What principle is the income approach to business valuation based on? Income approach.

The task of assessing the value of a business at different stages of its development does not lose its relevance. An enterprise is a long-term asset that generates income and has a certain investment attractiveness, so the question of its value is of interest to many, from owners and management to government agencies.

Most often, to assess the value of an enterprise, they use income method (income approach), because any investor invests money not just in buildings, equipment and other tangible and intangible assets, but in future income that can not only recoup the investment, but also bring profit, thereby increasing the investor’s well-being. At the same time, the volume, quality and duration of the expected future income stream play a special role when choosing an investment object. Undoubtedly, the amount of expected income is relative and is subject to the enormous influence of probability, depending on the level of risk of possible investment failure, which must also be taken into account.

Note! The main cost factor in use this method- expected future income of the company, representing certain economic benefits for the owners of the enterprise. The higher the company's income, the higher, other things being equal, its market value.

The income method takes into account the main goal of the enterprise - making a profit. From these positions, it is most preferable for business assessment, as it reflects the development prospects of the enterprise and future expectations. In addition, it takes into account the economic obsolescence of objects, and also takes into account the market aspect and inflationary trends through the discount rate.

Despite all the undeniable advantages, this approach is not without controversial and negative aspects:

it is quite labor intensive;
it is characterized by a high level of subjectivity when forecasting income;
there is a high proportion of probabilities and conventions, as various assumptions and restrictions are established;
the influence of various risk factors on the projected income is great;
it is problematic to reliably determine the real income shown by the enterprise in the statements, and it is possible that losses are deliberately reflected for various purposes, which is associated with the opacity of information from domestic enterprises;
accounting for non-core and excess assets is complicated;
the assessment of unprofitable enterprises is incorrect.

It is imperative to pay special attention to the ability to reliably determine the future income streams of the enterprise and the development of the company’s activities at the expected pace. The accuracy of the forecast is also greatly influenced by the stability of the external economic environment, which is important for the rather unstable Russian economic situation.

So, it is advisable to use the income approach to evaluate companies when:

they have a positive income;
it is possible to draw up a reliable forecast of income and expenses.

Calculating the value of a company using the income approach

Estimating the value of a business using the income approach begins with solving the following problems:

1) forecast of future income of the enterprise;

2) bringing the value of future income of the enterprise to the current moment.

The correct solution of these problems contributes to obtaining adequate final results of the assessment work. Of great importance in the course of forecasting is the normalization of income, with the help of which one-time deviations are eliminated, appearing, in particular, as a result of one-time transactions, for example, when selling non-core and excess assets. To normalize income, statistical methods are used to calculate the average, weighted average average size or an extrapolation method representing represents a continuation of existing trends.

In addition, it is imperative to take into account the factor of changes in the value of money over time - the same amount of income currently has a higher price than in a future period. The difficult question of the most acceptable timing for forecasting a company's income and expenses needs to be resolved. It is believed that to reflect the inherent cyclical nature of industries, in order to make a reasonable forecast, it is necessary to cover a period of at least 5 years. When considering this issue through a mathematical and statistical prism, there is a desire to lengthen the forecast period, assuming that a larger number of observations will give a more reasonable value market value companies. However, increasing the forecast period in proportion makes it more difficult to predict the values of income and expenses, inflation and cash flows. Some appraisers note that the most reliable income forecast will be for 1–3 years, especially when there is instability in the economic environment, since as the forecast periods increase, the conditionality of the estimates increases. But this opinion is only true for sustainably operating enterprises.

Important!In any case, when choosing a forecast period, you need to cover the period until the company’s growth rate stabilizes, and to achieve the greatest accuracy of the final results, you can divide the forecast period into smaller intermediate periods of time, for example, half a year.

In general terms, the value of an enterprise is determined by summing up the income streams from the activities of the enterprise during the forecast period, previously adjusted to the current price level, with the addition of the value of the business in the post-forecast period (terminal value).

The most common two methods for assessing the income approach are: income capitalization method And discounted cash flow method. They are based on estimated discount and capitalization rates that are used to determine the present value of future earnings. Of course, within the framework of the income approach, many more varieties of methods are used, but basically they are all based on discounting cash flows.

A major role in choosing an assessment method is played by the purpose of the assessment itself and the intended use of its results. Other factors also have an impact, for example, the type of enterprise being valued, the stage of its development, the rate of change in income, the availability of information and the degree of its reliability, etc.

Methodcapitalizationincome(Single-Period Capitalization Method, SPCM)

The income capitalization method is based on the proposition that the market value of a business is equal to the present value of future earnings. It is most appropriate to apply it to those companies that have already accumulated assets, have a stable and predictable amount of current income, and the rate of its growth is moderate and relatively constant, while the current state gives a certain idea of \u200b\u200blong-term trends in future activities. And vice versa: at the stage of active growth of the company, during the process of restructuring or at other times when there are significant fluctuations in profits or cash flows (which is typical for many enterprises), this method is undesirable for use, since there is a high probability of obtaining an incorrect value assessment result.

The income capitalization method is based on retrospective information, while for a future period, in addition to the amount of net income, other economic indicators are extrapolated, for example, capital structure, rate of return, and the company's risk level.

The valuation of an enterprise using the income capitalization method is carried out as follows:

Current market value = DP (or P net) / Capitalization rate,

where DP is cash flow;

P is clean - net profit.

Note! The reliability of the assessment result very much depends on the capitalization rate, so special attention should be paid to the accuracy of its calculation.

The capitalization rate allows you to convert earnings or cash flow values for a specific period of time into a measure of value. As a rule, it is derived from the discount factor:

Capitalization rate =D- T r,

Where D- discount rate;

T r - growth rate of cash flow or net profit.

It is clear that the capitalization ratio is most often less than the discount rate for the same company.

