Handbook of Business Valuation

By Thomas L. West; Jeffrey D. Jones | Go to book overview

CHAPTER NINETEEN
Discounted Future Benefits
Method: An Income Approach

GREGORY A. GILBERT

In the seven years since this chapter was originally written, the theory underlying the discounted future income method has not changed in a meaningful way. However, significant progress has been made in areas relating to the Discounted Future Benefits Method. More marketbased data sources are available for estimation of discount rates. More studies have been done on various aspects of the discount rate buildup, particularly the so-called small company premium.

Finally, over the seven years, in the bond markets, interest rates have fallen significantly, and in the stock market, shares prices have risen steadily. What wisdom do these changes have for execution of the Discounted Future Benefits Method?

One of the primary keys to valuation estimates from the Income Approach is the development of discount rates (and their near relative, capitalization rates). When valuers assess discount and capitalization rates, they look to the market for data on which to base the rates. The market's indication of those rates over the seven-year period is illuminating. Long-term government interest rates went from 8.3 percent as of December 31, 1990, to 5.8 percent as of June 30, 1998. This fall in interest rates, all other things being equal, caused discount rates (and capitalization rates) to fall by 2.5 percentage points, which led values to increase significantly. In order to give a simple example, note that $1,000,000 of income capitalized at 15 percent calculates a value of $6,667,000. If the capitalization rate is reduced by 2.5 percentage points, to 12.5 percent, the calculated value increases to $8,000,000. The increase in calculated value relates directly to the increase in the

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