Question

Make an argument that the income based approach / earnings based approach is the best business valuation approach.

Answer 1

This approach is primarily based on going-concern concept where the company is expected to have infinitely long working period and not liquidate in near future. Under such circumstances, the economic benefit in terms of net cash flow etc is discounted, capitalized etc to provide the current firm value.

The economic benefit such as the seller’s discretionary cash flow or net cash flow is capitalized, discounted or multiplied to perform the valuation. Key to the effective use of the income-based business valuation methods is the proper selection of the capitalization rate, discount rate, and valuation multiples. The well known methods under the income approach are:

• Discounted cash flow method
• Capitalization of earnings method
• Multiple of discretionary earnings method

The earnings based approach to valuation is on the proposition that the business valuation should be based on future earnings or the firm's capacity to generate cash flows. Thus, this approach eliminates the limitation of the asset based approach which totally ignores the firm's potential to generate cash flows and earnings. Earnings can be measured on two bases:

• Earnings measured by accounting and
• Earnings measured by cash flows.

An earning value approach is based on the idea that a business's value lies in its ability to produce wealth in the future and income based approach is the value of a business based on its ability to generate desired economic benefit for the owners.

Both are good and can use interchangably