CHAPTER 4
INCOMEBASED
VALUATION
PRESENTED BY
ALBESOR-BERNALDEZ-DELFIN-DIAZ-DINZON-SILVINO-VILLARINA
OVERVIEW
Introduction
WACC
DISCOUNTED CASH
FLOW
Two Opposing Theories
CAPM
SUMMARY
Factors affecting proper
asset valuation
EVA
THEORY QUESTIONS
CEM
PROBLEMS
QUESTIONS
Key drivers in IncomeBased Valuation
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. Thus, most of
them are more particular in determining the
total income that the asset will generate.
INCOME
Income is based on the amount of money
that the company or assets will generate
over the period of time. These amounts will
be reduced by the costs that they need to
incur in order to realize the cash inflows and
operate the assets.
EXPENSE
Being the opposite of income, it represents a
decrease in economic benefit during the
accounting period in the form of a decrease in
asset or an increase in liability that results in a
decrease in equity other than distributions
from the equity participants.
In income based valuation,
investors consider the two
opposing theories: the dividend
irrelevance theory and the birdin-hand theory.
DIVIDEND
IRRELEVANCE
THEORY
(MODIGLIANI & MILLER)
Stock prices are not
affected by dividends or
the returns on the stock
but more on the ability
and sustainability of the
asset of the company.
DIVIDEND
RELEVANCE
THEORY/BIRD IN
HAND THEORY
(GORDON&LINTNER)
Dividend or capital gains
impact the price of the
stock.
Once the value of the asset has
been established, investors and
analysts are also particular about
certain factors that can be
considered to properly value the
asset.
Additional value inputted in the
calculation that would account
for the increase in value of the
firm:
Potential Growth
Price Increases
Operating Effeciences
Both are considered in the sensitivity
analysis.
Reduces the value when
there
are
future
circumstances that affects
the firm negatively.
SENSITIVITY
ANALYSIS
Multiple analysis are done to
understand how changes in an input or
variable will affect the outcome (firm
value).
Amount added to the value
of the firm in order to gain
control of it.
Risk that may affect a firm's
ability to realize projected
earnings.
TRUE OR FALSE
THEORY QUESTIONS
1. 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.
2. INCOME IS BASED ON THE AMOUNT OF MONEY THAT THE COMPANY OR THE ASSETS WILL
GENERATE OVER THE PERIOD OF TIME.
3. IN INCOME BASED VALUATION, INVESTORS CONSIDER TWO OPPOSING THEORIES: THE DIVIDEND
IRRELEVANCE THEORY AND THE BIRD-IN-HAND THEORY.
4. THE DIVIDEND IRRELEVANCE THEORY WAS INTRODUCED BY MODIGLIANI AND MYRON GORDON
THAT SUPPORTS THE BELIEF THAT THE 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.
5. BIRD-IN-HAND THEORY BELIEVES THAT THE DIVIDEND OR CAPITAL GAINS HAS IMPACT ON THE
PRICE OF THE STOCK.
IN INCOME BASED APPROACH,
A KEY DRIVER IS THE COST OF
THE CAPITAL OR THE
REQUIRED RETURN FOR A
VENTURE
COST OF CAPITAL
Represents the firm's cost of financing and its minimum
rate of return that a project must earn to increase its
value.
It refers to the cost of the next dollar (or peso) of
financing necessary to finance a new investment
opportunity.
It is an extremely important financial concept.
It is the major link between the firm's long-term
investment decisions and the wealth of the firm's owners
as determined by the market value of thier shares.
COST OF
CAPITAL
INVESTMENT 1
INVESTMENT 2
Investments with a
rate of return above
the cost of capital
will increase the
value of the firm.
Projects with a rate
of return below the
cost of capital will
decrease firm value.
SOURCES OF LONG
TERM CAPITAL
CAPITAL
COST OF CAPITAL
Long term Debt
After tax rate of interest (1 - tax
rate)
Common Stock
CAPM
Preferred Stock
Annual dividend per share/Net
proceeds from the sale of
preferred shares
Retained Earnings
Addition to RE for the year/Equity
Fraction
KEY DRIVERS IN INCOME
BASED VALUATION
01
WEIGHTED AVERAGE COST OF CAPITAL OR WACC
02
CAPITAL ASSET PRICING MODEL OR CAPM
WEIGHTED AVERAGE COST
OF CAPITAL(WACC)
It reflects the expected average future cost of capital over
the long run. It is found by weighting the cost of each
specific type of capital by its proportion in the firm's
capital structure.