As can be seen from the presented formulas, depending on what amount is capitalized, the expected growth rate of cash flow or net profit is taken into account. Of course, the capitalization rate will vary for different types of income. Therefore, the primary task when implementing this method is to determine the indicator that will be capitalized. In this case, income can be predicted for the year following the valuation date or the average income calculated using retrospective data is determined. Since net cash flow fully takes into account the operating and investment activities of an enterprise, it is most often used as a base for capitalization.

So, the capitalization rate in its own way economic essence is close to the discount factor and is strongly interrelated with it. The discount rate is also used to reduce future cash flows to the present time.

Discounted cash flow method ( Discounted Cash-Flows, DCF )

The discounted cash flow method allows you to take into account the risks associated with obtaining the expected income. The use of this method will be justified when a significant change in future income is predicted, both up and down. In addition, in some situations, this method aloneis applicable, for example, expansion of the enterprise’s activities if at the time of assessment it does not operate at its full production capacity, but intends to increase it in the near future;planned increase in production volume; business development in general; mergers of enterprises; introduction of new production technologies, etc.Under such conditions, annual cash flows in future periods will not be uniform, which, naturally, makes it impossible to calculate the market value of the company using the income capitalization method.

For new enterprises, the only possible method to use is also the discounted cash flow method, since the value of their assets at the time of valuation may not coincide with the ability to generate income in the future.

Of course, it is desirable that the company being assessed has favorable development trends and a profitable business history. For companies suffering systematic losses and having a negative growth rate, the discounted cash flow method is less suitable. Particular care must be taken when evaluating companies with a high probability of bankruptcy. In this case, the income approach is not applicable at all, including the income capitalization method.

The discounted cash flow method is more flexible becausecan be used to evaluate any operating enterprise usingline-item forecast of future cash flows. It is of no small importance for the management and owners of the company to understand the influence of various management decisions to its market value, that is, it can be used in the value management process based on the resulting detailed business value model and see its susceptibility to the allocated internal and external factors. This allows you to comprehend the activities of the enterprise at any stage life cycle in future. And most importantly: this method is most attractive to investors and meets their interests, since it is based on forecasts of future market development and inflationary processes. Although there is also some difficulty in this, sincein an unstable crisis economy With It is quite difficult to predict your income stream several years in advance.

So, the initial basis for calculating the value of a business using the methoddiscounting cash flowsis a forecast, the source of which is retroinformation about cash flows. The traditional formula for determining the current value of discounted future income is as follows:

Current market value = Cash flows for the periodt / (1 + D) t.

The discount rate is the interest rate required to reduce future earnings to a single value for the current value of the business. For an investor, it is the required rate of return on alternative investments with a comparable level of risk at the time of valuation.

Depending on the type of cash flow chosen (equity or total invested capital) used as the basis for valuation, the method for calculating the discount rate is determined. Cash flow calculation schemes forinvested and equity capital are presented in table. 12.

Table 1. Calculation of cash flow for invested capital
Index	Impact on the bottom line cash flow (+/–)
Net profit
Accrued depreciation
Decrease own working capital
Increase in own working capital
Sale of assets
Capital investments
Cash flow for invested capital

Table 2. Calculation of cash flow for equity
Index	Impact on the bottom line cash flow (+/–)
Net profit
Accrued depreciation
Decrease in own working capital
Increase in own working capital
Sale of assets
Capital investments
Increase in long-term debt
Reducing long-term debt
Cash flow for equity

As you can see, calculating cash flow forequity capital differs only in that the result obtained from the algorithm for calculating cash flow for invested capital is additionally adjusted for changes in long-term debt. Then the cash flow is discounted in accordance with the expected risks, which are reflected in the discount rate calculated in relation to a specific enterprise.

So, the cash flow discount rate for equity capital will be equal to the rate of return on invested capital required by the owner,invested capital- the sum of weighted rates of return on borrowed funds (that is, the bank’s interest rate on loans) and on equity capital, while their specific gravity are determined by the shares of borrowed and equity funds in the capital structure. Cash flow discount ratefor invested capitalcalled weighted average cost of capital, and the corresponding method for calculating it isweighted average cost of capital method (WeightedAverageCost ofCapital, WACC). This method of determining the discount rate is used most often.

Besides, to determine the cash flow discount rate for equity may be applied the following are the most common methods:

capital asset valuation model ( CAPM);
modified capital asset valuation model ( MCAPM);
cumulative construction method;
excess profit model ( EVO) and etc.

Let's consider these methods in more detail.

Methodweighted average capital costs ( WACC)

It is used to calculate both equity and borrowed capital by constructing the ratio of their shares; it shows not the balance sheet, butmarket value of capital. The discount rate for this model is determined by the formula:

DWACC = S zk × (1 – N prib) × D zk + S pr × D pr + S oa × D ob,

where C зк is the cost of borrowed capital;

N profit - income tax rate;

Дзк - share of borrowed capital in the company's capital structure;

Ср - cost of attracting share capital (preferred shares);

D pr - share of preferred shares in the company's capital structure;

Соа - cost of attracting share capital (ordinary shares);

D ob - the share of ordinary shares in the capital structure of the company.

The more a company attracts cheap borrowed funds instead of expensive equity capital, the lower the value WACC. However, if you want to use as many cheap borrowed funds as possible, you should also remember about the corresponding decrease in the liquidity of the enterprise’s balance sheet, which will certainly lead to an increase in credit interest rates, since for banks this situation is fraught with increased risks, and the amount WACC, of course, will grow. Thus, it would be appropriate to use the “golden mean” rule, optimally combining own and borrowed funds based on their balance in terms of liquidity.

Methodestimatescapitalassets (Capital Asset Pricing Model, CAPM)

Based on the analysis of information from stock markets about changes in the profitability of publicly traded shares. In this case, when calculating the discount rate for equity capital, the following formula is used:

DCAPM = D b/r + β × (D r − D b/r ) + P 1 + P 2 + R,

where D b/r - risk-free rate of return;

β - special coefficient;

D r - the total return of the market as a whole (the average market portfolio of securities);

P 1 - bonus for small enterprises;

P 2 - premium for risk specific to an individual company;

R- country risk.

