1.

0 Traditional method of valuation

This chapter describes the three traditional methods of valuing a business: Income

Approach, Contractors Method of Valuation, Investment Valuation and Comparable

valuation method. For each,it describes a valuation principle and an underlying

mathematical equation.

1.1 The Income Approach to Valuation

Investors in publicly-traded companies have the luxury of knowing the value of their investment

at virtually any time. An internet connection and a few clicks of a mouse are all its takes to get

an up-to-date stock quote. Of all U.S. companies, however, less than 1% are publicly-traded,

meaning that the vast majority of companies are privately-held. Investors in privately-held

companies do not have such a readily available value for their ownership interests. How are

values of privately-held businesses determined, then? Each month, this eight blog series will

answer that question by examining a key component of how ownership interests in privately-held

companies are valued.

The Capitalization of Cash Flow Method is most often used when a company is expected to have

a relatively stable level of margins and growth in the future – it effectively takes a single benefit

stream and assumes that it grows at a steady rate into perpetuity. The Discounted Cash Flow

method, on the other hand, is more flexible than the Capitalization of Cash Flow Method and

allows for variation in margins, growth rates, debt repayments and other items in future years

that may not remain static. As a result, the Capitalization of Cash Flow Method is typically

applied more often when valuing mature companies with modest future growth expectations. The

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Discounted Cash Flow Method is used when future growth rates or margins are expected to vary

or when modeling the impact of debt repayments in future years (although it can still be used in

same sort of “steady growth” situations in which the Capitalization of Cash Flow Method can be

applied). Discounted Cash Flow Method – The Discounted Cash Flow Method is an income-

based approach to valuation that is based upon the theory that the value of a business is equal to

the present value of its projected future benefits (including the present value of its terminal

value). The terminal value does not assume the actual termination or liquidation of the business,

but rather represents the point in time when the projected cash flows level off or flatten (which is

assumed to continue into perpetuity). The amounts for the projected cash flows and the terminal

value are discounted to the valuation date using an appropriate discount rate, which encompasses

the risks specific to investing in the specific company being valued. Inherent in this method is

the incorporation or development of projections of the future operating results of the company

being valued.

Distributable cash flow is used as the benefit stream because it represents the earnings available

for distribution to investors after considering the reinvestment required for a company’s future

growth. The discounted cash flow method can be based on the cash flows to either a company’s

equity or invested capital (which is equal to the sum of a company’s debt and equity). A “direct

to equity” discounted cash flow method arrives directly at an equity value of a company while a

“debt-free” discounted cash flow method arrives at the invested capital value of a company, from

which debt must be subtracted to arrive at the company’s equity value.

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1.2 Contractors Method of Valuation

In commercial property circles the contractors method of valuation, also known as

summation, is a very useful valuation tool for aspiring property investors or real estate

developers as it helps to identify the value of unusual or very specialist properties that

rarely come to market, and are generally unsuited to other, more common valuation

techniques.

The contractors method of valuation is not as well-known as some of the other commercial

property valuation techniques that are more commonly used to determine property values.

In fact, very few property investors are aware that there is such a thing as a contractors valuation

approach… however under certain circumstances it can be a particularly helpful commercial

property valuation tool where other methods fail to deliver.

Generally however, the most common commercial property valuation techniques include the

comparison method, the residual and profit technique, and the investment method; with most of

these used to help property investors and developers calculate commercial property values prior

to a purchase, investment appraisal or similar activity.

What is the Contractors Method of Valuation?

So why isn’t the contractors method of valuation as highly recognised as some of the other

valuation approaches?

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Generally it is because the other methods of property valuation can be applied to the majority of

properties; and because property investors, developers and valuation professionals are more

familiar with them and recognise that they work well… most of the time.

What lots of investors are unaware of however, is the fact that the comparison method, the

residual and profit technique, and the investment methods are not suitable for the valuation of

every property.

Valuing Unusual or Very Specialist Properties

Some buildings for instance, are extremely specialist in their nature and very rarely change hands

on the open market.

This means that there will be very little comparable evidence on similar property sales available

for an investor or valuer to be able to use in building their valuation for the property.

Similarly some buildings were never designed for commercial use, meaning it may not be

appropriate to use these commercial valuation methods.

This is where the contractors method of commercial property valuation comes in.

When to use the Contractors Method

The contractors method of valuation is normally used if none of the other commercial valuation

approaches are appropriate for the property in question.

The contractors method is fairly simple and operates on the basis of the cost of the land, plus the

cost to construct the buildings situated on the land, equals the worth of the property in general.

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It has to be said though, there have been doubts as to whether this is an accurate enough

valuation method.

