# Income capitalization

The capitalized earnings value methods evaluate a company on the basis of the expected future income sources that the company will generate for the company owners with the existing assets. The future sources of income can be profits or cash flows.

## Capitalized earnings methods

The capitalized earnings or simply earnings methods evaluate a company based on the anticipated sources of income, which the company will generate for the company owners in the future by using its existing substance. The future sources of income may be in profits or cash flows. The individual earning value methods can be distinguished depending on the various income streams. The widespread Discounted Cash Flow method, considered a standard valuation method, is based on a cash flow whereas the pure earning value methods and also the excess profit methods are based on some form of profit. So-called dividend models (e.g. discounted dividends or the dividend growth models) are based on expected revenue in the form of dividends that accrue to the benefit of the shareholders in the future. The dividend models are not listed here, because they are relevant for stock exchange listed companies with a constant dividend.

## Basic principles of the earnings based valuation methods:

### Time value of the money and consideration of risks

Earning value methods are all based on the same methodology: Anticipate future income that accrues to the company owners and discount it back to the point in time of the valuation. The underlying concept is that of the time value of money. This means that a franc is worth more today than tomorrow, as the money today can be invested at a specified interest rate. In addition to the time value of money, the risk is taken into account, with which the returns vary in the future, which is referred to as volatility. The higher such volatility, the higher the risk and therefore the cost of capital with which the projected income streams are discounted, i.e. discounted back to the point in time of the valuation.

The cost of capital is an interest rate that considers both the temporal component mentioned, as well as the perceived risk. Discounting specifically means that a future stream of income (FS) is divided by the term (1 + interest rate) period (T) to obtain the todays value of such income (present value). The earings to be valued can take the form of profits or cash flows, which accrue at the end of each fiscal year to the company owner.

Future value | = | Present value + Present value × Interest rate |

= | Present value × (1 + Interest rate) |

Present value | = | Future value |

(1 + Interest rate) |

## Determining the cost of capital

The cost of capital has a major impact on a company's value, since the projected streams of income will be discounted at this cost of capital. The cost of capital is composed of the expected rates of returns of the equity owners (cost of equity) and the expected return of debt providers (borrowing costs). To determine the cost of capital, the cost of equity is weighted with the equity ratio while the interest rate on the debt multiplied by the debt ratio. For the cost of debt, corporate taxes are also taken into account because the interest expenses are tax deductible. Hence the abbreviation WACCs (tax-adjusted Weighted Average Cost of Capital) is used (see Section 3.3.2 Discounted cash flow method). Equity is the most expensive, long-term bank debt the cheapest form of capital. The required rate of return of the equity investors is much higher than that of debt providers. By borrowing funds (for example in the form of a bank loan), the total capital costs are reduced, thereby changing the financing structure (it is the so-called financial leverage effect).

The required rate of return of equity can be determined using CAPM (Capital Asset Pricing Model). In this model a risk premium is added to the risk free rate (i.e. for 10-year government bonds) and where applicable further risk premiums are added for the limited tradability (for listed companies) and the size (in case of small and medium-sized, unlisted companies) of any company. The risk premium is derived from the product of the equity beta ßEK and the market risk premium or market returns. The equity beta ßEK indicates how much the stock price fluctuates compared to the market (e.g. in Switzerland SMI or SPI). The empirical determination of the equity beta ßEK requires a stock market listing. Since each company has a different funding structure and capital structure, this must be taken into account when calculating the beta.

This is done by using the so-called Hamada's formula, which transforms the beta values ßGK of a stock market (this refers only to the business risk) into the ßEK, which in addition to the business risk also incorporates the notion of the company-specific financial risk. For unlisted companies, determining the cost of equity is more difficult because no or very little empirical data on market beta derivation is available. In determining the betas, the experience of past transactions, especially in the field of small and medium enterprises (SMEs), plays a very important role. In addition, comparative values of publicly traded companies in the same industry can be used.

## Discounted Cash Flow Method

The discounted cash flow method (DCF) is, as the name suggests, a cash flow-based company valuation method. In a first phase, the projected free cash flows have to be derived and then discounted to the present using the tax-adjusted average cost of capital WACCs.