The risk-free rate is used as a basis for assessing the various types of risk associated with investing in a company. Special beta coefficient ( β ) represents the amount of systematic risk associated with economic and political processes occurring in the country, which is calculated based on deviations in the total return of shares of a particular company compared to the total return of the stock market as a whole. The total market return indicator is the average market return index, which is calculated by analysts based on long-term research of statistical data.

CAPMquite difficult to apply in the conditions of underdevelopment of the Russian stock market. This is due to the challenges of determining betas and market risk premiums, especially for closely held businesses that are not listed on a stock exchange. In foreign practice, the risk-free rate of return, as a rule, is the rate of return on long-term government bonds or bills, since they are considered to have high degree liquidity and a very low risk of insolvency (the likelihood of state bankruptcy is practically excluded). However, in Russia, after some historical events, government securities are not psychologically perceived as risk-free. Therefore, the average rate on long-term foreign currency deposits of the five largest Russian banks, including Sberbank of Russia, which is formed mainly under the influence of internal market factors, can be used as a risk-free rate. Regarding the odds β , then abroad they most often use ready-made publications of these indicators in financial directories calculated by specialized firms by analyzing statistical information of the stock market. Appraisers generally do not need to calculate these ratios themselves.

Modified capital asset valuation model ( MCAPM)

In some cases, it is better to use a modified capital asset valuation model ( MCAPM), in which an indicator such as a risk premium is used, taking into account the unsystematic risks of the enterprise being valued. Unsystematic risks (diversifiable risks)- These are risks that arise randomly in a company that can be reduced through diversification. In contrast, systematic risk is caused by the general movement of the market or its segments and is not associated with a specific security. Therefore, this indicator is more suitable for the Russian conditions of stock market development with its characteristic instability:

DMCAPM = D b/r + β × (D r − D b/r ) + P risk,

where D b/r is the risk-free rate of return on Russian domestic foreign currency loans;

β - a coefficient that is a measure of market (non-diversifiable) risk and reflects the sensitivity of changes in the profitability of investments in companies in a certain industry to fluctuations in the profitability of the stock market as a whole;

D r - profitability of the market as a whole;

P risk is a risk premium that takes into account the unsystematic risks of the company being evaluated.

Cumulative method

Takes into account different kinds investment risks and involves an expert assessment of both general economic and industry-specific and enterprise-specific factors that create the risk of not receiving planned income. The most important factors are the size of the company, structure finance, production and territorial diversification,quality of management, profitability, predictability of income, etc.The discount rate is determined based on the risk-free rate of return, to which is added an additional premium for the risk of investing in a given company, taking into account these factors.

As we can see, the cumulative approach is somewhat similar to CAPM, since they are both based on the rate of return on risk-free securities with the addition of additional income associated with the risk of the investment (it is believed that the greater the risk, the greater the return).

Olson model (Edwards - Bell - Ohlson valuation model , EVO ), or the excess income (profit) method

Combines the components of the income and cost approaches, to some extent minimizing their disadvantages. The value of the company is determined by discounting the stream of excess income, that is, deviating from the industry average, and the current value of net assets. The advantage of this model is the ability to use available information on the value of assets available at the time of assessment to calculate. A significant share in this model is occupied by real investments, and only residual profit is required to be predicted, that is, that part of the cash flow that actually increases the value of the company. Although this model is not without some difficulties in use, it is very useful in developing an organization development strategy related to maximizing business value.

Drawing up the final the company's market value

Once the preliminary value of the business has been determined, a number of adjustments must be made to obtain the final market value:

for excess/shortage of own working capital;
on non-core assets of the enterprise;
on deferred tax assets and liabilities;
on net debt, if any.

Since the calculation of discounted cash flow includes the required amount of own working capital associated with the revenue forecast, if it does not coincide with the actual value, the excess of own working capital must be added, and the deficiency must be subtracted from the value of the preliminary cost. The same applies to non-performing assets, since only those assets that were used in generating cash flow were included in the calculation. This means that if there are non-core assets that have a certain value that is not taken into account in the cash flow, but can be realized (for example, upon sale), it is necessary to increase the preliminary value of the business by the value of such assets, calculated separately. If the value of the enterprise was calculated for the invested capital, then the resulting market value applies to the entire invested capital, that is, it includes, in addition to the cost of equity, also the value of the company’s long-term liabilities. This means that to obtain the value of equity capital, it is necessary to reduce the value of the established value by the amount of long-term debt.

After making all the adjustments, the value will be obtained, which is the market value of the company's equity.

The business is capable of generating income even after the end of the forecast period. Revenues should stabilize and reach a uniform long-term growth rate. To calculate the cost inpost-forecast period, you can use one of the following methods for calculating the discount:

according to liquidation value;
by net asset value;
according to Gordon's method.

When using the Gordon model, the terminal value is defined as the ratio of cash flow for the first year of the post-forecast period to the difference between the discount rate and the long-term growth rate of cash flow. The terminal value is then reduced tocurrent cost indicators at the same discount rate that is used to discount cash flows of the forecast period.

As a result, the total value of the business is determined as the sum of the current values of income streams in the forecast period and the value of the company in the post-forecast period.

Conclusion

In the process of assessing the value of a company using the income approach, a financial model of cash flows is created, which can serve as the basis for making informed management decisions, optimizing costs, analyzing the possibilities of increasing design capacity and diversifying the volume of products. This model will remain useful after the assessment has been completed.

To choose one or another method for calculating market value, you first need to decide on the purpose of the assessment and the planned use of its results. Then you should analyze the expected change in the company's cash flows in the near future, consider financial condition and development prospects, as well as assess the surrounding economic environment, both global and national, including industry. If, when there is a lack of time, you need to find out the market value of a business, or confirm the results obtained using other approaches, or when an in-depth analysis of cash flows is impossible or not required, you can use the capitalization method to quickly obtain a relatively reliable result. In other cases, especially when the income approach is the only option To calculate market value, the discounted cash flow method is preferred. It is possible that in certain situations both methods will be needed simultaneously to calculate the value of a company.

