NOTES IN VALUATION METHOD

CHAPTER 1: FUNDAMENTAL PRINCIPLES OF both time value of money and risk

VALUATION premium
INTERPRETING DIFFERENT CONCEPTS
LEARNING CONTENTS
OF VALUE
• Interpreting Different Concepts of Value
The value of a business can be basically linked to
• Roles of Valuation in Business three major factors:
• Valuation Process
• Key Principles in Valuation
• Risks in Valuation • Current operations - how is the
operating performance of the firm
VALUATION in recent year?
• the estimation of an asset’s value based
on variables perceived to be related to • Future prospects - what is the long
future investment returns, on term, strategic direction of the
comparison with similar assets or, when company?
relevant, on estimates of immediate
liquidation proceeds • Embedded risk - what are the business
risks involved in running
• includes the use of forecasts to come up
the business?
with reasonable estimate of value of an
entity’s assets or its equity
• mostly deals with projections about The definition of value may also vary depending
future events, analysts should hone on the context and objective of the valuation
their ability to balance and evaluate exercise.
different assumptions used in each
phase of the valuation exercise, assess INTRINSIC VALUE
validity of available empirical evidence - refers to the value of any asset based on the
and come up with rational choices that assumption assuming there is a hypothetically
align with the ultimate objective of the complete understanding of its investment
valuation activity characteristics It is the value that an investor
considers, on the basis of an evaluation or
available facts, to be the “ or “ value that will
INTERPRETING DIFFERENT CONCEPTS OF become the market value when other investors
VALUE reach the same conclusion
• Fundamental equation of value is GOING CONCERN VALUE
grounded on that principle as
popularized by Alfred Marshall – a - the going concern assumption believes that
company creates value if and only if the the entity will continue to do its business
return on invested capital exceed the activities into the foreseeable future
cost of acquiring capital LIQUIDATION VALUE
• Value relates to the difference between
cash inflows generated by an - the net amount that would be realized if the
investment and the cost associated with business is terminated and the assets are sold
the capital invested which captures piecemeal. It is particularly relevant for
 NOTES IN VALUATION METHOD

companies who are experiencing severe INFORMATION TRADERS

financial distress.
- they react based on new information about
FAIR MARKET VALUE firms that are revealed to the stock market The
underlying belief is that information traders are
- the price, expressed in terms of cash
more adept in guessing or getting new
equivalents, at which property would change
information about firms and they can make
hands between a hypothetical willing and able
predict how the market will react based on this.
buyer and a hypothetical willing and able seller,
acting at arm’s length in an open and ACTIVITIES CAN BE PERFORMED THROUGH THE
unrestricted market, when neither is under USE OF VALUATION TECHNIQUES:
compulsion to buy or sell and when both have
STOCK SELECTION
reasonable knowledge of the relevant facts.
-Is a particular asset fairly priced, overpriced, or
ROLES OF VALUATION IN BUSINESS
underpriced in relation to its prevailing
Portfolio Management computed intrinsic value and prices of
comparable assets?
FUNDAMENTAL ANALYSTS
DEDUCING MARKET EXPECTATIONS
- these are persons who are interested in
understanding and measuring the intrinsic value -Which estimates of a firm’s future performance
are in line with the prevailing market price of its
of a firm.
stocks? Are there assumptions about
✓ Fundamentals refer to the fundamentals that will justify the prevailing
characteristics of an entity related to its price?
financial strength, profitability or risk
ROLES OF VALUATION IN BUSINESS
appetite.
Analysis of Business Transactions/Deals
ACTIVIST INVESTORS
ACQUISITION
- activist investors tend to look for companies
with good growth prospects that have poor - an acquisition usually has two parties the
management. Activist investors usually do buying firm that needs to determine the fair
“takeovers” – they use their equity holdings to value of the target company prior to offering a
push old management out of the company and bid price and the selling firm who gauge
change the way the company is being run. reasonableness of bid offers

CHARTISTS MERGER

- they rely on the concept that stock prices are - transaction of two companies combined to
significantly influenced by how investors think form a wholly new entity
and act and on available trading KPIs such as
DIVESTITURE
Price movements, trading volume, short sales
- sale of a major component or segment of a
when making their investment decisions
business to another company
 NOTES IN VALUATION METHOD

