When a buyer is really paying for the profit still to come, this approach converts that expected profit, and the risk attached to it, into one present-day value.
Under the income approach, an Adelaide business is worth the present value of the earnings it can sustain. The valuer either capitalises one year of normalised earnings at a rate that reflects risk and growth, or forecasts cash flow year by year with discounted cash flow, brings each year back to the valuation date and adds a terminal value. Either way the rate is built from risks the report names one by one.
The valuer forecasts cash flow for each year ahead, discounts every year to the valuation date and adds a terminal value for the years beyond the forecast. This is the method for a business that is about to look different from its history: a cyber security firm at Lot Fourteen still adding customers, an engineering consultancy whose defence work at Osborne is scheduled to finish in year three, or an allied health group opening a second clinic in Mount Barker.
One year of normalised earnings, selected because it fairly represents what the business can go on earning, is divided by a capitalisation rate, which is the discount rate less long-term growth. It works best where recent years look much the same, as they would for an Unley accounting practice with a settled client list and fees that have moved only gradually.
The discount rate is constructed, never pulled from a table, and each piece of it corresponds to a risk the valuer can point to. It begins with a risk-free rate based on long-dated Australian Government bond yields (Source: RBA, Statistical Tables F2 Capital Market Yields). On top of that sit an equity risk premium, because owning a business is riskier than holding a bond; a size premium, because a private company is more exposed than a listed one; an industry premium for the cycles and regulation of its sector; and a company-specific loading for what is particular to this business, such as customer concentration, dependence on the owner, the quality of its books and its location.
Added together, those layers produce the cost of equity. When the valuation covers all invested capital rather than equity alone, the cost of equity is combined with the after-tax cost of debt to give a weighted average cost of capital. Subtracting sustainable long-term growth gives the capitalisation rate, and dividing one by that rate gives the equivalent earnings multiple.
Take an illustrative general practice in Norwood with five doctors who bill through a service entity owned by the principal. Normalisation swaps the principal's drawings for a market salary, resets the rent paid to the principal's family trust for the consulting rooms on The Parade to a market rate, removes a one-off insurance recovery after a hailstorm, and reviews how the doctors' arrangements are treated under the Payroll Tax Act 2009 (SA), administered by RevenueSA, so that payroll tax is forecast on today's footing rather than repeated from earlier accounts. The company-specific loading then allows for the fact that two doctors generate most of the billings and that the lease has three years to run. Applying the resulting rate to the normalised earnings produces an enterprise value range, which the market approach then checks against sales of comparable practices in Adelaide's eastern suburbs.
Businesses whose earnings have a settled history: general and specialist practices around the BioMed City precinct, North Adelaide and Flinders Medical Centre at Bedford Park, dental surgeries in Burnside and Prospect, professional firms in the Square Mile and Kent Town, software and cyber businesses at Lot Fourteen and Mawson Lakes, disability and home care providers, broking books, and trade contractors whose service agreements renew every year.
The earnings result is always tested. Where enough comparable sales exist, the market approach is run beside it, and the adjusted net asset figure is calculated in every case as the floor. The report explains why, for this business, the income result deserved the greatest weight.