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IVS 105 Income approach

"40.           Income Approach"

40.1 The income approach provides an indication of value by converting future cash flow to a single current value.  Under the income approach, the value of an asset is determined by reference to the value of income, cash flow or cost savings generated by the asset.

"40.2 The income approach should be applied and afforded significant weight under the following circumstances:

(a)              the income-producing ability of the asset is the critical element affecting value from a participant perspective, and/or

(b)              reasonable projections of the amount and timing of future income are available for the subject asset, but there are few, if any, relevant market comparables."

"40.3 Although the above circumstances would indicate that the income approach should be applied and afforded significant weight, the following are additional circumstances where the income approach may be applied and afforded significant weight.  When using the income approach under the following circumstances, a valuer should consider whether any other approaches can be applied and weighted to corroborate the value indication from the income approach:

(a)              the income-producing ability of the subject asset is only one of several factors affecting value from a participant perspective,

(b)              there is significant uncertainty regarding the amount and timing of future income-related to the subject asset,

(c)              there is a lack of access to information related to the subject asset (for example, a minority owner may have access to historical financial statements but not forecasts/budgets), and/or

(d)              the subject asset has not yet begun generating income, but is projected to do so."

"40.4.        A fundamental basis for the income approach is that investors expect to receive a return on their investments and that such a return should reflect the perceived level of risk in the investment."

"40.5.        Generally, investors can only expect to be compensated for systematic risk (also known as “market risk” or “undiversifiable risk”).  "

"50.           Income Approach Methods"

50.1 Although there are many ways to implement the income approach, methods under the income approach are effectively based on discounting future amounts of cash flow to present value. They are variations of the Discounted Cash Flow (DCF) method and the concepts below apply in part or in full to all income approach methods. 

Discounted Cash Flow (DCF) Method

50.2 Under the DCF method the forecasted cash flow is discounted back to the valuation date, resulting in a present value of the asset. 

50.3 In some circumstances for long-lived or indefinite-lived assets, DCF may include a terminal value which represents the value of the asset at the end of the explicit projection period.  In other circumstances, the value of an asset may be calculated solely using a terminal value with no explicit projection period.  This is sometimes referred to as an income capitalisation method.

"50.4. The key steps in the DCF method are:

(a)              choose the most appropriate type of cash flow for the nature of the subject asset and the assignment (ie, pre-tax or post-tax, total cash flows or cash flows to equity, real or nominal, etc),

(b)              determine the most appropriate explicit period, if any, over which the cash flow will be forecast,

(c)              prepare cash flow forecasts for that period,

(d)              determine whether a terminal value is appropriate for the subject asset at the end of the explicit forecast period (if any) and then determine the appropriate terminal value for the nature of the asset,

(e)              determine the appropriate discount rate, and

(f)               apply the discount rate to the forecasted future cash flow, including the terminal value, if any."

Type of Cash Flow

"50.5. When selecting the appropriate type of cash flow for the nature of asset or assignment, valuers must consider the factors below.  In addition, the discount rate and other inputs must be consistent with the type of cash flow chosen.

(a)              Cash flow to whole asset or partial interest: Typically cash flow to the  whole asset is used.  However, occasionally other levels of income may be used as well, such as cash flow to equity (after payment of  interest and principle on debt) or dividends (only the cash flow distributed to equity owners). Cash flow to the whole asset is most commonly used because an asset should theoretically have a single value that is independent of how it is financed or whether income is paid as dividends or reinvested.

(b)              The cash flow can be pre-tax or post-tax:  The tax rate applied should be consistent with the basis of value and in many instances would be a participant tax rate rather than an owner-specific one.

(c)              Nominal versus real: Real cash flow does not consider inflation whereas nominal cash flows include expectations regarding inflation.  If expected cash flow incorporates an expected inflation rate, the discount rate has to include an adjustment of inflation as well.

(d)              Currency:  The choice of currency used may have an impact on assumptions related to inflation and risk.  This is particularly true in        emerging markets or in currencies with high inflation rates. The currency in which the forecast is prepared and related risks are separate and distinct from risks associated with the country(ies) in which the asset resides or operates.                                                                                                               

(e) The type of cash flow contained in the forecast: For example, a cash flow forecast may represent expected cash flows, ie, probability-weighted scenarios), most likely cash flows, contractual cash flows, etc."

