People in the Houston area, and throughout the country, who rely on appraisal conclusions, such as judges and attorneys, are becoming more comfortable with the income approach as the business valuation discipline matures. But how does a business’s perceived risk translate into a reasonable discount rate? This is one of the most subjective, and contentious, aspects of valuing a business.
Breaking down the income approach
Value is a function of a company’s expected economic benefits and its risk relative to other investment types, under the income approach. Valuators typically gauge expected economic benefits in terms of net cash flow. They measure risk by the company’s cost of capital, which is the expected rate of return investors require to invest in the subject company.
Lower projected income, higher discount rates, or a combination of the two, causes riskier businesses to have lower values. The two most common methods that fall under the income approach are the capitalization of earnings and discounted cash flow methods.
Discounting future cash flow
Converting expected cash flows (or economic benefits) to present value is key to both of these methods. The valuators are required to use a discount rate that reflects the time value of money and the degree of risk associated with an investment in the business. In other words, the discount rate reflects the risk associated with achieving the expected cash flows.
Valuators may estimate expected cash flows to equity investors and use the cost of equity as the discount rate when valuing a company’s equity. There are several methods for calculating the cost of equity, including the capital asset pricing model (CAPM) and the build-up method.
In other situations, a valuator may decide to value the company’s invested capital, that is, its equity and interest-bearing debt. For example, what if a company’s capital structure is different from those of other companies in the same industry or the company is under- or overleveraged? Under these scenarios, it may be more appropriate to use an invested capital technique to value the business and then subtract interest-bearing debt to arrive at the value of equity.
A valuator estimates future cash flows to both equity investors and lenders and then uses a blended cost of capital as the discount rate when valuing a company’s invested capital. A common example of a blended discount rate is the weighted average cost of capital (WACC), which is the average of the subject company’s cost of equity and cost of debt, weighted according to the relative percentages of each. Because the discount rate is based on the expected cost of new capital, valuators typically measure equity and debt by their market values, not their book values.
Again, the cost of equity is typically derived using the CAPM and the build-up method. And the cost of debt is usually based on the company’s actual borrowing costs. The WACC formula also takes into account the company’s effective tax rate to reflect the tax deductibility of interest expense.
Blending debt and equity
It’s vital to determine the right “capital structure” (relative percentages of debt and equity) when valuing invested capital. The most appropriate structure is the mix of debt and equity likely to occur in the future.
When valuing a minority interest in a company, appraisers often use the company’s actual capital structure. But when a controlling interest is being valued, it may be more appropriate to use an optimal capital structure, because a controlling owner has the power to change the company’s capital structure.
For most companies, the ideal capital structure involves a manageable amount of debt that allows owners to leverage their investment and boost their returns. However, there is a common misconception that the optimal capital structure means no debt at all. Methods for determining a company’s optimal capital structure include industry averages, capital structures of guideline companies and debt-to-equity criteria used by lenders.
Using a proven approach
Experienced valuators use proven, systematic approaches based on objective market evidence to quantify reasonable discount rates, because all businesses have different needs when it comes to which method is used for computing discount rates.