Income Approach
Core concepts
The income approach converts expected future economic benefits to present value. Two families: capitalization of a single benefit stream (Gordon growth: value = next-year benefit ÷ (discount rate − growth)) and discounted cash flow (project each year, discount, add terminal value). Choose the benefit stream deliberately: free cash flow to the firm discounted at WACC (equity value = enterprise value − debt + cash); free cash flow to equity discounted at cost of equity; or net income / net cash flow capitalized at an equity discount rate. Match stream to rate-mismatching is the most common error.
Discount rate builds: risk-free rate + equity risk premium × beta + size premium + company-specific risk premium = cost of equity. WACC weights debt and equity after tax. The build-up method omits beta; the modified CAPM adds size and specific risk. Terminal value uses a perpetuity growth or exit multiple method, discounted back from the end of the projection.
Traps
- Discounting pre-tax cash flows at an after-tax rate (or vice versa).
- Using WACC with equity cash flows, or cost of equity with firm cash flows.
- Forgetting to subtract interest-bearing debt and add excess cash when converting enterprise to equity value.
- Mid-year convention errors-apply consistently to all periods including terminal value.
- Terminal value growth exceeding the discount rate, producing a nonsensical result.
- Ignoring capital expenditures and working capital needs in free cash flow.
Worked rule of thumb
Next-year cash flow $1,000,000; discount rate 15%; growth 3%. Capitalized value = $1,000,000 ÷ (0.15 − 0.03) = $8,333,333. If growth rises to 5%, value jumps to $10,000,000-growth is highly sensitive, so justify it.
Exam strategy
Label the stream and the rate before calculating. Verify the terminal value fraction of total value; if it dominates unreasonably, revisit assumptions.