Assuming that the company being valued has an indefinite lifespan, financial surpluses are derived from the projected future annual earnings, which can be distributed to the company’s owners. The expected earnings are discounted accordingly so that the value of these future financial surpluses, as of the valuation date, can be assessed. The traditional income approach must be modified, particularly for small and medium-sized enterprises.
Modified Income Approach
The diversity of small and medium-sized enterprises with regard to their fields of activity (industries), company size, legal form, owner dependency, and many other criteria is not sufficiently reflected in the classic business valuation based on the standards for business valuation published by the Institute of Public Auditors in Germany e. V. (IDW).
Since the calendar year 2000, this standard has been developed and updated primarily for publicly traded, capital-market-oriented, and other large companies—mostly corporations. As a result, however, IDW S 1 is suitable for the proper valuation of only about 1% of German companies. 99% of companies in the Federal Republic of Germany are small and medium-sized enterprises (SMEs). These are mostly entrepreneur-led and are operated as sole proprietorships, partnerships, or corporations. In this context, these companies are often characterized by a manageable number of shareholders and their close personal ties to the company.
The Modified Income Approach provides a recognized method based on the principles of IDW S 1 that takes into account the specific characteristics of small and medium-sized enterprises. This method is being used with increasing frequency in the valuation of SMEs. The Modified Income Approach differs from the classic income approach in that it limits the capitalization period to a few years (typically 1–10 years) and, as a result, requires an additional assessment of the net asset value.
