Limitations of Traditional Income Methods
Traditional income approach has too many unrealistic assumptions and it uses WACC, which mathematically overvalues equity return if debt has a priority over equity. Many of the limitations discussed below are known, but are often forgotten or not properly understood. Limitations of the traditional income approach are,
1) Use of WACC (Weighted Average Cost of Capital).
2) Use of the capitalization formula.
3) Discounting "generated" or "available" cash or profits.
4) Ignores deal structure
5) Ignores debt repayment
6) Ignores the "circular" problem
7) Ignores the "willing seller" requirement
8) Ignores the organization form
These limitations are further explained below.
1) Use of WACC: When one uses WACC, the mathematics behind it assumes that both the debt holder and the equity holder will get current return on their respective investment; meaning that every year the debt holder will be paid interest to cover the cost of debt and the equity holder will be paid dividends to cover the cost of equity. This is not achievable in real life because debt principal has to be repaid before dividends. The equity holder, however, does build "equity" on paper every year as the debt is reduced. But, the time value of such built-up equity is reduced every year the dividends are deferred. Such deferral causes the actual equity return to be lower than the one used in calculating WACC. In other words, WACC will always overvalue. The cost of debt is not only its interest cost, but also the cost of its priority over equity.
Traditional valuation assumes constant WACC for each year. In real life WACC changes (usually increases) every year as debt gets paid and equity builds up. Constant WACC can occur only if debt is never paid and if equity does not increase, or it can be achieved if the business increases its debt as equity builds up. Such situation is not realistic and hence constant WACC is more of a theoretical concept than an achievable reality.
WACC requires one to know the debt/equity ratio. Theoretically, this is supposed to be buyer's post-valuation ratio; which cannot be known at the time of the valuation. To resolve this matter, traditional income approach uses industry's debt/equity ratio as a reasonable proxy. This implies that all buyers, large or small, have equal access to capital. It also implies that the debt/equity ratio is industry-specific, not company-specific. Often, one uses seller's existing debt/equity ratio as a proxy. Again, the debt/equity ratio is supposed to be that of the buyer, not that of the seller. Traditional income approach is subject to errors caused by such substitution.
2) Use of the capitalization formula. The capitalization formula is x/(k-g), where x is year-1 distribution to the shareholder, k is the cost of capital and g is the growth rate. This formula is used in all income approaches to valuation; either it is used on its own in the excess earnings method, or it is used to calculate the terminal value in the Discounted Cash Flow (DCF) method.
The numerator, x, is supposed to be dividends, i.e. actual payments to the investor. However, actual dividends are often absent and/or are small relative to the overall profits. Hence, if the valuation is based on actual dividends, it is likely to cause under valuation. Alternatively, earnings or business cash flow (each one of them having multiple variations) are often used in the numerator. However, such substitution causes overvaluation because return on investment can only be measured on actual cash paid to the investor, not on earned profit or cash. Traditional income approach is subject to errors caused by such substitution.
Also, the numerator, x, is supposed to grow at a constant rate g. This is theoretically not possible if there are debt repayments, or if there are tax incentives like depreciation that have asynchronous relationship in cash outflow and tax benefits.
3) Discounting "generated" or "available" cash or profits. No finance textbook teaches that DCF technique can be applied to discount earnings or generated cash flow. However, this is a common practice due to its simplicity and convenience, but it does add errors to valuation. Many sophisticated valuation specialists and investment bankers calculate the actual cash flow to the investor after all obligations of the company for the first 5-10 years. However, they have to pre-suppose debt structure and have to use the capitalization formula for terminal value determination, which as discussed earlier, contributes valuation error. (Also see Net Cash Flow method.)
4) Ignores deal structure. Deal structure has an impact on value. For example, in an Asset purchase, unlike Stock purchase, the buyer is able to reduce the taxable income by the goodwill amortization. Thus the buyer should be able to pay a higher price for an Asset purchase than for a Stock purchase. However, traditional Income approach to valuation does not distinguish between these two deal structures. Similarly, other tax oriented issues like purchase price allocation, asset write-up, personal goodwill, etc. are not addressed by the traditional valuation methods.
5) Ignores debt repayment. There is no input for debt repayment schedule in traditional valuation because there is an implicit assumption that debt is never repaid. This assumption has material impact on investor's cash flow and hence the value of the business.
6) Ignores the "circular" problem. There are many "circular" problems in business valuation. One of them is, value to the investor depends on the cash flow to the investor, but cash flow to the investor depends on the amount of debt and its repayment schedule, and the amount of debt depends on the value. Traditional method ignores this "circular" problem.
7) Ignores the "willing seller" requirement. The concept of "willing buyer" and "willing seller" is in almost all definitions of value. For 'willing buyer" it appears clear that the traditional income approach does consider at least one requirement i.e. buyer should achieve the expected ROI. However, it is not clear what, if any, requirement of a "willing seller" is incorporated in the traditional income approach.
8) Ignores organization form. Traditional income approach does not distinguish between valuation of single-tax entities (S Corporations, Partnerships, LLC, etc.) and double-tax entities (C Corporations). These organization forms impact yearly cash flows as well as the taxation upon sale of the business. Absence of this variable in the traditional income approach has led many to make their own conclusions on whether the valuations of such entities are different. The reality is that traditional valuation does not have an analytical way of analyzing the valuation impact of various organization forms.