Valuation of Software Companies – The Income-Based Approach
November 2, 2016
To conclude our blog series in the valuation of software companies, we focus our attention this week to the income-based approach. Click here if you missed any of our blogs or want a quick refresher on this series.
The income-based approach is used to value software companies that are a going concern and have predictable earnings and cash flow (or at least earnings and cash flow are able to be forecasted). Typical income-based approaches include the capitalized earnings method, the capitalized cash flow method and the discounted cash flow method. As the name implies, the value, determined from the three methods noted above, is dependent on the software company’s earnings or cash flow. Each of these methods is described briefly below:
Capitalized earnings method – the earnings method values a software company based on a stable and steady stream of predictable earnings. This method assumes that earnings will be achieved by the company indefinitely, and that the company is in a mature industry where historical earnings are representative of future anticipated results. Other assumptions used in this method include the assumption that the software company’s annual amortization (or depreciation) on its capital assets approximates the annual capital expenditures required to sustain normal company operations. This implies that the company is not capital intensive and has insignificant fixed asset requirements. The capitalized earnings method is also used when future forecasts of the software company are unreliable or unavailable (e.g., where management does not typically perform forecasts or budgets for the company).
Capitalized cash flow (CCF) method – the CCF method is very similar to the capitalized earnings method whereby it shares many of the same assumptions and requirements. The differentiating factor between the two methods is that the CCF method is applied for companies where the annual amortization expense does not approximate the required annual sustaining capital expenditures or if the company is capital intensive in nature.
Discounted cash flow (DCF) method – the DCF method is used when management is able to provide (to the valuator) reliable company forecasts. Forecasts are usually prepared for a five year outlook. A drawback to the DCF method is that such forecasts contain a level of uncertainty in whether the company is able to achieve such forecasted cash flows. The valuator typically reflects this risk by applying an appropriate discount rate to the forecasted cash flows. For software companies, risks in achieving the forecasted cash flows may include potentially losing a product’s (or service’s) uniqueness in the marketplace, market changes to technological advancements, new government regulations, loss of key employees, and new competitors who develop a better and/or cheaper alternative product/service. Similar to the capitalized earnings and CCF methods above, the DCF method assumes the software company is a going concern and historical results of operations in the company are not indicative of future earnings.
We wish to point out there is a higher level of complexity in each of the methods detailed above, given that each company is unique and each valuation is case-specific and requires a deep level of judgment applied by the valuation professional. Nonetheless, we hope this five-part blog series has been an informative read and has provided you with some insight to the processes and complexities in the valuation of software companies.