And of course, we should not forget that the value obtained using the income approach directly depends on the accuracy of the analyst’s long-term macroeconomic and industry forecasts. However, even the use of rough forecast indicators in the process of applying the income approach can be useful in determining the estimated value of the company.

Topic 7. Income method of real estate valuation.

1. Structure of the income method.

2. Fundamental principles of the income method.

3. Capitalization rate, discounting rate.

4. Terms of rental payments.

5. Reconstructed income and expense statement.

6. Direct capitalization method.

7. Estimation using the residual technique.

8. Second method of capitalization.

The income method of real estate valuation reflects the motivation of the typical buyer of income real estate: expected future income with the required characteristics. Given that there is a direct relationship between the size of the investment and the benefits from the commercial use of the investment object, the value of real estate is defined as the value of the rights to receive the income it generates. This value (market, investment) is defined as the present value of future income generated by the asset being valued.

The main advantage of the income method compared to the market and cost method is that it largely reflects the investor’s idea of real estate as a source of income, i.e. This quality of real estate is taken into account as the main pricing factor. The income method of valuation is closely related to the market and cost methods. For example, the rates of return used in the income method are usually determined from an analysis of comparable investments, renovation costs are used in determining cash flow as additional investments, and capitalization methods are used to adjust for differences between the market and cost methods. The main disadvantage of the method is that, unlike the other two assessment methods, it is based on forecast data.

1. Structure of the income method.

At the first stage, when using the income method, a forecast of future income from renting out the assessed space for the period of ownership is made, i.e. for the time during which the investor intends to retain ownership of the property. Lease payments are cleared of all operating periodic costs necessary to maintain the property in the required commercial condition and management, after which the value of the property at the end of the ownership period is predicted in absolute or fractional terms relative to the original cost - the so-called reversion value. On last stage Forecasted earnings and reversals are converted to present value using direct capitalization and discounted cash flow methods. The choice of capitalization method is determined by the nature and quality of expected income.

Direct capitalization is used if income is forecast to be constant or smoothly changing at a slight pace. If the dynamics of changes in income are significant or these changes are irregular, then cash flow discounting is used.

If an uncertain situation regarding future income is expected in the future, then it is also advisable to use the direct capitalization method, relying on retrospective and current data on sales and lease agreements in relation to similar objects.

The value is determined using the direct capitalization method using only two variables: the projected net annual income and the corresponding capitalization rate. The basis of the method is the fact that in a free and competitive market, the ratio of rental income values to sales prices for each of the identified real estate objects of the same use are distributed around a certain value, which is the main indicator for choosing the capitalization rate.

Thus, value is determined by dividing the projected annual income by the market capitalization rate, which is either determined based on historical and current sales and lease information, or is calculated as the rate of return on capital adjusted to compensate for changes in the value of the original capital during the holding period.

The second capitalization method, as already noted, determines the value of real estate as the sum of the present values of future income by separately discounting each of the periodic income and the projected future value of the property. In these calculations, a discount rate is used, which is the corresponding rate of return on capital, otherwise called the rate of return or rate of return.

2. Fundamental principles of the income method.

The theoretical basis of the income method is the principles of valuation, which represent a generalization of the analysis of the behavioral characteristics of participants in the real estate market and the functional relationships between prices and price-forming factors.

We present the principles that are most significant for the income method, as well as factors and circumstances, the analysis of which is based on the corresponding principle.

PRINCIPLE SPHERE OF INFLUENCE

Expectations Full range of forecast data:

(basic principle, pricing factors,

on which the characteristics of income, capital,

income estimate) coefficients

Substitutions Selection and analysis of analogue objects,

Analysis of alternative investments

Demand Accounting and analysis of factors:

And suggestions usefulness, scarcity,

Competitiveness,

Availability of the capital market,

Monopoly, state control

Business activity,

population characteristics

ultimate Analysis of the property:

productivity economic compliance of documents

(balance, deposit) real estate,

its use and type of land use

3. Capitalization rate, discounting rate.

Capitalization rate Ro used in the direct capitalization method according to the formula

Where V is the cost

NOI is a representative value of expected net operating income

The capitalization rate includes the rate of return on capital (invested funds, or initial investment) and the rate of return, which takes into account the recovery of the original funds invested.

Like any rate of return, the capitalization rate primarily reflects the risks to which funds invested in a given asset are exposed.

Discount rate(rate of return, rate of return) is used in the second capitalization method - the discounted cash flow method. The general expression for determining cost is as follows:

where i is the discount rate

FV – resale price of the property at the end of the ownership period (reversion)

N – holding period

L – payment period number

The value is defined as the sum of the current values of income for each reversion period, calculated at the appropriate rate. The discount rate i is otherwise called the rate of return on investment. This value also characterizes the efficiency of capital investments. It takes into account all total income (return on investment and income from changes in the value of the asset), bringing the initial investment and the realized economic effect into line with time and risk factors. The discount rate should be considered taking into account that the capital market, securities market and real estate market are unified system investment instruments. The unity of this system, in particular, is determined by common selection criteria: risk and profitability. The choice of discount rate is based on an analysis of available alternative investment options with a comparable level of risk, i.e. this rate is considered as an opportunity cost of capital.

4. Terms of rental relations.

The basis for forecasting income from real estate is the analysis of rental relations. The appraiser or real estate analyst needs to collect all available historical and current information on leases and, based on their analysis, determine the impact of the terms contained in the leases on the characteristics of lease payments.

Let's look at the main conditions under which lease agreements may differ, although in practice the range of these conditions can be much wider. It is necessary to identify the rental conditions that are most typical for the local real estate market for a specific purpose, and make adjustments to the values of contract rental rates for analogue properties to bring them to market conditions.