SPIN-OFF VALUATION PROCESS

- separating a segment or component business 5 Steps in the Valuation Process

and transforming this into a separate legal entity
1. Understanding the business
whose ownership will be transferred to
2. Forecasting financial performance
shareholders
3. Selecting the right valuation model
LEVERAGE BUYOUT 4. Preparing valuation model based on
forecasts
- acquisition of another business by using
5. Applying valuation conclusions and
significant debt which uses the acquired
providing recommendation
business as a collateral.
1. UNDERSTANDING THE BUSINESS
TWO IMPORTANT UNIQUE FACTORS:
- includes performing industry and competitive
SYNERGY
analysis and analysis of publicly available
- potential increase in firm value that can be financial information and corporate disclosures
generated once two firms merge with each
One of the most common tools used in
other
encapsulating industry is Porter’s Five Forces:
CONTROL
A. Industry Rivalry - refers to the nature and
- change in people managing the organization intensity of rivalry between market players in
brought about by the acquisition the industry.

ROLES OF VALUATION IN BUSINESS - Rivalry is less intense if there is lower

number of market players or
Corporate finance involves managing the firm’s competitors which means higher
structure, including funding sources and potential for industry profitability.
strategies that the business should pursue to
maximize firm value. B. New Entrants - refers to the barriers to entry
to industry by new entrants.
Legal and Tax Purposes. Valuation is also
important to businesses because of tax and • includes entry costs, speed adjustment,
legal purposes. economies of scale, reputation,
switching costs, sunk costs and
Other Purposes government restraints
- Issuance of a fairness opinion for
C. Substitutes and Complements - this refers to
valuations provided by third party
the relationships between interrelated products
- Basis for assessment of potential and services in the industry (prices of substitute
lending activities by financial
products/services, complement products
institutions
/services and government limitations).
- Shared based payment/compensation
D. Supplier Power - refers to how suppliers can
negotiate better terms in their favor supplier
concentration, prices of alternative inputs,
relationship specific investments, supplier
switching costs and government regulations
 NOTES IN VALUATION METHOD

mandated disclosures like audited

financial statements
E. Buyer Power - pertains to how customers can
• In analyzing historical financial
negotiate better terms in their favor for
information, focus is afforded in looking
products/services they purchase ..(buyer
at quality of earnings.
concentration, value of substitute products,
• Quality of earnings analysis pertain to
customer switching costs and government
the detailed review of financial
restraints
statements and accompanying notes to
Competitive position refers to how the assess sustainability of company
products, services and the company itself is set performance and validate accuracy of
apart from other competing market players. financial information versus economic
reality.
Generic Corporate Strategies to achieve
• During analysis, transactions that are
Competitive Advantage
nonrecurring such as financial impact of
• Cost leadership - incurring the lowest litigation settlements, temporary tax
cost among market players with quality reliefs or gains/losses on sales of
that is comparable to competitors allow nonoperating assets might need to be
the firm to be price products around the adjusted to arrive at the performance of
industry average the firm’s core business.
• Differentiation - offering differentiated
2. FORECASTING FINANCIAL PERFORMANCE
or unique product or service
characteristics that customers are - can be looked at two perspectives on a macro
willing to pay for an additional premium perspective viewing the economic environment
• Focus - identifying specific demographic and industry where the firm operates in and
segment or category segment to focus micro perspective focusing in the firm’s financial
on by using cost leadership strategy or and operating characteristics
differentiation strategy
Two Approaches of Forecast Financial
Understanding Company’s Business Model Performance

• Business model pertains to the method 1. TOP DOWN FORECASTING APPROACH -

how the company makes money what international or national
are products or services they offer, how macroeconomic projections with
they deliver and provide these to utmost consideration to industry
customers and their target customers specific forecasts
• The results of execution of 2. BOTTOM UP FORECASTING APPROACH
aforementioned strategies will - forecast starts from the lower levels of
ultimately be reflected in the company the firm and builds the forecast as it
performance results contained in the captures what will happen to the
financial statements company based on the inputs of its
• Analysis of historical financial reports segments/units
typically use horizontal, vertical and
ratio analysis
• Typical sources of information about
companies can be found in government
 NOTES IN VALUATION METHOD

