✈ May 31, 2017, Avicor Aviation Inc.
Methods for valuing businesses that fall under the income approach can be divided into capitalizing and discounting. Last week we discussed the capitalizing side of the income approach. The income approach is one of three that can be applied to business valuation. The other two major approaches are the asset approach and the market approach.
This week we will discuss discounting as it applies to the income approach.
In its most basic definition, using capitalization to determine a company's value involves multiplying the expected economic benefit of the business by a discount rate. If it sounds like the opposite of capitalization, that is essentially correct. But as with capitalization, once again the first step is to determine the economic benefit that will be discounted, then a discount can be applied.
The benefit stream is dependent on which earnings base is selected. Either earnings or cash flow can be chosen: pretax or after tax; before taxes, interest, depreciation and amortization; or only before taxes and interest. The benefit stream can also be based on historic numbers or those that have been normalized or adjusted for income or expenses that are not a regular part of the business.
The economic benefit stream also needs to be assessed with respect to how it represents the future of the company. Factors such as what the future growth of the company is expected to look like are key in defining this. The specifics can be developed for several years into the future based on events that are expected to take place. For example, if it is known that the company will be launching a major new product next year and that sales for the product are expected to take off in the following year and then level out, those details can be made part of the projection. If it is known that the company will require a major investment in new assets or development costs, those can be factored in. Financing needed to make those investments must be part of the projection.
One key factor in developing the estimated future benefit stream is that a benefit stream is considered to be perpetual. At some point, we all know that an aggressive growth rate cannot continue forever. That also needs to be worked into the future benefit stream before it is discounted.
The most common, and perhaps most familiar method of applying discounting is to develop a "discounted cash flow," or "DCF" as it is often referred to. Discounting the cash flow (or other benefit stream) considers the present value of the benefit stream as it is projected out into the future. Since the net present value of something gained in the future is less now than it will be then, it must be discounted to determine its worth now.
As with capitalization, rates of return are added together with various risk premiums to develop the discount rate. These include rates such as the "risk free rate" which is based on historical trends and government bond rates, and risk premiums that are specific to the company itself.
The benefit stream is then multiplied by the growth rate and its present value is discounted by the rate developed from adding together the various risk premiums. Adding the net present value of the discounted benefit stream for each year produces the present value of that revenue stream out into the future, which is the discounted cash flow.
Because this type of approach requires knowledge about the aviation company's future plans as well as factors that affect its market, management of the company need to provide direct input into projections. While such projections can just be based on carrying out historical trends into the future, most business owners or senior management will have direct knowledge and experience that makes those projections meaningful and more realistic. Of course, all projections are educated guesses about future events, but the key is knowledge.
And then there is the market approach to valuing an aviation business...we will be taking a look at the options for that next week.
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