CHAPTER 4: INCOME-BASED VALUATION
of capital or the required return for a venture.
- 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 the
income that it will generate.
- Income – is based in the amount of money that the
company or the assets will generate over the period
of time.
o 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:
1.) Dividend Irrelevance Theory
o Introduced by Modigliani and Miller
o Believes that the stock prices are not
affected by dividends or the returns on the
stock but more on the ability and
sustainability of then asset or company.
2.) Bird-in-the-hand Theory
o Also known as dividend relevance
theory.
o Developed by Myron Gordon
o Believes that dividends or capital
gains has an impact on 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.
1.) Earning accretion – the additional value
inputted in the calculation that would
account for the increase in the value of
the firm due to other quantifiable
attributes like:
 Potential growth
 Increase in prices and even
 Operating efficiencies
2.) Earnings dilution – will reduce value if
there are future circumstances that will
affect the firm negatively.
3.) Equity control premium – the amount
that is added to the value of the firm in
order to gain control of it.
4.) Precedent Transaction – are previous
deals or experiences that can be similar
with the investment being evaluated.
 NOTE: these transactions are
considered risks that may affect
further the ability to realize the
projected earnings. `
- In income-based valuation, a key driver id the cost
- COST OF CAPITAL can be computed through:
A.) Weighted Average Cost of Capital (WACC)
o Can be used in determining the
minimum required return.
o It can be used to determine the
appropriate cost of capital by
weighing the portion of the asset
funded through equity and debt.
o 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
B.) Capital Asset Pricing Model (CAPM)
o FORMULA:
Re = Rf + β × (Rm − Rf)
Rf = Risk free rate
β = beta
Rm = Market return
Kd = Rf + DM
Rf = Risk free rate
DM = Debt margin
ECONOMIC VALUED ADDED
- the most conventional way to determine the value
of the asset is through its EVA.
- In Economics and Financial Management, 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.
 NOTE: Higher excess earnings is
better for the firm.
- Elements that must be considered in using EVA
are:
 Reasonableness of earnings or returns
Appropriate cost of capital
- FORMULA:
EVA = Earnings - Cost of Capital
Cost of Capital = Investment Value X Rate of
Cost of Capital
CAPITALIZATION OF EARNINGS METHOD
- The value of the company can also be associated
with the anticipated returns or income earnings on
the historical earnings and expected earnings.

- For greenfield 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 the
capitalization rate (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
the return
3.) Estimated equity value
- EQUITY VALUE FORMULA:

Equity Value = Equity Value

Required Return

DISCOUNTED CASH FLOWS METHOD

o Is the most popular method of determining the
value.
o The most sophisticated approach in
determining the corporate value.
o More verifiable since this allows for a more
detailed approach in valuation.