annual Growth Rate -5.00%
Equals: Capitalization Rate Used for Final Year 17.00%

working capital needs and debt repayment (or new years 1 to 5 to arrive at the present worth today of each
borrowings which represent a source of cash), as seen in anticipated annual cash flow. When summed together,
Table C. Using a discount rate of 22% (the annual rate of these five years of cash flows are worth a total present
return to compensate the buyer for risk), present value value to the buyer of $2,588,744.
factors are then shown to enable the translation of each However, the business and its cash flows are not
year’s cash flow into its present worth today to a buyer. likely to come to a screeching halt at the end of year 5.
For example, in year three the present value factor is Therefore, the capitalized value of the long-term
0.6083. This was determined as follows using mid-period continuing income (cash flow) needs to be determined
discounting (assumes each year’s cash flow is realized, and also converted into its present value today. The final
on average, in the middle of the year), where n stands for year’s forecasted cash flow is capitalized (more about this
the year (here, the n is 2.5, or 3-0.5, because the cash later) by dividing the cash flow (here $665,512) by a
flow is realized midway during year 3): capitalization rate (here 17%, which is based on the
annual discount rate of 22% for risk, minus a long-term
1
_________________ 1
___________ sustainable annual growth rate of 5%) to arrive at a value
(1 + discount rate)n-0.5 = (1 +0.22)3-0.5 estimate of $3,914,777. In other words, if the business
were sold at the end of year 5 based on its expected cash
= 0.6083 (Present Value Factor)
flow for year 6, it would be worth $3,914,777 at that
where “n” stands for the period in which the time. However, the buyer of the company today is not
cash flow is to be received standing out at the end of year 5 about to pocket these
In other words, the present worth today of the proceeds. Therefore, these proceeds must be discounted
cash flow in year 3 (which is realized in the middle of back to their present worth today.
year 3, or period 2.5) is about $0.61 per dollar. Since the sale and its proceeds are assumed to
Therefore, the present value, today, of the cash flow in come at the end of year 5 (and not at the middle of year
year 3 ($796,552) is $484,523 ($796,552 times 0.6083). 5), then the end of period discounting convention rather
This same calculation is repeated for each year from than mid-period discounting convention needs to be used.
Since the buyer requires a 22% rate of return, the present

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INCOME APPROACH (continued)
value factor for the end of year 5 is 0.3700, calculated as approach much more difficult to employ in the typical
follows, where n stands for the year: valuation assignment.

