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CH04 Incomebasedvaluation
Valuation Concepts and Methods (Misamis University)
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Computations:
VALMET
Chapter 4

Income Based Valuation

Many investors and analysts find that the best
estimate for the value of the company or an asset
is the value of the returns that it will yield or
income that it will generate.
Income- based on the amount of money that the
company or the assets will generate over the
period of time.
In income-based valuation, investors consider
two opposing theories:
1.Dividend Irrelevance Theory- stock prices
are not affected by dividends or the returns
on the stock but more on the ability and
sustainability of the asset or company.
2.Bird-in-the hand Theory -dividend or capital
gains has an impact on the price of the stock.
Factors that can be considered to properly value
the asset:
i.
ii.
iii.
Earning accretion or dilution
Equity control premium
Precedent transactions
Earning Accretion- additional value inputted in
the calculation that would account for the
increase in value of the firm due to other
quantifiable attributes like potential growth,
increase in prices, and even operating
efficiencies.
Equity Control Premium- an amount that is
added to the value of the firm in order to gain
control of it.
Weighted Average Cost of Capital
WACC
Capital Asset Pricing model
Weighted Average Cost of Capital (WACC)
formula can be used in determining the
minimum required return. It can be used to
determine the appropriate cost of capital by
weighing the portion of the asset funded through
equity and debt.
WACC= (ke x We) + (ka x Wd)
Ke= Cost of equity
We= weight of equity financing
Kd= cost of debt after tax
Wd= weight of the debt financing
-WACC may also include other sources of
financing like preferred stock and retained
earnings. Including other sources of financing
will have to require redistributing the weight
based on the contribution of the asset.
The cost of equity may also be derived using
Capital Asset Pricing Model or CAPM.
ECONOMIC VALUE ADDED
The most conventional way to determine the
value of the asset is through its economic value
added. In economics and financial management,
Economic Value Added (EVA) is a convenient
metric in evaluating investment as it quickly
measures the ability of the firm to support its
cost of capital using its earnings.
Elements that must be considered in using EVA:
-Reasonableness of earnings or returns
Precedent transactions- are previous deals or
experiences that can be similar to the investment
being evaluated.
Cost Capital- a key driver in the income-based
approach.
-Appropriate cost of capital
EVA= Earnings – Cost of Capital
Cost of Capital= Investment value x Rate of
Cost Capital
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Capitalization of Earnings Method
- is an income-oriented approach. This
method is used to value a business based on
the future estimated benefits, normally using
some measure of earnings or cash flows to be
generated by the company.
Equity Value= Future Earnings/ Required
Return
-This method assumes all of the assets, both
tangible and intangible, are indistinguishable
parts of the business and does not attempt to
separate their values
DISCOUNTED EARNINGS/CASH FLOWS
METHOD
The Discounted Earnings Method is sometimes
referred to as the Discounted Cash Flow
Method, which suggests the only type of
earnings to be valued, using this method, would
be some definition of cash flow, such as
operating cash flow, after-tax cash flow or
discretionary cash flow. The Discounted
Earnings Method is more general in its
definition as to the type of earnings that can be
used.
The Discounted Earnings Method is an incomeoriented approach. It is based on thetheory that
the total value of a business is the present value
of its projected future earnings, plus the present
value of the terminal valu
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