"50.6.        The type of cash flow chosen should be in accordance with participant’s viewpoints.  For example, cash flows and discount rates for real property are customarily developed on a pre-tax basis while cash flows and discount rates for businesses are normally developed on a post-tax basis.  Adjusting between pre-tax and post-tax rates can be complex and prone to error and should be approached with caution."

"50.7.        When a valuation is being developed in a currency (“the valuation currency”) that differs from the currency used in the cash flow projections (“the functional currency”), a valuer should use one of the following two currency translation methods:

(a)              Discount the cash flows in the functional currency using a discount rate appropriate for that functional currency.  Convert the present value of the cash flows to the valuation currency at the spot rate on the valuation date.

(b)              Use a currency exchange forward curve to translate the functional currency projections into valuation currency projections and discount the projections using a discount rate appropriate for the valuation currency.  When a reliable currency exchange forward curve is not available (for example, due to lack of liquidity in the relevant currency exchange markets), it may not be possible to use this method and only the method described in para 50.7(a) can be applied. "

Explicit Forecast Period

50.8. The selection criteria will depend upon the purpose of the valuation, the nature of the asset, the information available and the required bases of value.  For an asset with a short life, it is more likely to be both possible and relevant to project cash flow over its entire life.   

"50.9. Valuers should consider the following factors when selecting the explicit forecast period:

(a)              the life of the asset,

(b)              a reasonable period for which reliable data is available on which to base the projections,

(c)              the minimum explicit forecast period which should be sufficient for an asset to achieve a stabilised level of growth and profits, after which a terminal value can be used,

(d)              in the valuation of cyclical assets, the explicit forecast period should generally include an entire cycle, when possible, and

(e)              for finite-lived assets such as most financial instruments, the cash flows will typically be forecast over the full life of the asset."

"50.10.      In some instances, particularly when the asset is operating at a stabilised level of growth and profits at the valuation date, it may not be necessary to consider an explicit forecast period and a terminal value may form the only basis for value (sometimes referred to as an income capitalisation method)."

"50.11.      The intended holding period for one investor should not be the only consideration in selecting an explicit forecast period and should not impact the value of an asset.  However, the period over which an asset is intended to be held may be considered in determining the explicit forecast period if the objective of the valuation is to determine its investment value. "

Cash Flow Forecasts

50.12. Cash flow for the explicit forecast period is constructed using prospective financial information (PFI) (projected income/inflows and expenditure/outflows). 

50.13. As required by para 50.12, regardless of the source of the PFI (eg, management forecast), a valuer must perform analysis to evaluate the PFI, the assumptions underlying the PFI and their appropriateness for the valuation purpose.  The suitability of the PFI and the underlying assumptions will depend upon the purpose of the valuation and the required bases of value. For example, cash flow used to determine market value should reflect PFI that would be anticipated by participants; in contrast, investment value can be measured using cash flow that is based on the reasonable forecasts from the perspective of a particular investor.

50.14. The cash flow is divided into suitable periodic intervals (eg, weekly, monthly, quarterly or annually) with the choice of interval depending upon the nature of the asset, the pattern of the cash flow, the data available, and the length of the forecast period. 

50.15. The projected cash flow should capture the amount and timing of all future cash inflows and outflows associated with the subject asset from the perspective appropriate to the basis of value. 

"50.16. Typically, the projected cash flow will reflect one of the following:

(a)              contractual or promised cash flow, (b) the single most likely set of cash flow, (c) the probability-weighted expected cash flow, or (d) multiple scenarios of possible future cash flow."

50.17. Different types of cash flow often reflect different levels of risk and may require different discount rates. For example, probability-weighted expected cash flows incorporate expectations regarding all possible outcomes and are not dependent on any particular conditions or events (note that when a probability-weighted expected cash flow is used, it is not always necessary for valuers to take into account distributions of all possible cash flows using complex models and techniques. Rather, valuers may develop a limited number of discrete scenarios and probabilities that capture the array of possible cash flows).  A single most likely set of cash flows may be conditional on certain future events and therefore could reflect different risks and warrant a different discount rate.