3. SELECTING THE RIGHT VALUATION MODEL RISKS IN VALUATION

- it depends on the context of the valuation and UNCERTAINTY

the inherent characteristics of the company
- refers to the possible range of values where
being valued
the real firm lies when performing any valuation
4. PREPARING VALUATION MODEL BASED ON method, analysts will never be sure if they have
FORECASTS accounted and included all potential risks that
may affect price of assets
- there are two aspects to be considered:
RISKS IN VALUATION
1. SENSITIVITY ANALYSIS
ASPECTS THAT CONTRIBUTES UNCERTAINTY
- common methodology in valuation exercises
wherein multiple other analyses are done to • Future estimates
understand how changes in an input or variable • Use of judgment
will affect the outcome • Business performance
• Innovations and entry of new
2. SITUATIONAL ADJUSTMENTS
businesses
- firm specific issues that affects firm value that
should be adjusted by analysts since these are
events that are not quantified if analysts only
look at core business operations

5. APPLYING VALUATION CONCLUSIONS AND

PROVIDING RECOMMENDATION

Once the value is calculated based on all

assumptions considered, the analysts and
investors use the results to provide
recommendations or make decisions thar suits
their investment objectives.

KEY PRINCIPLES IN VALUATION

• The value of a business is defined only

at a specific point in time.
• Value varies based on the ability of
business to generate future cash flows.
• Market dictates the appropriate rate of
return for investors.
• Firm value can be impacted by
underlying net tangible assets.
• Value is influenced by transferability of
future cash flows.
• Value is impacted by liquidity.
 NOTES IN VALUATION METHOD

CHAPTER 2: ASSET-BASED VALUATION The Committee of Sponsoring Organization of

the Treadway Commission (COSO) suggests that
LEARNING CONTENTS
risk management principles must be observed
1. Book Value Method in doing businesses and determining its value.
2. Replacement Value Method
Sound Enterprise wide Risk Management
3. Reproduction Value Method
allows the company to:
4. Liquidation Value Method
5. Liquidation Value 1. Increase the opportunities.
6. Situations to Consider Liquidation Value 2. Facilitates the management and
7. General Principles on Liquidation Value identification of the risk factors that
8. Types of Liquidation affect the business.
9. Calculating Liquidation Value 3. Identify or create cost efficient
opportunities.
ASSET
4. Manages the performance variability.
• transactions that would yield future 5. Improve management and distribution
economic benefits as a result of past of resources across the enterprise.
transactions 6. Make the business more resilient to
✓ the value of investment opportunities is abrupt changes.
highly dependent on the value that the
ASSET-BASED VALUATION
asset will generate from now until the
future - familiarity with the generally accepted
• value should also include all cash flows accounting principles is a key attribute
that will be generated until the disposal for an analyst to enable them to
of the asset establish the value
• GREEN FIELD INVESTMENTS
Information required for asset-based valuation
investments that started from scratch
include:
• BROWN FIELD INVESTMENTS - already
in the going concern state, as most • Total value of the assets
businesses are in the optimistic • The financing structure
perspective that they will grow in the • Classes of equity and other sources of
future funding
✓ Opportunities that can be either
POPULAR METHODS USED TO DETERMINE THE
partially or fully operational
✓ Considered as going concern business VALUE USING ASSET
opportunities (GCBO)
1. Book Value Method
GOING CONCERN BUSINESS OPPORTUNITIES ( 2. Replacement Value Method
GCBOs) 3. Reproduction Value Method
4. Liquidation Value Method
• businesses that has a long term to
infinite operational period BOOK VALUE METHOD
• risk indicators of GCBOs are identified
easily and can be quantified accordingly Book value can be defined as the value
recorded in the accounting records of the
company.
 NOTES IN VALUATION METHOD

With the given information, the net book value

of the assets is P 600 per share computed as
✓ Book value is highly dependent on the
follows:
value of the assets as declared in the
audited financial statements,
particularly the balance sheet or the
statement of financial position.
• IAS No. 1 requires that the statement of
financial position to summarize the total
value of its assets, liabilities and equity
of a firm.
• Assets are required to be categorized SOLUTION:
into current and non current
✓ Current Assets – expected to be
realized within the company’s
normal operating cycle, expected to
be realized within 12 months after
these transactions were reported
• Liabilities is also categorized as current
and non current
✓ Current Liabilities – due to be settled
within 12 months
✓ Non-current Liabilities – due to be
settled longer than 12 months
Advantages and Disadvantages
Book value method the value of the enterprise
is based on the book value of the assets less
non equity claims against it.