1
_______________ 1
________ The “Invested Capital” (or “Net of Debt”)
(1 + discount rate)n = (1 +0.22)5 Valuation Alternative
Instead of forecasting the individual changes in
= 0.3700 (Present Value Factor)
the debt levels of a company, one alternative is to assume
where “n” stands for the period in which the that the company employs a constant level of interest-
cash flow is to be received bearing debt over the forecast period in proportion to the
In other words, proceeds from the sale received market value of equity in its capital structure. That
at the end of year 5 are only worth $0.37 per dollar today, proportion of debt might be assumed to be its actual
taking into account the risk of their receipt and the time current amount, or an amount based upon some normal
value of money. Multiplying the estimated sale value of industry standard (such as in the case of the previously
$3,914,777 by a present value factor of 0.3700 results in a discussed company which under-utilizes debt and
present worth, today, of $1,448,464. therefore has an inefficient capital structure). This method
Finally, reaching the overall company value is is often referred to as either the “invested capital” or “net
simply a matter of adding the sum total of the present of debt” variation, each of which can be misleading to the
values of the individual annual cash flows ($2,588,744) to uninformed. “Net of debt” does not mean that the
the present value of the terminal year value ($1,448,464) company has no debt. Rather, it means that the income
to arrive at a total value of $4,037,208. This represents streams (cash flows) exclude any impact of the claims of
the value of the company before other possible interest-bearing creditors who expect the repayment of
adjustments such as for issues related to control, lack of interest and principal (i.e., interest expense or principal
marketability and other factors, subjects for a different debt repayment is not incorporated into the discounted
discussion. cash flow model). Said another way, the forecasted cash
flows do not take into account how the company is
The Result is an “Equity” Value financed, whether with debt, equity, or a combination of
Because the cash flow measure previously used is the two.
after the repayment of interest expense and debt to In addition, net of debt does not mean that the
creditors it represents the potential discretionary cash flow impact of the company’s ultimate obligation to repay the
of the business that might be paid out to the common actual debt is ignored. In the final step using the invested
shareholders. Therefore, the value of the company in this capital technique, the value of a company’s actual debt
instance is synonymous with the value of its common outstanding is subtracted to arrive at the value of its
shares. This is referred to as an equity-oriented use of common stock. For this reason some valuators also refer
the discounted future income method. For this same to this method as an enterprise valuation method, as
reason, the discount rate that was used to discount the opposed to an equity valuation method. The earlier equity
equity cash flows is called an equity discount rate. version of the discounted cash flow method goes directly
This equity valuation technique is not always the to the value of the equity, never dealing with the question
easiest or the best valuation method to employ. Practically of the value of the enterprise or how the company is
speaking, it is often difficult to forecast individual financed.
borrowing and repayment plans in the future on a year-by­ When an “invested capital” approach is
year basis, however, those forecasted changes in the debt employed, the income streams are discounted back to their
of the business can have a significant impact on its interest present value at a “weighted average cost of capital,” or
expense, and therefore, its earnings and cash flows. “WACC.” The WACC is simply a discount rate measure
Finally, the use of debt (up to a certain prudent point) in a (again, an annual return for risk) which incorporates the
company’s capital structure can lower its overall cost of costs of debt and equity assumed to be used in the capital
capital because borrowing is much cheaper than the cost structure, assuming that this capital structure stays at a
of equity, and interest expense is tax deductible. But what constant fixed proportion. Remember that the earlier
if the company being valued is for sale, but has been very example of the discounted cash flow method used an “all
conservative and uses no debt whatsoever? Or, what if the equity discount rate.” The weighted average cost of capital
company uses a less than efficient level of debt? These simply moves a step further and says that the investor’s
factors make an equity-oriented discounted future income required annual rate of return (a discount rate) is really a

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INCOME APPROACH (continued)
blend of the cost of equity capital and the cost of debt Example Using the Capitalization of Earnings Method
since companies typically employ both in the capital The use of numbers illustrates how the method
structure. Thus, the weighted average cost of capital is actually results in a value estimate (Table E). Suppose
able to capture the effects of the cost of equity and the XYZ Company had historic annual net income for 2004
after tax cost of debt on the value of the forecasted cash of $500,000. Further, assume that income is expected to
flows today. The resulting value after discounting the cash grow 5% annually (the “g”, or annual growth rate). Since
flows of the business is called the “total invested capital 2005 income is expected to grow at this constant rate, the
value” of the company, without respect to how the income for 2005 is an estimated $525,000 ($500,000 of
company is financed. From this value is then subtracted 2004, plus 5% growth in 2005). After a full analysis of
the actual current value of the business’s interest-bearing the business, the industry and other factors, the valuator
long-term debt to arrive at the fair market value of the estimates the annual rate of return required by a buyer for
company’s equity, before other adjustments. risk to be 25% (the “d”, or discount rate). Therefore, the
preliminary value of the company by the capitalization of
Capitalization of Income Method Explained in General earnings method is $2,625,000, calculated as shown in
Theoretically, in every business valuation the Table E below:
valuator could forecast year-by-year results into the future
and then discount each individual income stream back to Table E

its present worth, as in the discounted future income Calcu lating The Valu e By The Capitalization Of

