UNIT 5: Market‐Based Valuation Models‐II (10
Hours)
Multiples Based on Fundamentals
Enterprise value (EV) Valuation
EV multiples‐
Residual Income Valuation
Economic value added (EVA)
Market value added (MVA)
Enterprise value
Enterprise value (EV) is a measure of a company's total value, often used as a more
comprehensive alternative to equity market capitalization. EV includes not only calculation of
market capitalization of a company but also short-term and long-term debt as well as any cash
on the company's balance sheet. Enterprise value is a popular metric used to value a company
for a potential takeover.
Formula and Calculation for EV
EV= MC + Total Debt − C
where:
MC = Market capitalization; equal to the current stock price multiplied by the number of outstanding stock shares
Total debt=Equal to the sum of short-term and long-term debt
C=Cash and cash equivalents; the liquid assets of a company.
To calculate the market capitalization if not readily available you would multiply the number of outstanding
shares by the current stock price. Next, total all debt on the company's balance sheet including both short-term
and long-term debt. Finally, add the market capitalization to the total debt and subtract any cash and cash
equivalents from the result.
EBITDA (earnings before interest, taxes, depreciation, and amortization are subtracted) is probably the most frequently used
denominator for EV multiples; operating income can also be used. Because the numerator represents total company value, it
should be compared to earnings of both debt and equity owners.
An advantage of using EBITDA instead of net income is that EBITDA is usually positive even when earnings are not. When net
income is negative, value multiples based on earnings are meaningless. A disadvantage of using EBITDA is that it often includes
non‐cash revenues and expenses. A potential problem with using enterprise value is that the market value of a firm’s debt is
often not available. In this case, the analyst can use the market values of similar bonds or can use their book values. Book value,
however, may not be a good estimate of market value if firm and market conditions have changed significantly since the bonds
were issued.
Step by Step Application of Enterprise Value Formula
The Calculation of Enterprise Value equation can be done in the following six simple steps:
Firstly, the current price per share of the company has to be found out from the stock market, and then the number of paid-up
equity shares has to be collected from the balance sheet.
Now, the current market capitalization of the stock can be derived by multiplying the current price per share with the
outstanding number of paid-up equity shares.
Now, the current value of the preferred stock is computed by multiplying the par value of the stock with the number of
outstanding preference shares, which are both available in the balance sheet.
Now, the current outstanding debt balance is calculated by adding financial liabilities
like bank loans and corporate bonds, which are again available in the balance sheet.
Now, the minority interest is captured, as reported in the balance sheet.
Now, the cash and cash equivalents are computed by adding the cash balance and fixed deposits and current account deposits
with banks, which are again mentioned in the balance sheet under the current asset section
.
Let us assume that a company ABC Limited has the following financial information:
•Shares Outstanding: 2,000,000 – Number of shares
•Current Share Price: $3
•Total Debt: $3,000,000
•Total Cash: $1,000,000
Solution:
Market capitalization = 2,000,000 * $3 = $6,000,000
Preferred stock = $0
Outstanding debt = $3,000,000
Minority interest = $0
Cash and cash equivalents = $1,000,000
Based on the above formula, the calculation of the enterprise value of ABC Limited can be as follows:
•EV Formula = Market capitalization + Preferred stock + Outstanding debt + Minority interest – Cash and cash
equivalents
•Enterprise value = $6,000,000 + $0 + $3,000,000 + $0 – $1,000,000
•Enterprise value = $8,000,000 or $8 million
2. Calculate the EV from the following details
The total outstanding shares of the company A is 50 Lakh equity shares
and the current market price of this company is Rs 450 each.
The company has borrowed Rs 2 crore of loan with 18% interest and also issued preference shares worth
of Rs 1.5 crore and there is no minority interest and cash balance of the company is Rs 1 crore.
Solution:
EV Formula = Market capitalization + Preferred stock + Outstanding debt + Minority interest – Cash
and cash equivalents
Calculate the EV from the following details
A B C D
CMP 120 135 120 100
Total outstanding 10 lakh 25 lakh 22 lakh 50 lakh
shares
Bank loan 5 crore 7.5 crore 8.2 crore 9 crore
Preference stock 1.5 crore -------- 2.1 crore 3 crore
Minority interest 50 lakh 15 lakh 80 lakh 2 crore
cash 1.2 cr 2.5 cr 0.5 crore 2.1 crore
17.8 crore 38.9 cr 37 cr 61.9 cr
Residual Income Valuation
•Residual income valuation (also known as residual income model or residual income method) is an
equity valuation method that is based on the idea that the value of a company’s stock equals the
present value of future residual incomes discounted at the appropriate cost of equity.
•Residual income is the income a company generates after accounting for the cost of capital.
•The residual income valuation formula is very similar to a multistage dividend discount model,
substituting future dividend payments for future residual earnings.
