Editor’s note: This is part three of a four-part series on practice valuation approaches. Read part one here. Read part two here.
Understanding the value of your business is critical for any business owner. The importance of this knowledge rests with many factors, such as strategic decision-making, growth, financial planning, exit strategy, and retirement planning. Determining business value is a complex process, and valuators always strive to establish the most accurate and least biased values.
Using the ability of a business to generate income may be the most precise way to estimate the value of an enterprise because it reflects authentic performance as presented by actual historical numbers. Here, we’ll explore perhaps the most complex approach to business valuation—an income-based approach.
The income-based valuation approach is a valuation method based on a business’s ability to generate future income. At its core, this method views a business enterprise as an investment, its future income stream as a return on the investment where the business value represents the current worth of that investment.
The income-based approach is valuable for estimating the value of businesses with a strong track record of profitability and predictable future cash flows. It relies on assumptions about future performance and selecting the appropriate discount rate, which tends to be subjective.
Remember that a dental practice is a long-term investment. There are several essential concepts one must understand to appreciate the income-based business valuation method.
Present value
Present value is the current value of a future sum of money or stream of cash flows given a specified rate of return. Present value takes the future value and applies a discount or interest rate that could be earned if invested.1
In a way, present value is a function of the future value of an investment. While future value indicates the total financial worth of the investment, the present value advocates its current value, indicating how much you’d need to pay in today’s dollars to earn a specific amount in the future.
How do you derive today’s value from the future value? This is where the “time value of money” comes into play. This concept is based on the notion that “a dollar today is worth more than a dollar tomorrow.”2 By applying a reasonably calculated discount rate to a future value, one can estimate the present value. The key term here is discount rate.
Future cash flow
Future cash flow is the central element of the income-based valuation approach, which focuses on estimating the amount of cash flow a business (a dental practice in this case) is likely to generate over a specific time period.
Discount rate
The discount rate answers the questions of how much the future value is worth today and why. The discount rate effectively reflects the risk involved in the investment. A higher risk usually leads to a better return and, therefore, translates into a higher discount rate, meaning that higher risk is associated with reduced present value of the future cash flows. In other words, one would pay less for riskier investments and expect higher returns. In contrast, less risky investments are not discounted as much as ones associated with higher risks.
The best example is the fact that a US Treasury bond, backed by the US government, carries the rate that is often used as the risk-free rate, meaning that the safest investment delivers the lowest yield.3
Capitalization rate
Capitalization rate allows the valuator to estimate future returns, as long as the enterprise has a relatively stable income stream. This rate reflects the expected return on the investment (dental practice), considering both the risk and the typical market returns for similar investment assets. The capitalization rate then converts a single period’s income (usually the last financial year) into a present value.4
Standard methods of income-based valuation
The income-based valuation approach rests on the foundation that the intrinsic value of an asset (the practice) is ultimately tied to its ability to generate future cash flow. Both methods described below are based on the concept of financial return on the investment into the business enterprise.
Standard methods of the income-based valuation approach include the discounted cash flow (DCF) method and the capitalization of earnings (cap rate) method.
Discounted cash flow method
The DCF method forecasts future cash flows that businesses will generate for a specific period (usually five years). To arrive at a final value, this value is discounted back (using the discount rate) to the present value, and then the procedure considers a terminal value of the business, assuming that the ongoing value of the business after the forecast period is still sound and marketable.
Capitalization of earnings method
The cap rate method uses a capitalization rate, which reflects the rate of return a hypothetical investor into the business expects on their investment. The cap rate is derived from market data reflecting current expectations of the returns investors expect from similar investment assets.
The cap rate method determines the value of an organization by calculating the worth of its anticipated profits based on current earnings and expected future performance.5 The core principle of both methods is to establish the present value or the current worth of the investment based on the income it is expected to generate in the future.
Benefits and disadvantages
Both valuation methods have strengths and weaknesses, which are associated with forecasting and the inherent weaknesses of the estimates.
While the cap rate method is simpler and easier to apply, it does not fully and accurately capture the variability of future income (either positive or negative). In contrast, the DCF method provides a more precise estimate of value by considering the timing and risk of future cash flows; however, it requires more detailed projections and is more sensitive to changes in assumptions. Additionally (and importantly), any minor adjustments within the DCF method calculations can disproportionately affect the valuation results.
Strengths of income-based valuation
The income-based valuation approach offers several benefits:
Focus on intrinsic value: An income-based approach focuses on the business enterprise’s income-generating abilities. The asset’s income-generating capacity is often the primary reason for its acquisition, and there is a clear link between the asset’s value and its ability to generate returns for the investor. As long as the asset valuated generates income, this approach can be applied.
