Title Page

Holy Angel University

Income Based
Valuation
XVALCON A435|A436
 Title Page Reporters Introduction

Income Based Valuation

Introduction
The bast estimate for the value of the
company or an asset is the value of
the returns that it will yield or income
that it will generate.

Income is based on the amount of

money that the company or asset will
generate over the period of time
reduced by the costs incurred in order
to realize the cash inflows and operate
the assets.
 Title Page Reporters Introduction

Income Based Valuation

Investors consider two opposing theories:

Dividend Irrelevance Theory Bird-in-hand Theory

This theory was introduced by Modigliani and Bird-in-the-hand theory believes that dividend
Miller that supports the belief that the stock or capital gains has impact on the price of the
prices are not affected by dividends or the stock. This theory is also known as dividend
returns on the stock but more on the ability relevance theory developed by Myron Gordon
and sustainability of the asset or company. and John Lintner.
 Title Page Reporters Introduction Introduction

Income Based Valuation

Factors to consider to properly value an

asset
Earning Accretion or Equity Control Precedent
Dilution Premium Transaction
Previous deals or
• Earning accretion is the Equity control premium
experiences that can be
additional value inputted in is the amount that is
similar with the
the calculation that would added to the value of the
investment being
account for the increase in firm in order to control
evaluated. These
the value of the firm. gain control of it.
transactions are
• Earning dilution will reduce
considered risks that
value if there future
may affect further the
circumstances that will
ability to realize the
affect the firm negatively
projected earnings.
• Both shall be considered in
sensitivity analysis.
Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Cost of Capital
• Cost of Capital is the rate of return necessary to maintain value or stock price of a
firm.
• The cost of using funds; it is also called the hurdle rate, required rate of return, or
cut-off rate.
• The weighted average rate of return the company must pay to its long-term
creditors and shareholders for the use of their funds.
• Cost of Capital is used for; (1) making capital budgeting decisions, (2) making long-
term financing decisions, and (3) helping establish the optimal capital structure.
• Cost of Capital is computed as a weighted average of the various long-term capital
sources that are items mostly found on the right-hand side of the balance sheet
such as long-term debt, preferred stock, common stock and retained earnings.
Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Computation of Cost of Capital

Source Caputal Cost of Capital

Creditors Long-term Debt After-tax yield rate; Yield Rate (1-TR)

Stockholders

Preferred dividends per share divided by

Preferred Preference shares
current market price or net issuance price

Capital Asset Pricing Model (CAPM) or

Common Ordinary Shares
Dividend Growth Model
Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Cost of Long-term Debt (Kd)

• Where, Rf is the risk free rate and DM is debt margin.

• Investors providing debt to companies expose themselves to risk since companies
can default on their obligations to lenders, whether they are banks or bondholders.
• To compensate them for taking on this default risk lenders require a higher return
for lending to a company rather than a government and this is known as the “debt
margin”, which is the difference in the redemption yield on a corporate bond and
the yield on a government bond (risk free rate).
Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Cost of Long-term Debt (Kd)

• YTM = yield to maturity

• Yield rate is based on a debts instrument’s effective interest rate, rather than its
nominal interest rate.
• Cost of long term debt is expressed as after tax since interest charges are tax
deductible expense.
Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Cost of Preferred Stocks (Kp)

• Dividend per share = preferred dividend rate x par value per share.
• Market price per share should be net of any floatation cost or issue cost.
• FLOTATION COST is the cost of issuing or ‘floating’ securities in the market,
normally incurred by issuing Initial Public Offering (IPO) shares in the exchange
market. The typical costs of selling stock include underwriter’s spread, direct
expenses, indirect expenses, abnormal returns, underpricing.
• Unlike the cost of common stock, growth rate is not added to the preferred dividend
yield since preferred dividends are relatively fixed every year.
• Tax is not considered since dividends paid are not deductible for tax purposes (i.e.,
no tax shield).
 Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Cost of Common Stock (CS) and

Retained Earnings (RE) - (Ke)
Gordon Model or Dividend Growth Model

• Where: P0 = current market price, D1 = next dividend, and G is the growth rate in
dividends per share (it is assumed that the dividend payout ration, retention rate,
and therefore the EPS growth rate are constant).
• For the cost of new CS, deduct floatation cost from the current market price.
 Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Capital Asset Pricing Model (CAPM)

