Income Approach and Methods – Capitalisation Method and Dividend Discount Model
Capitalisation Method
The formula for calculating the value under the capitalization method is as follows.
Capitalisation Method = Future Maintainable Profits/ Desired Rate of Return
The capitalization method to the income approach of valuation takes the total future maintainable profits based on the historical cash flows of a business which are non-exceptional and recurring in nature and divides the same with the help of a capitalization rate. Non-recurring, exceptional, and extraordinary events are not taken into consideration. The capitalization rate is usually like a discount rate which reflects the risk of the business and the expected growth in the future.
The future projection of cash flows is made with the help of historical cash flows and trends. The capitalization rate takes into account various factors such as the level of interest rates, the expected rate of return, and the inherent risk. This method has its limitations in that it is backward-looking.
Another method that is a part of the capitalization method is the capitalization of earning method:
Capitalization of earning method
Value of the business = Expected Business Earnings/ Capitalisation Rate
Here, instead of the future maintainable profits, we have the Expected business earnings which account for adjustments of non-arms length transactions, transactions with related parties, events non-recurring in nature, etc.
Dividend Discount Model
The dividend discount model of the income approach to valuation is one of the simplest methods of present value models and is based on the assumption the value or the price is equal to the present value of the future dividends and the terminal value. The dividend discount model using the Gordon Growth Model can be calculated using the following formula
V0 = D1/ (r-g)
Where:
V0 is the current fair value of the stock
D1 is the value of the next year’s dividend
r is the cost of equity capital (Using CAPM)
g is the constant growth rate from dividends expected forever
g can be computed with the help of a formula:
g = Return on Equity of a company * Retention Ratio (or)
g = Return On Equity *(1- Payout Ratio)
Payout Ratio
The payout ratio is a measure of the proportion of the earnings given out to shareholders by the company in the form of dividends.
Payout Ratio = (1 – Retention Ratio)
Retention Ratio
The retention ratio is the opposite of the payout ratio and measures the proportion of earnings retained by the company without it being distributed to the shareholders in the form of dividends.
Retention ratio = (1- Payout Ratio)