INCOME IS KING
Income-based valuations are used to determine the value of a business (or an asset in general), based on its expected future financial performance. This approach looks at the future cash flow that the asset generates or is expected to generate in the future and uses it to estimate its value after discounting it to today’s value.
This kind of valuations are an important tool for both investors and business owners, as it provides a way to determine the worth of an investment based on its potential to generate income. In this article, we will explore the basics of income-based valuation, its advantages, and how it is applied in different scenarios.
Two of the main techniques used in income-based valuations are the discounted cash flow (DCF) method and the venture capital (VC) method. The discounted cash flow method involves projecting the future cash flows that an asset will generate, and then discounting those cash flows back to their present value using a discount rate, while the VC method takes into consideration the return that a Venture Capital needs to obtain if they decide to invest into the company.
DISCOUNTED CASH FLOW
The Discounted Cash Flow (DCF) technique can be applied to any projected stream of revenues (and the deriving cash flows) and therefore it can be applied to companies in a variety of situations, from listed companies to start-ups (ideally that are already generating revenues). The DCF method is one of our methods of choice when assessing and valuing companies and start-ups that already have some history of sales, as this creates a strong foundation for reliable projections.
As the name suggests, the DCF method takes into consideration the cash flow of the company and discounts them by a specific rate, called the discount rate. The discount rate takes into account several factors, including the cost of money (i.e., the return required by an investor), the risk associated with the investment, and the opportunity cost of investing in the asset.
The discount rate is used to account for the time value of money (i.e. a dollar received in the future is worth less than a dollar received today) and it also reflects the opportunity cost of investing in the asset, as well as the risk that the future cash flows may not materialize as expected.
Once the future cash flows have been projected and discounted, they are summed to determine the present value of the business.
DCF WITH LONG TERM GROWTH (LTG) VS. DCF WITH MULTIPLES
The difference between DCF with Long Term Growth and DCF with Multiples is in how these two methods calculate the Terminal Value (TV) of their forecasts. This value encapsulates the value of the cash flows beyond the forecasted period (i.e. the last year of your projections).
The LTG assumes the cash flows beyond the projected ones will grow forever at a constant rate while the DCF with Multiples assumes the TV is equal to the exit value of the company based on industry multiples (in this sense, a DCF with multiples can be considered as both an Income and a Market-based valuation methodology).
Generally speaking, the DCF with Multiples is typical of the Private Equity sector, where companies are most often bought and sold between firms, while the DCF with LTG is typical of a publicly listed company.
Stable Diffusion: London Skyline with flying money in an abstract style
The venture capital method, on the other hand, is used to value early-stage companies and startups. It estimates the company’s value based on a multiple of its revenue or earnings. The multiple is determined based on the perceived level of risk and the growth potential of the company.
The VC method is one of the most common approaches when valuing start-ups. It all starts by figuring out the return that an investor wants, in order to deploy cash into a business. The company will have a valuation that is therefore consistent with a predetermined return at the exit. The potential exit value is derived from the specific EV/EBITDA multiple of the benchmarked market and the final valuation equals this exit value discounted by a required return on investment (ROI). This depends on a number of factors, including the startup’s stage of development, as well as the kind of investors that might invest in the company.
As this technique relies on a multiple in order to calculate the exit value, the VC method can also be considered a Market-Based method.
The return on investment will naturally be higher for early stage and riskier companies, lower for more mature and stable ones, and it is the minimum rate that will allow investors to have positive returns from portfolios where most companies fail and gains come from a selected few.
We use different ROI rates based on the stage of development of the company, assuming that companies at different levels of maturity will attract different investors with different risk tolerances. In particular, we use percentages that range from 50% to 25% returns according to several development stages. We use mainly 7 stages and we define them like this:
- Idea stage
- Proof Of Concept (POC) / Prototype / Minimum Viable Product (MVP)
- First production run
- First sales in
- Established sales with little penetration
- Established sales but capital intensive
- Established sales and still booming
In conclusion, income-based valuations are a crucial tool for investors and business owners in determining the value of an asset based on its expected financial performance. But they are not the only way to go.
WHICH IS THE RIGHT METHOD FOR YOU?
Want to know more about how we blend many of these methodology into our Third Party Pre-Money Valuation? Check out our Valuation Report here.