RENTAL CONDITIONS BRIEF EXPLANATION

AGREEMENTS

Types of rental payments

With a fixed agreement, the agreement is usually concluded on

Rental rate short time or when expected

Economic stability

Adjusted to take into account possible price changes

Rent payments or property value

With percentage rental To constant rental value

Payments add a percentage of

Income generated by the entrepreneur

Telly activity of the tenant

Distribution of exploitation

Zion expenses

Gross rent All operating costs are borne by

Owner

Net rent All operating costs are borne by

Tenant

Intermediate option: Owner and tenant share the burden

Operating costs in

In accordance with the terms of the lease

Go agreements

Duration

Lease agreements

Short-term Up to 1 year

Medium term 1 – 3 years

Long-term Over 3 years

To extend the lease Represents an additional right-

Agreements with the tenant to extend the contract

Vora after the expiration of the validity period

Via current agreement

For the purchase of property rights Provides preferential

For leased real estate, the tenant has the right to purchase

The income approach is applied when there is reliable information that allows one to predict the future income that the valuation object is capable of generating, as well as the costs associated with the valuation object. When applying the income approach, the appraiser determines the amount of future income and expenses and the moments of their receipt.

The income approach is a set of methods for assessing the value of the valuation object, based on determining the expected income from the valuation object. Stages of the income approach:

1. Calculation of gross income from the use of an object based on an analysis of current rates and tariffs in the rental market for comparable objects.
2. The assessment of losses from incomplete occupancy (renting) and uncollected rental payments is made on the basis of an analysis of the market and the nature of its dynamics in relation to the real estate being valued. The amount calculated in this way is subtracted from the gross income, and the resulting figure is the actual gross income.
3. Calculation of costs associated with the subject of assessment:

* operational (maintenance) - costs of operating the facility;

* fixed - costs of servicing accounts payable (interest on loans, depreciation, tax payments, etc.);

* reserves - costs for the purchase (replacement) of accessories for the property.

4. Determination of the amount of net income from the sale of the object.
5. Calculation of capitalization ratio. In the practice of Russian valuation, the concept of the income approach is usually associated with two methods: direct capitalization of income and discounted cash flows. The direct capitalization method converts income over one time period into value, while the discounted cash flow method converts income over a number of years. [assessment questions, Levada]

The advantages and disadvantages of the methods are determined by the following:

- the ability to reflect actual intentions potential buyer(investor);
- the type, quality and breadth of information on which the analysis is based;
- ability to take into account competitive fluctuations;
- the ability to take into account the specific features of an object that affect its value (location, size, potential profitability).

The income capitalization method is used if:

- income streams are stable for a long period of time and represent a significant positive value;
- income streams are growing at a steady, moderate pace.

The result obtained by this method consists of the cost of buildings, structures and the cost land plot, i.e. is the cost of the entire property. The basic calculation formula is as follows:

where C is the cost of the property (monetary units);

Capitalization ratio, (%);

NOR - net operating income

The main problems of this method:

1. The method is not recommended for use when the property requires significant reconstruction or is in a state of unfinished construction, i.e. It is not possible to reach a level of stable income in the near future.
2. In Russian conditions, the main problem faced by the appraiser is the “information opacity” of the real estate market, primarily the lack of information on real transactions for the sale and rental of real estate, operating costs, lack statistical information by load factor in each market segment in different regions. As a result, the calculation of NRR and capitalization rate becomes very challenging task. [Gryaznova]

Sequence of actions when applying the direct capitalization method:

1. Determine the amount of stabilized net income for one year following the actual valuation date (usually by averaging annual income over several previous years based on retroanalysis).
2. Determine the value of the capitalization ratio using one of the methods.
3. Divide the net operating income for one year by the total capitalization ratio in order to obtain the current value of the property being valued as the result of the division. [Kasyanenko]

When using this method, the following income is used:

1) potential gross income (PVI) - income that can be received from real estate, with 100% of its use without taking into account all losses and expenses. PPV depends on the area of the property being assessed and the established rental rate and is calculated using the formula:

PVD = S * C a, (7)

where S is the area rented out, m2;

C a - rental rate per 1 m 2.

2) actual gross income (AGI) is the potential gross income minus losses from underutilization of space and when collecting rent, with the addition of other income from the normal market use of the property:
3) net operating income (NOI) - actual gross income minus operating expenses (OR) for the year (excluding depreciation charges). [Gryaznova]

There are several methods for determining the capitalization ratio:

* taking into account the reimbursement of capital costs (adjusted for changes in the value of the asset);

* linked investment method, or investment group technique;

* direct capitalization method.

When determining the capitalization ratio taking into account the reimbursement of capital costs, it should be taken into account that the capitalization ratio consists of two parts:

1) the rate of return on investment (capital), which is the compensation that must be paid to the investor for the use of funds, taking into account the risk and other factors associated with specific investments;
2) capital return rates, i.e. repayment of the initial investment amount. Moreover, this element of the capitalization ratio applies only to the depreciable part of the assets.

The rate of return on capital is constructed using the cumulative method by adding the risk-free rate of return, risk premium, real estate investment, premium for low liquidity of real estate and premium for investment management. [Bugaeva]

Risk-free rate of return - the rate of return on highly liquid assets that are available to the investor and have a guarantee of return, i.e. for which there is no risk.

Risk-free rate requirements:

* return on the most liquid assets, which are characterized by a relatively low rate of return, but with a guarantee of return of capital;

* availability for investors as an alternative investment option. [Vandanimaeva]

There are three ways to recoup invested capital:

* straight-line return of capital (Ring method);

ѕ return of capital according to the replacement fund and the rate of return on investment (Inwood method). It is sometimes called the annuity method;

ѕ return of capital based on the compensation fund and the risk-free interest rate (Hoskold method). [Gryaznova]

The Ring method is appropriate to use when it is expected that the principal amount will be recovered in equal parts. Annual norm Return on capital is calculated by dividing 100% of the asset's value by its remaining useful life, i.e. It is the reciprocal of the asset's service life. Return rate - annual share of the initial capital placed in the interest-free recovery fund:

R K = R y +1/n (8)

where n is the remaining economic life.