For instance, it makes the assumption that property values will be the same as the cost of

construction, which no matter what way you look at it is a flawed assumption, because the

construction cost is an exact figure, whereas value being subjective, certainly isn’t.

Calculating Commercial Property Values

The formula for the contractors valuation method is: the cost of the building, plus the cost of site,

equals the entire cost of a similar building (minus the figure for depreciation and obsolescence

and such like), which then finally results in the value for the existing property.

Property Value = Cost of Site + Construction Cost of Buildings

To put this formula into action, you would apply build costs at a rate per m 2 at the time of

valuation, and discount this by a percentage to make allowances for depreciation (i.e. 10% for

depreciation).

You would then need to tally-up the revised total build costs, add this to the land value

(incorporating the costs of remediation and site preparation works and any other additional fees)

and the result of this would give you the “contractors” value of the property.

It may sound complicated, and the above is only a brief example of the formula used in this

valuation method, but it is not actually as complicated as it sounds.

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If you want to know more about the method and how it works, you should research it further so

as to fully understand where it is applicable, its advantages and disadvantages.

What about Valuation Accuracy?

Generally speaking the contractors method of valuation is worth a try if none of the other

commercial property valuation methods seem applicable to the circumstances.

However, you should always remember that this valuation method does have its limitations and

is not overly reliable, especially when it comes to valuation accuracy, so don’t take the result as

the be all and end all.

We would normally recommend that the contractors valuation approach is used as part of a

wider, more comprehensive valuation approach.

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1.3 Investment Valuation

What is investment valuation?

This method involves reflecting risk, return and expectations of growth through the use of a

yield. This yield is fed into the years purchase (YP) formula and the present value of £1 (PV £1)

formula to produce the figures that the rent is multiplied by.

Years purchase and present value are explained mathematically below but first we need to

understand the concept of the time value of money.

Why do we do this?

Time value of money is an economic principle that is always in the news as politicians argue

about the cost of living.

Think about inflation: a loaf of bread costs more this year than last year. The amount of the

increase is the inflation percentage, averaged over many products to produce the retail price

index and the headline inflation figures.

It is the same principle in valuation: your money will buy less in the future than it does today.

There is also a risk that you might not get any future promised income. There is an opportunity

cost, you can’t invest it elsewhere and make more money.

The investor may be optimistic about capital or rental growth and be prepared to accept a lower

yield in exchange, this investor thought process is also reflected. So, this yield percentage has a

lot of thinking behind it.

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How is the time value of money reflected?

If you were to multiply an income of £10,000 per year for 4 years on a straight line basis the

answer would be £40,000. But we now know this is not accurate enough because there is no

allowance for the risk, return (reflecting time value of money) and expectations of growth.

The answer will be less… but how much less?

Valuers use a formula called years purchase (which is also used throughout the financial world)

to work this figure out. This is the number of years it will take the income of £10,000 to add up

to the capital value reflecting the time value of money.

This formula has another name: the present value of £1 per annum and this means, the current

value of the right to receive £10,000 income for 4 years.

Same thing, different words.

The formula is:

YP = 1-PV/ i

Mathematical proof

Let’s assume that the valuer thinks 8% is the appropriate yield.

Present value PV = 1/(1+i)^n

Same thing, different words.

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The formula is:

PV = 1/(1+0.08)^4

PV = 0.73503

Years purchase

Same thing, different words.

The formula is:

YP = (1- 0.73503)/0.08

YP = 3.3121

This means that the right to receive £1 per annum for 4 years at 8% is worth £3.3121. This is less

than £4 because of the time value of money and risk.

Put another way, it will take 3.3121 years for the income to equal the capital value.

The valuation should be laid out in columns with the YP calculation factors in the first column

and the calculation outcome in the second column.

Valuation

£ £

Rent 10,000

YP 4 years @ 8% 3.3121

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Capital value 33,120

That is how we value the period up until the next rent review – the term.

Future money

What if there is a reversion?

In many valuations, the rent will go up at a rent review (or at the end of the lease). There is often

about 3 years between rent reviews. In this period rents will go up but the landlord can’t increase

the rent until the review.

Let’s assume the property is 1 year into a 3-year review and rents have increased to, say,

£12,000.

So, the valuer needs to value an income of £10,000 for 2 years till review – this is the term.

The valuer then needs to value the market rent of £12,000 after 2 years – this is the reversion.

It is a fundamental principle with the traditional method that we do not project rental growth and

today’s full market rent is the highest figure we can use.

We will also assume that this figure is received into perpetuity – forever.

