Valuation Methods Report(Final PPT).pptx

Analysis

1. INCOME BASED VALUATION CEN TRAL MINDANAO COLLEGES PREPARED BY: QUEEN ROSS PERMANGIL ADAJAR JANICE VERANO BATIDA VANESSA CANIEDO BINOYA JEMAIMA GALOPO CATINGUB HONEY MAE ORTEGA COLINARES MITCHIE RAMOS CATUBAG

2. 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: 1. The dividend irrelevance theory- it 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. 2. Bird-in- the hand theory- believes that dividend or capital gains has the an impact on the price of the stock. This theory is also known as dividend relevance theory developed by Myron Gordon and John Lintner . INCOME BASED VALUATION

3. INCOME BASED VALUATION 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 - 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. Equity control premium - T he amount that is added to the value of the firm in order to gain control of it. Precedents transaction, 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.

4. INCOME BASED VALUATION 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 Capital Asset Pricing Model Weighted Average Cost of Capital (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 × We) + ( Kd × Wd ) Ke = cost of equity We= weight of the equity financing Kd = cost of debt after tax Wd = weight of the debt financing

5. INCOME BASED VALUATION . 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(CAPM). The formula to be used is as follows: Ke = Rf + ß ( Rm - Rf ) 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 . WACC ( Ke x We ) + ( Kd x Wd ) WACC (15.365% x 30% ) + (11% x (1- 30%) x 70%) WACC 4.61% + 5.39% WACC = 10%

6. INCOME BASED VALUATION The cost of debt can be computed by adding debt premium over the risk-free rate. Kd = Rf + DM Rf = 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 8%. Given the foregoing, the cost of the debt is 11% [5% +6% ] . Now, assuming that the share of financing is 30% equity and 70% debt, and the tax rate is 30%. The weighted average cost of capital will be computed as: WACC ( Ke x We) + ( Kd x Wd ) WACC (15.365% x 30% ) + (11% x (1- 30%) x 70%) WACC 4.61% + 5.39% WACC = 10%

7. INCOME BASED VALUATION 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 .

8. INCOME BASED VALUATION 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.

9. INCOME BASED VALUATION The elements that must be considered in using EVA are: • Reasonableness of earnings or returns • 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 financing that will be employed for the asset. The EVA is computed using this formula:

10. INCOME BASED VALUATION : 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.

11. INCOME BASED VALUATION 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, 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.

12. INCOME BASED VALUATION The value of the equity can be calculated using this formula: Equity Value = Future Earnings 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%:

13. INCOME BASED VALUATION The equity value is determined to be Php3,750,000 computed as follows: Equity Value= Php450,000 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%: Year Net Cash Flows (in Php ) 1 450,000 2 500,000 3 650,000 4 700,000 5 750,000

14. INCOME BASED VALUATION 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 (in Php ) 1 450,000 2 500,000 3 650,000 4 700,000 5 750,000 Average 610,000 Once the average of the net cash flows was determined, the equation will be applied . Equity Value = Php610,000 12% Equity Value = Php5,083,333

15. INCOME BASED VALUATION 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

16. INCOME BASED VALUATION 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.

17. INCOME BASED VALUATION 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).

18. INCOME BASED VALUATION Important Key Terms Income based valuation theorizes that the best estimate of value is based on the returns that an asset or business can generate in the future . Income based valuation approaches require the use of cost capital to calculate value of future earnings. Cost of capital can be derived using two means(based on available information): through calculating the weighted average cost of capital or through the Capital Asset Pricing Model(CAPM). Income based valuation approaches include economic value added, capitalized earnings approach and discounted cash flow approach. Economic value added calculates the excess of company earnings after deducting cost of capital. Capitalized earnings approach is a simple calculation approach which divides forecasted earnings of the company by the cost of capital. Discounted cash flow approach is the most popular method of determining the value as it considers the present value of future cash flows associated with business operations. .

19. INCOME BASED VALUATION Relevant Facts Income-based valuation refers to a set of methods used to estimate the value of a business, investment, or asset based on its capacity to generate income.These valuation methods typically involve forecasting future cash flows or earnings and discounting them to present value using an appropriate discount rate. Income-based valuation methods are widely used in various financial contexts, including mergers and acquisitions, equity valuation, and investment analysis. They provide an objective framework for assessing the financial performance and growth prospects of a business, enabling investors and business owners to make informed decisions.

