NOTES IN VALUATION METHOD
CHAPTER 1: FUNDAMENTAL PRINCIPLES OF
VALUATION
LEARNING CONTENTS
• Interpreting Different Concepts of Value
• Roles of Valuation in Business
• Valuation Process
• Key Principles in Valuation
• Risks in Valuation
VALUATION
• the estimation of an asset’s value based
on variables perceived to be related to
future investment returns, on
comparison with similar assets or, when
relevant, on estimates of immediate
liquidation proceeds
• includes the use of forecasts to come up
with reasonable estimate of value of an
entity’s assets or its equity
• mostly deals with projections about
future events, analysts should hone
their ability to balance and evaluate
different assumptions used in each
phase of the valuation exercise, assess
validity of available empirical evidence
and come up with rational choices that
align with the ultimate objective of the
valuation activity
INTERPRETING DIFFERENT CONCEPTS OF
VALUE
• Fundamental equation of value is
grounded on that principle as
popularized by Alfred Marshall – a
company creates value if and only if the
return on invested capital exceed the
cost of acquiring capital
• Value relates to the difference between
cash inflows generated by an
investment and the cost associated with
the capital invested which captures
both time value of money and risk
premium
INTERPRETING DIFFERENT CONCEPTS
OF VALUE
The value of a business can be basically linked to
three major factors:
• Current operations - how is the
operating performance of the firm
in recent year?
• Future prospects - what is the long
term, strategic direction of the
company?
• Embedded risk - what are the business
risks involved in running
the business?
The definition of value may also vary depending
on the context and objective of the valuation
exercise.
INTRINSIC VALUE
- refers to the value of any asset based on the
assumption assuming there is a hypothetically
complete understanding of its investment
characteristics It is the value that an investor
considers, on the basis of an evaluation or
available facts, to be the “ or “ value that will
become the market value when other investors
reach the same conclusion
GOING CONCERN VALUE
- the going concern assumption believes that
the entity will continue to do its business
activities into the foreseeable future
LIQUIDATION VALUE
- the net amount that would be realized if the
business is terminated and the assets are sold
piecemeal. It is particularly relevant for
 NOTES IN VALUATION METHOD
companies who are experiencing severe
financial distress.
FAIR MARKET VALUE
- the price, expressed in terms of cash
equivalents, at which property would change
hands between a hypothetical willing and able
buyer and a hypothetical willing and able seller,
acting at arm’s length in an open and
unrestricted market, when neither is under
compulsion to buy or sell and when both have
reasonable knowledge of the relevant facts.
ROLES OF VALUATION IN BUSINESS
Portfolio Management
FUNDAMENTAL ANALYSTS
- these are persons who are interested in
understanding and measuring the intrinsic value
of a firm.
✓ Fundamentals refer to the
characteristics of an entity related to its
financial strength, profitability or risk
appetite.
ACTIVIST INVESTORS
- activist investors tend to look for companies
with good growth prospects that have poor
management. Activist investors usually do
“takeovers” – they use their equity holdings to
push old management out of the company and
change the way the company is being run.
CHARTISTS
- they rely on the concept that stock prices are
significantly influenced by how investors think
and act and on available trading KPIs such as
Price movements, trading volume, short sales
when making their investment decisions
INFORMATION TRADERS
- they react based on new information about
firms that are revealed to the stock market The
underlying belief is that information traders are
more adept in guessing or getting new
information about firms and they can make
predict how the market will react based on this.
ACTIVITIES CAN BE PERFORMED THROUGH THE
USE OF VALUATION TECHNIQUES:
STOCK SELECTION
-Is a particular asset fairly priced, overpriced, or
underpriced in relation to its prevailing
computed intrinsic value and prices of
comparable assets?
DEDUCING MARKET EXPECTATIONS
-Which estimates of a firm’s future performance
are in line with the prevailing market price of its
stocks? Are there assumptions about
fundamentals that will justify the prevailing
price?
ROLES OF VALUATION IN BUSINESS
Analysis of Business Transactions/Deals
ACQUISITION
- an acquisition usually has two parties the
buying firm that needs to determine the fair
value of the target company prior to offering a
bid price and the selling firm who gauge
reasonableness of bid offers
MERGER
- transaction of two companies combined to
form a wholly new entity
DIVESTITURE
- sale of a major component or segment of a
business to another company
 NOTES IN VALUATION METHOD
SPIN-OFF
- separating a segment or component business
and transforming this into a separate legal entity
whose ownership will be transferred to