Forward-looking perspective: The income-based approach often involves projecting future cash flows, which inherently provides a forward-looking perspective on the asset’s value, reflecting investors’ interest in the long-term potential of an investment.
Flexibility: The income-based approach is flexible and customizable and can be successfully adapted to various asset types by adjusting the cash flow. Depending on the specifics of the asset and the analysis, different variations of the method can be employed. For instance, while the capitalization method is best used for stable income streams, the discounted cash flow method is more suitable for valuing business entities with uncertain or fluctuating cash flows. Furthermore, in addition to business valuation, this approach can be used to value other types of assets, including real estate properties and financial instruments.
Reflective of market dynamics: The income-based approach incorporates market data such as capitalization rates and discount rates. Since these values are derived from market data, they reflect investors’ expectations and perceptions of risk well. Such a reflective approach ensures that the valuation of the asset (dental practice) reflects the prevailing market conditions and investor sentiment.
Weaknesses of income-based valuation
While the income-based valuation approach offers several benefits, it also comes with its own set of disadvantages:
Dependence on projections: The accuracy of income-based value heavily relies on the accuracy of future income projections. Projections are based on predicting future cash flows and can be challenging. Even minor inaccuracies or errors in forecasts can lead to significant discrepancies in the estimated value, especially for assets with uncertain or volatile income streams.
Difficulty in determining discount rates: The crucial part of the process is determining the appropriate discount rate. While the discount rate should optimally reflect the risk associated with the investment, assessing risk can often be subjective and uncertain, significantly affecting the valuation results.
Sensitivity to assumptions: The income-based valuation method requires assumptions about factors such as discount, growth rates, and terminal values. These assumptions can be subjective based on the analyst’s judgment and experience. Moreover, small changes in key assumptions can result in significant variations in the estimated value.
Vulnerability to market fluctuations: Since income-based valuations rely heavily on market data such as capitalization rates, they can be influenced by market conditions, interest rates, or investor sentiment changes. Fluctuations in these factors can impact the valuation’s accuracy, affecting the asset’s actual intrinsic value. This is especially important in valuations of dental or medical practices, which are not as affected by market fluctuations as other business entities.
Limited applicability for non-income-generating assets: This methodology is significantly limited when valuing assets that do not generate income because it relies on valuing income streams. In these cases, other valuation methods—such as the market or cost approach—may be more appropriate.
Ignores asset values: The income-based approach primarily focuses on the income generated by the asset and, when the income is not generated, may neglect the underlying asset value. For instance, while a property with high rental income—however seriously physically deteriorated—may be overvalued, the other property—which is newly built and has a long-term use potential—may be undervalued due to the current lack of rental income. This highlights yet another weak side of this methodology.
Complexity: The income-based valuation approach—particularly the DCF method—can be complex and resource-intensive. This method requires detailed financial analysis, including forecasting future cash flows, selecting appropriate discount rates, and performing sensitivity analysis. This complexity and resource requirement may make certain assets or situations impractical.
Conclusion
The income-based valuation approach provides a robust framework for estimating the value of income-generating assets, considering income and growth potential, market expectations, and investor priorities.
However, this approach is considered the most challenging valuation methodology because it relies on estimates and projections that, in theory, must be valid and underpinned by accurate data; further, it may be subjective.
While income-based valuation is widely used and offers valuable insights into the value of income-generating assets, it has drawbacks. These limitations should be carefully considered, and the employment of additional valuation methods or sensitivity analyses to mitigate potential biases and errors is encouraged.
Editor's note: This article appeared in the October 2024 print edition of Dental Economics magazine. Dentists in North America are eligible for a complimentary print subscription. Sign up here.
References
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- Myers N. Emergent issues of environmental economics: what we should be analysing closely but haven’t thought much about. Int J Soc Econ. 1998.25(6/7/8):1271-1278. doi:1108/03068299810212748
- Chen J. Yields in finance: formula, types, and what it tells you. Investopedia. Updated May 31, 2024. https://www.investopedia.com/terms/y/yield.asp
- Gottlieb MS. Scrutinizing the capitalization rate within a business valuation report. MSG Accountants, Consultants, and Business Valuators. February 2024. https://www.msgcpa.com/forensicperspectives/cap-rate-bv-report/
- Scott G. Capitalization of earnings: definition, uses and rate calculation. Investopedia. Updated April 23, 2024. https://www.investopedia.com/terms/c/capitalization_of_earnings.asp
