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A Reviewer's Handbook to Business Valuation: Practical Guidance to the Use and Abuse of a Business Appraisal by Timothy R. Lee, L. Paul Hood Jr.

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Chapter 6

The Income Approach to Value

There are numerous methodologies subsumed under the broad domain of the income approach. Regardless of financial composition and organization, these methods develop their value indications through the conversion of a future economic benefit stream into a single, present value expression of value.

Investors in the public marketplace are accustomed to assessing the valuation of an equity security by observation of the security's price-to-earnings ratio (P/E). The P/E of a security is a relative value measure that represents the present value of the future earnings allocable to the security (per dollar of current earnings). An owner of a publicly traded stock can be said to hold equity in the earnings of the issuing business entity. The P/E ratio is a simplified mathematical expression that translates the stock's beneficial portion of the issuer's future earnings stream to an expression of price.

The P/E ratio is applicable to the earnings per share of the issuing entity and is the consequential measure of dividing the market price of the security by its share of the entity's earnings. Conversely, the earnings per share multiplied by the P/E ratio equals the market's price for the security. Appraisers use this relationship in numerous variations to develop the value of a business, a business ownership interest, security, or intangible asset. The P/E ratio answers the investor's question: What will I pay, today, in cash, for the present value ...

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