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    The financial statements include the income statement, balance sheet, and statement of cash flows, of which the income statement is most

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    Document 5

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    The financial statements include the income statement, balance sheet, and statement of cash flows, of which the income statement is most

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    The financial statements include the income statement, balance sheet, and statement of cash flows, of which the income statement is most

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    56 views17 pages

    Document 5

    Uploaded by

    Mika Molina
    The financial statements include the income statement, balance sheet, and statement of cash flows, of which the income statement is most

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 17

    VALUATION CONCEPTS AND METHODOLOGIES

    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 Phpl
    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 Eamings Php
    Add: Idle Assets
    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.
    The equity value is determined to be computed as follows.
    Php450,OOO
    Equity Value =
    12%
    Equity Value =
    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 flows in the next five
    years, with the required retum of
    VALUATION CONCEPTS AND METHODOLOGIES

    that Will be employed foc the asset, Tho EVA computed this formula

    EVA = - Cost of Capital

    Cost o/ Capual Investntent value x Rate o/ (.'ost o/ Capital

    To Illustrate, Chandelier Co. projected earnings to be Php350 Million pec


    year,
    The board of directors decided to sell the company for Phpl Billion With
    a cost of capital appropriate foc this type of business at 10%. Given the
    foregoing, the EVA IS Php200 [Php360 (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 eam Php450,000 per
    year expecting a retum at 12%,

    86
    capital equity and will be 70% computed debt, and as:the tax rate is 30%. The
    weighted average cost q

    WACC = (ke X we) + (Rd 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 in
    that the interest incurred, or cost of debt is tax-deductible, hence, there
    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 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


    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 will be lengthilY discussed in the succeeding chapters can be
    determined based on the miX0f
    85
    VALUATION CONCEPTS AND METHODOLOGIES

    Average Cost of Capital or WACC formula can be used in Weighted


    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 = (Ice X we) + (k d 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:

    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 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.

    ltd =

    Rf = risk free rate


    DM debt margin
    TO illustratef the risk-free rate is 5% and jn 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% 15% + 6%]. Now, assuming that the share of financing is
    30%
    VALUATION CONCEPTS AND METHODOLOGIES

    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 it 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
    costs that they need to incur in order to realize the cash inflows and operate
    the 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 and 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, eamings 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

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