method just described. That may be unnecessary, Earnings Method

however, if the enterprise’s annual historic income is

Company
expected to grow in the future at a more or less stable
Income, Divided By: Equ als: Valu e
annual rate of increase. In this circumstance, math comes Coming Year Capitalization Rate Estimate
to the rescue with elegant simplicity.
If a company’s annual income grows at a constant $525,000 0.20 $2,625,000
rate into the future, the valuator can obtain exactly the (25%-5%)
same value as with year-by-year forecasts simply by
dividing the company’s historic income stream by a Said another way, a capitalization rate of 20% (as
capitalization rate. Also called a “single period” valuation in Table E) is the same as saying that the multiple applied
method, the formula is shown in Table D. to coming year earnings is 5 times (inverse of 0.20),
assuming that earnings grow at a constant annual growth
Table D
rate of 5%. Alternatively expressed, the buyer is
Formu la for the Use of the Capitalization of
expected to recoup his or her purchase price in 5 years
Income Method
through the income generated by the business.
Note that the method illustrated above was
Value = Income Stream for the Coming Year calculated by dividing coming year earnings by the
(d-g) capitalization rate. Suppose, instead, that the desire is to
use the latest actual year earnings results (2004). Since
Where: the cap rate is to be applied to coming year earnings in
d= Discount Rate (Required Annual the capitalization method, the cap. rate must be adjusted
Rate of Return For Risk) downward to back out the coming year’s assumed annual
g= Annual Future Growth Rate growth in earnings before the cap rate can be applied to
the latest year’s actual results, as shown in Table F. The
The “d-g” component above is called a effect of backing out the coming year’s growth is to lower
capitalization rate and is determined by subtracting the the capitalization rate.
estimated future long term annual growth rate of income If the latest year’s actual income of $500,000 is
from the rate of return for risk required for that income. divided by the capitalization rate of 19.05% the result is a
The capitalization method simply says that value is a value of $2,624,672, differing from the earlier value only
function of the elements of a company’s income, the risk due to rounding in adjusting the cap rate to back out the
associated with that income (reflected in the discount coming year’s growth.
rate), and the income’s expected rate of future annual
growth.

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INCOME APPROACH (continued)
Table F annual rate of increase each year into the future, into
Adju sting the Capitalization Rate For Use With Historic Resu lts perpetuity. By contrast, the discounted future income
method enables the valuator to forecast each specific
Capitalization Rate, Coming Year 20.00%
Times: Adjustment for Assumed Growth X 0.9524
year’s anticipated results, thus capturing the impacts of
1/(1 + annual growth rate), changing growth rates, profit margins and other key
or 1/(1 + 0.05) for 5% growth factors. Selecting the appropriate method to use, or, if
both are used, determining which method warrants the
Equ als: Capitalization Rate Used For Actu al greater weight involves a number of different
Latest Year Resu lts 19.05%
considerations discussed in the following sections.

Capitalizing Earnings Is Not Just A Theory, But Is Specific Situations and Their Ramifications to the
Evident In the Real World Method Indicated
It is a common reaction of business owners, a. Rapid Growth Companies- Going back to the
attorneys and others not familiar with valuation theory to importance of the time value of money, remember that the
react with disbelief and skepticism at the idea of earlier in time an income stream is received, the greater
capitalizing a company’s earnings into a value estimate. its present worth today. Suppose the valuation
Typically, either the math makes no sense to them or they assignment involves a rapidly growing company. In the
react with the notion that this is all just an exercise latest historic year (year 0), the company had annual
devised by esoteric academics in ivory towers. after-tax earnings of $100,000. Over each of the next
For the best real world laboratory of why these three years, management expects annual earnings to grow
theories actually work, simply follow the stock market at a 35% annual rate of increase because of the market
daily and see what happens to public company share acceptance of a new product line. In years four and five
values. If a business comes out with a new product that the rate of growth is expected to slow to 8% increases,
brightens its future earnings outlook the share value rises followed by a long-term growth rate of 5% from years six
as investors, in effect, “capitalize” the higher anticipated onward as the demand for the product reaches maturity.
future stream of income. Or consider two competitors in In this example an explosion in earnings will
the same industry and with the same annual income. One occur in the next few years, therefore having a large
has just become the target of a product liability lawsuit, impact on overall company value from the standpoint of
calling into doubt its future survival. Its share value is the time value of money. How can this valuation impact
driven down due to an increase in its perceived risk (the best be captured? This situation is clearly difficult to
“d,” or discount rate discussion earlier), possibly handle in the context of a single period valuation model
combined with a diminished future earnings outlook ( a such as the capitalization of earnings method. Under that
change in the “g,” or annual growth factor earlier). method the capitalization rate is determined by
Values of private companies, large and small, are subtracting a sustainable and constant annual rate of
impacted by the same factors of risk and growth. If two growth from the discount rate. Use of a 35% constant
companies have the same risk profile but one has a higher annual growth rate is clearly not appropriate, as it is
anticipated growth rate of earnings, the rational investor practically impossible for this to be maintained by any
will pay more for the one with growth. Similarly, if two company on a long-term basis. If compounded long
companies have the same income and growth outlook but enough at 35% the company would eventually become
one is much riskier, the one with greater risk will be larger than the entire U.S. economy! Alternatively, if 5%
worth less. is used as the long-term annual growth rate, the company
will be materially undervalued since the capitalization
Determining the Appropriate Income Method to Use- model will fail to capture the major impact of substantial
An Overview near-term growth rates that are seven times higher than
The two income methods just described quantify the long-term rate.
value in two fundamentally different ways that have By contrast, the discounted future income
important implications about which one is appropriate in method is perfectly suited to handle the rapid growth
a given valuation assignment. This distinction arises company and its valuation implications. Each individual
from the different underlying assumptions used in each year of the rapid growth phase can be separately
model. The capitalization method assumes that company forecasted and discounted back to a present worth. Then,
income (however defined) grows at the same constant the long-term growth would be captured by capitalizing

