Business Valuation

Other valuation methods

Equity methods - Income method
Marco Vulpiani

"What I have here in my heart is like faith, but not faith.

What I have here in this room is knowledge without proof..
What I have here in my hand is like knowing but deeper
It's why I have faith"
(Marillion, Faith)

Contents
1. Equity methods
2. Net Income method

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

Other valuation methods

Equity methods
The equity valuation method is based on identification of the market value
or current value of all assets less liabilities on a going concern basis,
through the discounting of all significant monetary values.

This value corresponds to the replacement or reconstruction value of both

tangible and intangible assets to a condition of use

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

Other valuation methods

Equity methods

Cons

The method has the

drawback of not
considering the financial
and income aspects of
future operations.

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

This method
guarantees a good
indication of capital
strength.

Pros

Other valuation methods

Equity methods
Application of Equity methods:
The equity estimation is based on the analytical valuation of the individual
assets and liabilities that make up the capital;
While liability items are always taken into account, the treatment of asset items
varies:
Tangible assets, receivables and cash and cash
equivalents always enter into the calculation.

Intangible assets are valued on the basis of different

methodologies, depending on whether or not they are
taken into account (and on the manner in which they are
taken into account).

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

Other valuation methods

Equity methods
Classification of Equity methods:
Involve the valuation of
intangible assets,
conducted through
analytical estimation criteria

Analytical
methods

Only comprise
tangible assets

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

Compex
Equity
methods

Equity
methods

Simple
Equity
methods

Involve specific valuation of

intangible assets (intangibles)

Empirical
methods

Involve the valuation of

intangible assets, on the
basis of the parameters
obtained from operator
negotiation behavior.
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Other valuation methods

Equity methods
Classification of Equity methods:
Complex equity methods have
a real significance when the
estimation criteria of intangible
assets reach a sufficient
degree of acceptance and
standardization (e.g. brands)

In professional practice,
simple equity methods have a
greater application in all
categories of companies,
while always forming a base
of relevant information

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

Other valuation methods

Equity methods
Simple Equity methods:

K = C + [( P1 + P2 + ) ( M1 + M2 + )] * (1 t )
K

= Adjusted shareholders' equity

= Book Value of shareholders' equity

= Gains

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

= Losses

= Theoretical tax liabilities

Other valuation methods

Equity methods
Simple Equity methods:
1
The starting element for the simple equity valuation method is
the Book Value of the equity, which includes the profit for the
year with the exclusion of any amounts to be distributed.

Analysis of assets and liability items so as to ensure their

compliance with correct, generally accepted accounting
principles.
Expression, in terms of current values (market or estimation) of
non-cash assets (fixed assets, inventories, securities, equity
investments..) thus generating a series of capital gains or
losses.

Steps for
application

4
Possibly restating the value of deferred receivables and
payables with or without interest.
Marco Vulpiani. For information contact: mvulpiani@deloitte.it

Other valuation methods

Equity methods
Simple Equity methods:
Check of accounting data:
All assets and liabilities are recognized;
All assets items are based on valid inventory documents;
Receivables take into account the actual possibility of recovery;
Liability provisions correspond to the actual or probable amounts accruing;
Risks expressed in the memorandum accounts are suitably valued.

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Equity methods
Complex Equity methods:

K' = K + I * (1 t)

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

K'

= adjusted net capital in the

presence of intangible assets (K)

= Intangible asset value

= Theoretical tax rate

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Other valuation methods

Equity methods
Complex Equity methods:
There are situations in which the adjusted shareholders equity K assumes a
more complex structure in order to account for intangible assets.

Valuation of intangible assets:

Cost Approach

Economical
Approach

historical residual cost;

cost of reproduction;
cost of loss

differential income;
cash flow differential;
market approach:
- Comparable royalty rate
- Market multiples for comparable intangible
assets
Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Contents
1. Equity methods
2. Net Income method

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

13

Other valuation methods

Net Income method
The income valuation method is used to determine the value of the
economic capital based on an estimation of the projected income flows that
the company is able to produce in future years

In its simplest form, it is based on identification of

Expected average normalized earnings, which represent the companys ability
to produce a stable flow of wealth within a given period of time

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Net Income method
Formula:
W

= Theoretical Equity Value

Ri

= Normalized income arising from

operations in year 1, 2, n

TV = Terminal Value

= Discount rate

= Theoretical Equity Value

= average normal income expected

over the long-term

= normal rate of return of the risk

capital invested for the sector of
origin

Simplified form:

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

= average long-term income growth

rate
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Other valuation methods

Net Income method
The flow that provides reliable income results is the economic flow that can be
obtained by supplementing and adjusting the accounting flow:
1
Normalization.

2
Integration that takes into account the dynamics of the
intangible assets and other assets that are currently not
recognized in the accounts.

Amendments

3
Alignment/adjustment is used to eliminate the distorting
effects of inflation and consequently gives uniformity to the
flows of various years.

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Net Income method
The elements necessary for performing a valuation using the income method
are:
Normalized Income
Final value of the Company
Key Inputs
Capitalization period
Discount rate

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Net Income method
Normalized Income:
Income normalization aims to remove the randomness of a series of income
components in order to ensure recognition in the relevant reporting period, thus
ensuring homogeneity of the flows for the various years over time.
1
The redistribution of extraordinary income and costs over
time

2
The elimination of income and expenses not directly
relating to operations

Normalization
process

3
Neutralization of accounting policies that are deemed
distortive as regards the objective
Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Net Income method
Expected income flows:
The expected income flows can be expressed with:
a series of results in the explicit forecast years;
an average value valid for an indeterminate period
or for a defined period of time;
a range of values that express the variability of
possible results depending on the scenarios that
arise.
These flows are selected for a restricted time period of about 3-5 years as
beyond this time period, reasonable and documented assumptions are replaced
by conventions and automatism that largely deprive the results of credibility.

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Net Income method
Capitalization period (n):
The choice of period n is intended to limit the growth of the value component
relating to the income results over time;

The tendency to limit the duration of the expected cash flows to just a few years,
derives from the following:
the increasing uncertainty as regards the estimation
of the income cash flows as they move away in
time;
the increasing reduction of the annual flows as a
result of the discounting process, as they move
further away in time.

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Net Income method
Capitalization period (n):

Professional
practice

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

The planning period more frequently varies

between 3 and 5 years, but in some cases, it can
encompass intervals of 5-10 years.
The latter is typically the case of companies
operating in sectors characterized by a long
economic cycle, or in those companies with a
strong market penetration.

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Other valuation methods

Net Income method
Discount rate
The discount rate corresponds to the expected rate of return on the capital
invested in the company for comparability against financial capital investment
alternatives;
in this sense, the cost of equity capital i, should be identified as the sum of the
return of capital in the absence of risk, and the return expected by an investor in
the specific sector.

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Net Income method
2
Integration that takes into account the dynamics of the intangible assets and other assets
that are currently not recognized in the accounts.

These are generally value categories that generate capital gains not recognized
in the accounts, which accumulate over time, acquiring decisive weight in terms
of measuring income.

The annual income can be integrated with accumulated capital gains in the
event in which:
they can be reliably measured, both in their global value and in their
distribution over time;
they are achievable;
they do not result in a duplication of values.
Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

References
M. Vulpiani, "Special Cases of Business Valuation", McGraw Hill
(Chapter 1, Par. 1.1.4, 1.3.1, 1.3.2)

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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Other valuation methods

Thank you for Your Attention

Marco Vulpiani. For information contact: mvulpiani@deloitte.it

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