The chances of future growth (or decline) and the risks are reflected in the choice of yield. The

valuer will make adjustments to comparable yields to reflect these risks.

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Imagine a good tenant covenant in a prime area, the risk of tenant default will be less and the

valuer will be expecting rental levels to rise. Imagine the comparable yields have poorer

locations and uncertain income – currently at say 6%.

The valuer will adjust the yield on the subject property to say 5% to reflect the better prospects.

This is somewhat counter-intuitive. The fundamental principle is that the better the prospects the

LOWER the yield. This is because an investor will accept a lower yield (return on his

investment) when he feels optimistic about the future.

The yield used as a starting point is found by analysing comparable transactions. Valuers will

divide the rent by the capital value to give a gross initial all risks yield, this is the starting point

for adjustments in our simple example.

Rent/capital value = gross initial yield

The key point with the traditional method is that these adjustments will be subjective and

selected using valuer judgement. The growth and risks are implicit in the yield with traditional

method. This is often cited as a major drawback of the method.

Applying the formula to the reversion

The same economic principles apply to the relationship between rent and capital value. We will

still need a YP to capitalise and we will also need to discount using present value £1 (PV).

Time value of money is a bigger issue with the reversion because:

 it is further away;

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  it has more risks;

 there is less value to the money because of inflation; and

 there is an inability to invest elsewhere.

This introduces an extra step in the valuation using the PV formula.

Capitalising

The YP reflects the time value of money in converting a flow of income into a lump sum. This is

the same formula as before but much simpler because the income is forever.

This is 100/i.

We need to reflect the risk and the fact that the expected growth has already happened so an

investor will be looking for a slightly higher yield. We will use 8.5%.

100/8.5 = 11.7647

This figure will be used to value the right to receive £12,000 p.a. forever.

Discounting

The PV formula is used to reflect the time value of money because it is future money.

The PV formula is 1/(1+i)^n.

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Mathematical proof

PV=1/(1+i)^n

PV=1/(1+0.085)^2

PV=1/1.085^2(^2=1.085x1.085)

PV=1/1.1772

PV = 0.8497

The YP is multiplied by the PV to give a deferred YP. It is easiest to explain in steps in the

valuation. The PV x YP calculation is shown in italics.

Term

£ £

Rent 10,000

YP 2 years @ 8% 1.7832

Capital value term rent 17,832.00

Reversion

Rent 12,000

YP perp @ 8.5% 11.7647

Deferred 2 years X

PV £1 @ 8.5% 2 years 0.8497

YP in perp @ 8.5% def 2 years 9.9964

Capital value reversion 119,956.80

Total 137,788.80

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1.4 Comparable valuation method

Comparable valuation methods consist in the comparison of valuation multiples and operating

metrics for a target company to those of different firms in a peer group. Peers may be grouped

based on different criteria, such as industry, company size, or growth, this being the base of the

benchmarking process. The popularity of the multiple valuation methods can be attributed to

their relative simplicity compared to other company valuation methods like discounted cash flow

techniques. As we will show, we think that the two methods can be combined to achieve our

goal, especially in case of a company which’s stocks is not traded on any stock exchange and is

part of a young industry whose companies are not listed on stock exchanges. Several studies and

surveys demonstrate that practitioners frequently use financial ratios or multiples for the

valuation of companies (see Graham and Harvey, 2001, Manigart et al., 2000, Lie and Lie, 2002,

Liu et al., 2002, Courteaua, 2003, Asquith et al., 2005, Roosenboom, 2007, Fidanza, 2008,

Mînjin, 2009). It also turns out to be surprisingly successful in comparative empirical studies by

Kaplan and Ruback (1995) and Gilson et al. (2000). In his study focusing on equity valuation

using multiples, Fernandez’s (2001) basic conclusion is that multiples almost always have a

broad dispersion, which is why valuations performed using multiples may be highly debatable.

However, Fernandez shows that multiples are useful in a second stage of any valuation: after

performing the valuation using another method, a comparison with the multiples of comparable

firms enables financial analysts to gauge the valuation performed and identify differences

between the firm valued, and the firms it is compared with. These are the two approaches that we

would like to merge in our valuation method: usage of financial ratios while utilizing another

valuation method. Dittmann and Weiner (2006) investigate the which comparables selection

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method generates the most precise forecasts when valuing companies with the enterprise value to

EBIT multiple, while Henschke and Homburg’s study (2009) addresses the problem of

differences between firms and the impact on valuations based on multiples. They investigate the

extent to which industry-based multiples ignore additional firm-

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1.0 Conventional method of valuation

This chapter describes the three Conventional methods of valuation method: Regression

Models, Hedonic Regression Analysis, Investment Valuation and Spatial Regression

Modeling. For each,it describes a valuation principle and an underlying mathematical

equation.

