How to Value a Business: The Income Approach (DCF)

Underneath every business valuation — every multiple, every rule of thumb, every comparable sale — there's just one core idea:

A business is worth the amount of cash that it'll produce in the future.

Today, we're going to unpack that through the lens of the Income Approach.

Intro

This is Part 2 in my four-part series on how to value a business. In Part 1, we covered the Market Approach — the most common method, based on what other similar businesses have sold for. If you haven't watched that yet, start there. The link will be in the description.

Today we're covering the Income Approach, also called a Discounted Cash Flow (DCF) analysis. I like this approach because it really reinforces the fundamental principles of business valuation.

For those who don't know me, I'm Ed — a business broker and the founder of Sundance Financial. We help small business owners sell their companies all over the US.

Let's get into it.

Why We Value Businesses The Way We Do

Before we get into the mechanics, let's first talk about why we value businesses the way we do.

The core idea behind every valuation method — Market, Income, or Asset — is simply this:

A business is worth the amount of cash it'll produce in the future, adjusted for two things:

1. The time value of money

2. The risk that the cash never actually shows up

A dollar earned today is worth a lot more than a dollar earned five years from now, for two reasons:

• Earnings potential. You could take that dollar today and reinvest it.
• Risk. No one knows what's going to happen five years from now, so no one knows whether you'll actually receive that dollar when the time comes. The longer the timeframe, the less certainty there is.

So when we value a business, what we're really doing is estimating the business's future cash income and discounting it back to today. Hence the name — Discounted Cash Flow analysis.

The Income Approach does this directly — you literally take the cash flows and discount them. The Market Approach (Part 1) does it indirectly — when buyers pay 2.5x earnings for a landscaping company, they're implicitly making the same calculation about future cash flows, timing, and risk, but using transaction data as a shortcut.

Both methods are really answering the same fundamental question. The Income Approach just shows you the underlying math, which is why — even though most small businesses will never use this approach — understanding it is really helpful for understanding business valuation.

Starting Point: Free Cash Flow (Not Sde)

Let's go back to the landscaping company from Part 1. The owner's SDE was about $300,000 per year, and the Market Approach gave us a value of $750,000.

For the Income Approach, we don't use SDE directly. We use free cash flow — the amount of cash a business generates after adjusting for required reinvestment, but excluding financing payments.

Free cash flow differs from SDE in two important ways:

	SDE	Free Cash Flow
Owner's salary	Added back	Not added back
Reinvestment in equipment/assets	Not accounted for	Subtracted

So if we take the $300,000 in SDE, assume the owner's salary is $80,000, and assume capital investments of about $20,000 per year:

$300,000 − $80,000 − $20,000 = $200,000 per year in free cash flow

That's our starting point.

The Three-Step Process

Step 1 — Project Future Cash Flows

Let's say we expect that $200,000 in free cash flow will grow at 5% per year for the next 10 years:

• Year 1: $200,000
• Year 2: ~$210,000
• Year 3: ~$220,000
• ...
• Year 10: ~$310,000

But we're not done. The Income Approach also includes a terminal value — what the business could theoretically be sold for at the end of the projection period.

Let's say our landscaping owner sells the business at the end of Year 10 for $900,000. We add that $900,000 to the $310,000 of cash generated in Year 10, giving us $1.21 million for that final year.

Step 2 — Pick the Discount Rate

The discount rate should reflect the underlying risk of the business:

• Lower discount rate → stable business with recurring revenue, multiple customers, and a management team that extends beyond just the owner
• Higher discount rate → business that depends on one customer, one owner, and operates in a volatile industry

The higher the discount rate, the higher the risk.

For small businesses, discount rates typically land somewhere between 20% and 40%. There are more technical ways to select a discount rate, but for our purposes today, let's just go with 30% — the midpoint.

Step 3 — Discount Each Year's Cash Flows Back to Today

To convert a future dollar into today's terms, you divide that future dollar by (1 + discount rate) raised to the power of t, where t is the number of years from today.

• Year 1: $200,000 ÷ 1.3 ≈ $154,000
• Year 2: $210,000 ÷ (1.3)² = $210,000 ÷ 1.69 ≈ $124,000
• Year 3: Year 3 cash flow ÷ (1.3)³
• ... and so on

Each year, the denominator gets larger, so the present value of that future cash flow gets smaller. By Year 10, that $1.21 million is worth only about $88,000 in today's terms.

Once we've calculated the present value of all 10 years' cash flows, we add them together:

Total = ~$770,000

That's the value of the business today, based on the Income Approach.

Convergence — And Sensitivity

Here's the interesting part. The Market Approach (Part 1) gave us a value of $750,000. The Income Approach gives us a value of about $770,000.

Those are pretty similar — and that's not a coincidence. When assumptions are reasonable, valuation methods tend to converge because they're all answering the same set of fundamental questions.

But watch what happens when I change just one assumption:

Change	New Value
Baseline (30% discount, 5% growth)	$770,000
Drop discount rate to 25%	~$920,000
Bump growth rate to 10%	~$880,000

Same business, same fundamentals — but small changes in the inputs drive big changes in the answer. That's the catch with the Income Approach.

Can You Trust The Income Approach For A Small Business?

The honest answer is: usually no. And that's exactly why most small business sales rely on the Market Approach instead.

The Income Approach only gives you a reliable answer when three conditions are met:

1. Stable, predictable earnings — at least five years of financial history showing consistent growth and margins. If your last three years look wildly different from each other, projecting the next 10 is going to be tough.
2. A clear understanding of reinvestment needs — free cash flow depends on knowing exactly what the business needs to reinvest to keep running. Without a strong grasp of your equipment replacement schedule or maintenance spend, your projections won't be reliable.
3. A diverse (or sticky) customer base — if half your revenue comes from one client and you don't know whether they'll stay, predicting 10 years out is really difficult. Losing that one client would cause a 50% swing in revenue.

Most small businesses don't check all three boxes, which is why — for owner-operated companies — the Market Approach, grounded in real transaction data, is far more reliable.

The Income Approach really comes into its own in the lower middle market — businesses doing well over $5 million in revenue, where there's enough operational history and organizational structure to make these projections meaningful.

Wrap-Up

So that's the Income Approach.

In Part 3, I'll cover the Asset Approach — what your business is worth based on the stuff it owns. It's simpler than today's video, but most people get its role wrong.

In Part 4, I'll cover the valuation method that most business brokers won't talk about — and the one that every serious buyer actually uses.

Subscribe so you don't miss those videos. If this series is helping you, do me a favor and hit subscribe.

And if you want to talk through what your specific business might be worth, I offer a free, no-obligation consultation — link in the description.

Again, I'm Ed from Sundance Financial. I'll see you in Part 3.