Income Capitalization Approach to Business Valuation
How Do Income Capitalization Approaches Work?
In a very simplified summary, the income capitalization approach is about
- estimating future profits
- discounting these profits
- adding up the discounted profits
This gives the present value of the company according to the income capitalization approach. The discount rate takes into account the timing of income in the future and the specific risk of the investment.
Different Approaches to Income Capitalization
There are different models within the income capitalization approach. These models differ in terms of the cash flows that are discounted. They also vary with regard to the discount rate used.
-
Income capitalization methods
- Simplified capitalised earnings value method
- Discounted Cash Flow (DCF) method
- Residual value method
- Multi-period dividend discount
Simplified capitalised earnings value method
Approach: This method assumes constant cash flows and is ideal for companies with a stable earnings situation.
What is discounted: A representative, normalized annual surplus.
How is it discounted: Using a capitalization interest rate that reflects the company’s risk and the market’s expectations of the return.
Advantages and Disadvantages of this Method
Discounted Cash Flow (DCF) Method
Approach: The DCF approach forecasts future cash flows that can vary, making it suitable for companies whose earnings change over time.
What is discounted: Estimated future cash flows over a specific forecast period.
How is it discounted Using the Weighted Average Cost of Capital (WACC), which reflects the average cost of capital employed.
Advantages and Disadvantages of this Method
Residual Value Method
Approach: This method focuses on the residual income, which results from profits less the cost of equity. It directly calculates the equity value by adding the current book value of equity and the discounted future residual earnings.
What is discounted: The cash flows for an explicit forecast period and, in addition, the residual value set for the subsequent period.
How is it discounted: Here, too, the WACC is often used to discount both the cash flows and the residual value to their present value.
Multi-period Dividend Discount
Approach: This approach is suitable for companies whose dividends vary over time, especially for listed companies.
What is discounted: Projected dividend payments that can change over different periods.
How is it discounted: Based on the cost of equity, which is usually calculated using the Capital Asset Pricing Model (CAPM) to reflect the risk of the share.
Example: Dividends of 1.00, 1.20, 1.40 over three years and an expected constant dividend of 1.50 thereafter, with a cost of equity of 5%, result in a value per share of approximately 29.00.
Advantages and Disadvantages of this Method
Income Capitalization Methods Compared to other Methods
The income capitalization method focuses on future cash flow and is therefore forward-looking. It is particularly valuable when it comes to assessing a company’s growth potential and sustainable profitability.
In contrast, the net asset value method measures the value of a company based on its current assets minus liabilities. This method is often relevant when valuing asset-intensive companies or in liquidation scenarios.
The comparable value method, on the other hand, uses market data to determine the company value and draws comparisons to recently sold, similar companies. This method depends heavily on the availability and comparability of market data. (Here NIMBO offers a company valuation calculator, which is based on current market data for the respective countries).
The real options method views a company from the perspective of future strategic options and is particularly applicable in industries with high uncertainty and rapid change.
Finally, the liquidation value approach estimates the amount that owners would receive in the event of a company liquidation. This approach is often used when companies are facing closure and is very present-oriented.
Each of these methods offers a different perspective on the value of a company and can be selected depending on the specific context and objective of the valuation.
The Income Capitalization Methods in an International Context
The application of the income capitalization method and its models is influenced by local valuation practices and regulatory frameworks. A look at the practices in different countries shows how diverse these approaches can be:
Europe
In Germany, the simplified income capitalization method is a preferred method, which is particularly used in the valuation of medium-sized companies. This approach is supported by the standards of the Institut der Wirtschaftsprüfer. In Italy, Spain and Poland, similar valuation methods are used, with local GAAPs and guidelines of the European Union influencing the specific valuation practices. The DCF method is also widespread in these countries, especially for larger, internationally active companies.
In Switzerland and the Netherlands, with their strongly internationally oriented economies, the DCF approach, which is familiar to international investors and in line with IFRS, often dominates. In Sweden and Norway, there is also a strong preference for the DCF, which is due to the transparency of the Nordic markets and the dominance of IFRS.
The United Kingdom follows similar valuation standards as the USA, with a pronounced inclination towards the DCF approach. This is favored by a market-oriented view and the availability of detailed financial information.
North America
In the United States and Canada, the DCF is the dominant method, which is supported by the preference for shareholder value and the mature capital markets. US GAAP and Canadian GAAP provide a solid framework for cash flow forecasting and valuation.
Africa and Middle East
In South Africa, the income capitalization method is also used, with the specific choice of model depending on the size and sector of the company. Due to the economic dynamics and volatility in some African markets, the simplified income capitalization method may be suitable here to mitigate the valuation risk.
In the United Arab Emirates, where the real estate market plays a major role, the simplified income capitalization method is particularly widespread in real estate valuation, while the DCF is preferred in the corporate sector to appeal to international investors.
Oceania
In Australia, with a developed capital market and a strong focus on international investors, the DCF is the predominant method, supported by the application of IFRS.
In summary, the DCF is the predominant method in developed markets with a strong international focus and readily accessible financial information. In markets characterized by a stronger focus on medium-sized businesses and local investments, the simplified income capitalization method is more frequently used. The specific models used in the individual countries reflect the requirements of local and international investors and depend on the respective regulatory and market-specific conditions.
Overview of the most important methods for company valuation