It can be used to determine the appropriate cost of capital
by weighing the portion of the asset funded through
equity and debt.
FORMULA
WACC= (Ke x We) + (Kd x Wd)
Ke= cost of equity
We=weight of the 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 to the asset.
WACC = (% of debt) (After-tax Cost of Debt) + (% of Preferred
share) (Cost of Preferred Shares) + (% of Ordinary Equity)
(Cost of Ordinary Equity)
Example:
Proportion
Specific Cost
Weighted
Cost of
Capital
Bonds
30%
6.6%
1.98%
Preferred
Shares
10%
10.21%
1.02%
Ordinary
Equity Shares
40%
13.33%
5.33%
Retained
Earnings
20%
13%
2.6%
WACC
10.93%
CAPITAL ASSET PRICING MODEL
(CAPM)
Shows the relationship between the market risk and the
expected return.
It is one of the major developments in modern financial
theory widely used in investment analysis.
It is a model based on the proposition that any stock's
required rate of return is equal to the risk-free rate of return
plus a risk premium that reflects only the risk remaining after
diversification.
FORMULA
Ke= Rf+B (Rm-Rf)
Ke/Re=Rate of Return
Rf= risk free rate
B = beta coefficient of an individual stock which is correlation between
the votality (price variation) of the stock market and the votality of the
price of the individual stock
Example: if the price of the individual stock rises 10% and the stock market 15%,
the beta is 1.5.
Rm = market return
(Rm-Rf)=market risk premium or the amount above risk free rate
required to induce average investors to enter the market.
To illustrate, the risk-free rate is 5% while the
market return is roving around at 11.91%, the
beta is 1.5. The cost of equity is 15.365% [5%
+1.5 (11.91% -5% ) ]. If the prospect can be
purchased by purely equity alone the cost of
capital is 15.365% already.
However, if there will be portion
raised through debt, it should be
weighted accordingly to determine
the reasonable cost of capital for the
project to be used for discounting.
Ke= Rf+B (Rm-Rf)
Ke= 5% + 1.5 (11.91% - 5%)
Ke= 5% + 1.5 (6.91%)
Ke= 5% + 10.365%
Ke= 15.365%
The cost of debt can be computed by adding debt premium over the riskfree rate.
Kd = Rf + DM
Rf= risk free rate
DM= debt margin
Kd = Rf + DM
Kd=5% + 6%
Kd= 11%
To illustrate, the risk-free rate is 5% and in order to borrow in the industry,
a debt premium is considered to be about 6%. Given the foregoing, the
cost of the debt is 11% [5% + 6% ] . Now, assuming that the share of
financing is 30% equity and 70% debt, and the tax rate is 30%. The
weighted average cost of capital will be computed as:
WACC= (Ke x We) + (Kd x Wd)
WACC = (15.365 % x 30% ) + (11% x (1-30% ) x 70%)
WACC = 4.61% + 5.39%
WACC = 10%
The WACC is 10%. Observe that tax was
considered in debt portion to factor in that the
interest incurred, or cost of debt is taxdeductible, hence, there is tax benefit from it.
You may also note that the cost of equity is
higher than cost of debt, this is because cost of
equity is riskier as compared to the cost of debt
which is fixed.
It may be observed that the
cost of capital is a major driver
in determining the equity value
using income based
approaches.
PROBLEMS QUESTIONS
Using Capital Asset Pricing
Method (CAPM), compute for
the cost of capital(equity) with
risk-free rate of 4%, market
return of 8% and Beta of 1.5.
PROBLEMS QUESTIONS
The appropriate WACC of a firm is
6.43% with risk free rate of 4%,
market return of 8%, prevailing
credit spread of 3%, tax rate of 30%
and equity ratio of 30%, compute
for the volatility of stocks or beta.
PROBLEMS QUESTIONS
With risk-free rate of 5%, Beta of 1.5,
market return of 8%, prevailing
credit spread of 3%, tax rate of 30%
and equity ratio of 30% compute for
the weighted average of cost of
capital.
THEORY QUESTIONS
True or False
1. WACC may also include other sources of financing like
preferred stock and retained earnings.