The Inwood method is used if the return on capital is reinvested at the rate of return on the investment. In this case, the return rate is component capitalization ratio is equal to the replacement fund factor at the same interest rate as for investments

RK = Ry + SFF (n, Y), (9)

where SFF is the compensation fund factor;

Y= R (rate of return on investment).

The Hoskold method is used in cases where the rate of return on the initial investment is somewhat high, making it unlikely that reinvestment will occur at the same rate. For reinvested funds, it is assumed that income will be received at a risk-free rate [Bugaeva]

R K = R y +SFF (n, Y b), (10)

where Y b is the risk-free interest rate.

Based on market data on sales prices and NAV values of comparable properties, the capitalization ratio can be calculated. [Gryaznova]

where NOY is the net operating income of the i-th analogue object;

Vi - sale price of the i-th analogue object

The discounted cash flow (DCF) method is more complex, detailed and allows you to evaluate an object in case of receiving unstable cash flows from it, modeling the characteristic features of their receipt. The DCF method is used when:

- it is assumed that future cash flows will differ significantly from current ones;
- there is data to justify the size of future cash flows from real estate;
- income and expense flows are seasonal;
- the property being assessed is a large multifunctional commercial facility;
- the property is under construction or has just been built and put into operation (or put into operation).

To calculate DCF, the following data is required:

- duration of the forecast period;
- forecast values of cash flows, including reversion;
- discount rate. In Western practice, the following methods are used to calculate the discount rate:
- 1) cumulative construction method - based on the premise that the discount rate is a function of risk and is calculated as the sum of all risks inherent in each specific property;
- 2) allocation method - discount rate, as a compound interest rate is calculated based on data on completed transactions with similar objects on the real estate market;
- 3) monitoring method - based on regular market monitoring, tracking the main economic indicators of real estate investments based on transaction data.

The residual value, or reversion value, must be discounted (by the factor of the last forecast year) and added to the sum of the present values of the cash flows.

Calculation of the value of a property using the DCF method is carried out using formula 12.

where PV is the current value;

C i - cash flow of period t;

i t - discount rate for cash flow of period t;

M - reversion cost, or residual value.

Thus, the value of the property is equal to the sum of the current value of the projected cash flows and the current residual value (reversion value).

The income approach is based on the assumption that the value of a real estate property is determined by the current value of future income from its use. However, money received in the future is not equal to the same amount received today. To determine the value of property that generates a stream of income in the future, it is necessary to bring the latter to its current value. In general, this uses the discounting procedure, which can be applied to any model of income and value of the object. Capitalization, unlike discounting, takes into account not only the return on capital, but also the return on capital. The methods of the income approach, as well as the cost approach, are applicable for estimating values in use (investment, consumption) and for financial accounting purposes.

MINISTRY OF FINANCE OF THE RUSSIAN FEDERATION

FEDERAL STATE EDUCATIONAL INSTITUTION

HIGHER PROFESSIONAL EDUCATION

"ALL-RUSSIAN STATE TAX ACADEMY

MINISTRY OF FINANCE OF THE RUSSIAN FEDERATION"

Discipline: “Real Estate Valuation”

Income approach to real estate valuation

Completed by: Skorodumova O.Yu.

Specialty: taxes and taxation

Group: NZ - 401

Moscow 2009

Introduction

Characteristics of the income approach

Determination of net operating income

Capitalization theory and capitalization ratios

Direct capitalization

Methods for calculating capitalization rates

Discounting income stream

Valuation using the residual technique

PROS AND CONS OF USING THE INCOME APPROACH

Conclusion

Literature

Introduction

Currently, real estate is one of the necessary resources (along with human, financial, material, technical and information resources) to ensure the effective operation of a joint stock company, state and municipal owner and, finally, the normal life of each individual individual.

At the same time, real estate is the most important property component of the owners. According to its estimated value, real estate is up to 30-40% (of course, there are a number of modern areas of activity where real estate is used minimally, for example, in small businesses, in online stores, etc.)

Therefore, real estate valuation is important and relevant in modern stage development. Valuation of movable property is also important both for taxation purposes and for the purposes of purchase and sale, pledge, lease, etc.

There are several methods for assessing real estate and other property of enterprises. Such as: income, comparative, cost and property approaches to the valuation of real estate and other property. In this paper, I discuss the income approach to real estate valuation, used to value income-producing real estate.

CHARACTERISTICS OF THE INCOME APPROACH

The income method is based on the expectation principle, which states that the typical investor or buyer purchases real estate in anticipation of receiving future income or benefits from it, that is, it reflects:

the quality and quantity of income that the property can generate over its life;

risks both specific to the object being assessed and to the region.

Thus, the value of an asset can be defined as its ability to generate income in the future. The time factor operates here, and the amount of future income must be reduced to the zero point in time by capitalizing income and discounting.

The theoretical basis of the income approach is the principles of valuation, the most significant of which, as well as factors and circumstances, the analysis of which is based on the corresponding principles (Fig. 1)

Principle Sphere of Influence

EXPECTATIONS (the basic principle on which income assessment is based)	Pricing factors
	Income characteristics
	Characteristics of capital
	Odds
SUBSTITUTIONS	Selection and analysis of analogue objects
SUBSTITUTIONS	Analysis of alternative investments
SUPPLY AND DEMAND	Accounting and analysis of factors: utility; scarcity; competitiveness; accessibility of the capital market; monopoly, state control, business activity; population characteristics
ULTIMATE PRODUCTIVITY (balance, deposit)	Analysis of the property: economic compliance of real estate elements; its use and type of land use

The main advantage of the income approach compared to the market and cost approach is that it largely reflects the investor’s idea of real estate as a source of income, that is, this quality of real estate is taken into account as the main pricing factor. The income approach to valuation is closely related to the market and cost approaches. For example, the rates of return used in the income approach are usually determined from an analysis of comparable investments; reconstruction costs are used in determining cash flow as additional investments; capitalization methods are used to adjust for differences between the market and cost approaches.