50.18. While valuers often receive PFI that reflects accounting income and expenses, it is generally preferable to use cash flow that would be anticipated by participants as the basis for valuations.  For example, accounting non-cash expenses, such as depreciation and amortisation, should be added back, and expected cash outflows relating to capital expenditures or to changes in working capital should be deducted in calculating cash flow.

50.19. Valuers must ensure that seasonality and cyclicality in the subject has been appropriately considered in the cash flow forecasts.

Terminal Value

50.20. Where the asset is expected to continue beyond the explicit forecast period, valuers must estimate the value of the asset at the end of that period.  The terminal value is then discounted back to the valuation date, normally using the same discount rate as applied to the forecast cash flow.

"50.21. The terminal value should consider:

(a)              whether the asset is deteriorating/finite-lived in nature or indefinite-lived, as this will influence the method used to calculate a terminal value,

(b)              whether there is future growth potential for the asset beyond the explicit forecast period,

(c)              whether there is a pre-determined fixed capital amount expected to be received at the end of the explicit forecast period,

(d)              the expected risk level of the asset at the time the terminal value is calculated,

(e)              for cyclical assets, the terminal value should consider the cyclical nature of the asset and should not be performed in a way that assumes “peak” or “trough” levels of cash flows in perpetuity, and

(f)               the tax attributes inherent in the asset at the end of the explicit forecast period (if any) and whether those tax attributes would be expected to continue into perpetuity. "

"50.22. Valuers may apply any reasonable method for calculating a terminal value.  While there are many different approaches to calculating a terminal value, the three most commonly used methods for calculating a terminal value are:

(a)              Gordon growth model/constant growth model (appropriate only for indefinite-lived assets),

(b)              market approach/exit value (appropriate for both deteriorating/finite-lived assets and indefinite-lived assets), and

(c)              salvage value/disposal cost (appropriate only for deteriorating/finite-lived assets)."

Gordon Growth Model/Constant Growth Model

50.23. The constant growth model assumes that the asset grows (or declines) at a constant rate into perpetuity. 

Market Approach/Exit Value

50.24. The market approach/exit value method can be performed in a number of ways, but the ultimate goal is to calculate the value of the asset at the end of the explicit cash flow forecast.

50.25. Common ways to calculate the terminal value under this method include application of a market-evidence based capitalisation factor or a market multiple.

50.26. When a market approach/exit value is used, valuers should comply with the requirements in the market approach and market approach methods section of this standard (sections 20 and 30). However, valuers should also consider the expected market conditions at the end of the explicit forecast period and make adjustments accordingly.

Salvage Value/Disposal Cost

50.27. The terminal value of some assets may have little or no relationship to the preceding cash flow.  Examples of such assets include wasting assets such as a mine or an oil well.

50.28. In such cases, the terminal value is typically calculated as the salvage value of the asset, less costs to dispose of the asset.  In circumstances where the costs exceed the salvage value, the terminal value is negative and referred to as a disposal cost or an asset retirement obligation.

Discount Rate

50.29. The rate at which the forecast cash flow is discounted should reflect not only the time value of money, but also the risks associated with the type of cash flow and the future operations of the asset.    

50.30. The discount rate must be consistent with the type of cash flow.

"50.31. Valuers may use any reasonable method for developing an appropriate discount rate. While there are many methods for developing a discount rate or determining the reasonableness of a discount rate, a non-exhaustive list of common methods includes:

(a) a capital asset pricing model (CAPM),

(b) a weighted average cost of capital (WACC),

(c) observed or inferred rates/yields,

(d) a  build-up method."

"50.32. Valuers should consider corroborative analyses when assessing the appropriateness of a discount rate. A non-exhaustive list of common analyses should include:

(a) an internal rate of return (IRR),

(b) a weighted average return on assets (WARA),

(c) value indications from other approaches, such as market approach, or comparing implied multiples from the income approach with guideline company market multiples or transaction multiples."

