Chapter 4

INCOME
BASED
VALUATION
INCOME
INCOME is based on the amount of money that the
company or the assets will generate over a 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.
 THE DIVIDEND IRRELEVANCE
THEORY

 THE BIRD-IN-HAND THEORY

 THE DIVIDEND IRRELEVANCE THEORY

• it was introduced by Modigliani and Miller that supports

the belief that the stock prices are not affected by
dividends or returns on the stock but more on the ability
and sustainability of the asset or company.
 THE BIRD-IN-HAND THEORY

• believes that the 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.
 FACTORS THAT CAN BE CONSIDERED TO
PROPERLY VALUE THE ASSET

• EARNING ACCRETION OR DILUTION

• EQUITY CONTROL PREMIUM
• 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 the 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 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 × 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
Weighted Average Cost of Capital or 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 + ß (Rm – Rf)

Rf = risk free rate

ß = 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
portiob 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

Rf = 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 × We) + (kd × Wd)
 WACC = (ke × We) + (kd × Wd)
WACC = (15.365% × 30%) + (11% × (1 – 30%) × 70%)
WACC = 4.61% + 5.39%
WACC = 10%
The WACC is 10%. Observe that tax was considered in debt portion
to factor 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 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 company in terms of
the risk appetite. The appropriate cost of capital 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 × 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 Billion with a cost of capital
appropriate for this type of business at 10%. Given the
foregoing, the EVA is Php200 [Php350 – (Php1500 ×
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:
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:

Equity Value = Php3,750,000

Another scenario is that the future earnings are not
constant and vary every year, the suggested approach is to
determine average of earnings of all the anticipated cash
flows.
For example, Mobile Inc. projects the following net cash in
the next five years, with the required return at 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,

Equity Value = Php5,083,333

The equity value calculated is Php5,083,333. 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.
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 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
underevaluation;
(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.
THANK YOU!
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