Chapter 4 Income Based Valuation

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income

based on the amount of money that the company or the assets will generate over the period, and the amounts will be reduced by the costs that they need to incur to realize the cash inflows and operate the assets

income based valuation

key driver is the cost of capital/required return for a venture

dividend irrelevance theory

(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/company

bird-in-the hand theory

believes that dividend or capital gains has an impact on the price of the stock (dividend relevance theory by Myron Gordon and John Lintner)

factors that can be considered to properly value the asset

• earning accretion

• earnings dilution

• equity control premium

• precedent transactions

cost of capital

major driver in determining the equity value using income-based approaches

earning accretion

additional value inputted in the calculation that would account for the increase in value of the firm due to other quantifiable attributes (potential growth, increase in prices, and operating efficiencies)

earnings dilution

will reduce value if there are future circumstances that will affect the firm negatively

equity control premium

amount that is added to the value of the firm to gain control of it

precedent transactions

previous deals/experiences that can be similar with the investment being evaluated

weighted average cost of capital and capital asset pricing model

COMPUTATION OF COST OF CAPITAL

weighted average cost of capital

• determining the minimum required return

• used to determine the appropriate cost of capital by weighing the portion of the asset funded through equity and debt

• may also include other sources of financing (preferred stock and retained earnings)

economic value added

• most conventional way to determine the value of the asset

• Economics and Financial Management (EVA) convenient metric in evaluating investment as it quickly measures the ability of the firm to support its cost of capital using its earnings

• excess of the company earnings after deducting the cost of capital

• higher excess earnings, better for the firm

elements considered in using EVA

• reasonableness of earnings or returns

• appropriate cost of capital

capitalization of earnings method

• value of the company can also be associated with the anticipated returns or income earnings based on the historical earnings and expected earnings

• value of the asset or the investment is determined using the anticipated earnings of the company divided by the capitalization rate

• if earnings are fixed in the future, the capitalization rate will be applied directly to the projected fixed earnings

earnings

resulting cash flows from operations, but net income may also be used if cash flow information is not available

• estimated earnings of the company

• expected yield or the required rate of return

• estimated equity value

capitalization of earnings method provides for the relationship of the

equity value = future earnings / required return

formula of value of the equity

discounted cash flows method

• most popular method of determining the value

• generally used by the investors, valuators, and analysts because this is the most sophisticated approach for corporate value

• more verifiable since this allows for more detailed approach in valuation

• calculates equity value by determining the present value of the projected net cash flows of the firm

 

earnings - cost of capital

formula of EVA

investment value x rate of cost of capital

cost of capital is equal to