### Calculation of Free Cash Flows (FCF)

Free cash flow estimates the cash flow from business operations, which, after investment in net operating working capital and fixed assets are freely available to the owers of the company's owners.

Free Cash Flow at Entity Level is derived as follows:

**EBIT (Earning before interest and taxes)**

- Taxes on EBIT**= NOPAT (Net operating profit after taxes)**

+ Deprecation on tangible assets

+ Amortisation of intangible assets

- Increase / + Reduction in Net Working Capital

- Capital Expenditures (Capex)

- Additions to Goodwill**= Unlevered Free Cash Flow (at enterprise/entity level)**

The DCF method according to the entity approach is considered Best Practice when it comes to valuing a company, whereby the free cash flows are discounted based on the tax-adjusted average cost of capital WACCs. The tax adjustment with the WACC is necessary because in the calculation of free cash flow, taxes are directly deducted from EBIT (earnings before interest and taxes). This is theoretically incorrect because the borrowing costs are tax deductible and so taxes must not be subtracted directly from the EBIT, but from the EBT (earnings before taxes) - (disclosure of too high taxes). However, since in practice it is difficult to predict the exact taxes applicable, the "incorrectness" mentioned is corrected via the WACCs, as the tax shield will reduce the overall cost of capital.

A projected income statement has to be drawn up for the next 4-5 years, starting from a valuation point. A simplified scenario is worked with for the time period beyond the initial 4-5 years.

A so-called residual value is determined. Here, the assumption is made that the investment currently meets the depreciation, such that the free cash flow on entity level to be discounted equals the NOPAT (Net Operating Profit after Taxes).

The gross value of the company consists of the present value of free cash flows at the Entity level and of the present value of the residual value. To obtain the net value of the company, the value of equity, the net debt is subtracted from the company's gross value.

### Residual value, planning horizon, eternal growth

The difficulty in defining the planning horizon is the weighting of the residual value. The greater the number of planned years, the more difficult it is to plan the future free cash flows. On the other hand, the impact of the residual value is reduced. It therefore makes sense to forecast only about 4-5 years, as these are justifiable and understandable, and as trade-off accept a higher proportion of the residual value on the company's value.

When planning future profits or free cash flows one can make the assumption that profits should show an eternal growth after the planning horizon.

In the denominator of the DCF formula, the growth rate g is then subtracted from the WACCs. The assumption of perpetual growth at the NOPAT level has a significant impact on the valuation and must be viewed with great caution and above all be based on a reasonable and well founded justification.

## Pure earnings value method

Aside from a detailed planning of the future years, one can perform a simplified earnings value calculation. Here it is assumed that a perpetual profit (before interest payments) can be achieved and that this profit is equivalent to the free cash flow at entity level. This stems from the fact that there are no changes in working capital and that investments just meet the depreciation, which implies that only replacement investments will be made.

The resulting profit is regarded as eternal and is discounted with the tax adjusted WACC, because the taxes in the calculation of EBIT (earnings before interest) are not calculated correctly.

## Goodwill

The difference in valuation between the earnings and net asset method is called goodwill. Goodwill describes the part of the purchase price, which is paid in addition to the value of the material asset on the balance sheet, e.g. for the customer base, reputation, brand, market position, access to the work related performance of employees and for other intangible assets. The amount of goodwill depends among other factors on the industry sector. If a company with a capital intensive business is sold, the goodwill in relation to the sales price is considerably lower than in the case of a pure service company, where there are few tangible assets on the balance sheet.

## Weighted average method (practitioner method)

The average method represents a weighted average of the net asset and capitalized earnings value.

Swiss practice:

## Excess profit methods

The intrinsic value method and the discounted cash flow method can be combined by using the excess profit method. Here recoverable excess profit is added to the gross asset value over a certain period T. The excess profit is the difference between the budgeted profit after tax (NOPAT) and the regular profit, which is the product of asset value and the tax-adjusted cost of capital (WACCS).

The budgeted profit can be higher than regular profit, for example due to a strong market position, due to competitive advantages, but it is time limited.

The excess profit adopted for a certain period is capitalized with the present value annuity factor, composed as in the following formula:

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