The previous article describes the valuation of shares using the comparative method. It is a simpler method compared to the income approach. The use of this method requires a lot of knowledge about the company as well as the industry in which the company is valued. The Income Approach is often used in practice.
Stocks valuation using the Income Approach
The valuation of shares (a company) using the Income Approach is based on the creation of a financial model, as we wrote earlier, in which we will forecast the financial situation of the company over the next few years (usually). More specifically, what may be future revenues, costs, operating profits, net profit and finally what company may generate future cash flows, or how much cash will be generated that can be freely disposed of.
Creating a reliable financial model is the most difficult and the most error-prone part of the entire valuation. It is easy to overestimate or not to value the future financial results of the company, hence the knowledge of the company being valued and the industry in which it operates is so important. The model can be created in Excel on the basis of historical data using the formula for linear regression, although every unpredictable event will not be included in the model, which means that many people prefer to forecast the company’s financial results based on their experience.
The model is created for different periods of forecast, which depend on the specifics of the company. The period of the detailed forecast is a period in which we anticipate significant development of a given company. We can specify three forecast periods:
- 1 year – companies operating on a very competitive market with low margins
- 5 years – companies with an established market position, well-known brand, e.g. Osram Light
- 10 years – companies with a dominant market position, operating on the market with high entry barriers, e.g. Microsoft, Google
Weighted Average Cost of Capital (WACC)
At the time when we were able to determine the future cash flows that the company will generate within 5 years, then we must forecast the cash flows to be valued at the moment of valuation of the company, that is, to discount them. Why do we need to bring future cash flows at the moment of valuation? Because money loses its value over time. A year’s 1 dollar will be worth $0.85 due to inflation and a drop in purchasing power. In the case of reducing cash flows at the moment of valuation, our discount rate depending on the model will be the cost of equity or the cost of equity in combination with the cost of debt.
We have set a period of rapid growth of the company for 5 years. We estimated future financial results and determined future free cash flow. Is this the end of our valuation? Unfortunately not. If we were to end our valuation now, it would mean that our company would disappear from the market after 5 years. In fact, we should estimate the future free cash flow for infinity, because we do not know when the company will end its operations.
This problem was solved by calculating the Terminal Value (TV). It can be very simply stated that this is the value that we would receive if the company’s sales were to occur after the fifth year of our forecast.
The pattern on the TV is as follows:
TV = CF(1+g)/(WACC-g)
CF – cash flow in the last year of the forecast, for the five-year period it will be cash flow in 5 years
g – long-term cash flow growth rate, it is usually lower than in a detailed forecast, usually (0-3%)
Types of valuation using the Income Approach
Income Approach valuation is based on projected cash flows and then bringing future cash flows to the value at the moment of valuation, i.e. discounting them, which is why this valuation is also referred to as the discounted cash flow (DCF) method. The DCF valuation can be used to determine future cash flows in various ways, which is why the discounted cash flow method is divided into several different variations:
The dividend discount model (DDM)
The dividend discount model is the oldest method of share valuation. In this model, cash flows are dividends. The method can be applied when the company pays dividends. We distinguish four types of the discounted dividend model:
- Gordon growth model (GGM) assumes a steady increase in the dividend. It is the simplest version and the most commonly used one.
- The two-stage model divides the forecast period into two stages, in which the dividend grows at different rates.
- Model H assumes that the dividend falls at a certain rate, and then grows.
- The three-stage model divides the forecast period into three stages, where the dividend first increases, in the second stage it decreases and in the third stage it grows again.
Residual income model
Residual income model is based on the concept of so-called economic profit, or residual income. Residual profit and subsequent development of this concept in the form of Economic Value Added (EVA) is the difference between the expected profit and the gained profit. For example, the owners have invested 2 million in the company and expect a 10% profit per year, 200,000. The company has reached 150,000 profit, which is an economic loss of 50,000, although net profit was achieved. The method is rarely used in practice.
Discounted Free Cash Flow
Discounted Free Cash Flow is the most commonly used valuation model. It consists in forecasting future net profits or operating profits and deducting taxes, investment outlays, etc. from them in order to estimate future free cash flows. Then we have to bring back to the current value using the discount rate.
Discounted Free Cash Flow model is divided into:
Free Cash Flow to Equity (FCFE), in which we focus on cash flows due to owners. The model applies to the valuation of companies that are characterized by a constant level of debt. Less frequently used in practice.
– Net Capital Expenditures (CAPEX)
– Change in Net Working Capital (NWC)
+ New debt
– Debt Repayment
Free Cash Flow to Firm (FCFF), in which equity and debt are taken into account. The difference between FCFE and FCFF is that in FCFF, after cash flows are discounted, Net Debt must be deducted from them to obtain the amount due to the owner. FCFF method is easier than FCFE and it is the most commonly used method in practice. The method will be described in more detail in the next article.
Net Debt = Long-Term Debt + Short-Term Debt – Cash and Cash Equivalents
In this method you should start with operating profit, which you can write in this way:
Earnings Before Interest and Taxes (EBIT)
– Income Tax
– Change in NWC
Buying a new car in a salon, and then leaving it outside the gate of this salon will lose its value. Only due to the fact that we passed a small section of the road for it, we will not sell it for the same price. Every user of a new car knows about it. The same equipment as the company loses exactly the same value. Month by month, it loses its value. In accounting, such equipment consumption is depicted by write-down. It has its justification, for example for tax purposes and for a reliable presentation of the company’s financial situation. Depreciation, however, is not an actual outflow of cash, therefore, when estimating free cash flows in DCF model, depreciation should be added.
Net Working Capital
NWC is a measure of the company’s liquidity. It can be said that this is the value of current assets (the most liquid) minus short-term liabilities.
NWC = current assets – current liabilities
Each company must make investments to develop its business. Capital expenditures can be found in the cash flow statement in cash flows from investing activities. One should check how investment expenditures were shaped in comparison to revenues, for example 15% of generated revenues and assume similar values, unless in the financial statement we read that in the coming years planning is to increase or decrease investment expenditures.
Valuation with Income Approach is the most commonly used method of company valuation in practice. Despite its popularity, it is not without flaws.
In addition, it should be remembered that each valuation is a subjective assessment of an author who makes calculations, because while making estimates, we can apply many different variables. The most important advantages and disadvantages of the Income Approach are listed below:
- Focuses on the future, not on what happened
- Takes into account the cost of equity and debt
- Quite a complicated method
- Valuation is based on financial forecasts and WACC which are very susceptible to manipulation
- Difficulty in determining the long-term cash flow growth rate when estimating the Terminal Value
In the next article, we will take a closer look at the most popular Income Approach method, Free Cash Flow to Firm.