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INCOME APPROACH (continued)
Table G
Using the Discou nted Fu tu re Earnings Method to Captu re The Impacts of Near-Term Rapid Growth

Actu al
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Growth Rate of 35% 35% 35% 8% 8% 5%

Earnings
Earnings $100,000 $135,000 $182,250 $246,038 $265,721 $286,979 $301,328

Present Value Factor

@20% Discount
Rate (Mid-Period 0.9129 0.7607 0.6339 0.5283 0.4402
Discounting)

Present Valu e of $123,242 $138,638 $155,963 $140,380 $126,328

Earnings

Terminal Valu e Calcu lation:

Final Year Earnings $301,328

Final Valu e Divided By Capitalization Rate

Calcu lation: (20% Discount Rate – 5%
Annual Growth Rate) 0.15
Present Worth of $684,551 Equals: Terminal Year
Annual Earnings (Continuing) Value $2,008,853

Plus: Present Worth of Times: Present Value Factor

Terminal Year $807,358 @20% (From End of Year X 0.4019
5)

Equ als Total Valu e $1,491,909 Equ als: Present Worth of

Final Year Terminal $807,358
Valu e

the final forecast year earnings, which represents the valuation approach. If a company is at the very zenith of
point at which this stabilized growth rate is reached. the cycle, capitalizing the highest earnings extrapolates
Reaching the final value is then simply a matter of adding this peak each year into the future, missing the negative
the present values of the annual earnings streams together impacts of the down years and therefore overvaluing the
with the present value of the continuing value at the company. If a company is at the bottom of the cycle and
terminal year. Table G shows how the discounted future losing money the capitalization method assumes this too
income approach is used to solve the earlier rapid growth will continue forever and gives an inaccurately low value
example in a simple, yet accurate manner. by that method. If a rebound in income is likely to come
b. Cyclical Companies- Some companies are soon then capitalizing trough year earnings fails to
highly cyclical, with earnings riding a periodic roller capture the effects of this recovery and leads to an under­
coaster tied to an overall industry or economic cycle. valuation.
Such a company might have two or three years of rapid This situation is well suited to the use of the
growth on the rebound from an economic slump, discounted future income method. However, there is one
followed by a slowing growth in earnings as market major caveat. For the discounted future income method
demand is satiated, followed by a downturn and then to work in this situation, the general nature of the cycle
potentially losses as the economy enters a recession. As must be reasonably predictable (i.e., as to the timing and
the economy recovers from a recession, earnings length of each phase of the cycle) and the associated
rebound, and the cycle is repeated. Examples of earnings for each year must be subject to estimation.
industries that are typically highly cyclical include This is easier said than done, since no two cycles are
general contractors, industrial truck manufacturers and exactly alike. Also, determining the patterns of a cycle
furniture manufacturers, to name just a few. As always, takes substantial time and effort and may require
the facts and circumstances affecting a particular obtaining a long history of financial results to help gauge
company will influence whether it is cyclical. the trends of past cycles and their impacts. Finally,
Consider the valuation dilemmas the cyclical determining when the final long-term sustainable terminal
company presents in the selection of the appropriate year will occur (which should represent the midpoint of