shareholders
LEVERAGE BUYOUT
- acquisition of another business by using
significant debt which uses the acquired
business as a collateral.
TWO IMPORTANT UNIQUE FACTORS:
SYNERGY
- potential increase in firm value that can be
generated once two firms merge with each
other
CONTROL
- change in people managing the organization
brought about by the acquisition
ROLES OF VALUATION IN BUSINESS
Corporate finance involves managing the firm’s
structure, including funding sources and
strategies that the business should pursue to
maximize firm value.
Legal and Tax Purposes. Valuation is also
important to businesses because of tax and
legal purposes.
Other Purposes
- Issuance of a fairness opinion for
valuations provided by third party
- Basis for assessment of potential
lending activities by financial
institutions
- Shared based payment/compensation
VALUATION PROCESS
5 Steps in the Valuation Process
1. Understanding the business
2. Forecasting financial performance
3. Selecting the right valuation model
4. Preparing valuation model based on
forecasts
5. Applying valuation conclusions and
providing recommendation
1. UNDERSTANDING THE BUSINESS
- includes performing industry and competitive
analysis and analysis of publicly available
financial information and corporate disclosures
One of the most common tools used in
encapsulating industry is Porter’s Five Forces:
A. Industry Rivalry - refers to the nature and
intensity of rivalry between market players in
the industry.
- Rivalry is less intense if there is lower
number of market players or
competitors which means higher
potential for industry profitability.
B. New Entrants - refers to the barriers to entry
to industry by new entrants.
• includes entry costs, speed adjustment,
economies of scale, reputation,
switching costs, sunk costs and
government restraints
C. Substitutes and Complements - this refers to
the relationships between interrelated products
and services in the industry (prices of substitute
products/services, complement products
/services and government limitations).
D. Supplier Power - refers to how suppliers can
negotiate better terms in their favor supplier
concentration, prices of alternative inputs,
relationship specific investments, supplier
switching costs and government regulations
 NOTES IN VALUATION METHOD
E. Buyer Power - pertains to how customers can
negotiate better terms in their favor for
products/services they purchase ..(buyer
concentration, value of substitute products,
customer switching costs and government
restraints
Competitive position refers to how the
products, services and the company itself is set
apart from other competing market players.
Generic Corporate Strategies to achieve
Competitive Advantage
• Cost leadership - incurring the lowest
cost among market players with quality
that is comparable to competitors allow
the firm to be price products around the
industry average
• Differentiation - offering differentiated
or unique product or service
characteristics that customers are
willing to pay for an additional premium
• Focus - identifying specific demographic
segment or category segment to focus
on by using cost leadership strategy or
differentiation strategy
Understanding Company’s Business Model
• Business model pertains to the method
how the company makes money what
are products or services they offer, how
they deliver and provide these to
customers and their target customers
• The results of execution of
aforementioned strategies will
ultimately be reflected in the company
performance results contained in the
financial statements
• Analysis of historical financial reports
typically use horizontal, vertical and
ratio analysis
• Typical sources of information about
companies can be found in government
mandated disclosures like audited
financial statements
• In analyzing historical financial
information, focus is afforded in looking
at quality of earnings.
• Quality of earnings analysis pertain to
the detailed review of financial
statements and accompanying notes to
assess sustainability of company
performance and validate accuracy of
financial information versus economic
reality.
• During analysis, transactions that are
nonrecurring such as financial impact of
litigation settlements, temporary tax
reliefs or gains/losses on sales of
nonoperating assets might need to be
adjusted to arrive at the performance of
the firm’s core business.
2. FORECASTING FINANCIAL PERFORMANCE
- can be looked at two perspectives on a macro
perspective viewing the economic environment
and industry where the firm operates in and
micro perspective focusing in the firm’s financial
and operating characteristics
Two Approaches of Forecast Financial
Performance
1. TOP DOWN FORECASTING APPROACH -
international or national
macroeconomic projections with
utmost consideration to industry
specific forecasts
2. BOTTOM UP FORECASTING APPROACH
- forecast starts from the lower levels of
the firm and builds the forecast as it
captures what will happen to the
company based on the inputs of its
segments/units
 NOTES IN VALUATION METHOD

