The Income Approach to Valuation
By Derek Oster, ASA, CVA, Manager, Valuation, Forensic & Litigation Services
On May 15, 1997, Amazon became a publicly traded company on the NASDAQ stock exchange in an initial public offering (“IPO”) that valued the then-online bookstore at approximately $438 million. It took more than four years for Amazon to report its first-ever profitable quarter. The company’s market capitalization over that same period, however, grew to over $4 billion. It then took two more years for Amazon to report its first full year of profitable results, at which point its market capitalization had climbed to over $21 billion. This example illustrates a common question or misinterpretation in valuation – how can a company with negative earnings be so highly valued?
There are three general types of approaches to determine value: (i) income approach; (ii) market approach; and (iii) asset (or cost) approach. This article focuses on the income approach – arguably the most widely used by valuation professionals.
What is the income approach?
In order to understand how a company with no profits or negative earnings can have value under the income approach, we must first understand how the income approach works conceptually. In general, income-based valuation methodologies convert an anticipated future benefit stream (e.g., cash flows or earnings) into a value by discounting that benefit stream to present value, using an appropriate discount rate. Under the income approach, the value of a business is derived from expectations of the future cash flow of the business (not historical results). This differs from market- and asset-based approaches whereby the market approach instead relies on a comparison of a subject interest to investments in comparable companies, and the asset approach relies on the premise that a prudent investor would not pay more for a group of assets than the cost to replace them.
The income approach is applied using one of two methods:
1. Capitalization of Cash Flow Method
This method values a business based on a single expected cash flow stream, capitalized by a risk-adjusted rate of return. It is most appropriate when a subject company (i) has current or historical results believed to be representative of future results; and (ii) is projected to grow at a modest but sustainable growth rate. In general, this approach is often used for mature companies experiencing relatively consistent streams of revenues and earnings.
2. Discounted Cash Flow Method
The Discounted Cash Flow Method (commonly referred to as the “DCF Method”) is a multi-period discounting model that determines the value of a business based on the present value of its expected future benefit stream. Specifically, the DCF Method is based on the theory that the value of a company is equal to the sum of both (i) the present value of projected future cash flows over a specific, discrete period, and (ii) the present value of a residual value that captures the economic benefit of the Company’s cash flows beyond the discrete projection period. The projection period typically extends to the point in time at which future cash flows are expected to stabilize and thereafter grow at a constant future rate. The DCF Method projects the distributable cash flows a business is expected to generate and discounts those cash flows to a present value, as of the date of analysis, using an after-tax, risk-adjusted rate of return. Distributable cash flow is used as the benefit stream in this analysis, as it represents the earnings available to distribute to investors after considering the reinvestment required to fund a company’s future growth. In general, the DCF Method is often used for companies that expect varying levels of revenue and earnings growth in the future.
Projected cash flows are often provided by management in the form of a forecast or budget. Since the DCF Method discounts expected cash flows to a present value using a rate of return that reflects both the inherent relative risk and the time value of money, this means that the valuation analyst must determine an appropriate rate of return that is commensurate with the overall risk of the forecasted cash flows. The risk of an investment is positive correlated with the required rate of return (or discount rate) – meaning that as risk increases, so must the required rate of return. An appropriate rate of return typically captures relative risk on a holistic basis and considers factors such as the overall market/economy, specific industry, and specific subject entity (including the believability of the prepared forecast relative to both itself and its peers).
So, how can a company with a history of reported losses have a positive value (massive in the case of Amazon) under the income approach? Using Amazon as an example, the substantial levels of expected revenue and earnings growth expected at the time of the IPO (which continue to this day) indicate it is most appropriate to use the DCF Method to value the company. Although Amazon had a history of losses at that time, investors expected those losses to transition into income over time and were willing to invest at a high value based on those expectations.
It is not always the case that a company with current negative earnings has value under the income approach. But an understanding of the nature and implications of the common methods utilized in the income approach can add the additional context needed to understand why an unprofitable company may command a surprisingly high value.
Do you have questions about valuation methodologies, or other valuation issues? Please contact Derek Oster, ASA, CVA, at [email protected].