ELEC2 - Module 4 - Income Based Valuation

CHAPTER 4
INCOME BASED
VALUATION
This Photo by Unknown Author is licensed under CC BY-SA
Department of Accountancy – MGT7A-Financial Management

LEARNING OUTCOME
• Discuss the concept of income-based valuation

• Compute the equity value using income-based
valuation.
Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Source: Valuation Concepts and Methodologies
By: Marvin V. Lascano, Herbert C. Baron and Andrew Timothy L. Cachero
LECTURE CONTENTS
• Income based valuation
• Economic value
• Capitalization of Earnings Method
• Discounted Cash Flows Method

INCOME BASED VALUATION
• Income is based on the amount of money that the

company or the 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.
• In income based valuation, investors consider two
opposing theories: the dividend irrelevance theory
and the bird-in-hand theory.

• Dividend irrelevance theory was introduced by

Modigliani and Miller 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.
• Bird-in-hand theory believes that the dividend or
capital gains has an impact on the price of the stock.
This theory also known as dividend relevance theory
developed by Myron Gordon and John Lintner.
• 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 asset.
These are earning accretion or dilution, equity control
premium and precedent transactions.

• Earning accretion is the 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.
• Earning dilution will reduce value if there future
circumstances that will affect the firm negatively.
• But in both cases, these should be considered in the
sensitivity analysis.

• Equity control premium is the amount that is added to

the value of the firm in order to gain control of it.
• Precedent transactions, on the other hand, are
previous deals or experiences that can be similar with
the investment being evaluated. These transactions
are considered risks that may affect further the ability
to realize the projected earnings.

• In income based approach, a key driver is the cost of

capital or the required return for a venture.
• Cost of capital can be computed through
a) Weighted Average Cost of Capital, or
b) Capital Asset Pricing Method

• Weighted Average Cost of Capital or 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) + (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.
The cost of equity may be also derived using Capital Asset
Pricing Model or CAPM. The formula to be used is as
follows:
Ke = Rf + β (Rm – Rf)
Rf = risk free rate

β = beta
Rm = market return

INCOME BASED VALUATION-
Illustration:
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.

The cost of debt can be computed by adding debt

premium over the risk-free rate.
Kd = Rf + DM
Rf = risk free rate

DM = debt margin

Illustration: 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 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
tax-deductible, 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.
The approach is the determination of the value using economic
value added, capitalization of earnings method, or discounted
cash flows method.
ECONOMIC VALUE ADDED
• Economic value added is the most conventional way to
determine the value of the asset.
• 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.
• 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
The earnings can easily determined, especially for GCBOs,
based on their historical performance of the similarly-
situated company in terms of the risk appetite. The EVA is
computed using this formula:
EVA = Earnings – Cost of Capital
Cost of Capital = Investment value x Rate of Cost of Capital
Illustration: Copper Co. projected earnings to be P350

million per year. The board of directors decided to sell
the company for P1.5 billion with a cost of capital
appropriate for this type of business at 10%. Given the
foregoing, the EVA is P200 = [P350 – (P1,500 x 10%)].
The result of P200 million means that the value offered
by the company is reasonable to for the level of earnings
it realized on an average and sufficient to cover for the
cost for raising the capital.

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 investment 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 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.

• The value of the equity can be calculated using this
formula:
Equity Value = Future Earnings
Required Return
• In the capitalization of earnings method, if earnings are
fixed in the future, the capitalization rate will be
applied directly to the projected fixed earnings.
• For example, Maple Inc. expects to earn P450,000 per
year expecting a return at 12%.

• The equity value is determined to be P3,750,000
computed as follows:
Equity Value = P450,000
12%
Equity Value = P3,750,000
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.

Example, Maple Inc. projects the following net cash
flows in the next five years, with the required return of
12%:
Year Net cash Flows In Pesos
1 450,000
2 500,000
3 650,000
4 700,000
5 750,000

To calculate for the equity value under variable net cash flows,
you need to determine the average of all the variable net cash
flows in the given period. Based on the given example, the
average of the cash flows is amounting to P610,000
Year Net cash Flows In Pesos
1 450,000
2 500,000
3 650,000
4 700,000
5 750,000
Average 610,000
Once the average of the net cash flows was determined,
the equation will be applied.
Equity Value = P610,000

12%
Equity Value = P5, 083,333

• The equity value calculated is P5,083,333.
• 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 Maple Inc. with
the calculated value of P5,083,333, assume that there
is an idle asset amounting to P1,350,000.
• This value should be included in the equity value but
on top of the capitalized earnings.
• Hence, the adjusted equity value is P6,433,333.
Capitalized Earnings P5,083,333
Add: Idle Assets 1,350,000
Equity Value P6,433,333

While the capitalization of earnings is simple and
convenient, there are limitations for this method:
1. This does not fully account for the future earnings
or cash flows thereby resulting to over or
undervaluation;
2. Inability to incorporate contingencies;
3. Assumptions used to determine the cashflows
may not hold true since the projections are based
on a limited time horizon.
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 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 projection.

THANK YOU
STAY SAFE
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Department of Accountancy – ELEC2

ELEC2 - Module 4 - Income Based Valuation

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CHAPTER 4

This Photo by Unknown Author is licensed under CC BY-SA

Department of Accountancy – MGT7A-Financial Management

• Discuss the concept of income-based valuation

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Income is based on the amount of money that the

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Dividend irrelevance theory was introduced by

• Once the value of the asset has been established,

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Earning accretion is the additional value inputted in

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• Equity control premium is the amount that is added to

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

• In income based approach, a key driver is the cost of

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Rf = risk free rate

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

The cost of debt can be computed by adding debt

Rf = risk free rate

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Illustration: The risk-free rate is 5% and in order to borrow

Illustration: Copper Co. projected earnings to be P350

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Equity Value = P610,000

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

Department of Accountancy – ELEC2 –Valuation Concepts and Methods

This Photo by Unknown Author is licensed under CC BY-SA

Department of Accountancy – ELEC2

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