The value of any business is defined by the amount of future cash flows it can generate. The three basic valuation methods are the income approach, the market approach, and the cost approach. Only the income approach directly addresses the question of value. It is the first on the list of recommended methods in all guideline literature. In fact, the mere absence of an income approach may put the validity of a valuation analysis into serious doubt.
The income approach relies on the specific amount, timing, and risk of the cash flows. While the inputs are often hard to ascertain, the method tells the full story of “why” the investment or an asset is worth what it does. By comparison, both the market and cost approaches are shortcuts. They may estimate the value but won’t tell you “why.” They can be informative but are often secondary to the well-executed income approach. Oh, and both are just as unreliable.
To be sure, the income approach can yield a broad range of potential values. The financial forecast, discount factor, and terminal value are all highly dependent on unobservable inputs and stakeholder biases. However, an intellectually honest exercise will point to clear value drivers and enable informed strategic choices.
The income approach shines in conjunction with the market approach. Finding the correct set of valuation inputs can be daunting. The market approach does not offer a high level of precision either, but it may help triangulate the estimate. Each method has to stand on its own while guiding the analysis to a similar value conclusion.
In business valuations (e.g., IRC 409(a)), the absence of the income approach may signal a serious problem. For startups, the quality of the market approach may range between extremely imprecise and arbitrary. This is because even well-chosen market peers trade at highly divergent market multiples. Selecting the right multiple is a shot in the dark without the supporting income approach.
In conclusion, make sure to ask your valuation specialist if their analysis includes the income approach, and beware of any answer that sounds like cost-cutting (e.g., the market approach is sufficient). While certain deterministic transactional information may be sufficient for certain valuations, a proper analysis should include a thorough income approach.