Hong Kong Business Valuation Income Approach

Hong Kong Business Valuation Income Approach | Bestar

Hong Kong Business Valuation Income Approach

In Hong Kong, business valuation using the income approach primarily relies on the principle that the value of a business is the present value of its expected future economic benefits. The two most common methods under this approach are the Discounted Cash Flow (DCF) method and the Capitalization of Earnings (COE) method.

Discounted Cash Flow (DCF) Method: This method projects the business's future free cash flows (FCF) over a discrete forecast period (typically 5-10 years) and then estimates a terminal value for the cash flows beyond that period. These future cash flows and the terminal value are then discounted back to their present value using a discount rate, often the Weighted Average Cost of Capital (WACC). This approach is generally preferred for businesses with fluctuating or high growth, as it allows for detailed forecasting of varying cash flow streams.

Capitalization of Earnings (COE) Method (also known as Capitalization of Income or Capitalization of Maintainable Earnings): This method is simpler and is best suited for mature businesses with stable and predictable earnings. It involves dividing the normalized or maintainable earnings of the business by a capitalization rate. The capitalization rate is essentially the discount rate minus the long-term sustainable growth rate of earnings. This method assumes that the current level of earnings is representative of future earnings.

Here's an example of how the Discounted Cash Flow (DCF) method might be applied.

To apply the Discounted Cash Flow (DCF) method, you need to project the company's free cash flows for a specific period and then calculate a terminal value, all discounted back to the present.

Step by step solution:

 1 Project Free Cash Flows (FCF)

First, estimate the Free Cash Flow (FCF) for each year of the explicit forecast period. Free Cash Flow represents the cash generated by the business after accounting for operating expenses and capital expenditures. It is typically calculated as: $$FCF = EBIT (1 - Tax Rate) + Depreciation & Amortization - Capital Expenditures - Change in Working Capital$$

 2 Determine the Discount Rate (WACC)

The Weighted Average Cost of Capital (WACC) is commonly used as the discount rate to reflect the risk of the projected cash flows. WACC considers the cost of both equity and debt financing, weighted by their proportion in the company's capital structure. WACC=(E/V)⋅Re​+(D/V)⋅Rd​⋅(1−T) Where: E = Market value of equity D = Market value of debt V = Total market value of equity and debt (E+D) Re​ = Cost of equity Rd​ = Cost of debt T = Corporate tax rate

 3 Calculate the Present Value of Projected FCFs

Discount each year's projected FCF back to its present value using the WACC. The formula for present value is: PVFCF​=(1+WACC)tFCFt​​ Where: FCFt​ = Free Cash Flow in year t WACC = Weighted Average Cost of Capital t = Year

 4 Calculate the Terminal Value (TV)

The Terminal Value represents the value of the company's cash flows beyond the explicit forecast period. It can be calculated using the Gordon Growth Model (Perpetual Growth Model) or the Exit Multiple Method. Using the Gordon Growth Model: TV=(WACC−g)FCFlastyearofforecast​⋅(1+g)​ Where: g = Perpetual growth rate of cash flows

 5 Calculate the Present Value of Terminal Value

Discount the Terminal Value back to the present value at the end of the explicit forecast period. PVTV​=(1+WACC)nTV​ Where: n = Last year of explicit forecast period

 6 Calculate the Enterprise Value (EV)

The Enterprise Value is the sum of the present values of all projected free cash flows and the present value of the Terminal Value. EV=t=1∑n​PVFCFt​​+PVTV​

 7 Calculate the Equity Value

To arrive at the Equity Value, adjust the Enterprise Value for net debt (total debt minus cash and cash equivalents) and other non-operating assets/liabilities. EquityValue=EV−NetDebt+Cash+Non−operatingAssets

Solution

The final step involves dividing the Equity Value by the number of outstanding shares to get the per-share value of the business, or presenting the total Equity Value as the valuation. Value=Equity Value or Per-Share Value

Here is a practice problem on the Discounted Cash Flow (DCF) method for business valuation:

Business Valuation: Discounted Cash Flow (DCF) Method

This quiz focuses on key concepts within the Discounted Cash Flow (DCF) method. I hope this helps you solidify your understanding of business valuation! Let me know if you'd like another problem or have any questions.