1.1 Regression Models in Real Estate Valuation

There are numerous benefits to using regression models for real estate valuation. The retail

industry has embraced its use for site selection, but the real estate industry, for the most part, has

overlooked its potential advantages. Regression analysis is particularly suitable for analyzing

large amounts of data. It would be practically impossible to have a strong knowledge of every

local real estate market in the country, but regression modeling can help narrow the search.

1. Flexibility

The greatest benefit of using regression modeling is its inherent flexibility - they can work

independently of other models or in concert with them.

The most direct approach is to use existing sales data to predict the value of a subject property,

as an output to the model. There are numerous sources of free data from local, state, and federal

agencies which can be supplemented with private data providers.

Another option is to use regression models to more accurately predict inputs for other traditional

valuation methods. For example, when analyzing a mixed-use commercial project, a developer

could build one model to predict the sales per square foot for the retail space, and another model

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to predict rental rates for the residential component. Both of these could then be used as an input

to an income approach for valuation.

2. Objective Approach

Using sound statistical principles yields a more objective approach to valuation. It’s one of the

best ways to avoid confirmation bias, which occurs when people seek out information that

confirms their preexisting opinion or reject new information that contradicts it. When I have built

models for retailers to predict new store sales, they were often surprised to learn that many

retailers benefit from being near a competitor. In fact, colocation with Walmart, who was often

their largest competitor, was one of the most common variables used in my models. Relying on

existing biases can lead to missed opportunities, or even worse, hide disasters right around the

corner.

Some of the objective advantages of statistical valuation are the following:

1. Statistical analysis allows you to determine the statistical significance (reliability) of

individual factors in the model.

2. While scenario or sensitivity analysis can give you a general idea about changes to inputs in

more traditional methods, it’s more akin to making multiple predictions rather than giving

you a better idea of the accuracy of the original prediction. On the other hand, when

building a regression model, you will know what the range of outcomes will be based on a

certain level of confidence.

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Regression models are unique in the fact that they have a built-in check for accuracy. After

building a model on a sample of the total population, you can use the model on out-of-sample

data to detect possible sampling bias.

2.3 Hedonic Price Method

The hedonic price method uses the value of a surrogate good or service to measure the implicit

price of a non-market good. For example, house prices can be used to provide a value of

particular environmental attributes. Individuals may be willing to pay a premium for a house

located close to a country park, while they may wish to have a discount on a house which is

located close to a open cast mining site.

House and other property prices are not simply determined by one variable as listed in the above

examples. They are a product of a number of factors including:

1. Characteristics of the property.

2. Characteristics of the location.

3. Characteristics of the environment.

The hedonic price method is used to measure the relative importance – through use of regression

analyses – of these independent ‘explanatory’ variables on house and property prices. If, for

example, through regression analyses increased distance from an open cast mining site is found

to be correlated with increased house prices, it can be ascertained that the open cast site is having

a negative impact on house prices. The regression analysis can also be used to provide a value

for the size of the relative impact. It may be found that a 1km movement away from the open

cast site equates to an increase of £5,000 on a house price.

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2.2 Hedonic Regression Analysis (adapted from Boardman et al, 2001, 349-352)

The hedonic regression analysis is conducted in two steps. The first step estimates the

relationship between the price of an asset (the dependent variable) and all of its various

characteristics (independent variables). For example, the price of a house can be summarised

using a hedonic price function as below:

Where the price of a house (P), is a function of its location relative to a local urban centre (LOC),

the type of house (TYPE), the size of the plot (SIZE), the quality of its view (VIEW), and

neighbourhood characteristics (NEIGH) such as school quality and crime.

The change in a house price resulting from the marginal change in one of these characteristics is

called the hedonic price (sometimes referred to as the implicit price or rent differential). The

hedonic price can therefore be interpreted as the additional cost of purchasing a house that is

marginally ‘better’ in terms of a particular characteristic.

Usually researchers estimating hedonic prices assume the hedonic price function has a

multiplicative functional form. This means that as a characteristic increases (or improves) the

house prices increase but at a decreasing rate. This is expressed in the following way:

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Here the parameters β1 to β5 are elasticities. These parameters measure the proportional change

in prices caused by proportional changes in characteristics. For example, we would expect β3 > 0

as house prices will increase as plot size increases. The hedonic price of a particular

characteristic is therefore the slope of this equation with respect to that particular characteristic.

