One of the most basic premises of business valuation is that “value” is forward-looking. A company’s historical financial results are only relevant to the extent they are indicative of future results. The Income Approach to business valuation embraces this forward-looking premise by estimating the future financial benefits to be generated and discounting those expected benefits to a present-day value. These future benefits are what the buyer is buying and the seller is giving up at sale.
In applying the Income Approach, the two primary methods relied upon are either capitalization or discounting. These two methods apply identical mathematical principles with the key difference being related to assumptions about the point in time when net cash flow and the rate of growth are expected to stabilize.
The capitalization method uses a single-period valuation model that converts a benefit stream into value by dividing the benefit stream by a rate of return that is adjusted for growth. Capitalization models assume that a company will experience consistent levels of growth and margins in the future. As a result, this method is most often applied to companies with mature operations and modest future growth expectations.
The discounting method uses a multiple-period valuation model that converts a discrete series of future benefit streams into value by discounting them at a rate of return that reflects the risk inherent in the benefit streams. Discounting models assume there is first a discrete projection period—that allows for short-term fluctuations in growth rates, operating margins, leverage, working capital needs, capital expenditures, etc.—prior to stabilization. Thus, discounting models are most often applied when future growth rates or margins are expected to vary prior to stabilizing.
The effects of COVID-19 have impacted businesses in ways that were hard to foresee. Most industries have experienced a high level of volatility in revenue and profits. In this type of economic environment, it is hard to justify the use of a capitalization model. Investors are unlikely to expect stable cash flows over the next few years and therefore a discounting method may be required to properly capture market expectations.