Economic Value

Added and
Capitalization of
Earnings Approach
 Income
Based
Valuation
 Dividend The
Irrelevance Bird-in-hand
●
Theory
Introduced by Modigliani and ●
Theory
Developed by Myron Gordon
Miller and John Lintner.
● supports the belief that the ● believes that dividend or
stock prices are not affected capital gains has an impact
by dividends or the returns on the price of the stock.
on the stock but more on the
ability and sustainability of
the asset or company.
 Earning Earnings
Accretion Dilution
● the additional value ● will reduce value if their
inputted in the calculation future circumstances that
that would account for the will affect the firm
increase in value of the firm negatively.
due to other quantifiable
attributes
Equity Control Precedent
Premium Transactions

● the amount that is added ● previous deals or

to the value of the firm in experiences that can be
order to gain control of it. similar with the investment
being evaluated.
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 Weighted
Average Cost of Capital or (b) Capital Asset
Pricing Model.
 Example

Suppose I promise to give you $1,000 next year in

exchange for money upfront. What’s the most you would
be willing to pay me for that today? Would you be willing
to pay me $500? What about $800?
● Low risk = low return

● High risk = high return

 Capital Asset Pricing Model (CAPM)

It is a framework for quantifying cost of equity.

The CAPM divides risk into two components:
● Unsystematic (company-specific) risk
● Systematic risk
Unsystematic Systematic
(company-sp risk
ecific) risk
● Risk that can be diversified ● the non-diversifiable portion
away (so ignore this risk). that is related to the
movement of the stock
market and is therefore
unavoidable, so investors will
demand returns for assuming
this risk.
ADVANTAGES OF
CAPM
ADVANTAGES OF CAPM
▪ The CAPM has several advantages over other
methods of calculating required return,
explaining why it has been popular for more
than 40 years:
▪ It considers only systematic risk, reflecting a
reality in which most investors have diversified
portfolios from which unsystematic risk has been
essentially eliminated.
▪ It is a theoretically-derived relationship between
required return and systematic risk which has
been subject to frequent empirical research and
testing.
ADVANTAGES OF CAPM
▪ It is generally seen as a much better method of
calculating the cost of equity than the dividend
growth model (DGM) in that it explicitly
considers a company’s level of systematic risk
relative to the stock market as a whole.
▪ It is clearly superior to the WACC in providing
discount rates for use in investment appraisal.
Disadvantages of the CAPM
Disadvantages of the CAPM
The disadvantage in using the CAPM in investment appraisal
is that the assumption of a single-period time horizon is at odds
with the multi-period nature of investment appraisal.

While CAPM variables can be assumed constant in

successive future periods, experience indicates that this is not
true in the real world.
 WEIGHTED
AVERAGE COST OF
CAPITAL (WACC)
WEIGHTED AVERAGE COST
OF CAPITAL (WACC)
▪ It 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 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:
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.
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% equity and 70% debt, and the tax rate is
30%. The weighted average cost of capital will be
computed as:
 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
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.
● the excess of the company earnings after deducting
the cost of capital.
The elements that must be considered in
using EVA are:

• Reasonableness of earnings or
• Returns Appropriate cost of capital
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 %)].
Capitalization of Earnings Method
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.
CAPITALIZATION OF EARNINGS METHOD
• 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

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%.

The equity value is determined to be

Php3,750,000 computed as follows:

Equity Value = Php450,000

12%
=Php 3,750,000
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%:
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.

Once the average of the net cash flows was determined, the equation will be
applied.
Equity Value = Php610,000
12%
=Php 5,083,333
The equity value calculated is Php 5,083,333. In the valuation
process, this value includes 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 Php 5,083,333, 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 Php 6,433,333 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 cash flows may not
hold true since the projections are based on a limited time
horizon.
THANK YOU

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