3. SELECTING THE RIGHT VALUATION MODEL RISKS IN VALUATION

- it depends on the context of the valuation and UNCERTAINTY

the inherent characteristics of the company
- refers to the possible range of values where
being valued
the real firm lies when performing any valuation
4. PREPARING VALUATION MODEL BASED ON method, analysts will never be sure if they have
FORECASTS accounted and included all potential risks that
may affect price of assets
- there are two aspects to be considered:
RISKS IN VALUATION
1. SENSITIVITY ANALYSIS
ASPECTS THAT CONTRIBUTES UNCERTAINTY
- common methodology in valuation exercises
wherein multiple other analyses are done to • Future estimates
understand how changes in an input or variable • Use of judgment
will affect the outcome • Business performance
• Innovations and entry of new
2. SITUATIONAL ADJUSTMENTS
businesses
- firm specific issues that affects firm value that
should be adjusted by analysts since these are
events that are not quantified if analysts only
look at core business operations

5. APPLYING VALUATION CONCLUSIONS AND

PROVIDING RECOMMENDATION

Once the value is calculated based on all

assumptions considered, the analysts and
investors use the results to provide
recommendations or make decisions thar suits
their investment objectives.

KEY PRINCIPLES IN VALUATION

• The value of a business is defined only

at a specific point in time.
• Value varies based on the ability of
business to generate future cash flows.
• Market dictates the appropriate rate of
return for investors.
• Firm value can be impacted by
underlying net tangible assets.
• Value is influenced by transferability of
future cash flows.
• Value is impacted by liquidity.
 NOTES IN VALUATION METHOD
CHAPTER 2: ASSET-BASED VALUATION
LEARNING CONTENTS
1. Book Value Method
2. Replacement Value Method
3. Reproduction Value Method
4. Liquidation Value Method
5. Liquidation Value
6. Situations to Consider Liquidation Value
7. General Principles on Liquidation Value
8. Types of Liquidation
9. Calculating Liquidation Value
ASSET
• transactions that would yield future
economic benefits as a result of past
transactions
✓ the value of investment opportunities is
highly dependent on the value that the
asset will generate from now until the
future
• value should also include all cash flows
that will be generated until the disposal
of the asset
• GREEN FIELD INVESTMENTS
investments that started from scratch
• BROWN FIELD INVESTMENTS - already
in the going concern state, as most
businesses are in the optimistic
perspective that they will grow in the
future
✓ Opportunities that can be either
partially or fully operational
✓ Considered as going concern business
opportunities (GCBO)
GOING CONCERN BUSINESS OPPORTUNITIES (
GCBOs)
• businesses that has a long term to
infinite operational period
• risk indicators of GCBOs are identified
easily and can be quantified accordingly
The Committee of Sponsoring Organization of
the Treadway Commission (COSO) suggests that
risk management principles must be observed
in doing businesses and determining its value.
Sound Enterprise wide Risk Management
allows the company to:
1. Increase the opportunities.
2. Facilitates the management and
identification of the risk factors that
affect the business.
3. Identify or create cost efficient
opportunities.
4. Manages the performance variability.
5. Improve management and distribution
of resources across the enterprise.
6. Make the business more resilient to
abrupt changes.
ASSET-BASED VALUATION
- familiarity with the generally accepted
accounting principles is a key attribute
for an analyst to enable them to
establish the value
Information required for asset-based valuation
include:
• Total value of the assets
• The financing structure
• Classes of equity and other sources of
funding
POPULAR METHODS USED TO DETERMINE THE
VALUE USING ASSET
1. Book Value Method
2. Replacement Value Method
3. Reproduction Value Method
4. Liquidation Value Method
BOOK VALUE METHOD
Book value can be defined as the value
recorded in the accounting records of the
company.
 NOTES IN VALUATION METHOD

With the given information, the net book value

of the assets is P 600 per share computed as
✓ Book value is highly dependent on the
follows:
value of the assets as declared in the
audited financial statements,
particularly the balance sheet or the
statement of financial position.
• IAS No. 1 requires that the statement of
financial position to summarize the total
value of its assets, liabilities and equity
of a firm.
• Assets are required to be categorized SOLUTION:
into current and non current
✓ Current Assets – expected to be
realized within the company’s
normal operating cycle, expected to
be realized within 12 months after
these transactions were reported
• Liabilities is also categorized as current
and non current
✓ Current Liabilities – due to be settled
within 12 months
✓ Non-current Liabilities – due to be
settled longer than 12 months
Advantages and Disadvantages
Book value method the value of the enterprise
is based on the book value of the assets less
non equity claims against it.

