The income approach, which determines the value of an appraised business by capitalizing or discounting the expected earnings of the appraised business. The income approach mainly utilizes the present value technique, i.e., the value of an asset is the present value of future earnings that can be obtained using it, and its discount rate reflects the risk-return rate of investing in the asset and obtaining the earnings. The income approach is the more mature and widely used valuation technique.
The main method in the income approach is the discounted cash flow method.
1. Valuation Ideas
Discounted cash flow method is a valuation method that judges the value of an enterprise by estimating the present value of the expected future cash flows of the enterprise being appraised.
The discounted cash flow method examines the value of an enterprise from the perspective of cash flow and risk.
①In the case of a certain risk, the more cash flows the assessed enterprise can generate in the future, the greater the value of the enterprise, i.e., the intrinsic value of the enterprise is directly proportional to the cash flows it generates in the future;
②In the case of a certain amount of cash flow, the greater the risk of the assessed enterprise, the lower the value of the enterprise, i.e., the intrinsic value of the enterprise and the risk of inversely proportional to the value of the enterprise.
2. Basic Steps
(1) Analyzing Historical Performance
The main purpose of analyzing the historical performance of an enterprise is to thoroughly understand the past performance of the enterprise, which can provide a perspective for determining and evaluating forecasts of future performance, and to prepare for forecasting future cash flows. Historical performance analysis focuses on the historical accounting statements of a business, with an emphasis on the key value drivers of the business.
(2) Determining the forecasting period
When forecasting the future cash flows of a business, a forecasting period is usually artificially determined, after which cash flows are no longer estimated. The length of the period depends on the industry background of the enterprise, the policies of the management, the environment of mergers and acquisitions, etc. It is usually 5-10 years.
(3) Forecasting future cash flow
The cash flow used in enterprise value appraisal refers to the portion of cash flow generated by the enterprise after deducting the inputs required for assets such as inventories, plant and equipment, and the payment of taxes, i.e., free cash flow. This can be expressed by the formula:
It is important to note that interest expense, although deducted from income as an expense, is a free cash flow belonging to creditors. Therefore, interest expense is deducted only when calculating equity free cash flow most, but not when calculating corporate free cash flow.
(4) Selecting an appropriate discount rate
The discount rate is the rate, sometimes called the cost of capital rate, that converts the expected future earnings over the forecast period to present value. Typically, the discount rate can be determined by a weighted average cost of capital model (a weighted average of the cost of equity capital and the cost of debt capital).
Calculation of the Cost of Equity Capital
Method 1: Capital Asset Pricing Model
Because M&A activities usually cause a change in a firm's debt ratio, which in turn affects the coefficient β, the β coefficient needs to be corrected as necessary. The β coefficient can be adjusted using Hamada's equation, which is calculated as follows:
Method 2: Dividend Discounting Model
①When dividends are constant each year
②When dividends are growing at a constant rate of growth g
Calculation of the Cost of Debt Capital
(v) Forecasting Terminal Value (Continuous Value of the Enterprise)
The estimation of the enterprise's future cash flows cannot be projected indefinitely, so the value of the business at some point in the future is assessed, i.e., the terminal value of the business is calculated.
The terminal value of a business can generally be calculated using a perpetual growth model (fixed growth model). The perpetual growth model is consistent with the DCF approach, which assumes that free cash flows grow at a fixed compound annual rate from the year in which the terminal value is calculated. The formula for calculating the terminal value of an enterprise is as follows:
(6) Forecasted enterprise value
Enterprise value is equal to the sum of the discounted values of the cash flows over the period of the determination of the forecast, plus the present value of the terminal value, which is calculated by the following formula:
(2) Market approach
The market approach involves comparing the enterprise under appraisal with a reference enterprise, an enterprise that has already been traded in the market with trading cases, shareholders' equity, securities and other equity assets to determine the value of the appraised enterprise.
1. Comparable Enterprise Analysis Method
(1) Valuation Idea
The Comparable Enterprise Analysis Method is based on the share prices and financial data of similar enterprises with active trading, and calculates some major financial ratios, and then uses these ratios as a multiplier to obtain the value of unlisted enterprises and listed enterprises with inactive trading. Comparable enterprise analysis is less technically demanding and less theoretical than the discounted cash flow method.
