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. The 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.
On the other hand, bird-in-hand theory believes that dividend or capital gains has an impact on
the price of the stock. This theory is also known as dividend relevance theory developed by
Myron Gordon and John Lintner.
 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 Model.
a. 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 may 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.

Weighted Average Cost of Capital Formula

WACC=(ke×We)+(kd×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 can be used to derive cost of equity.

Capital Asset Pricing Model Formula

ke=Rƒ+ß(Rm - Rƒ)

Rƒ= risk free rate

ß= beta
Rm= market return