"50.33. In developing a discount rate, a valuer should consider:

(a) the type of asset being valued. For example, discount rates used in valuing debt could be different to those used when valuing real property or a business,

(b) the rates implicit in comparable transactions in the market, General Standards – IVS 105 Valuation Approaches and Methods

(c) the geographic location of the asset and/or the location of the markets in which it would trade,

(d) the life/term and/or maturity of the asset and the consistency of inputs. For example, the maturity of the risk-free rate applied will depend on the circumstances, but a common approach is to match the maturity of the risk-free instrument to the time horizon of the cash flows being considered.

(e) the bases of value being applied.

(f) the currency denomination of the projected cash flows."

"50.34. In developing a discount rate, the valuer must:

(a) document the method used for developing the discount rate and support its use,

(b) provide evidence for the derivation of the discount rate, including the identification of the significant inputs and support for their derivation or source."

50.35. Valuers must consider the purpose for which the forecast was prepared and whether the forecast assumptions are consistent with the basis of value being applied. If the forecast assumptions are not consistent with the basis of value, it could be necessary to adjust the forecast or discount rate (see para 50.38).

50.36. Valuers must consider the risk of achieving the forecast cash flow of the asset when developing the discount rate. Specifically, the valuer must evaluate whether the risk underlying the forecast cash flow assumptions are captured in the discount rate.

"50.37. While there are many ways to assess the risk of achieving the forecast cash flow, a non-exhaustive list of common procedures includes:

(a) Identify the key components of the forecast cash flow and compare the forecast cash flow key components to:

• Historical operating and financial performance of the asset,

• Historical and expected performance of comparable assets,

• Historical and expected performance for the industry, and

• Expected near-term and long-term growth rates of the country or region in which the asset primarily operates,

(b) Confirm whether the forecast cash flow represents expected cash flows (ie, probability-weighted scenarios), as opposed to most likely cash flows (ie, most probable scenario), of the asset, or some other type of cash flow,

(c) If utilising expected cash flows, consider the relative dispersion of potential outcomes used to derive the expected cash flows (eg, higher dispersion may indicate a need for an adjustment to the discount rate), General Standards – IVS 105 Valuation Approaches and Methods

(d) Compare prior forecasts of the asset to actual results to assess the accuracy and reliability of managements’ estimates,

(e) Consider qualitative factors, and

(f) Consider the value indications such as those resulting from the market approach."

"50.38. If the valuer determines that certain risks included in the forecast cash flow for the asset have not been captured in the discount rate, the valuer must 1) adjust the forecast, or 2) adjust the discount rate to account for those risks not already captured.

(a) When adjusting the cash flow forecast, the valuer should provide the rationale for why the adjustments were necessary, undertake quantitative procedures to support the adjustments, and document the nature and amount of the adjustments,

(b) When adjusting the discount rate, the valuer should document why it was not appropriate or possible to adjust the cash flow forecast, provide the rationale for why such risks are not otherwise captured in the discount rate, undertake quantitative and qualitative procedures to support the adjustments, and document the nature and amount of the adjustment. The use of quantitative procedures does not necessarily entail quantitative derivation of the adjustment to the discount rate. A valuer need not conduct an exhaustive quantitative process but should take into account all the information that is reasonably available."

50.39. In developing a discount rate, it may be appropriate to consider the impact the asset’s unit of account has on unsystematic risks and the derivation of the overall discount rate. For example, the valuer should consider whether market participants would assess the discount rate for the asset on a standalone basis, or whether market participants would assess the asset in the context of a broader portfolio and therefore consider the potential diversification of unsystematic risks.

"50.40. A valuer should consider the impact of intercompany arrangements and transfer pricing on the discount rate. For example, it is not uncommon for intercompany arrangements to specify fixed or guaranteed returns for some businesses or entities within a larger enterprise, which would lower the risk of the entity forecasted cash flows and reduce the appropriate discount rate. However, other businesses or entities within the enterprise are deemed to be residual earners in which both excess return and risk are allocated, thereby increasing the risk of the entity forecasted cash flows and the appropriate discount rate."