For example, the hedonic price of plot size is expressed as:

The hedonic price of house sizes is dependent on the value of the parameter β3, the price of the

house, and the size of the house. The hedonic price of a characteristic can be interpreted as the

willingness to pay of households for a marginal increase in that particular characteristic.

The second step of the hedonic regression analysis estimates the willingness to pay of

households but additionally accounts for households having different incomes and tastes. The

willingness to pay function therefore becomes:

Where the willingness to pay for the size characteristic is dependent on size of the house (SIZE),

income of the household (Y), and a vector (Z) which denotes tastes (based on age, race, social

background, family size etc).

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Problems with Hedonic Models

There are a number of limitations in the use of the hedonic pricing method. These include:

(1) Information: the model requires that all individuals have prior knowledge of the potential

positive and negative externalities they may face having purchased a house. For example, they

should have prior knowledge of the level of pollution an open cast mining site will cause and

how this will affect them. Of course in reality this is not always the case.

(2) Measurement validity: the quality of the measures used in the independent ‘explanatory’

variables is of key importance. If proxy measures are used, for example for the build quality of a

house, this could result in an inaccurate coefficient being generated in the regression analyses.

(3) Market limitations: the model ideally requires that a variety of different houses are available

so that individuals are able to obtain the particular house of their choosing, with a combination of

characteristics they desire. However, in reality it may be the case that a family wishing to

purchase a large house with a garden in a busy city centre location, may find that the city centre

only contains small houses, or houses without gardens.

(4) Multicollinearity: it may be the case that large houses are only found in green areas with low

pollution, and small houses are only found in urban areas with high pollution. In this case it

would be impossible to separate out pollution and house size accurately.

(5) Price changes: the model assumes that market prices adjust immediately to changes in

attributes. In reality there will likely be a lag associated with this, especially in areas where house

sales and purchases are rare.

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2.3 Spatial Regression Modelling (SRM)

Spatial Regression Modelling (SRM) specifically used to address the spatial autocorrelation error

(Suriatini Ismail, 2005; Löchl and Axhausen, 2010). It has the capability to detect the spatial

autocorrelation in two different forms namely, spatial error model and spatial lag model using

the Lagrange Multiplier (LM) test (Wilhelmsson, 2002).

A spatial lag model or a mixed regressive, spatial autoregressive model is appropriate when the

focus of interest is the assessment of the existence and strength of spatial interaction. In this

model, the property value would be estimated partially from nearby or neighboring observations

of other property values. This model would assume that the property value of each property was

affected by the property values in the neighborhood in a form of spatial weighted average

(Suriatini Ismail, 2005). This is in addition to the other variables that provide indirect effect to

the property value which represent the property and neighbourhood characteristics. The spatial

error model was used for spatially autocorrelated model which occurred because of the error

term in the model. Thus, the spatial error model is capable to rectify any potential bias influence

of spatial autocorrelation due to the use of spatial data. It helps to find the most suitable

coefficients estimation in the model and ensure that the correct inference is adopted. It is

however, not appropriate for model which indicates no spatial interaction (Suriatini Ismail,

2005). Thus, SRM managed to provide good estimation in some property value model studies

(Suriatini Ismail, 2005; Löchl and Axhausen, 2010) and potentially managed to eliminate the

model error.

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3.0 REFERENCES

1. Asquith, P., Squith, P., Mikhail, M.B., Au, A.S., 2005. Information content of equity analyst

reports, Journal of Financial Economics, no.75, pp.245-282 2. Baker, M., Ruback, R.S., 1999.

Estimating industry multiples, Harvard Univ. Working Paper

3. Cheng, Agnes, McNamara, 2000. The valuation accuracy of the price-earnings and price-

book benchmark valuation methods, Review of Quantitative Finance and Account. no.15,

pp.349-370

4. Courteaua, L., Kaob, J.L., Keefec, T.O., Richardsond, G.D., 2003. Gains to Valuation

Accuracy of Direct Valuation Over Industry Multiplier Approaches, SSRN Working Paper

5. Damodaran, A., 2009. Valuing Young, Start-up and Growth Companies: Estimation Issues

and Valuation Challenges

6. Dittmann, I., Weiner, C., 2006. Selecting Comparables for the Valuation of European Firms,

SSRN Working Paper

7. Faccio, M., Masulis, R.W., 2003. The choice of financing method in European mergers &

acquisitions, available at: www.docs.fce.unsw.edu.au/banking/.../Masulis-Seminar.pdf

8. Fernandez, P., 2001. Valuation Using Multiples. How Do Analysts Reach Their Conclusions?,

SSRN Working Paper

9. Fidanza,B., 2008. The Valuation by Multiples of Italian Firms, Universita degli Studi di

Macerata Working Paper no.14

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