Formula

Book Value = Total Assets - Total Liabilities

Book Value = Total Equity

REPLACEMENT VALUE METHOD

EX:
- the value of the individual assets shall
Grape and Vines Corp. in the Year 20XX be adjusted to reflect the relative value
presented their statement of financial position or cost equivalent to replace that asset
with the following balances: Current Assets P
500 Million; Non current Assets P 1 Billion; REPLACEMENT COST
Current Liabilities is P 200 Million; Non-current • the cost of similar assets that have the
Liabilities is P 700 Million and the Outstanding nearest equivalent value as of the
shares is 1 Million. valuation date. (National Association of
aluators and Analysts)
 NOTES IN VALUATION METHOD

Factors that can affect the replacemen value of 1. Calculate the replacement value of the
an asset affected items.

• Age of the asset - enable the valuator to 2. Add back the unadjusted components
determine the costs related in order to
upkeep a similarly aged asset and
whether assets with similar engineering
design are still available in the market 3. Apply the Replacement Value Formula
• Size of the asset - is important for fixed
assets particularly real property where
assets of the similar size will be
compared
• Competitive advantage assets - which
have distinct characteristics are hard to
replace However, the characteristics and
REPRODUCTION VALUE METHOD
capabilities of the distinct asset might
be found in similar, separate assets Reproduction value is an estimate of cost of
reproducing, creating, developing or
REPLACEMENT VALUE METHOD
manufacturing a similar asset.
The value of the equity using the replacement
Reproduction value method requires
value method is computed using the formula.
reproduction cost analysis which is internally
Replacement Value = Net Book Value ± done by companies especially if the assets are
Replacement Adjustments internally developed.

CHALLENGE IN USING THIS METHOD

EXAMPLE: Following through the given • Ability to validate the reasonableness of

information for Grapes and Vines Corp., the value calculated
suppose that 50% of the non-current assets has • Only limited sources of comparators
an estimated replacement value of 150% of its and benchmark information
recorded net book value while the remaining
STEPS IN DETERMINING THE EQUITY VALUE
half has a estimated replacement value of 75%
USING THE REPRODUCTION VALUE METHOD
of their recorded net book value With the given
ARE AS FOLLOWS
information, the equity value is adjusted:
1. Conduct reproduction costs analysis on all
assets

2. Adjust the book values to reproduction costs

values (similar as replacement value)

3. Apply the replacement value formula using

the figures calculated in the preceding step.

EX: Using the information of Grapes and Vines

Corp., supposed that it was noted that the 80%
of the total non-current assets are cheaper by
 NOTES IN VALUATION METHOD

90% of the book value when reproduced. 20% • represents the net amount that can be
of the total non-current assets are comprised of gathered if the business is shut down
goodwill which upon testing was proven to be and its assets are sold piecemeal
valued correctly • considered as the minimum or floor
value for any firm valuation exercise
1. Conduct reproduction cost analysis to all
assets. Appropriate to use in cases of:
80% of the Total Non current Assets if • business failures
reproduced is equal to 90% of its value. • end of life of business or project
• depletion of scarce resources

When should be used:

Since the remaining 20% or P 200 million is
• when liquidation value is greater than
Goodwill and already in its proper value, it will
going concern value
not be adjusted.
• when business has finite life
2. Adjust the book value to reproduction costs • to value non operating assets
• if business continuity is dependent on
current management who will not stay

SITUATIONS TO CONSIDER LIQUIDATION VALUE

a. Business Failures - low or negative returns

are signs of business failures that is why it is the
common or usual reason why a certain business
3. Apply the replacement value formula using closes or liquidates
the figures calculated in the preceding step Types of Business Failures

1. Insolvency, when a company cannot pay

liabilities as they become due

2. Bankruptcy, when liabilities become greater

than an asset balance

FACTORS CAUSING BUSINESS FAILURES

LIQUIDATION VALUE METHOD • Internal Factors can come from
Liquidation value method is an equity valuation mismanagement, poor financial
approach that considers the salvage value as the evaluation and decisions, failure to
value of the asset. This assumes that the execute strategic plans, inadequate cash
reasonable value for the company to be flow planning or failure to manage
purchased is the amount which investors will working capital.
realize in the end of its life or the value of the • External Factors are severe economic
business when it is terminated. downturn, occurrence of natural
calamities or pandemic, changing
• value of a company if it were dissolved customer preferences, and adverse
and its assets sold individually governmental regulations.
 NOTES IN VALUATION METHOD

b. Corporate/Project End of Life - normally, firm’s operating activities, it might be

