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 value is determined by converting the economic benefits that are expected in the future. The theoretical foundations of such an approach are quite convincing. The cost of investment is the present value of future benefits that are discounted at a rate of return that reflects the riskiness of the investment.
This is reasonable and suitable for any existing enterprise used in the production and sale of the property, as well as its business, subject to the generation of positive profits. The magnitude of the risks of investing in the business being evaluated is demonstrated through 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 this is the rate of return on alternative investment options with comparable risks at the time of assessment.
Features
Applying the income approach in practice is quite a difficult task, since it is necessary to evaluate each important determinant of value — the rate of return and profit. If these techniques are used to evaluate an enterprise, then a thorough analysis of all of their key elements, including cost, company turnover, which have a direct impact on the profit, costs and risks that each individual element creates, is required.
Income approach to business valuation is used quite often. For example, if it is a takeover or merger, then this method is used much more often than costly or market. The buyer's capital is now being invested 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 allows us to evaluate these key determinants of value, while the use of the market approach usually requires a price-earnings ratio or some other similar income multipliers for the retrospective period, without taking into account the future.
Market multipliers are characterized by such features as insecurity, as well as the inability to provide the same thoroughness that can be achieved by using an income approach with a forecast of future profits and discount rates. For example, the price-earnings ratio, which is used for the year, does not reflect adequately the expected changes in future years. The correct use of the odds provides an opportunity to demonstrate the general preferences of investors, they are often quoted by sellers or industry sources.
Using
Information regarding the enterprise’s budget, which makes changes and refinement of the financial consequences of the created plan, forecasts and basic proposals, also needs analysis and protection. The income-based approach to business valuation allows you to measure all assumptions that relate to whether certain benefits from a takeover arise as a result of revenue growth, cost reduction, process improvements, or lower capital costs. Using this approach, you can measure and discuss all this. In addition, with its help it is possible to determine the time of the expected benefits onset, as well as demonstrate the process of reducing the value of the enterprise as the benefits are transferred to the more distant future.
Using the income approach provides buyers and sellers with the opportunity to calculate the fair market value of the enterprise, as well as its investment value for one or more strategic buyers. If this difference is displayed clearly enough, then sellers and buyers can easily determine the benefits of synergy, as well as make informative 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 used in the process of direct activity. Within the framework of the approach used, there are several methods for evaluation that are of most 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 method of capitalization of cash flows, the total value of the enterprise is detected depending on the cash flows generated by the property potential of the enterprise. The cash flows of a business or enterprise as a whole is the difference between all inflows and outflows of financial assets for a certain settlement period. Usually, a period of one year is used for calculations. The methodology is to convert a representative level of the expected flow of money into a present value by dividing the total amount of the flow by the accepted capitalization rate. In this case, the revenue stream with certain adjustments is appropriate.
To use the usual method of calculating cash flows, an addition of net profit (calculated after tax) of non-cash expenses is used to determine the absolute cash flow to capitalization. This method of calculation can be considered more simplified in comparison with the calculation of the free flow of money, where the required capital investments and the need for replenishment of working capital are taken into account as an addition.
Cash flow discounting
This method is basically based only on the expected cash flows that are generated by the enterprise itself. A characteristic difference is that a cost estimate is required to calculate a determination of a representative level of cash flow. This method is most widely used in developed countries due to the fact that it can be used to take into account all development prospects. Cash flow in general is equal to the sum of net income and depreciation, subject to subtracting the increase in net working capital and capital investments.
The following conditions exist for using the discounted cash flow method:
- there is reason to believe that future levels of financial flows will differ from current ones, that is, we are talking about a developing enterprise;
- there are opportunities for a reasonable estimate of future cash flows when using a business or commercial real estate ;
- the object is under construction, full or partial;
- the enterprise is a large multifunctional object of commercial importance.
A profitable approach to real estate valuation using the cash flow discounting method is the best, but its use is very laborious. There are estimates that cannot be made without using this method. Among them are the development of an investment project with its subsequent evaluation.
Advantages of the discount method
If you practice a profitable approach to the valuation of real estate or business using the discount method, then you can identify some of the main advantages. First of all, we are talking about the fact that future business profits directly take into account only the expected current costs of manufacturing products with their subsequent sale, and future investments related to the maintenance and expansion of production or trading capacities are reflected in the profit forecast only indirectly through their current depreciation.
Important points
An object is assessed with the income approach when there is a lack of profit or loss as an indicator of investment calculations, adjusted for the fact that the profit serves as an accounting reporting indicator, therefore it is subject to significant manipulations in the process.
Three groups of models are included in the cash flow discounting method:
- discounted dividends;
- residual income;
- discounted cash flows.
If a revenue approach is practiced in accordance with the dividend discount model as evidence of cash flow, the amount of the payout for the shares is applied. Despite the fact that the model is significantly widespread in foreign practice for determining and assessing the value of the assets of an enterprise, it has a lot of disadvantages. 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 residual income, i.e. the difference between the actual profit and the amount of profit predicted by the shareholders at the time of purchase of the company or its shares, will be used as an indicator of cash flow. If the value of the enterprise was calculated on the basis of the assumptions corresponding to 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 substantial doubt.
Benefits to shareholders
Naturally, shareholders or shareholders of an enterprise that has a certain history, as well as facts of dividend payment, 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, therefore, the most suitable way for them would be to use a profitable approach to valuing real estate and business through a discount model of free cash flows. In this system, free cash flows with discount rates or the expected return on invested capital are key. The biggest problem with using this model is the accuracy of the forecast of free financial flow, as well as the adequate determination of the discount rate.
If we apply the income approach, the definition of which was given above, then when using the discounted cash flow method as the expected income from the business, we take 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 are independent of 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 is such that as a result of these processes, they decrease by the amount that would be available to the investor at the time of receipt of the specified cash flow, provided that he invested his money not in this business right now, but in which Some other investment asset of a generally accessible nature, for example, a liquid security or a bank deposit.
Additional techniques
The revenue approach, an example of which was described earlier, has been used less and less recently, now the most common is the valuation method. It is used to evaluate all kinds of assets, and the basis for it is the idea that any asset that shares the main characteristics of options can be evaluated as this option. At the moment, the rejection of the income approach is most often carried out in favor of the option pricing model (respectively, the Black-Scholes model).
Such a system, provided it is used, makes it possible to assess the total cost of equity of a company or enterprise in the case when it operates with large losses. This model is intended to further explain why the cost of equity of the enterprise is not zero, even if there is a decrease in the value of the entire enterprise below the level of the nominal amount of debt. But even with such an advantage, it can be noted that the Black-Scholes model for assessing the value of Russian enterprises at the moment is more and more theoretical. The main problem because of which this model cannot be applied to domestic business is the lack of some evidence for the model parameters, which are extremely necessary.
conclusions
A profitable approach to evaluating business and real estate has become much less common, and this happens for many reasons. In particular, this concerns the drawbacks that make it difficult to use it in the consumer market. First of all, it should be noted how difficult it is to make forecasts of the future cost of services and products, materials and raw materials, as well as a set of other cost indicators. Moreover, we can talk about some subjectivity of expert assessments. In addition, the problem is the low disclosure of information on Russian enterprises, but it is necessary for conducting competent calculations and compiling a Black Scholes model. This is largely due to the low corporate culture of such enterprises.
The overwhelming majority of shares, including large blocks, is 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 uninterested in the disclosure of any information. That is why the calculation is significantly complicated by the revenue approach in relation to most industries and business in Russia. In other conditions, it works in the best way, demonstrating all its advantages and reliability.