Income approach to real estate and business valuation. Applying the Income Approach

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

The income approach is a whole combination of methods for assessing the value of real estate, the property of an organization, the business itself, in which the determination of value is made by converting economic benefits that are expected in the future. The theoretical foundations of such an approach are quite convincing. The value of an investment is the value of future benefits to date, discounted at a rate of return that reflects the riskiness of the investment.

This is reasonable and suitable for any operating enterprise used in the field of production and sale of property, as well as its business, subject to the generation of positive profits. The value of investment risks in the assessed business is demonstrated by means of a discount rate. In the economic sense, this is now the rate of return that investors require on invested capital in comparable investment objects by risk level, or it is the rate of return on alternative investment options with comparable risks at the time of assessment.

Features

Application of incomeapproach in practice turns out to be quite a difficult task, since it is necessary to evaluate each important determinant of cost - the rate of return and profit. If these methods are used to evaluate an enterprise, then it is imperative to conduct a thorough analysis of all their key elements, including cost, company turnover, which have a direct impact on profits, costs and risks that are created by each individual element.

The income approach to business valuation is used quite often. For example, if we are talking about an acquisition or merger, then this method is used much more often than the costly or market one. The buyer's capital investment is now made with the expectation that in the future net cash flows will be received, which cannot be called guaranteed, since they are characterized by certain risks. The income approach captures these key determinants of value, while using the market approach usually requires a price-to-earnings ratio or some other similar multiple of earnings in retrospect, without taking into account the future.

Market multiples are inherently unreliable and fail to provide the same level of thoroughness that can be achieved by using an income approach with forecasts of future returns and discount rates. For example, a price-to-earnings ratio that is applied yearly does not adequately reflect expected changes in future years. Correctthe use of ratios provides an opportunity to show general investor preferences and are often quoted by sellers or industry sources.

Use

The information concerning the budget of the enterprise also needs to be analyzed and protected, which makes it necessary to carry out changes and work out the financial consequences of the created plan, forecasts and basic proposals. The income approach to business valuation measures all assumptions that relate to whether certain acquisition benefits arise from revenue growth, cost reductions, process improvements, or capital cost reductions. With this approach, all this can be measured and discussed. In addition, it can be used to determine the timing of expected benefits, as well as to demonstrate the decline in the value of an enterprise as benefits shift into the more distant future.

Using the income approach provides buyers and sellers with the ability to calculate the fair market value of an enterprise as well as its investment value for one or more strategic buyers. If this distinction is displayed clearly enough, then sellers and buyers can easily identify synergy benefits and make informed decisions.

When using the income approach to business valuation, it must be borne in mind that the calculated value consists of the value of all property that is used in the course of direct activity. ATWithin the framework of the approach used, there are several methods for evaluation that are of the greatest interest. In particular, such methods of the income approach are applicable: capitalization and discounting of cash flows. You can consider them in more detail.

Methods

Using the cash flow capitalization method, the total value of an enterprise is detected depending on the cash flows generated by the property potential of the enterprise. The cash flows of a business or an enterprise as a whole are the difference between all inflows and outflows of financial resources for a certain billing period. Typically, a period of one year is used for calculations. The technique is to convert a representative level of expected cash flow into a present value by dividing the total amount of the cash flow by the assumed capitalization rate. In this case, an income stream with certain adjustments is appropriate.

To use the conventional cash flow method, the addition of net income (calculated after taxes) of non-cash expenses is used to determine the amount of absolute cash flow to capitalization. This calculation method can be considered more simplified than the free cash flow calculation, which takes into account the required capital investment and the need to replenish working capital as an addition.

Discounting cash flows

This method is basically based only on the expected cash flows that are generated by the enterprise itself. Its characteristic difference is thatcost estimation is required to calculate the definition of a representative level of cash flow. This method in developed countries is most widely used due to the fact that it can be used to take into account all development perspectives. Cash flow in general terms equals the sum of net income and depreciation, subject to subtracting the increase in net working capital and capital investments.

There are the following conditions for using the discounted cash flow method:

• there is reason to believe that future levels of financial flows will differ from the current ones, that is, we are talking about a developing enterprise;
• there are opportunities to reasonably estimate future cash flows when using a business or commercial property;
• the object is under construction, full or partial;
• the enterprise is a large multifunctional facility of commercial importance.

The income approach to real estate valuation through the discounted cash flow method is the best, but its use is very laborious. There are estimates that cannot be made without the use of this method. Among them is the development of an investment project with its subsequent evaluation.

