PRACTICAL APPLICATION OF INCOME CAPITALIZATION METHOD IN BUSINESS VALUATION – SOME HIGHLIGHTS

Abstract

The paper describes the advantages and disadvantages of the income approach in business valuation, the essence of the method of income capitalization, as well as the peculiarities related to its application. Two main variants of the method are presented, depending on the choice of income to be capitalized. The first option is based on the net cash flow and is mainly applied to the valuation of enterprises with high investment absorption and, respectively, high share of depreciation in total expenses. The second option is based on net profit and is preferred by valuers when valuing low investment absorption firms or holding companies.A practical case study is presented to evaluate a holding company related to the determination of the market value of a minority share package. The cost of equity of the rated entity is determined by the CAPM model modifications for emerging markets. At the end, conclusions have been drawn and some problems have been described that appraisers should pay attention to. The Income Capitalization method has an easy algorithm, but its practical application is not so simple. Both fundamental knowledge and experience, as well as evaluators' attention are required, as a number of factors and circumstances must be taken into account regarding: the choice of income to be capitalized, the choice of variant for valuation methodology, model for determining the cost of equity or the weighted average cost of capital, determining the “small firm risk premium”, determining the normalized income, the long-term rate of income growth, adjustments for minority or majority ownership, adjustments for marketability and others. In this method, the market value of equity (VE) is highly sensitive to the discount rate (the cost of capital), the long-term growth rate and the capitalization rate, respectively. Even small differences in these parameters can lead to a large difference in the value of the estimate. This requires precision and good argumentation on the part of the valuers regarding the pricing of equity, the cost of debt and the long-term average annual growth rate of income.For companies with stable incomes and good prospects for development, this method provides a relatively accurate estimate of the market value of equity. However, it must be borne in mind that the future is always uncertain. In this regard, appraisers should make a sufficiently accurate assessment of the level of business risk and financial risk of the entity being evaluated.