Recently, I was exposed to a commonly accepted income-based valuation approach in academic circles referred to as APV. After close examination, it occurred to me that it should be at least part of the conversation in our industry. It has clear advantages over the often used discounted cash flow approach which uses what we will refer to here as the WACC method. The essential difference between the two is that APV incorporates the tax benefits of debt financing into the cash flows as opposed to the discount rate.
To me this makes sense for two primary reasons. First, the interest expense and its tax shield are modeled to account for deleveraging over the projected period (presuming a private equity backed company, a critical assumption here). The APV takes the present value of these savings, which provides it the ability to account for a dynamic capital structure over the forecast period. Second, the cost of the debt can also change in future periods as the company pays down the more expensive subordinated debt first.
I will leave the nuances of specific calculations to the academic papers (a simple Google search of APV vs WACC returns a plethora of results). It would be nice to see some mention of it in business valuation periodicals. At our firm, we’re absolutely considering the incorporation of it into our valuations.