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INCOME APPROACH (continued)
the cycle, i.e., between the high and the low points) is d. Mature Companies- A mature company is
quite difficult. Determining the appropriate sustainable one that has normally passed a rapid growth phase and is
year requires the ability to forecast what year this probably at or near its sustainable long-term rate of
midpoint will actually occur, as well as the earnings in growth. While not universally true, many mature
that year. companies will have stable and predictable earnings
Alternatively, the capitalization of earnings patterns. A soft drink bottler is a good example of a
method brings substantial simplicity to the problem, but mature business. This fact set typifies the type of
not without its own dilemmas. Positively, the valuator company for whom the capitalization approach is often
could simply select a multi-year average of historic best suited. Whether or not earnings, free cash flow or
earnings that captures the full range of the typical cycle. some other measure is the most appropriate income
Thus, the value takes into account that neither the high or stream to capitalize is open to debate. It is often true that
low years are extrapolated into the future, but rather the a mature company will generate sizeable cash flows that
average year. Negatively, several problems arise with this can lead to greater dividends to shareholders. Unless the
method. For example, if the company is now entering a company intends to use its excess cash resources to invest
losing, recessionary phase that might last several years, it in new product lines or acquiring growing businesses,
is certainly not likely to post an average profitable year cash flow is often be a better valuation measure.
for some time to come. The capitalization method then e. Synergistic Acquisitions- In some industries
overstates company value from the time value of money there exist opportunities for an acquiror to purchase a
standpoint. Additionally, simply using the historical similar company or competitor and eliminate duplicative
average earnings pattern does not mean this will be the overhead costs, achieve distribution or marketing
pattern in the future as the magnitude and duration of the efficiencies, and realize other benefits. As a result, the
current cycle may differ from those of the past. sum of the parts may generate more together than they
Both methods clearly have their merits and each could separately. Arguably this “synergy,” in some
shortcomings in dealing with the valuation needs of the cases, represents investment value to the specific buyer,
cyclical company. Which one is appropriate to use will and not fair market value. However, if acquisitions in an
ultimately depend in large part on the judgment of the industry are driven by synergism and there are numerous
valuator in determining the predictability of earnings over transactions occurring, the fair market value of companies
the cycle and the nature of the cycle. However, real may converge on their synergistic value.
world buyer considerations might influence this decision- Realizing the benefits of synergism sometimes
making process. Buyers of highly cyclical companies takes several years or more to be fully implemented and
(particularly smaller companies where the buyer is often realized. Additionally, initial restructuring costs and
less sophisticated) might consider a discounted future outlays might be incurred, divisions sold, and other
income approach to be highly speculative and place their factors come into play. All of these factors are best
focus on the average results of the past as a known capturing using the discounted cash flow method.
quantity. While business valuators might argue with However, its implementation may require forecasting of
whether or not the buyer is using the most theoretically substantial complexity.
correct method, they must not forget the realities of how f. Companies with Multiple Subsidiaries or
buyers and sellers sometimes think. Divisions- The overall earnings and cash flows of a
c. Start-Up Companies- In a start-up company company with multiple divisions or subsidiaries is really
there is no historical income to enable the use of the the sum of the respective results of each individual
capitalization of earnings method. In such a situation the operation. Each division might have different growth
discounted future income method might be the only rates and forces at work that bear little similarity. One
valuation method available. As should be obvious, the division might be mature, growing slowly, and generating
real difficulty in using this method is the ability to substantial cash flows, while another might be rapidly
estimate year-by-year results when the company has little growing and consuming cash to support the demands of
or no actual record of accomplishment. However, the rapid growth. It is sometimes the case that this type of
company may have a patent on a promising new valuation engagement is best captured by the use of the
technology that has the potential to generate substantial discounted future income method. Forecasts are
earnings. The fact that the company does not have a developed for each division or business unit, and then
history of earnings does not therefore necessarily mean aggregated into overall company results. If subsidiaries
that the company has no value. or divisions are few and if a second business unit is

