A Look at the Income Approach

The Cost of Capital Professional platform provides you with a comprehensive range of tools that enable you to compute cost of equity and WACC estimates easily and effectively allowing you to determine your cost of capital with minimal fuss. The income approach is one such way to approach these valuations. What follows is a selection from a comprehensive article on the topic written by Jim Alerding.

Whenever I teach valuation basics, I always start with the easy part. I tell the students that the valuation premise is very simple: V = I/R where V = value, I = income, and R = the required rate of return. Of course, even in the early days of valuation, that simple formula became complex very quickly. In my opinion, in today’s world of valuation, we are coming close to the breaking point. How much is enough? Let’s look at some of the elements now flooding the process under the income approach. Once again, I am not advocating for eliminating the basic steps required to arrive at a supportable and reasonable value, but it does seem that there continue to be added complications that might confuse rather than aid the process. It hearkens to the old adage: “How many angels can dance on the head of a pin?” Here is a sampling of the head notes on the methods to define the benefit stream from Financial Valuation Applications and Models (FVAM), 4th edition:

  • Net income;
  • Net cash flow;
  • Defining net cash flow: cash flow direct to equity (direct equity method), cash flow to invested capital (invested capital method);
  • Current earnings method;
  • Simple average method;
  • Weighted average method;
  • Trend line-static method; and
  • Formal projection method (detailed cash-flow projections).

OK, I get that these are all helpful methods and things that should be considered, but the process really starts to become complicated when we move from the “I” in our value equation to the “R,” required rate of return, represented in the process by the “cost of capital” (COC), also known as the discount rate. The common measurement for the COC is the modified capital asset pricing model (MCAPM). The equation for that model, which all are likely familiar with, is:

E(Ri) = Rf + B x RPm + RPs +/- RPc2

Where: E(Ri) = Expected rate of return on security
Rf = Rate of return available on a risk-free security as of the valuation date
B = Beta
RPm = Equity risk premium (ERP) for the market as a whole
RPs = Risk premium for smaller size
RPc = Risk premium attributable to other company risk factors

The other popular method of determining the COC is the buildup method (BUM). The difference between the MCAPM and the BUM is that the BUM uses an estimate of the industry risk premium (RPi) instead of a beta.

The full article goes into great detail on this topic and can be found here. Once you’re done with the article, take the opportunity to examine all the benefits that Cost of Capital Professional provides, including a free webinar that showcases the reliability, flexibility, accuracy, and replicability of this must-see valuation platform!