(2) Methodological Steps
①Selection of Comparable Enterprises.
The selected comparable enterprises should have similar characteristics to the appraised enterprise in terms of operation and finance.
After the initial industry-based search has yielded a sufficiently large pool of potential comparables, further criteria should be used to determine which comparables are most similar to the assessed enterprise.
Commonly used criteria such as size, range of products or services offered by the business, markets served and financial performance. The closer the selected comparable enterprise is to the target enterprise, the better the reliability of the appraisal results.
②Select and calculate the multiplier. There are generally two types of multipliers:
One is the multiplier based on market price. Common multipliers are price-earnings ratio (P/E), price-to-revenue ratio (P/R), price-to-net cash flow ratio (P/CF) and price-to-book value of tangible assets (P/BV).
The most important of the market price-based multipliers is the P/E ratio. To calculate a firm's P/E ratio, either historical earnings (earnings for the past 12 months or the previous year or the average earnings for the past number of years) or projected earnings (earnings for the next 12 months or the next year) can be used, and the corresponding ratios are known as the retrospective and projected P/E ratios, respectively. For valuation purposes, the forecast P/E ratio is usually preferred because it is the future earnings that receive the most attention. Moreover, it is the enduring components of a business's earnings that are meaningful for valuation purposes, so non-recurring items that will not recur are generally excluded.
The second is a multiplier based on enterprise value.
Common valuation multipliers based on enterprise value are EV/EBIT, EV/EBITDA, and EV/FCF, where EV is the enterprise value, EBIT is EBIT, EBITDA is EBITDA, and FCF is the free cash flow of the enterprise.
3) Calculate an estimate of the value of the business being valued by applying the numerous multipliers selected.
After selecting a certain multiplier, multiplying the multiplier with the corresponding adjusted financial data of the appraised enterprise will result in a market price valuation of the appraised enterprise. The closer the valuations obtained from multiple multipliers are, the more accurate the appraisal results are.
Hints
The valuation of the appraised enterprise derived from the equity multiplier is an estimate of the market value of shareholders' equity. --Equity value
The total capital multiplier is an estimate of the market value of the total capital including equity and debt of the appraised enterprise. --Company value
④Average the individual estimates of the value of the business.
Multiple estimates of enterprise value derived from the application of different multipliers are not the same. To ensure the objectivity of the appraisal results, each estimate of enterprise value can be assigned a corresponding weight, and the allocation of the weight depends on the magnitude of the impact of the multiplier on the market value of the enterprise. The weighted average method is then used to calculate the value of the enterprise under appraisal.
2. Comparable Transaction Analysis Method
(1) Valuation Idea
Based on the principle that similar targets should have similar transaction prices, the Comparable Transaction Analysis Method advocates obtaining useful financial data from similar M&A transactions to assess the value of the target enterprise.
It does not analyze the market value, but only counts the average premium level of the price paid by the acquiring company when similar enterprises are acquired, and then uses this premium level to calculate the value of the target enterprise. This method needs to find out the recent average actual trading price of enterprises with similar business performance as the target enterprise, and use it as the reference for estimating the enterprise value. This method is less applied in China.
(2) Steps of the method
① Selecting comparable transactions. Using the comparable transaction analysis method, it is first necessary to find out the recent average actual transaction prices of enterprises with similar business performance to the target enterprise, and use them as the reference for estimating the enterprise value. In order to obtain reasonable appraisal results, the transaction data must be that of an enterprise similar to the appraisal target.
②Selection and calculation of multipliers. Such as price paid earnings ratio, book value multiples, market value multiples, etc. Comparable transaction analysis is similar to comparable enterprise analysis, which is to obtain useful financial data from the merger and acquisition transactions of comparable enterprises similar to the target enterprise, and to determine the average market premium level of comparable transactions.
The formula for calculating the relevant ratios is as follows:
①Price Paid/Earnings Ratio=Price Paid by the Acquirer/Profit After Tax
Price Paid refers to the purchase price paid by the acquiring company for the subject matter of the transaction in a comparable M&A transaction;
Profit After Tax refers to the pre-acquisition (or average) after-tax profit of the acquired company that is similar to the target company.