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INCOME APPROACH (continued)
immaterial to overall results, or if the business units are and sellers think and act. Even though both discounted
similar and both mature, it might be that a simple future income and capitalization methodologies might
capitalization method for the entire enterprise will suffice. well be warranted, the marketplace might influence the
g. Finite Contracts or Joint Ventures- final weightings or emphasis on the findings of each in
Companies or joint ventures are sometimes formed to arriving at a final value. For larger corporate buyers,
fulfill a single purpose or to perform a contract having a institutional investors, venture capital firms and
specified duration. Alternatively, a contract might have a financially sophisticated parties, there is a clear bias
strong likelihood of non-renewal at the end of the towards the use of the discounted future income method,
contract term. The latter case raises a question as to and, more specifically, the discounted cash flow
management’s ability to successfully re-deploy company technique. By contrast, the individual purchaser of a very
assets into another business at the termination of the small business is often financially unsophisticated and
contract. Because capitalization methodologies assume might look entirely at the actual results of the company,
earnings or cash flows will continue indefinitely, they are placing no credence on forecasts. Thus the decision
not appropriate for use in valuing the finite-lived venture. about which method to use and the weight to put on each
In contrast, the discounted future income method is well in arriving at a final value must be carefully considered in
suited to this scenario. each case.
h. Liquidation- If liquidation is pending or in j. The Purpose of the Valuation- As odd as it
progress, many of the same issues present in valuing the may seem, the purpose of the valuation might dictate the
finite venture or contract also come into play. If the relevant income methodologies used. For example, North
timing of the liquidation will occur in a matter of months, Carolina equitable distribution case law suggests that the
the impact from a time value of money standpoint may be post-marital efforts of the spouse are considered his or her
negligible. This suggests that the use of the discounted separate property since they occur after the marriage has
future income approach might be inappropriate. ended. Does this suggest that discounted future income
However, the longer the duration of the liquidation method is not appropriate in this case? Some attorneys
process, the more important a role the time value of have argued this is the case, suggesting that only historic
money aspect will play in affecting the present value of capitalization results should be used. The problem with
shareholder cash returns, leading, in turn, to the use of the their suggestion, however, is that a capitalization method
discounted future income method. always involves a future forecast. The only difference is
Liquidation does not necessarily imply a that the assumed rate of annual growth in the
bankrupt or failing company. A winding down may capitalization method is assumed constant.
simply be the natural course of business. An excellent Another example where the purpose can dictate
example is a real estate venture where the developer the method involves the valuation of medical practices or
originally purchased raw land, put in roads and sewer other health care entities for purchase or sale by tax-
service, and has begun marketing the lots for sale for exempt hospitals. The Internal Revenue Service and the
some commercial or residential use. As lots are sold and U.S. Department of Health and Human Services (which
development loans are paid down, the project begins to administers Medicare) is highly suspicious of these
generate cash payouts to its shareholders or partners. transactions. Their primary concern is the great potential
Unless some new project is undertaken, the ultimate for hospitals to overpay the selling physicians in a
impact is that the development venture is in a steady but purchase of the practice (or sell a practice to physicians at
deliberate state of liquidation, perhaps better described as an abnormally low price) as an inducement or kickback to
a winding down process. The developer might have a continue to generate patient referrals to the hospital after
history of lot sales, prices realized per lot, and an estimate the purchase (or sale). Such a kickback is a felonious
of the time required for the market to absorb the violation of the Medicare Fraud and Abuse Statutes. As a
remaining lot inventory. From these and other inputs it is result, internal IRS valuation training manuals for their
relatively straightforward to construct a simple agents (which are not meant to represent official policies
discounted cash flow valuation forecast that captures the or positions), nonetheless give some indication of
associated impacts on value of the cash returns these lots possible Service thinking on valuation methodologies.1
will generate.
i. Size of the Company Being Valued and the 1
Integrated Delivery Systems and Joint Venture Dissolutions
Sophistication of Typical Buyers and Sellers- Valuators Update- CPE Update for 1994/1995, Internal Revenue
must not disregard the marketplace and how real buyers Service, by Charles Kaiser, Phyllis Haney and T.J. Sullivan.