• Where:
⚬ KRF is the risk free rate determined by government securities
⚬ β is the beta coefficient of an individual stock which is the correlation between
the volatility (price variation) of the stock market and the volatility of the price
of the individual stock.
⚬ KM is the market rate of return
⚬ KM - KRF is the market risk premium or the amount above risk free rate required
to induce average investors to enter the market.
⚬ β (KM-KRF) is the risk premium
 Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Capital Asset Pricing Model (CAPM)

• A security risk consists of two components: 1) diversifiable risks and 2) non-
diversifiable risks.
• DIVERSIFIABLE RISK, a.k.a. controllable risk or unsystematic risk or company-
specific risk, represents the portion of a security’s risk that can be controlled
through diversification. This type of risk is unique to a given security. Business,
liquidity, and default risks fall into this category.
⚬ BUSINESS RISK is caused by fluctuations of earnings before interest and taxes
(operating income). It depends on variability in demand, sales price, input
prices, and amount of operating leverage.
⚬ LIQUIDITY RISK is the possibility that an asset may not be sold on short notice
for its market value. If an asset is sold at a high discount, then it is said to have
a high level of liquidity risk.
⚬ DEFAULT RISK is the risk that a borrower will be unable to make interest
payments or principal repayments on debt.
 Title Page Reporters Introduction Cost of Capital

Income Based Valuation

Capital Asset Pricing Model (CAPM)

• NON-DIVERSIFIABLE RISK, a.k.a. noncontrollable risk or systematic risk or market-
related risk, results from forces outside of the firm’s control and is therefore not
unique to the given security. Purchasing power, interest rate, and market risks fall
into this category.
⚬ MARKET RISK is the risk that a stock’s price will change due to changes in stock
market as a whole since prices of all stocks are correlated to some degree with
broad swings in the stock market.
⚬ INTEREST RATE RISK is the risk resulting from fluctuations in the value of an
asset as interest rates change. For example, if interest rates rise (fall), bond
prices fall (rise).
⚬ PURCHASING POWER RISK is the risk that a rise in price will reduce the quantity
of goods that can be purchased with a fixed sum of money.
 Title Page Reporters Introduction Cost of Capital EVA

Income Based Valuation

Economic Value Added (EVA)

• 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 earning after deducting the cost of capital.
• Elements that must be considered in using EVA:
⚬ Reasonableness of earnings or returns
⚬ Appropriate COC.
• Economic Value Added (EVA) is the net operating profit minus an appropriate charge for the
opportunity cost of all capital invested in an enterprise or project. It is an estimate of true
economic profit, or amount by which earnings exceed or fall short of the required minimum
rate of return investors could get by investing in other securities of comparable risk
• Formula: EVA = Earnings - Cost of Capital, where COC is equal to Investment Value * Rate of
COC.
• Other formula: EVA = NOPAT - (Invested Capital * WACC)
 Capitalization of
Title Page Reporters Introduction Cost of Capital EVA
Earnings Method

income Based Valuation

Capitalization of Earnings Method

• The value of the company can also be associated with the anticipated returns
or income earning based on the historical earnings and expected earnings.
• In this method, the value of the asset or the investment is determined using
the anticipated earning of the company divided by the capitalization rate (i.e.,
COC)
• This method provides for the relationship of the (1) estimated earning of the
company; (2) expected yield or the required rate of return; (3) estimated
equity value.
• Formula: Equity Value = Future Earnings divided by Required Return
• IF earnings are fixed in the future, the capitalization rate will be applied
directly to the projected fixed earnings.
• IF earnings are not constant and vary every year, determine the average
earnings using simple average then divide the average by required rate of
 Capitalization of
Title Page Reporters Introduction Cost of Capital EVA
Earnings Method

income Based Valuation

Capitalization of Earnings Method

• Limitations of this method:
⚬ This does may not fully account for the future earnings or cash flows
thereby resulting to over or undervaluation;
⚬ Inability to incorporate contingencies;
⚬ Assumptions used to determine the cashflow may not hold true since the
projections are based on a limited time horizons.
 Capitalization of
Title Page Reporters Introduction Cost of Capital EVA DCF
Earnings
Method

Income Based Valuation

Discounted Cash Flow Method

• Most popular method of determining the value.
• The discounted cash flows or DCF Model calculated the equity value by
determining the present value of the projected net cash flows of the
firms.
• The net cash flows may also assume a terminal value that would serve as
a representative value for the cash flows beyond the projection.
Title Page Reporters

Income Based Valuation

ANY QUESTIONS?