What’s My Business Worth? Part 3: The Income Method

“What’s my business worth?”

This post is the final installment in a three-part series on valuing a business. The series was inspired first by an article I read that contained too many errors and misconceptions to be of much help to anyone and, second, by the question we get all the time: “What’s my business worth?” Two weeks ago, I addressed the Asset Method in Part 1. Last week, in Part 2, I discussed the Market Method. This post is about the Income Method. As I mentioned in Part 1, this series is essentially for business owners, but I know that a lot of business brokers could benefit from what is discussed because it not only gets into the “how” but also the “how not” of valuing businesses.

Buyers: Financial or Strategic?

For most businesses and in most situations, the Income Approach is the best method of valuing a business for the simple reason that it answers the buyer’s biggest question: “How much will this business put in my pocket?” But this doesn’t apply universally. There are two types of buyers: financial and strategic. The most important consideration for financial buyers is the earnings of the target business – the answer to the ago-old question, “How much will this business put in my pocket”. Strategic buyers, on the other hand, while not ignoring earnings, are generally more interested in how a target business’ products, services, technologies or other assets might fit with the acquiring company’s existing offerings to help it gain strategic advantage in the marketplace. The Income Approach entails three very specific and very important aspects. The first is determining what the “real” net income is; again, the answer to the question, “How much will this business put in my pocket?” This is rarely the taxable income shown on tax returns or the bottom line of the profit and loss statements. The second is determining what similar businesses, with similar “real” net income have sold for. (See last week’s post: “The Market Method”.) The third is determining the “multiples” represented in previous sales and applying those multiples to the subject business – the one we’re valuing. The key to all this is to have – and use – the correct numbers. And this is where the article that inspired this series of posts comes in.

Revenue or Earnings?

One of the calculations we use when valuing a business is the capitalization of earnings method which is used to value a business by estimating the net present value of its projected future earnings. It does this by applying a “discount rate”, approximating a buyer’s required rate of return given the risk the investment entails. But in order for this method to be at all meaningful, we have to start with the business’ actual earnings. The article I read used in its example a discount rate of 25%, which is not unreasonable. (In our experience, we’ve seen cap rates of anywhere between 20% and 50%, depending on the level of risk to the business’ earnings.) But the critical point in this discussion is that the discount rate has to be applied to the proper number – earnings. The example used in the article was of a company that had revenue of $500,000. The author applied the 25% cap rate to that $500,000 and arrived at a value of $125,000. But here’s the problem. The business may have had revenue of $500,000 but it may have had earnings of only $15,000. Who would pay $125,000 for a business that put only $15,000 into the owner’s pocket?

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That business, even if we used the somewhat low cap rate of 25%, would be worth, at most, $60,000. But I would argue that, unless the business just signed a lucrative 10-year contract with one of the Federal government’s countless ridiculous, wasteful and nonsensical departments – such as the Department of Defense which recently spent $283,500 to monitor the day-to-day life of baby gnatchatchers – the risk to its survival is such that it would warrant a higher cap rate – say 35% – which would value it at less than $43,000. The Income Approach must be used with the Market Approach insofar as “the market” will tell us what similar businesses with similar earnings numbers have sold for but the Income Approach is the only one that answers every buyer’s question: “How much will this business put in my pocket?” And the only way to get an answer worth having is to start with the right numbers.

The Bottom Line

The bottom line here is essentially exemplified in the adage that was coined in 1957, roughly the beginning of the computer revolution: “Garbage in, garbage out.” It is the concept that flawed or nonsense input data produces nonsense output or “garbage”. For us, this means that, in order to arrive at a meaningful result, we have to have all the correct numbers. If the advice in the article I read was followed by any business owner, that owner’s business would never sell. If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast. I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.