VALUATION CONCEPTS AND METHO! oles 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 retums 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 contro! 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 contro! 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. rit ls: |VALUATION CONCEPTS AND METH! [oily 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) + (ka X Wa) ke = cost of equity We = weight of the equity financing ka = cost of debt after tax Wa = 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 = Ry + B(Rm— Rp) Rr = risk free rate B = 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. ka = Rp+ DM Rr = 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%VALI 1ON CONCEPTS AND METHODOLOGIES equity and 70% debt, and the tax rate is 30%. The weighted average cost of capital will be computed as: WACC = (ke X We) + (Ka * wa) 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 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, 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 e 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 will be lengthily discussed in the succeeding chapters can be determined based on the mix ofVALI ION CONCEPTS AND METHO! 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 Billion 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: Equity Value = Future Earnings quity 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%.VALUATION CONCEPTS AND METHODOLOGIES The equity value is determined to be Php3,750,000 computed as follows: 7 Php450,000 Equity Value = 12% 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 flows in the next five years, with the required return of 12%: Net Cash Flows Year in Ph 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 7 2 [3 —« 50,000 + 4 5 Average Once the average of the net cash flows was determined, the equation will be applied. Php610,000 Equity Value = Pr 12% Equity Value = Php5,083,333 Sa |VALUATION CONCEPTS A! 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 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.