Income Approaches to estimating business valuation are typically based an a projection of future cash flows from the business, discounted to reflect present day value considering market conditions and risk factors.
To estimate business valuation under an Income Approach, RISR applies the Capitalization of Earnings Method.
RISR applies the Income Approach detailed here in tandem with two Market Approaches to estimate the Equity Value of client businesses.
Income Approaches to estimating business valuation are typically based an a projection of future cash flows from the business, discounted to reflect present day value considering market conditions and risk factors.
This may be done through several techniques including the Capitalization of Earnings Method or a Discounted Cash Flow Method.
RISR uses the Capitalization of Earnings Method to estimate the value of the business.
💡 Why isn't the Discounted Cash Flow (DCF) method used?
The Discounted Cash Flow (DCF) Model is a commonly used approach for valuing businesses based on future earnings potential and requires business owners to provide long term financial forecasts for the company.
Private small-to-medium businesses are notoriously hard to project earnings for, so the DCF model is typically reserved for larger businesses with robust pro formas.
For this reason, this method is not implemented in the RISR platform.
RISR uses the Capitalization of Earnings Model to identify the present value of estimated future earnings for each client.
Estimating Enterprise Value using the Capitalization of earnings method generally consists of the following steps.
1. Identify Average Historic Earnings
A representation of the business's hypothetical future cash flows. This is can be done by assessing recent financial performance to develop a weighted average of historic earnings before interest, taxes, depreciation, and amortization (EBITDA).
2. Normalize Average Historic Earnings
Normalized EBITDA represents a business’s ability to generate earnings in the future based on historic earnings and adjustments to remove unusual, non-recurring, or discretionary expenses to better reflect true earnings.
3. Determine a Capitalization Rate
Capitalization Rate reflects the required return and risk on invested capital. It is estimated by considering market conditions and the specific risk of the business.
4. Apply Capitalization Rate to estimate Enterprise Value
Once Normalized EBITDA and a Capitalization Rate are estimated, they can be applied together to estimate enterprise value under the Capitalization of Earnings method.
5. Apply balance sheet adjustments to convert Enterprise Value into Equity Value
To adjust Enterprise Value to reflect Equity Value, add net working capital to and subtract interest-bearing debt to Enterprise Value.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is is a measure of a company’s operating profitability. It's a key component of estimating normalized EBITDA, which serves as the basis of the Capitalization of Earnings method.
Taking a weighted average of recent historic EBITDA helps reflect the business's current ability to generate earnings, signals the trajectory of the business, and helps smooth out any impacts from one-off events that may have impacted earnings.
An overview of how to estimate weighted average historic EBITDA is provided here.
Normalized EBITDA is a key component to estimating the value of a client's business under the Capitalization of Earnings method. It represents a business’s ability to generate earnings in the future based on historic earnings and adjustments to remove unusual, non-recurring, or discretionary expenses to better reflect true earnings.
Normalized EBITDA can be estimated by taking the weighted average of historic EBITDA and adding the value of any unusual, non-recurring, or discretionary expenses. These expenses, or "add-backs", represent the adjustments to normalize EBITDA.
Estimating normalized EBITDA
Normalized EBITDA = Weighted Average of Historic EBITDA + Adjustments to Normalize EBITDA
Normalizing earnings is a nuanced and complex task. Work with your client and their accountant directly to identify which expenses make sense to "add-back" to normalize EBITDA when estimating business valuation.
Learn more about how to normalize earnings with "add-backs" here.
Under the Capitalization of Earnings method, Capitalization Rate reflects the required return and risk on invested capital. It is estimated by considering market conditions and the specific risk of the business.
Estimating Capitalization Rate
When estimating Capitalization Rate, the discount rate reflects the average return investors expect. This can be estimated using a weighted average cost of capital (WACC) approach.
Estimating Discount Rate (Weighted Average Cost of Capital)
Components of Discount Rate
| Component | How to estimate |
|
Cost of Equity |
Cost of Equity = Risk-Free Rate + Equity Risk Premium + Size Premium + Company-Specific Risk
To estimate the cost of equity, market conditions and risks associated with the business should be considered. |
| Cost of Debt | The cost of debt can be estimated by referencing current interest rates on loans. |
| Equity & Debt Ratios | Capital structure is the mix of debt and equity a company uses to fund its operations and growth. The ratio of equity and debt directly shapes the capitalization rate, because the capitalization rate reflects the return required by both lenders (debt) and owners (equity) given the risks of the business. To estimate debt and equity, it's important to think about the ideal capital structure for a business, rather than the current capital structure of the business. This is because, in theory, a hypothetical informed buyer would restructure the financing of the company to reflect the ideal capital structure. Although ideal capital structure varies by industry and type of business, a standard benchmark of 15% debt and 85% equity may be appropriate. |
When estimating the growth rate for the Capitalization Rate calculation, it's best to estimate what a long-term sustainable growth rate may be. This approach assumes the business cannot grow indefinitely faster than the economy or its industry.
To estimate growth rate:
Start with macroeconomic benchmarks. Look at long-term GDP growth, inflation expectations, and industry forecasts.
Overlay industry dynamics. Adjust for whether the company’s sector is expected to grow faster or slower than the economy overall.
Stay conservative. In practice, growth rates above 3–5% long term are rare, since they imply the business will outpace the economy indefinitely.
RISR applies a conservative long-term sustainable growth rate for each business.
Once Normalized EBITDA and a Capitalization Rate are estimated, they can be applied together to estimate enterprise value under the Capitalization of Earnings method.
Estimating Enterprise Value under Capitalization of Earnings method
When working with business owners as a financial advisor, it’s important to focus on the Equity Value within the business. This is a nuanced difference from Enterprise Value and is intentional.
To adjust Enterprise Value to reflect Equity Value, add net working capital to and subtract interest-bearing debt to Enterprise Value.
Estimating Equity Value
Equity Value = Enterprise Value + Net Working Capital - Interest-bearing Debt
