Income Approach

The Income Approach – A Brief Introduction

The income approach is a family of income-based valuation methods built on a simple idea: a business is worth the economic benefit it can produce. In practice, the two workhorses are discounted cash flow (DCF) and capitalization of earnings (or cash flow).

The income approach also appears in commercial real estate appraisals; that specialty is outside the scope of this article.

When to use the Income Approach?

The income approach is one of the most widely applied valuation frameworks. It’s often preferred for companies with demonstrated earnings history—and, because it can incorporate forward-looking cash flows, it can also be adapted for businesses that are not yet consistently profitable.

Common use cases include:

• Acquisitions and business sales
• Capital budgeting and investment decisions
• Disputes, damages, and other litigation matters
• Mergers, recapitalizations, and restructurings

For asset-intensive companies, the asset approach may be used instead of—or alongside—the income approach. Where robust market comparables exist, the market approach can provide a helpful cross-check or, in some cases, a primary indication of value.

Nielsen Valuation Florida supports most assignments requiring the income approach; however, we respectfully do not perform start-up valuations.

Two Income Approach Methods

Valuation professionals employ several techniques within the income approach. The two most common are capitalization of earnings/cash flow and the discounted cash flow (DCF) method.

Used carelessly, these tools can mislead—particularly when they depend on speculative projections, one-size-fits-all formulas, or standardized capitalization tables.

DCF – Discounted Cash Flow Method

The DCF estimates value by forecasting future cash flows and discounting them back to present value at an appropriate rate of return.

A terminal value models the enterprise beyond the explicit forecast period.

Because outcomes hinge on numerous assumptions—growth, margins, reinvestment, risk—the indicated value can swing dramatically with small input changes or between appraisers.

While widely used, we find DCF too assumption-sensitive for most operating-company engagements. A notable exception is early-stage or venture scenarios, where projection-driven analysis may be the only feasible path.

Straight Capitalization of Earnings

Single-period capitalization starts with a normalized measure of one year’s earnings or cash flow and capitalizes it using a rate that reflects expected growth and risk.

Conceptually similar to DCF but far simpler, it substitutes a steady-state view for a multi-year forecast, making it a practical choice for businesses with stable performance.

The multiple (or its inverse, the cap rate) rises with sustainable growth and falls as risk increases.

How to Apply the Income Approach?

At Nielsen Valuation Florida, our aim is to present a defendable indication of fair market value rooted in facts, not wishful thinking.

We weigh the company’s history, risk profile, and transactional realities, and we ensure full conformity with Internal Revenue Service (IRS) Revenue Ruling 59-60.

A few guiding principles:

We Never use Standardized Cap-Rate Tables

Convenient as they seem, standardized cap rate tables gloss over company-specific risk and opportunity, and they don’t reflect how owners actually earn returns.

At Nielsen Valuation Florida, we do not rely on such tables. We evaluate the subject’s economics, risk, and earnings stability—exactly as IRS RR 59-60 contemplates, which states:

”No standard tables of capitalization rates applicable to closely held corporations can be formulated.”

Use a Preset Income-Approach Formula? No Thanks.

Prepackaged income approach formulas may speed up the work but create an illusion of precision.

They compress complex realities into a shortcut. IRS Ruling 59-60 is explicit:

“Valuations cannot be made on the basis of a prescribed formula.”

Online “income approach calculators” are therefore unreliable without rigorous scrutiny of inputs and context.

At Nielsen Valuation Florida, we analyze each company on its own merits—history, growth durability, customer and product concentration, dependence on key people, and more. When appropriate, we interview stakeholders and conduct site visits.

Thoughtfully Incorporate Historical Data

Forward expectations matter, but ignoring current and past performance often leads to overconfident projections.

Revenue Ruling 59-60 states:

“Prior earnings records usually are the most reliable guide as to the future expectancy, but resort to arbitrary five-or-ten-year averages without regard to current trends or future prospects will not produce a realistic valuation.”

Accordingly, we assess long-term and recent trends, the consistency of earnings, and any emerging risks or opportunities that may alter the outlook.

Marketability Discount Studies Should be Used With Caution

Discounts for lack of marketability (DLOM) reflect the difficulty of converting an interest to cash quickly at fair market value.

Academic compilations can inform judgment, but in many assignments they don’t mirror real-world deal behavior.

We prioritize observed market practices and transaction dynamics over theoretical averages when determining any applicable discount.

Always Normalize First

Before running any income-approach math, the financials must be normalized so the inputs represent ongoing economics.

Here’s how that preparation typically looks:

It is Essential to Normalize the Income Statements

Start with normalization adjustments to the income statement to remove items that distort sustainable performance.

That means eliminating nonrecurring, unusual, and discretionary items so the baseline reflects what a rational buyer would expect going forward.

Skipping this step can produce wildly inaccurate conclusions—sometimes not just a few percent off, but multiples away from fair market value.

Typical adjustments include:

• Asset sales: Remove gains or losses from disposing of long-lived assets that won’t recur.
• Legal settlements: Back out one-time gains or losses related to lawsuits or claims.
• Restructuring charges: Exclude exceptional costs tied to rare events like plant closures or major reorganizations.
• Insurance proceeds: Eliminate nonrecurring payouts (e.g., casualty recoveries) from earnings.
• Owner discretionary items: Adjust for expenses that benefit owners personally and wouldn’t persist in a market-based, professionally managed company.