Advantages of the discount method

If you practice an income approach to the valuation of real estate or business through the discount method, you can identify some major advantages. First of all, speechThis means that future business profits directly take into account only the expected current costs of manufacturing products and then selling them, and future capital investments related to maintaining and expanding production or trading facilities are reflected in the profit forecast only indirectly through their current depreciation.

Important points

Evaluation of an object by the income approach with a lack of profit or loss as an indicator of investment calculations is carried out adjusted for the fact that profit serves as an accounting reporting indicator, therefore it is subject to significant manipulations in the course of work.

The discounted cash flow method includes three groups of models:

• discounted dividends;
• residual income;
• discounted cash flows.

If an income approach is practiced in accordance with the dividend discount model as evidence of cash flow, share payouts are used. Despite the fact that the model is significantly common in foreign practice for determining and evaluating the value of an enterprise's assets, it has a lot of shortcomings. In models with retained earnings, there is no degree of accounting. There is a difference in dividend policies not only for specific enterprises, but also for countries as a whole. This method cannot be used in enterprises that have no profit. This model is best suited for calculating the value of minority shares.

Residual income model

The income approach to valuation through the residual approach model assumes that the amount of residual income, that is, the difference between the actual profit and the profit that the shareholders predicted at the time of the purchase of the company itself or its shares, will be used as an indicator of cash flow. If the value of the enterprise was calculated on the basis of assumptions consistent with this model, then it will be equal to the sum of the book value with the present value of the expected amount of income remaining after that. This model demonstrates significant sensitivity to the quality of the data presented in the financial statements. For Russian conditions, the adequacy of such information is subject to significant doubts.

Benefit for shareholders

Of course, shareholders or shareholders of an enterprise that has a certain history, as well as the facts of paying dividends, can use the discount model to calculate the value of their own company. The situation is such that the shareholders of enterprises in this sector are rarely minority, so for them the most appropriate way would be to use an income approach to the valuation of real estate and business through a discounted free cash flow model. In this system, free cash flows with discount rates or expected return on invested capital are the key ones. The biggest problem with using this model is the accuracy of the free cash flow forecast, as well as the adequate determination of the discount rate.

If the income approach as defined above is applied, then when using the discounted cash flow method, the income expected from the business takes into account the projected cash flows that can be withdrawn from circulation after the required reinvestment of part of the cash profit. As an indicator, cash flows do not depend on the accounting system used by the enterprise and its depreciation policy. At the same time, any cash flows - inflows and outflows - must be taken into account. The assessment of the financial meaning of discounting cash turns out to be such that as a result of these processes, they are reduced by amounts that would have been available to the investor by the time the specified cash flow was received, provided that he invested his funds not in this business right now, but in some - some other investment asset of a public nature, for example, a liquid security or a bank deposit.

Additional techniques

The income approach, an example of which was described earlier, has been used less and less recently, and now the valuation method has become the most common. It is used to value all kinds of assets, and is based on the idea that any asset that shares the basic characteristics of options can be valued as this option. At the moment, the income approach is most often abandoned in favor of the option pricing model (respectively, the Black-Scholes model).

Such a system, if used, makes it possible to estimate the total cost of equity of a company or enterprise in the event that it operates at large losses. This model is intended to further explain why the cost of an enterprise's equity is not zero, even if the value of the entire enterprise declines below the nominal amount of debt. But even taking into account this advantage, it can be noted that the Black-Scholes model for assessing the value of Russian enterprises at the moment is increasingly theoretical. The main problem due to which this model cannot be applied to domestic businesses is the lack of some evidence for the model parameters, which are essential.

Conclusions

The income approach to business and real estate valuation has become much less common, and this is happening for many reasons. In particular, this concerns the shortcomings, due to which there are difficulties in its use in the consumer market. First of all, it should be noted how difficult it is to forecast the future cost of services and products, materials and raw materials, as well as a set of other cost indicators. At the same time, we can talk about some subjectivity of expert assessments. In addition, the problem lies in the low disclosure of information on Russian enterprises, and in fact it is necessary for making competent calculations and compiling the Black-Scholes model. This is largely due to the low corporate culture of suchenterprises.

The vast majority of shares, including large stakes, are concentrated in the hands of a small circle of people, and the share of minority shareholders and small owners, whose share is very small, in the authorized capital is insignificant. It turns out that many enterprises are simply not interested in disclosing any information. That is why the calculation by the income approach is noticeably more complicated in relation to most industries and businesses in Russia. In other conditions, it works best, showing all its advantages and reliability.