Formula

Book Value = Total Assets - Total Liabilities

Book Value = Total Equity

REPLACEMENT VALUE METHOD

EX:
Grape and Vines Corp. in the Year 20XX
presented their statement of financial position
with the following balances: Current Assets P
500 Million; Non current Assets P 1 Billion;
Current Liabilities is P 200 Million; Non-current
Liabilities is P 700 Million and the Outstanding
shares is 1 Million.
- the value of the individual assets shall
be adjusted to reflect the relative value
or cost equivalent to replace that asset
REPLACEMENT COST
• the cost of similar assets that have the
nearest equivalent value as of the
valuation date. (National Association of
aluators and Analysts)
 NOTES IN VALUATION METHOD

Factors that can affect the replacemen value of 1. Calculate the replacement value of the
an asset affected items.

• Age of the asset - enable the valuator to 2. Add back the unadjusted components
determine the costs related in order to
upkeep a similarly aged asset and
whether assets with similar engineering
design are still available in the market 3. Apply the Replacement Value Formula
• Size of the asset - is important for fixed
assets particularly real property where
assets of the similar size will be
compared
• Competitive advantage assets - which
have distinct characteristics are hard to
replace However, the characteristics and
REPRODUCTION VALUE METHOD
capabilities of the distinct asset might
be found in similar, separate assets Reproduction value is an estimate of cost of
reproducing, creating, developing or
REPLACEMENT VALUE METHOD
manufacturing a similar asset.
The value of the equity using the replacement
Reproduction value method requires
value method is computed using the formula.
reproduction cost analysis which is internally
Replacement Value = Net Book Value ± done by companies especially if the assets are
Replacement Adjustments internally developed.

CHALLENGE IN USING THIS METHOD

EXAMPLE: Following through the given • Ability to validate the reasonableness of

information for Grapes and Vines Corp., the value calculated
suppose that 50% of the non-current assets has • Only limited sources of comparators
an estimated replacement value of 150% of its and benchmark information
recorded net book value while the remaining
STEPS IN DETERMINING THE EQUITY VALUE
half has a estimated replacement value of 75%
USING THE REPRODUCTION VALUE METHOD
of their recorded net book value With the given
ARE AS FOLLOWS
information, the equity value is adjusted:
1. Conduct reproduction costs analysis on all
assets

2. Adjust the book values to reproduction costs

values (similar as replacement value)

3. Apply the replacement value formula using

the figures calculated in the preceding step.