The main disadvantage of the income approach is that, unlike other approaches to valuation, it is based on forecast data.

Within the framework of the income approach, two methods can be used:

direct capitalization of income;

discounted cash flows.

The advantages and disadvantages of the methods are determined according to the following criteria (Fig. 2)

Criteria for comparing income approach methods	The ability to reflect the actual intentions of a potential buyer (investor)
	The type, quality and breadth of information on which the analysis is based
	Ability to take into account competitive fluctuations
	The ability to take into account the specific features of an object that affect its value	location

		potential profitability

These methods are based on the premise that the value of real estate is determined by the ability of the property being valued to generate income streams in the future. In both methods, future income from a real estate property is converted into its value, taking into account the level of risk characteristic of this property. These methods differ only in the way they transform income streams.

When using income capitalization methods, income for one time period is converted into the value of real estate, and when using the discounted cash flow method, income from its proposed use for a number of forecast years is converted, as well as proceeds from the pre-sale of a property at the end of the forecast period.

DETERMINATION OF NET OPERATING INCOME

To evaluate full ownership and tenant rights, net operating income (NOI) is calculated as an income stream.

A real estate appraiser works with the following income levels:

Potential Gross Income (GPI)

Actual Gross Income (DVD)

Net operating income (NOI)

Potential gross income (GPI) is the income that can be received from real estate if it is used 100% without taking into account all losses and expenses. Potential gross income depends on the area of the property being valued and the established rental rate and is calculated using the formula:

PVD= S x Ca

Where S is the area for rent, m2;

Ca - rental rate per 1m2

The rental rate depends on the location of the property, its physical condition, availability of communications, lease term, etc.

There are two types of rental rates (Fig. 3)

contractual

market

The market rent is the rate prevailing in the market for similar properties, and is the most likely rent that a typical landlord would be willing to rent and a typical tenant would be willing to lease the property, which is a hypothetical transaction. Market rental rates are used to value freehold ownership, where the property is essentially owned, operated and enjoyed by the owner himself: what would be the income stream if the property were rented out.

The contract rental rate is used to value the lessor's partial property rights. In this case, it is advisable for the appraiser to analyze lease agreements from the point of view of the terms of their conclusion.

According to the types of rental rates, lease agreements are divided into three large groups:

with a fixed rental rate (used in conditions of economic stability);

with a variable rental rate (revision of rental rates during the term of the contract is carried out, as a rule, in conditions of inflation);

with an interest rate (when a percentage of the income received by the tenant as a result of the use of the leased property is added to the fixed amount of rental payments).

It is advisable to use the income capitalization method in the case of concluding an agreement with a fixed rental rate; in other cases, it is more correct to use the discounted cash flow method. To assessment real estateAbstract >> Economic theory

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The income approach is a whole combination of methods for assessing the value of real estate, the property of an organization, and the business itself, in which the determination of value is made by converting economic benefits that are expected in the future. Theoretical basis This approach is quite convincing. The value of an investment is the current value of future benefits, discounted at a rate of return that reflects the riskiness of the investment.

This is reasonable and suitable for any existing enterprise used in the production and sale of property, as well as its business, subject to the generation of positive profits. The magnitude of the risks of investing in the business being valued is demonstrated through the discount rate. As such in economic sense now is the rate of return that investors require on invested capital in comparable investment objects in terms of risk level, or this is the rate of return on alternative investment options with comparable risks at the time of assessment.

Peculiarities

Applying the income approach in practice turns out to be quite difficult, since it is necessary to evaluate each important determinant of value - rate of return and profit. If these methods are used to evaluate an enterprise, then it is necessary to conduct a thorough analysis of all their key elements, including cost, the company’s turnover, which have a direct impact on profits, costs and risks that are created by each individual element.

Used quite often. For example, if we are talking about an acquisition or merger, then this method is used much more often than the cost or market method. The buyer's capital investment is now made with the expectation that net cash flows will be received in the future, which cannot be called guaranteed, since they are characterized by certain risks. The income approach allows us to estimate these key determinants of value, whereas the market approach usually requires the price-earnings ratio or some other similar earnings multiples for a retrospective period, without taking into account the future.

Market multiples tend to be unreliable and fail to provide the same level of rigor that can be achieved using an income approach with projections of future earnings and discount rates. For example, the price-earnings ratio that is applied for the year does not sufficiently reflect expected changes in future years. The right ones provide an opportunity to demonstrate general investor preferences and are often cited by salespeople or industry sources.

Usage

Information regarding the enterprise budget also needs analysis and protection, which forces changes and development of the financial consequences of the created plan, forecasts and basic proposals. The income approach to business valuation measures all assumptions that relate to whether certain benefits of an acquisition arise from increased revenues, cost reductions, process improvements, or lower capital expenditures. Using this approach, you can measure and discuss all this. In addition, it can be used to determine the timing of the expected benefits, and also demonstrate the process of reducing the value of the enterprise as benefits move into the more distant future.

Using the income approach provides a means for buyers and sellers to calculate the fair market value of a business, as well as its investment value for one or more strategic buyers. If this distinction is clearly displayed, sellers and buyers can easily identify the benefits of synergies and make informed decisions.

When using the income approach to business valuation, it must be borne in mind that the calculated value consists of the value of all property that is used in the direct activity. Within the approach used, there are several methods for assessment that are of greatest interest. In particular, the following methods of the income approach are applicable: capitalization and discounting of cash flows. You can look at them in more detail.