20. INCOME BASED VALUATION Types of Income-Based Valuation Methods 1. Discounted Cash Flow (DCF) Method- it is a widely used income-based valuation technique that estimates the value of an investment or business by forecasting its future cash flows and discounting them to present value. Steps in Calculating DCF • Estimate future cash flows for a specific period • Determine an appropriate discount rate • Discount future cash flows to present value • Sum the present values of all discounted cash flows to obtain the total DCF value

21. 2. Dividend Discount Model (DDM )- is an income-based valuation method specifically designed for valuing equity investments, such as stocks . It calculates the value of a stock by forecasting its future dividend payments and discounting them to present value using a discount rate that reflects the required rate of return for the investment . Steps in Calculating DDM • Estimate future dividend payments for a specific period • Determine an appropriate discount rate (required rate of return ) • Discount future dividend payments to present value • Sum the present values of all discounted dividend payments to obtain the total DDM value INCOME BASED VALUATION

22. INCOME BASED VALUATION Factors Influencing Income-Based Valuation 1.Company's Financial Performance- T he financial performance of a company, including its revenue, expenses, and profit margins, is a critical factor in income-based valuation. 2 . Company's Growth Prospects- T he growth prospects of a company, such as market size, market share, and competitive advantage, also significantly influence its income-based valuation. Companies with strong growth prospects are likely to generate higher future cash flows or earnings, resulting in higher valuations. 3. Discount Rate- T he discount rate used in income-based valuation methods reflects the risk-free rate and the company's risk premium. A higher discount rate will result in a lower present value of future cash flows or earnings, leading to a lower valuation.

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24. INCOME BASED VALUATION Advantages of Income-Based Valuation Methods • Objective and Quantitative- P rovide an objective and quantitative framework for assessing the value of a business or investment, making them a popular choice among financial professionals . • Forward-Looking- Rely on projections of future cash flows or earnings. This approach enables investors and business owners to account for the potential growth and risks associated with a business or investment when determining its value. • Considers Time Value of Money- these valuation methods incorporate the time value of money, acknowledging that cash flows or earnings generated in the future are worth less than those received today. This principle is important in accurately estimating the value of a business or investment .

25. INCOME BASED VALUATION Limitations of Income-Based Valuation Methods • Reliance on Assumptions and Estimates- income-based valuation methods depend on various assumptions and estimates, such as future cash flows, earnings, and discount rates. Inaccurate or overly optimistic assumptions can lead to overvaluation, while overly pessimistic assumptions can result in undervaluation. • Sensitivity to Changes in Inputs- the valuation results obtained through income-based methods are sensitive to changes in inputs, such as cash flow projections and discount rates. • May Not Be Suitable for Companies With Irregular Cash Flows- income-based valuation methods may not be appropriate for companies with irregular or unpredictable cash flows .as it can be challenging to accurately forecast future cash flows or earnings for such businesses .

26. INCOME BASED VALUATION Choosing the Appropriate Income-Based Valuation Method • Nature of the Business- the choice of the appropriate income-based valuation method depends on the nature of the business being valued. For example, the DCF method is suitable for companies with predictable cash flows, while the DDM is more appropriate for valuing stocks that pay regular dividends . • Availability of Reliable Financial Data- reliable financial data is essential for conducting accurate income-based valuations. The availability of such data may influence the choice of the valuation method . • Industry Norms and Standards- Industry norms and standards may also dictate the choice of the valuation method. Certain industries may favor specific valuation methods based on historical practices or the unique characteristics of businesses operating within that industry .

27. INCOME BASED VALUATION Income-based valuation methods play a crucial role in investment and business decision-making, as they provide an objective and quantitative framework for assessing the financial performance and growth prospects of a business. I ncorporating future cash flows or earnings and considering the time value of money, these valuation methods enable investors and business owners to make informed decisions based on the potential value of a business or investment. I ncome-based valuation methods offer several advantages, they also have inherent limitations, such as reliance on assumptions and sensitivity to changes in inputs . To obtain accurate valuations, it is essential to balance these advantages and limitations by selecting the appropriate valuation method, considering the nature of the business, the availability of reliable financial data, and industry norms and standards.

28. VALUE ADDED TAX (VAT) AND OTHER INDIRECT TAXES Issues with Income-Based Valuation Methods Generally ( Jason Gordon, August 14,2023) Income-based valuation approaches depend on a number of criteria in valuing a firm, such as a capitalization rate, risk-related discount factors, and the projection of future cash flows. Capitalization rates are often determined from historical transactions, the market rate of return, and other indefinite factors. Discount factors are based largely upon the perception of risk and the identification of possible risk factors. Various methods, such as the build-up method and CAPM, take into consideration the systemic risk associated with investing in a firm. These methods, however, often do little to account for the firm-specific risk. The projection of future cash flows is very imprecise and rarely accurate due to the tenuous nature of startup operations. The usefulness of these projections is further distorted when they are discounted to present value .

29. INCOME BASED VALUATION Importance of Income-Based Valuation Methods These kind of valuations are an important tool for both investors and business owners, as it provides a way to determine the worth of an investment based on its potential to generate income.