In a Discounted Cash Flow (DCF) valuation, what impact does an increase in the perceived risk of a business typically have on its valuation, assuming all other factors remain constant?

A. A lower discount rate, leading to a lower present value.

B. The discount rate has no impact on the present value of future cash flows.

C. A higher discount rate, leading to a higher present value.

D. A higher discount rate, leading to a lower present value.

That's right!

A higher discount rate reflects a greater perceived risk or a higher required rate of return, which reduces the present value of future cash flows.

How Bestar can Help

When it comes to business valuation, engaging professional valuers offers numerous benefits, ensuring accuracy, objectivity, and compliance. Here's how we can assist:

1. Objective and Independent Assessment

Bestar provides an impartial and unbiased assessment of a business's worth. This objectivity is crucial in situations where neutrality is paramount, such as:

• Mergers and Acquisitions (M&A): Helping both buyers and sellers determine a fair transaction price and negotiate terms.

• Fundraising: Establishing a credible valuation for investors to determine equity stakes.

• Dispute Resolution: Providing an independent valuation in legal disputes, shareholder disagreements, or divorce proceedings.

2. Expertise in Valuation Methodologies

Bestar possesses in-depth knowledge of various valuation approaches and methods, including:

• Income Approach (e.g., Discounted Cash Flow, Capitalization of Earnings): Projecting future cash flows or earnings and discounting them to present value. They can skillfully estimate future cash flows, determine appropriate discount rates (like WACC), and calculate terminal values, which are highly sensitive inputs.

• Market Approach (e.g., Market Multiples, Precedent Transactions): Comparing the business to similar companies that have been recently sold or are publicly traded. They have access to databases and experience in identifying truly comparable transactions and adjusting for differences.

• Asset-Based Approach (e.g., Net Asset Value, Liquidation Value): Valuing the business based on the fair value of its assets minus liabilities. This is particularly relevant for asset-heavy businesses or for liquidation scenarios.

We select the most appropriate method based on the nature of the business, industry, purpose of the valuation, and data availability.

3. Thorough Due Diligence

A comprehensive valuation requires meticulous examination of all relevant aspects of the business. Bestar conducts thorough due diligence, scrutinizing:

• Financial Performance: Analyzing historical financial statements (income statements, balance sheets, cash flow statements) to understand revenue growth, profitability, and cash generation.

• Business Operations: Assessing the business model, operational efficiency, technology, and innovation.

• Market and Industry Conditions: Evaluating market size, growth potential, competitive landscape, and industry trends in Hong Kong and globally.

• Intangible Assets: Valuing crucial non-physical assets like brand recognition, intellectual property (patents, trademarks), and customer relationships, which often contribute significantly to a company's value but are difficult to quantify.

4. Compliance with Accounting Standards and Regulations

In Hong Kong, especially for listed companies, business valuations must comply with International Financial Reporting Standards (IFRS), adopted as HKFRS. Bestar ensures compliance in areas such as:

• Business Combinations (IFRS 3/HKFRS 3): Valuing all acquired assets and liabilities at fair value during mergers and acquisitions, impacting goodwill calculations.

• Impairment Testing (IAS 36/HKAS 36): Annually assessing the "recoverable amount" of assets and cash-generating units, often requiring DCF analysis.

• Fair Value Measurement (IFRS 13): Ensuring that fair value is determined based on market data and appropriate valuation techniques, adhering to the fair value hierarchy.

• Share-Based Payments (IFRS 2): Valuing employee stock options and other share-based compensation.

We also ensure that valuation reports meet the disclosure requirements of regulatory bodies like HKEX.

5. Strategic Insights and Decision Making

Beyond just providing a number, Bestar offers insights that help businesses make informed strategic decisions. Our reports can:

• Identify value drivers and areas for improvement within the business.

• Support strategic planning, investment decisions, and capital allocation.

• Provide a baseline for tracking performance and assessing growth strategies.

By leveraging the expertise of Bestar, businesses can gain a clear, defensible understanding of their value, which is critical for various financial, strategic, and compliance purposes.

Request for Proposal