EX: Using the information of Grapes and Vines

Corp., supposed that it was noted that the 80%
of the total non-current assets are cheaper by
 NOTES IN VALUATION METHOD
90% of the book value when reproduced. 20%
of the total non-current assets are comprised of
goodwill which upon testing was proven to be
valued correctly
1. Conduct reproduction cost analysis to all
assets.
80% of the Total Non current Assets if
reproduced is equal to 90% of its value.
Since the remaining 20% or P 200 million is
Goodwill and already in its proper value, it will
not be adjusted.
2. Adjust the book value to reproduction costs
3. Apply the replacement value formula using
the figures calculated in the preceding step
LIQUIDATION VALUE METHOD
Liquidation value method is an equity valuation
approach that considers the salvage value as the
value of the asset. This assumes that the
reasonable value for the company to be
purchased is the amount which investors will
realize in the end of its life or the value of the
business when it is terminated.
• value of a company if it were dissolved
and its assets sold individually
• represents the net amount that can be
gathered if the business is shut down
and its assets are sold piecemeal
• considered as the minimum or floor
value for any firm valuation exercise
Appropriate to use in cases of:
• business failures
• end of life of business or project
• depletion of scarce resources
When should be used:
• when liquidation value is greater than
going concern value
• when business has finite life
• to value non operating assets
• if business continuity is dependent on
current management who will not stay
SITUATIONS TO CONSIDER LIQUIDATION VALUE
a. Business Failures - low or negative returns
are signs of business failures that is why it is the
common or usual reason why a certain business
closes or liquidates
Types of Business Failures
1. Insolvency, when a company cannot pay
liabilities as they become due
2. Bankruptcy, when liabilities become greater
than an asset balance
FACTORS CAUSING BUSINESS FAILURES
• Internal Factors can come from
mismanagement, poor financial
evaluation and decisions, failure to
execute strategic plans, inadequate cash
flow planning or failure to manage
working capital.
• External Factors are severe economic
downturn, occurrence of natural
calamities or pandemic, changing
customer preferences, and adverse
governmental regulations.
 NOTES IN VALUATION METHOD
b. Corporate/Project End of Life - normally,
corporations have stated their finite life in their
articles of Incorporation. If there will be no
extension on the corporate life, the terminal
value may be computed using liquidation value.
c. Depletion of Scarce Resources - this is most
applicable to mining and oil where availability of
scarce resources influences the value of the firm
Liquidation happens in this business when the
permits or contracts with the government
expire and the operation will no longer be
allowed to execute.
GENERAL PRINCIPLES ON LIQUIDATION
VALUE
Liquidation value is the most conservative
approach among all as it is considers the
realizable value of the asset if it is sold now
based on current conditions. This captures any
markdowns (or markups) that potential buyers
negotiate to buy the assets.
GENERAL CONCEPTS CONSIDERED IN
LIQUIDATION VALUE
• If the liquidation value is above income
approach valuation (based on going
concern principle) and liquidation
comes into consideration, liquidation
value should be used.
• If the nature of the business implies
limited lifetime (e.g. quarry, gravel, fixed
term company etc.), the terminal value
must be based on liquidation All costs
necessary to close the operations (e g
plant closure costs, disposal costs,
rehabilitation costs) should also be
factored in and deducted to arrive at
the liquidation value.
• Non operating assets should be valued
by liquidation method as the market
value reduced by costs of sales and
taxes. Since they are not part of the
firm’s operating activities, it might be
inappropriate to use the same going
concern valuation technique used for
business operations If such result is
higher than net present value of cash
flows from operating the asset, the
liquidation value should be used.
• Liquidation value must be used if the
business continuity is dependent on
current management that will not stay.
TYPES OF LIQUIDATION
Orderly liquidation - assets are sold strategically
over an orderlynperiod to attract and generate
the most money for the assets.
✓ Liquidation process will expose assets
for sale on the open market with a
reasonable time allowed to find a
purchaser, both the buyer and seller
having knowledge of the uses and
purposes to which asset is adapted and
for which it is capable of being used, the
seller being compelled to sell and the
buyer being willing, but not compelled,
to buy.
Forced liquidation - assets are sold as quickly as
possible, such as at an auction
• Liquidation is done immediately
especially if creditors have sued or
bankruptcy is filed
• Assets are sold in the market at the
soonest time possible which result in
lower prices because of the rush sale
• Ultimately drives down the liquidation
value
CALCULATING LIQUIDATION VALUE
• Liquidation value considers the present
value of the sums that can be obtained
through the disposal of the assets of the
firm in the most appropriate way, net of
the sums set aside for the closure costs,
 NOTES IN VALUATION METHOD
repayment of the debts and settlement
of all liabilities, and net of the tax
charges related to the transaction and
the costs of the process of liquidation
itself.
• It can also be computed on a per share
basis by dividing total liquidation value
by outstanding ordinary shares and be
considered together with other
quantitative and qualitative metrics to
justify business decisions to be made.
• Calculation for liquidation value at
closure date is somewhat like the book
value calculation, except the value
assumes a forced or orderly liquidation
of assets instead of book value.
• Book value should not be used as
liquidation value.
• Liquidation value can be obtained based
on the potential sales price of the assets
being sold instead of relying on the
costs recorded in the books.
