Conceptual Framework
Like beauty, the value of any object—such as a piece of artwork, a patent, real estate, financial securities, or even an operating business—is in the eye of the beholder. If enough beholders are able to act on their own perception of value, then there’s a market for the object, and its value can be directly observed once a transaction is completed. However, in many cases, exposing an object to a real-world transactional marketplace is not practical or even possible. Its value needs to be estimated in a simulated transaction that incorporates the factors that hypothetical buyers and sellers would consider if given the opportunity.
The framework for measuring value consists of three approaches: the income approach, the market approach, and the cost approach. These approaches can be applied to almost any object. To illustrate their application, we’ll consider an expert’s valuation of an asset that most readers are familiar with: real estate—specifically, an apartment building in west Los Angeles that we’ll call the LA Building.
Building Valuation
The income approach focuses on future net operating income. The income approach measures the value of the LA Building based on its future net operating income. In our hypothetical, the LA Building currently yields $400,000 a year in net operating income. Because the future is uncertain and involves risk, the net operating income that we expect to generate from the LA Building in the future needs to be discounted to its present-value equivalent. This discount reflects the fact that having someone’s promise to pay $1 at some point in the future is worth less than being paid $1 today.
In the case of the LA Building, the expert uses a discount rate of 10 percent in the valuation. While the derivation of the 10 percent rate is beyond the scope of this article, it is based primarily on analysis of similar rental properties and market research involving real property investment returns. The LA Building is expected to increase its $400,000 annual net operating income by 3 percent each year. The mathematics of growing net operating income by 3 percent annually into perpetuity and then discounting those future amounts back to the present using a 10 percent rate can be condensed into a simple formula (as shown below) or by using an electronic spreadsheet. In the example below, our assumptions result in a net operating income multiplier of 14.7x and a value of $5.9 million.
Figure 1: Income Approach Valuation of LA Building
The market approach focuses on prices paid for similar assets. The market approach estimates the value of the LA Building based on prices paid by other buyers for reasonably similar assets.
There were three recent transactions involving comparable buildings in close proximity to the LA Building. Analyzing the transaction metrics for those purchases, making adjustments to reflect whether the LA Building is better or worse than the others, and applying the selected “sales price per square foot” metric to the LA Building square footage yields a value of $6.1 million.
Figure 2: Market Approach Valuation of LA Building
The cost approach focuses on replacement or reproduction cost. The cost approach determines the value of the LA Building based on its replacement or reproduction cost.
The cost to reconstruct a new building is estimated to be nearly $8.8 million. However, because the LA Building is 20 years old and in need of major repairs and upgrades, a material downward adjustment to value is warranted. In the example below, a 40 percent adjustment is applied to the cost of a newly constructed building to result in a value of $5.3 million for the LA Building.
Figure 3: Cost Approach of LA Building
Concluded values take into account value reference points of the three approaches. In reaching a final concluded value for the LA Building, the expert would assess the value reference points obtained from each of these three approaches in an effort to select a point estimate or value range. As the cost approach often provides a “floor” for the value of an asset, more consideration is sometimes given to the income and market approach reference points. In our hypothetical, considering the close proximity of the value reference points discussed above, the expert might reasonably select $6 million as the concluded value of the LA Building.
Company Valuation
Let’s assume that the LA Building is actually an operating business designing and marketing branded apparel and accessories—we’ll call it the LA Business—rather than an apartment building. In that case, the expert’s application of the valuation methods described above would be nearly the same, particularly in terms of the market and income approaches. The cost approach, however, would be less useful for measuring the value of the operating business as a going concern.
The income approach includes two possible methods. In the case of the income approach, the net operating income figure used to value the LA Building would be exchanged for a different measure of income, such as after-tax earnings or cash flow.
In the method below, the LA Business’s earnings of $1.2 million per year are expected to increase 2.5 percent each year for the indefinite future. The expert selects a discount rate of 11.5 percent to compensate an investor in the LA Business for time value of money and investment risk. The selected discount rate is based on analysis of similar rates estimated for comparable publicly traded companies. Applying the earnings multiplier to the LA Business’s earnings yields a value of $13.7 million.
