THE INCOME METHOD OF DETERMINING ECONOMIC CAPITAL FOR BUSINESS VALUATION PURPOSES

THE INCOME METHOD OF DETERMINING ECONOMIC CAPITAL FOR BUSINESS VALUATION PURPOSES

Business valuation can be carried out to estimate the economic value of the company with the intention of fulfilling different purposes, among the most important of which are:

  • carrying out extraordinary M&A transactions, transformations, contributions, mergers, divestitures, demergers or equity research in which the target price of the company is established, 
  • preliminary evaluations for IPO, initial public offering, through the definition of a price range for the share of a company that wants to list on the markets, 
  • fairness opinions, i.e., fairness opinions involving transactions that have already begun,
  • arbitrations or civil proceedings regarding legal disputes related to corporate sale price.

VALUATION METHODOLOGIES

There are several business valuation methods; the main features are represented below:

  • methods based on result flows, for which the economic value is calculated as a discounting of the company's future cash flows (financial method) or income produced by operations (income method). These flows can be the result of explicit forecasting through the preparation of forward-looking documents such as business plans and business plans or a normalized average flow derived from history and estimates;
  • multiples method, which expresses economic value as a function of prices expressed by the market or transaction prices of comparable companies, i.e., similar listed and unlisted companies. Multiples, such as EV/EBITDA, EV/EBIT, P/E, among the most widely used, are calculated and updated by qualified entities, and then applied to the company to be valued and, therefore, the choice must be weighted according to the relevant industry sector and the geographical area of expertise;
  • capital methods, are based on the redefinition of the enterprise's assets. The simple equity method provides that the value of the enterprise is equal to the adjusted equity, obtained by re-expressing the asset book values according to their current values; on the other hand, the complex equity method provides that the value of the enterprise is equal to the value of the adjusted equity with the addition of intangible assets that do not pass through the balance sheet formats, such as the estimated goodwill;
  • mixed methods, based on the concept of economic profit, so called since they are composed of an income element known as extra-income, compared to the return on one's assets, and by an equity element, i.e., equity adjusted to current values. This methodology expresses the economic value of a company as a function of its adjusted net worth and its ability to generate an average normalized income in excess of its normal return, thus providing a particularly complete and comprehensive assessment.

THE INCOME METHOD

Delving into the earnings estimation method, the value of the company is represented as its ability to produce income in the future: placing oneself in the hypothetical figure of a buyer, one seeks to ascertain whether one is adequately remunerated for the capital potentially invested in the company.

For this reason, the expected future income is contrasted with the remuneration obtainable on the capital market by a person investing an equal amount of capital: an evaluation is made which, unlike the patrimonial methods, is synthetic and unitary and which does not take into consideration items extraneous to those of the company's characteristic management, thus not considering the ancillary one.

In practical terms, it takes the form of forecasting future income and then discounting the economic results thus determined, according to the formula deemed most appropriate depending on the time horizon, whether fixed or indefinite. The fundamental variables to be estimated are:

  • the expected income flows or alternatively the average income flow,
  • the discount rate, which usually corresponds to the cost of equity capital,
  • the determination of the time horizon, which indicates the expected duration of future income generation; in most cases, a limited duration is assumed, usually around 3 to 5 years, because theoretically the time horizon is indefinite since the enterprise has no disposal date, but the data would be insignificant.

For the determination of expected income, it is possible to choose a single average income quantity or the different income streams determined for each forecast year. The starting point is constructed from historical data, and there are the following possible approaches:

  • past performance, which assumes for the future the same levels of results historically recorded, projecting the same trend into the future,
  • of the projection of historical performance, which identifies a possible average trend of growth in profitability, on the basis of which future expected incomes can be weighted (analysis of growth rate, efficiency levels, organization of sales networks, labor cost variation, and so on, in order to assess the impact of all variables that can determine the correct growth rate),
  • planned performance, when it is possible to use management's industrial plans (budgets and multi-year plans), as long as their reliability can be verified.

In any case, the income quantity to be used is normalized income, adjusted by excluding extraordinary and unrepeatable components, as well as purified by the balance sheet policies adopted; in fact, extraordinary income components, such as extraordinary income and expenses unrelated to characteristic operations, are eliminated from the assumed historical data, and then the accrual taxes are recalculated by assuming a normalized measure that is expressive of the actual average tax incidence, adding any latent revenues and costs, correcting accounting conversions and neutralizing the balance sheet policies. 

It follows that, an adjustment is made of all items that are a cause of distortion and lead to the determination of an expected flow that is not sufficiently reliable for the purposes of the valuation process: the items that in practice lend themselves most to such operations are certainly depreciation or leased assets. 

The normalized income will then have to be discounted, using the capitalization rate i: the choice of capitalization rate represents the main critical point of the income approach, since it is linked to the concept of risk, since conservative measures of expected flow imply low rates and vice versa. 

The determination of the capitalization rate is usually linked to 2 parameters:

  • the pure interest rate, that is, the rate paid for the use of capital in investments with zero risk;
  • markup for the assumed business risk, that is, the risk of incurring losses and not profits from the capital investment made.

The most widely used model for estimating these parameters is the CAPM

CAPM = Ke = Rf + β(Rm-Rf) = Rf + β(ERP)

see the previous article for related discussion, https://bit.ly/3JpaqG6.

Lastly, in income or financial estimation methods based on result flows, the terminal value or terminal value is also usually considered: it is the final discounted value expressive of the realizable value of the company, which will be added at the end of the plan to the summation of the present values of future cash flows in order to assess the overall value of the company. There are various methodologies for a company's TV to be calculated correctly, one of the most widely used considers the value of normalized income in the last year of the plan discounted by a rate equal to the difference between the previously estimated cost of equity and the rate g or "growth rate" that turns out to be the company's growth rate: in doing so, the TV consists of discounting the estimated income in the last year of the plan, projected over a potentially infinite time horizon, at the discount rate Ke, where the cash flow grows at a rate equal to g.

Summarizing the income valuation method in formulas

page5image23386912

Where

  • W, denotes the value of the company being valued, 
  • Rn, denotes the value of normalized operating income, 
  • n, denotes the duration of the time horizon,
  • Ke, denotes the discount rate or cost of equity capital,
  • TV, denotes the terminal value of the company under evaluation.

ADVANTAGES AND DISADVANTAGES OF THE INCOME METHOD

The application advantages of the income method lie in the soundness of the underlying logic, since the company even in reality takes on a value, first and foremost, depending on the income that will be possible to derive from it; in addition, the income methods are well suited to those business realities that do not have problems related to the financial structure and adequately exploit their productive capacity, such as companies with a low level of capitalization for which profitability is expressed in terms of current capital and not in terms of fixed assets, then commercial, service, consulting, brokerage companies; the method is widely used in business disposals, as well as for the valuation of individual business units. The reliability of the model is related to the fact that concrete and certain data are used, pertaining exclusively to the company's characteristic operations.

On the other hand, for the above reasons, it is not best suited to real estate companies, insurance companies, holding companies, and nonprofit entities: in general, to all companies that generate income in a non-monetary but capitalization form; in addition, the disadvantages are related to the uncertainties and difficulties associated with the procedure of determining the value of the company: numerous are the quantities to be estimated, which will become more random, as well as less reliable and unreliable, as the time horizon of estimation continues; in addition, it is necessary for the estimated growth to be in line with the market and the sector to which it belongs, in order for it to be credible.

 

Edited by: Antonio Russo, Chartered Accountant and Statutory Auditor

You can download the article in PDF here

For more information:

antoniorusso@valoreassociati.it

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