• Liquidation value is far more realistic as
compared to the book value method.
• Liquidation value should be based on
the potential earning capacity of the
individual asset when sold to the buying
party instead of the original capital
invested.
• The present value of a business or
property on a liquidation basis is
computed as the estimated net
proceeds should be discounted at a rate
reflects the risk involved back to the
date of the original valuation.
• Liquidation value can be used as basis
for terminal cash flow in DCF calculation
in order to compute firm value in case
there are years that the firm will still be
operational prior to liquidation.
• Special consideration should be
emphasized for intangible assets like
patents and internally developed
software programs which are often
unsaleable.
• When takeovers occurs, it is usual that
goodwill is recognized as part of the
transactions.
• Monetary equivalent specific for
intangible assets cannot be reliably and
separately measured.
• Instead, intangible assets are offset
against shareholders’ equity to come up
with conservative liquidation value.
ILLUSTRATIVE EXAMPLE 1
Pavement Company below balances based on
its accounting books records. Pavement
company has 250,000 outstanding shares.
Pavement Company is undergoing financial
problems and management would like to assess
liquidation value as part of their strategy
formulation If assets will be sold/realized, they
will only realize amount based on the table on
the next slide.
To compute for the adjusted value of the assets,
the current book value should be multiplied by
the assumed realizable value if they are
liquidated Next, the liabilities should be
 NOTES IN VALUATION METHOD
deducted from the asset adjusted value to
arrive at the liquidation value (or net asset
Value).
ILLUSTRATIVE EXAMPLE 2
Golden Company, which is a company
specifically created for a venture agreement to
extract gold, will end its corporate life in 3 years
Net Cash Flow expected during the years it still
operate is at P 3 000 000 per year At the end of
its life Golden estimates to incur P 10 000 000
for closure and rehabilitation costs for its mining
site and other costs related to the liquidation
process Cost of capital is set at 10%. Remaining
assets by end of the corporate life will be
bought by another company for P 30 000 000
and remaining debt of P 4 000 000 will be fully
paid off by then If the valuation happens now,
compute for the value of Golden Company.
Since Golden Company will terminate its life
after 3 years, it is more appropriate to use
liquidation value as terminal value input to the
DCF model. For the three years prior to the
closure, Golden Company will continue to
generate positive Net Cash Flow and this will
form part of its value.
Since corporate life ends by Year 3, terminal
value will be based on the liquidation value by
end of Year 3.
Cash flows during the remaining operating life
and liquidation value by end of year 3 should be
combined to arrive at the value of Golden
Company now.
ILLUSTRATIVE EXAMPLE 3
Diamond Company’s statement of financial
position revealed total assets of P 3 million,
total liabilities of P 1 million, and 100 000 shares
of outstanding ordinary shares. Upon checking
with potential buyers, the assets of Diamond
can be sold for P 1 8 million if sold today
Additional P 300 000 will also be incurred to
cover liquidation expenses. How much is the
liquidation value of Diamond Company per
share?
To compute for the liquidation value in this
example, we need to consider how much the
company will receive from the assets if it will
sell today This money will also be used to pay
for the remaining liabilities and liquidation
expenses.
 NOTES IN VALUATION METHOD
CHAPTER 3: INCOME-BASED VALUATION
LECTURE CONTENTS
▪ Economic Value Added
▪ Capitalization of Earnings Method
▪ Discounted Cash Flows Method
INCOME
- based on the amount of money that the
company or the assets will generate
over the period of time
- reduced by the costs that they need to
incur in order to realize the cash inflows
and operate the assets
TWO OPPOSING THEORIES
DIVIDEND IRRELEVANCE THEORY
✓ 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
✓ the dividend or capital gains has an
impact on the price of the stock
✓ also known as dividend relevance
theory developed by Myron Gordon and
John Lintner
FACTORS TO BE CONSIDERED TO PROPERLY
VALUE AN ASSET
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, increase in prices, and even
operating efficiencies
EARNING DILUTION
reduce value if there future circumstances that
will affect the firm negatively
EQUITY CONTROL PREMIUM
the amount that is added to the value of the
firm in order to gain control of it
PRECEDENT TRANSACTIONS
previous deals or experiences that can be
similar with the investment being evaluated
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
▪ 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
▪ reflects the expected average future
cost of capital over the long run
 NOTES IN VALUATION METHOD
▪ weighing the cost of each specific type
of capital
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:
ECONOMIC VALUE ADDED
▪ 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.
ELEMENTS THAT MUST BE CONSIDERED IN
USING EVA
✓ 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
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.
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
 NOTES IN VALUATION METHOD

The value of the equity can be calculated using ▪ more verifiable since this allows for a
this formula: 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.
• In the capitalization of earnings method,
if earnings are fixed in the future, the The net cash flows may also assume a terminal
capitalization rate will be applied value that would serve as a representative value
directly to the projected fixed earnings. for the cash flows beyond projection.
• 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.

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

the most popular method of determining the

value

▪ generally used by the investors,

valuators and analyst because this is the
most sophisticated approach in
determining the corporate value