In our previous blog post, we used a real-world example to show why valuation outcomes can differ, highlighting both the importance of the chosen methodology and the assumptions within it.

In the next few posts, we turn to the income approach and its key assumptions.

WHAT IS THE INCOME APPROACH?

The income approach values an asset based on the future income it is expected to generate. These future income streams are discounted, meaning that future payments are made less valuable to reflect that economic agents need to be compensated for (1) waiting for payment (the “time value of money”) and (2) the risk that those payments may not materialize as expected. The discounted cash flows are then added together to arrive at a single value today, representing the estimated value of the asset.

In practice, the most commonly applied form of the income approach is the discounted cash flow (DCF) method, which focuses on expected future cash flows as a proxy for income. Cash flows can be thought of as the actual money a business generates over time, after paying for its operating costs and necessary investments and that is available to its owners or investors.

Given its popularity, we will focus on this widely used implementation.

The mechanics are as follows: cash flows are projected over a defined period (the “explicit projection horizon”, usually between 5 and 15 years). Because businesses are typically expected to continue beyond this period, an additional value is included to represent all cash flows beyond the forecast horizon (the “terminal value”). Finally, all projected cash flows, including this terminal value, are translated into today’s terms (“present value”) by discounting them back to the present.

Source: Own diagram, based on francineway.com

This leads to three primary assumptions which must be made for any valuation under the DCF method:

1. Projected cash flows

2. Terminal value

3. Discount rate

In this post, we focus on cash flow projections. The next two posts will examine the terminal value and discount rate in more detail.

WHY CASH FLOW PROJECTIONS MATTER

Cash flow projections have a direct and intuitive impact on valuation: higher expected future cash flows lead to higher valuations.

However, as we briefly introduce above, not all cash flows matter equally. Cash flows in the near term typically have a greater impact on value than those further in the future because they are more valuable. Flows further in the future are worth less because economic agents need to be compensated for (1) waiting for payment (the “time value of money”) and (2) the risk that those flows may not materialize as expected.

To illustrate the impact of projections, it is useful to return to the example from our first blog post: the valuation of Dell Inc. One of the key drivers behind the wide range of valuation outcomes in that case was the use of different projections. Court documents show that multiple projections were put forward, three prepared by an advisor and one by an investment bank. Each reflected a slightly different view of Dell’s future performance.

If we take these four projections and feed them into a stylized DCF framework, the impact on the valuation becomes visible.

In the interactive tool below, you can select between these scenarios or adjust the projections yourself. The model is deliberately stylised: the discount rate and terminal value are held constant, allowing you to focus solely on the role of cash flow projections. As you vary projected cash flows over a five-year horizon, you will see how changes, particularly in earlier years, affect the resulting valuation.

For example, if we select the “Advisor Base Case”, we arrive at a starting valuation of USD 12’090k. Increasing cash flows leads to a higher valuation, but the timing of the increases matters. An increase of USD 500k in the first year translates one-for-one into value today, increasing the value by USD 500k. The same increase in the fifth year, by contrast, results in a smaller uplift of around USD 241k in the valuation.

flows by USD 500k results in a smaller increase of USD 241k.

It is important to note that this is not a recreation of the valuations in the Dell case. Rather, it is just an isolation of the projected cash flows to demonstrate how differing expectations alone can lead to materially different valuation outcomes.

ASSESSING PROJECTIONS: FROM ART TO DISCIPLINE

While projections are inherently uncertain, valuation practice has developed structured ways to assess their plausibility. The goal is not to eliminate uncertainty, but to ensure that assumptions are internally consistent, evidence-based, and economically grounded.

A widely accepted starting point is to disaggregate projections into their key drivers, such as price and quantity. This allows assumptions to be tested against observable data and economic logic. For example, revenue growth driven by price increases should be consistent with market conditions and competitive dynamics.

Another common approach is benchmarking against peers. Comparing projected margins, growth rates, or capital intensity with those of similar companies provides a reality check. Empirical evidence shows that long-term profitability and growth tend to converge toward industry norms over time (see e.g. Valuation).

Where relevant, projections should also be assessed against overall market developments. In mature or stable markets, company growth is typically constrained by broader market growth. Assuming sustained outperformance without a clear competitive advantage may therefore be difficult to justify.

A more structured extension of this idea is the total market (or “top-down”) approach, where projections are anchored in estimates of total addressable market size and expected market share. This is particularly useful in high-growth or evolving industries, where aggregate market expansion is a key driver of company performance.

Finally, best practice emphasises scenario and sensitivity analysis. Rather than relying on a single “base case”, valuation experts assess a range of possible outcomes, reflecting different assumptions about growth, margins, or market conditions. This approach is widely recommended in professional standards such as those of the International Valuation Standards Council and helps make uncertainty explicit rather than implicit.

TAKEAWAY

Cash flow projections are a central input in any valuation based on the income approach. Small changes in assumptions can lead to large differences in outcomes, particularly when they affect near-term cash flows, as we saw in our brief example above.

While projections will always involve judgment, they are not arbitrary. A disciplined approach, grounded in data, economic reasoning, and benchmarking, can significantly improve their robustness.

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