2. The cost of equity may be also derived using the Capital Asset
pricing.
3. cost of capital is a major driver in determining the equity value
using income based approaches.
4. The cost of capital can be computed primarily by getting the
weight of cost of sources of fund, through weighted average
cost of capital and capital asset pricing model.
5. The beta in Capital Asset pricing model is used to represent
volatility/risk of the market.
In the succeeding discussions, the value of the
stocks will be based on the value of the cash
flows that the company will generate. The
approach is the determination of the value
using economic value added, capitalization
of earnings method, or discounted cash
flows method.
ECONOMIC VALUE ADDED
(EVA)
"EXCESS EARNING"
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.
ECONOMIC VALUE ADDED (EVA)
"EXCESS EARNING"
EVA is the excess of the company earnings after
deducting the cost of capital. The excess earnings shall
be accumulated for the firm. The general concept here
is that higher excess earnings is better for the firm.
The elements that must be considered in using
EVA are:
Reasonableness of earnings or returns
Appropriate cost of capital
ECONOMIC VALUE ADDED (EVA)
"EXCESS EARNING"
The earnings can easily be determined, especially for
GCBOS, based on their historical performance or the
performance of the similarly-situated company in
terms of the risk appetite. The appropriate cost of
capital will be lengthily discussed in the succeeding
chapters can be determined based on the mix of
financing that will be employed for the asset.
ECONOMIC VALUE ADDED (EVA)
"EXCESS EARNING"
Measures the ability of the firm to support its cost of capital
using its earnings.
EVA= Earnings -Cost of Capital
Cost of Capital=Investment Value x Rate of Cost of Capital
ECONOMIC VALUE ADDED (EVA)
"EXCESS EARNING"
ILLUSTRATIONS:
Chandelier Co. projected earnings to be Php350 Million per year.
The board of directors decided to sell the company for Php1.5
Billion with a cost of capital appropriate for this type of business at
10%. Solve for EVA.
EVA= Earnings -Cost of Capital
Cost of Capital=Investment Value x Rate of Cost of Capital
ECONOMIC VALUE ADDED (EVA)
"EXCESS EARNING"
EVA= Earnings - (Investment Value x Rate of Cost of Capital)
SOLUTION:
EVA= Earnings - (Investment Value x Rate of Cost of Capital)
= 350M - ( 1.5 B X 10%)
= 350M-150M
=200M
 he result of Php200 million means that the value offered by the
T
company is reasonable to for the level of earnings it realized on an
average and sufficient to cover for the cost of raising the capital.
Problem:
SPPE Corp. is planning to expand and new projects is
expecting to earn an average of Php 375,000.00 annually. If the
projected requires for Php 5,000,000 investment at 10% cost of
capital. Compute for the Economic Value Added.
a. Php 125,000
b.(Php 125,000.00)
c. Php 875,000.00
d. (Php 875,000.00)
Problem:
SPRO Corp. is planning to expand and new projects is
expected to have an EVA of Php 200,000.00. The annual cost of
capital at 10% amounts to Php 400,000.00. What is the average
monthly earning projected for this project?
a. Php 600,000.00
b. Php 50,000.00
c. Php 60,000.00
d. Php 500,000.00
Problem:
SPLI, Inc. has a debt to equity ratio of 3:1. After tax cost of
debt is 5% while cost of equity is 10%. The board of directors of
the company decided to sell 100% of the company for Php 1
Billion. Compute for the projected monthly average earnings
assuming an EVA of Php 57,500,000.00
a. Php 37,500,000.00
b. Php 10,000,000.00
c. Php 120,000,000.00
d. Php 100,000,000.00
CAPITALIZATION OF EARNINGS
METHOD
The value of the company can also be associated with
the anticipated returns or income earnings based on
the historical earnings and expected earnings. For
green field investments which do not normally have
historical reference, it will only rely on its projected
earnings. Earnings are typically interpreted as
resulting cash flows from operations but net income
may also be used if cash flow information is not
available.
In capitalized earnings method, the value of the
asset or the investment is determined using the
anticipated earnings of the company divided by
the capitalization rate (i.e. cost of capital). This
method provides for the relationship of the (1)
estimated earnings of the company; (2)
expected yield or the required rate of return; (3)
estimated equity value.