Figure 4: Income Approach of LA Business, Single Period Capitalization Method
This method is used to value the LA Business under the income approach because the company is expected to generate a stable level of earnings into the foreseeable future. This method is commonly called the “single period capitalization method” because it capitalizes into value the LA Business’s earnings based on a single year’s level of earnings.
The expert could use an alternative method of the income approach in the event that the LA Business is expected to experience abnormal earnings for a period of time before reaching a stabilized level. This alternative format is commonly called the “discounted future earnings method” and is illustrated below.
Figure 5: Income Approach of LA Business, Discounted Future Earnings Method
There are two primary differences between the discounted future earnings method and single period capitalization method. First, the expected growth rate for the LA Business fluctuates in the first two years of the projection period before reaching the normalized level of 2.5 percent in year 3. Second, because the earnings multiplier is applied to year 3 rather than current-year earnings, the value of the LA Business at that future point in time (referred to above as the “residual value”) needs to be discounted back to its present-value equivalent. (The present-value factor in year 3 is calculated as follows: 1 ÷ (1 + 0.115)3.)
The market approach incorporates a valuation multiple. In the case of the market approach, the “sales price per square foot” metric used to measure the value of the LA Building would be exchanged for a valuation multiple, such as the price-to-earnings ratio (P/E), when applying the market approach to the LA Business. P/E multiples can be derived from stock prices of reasonably similar publicly traded companies (or derived from merger and acquisition transactions of entire companies), adjusted to reflect whether the LA Business is better off or worse off than the other companies. They may then be applied to the LA Business’s earnings and shares outstanding to yield a value for the company.
In the example below, the expert multiplies the selected P/E multiple of 12x by the LA Business’s earnings per share of $2 to result in an implied price per share of $24. This price per share, in turn, is multiplied by the LA Business’s 600,000 shares outstanding to yield a value of $14.4 million.
Figure 6: Market Approach of LA Business
The cost approach is less useful in a business-valuation context. As noted earlier, the cost approach is often not useful for measuring the value of an operating business on a going-concern basis because it generally lacks the ability to explicitly capture a company’s income or cash flow generating capacity.
Applying the cost approach to an operating business first requires the expert to adjust all of the company’s individual asset and liability values from a book value basis to a market value basis. This step includes not only the assets and liabilities observed on the company’s balance sheet (i.e., the “on-balance” sheet accounts) but also any “off-balance” sheet items, such as intangible assets, goodwill, litigation liabilities, and contingent obligations. The expert would then derive the company’s equity value by subtracting the market value of a company’s liabilities from its assets.
Despite its limitations and challenges, the cost approach can provide relevant value indications for asset-holding companies, or even operating companies where the value of the underlying tangible assets in liquidation would likely exceed the value of the business as a going concern.
Concluded values take into account value reference points for two of the approaches. As in the case of the LA Building, the expert would assess the value reference points for the LA Business obtained from the income and market approaches in an effort to select a point estimate or value range for the company. Here, the expert might reasonably select $14 million as the estimated value of the LA Business, which approximates the average value obtained from the income and market approaches.
Summary
The above examples for the LA Building and the LA Business illustrate that the value of an asset is influenced by three key concepts:
- The amount of income that the asset can generate (income approach)
- The prices paid for reasonably similar assets (market approach)
- The cost required to recreate the asset (cost approach)
The degree of relevance that each concept has on any given valuation scenario depends on the nature and characteristics of the asset in question.
In the case of an operating business, the income and market approaches are highly relevant. And while these approaches have different names, the simplified illustrations for the LA Business show that the market and income approaches both rely on some form of multiple or multiplier. In fact, it is for this reason that some valuation experts contend that the market approach is essentially the income approach in disguise.
The logical follow-up question is this: How does the expert determine the “right” multiple or multiplier for any given asset? The answer to this question will be the subject of the second article of this series. For now, the short answer can be gleaned from the primary objective for performing a valuation in the first place—to simulate a transaction that incorporates the factors that hypothetical buyers and sellers would consider if given the opportunity. While the list of these possible factors is virtually endless, the right multiple will become evident after the expert analyzes those items that have the greatest impact on the asset’s ability to generate income or cash flow in the future, as well as the degree of risk or uncertainty in realizing those future amounts.
Marc Asbra is a managing director at Stout Risius Ross, LLC, based in Los Angeles, California.