CHAPTER 04: INCOME BASED VALUATION
Economic Value Added
● The EVA is a convenient metric in evaluating investment as itquicklymeasures
the ability of the firm to support its cost of capital using its earnings.
● It is the excess of the company earnings after deducting the cost of capital.
● Two elements to be considered are: reasonableness of earnings or returnsand
appropriate cost of capital.
Formula for EVA:
EVA = Earnings - Cost of Capital
COC = Investment Value x Rate of Cost of Capital (WACC)
Capitalization of Earnings Method
● In this method, the value of theassetortheinvestmentisdeterminedusingthe
anticipatedearningsofthecompanydividedbythecapitalizationrate(costof
capital). This method provides for the relationship of the estimated earnings of
the company, expected yield or therequiredrateofreturn,andtheestimated
equity value.
● Limitations are:
➔ Does not fully account for the future earnings or cash flows thereby
resulting in over or undervaluation.
➔ Inability to incorporate contingencies.
➔ Assumptionsusedtodeterminethecashflowsmaynotholdtruesincethe
projections are based on a limited time horizon.
Formula for Equity Value:
Future Earnings / Required Return
Formula for Equity Value with Variable Net Cash Flows
Average of Net Cash Flows / Required Return
Discounted Cash Flows Method
● Most popular method of determining the equity value.
● Generally used by the investors, valuators, and analysts because it is the most
sophisticated approach in determining the corporate value.
● TheDCFModelcalculatestheequityvaluebydeterminingthepresentvalueof
the projected net cash flows ofthefirm.Thenetcashflowsmayalsoassumea
terminal value that would serve as a representative value for the cash flows
beyond the projection.