•Residual income models make use of data readily available from a firm's financial statements.
•These models look at the economic profitability of a firm rather than just its accounting profitability.
Formula
Residual income valuation model
Vo= BV0 + RI t1 + RI t2 + RI t3 . . . . . . Rn
(1 + r)1 (1+r)2 (1+r)3 (1+r)n
V0 = value of a company's stock
BV0 = book value
r = cost of equity
RI_t = residual income in future periods
t = time
Company Residual income yearly Book value Return on equity (%) V0
A 100 12 146
1st – 10
2nd –20
3rd -30
B 150 13 189.7
1st – 12
2nd –15
3rd -25
C 175 13 227.3
1st – 20
2nd –22
3rd -25
D 200 14 258.5
1st – 24
2nd –25
3rd -27
E 225 12 288.9
1st – 24
Company Residual income yearly Book value Return on equity (%) V0
A 120 10 222.4
1st – 35
2nd – 40
3rd - 50
B 170 11 312.17
1st – 28
2nd –35
3rd -40
4th - 90
C 195 10 285.8
1st – 30
2nd –45
3rd -35
D 210 12 351.6
1st – 30
2nd –40
3rd -45
Residual income valuation model
A Vo= BV0 + R1 + R2 + R3
(1 + r)1 (1+r)2 (1+r)3
= 100 + 10 / (1+.12)1 + 20 / (1+.12)2 + 30 / (1+.12)3
= 100 + 10
= 146.23
Economic value added (EVA)
Economic value added (EVA) is a measure of a company's financial performance based on the residual wealth
calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA
can also be referred to as economic profit, as it attempts to capture the true economic profit of a company.
This measure was devised by management consulting firm Stern Value Management, originally incorporated
as Stern Stewart & Co.
The formula for calculating EVA is:
EVA = NOPAT - (Invested Capital * WACC)
Where:
•NOPAT = Net operating profit after taxes
•Invested capital = Debt + capital leases + shareholders' equity
•WACC = Weighted average cost of capital
Example – Calculating EVA for XX Company
2018 2019 2020
Capital invested $54,236.00 $50,323.00 $55,979.00
(beginning of year)
x WACC 8.22% 8.28% 8.37%
Finance Charge $4,459.56 $4,168.90 $4,682.80
NOPAT $7,265.00 $5,356.00 $4,336.00
– Finance Charge $4,459.56 $4,168.90 $4,685
Economic Value $2,805.44 $1,187.10 -$346.80
Added
Calculate EVA from the following when the tax rate is 30%
$ A B C D E F
Profit 12000 14000 15000 12500 14520 16850
before tax
The WACC 12% 14% 13.5% 10% 8.5% 15.5%
The total 60000 58500 62500 61450 25000 105000
capital
invested
A B C D E F
Capital 60000 58500 62500 61450 25000 105000
invested
(beginning of
year)
x WACC 12% 14% 13.5% 10% 8.5% 15.5%
Finance 7200 8190 8437.5 6145 2125 16275
Charge
NOPAT 12000-30% 14000 – 30% 15000 – 30% 12500-30% 14520-30% 16850-30%
= 8400 = 9800 = 10500 = 8750 = 10164 11795
– Finance 7200 8190 8437.5 6145 2125 16275
Charge
Economic 1200 1610 2062.5 2605 8039 -4480
Value Added
A B C D E F
Capital 60000 58500 62500 61450 25000 105000
invested
(beginning of
year)
x WACC 12% 14% 13.5% 10% 8.5% 15.5%
Finance 7200 8190 8437.5 6145 2125 16275
Charge
NOPAT 12000-30% 14000 – 30% 15000 – 30% 12500-30% 14520-30% 16850-30%
= 8400 = 9800 = 10500 = 8750 = 10164 11795
– Finance 7200 8190 8437.5 6145 2125 16275
Charge
Economic 1200 1610 2062.5 2605 8039 -4480
Value Added
2. Calculate EVA from the following
when the tax rate is 35%
$ A B C D E F
Profit before tax 25250 20500 15200 25200 34520 17850
The WACC 12.5% 13.4% 7.5% 11.5% 8.5% 14.7%
The total capital Equity= Equity= 90000 Equity= 80000 Equity= 20000 Equity= 70000 Equity= 75000
invested 100000 Debt = 120000 Debt = 70000 Debt = 40000 Debt = 40000 Debt = 25000
Debt =
200000
A B C D E F
Capital invested
(beginning of
year)
x WACC
Finance Charge
NOPAT
– Finance Charge
Economic Value - 21087.5 -14815 -1370 9480 13088 -3097.5
Added
MARKET VALUE ADDED
Market value added (MVA) is the difference between the market value of a firm’s long‐term debt
and equity and the book value of invested capital supplied by investors. It measures the value
created by management’s decisions since the firm’s inception.