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INCOME APPROACH (continued)
The IRS manual (albeit now very dated, but the forming new joint ventures with physicians and valuation
only item available) appears to give an indication of the issues become critical to the determination of the
Service’s preference for the discounted cash flow capitalization of these ventures and the resulting
valuation approach. Since the Service requires the ownership positions of the parties.
valuation to take into account the planned post- A final example of how the valuation purpose
transaction annual compensation and benefits to be paid influences the methods selected involves the valuation of
by the hospital to the selling physicians in determining financially distressed companies operating under
the pre-transaction value of the practice, it appears that bankruptcy court protection. Although the subject
the Service is emphasizing the use of the discounted cash company might potentially be awash in debt, the relevant
flow method. In a hospital purchase of a medical approach in some cases may be to value the company
practice, the Government is concerned that the selling without respect to its current actual debt load, but rather
physicians will continue to realize compensation or based on some normal debt level. This sometimes is the
benefits that equal or exceed what they made as owners appropriate method to use so that the Bankruptcy Court
prior to the sale, with the result being that the acquiring can then determine how it will allocate the continuing
hospital might actually realize little or no cash return on value of the business across the various classes of secured
its investment. Hence, by not taking the post transaction and unsecured creditors and equity holders. This can use
compensation into account, the selling physicians would be used by the Court to set the stage to enable the
have their cake and eat it too- being paid compensation as company to emerge from bankruptcy protection.
if they were still owners, yet receiving a selling price
based on their working at salaried employee levels. Conclusion
Similarly, the hospital would have paid for goodwill it The income valuation approach is a powerful
never actually received in the form of cash returns. This way of estimating a company’s value, offering the
in essence, is the payment of a kickback to the selling valuator several different methods including the
physicians. By modeling the post-transaction cash flows capitalization of income, and the discounted future
(and taking into account the planned physician income techniques. Both methods ultimately derive value
compensation if the hospital is purchasing the practice), from the underlying notion that the present worth of an
the Service believes that the discounted cash flow method investment is simply the present worth, today, of a future
enables the determination of the real economic substance return or series of returns, whether from income, cash
of the transaction and the actual value to be transferred to flow, dividends, or a future sale or liquidation. This
the hospital. present worth is tied to an annual investor required rate of
This is obviously a complex area that is subject return (a discount rate), which encompasses risk and the
to change over time, as the Service either explicitly time value of money. Both methods have their pros and
makes its position officially known, or policy is cons and one or the other, or both, might not be
established through case law decisions. Therefore, the appropriate for a given valuation assignment. This article
valuator considering the valuation of a medical practice has covered broad issues in deciding how to make
or another type of health care entity (with any potential practical judgments in the valuation process. ♦
for Medicare fraud and abuse issues) should consult a
competent health care law attorney. The ramifications of George B. Hawkins is co-author of the CCH Business
an improperly or poorly prepared valuation could be the Valuation Guide and a Managing Director of Banister
loss of a hospital’s tax-exempt status, fines or penalties, Financial, Inc., a business valuation firm in Charlotte,
or possibly even a felony charge. North Carolina. He can be reached at
During the mid and late 1990s, the trend was for [email protected] or 704-334-4932.
hospitals to acquire medical practices. However, many of
these acquisitions did not work out well for hospitals, This article is an abbreviated discussion of a
many of whom lost large amounts of money on the complex topic and does not constitute advice to be
practices that they purchased. As a consequence, during applied to any specific situation. No valuation, tax or
the current century the trend is now in the other direction- legal advice is provided herein. Readers of this article
many hospitals are divesting of their medical practice should seek the services of a skilled and trained
holdings, typically selling them back to the physicians, professional.
transactions which also have Medicare fraud and abuse
implications. In addition, hospitals are constantly

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