Where a buyer is paying for profit that has yet to be earned, this method turns expected earnings, and the risk that they fall short, into a single value as at today.
The income approach values a Wollongong business at the present value of the profit it can keep earning. A valuer either capitalises one normalised year of earnings at a rate allowing for risk and growth, or builds a year-by-year cash flow forecast, discounts it to the valuation date and adds a terminal value. In both cases the rate is assembled from risks that the report lists one at a time.
The valuer projects cash flow for each coming year, discounts every year back to the valuation date and adds a terminal value for the period after the forecast. It suits a business whose next few years will differ from its past: a Port Kembla engineering firm whose large maintenance contract ends in year three, an allied health group opening a second clinic in Shellharbour, or a Dapto trade business moving from its founder to a hired manager.
A single year of normalised earnings, chosen because it fairly shows what the business will go on earning, is divided by a capitalisation rate (the discount rate less long-run growth). It fits a business whose recent years look alike, such as a North Wollongong accounting practice with a settled client base and fees that have crept up slowly.
A discount rate is built, not looked up, and every part of it matches a risk the valuer can name. The base is a risk-free rate taken from long-dated Australian Government bond yields (Source: RBA, Statistical Tables F2 Capital Market Yields). Above it sit an equity risk premium, since owning a business is riskier than holding a bond; a size premium, since a private company is more exposed than a listed one; an industry premium for the cycles and regulation of its sector; and a company-specific loading for what is particular to this business, such as reliance on a few customers or on the owner, the quality of its records and where it trades.
Together these layers give the cost of equity. Where the valuation covers all invested capital and not only equity, the cost of equity is blended with the after-tax cost of debt into a weighted average cost of capital. Taking away sustainable long-term growth leaves the capitalisation rate, and one divided by that rate gives the matching earnings multiple.
Picture an accounting and advisory practice in the Wollongong CBD with one principal, three fee earners and a lease with three years left. Normalisation replaces the principal's drawings with a market salary, resets the rent paid to the principal's family trust for the office to a market rate, strips out a one-off gain from selling a small client book, and checks how the practice's contractors and associates are treated under the Payroll Tax Act 2007 (NSW), administered by Revenue NSW, so payroll tax is forecast on the current position instead of copied from earlier accounts. The company-specific loading then reflects that two people hold most of the client relationships. The rate applied to the normalised earnings gives an enterprise value range, which the market approach then tests against sales of comparable practices elsewhere in the Illawarra.
Businesses with an established earnings record: medical and specialist rooms around Wollongong Hospital and North Wollongong, dental surgeries in Fairy Meadow and Shellharbour, accounting and law firms in the Wollongong CBD, IT and managed service providers, home care and disability providers, broking books, and trade contractors whose maintenance agreements renew every year.
Each earnings result is tested. Where sales evidence is available the market approach runs beside it, and adjusted net assets are worked out every time as the floor. The report sets out why, for this business, the income result earned the greatest weight.