What Is It?
Under the income approach valuation, the fair market value of a closely held business is determined based on how much income the business is expected to generate in the future. The appraiser thinks of the business as a goose that lays golden eggs. How much would you pay for the goose? Find out how many golden eggs the goose lays, consider the chances that the goose will stop laying eggs, and make a valuation decision.
When Is It Used?
In most cases, the income a business generates is the best way of determining what the business is worth. The income method is therefore probably the most common valuation approach, especially in valuing small, operating businesses. Specifically, this approach is used on service businesses or other noncapital-dependent businesses.
Generally, the primary alternative to the income approach is the market approach. Some appraisers believe that the IRS prefers the market approach, especially if the business is comparable in some way to a publicly traded business. The preference for the market approach may be motivated by the fact that the market approach often results in a higher value.
How Is It Used?
In general terms, the appraiser will consider how much income the business generates now, consider the odds that the business will continue to generate that much income in the future, and then decide how much such an income stream is worth. Appraisers use discretion in determining which factors will be used. Appraisers using the same named approach may use different techniques to determine the value.
Technical Note: While there are no set definitions for the income approach, there are some general methods that your appraiser might use:
- The capitalization of earnings or discounted earnings method: Determine earnings, then capitalize those earnings--calculating how much an investor would expect to earn on such an investment.
- The capitalization of income method: Determine some income number (possibly before-tax income, after-tax income, net income, gross income, or operating income), multiply that amount by a percentage that accurately anticipates growth, then determine how much money a rational investor would invest to get that return.
- The discounted cash flow or discounted income method: Determine how much money the business will generate in the future and discount that to its present value.
Caution: You and the IRS are most likely to disagree on the capitalization or discount rate that is applied. This is probably because a small shift in the rate can have a dramatic difference in the fair market value. Since there is no objectively correct rate, the best you can do is carefully select an appraiser to decide the rate you will use.
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