INCOME BASED VALUATION

Retchie Jasper D. Lorenzo, CPA, MBA

October 11, 2021
INTRODUCTION TO 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.
DEFINITION OF INCOME
 The amount of money that the company or the asset will generate over the period of
time.

Reduced by the cost that they need to incur in order to realize the cash inflows and
operate the asset.
TWO OPPOSING THEORIES
1. Dividend irrelevance theory
introduced by Modigiliani and Miller that supports the belief that the stocks 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. Hand bird-in-bird theory

 believes that dividend or capital gains has an impact on the price of the stock.
Also known as dividend relevance theory developed theory by Myron Gordon and John
Lintner.
INCOME BASED VALUATION
 Investors and analysts are also are also particular about certain factors that can be considered to property value such
as earning accretion or dilution, equity control premium and precedent transaction.

a. 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, increases in prices, and even operating efficiencies.

b. Earnings dilution
 Reduce value if there future circumstances that will affect the firm negatively

c. Equity control premium

 Amount that is added to the value of the firm in order to gain control of it

d. Precedent transactions
 Previous deals or experiences that can be similar with the investments being evaluated.
 These transactions are considered risks that may affect further the ability to realize the projected earnings
INCOME BASED VALUATION
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
(b) Capital Asset Pricing Model.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
can be used in determining the minimum required return
can be used to determine the appropriate cost of capital by weighing the portion of the
asset funded through equity and debt.

WACC = (ke + we) + (kd x wd)

Ke = cost of equity
We = weight of the equity financing
Kd = cos of debt after tax
Wd = weight of debt financing

WACC may also include other sources of financing like Preferred Stock and retained
Earnings.
 CAPITAL ASSET PRICING MODEL OR CAPM
The cost of equity may be also derived using Capital Asset Pricing Model or CAPM.
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 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
ILLUSTRATION
To illustrate, the risk-free rate is 5% and in order to borrow in the industry, a debt premuim 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:

The WACC is 10%. The 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. 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.

The cost of capital is a major driver in determining the equity value using income based approaches.
VALUE OF STOCKS
The value of 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
 The most conventional way to determine the value of the asset
 The convenient metric in evaluating investments as it quickly measures the ability of the firm to support
its cost of capital using its earnings
 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:

a. Reasonableness of earnings or returns
b. Appropriate cost of capital

The formula is:

EVA = Earnings - Cost of Capital
Cost of Capital = Investment value x Rate of Cost of Capital
ILLUSTRATION
Chandelier Co. Projected earnings to be Php350Million per year. The board of directors
decided to sell the company for Php1.5 Billion with a foregoing, the EVA is Php200
[Php350-(Php1,500 x 10%)]. The result of Php200 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 of 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 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
The value of the asset or the investments is determined using the anticipated earnings
of the company divided by 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
The formula for value of equity:

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.
ILLUSTRATION
Mobile Inc. expects to earn P450,000 per year expecting a return of 12%. The equity
value is determined to be Php3.750.000 computed as follows:

Equity value = P450,000

12%
Equity value = P3,750,000
ILLUSTRATION
• 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

• For example, Mobile Inc. projects the following net cash flows in the next five years,
with the required return of 12%
Year Net cash Inflows
1 P450,000
2 P500,000
3 P650,000
4 P700,000
5 P750,000
ILLUSTRATION
 Once The average of the net cash flows was determined, the equiation will be applied

Equity value = P610,000

12%
Equity value = P5,083,333

 It is generally assumed that all asset are income generating. In case there are idle assets, this will
be an addition to the calculated capitalized earnings. Capitalized earnings only represent the
assets that actually generate income or earnings and do not include value of the idle assets.
ILLUSTRATION
Folowing through the information on Mobile Inc with the calculated equity
value Php5,083,333, assume that there is an idle asset amounting to
Php1,350,000. This value should be included in the equity value but on top of
the capitalized earnings. The adjusted equity value of P6,433,333.
LIMITATIONS
(1)This does may 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 limited time horizon
DISCOUNTED CASH FLOWS METHOD

the most popular method of determining the value.

Generally used by the investors, valuations and analyst because this is the most
sophisticated approach in determining the corporate value.
More verifiable since this allows for a more detailed approach in valuation
Calculated 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.
SUMMARY
Income based valuations theorizes that the best estimate value is based on the returns
that an asset or business can generate in the future.
Income based valuations approaches require the use of cost of capital to calculate value
of future earnings.
Costs 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 value approaches include economic value added, capitalized earnings
approach and discounted cash flows approach
REFERENCE

Valuation Concepts and Methodologies by Lascano, Baron, and Cachero (2021 edition)