Income Approach Methods to Valuing a Professional Practice
The Income Approach Method to valuing is a widely recognized approach to estimating economic value of a business during a divorce. There is often an emphasis on Income Approach Methods to valuing a business since they are based on anticipated earnings. Income Approach Methods is a way to determine future income and convert the income into an estimate of value.
Multiple of Discretionary Earnings
This method used for some divorces presents the value of the business’ discretionary earnings. Discretionary earnings are adjusted pre-tax earnings plus depreciation, interest expense, and the salary of the owner. A multiplier ranging from 1- 3 (representing all the risk elements associated with the business as well as the required rate of return) are applied to convert Discretionary Earnings into a “derived value.” The derived value encompasses the business’ operating expenses. Real estate and net working capital are considered “additive values.”
This method used for some divorces is based on adjusted pre-tax or after-tax earnings and reflect the salary of a manager to operate the business and economic depreciation. An amount is deducted from earnings representing the required return needed to support the tangible asset value. If there are excess earnings, they are attributed to intangible assets. Tangible asset value is added to the derived value of intangible assets to express the total value of the company.
Capitalization of Earnings Method
This Canadian family law method also uses adjusted pre-tax or after-tax earnings for calculations. The earnings are capitalized into an indication of value that reflects all risk associated with the tangible and intangible assets. The value derived by this method includes the business’ operating assets, including net working capital. Here again, real estate is considered an “additive value” as long as a reasonable rent has been included on the business’ operating expense sheet.
Discounted Future Benefits Method
In some companies, forecasted future earnings can be reasonably developed. In those situations, the Discounted Future Benefits Method may be applied for divorce purposes. This method utilizes forecasted after-tax earnings. These five- to ten-year earnings projections are then converted into a value using a present value concept. The Discounted Future Benefits Method is most often appropriate for large businesses with stable, predictable annual earnings. The average small business may have difficulty forecasting for five months, let along five years.