CHAPTER 4: INCOME BASED VALUATION

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 will generate Thus, most of them are more particular
in determining the total income that the asset will generate. 

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 cost that they need to incur in order to realize the cash
inflows and operate thy 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-the 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. 

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. These are earning accretion or dilution,
equity control premium ang Precedent transactions. 

Earning accretion is the 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. At the opposite end, earnings dilution will reduce value if there future
circumstances that will affect the firm negatively. But in both cases, these should be considered in the
sensitivity analysis. 

Equity control premium is the amount that is added to the value of the firm in order to gain control of it.
Precedent transactions, on the other hand, are previous deals or experiences that can be similar with
the investment being evaluated. These transactions are 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
Model. 

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 = (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
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: 

ke = Rf + β (Rm – Rf)
Rf = risk free rate 6
β = beta
Rm = market return 
To illustrate, 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 be 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. 

Kd = Rf + DM
Kd = risk free rate
DM = debt margin 
To illustrate, the risk-free rate is 5% and in order to borrow in the industry, a debt premium 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: 
 WACC = (ke x we) + (kd x wd)
WACC = (15.365% x 30%) + (11% x (1 — 30%) x 70%)

WACC = 4.61% + 5.39%

WACC = 10%

The WACC is 10%. Observe that tax was considered in debt portion to facto; in that the interest
incurred, or cost of debt is tax-deductible, hence, there is tax benefit from it. You may also note that the
cost of equity is higher than cost of debt, this is because cost of equity is riskier as compared to the cos
of debt which is fixed. 

It may be observed that the cost of capital is a major driver in determining the equity value using income
based approaches. In the succeeding discussions, the value of the 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 is through its economic value added. 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. 

The elements that must be considered in using EVA are: 

 Reasonableness of earnings or returns

 Appropriate cost of capital 

The earnings can easily be determined, especially for GCBOs, based on their historical performance or
the performance of the similarly-situated companyin terms of the risk appetite. The appropriate cost of
capital will be length, discussed in the succeeding chapters can be determined based on the mix of
financing that will be employed for the asset. The EVA is computed using this formula. 

EVA = Earnings - Cost of Capital

Cost of Capital = Investment value x Rate of Cost of Capital

To illustrate, Chandelier Co. projected earnings to be Php350 Million per year. The board of directors
decided to sell the company for Php1.5 Billon with a cost of capital appropriate for this type of business
at 10%. Given the 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 for 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. 

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 (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. 

The value of the equity can be calculated using this formula: 

Future earnings
Equity Value=
Required return
 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. For example, Mobile Inc. expects to earn Php450,000
per year expecting a return at 12%. 

The equity value is determined to be Php3,750,000 computed as follows:

Php 450,000
Equity Value=
12 %
Equity Value=Php 3,750,000
Another scenario is that the future earnings are not constant and vary every year, the suggested
approach is to determine average 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 Flows

(in Php)
1 450,000
2 500,000
3 650,000
4 700,000
5 750,000

To calculate for the equity value under variable net cash flows, you need to determine the average of all
the variable net cash flows in the given period Based on the given example, the average of the cash
flows is amounting to Php610,000. 

Year Net Cash Flows

(in Php)
1 450,000
2 500,000
 3 650,000
4 700,000
5 750,000
Average 610,000

Once the average of the net cash flows was determined, the equation will be applied.

Php 610,000
Equity Value=
12%
Equity Value=Php 5,083,333
The equity value calculated is Php5,083,333. In the valuation process, this value includes 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 represent the assets that
actually generate income or earnings and do not include value of the idle assets. 

Following through the information of Mobile Inc. with the calculated equity value of 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. Hence, the adjusted equity value is Php6,433,333
computed as follows: 

Capitalized Earnings Php 5,083,333

Add: Idle Assets 1,350,000

Equity Value Php 6,433,333 

While the capitalization of earnings is simple and convenient, there are limitations for this method:

(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 a
limited time horizon. 

Discounted Cash Flows Method 

Discounted Cash Flows is the most popular method of determining the value. This is generally used by
the investors, valuators and analyst because this is the most sophisticated approach in determining the
corporate value. It is also more verifiable since this allows for a 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. The net cash flows may also assume a terminal value that
would serve as a representative value for the cash flows beyond the projection. 

This approach will be discussed thoroughly in the Chapter 5.