Valuation techniques Income approach

Valuation techniques Income approach – When valuing a company as a going concern there are three main valuation methods used by industry practitioners: the cost approach, the market approach and the income approach.  These are the most common methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO) and most areas of finance. Valuation techniques Income approach

Valuing a Business, Group of assets (and liabilities) or a Cash generating unit

Cost approach

Market approach

Income approach

Cost to build

Precedent transactions

Forecast of business results

Replacement costs – the amount that would be required currently to replace the service capacity of an asset.

Comparable company transaction data

– Public company transactions

– Private company transactions

– Prior transactions of the subject company

Present value techniques discounting future cash flows using a risk adjusted discount rate

Multi-period excess earnings method

Option pricing models and others

Appraised value by a specialised industry expert – Validation of replacement calculation to objectify the value estimate.

Special purpose report by a specialised business valuator – Validation of data used to objectify the value estimate.

Special purpose report by a specialised business valuator – Comparison of valuation models and inputs used to objectify the value estimate.

The income approach converts future amounts (e.g. cash flows or income and expenses) to a single current (i.e. discounted) amount. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts. Valuation techniques Income approach

Those valuation techniques include, for example, the following (see summary of techniques here):

  1. present value techniques; Valuation techniques Income approach
  2. option pricing models, such as the Black-Scholes-Merton formula or a binomial model (i.e. a lattice model), that incorporate present value techniques and reflect both the time value and the intrinsic value of an option; and Valuation techniques Income approach
  3. the multi-period excess earnings method, which is used to measure the fair value of some intangible assets. Valuation techniques Income approach

Application of present value techniques

As said above, present value techniques are a type of income approach valuation technique. IFRS 13 does not prescribe the use of one single and specific present value technique nor limits the use of present value techniques to estimate fair value. IFRS 13 states that a reporting entity should use the appropriate technique based on facts and circumstances specific to the asset or liability being measured and the market in which it is traded. (IFRS 13 B12) Valuation techniques Income approach

In line with IFRS 13 B13 the following key elements from the perspective of market[participants should be captured in developing a fair value measurement model using present value at the measurement date:

  • an estimate of future cash flows for the asset or liability being measured. Valuation techniques Income approach
  • expectations about possible variations in the amount and timing of the cash flows representing the uncertainty inherent in the cash flows. Valuation techniques Income approach
  • the time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder (ie a risk-free interest rate). Valuation techniques Income approach
  • the price for bearing the uncertainty inherent in the cash flows (ie a risk premium). Valuation techniques Income approach
  • other factors that market participants would take into account in the circumstances. Valuation techniques Income approach
  • for a liability, the non-performance risk relating to that liability, including the entity’s (ie the obligor’s) own credit risk.
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The general principles that are the basis of the application of all present value techniques are as follows (IFRS 13 B14):

  • Cash flows and discount rates should reflect assumptions that market participants would use when pricing the asset or liability.
  • Cash flows and discount rates should take into account only the factors attributable to the asset or liability being measured.
  • To avoid double-counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using contractual cash flows of a loan (ie a discount rate adjustment technique). That same rate should not be used if using expected (ie probability-weighted) cash flows (ie an expected present value technique) because the expected cash flows already reflect assumptions about the uncertainty in future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used.
  • Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows, which include the effect of inflation, should be discounted at a rate that includes the effect of inflation. The nominal risk-free interest rate includes the effect of inflation. Real cash flows, which exclude the effect of inflation, should be discounted at a rate that excludes the effect of inflation. Similarly, after-tax cash flows should be discounted using an after-tax discount rate. Pre-tax cash flows should be discounted at a rate consistent with those cash flows.
  • Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.
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Valuation techniques Income approach

Valuation techniques Income approach

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

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