CAPITALIZATION OF EARNINGS
METHOD
ILLUSTRATIONS:
Mobile Inc. expects to earn Php450,000 per year expecting a
return at 12%.
SOLUTION:
EQUITY VALUE= 450,000 / 12% = 3,750,000
Another scenario is that the future
earnings are not constant and vary
every year, the suggested approach
is to determine average of earnings
of all the anticipated cash flows.
CAPITALIZATION OF EARNINGS
METHOD
ILLUSTRATIONS:
Mobile Inc. projects the following net cash flows in the next five
years, with the required return of 12%:
SOLUTION: To calculate the
equity value with variable cash
flows, get the average in the
given period:
SOLUTION:
EQUITY VALUE= 610,000/12% = 5, 083, 333
The equity value calculated is Php5,083,333. In the
valuation process, this value include all assets. It is
generally assumed that all assets are income
generating. In case there are idle assets, this will be
an addition to the calculated capitalized earnings.
Capitalized earnings only represents the assets that
actually generate income or earnings and do not
include value of the idle assets.
Following through the information of Mobile Inc. with the
calculated equity value of Php5,083,333, assume that there is an idle
asset amounting to Php 1,350,000. This value should be included in
the equity value but on top of the capitalized earnings. Hence, the
adjusted equity value is Php6,433,333 computed as follows:
Capitalized Earnings
Add: Idle Assets
Equity Value
5,083,333
1,350,000
6,433,333
Problem:
Heinz, Inc. expects to generate earnings over the next five
years of Php 50,000.00; Php 60,000.00; Php 65,000.00; Php
70,000.00; and Php 75,000.00. Using the Capitalization of
Earnings Method, what is the estimated value of the firm using
10.00% required rate of return?
a. Php 640,000.00
b.Php 657,378.72
c.Php 657,738.72
d.Php604,000.00
Problem:
Hai-dee is looking to buy a property that costs Php 115,000,
and can be leased out of Php 750 a month. She has done some
research and has determined the net operating expenses to be
Php 5,000 per year. Her desired capitalization rate is 10%. What is
the appraisal value of this property using the capitalization of
earnings approach?
a. Php 40,000.00
b. Php 42,500.00
c. Php 45,000.00
d. Php 50,000.00
DISCOUNTED CASH FLOWS METHOD
Discounted Cash Flows is the most popular method of determining the
value. This is generally used by the investors, valuators and analyst
because this is the most sophisticated approach in determining the
corporate value. It is also more verifiable since this allows for a more
detailed approach in valuation.
The discounted cash flows or DCF Model calculates the equity value by
determining the present value of the projected net cash flows of the
firm. The net cash flows may also assume a terminal value that would
serve as a representative value for the cash flows beyond the projection.
SUMMARY
Income based valuation theorizes that the best estimate of value is based
on the returns that an asset or business can generate in the future.
Income based valuation approaches require the use of cost of capital to calculate value
of future earnings. Cost of capital can be derived using two means (based on available
information): through calculating the weighted average cost of capital or through the
Capital Asset Pricing Model (CAPM). Income based valuation approaches include
economic value added, capitalized earnings approach and discounted cash flow
approach.
SUMMARY
Economic value added calculates the excess of company earnings after
deducting cost of capital.
Capitalized earnings approach is a simple calculation approach which divides
forecasted earnings of the company by the cost of capital.
Discounted cash flow approach is the most popular method of determining the
value as it considers the present value of future cash flows associated with business
operations.
TRUE OR FALSE
THEORY QUESTIONS
1. THE MOST CONVENTIONAL WAY TO DETERMINE THE VALUE OF THE ASSET
IS THROUGH ITS ECONOMIC VALUE ADDED.
2. IN MATHEMATICS, ECONOMIC VALUE ADDED IS A QUICKLY MEASURES THE
ABILITY OF THE FIRM TO SUPPORT ITS COST OF CAPITAL USING ITS
EARNINGS.
3. EVA IS THE EXCESS OF THE COMPANY EARNINGS AFTER DEDUCTING THE
COST OF CAPITAL.
4. THE GENERAL CONCEPT OF EVA IS THAT HIGHER EXCESS EARNING IS
BETTER FOR THE FIRM.
5. ONE OF THE ELEMENTS THAT MUST BE CONSIDERED IN USING EVA IS THE
REASONABLESNESS OF EARNINGS OR RETURNS.
THANK
YOU!