②Calculate the price paid/earnings ratio of the acquired company in a similar transaction and multiply it by the current after-tax profit of the target company to arrive at the valuation of the target company.
Book value multiple = price paid by the acquirer/net asset value
Book value is the pre-merger book value of an acquired company similar to the target company, i.e., the net asset value recorded in its accounting statements.
The book value multiple of the acquired company in a similar transaction is calculated and multiplied by the net asset value of the target company to arrive at the valuation of the target company.
Market value multiple = price paid by acquirer/market value of stock
Market value is the market value of the pre-merger stock of an acquired business similar to the target business, i.e., the product of the per-share price of its stock and the number of shares issued and outstanding.
The market value multiple of the acquired company in a similar transaction is calculated and multiplied by the current stock value of the target company to arrive at the valuation of the target company.
3) Calculate an estimate of the value of the business being valued by applying the numerous multipliers selected. After selecting a certain multiplier, an estimate of the value of the appraised enterprise is obtained by multiplying the multiplier with the adjusted corresponding financial data of the appraised enterprise. The closer the valuations obtained from multiple multipliers are, the higher the accuracy of the appraisal results.
4. The estimates of enterprise value are averaged. The multiple estimates of enterprise value derived from the application of different multipliers are not the same, in order to ensure the objectivity of the appraisal results, each estimate of enterprise value can be assigned a corresponding weight, and the allocation of the weight depends on the magnitude of the impact of the multiplier on the market value of the enterprise; and then, the value of the appraised enterprise is calculated using the weighted average method.
(C) Cost Approach
The cost approach, also known as the asset-based approach, determines the value of the target enterprise on the basis of a reasonable assessment of the value of the target enterprise's assets and liabilities.
Applying the cost approach requires consideration of various depletion factors, including physical, functional and economic depletion. The key to the cost approach is to choose the appropriate standard of asset value. The cost method is mainly book value method, replacement cost method and liquidation price method.
1. Book value method
Book value method is a valuation method based on the historical cost principle of accounting, which recognizes the value of the target enterprise based on the calculation of the net book assets of the enterprise.
The advantage of book value method is that it is calculated according to the general accounting principles, which is more objective and easy to take the value.
The disadvantage of the book value method is that it is a static valuation method that takes into account neither the market value of the asset nor its earnings. In practice, there are three reasons why the book value is often a large deviation from the market value: First, the existence of inflation so that the value of an asset is not equal to its historical value minus depreciation; Second, technological advances in the end of the life of certain assets have become obsolete and depreciation; Third, due to the existence of the organizational capital so that the combination of multiple assets will be more than the value of the corresponding sum of the individual assets. Therefore, this method is mainly applicable in simple mergers and acquisitions, mainly for unlisted companies whose book value does not deviate much from the market value.
2. Replacement cost method
Replacement cost method is a valuation method that recognizes the value of the target enterprise based on the replacement cost of each individual asset of the target enterprise.
The replacement asset method is similar to the book value method in that it is also based on the assets of the business. However, instead of using the historical cost of purchasing the assets, it estimates the value of the business based on the amount of money it would take to purchase the same assets or rebuild an identical business at the current price level.
Using the replacement cost method requires appropriate adjustments to the book value of assets. In practice, there are two methods of adjustment: one is the price index method, that is, the selection of a price index, the value of the year of acquisition of assets into the current value. The biggest problem with the price index method is that it does not reflect the impact of factors such as technological depreciation on the value of certain important assets. The second is the itemized adjustment method, that is, according to inflation and technical depreciation of the two factors on the asset value of the magnitude of the impact of the book value of each asset, item by item to adjust the book value of each asset, in order to determine the current replacement cost of each asset.
3. Liquidation Price Method
The liquidation price method is a method of determining the value of a target business by estimating the net liquidation income of the target business. The net liquidation income of a business is the proceeds from the sale of all divisions and all fixed assets of the business, less the debts payable by the business. This estimate is based on an estimate of the value of the real estate of the business (including plant, factory and equipment, various natural resources or reserves, etc.).
The liquidation price method is a method of valuation where the target business as a whole has lost its value-added capacity, and the estimate is the realizable price of the target business. This method is mainly applicable to the assessment of the value of troubled enterprises.