Methods

Using the cash flow capitalization method, the total value of an enterprise is detected depending on the cash flows generated by the property potential of the enterprise. business or enterprise as a whole is the difference between all inflows and outflows of financial resources for a certain billing period. Typically, a period of one year is used for calculations. The technique is to convert a representative level of expected cash flow into a present value by dividing the total amount of the flow by the assumed capitalization rate. In this case, an income stream with certain adjustments is appropriate.

To use the conventional method of calculating cash flows, add net profit (calculated after taxes) to non-cash expenses to determine the amount of absolute cash flow to capitalization. This method of calculation can be considered more simplified in comparison with the calculation of free cash flow, which in addition takes into account the required capital investments and the need to replenish working capital.

Cash flow discounting

This method is basically based only on the expected cash flows that are generated by the enterprise itself. Its characteristic difference is that an estimate of value is required to calculate the definition of a representative level of cash flow. This method is most widespread in developed countries due to the fact that it can be used to take into account all development prospects. Cash flow in general view equals the sum and depreciation, subject to the subtraction of the increase in net working capital and capital investments.

Exist following conditions to use the discounted cash flow method:

there is reason to believe that future levels of financial flows will differ from current ones, that is, we are talking about a developing enterprise;
there are opportunities for a reasonable estimate of future cash flows from the use of the business or;
the object is at the stage of construction, full or partial;
The enterprise is a large multifunctional commercial facility.

The income approach to real estate valuation through the discounted cash flow method is the best, but its use is very labor intensive. There are estimates that cannot be made without using this method. Among them are the development investment project with its subsequent evaluation.

Advantages of the discounting method

If you practice the income approach to valuing real estate or business through the discounting method, you can identify some major advantages. First of all, we are talking about the fact that future profits from a business directly take into account only the expected current costs of manufacturing products with their subsequent sale, and future capital investments associated with maintaining and expanding production or trading facilities are reflected in the profit forecast only indirectly through their current depreciation.

Important points

The assessment of an object using the income approach when there is a lack of profit or loss as an indicator of investment calculations is carried out with an adjustment to the fact that profit serves as an accounting reporting indicator, and therefore is subject to significant manipulations in the process.

The discounted cash flow method includes three groups of models:

If the income approach is used in accordance with the dividend discount model, the value of the share payout is used as evidence of cash flow. Despite the fact that the model is widely used in foreign practice for determining and assessing the value of an enterprise's assets, it has many disadvantages. There is no degree of accounting in models with retained earnings. There is a difference in dividend policies not only specific enterprises, but also for countries as a whole. This method cannot be used in enterprises that have no profit. This model is best suited for calculating the value of minority shares.

Residual income model

The income approach to valuation through the residual approach model assumes that the amount of residual income will be used as an indicator of cash flow, that is, the difference between the actual profit and the amount of profit that was predicted by shareholders at the time of purchase of the company itself or its shares. If the value of the enterprise was calculated on the basis of assumptions consistent with this model, then it will be equal to the sum with the present value of the expected amount of income remaining after that. Such a model demonstrates significant sensitivity to the quality of the data presented in financial statements. For Russian conditions, the adequacy of such information is subject to significant doubts.

Benefit for shareholders

Naturally, shareholders or shareholders of an enterprise that has a certain history, as well as facts of dividend payments, can use the discounting model to calculate the value of their own company. The situation is that shareholders of enterprises in this sector are rarely minority, so for them the most in a suitable way will use an income approach to real estate and business valuation through a discounted free cash flow model. In this system, the key ones are free cash flows with discount rates or expected returns on invested capital. The most a big problem using this model is the accuracy of the forecast of free financial flow, as well as the adequate determination of the discount rate.

If we apply the income approach, the definition of which was given above, then when using the discounted cash flow method, the projected financial flows that can be withdrawn from circulation after the required reinvestment of part of the cash profit are taken into account as income expected from the business. As an indicator, cash flows do not depend on the system accounting, used at the enterprise, and its depreciation policy. At the same time, any cash movements - inflows and outflows - must be taken into account. Assessing the financial meaning of discounting cash it turns out that as a result of these processes, they are reduced by amounts that would have been available to the investor at the time of receipt of the specified cash flow, provided that he did not invest his funds in this business right now, but in some other investment asset of a publicly available nature, for example, liquid security or bank deposit.

Additional techniques

The income approach, an example of which was described earlier, has recently been used less and less; now the valuation method has become the most common. It is used to value all kinds of assets, and is based on the idea that any asset that shares the basic characteristics of options can be valued as an option. On this moment rejection of the income approach is most often carried out in favor of the option pricing model (respectively, the Black-Scholes model).

Such a system, if used, makes it possible to estimate the total value of the equity capital of a company or enterprise in the event that it operates with large losses. This model is intended to further explain why the value of an enterprise's equity capital is not zero, even if the value of the entire enterprise declines below the level of the nominal amount of debt. But even taking into account this advantage, it can be noted that the Black-Scholes model for assessing the value of Russian enterprises is currently increasingly of a theoretical nature. The main problem due to which this model cannot be applied to domestic business, is the lack of some actual data for the model parameters, which are extremely necessary.

conclusions

The income approach to business and real estate valuation has become much less common, and this happens for many reasons. In particular, this concerns the shortcomings that make it difficult to use in the consumer market. First of all, it should be noted how difficult it is to make forecasts of the future cost of services and products, materials and raw materials, as well as a set of other cost indicators. In this case, we can talk about some subjectivity expert assessments. In addition, the problem is the low disclosure of information on Russian enterprises, but it is necessary for carrying out competent calculations and drawing up the Black-Scholes model. This is largely due to the low corporate culture of such enterprises.

The overwhelming number of shares, including large blocks of shares, are concentrated in the hands of a small circle of persons, and the share of small owners, whose share is very small, in the authorized capital is insignificant. It turns out that many enterprises are simply not interested in disclosing any information. That is why the calculation by the income approach becomes noticeably more complicated in relation to most industries and businesses in Russia. In other conditions, it works best, demonstrating all its advantages and reliability.