corporations have stated their finite life in their inappropriate to use the same going
articles of Incorporation. If there will be no concern valuation technique used for
extension on the corporate life, the terminal business operations If such result is
value may be computed using liquidation value. higher than net present value of cash
flows from operating the asset, the
c. Depletion of Scarce Resources - this is most
liquidation value should be used.
applicable to mining and oil where availability of
• Liquidation value must be used if the
scarce resources influences the value of the firm
business continuity is dependent on
Liquidation happens in this business when the
current management that will not stay.
permits or contracts with the government
expire and the operation will no longer be TYPES OF LIQUIDATION
allowed to execute.
Orderly liquidation - assets are sold strategically
GENERAL PRINCIPLES ON LIQUIDATION over an orderlynperiod to attract and generate
the most money for the assets.
VALUE
✓ Liquidation process will expose assets
Liquidation value is the most conservative
for sale on the open market with a
approach among all as it is considers the
reasonable time allowed to find a
realizable value of the asset if it is sold now
purchaser, both the buyer and seller
based on current conditions. This captures any
having knowledge of the uses and
markdowns (or markups) that potential buyers
purposes to which asset is adapted and
negotiate to buy the assets.
for which it is capable of being used, the
GENERAL CONCEPTS CONSIDERED IN seller being compelled to sell and the
buyer being willing, but not compelled,
LIQUIDATION VALUE to buy.
• If the liquidation value is above income Forced liquidation - assets are sold as quickly as
approach valuation (based on going possible, such as at an auction
concern principle) and liquidation
comes into consideration, liquidation • Liquidation is done immediately
value should be used. especially if creditors have sued or
• If the nature of the business implies bankruptcy is filed
limited lifetime (e.g. quarry, gravel, fixed • Assets are sold in the market at the
term company etc.), the terminal value soonest time possible which result in
must be based on liquidation All costs lower prices because of the rush sale
necessary to close the operations (e g • Ultimately drives down the liquidation
plant closure costs, disposal costs, value
rehabilitation costs) should also be
CALCULATING LIQUIDATION VALUE
factored in and deducted to arrive at
the liquidation value. • Liquidation value considers the present
• Non operating assets should be valued value of the sums that can be obtained
by liquidation method as the market through the disposal of the assets of the
value reduced by costs of sales and firm in the most appropriate way, net of
taxes. Since they are not part of the the sums set aside for the closure costs,
 NOTES IN VALUATION METHOD

repayment of the debts and settlement there are years that the firm will still be
of all liabilities, and net of the tax operational prior to liquidation.
charges related to the transaction and • Special consideration should be
the costs of the process of liquidation emphasized for intangible assets like
itself. patents and internally developed
• It can also be computed on a per share software programs which are often
basis by dividing total liquidation value unsaleable.
by outstanding ordinary shares and be • When takeovers occurs, it is usual that
considered together with other goodwill is recognized as part of the
quantitative and qualitative metrics to transactions.
justify business decisions to be made. • Monetary equivalent specific for
intangible assets cannot be reliably and
separately measured.
• Instead, intangible assets are offset
against shareholders’ equity to come up
with conservative liquidation value.

ILLUSTRATIVE EXAMPLE 1
• Calculation for liquidation value at
closure date is somewhat like the book Pavement Company below balances based on
value calculation, except the value its accounting books records. Pavement
assumes a forced or orderly liquidation company has 250,000 outstanding shares.
of assets instead of book value.
• Book value should not be used as
liquidation value.
• Liquidation value can be obtained based
on the potential sales price of the assets
being sold instead of relying on the
costs recorded in the books.
• Liquidation value is far more realistic as
compared to the book value method.
• Liquidation value should be based on
the potential earning capacity of the
individual asset when sold to the buying
party instead of the original capital Pavement Company is undergoing financial
invested. problems and management would like to assess
• The present value of a business or liquidation value as part of their strategy
property on a liquidation basis is formulation If assets will be sold/realized, they
computed as the estimated net will only realize amount based on the table on
proceeds should be discounted at a rate the next slide.
reflects the risk involved back to the
date of the original valuation. To compute for the adjusted value of the assets,
• Liquidation value can be used as basis the current book value should be multiplied by
for terminal cash flow in DCF calculation the assumed realizable value if they are
in order to compute firm value in case liquidated Next, the liabilities should be
 NOTES IN VALUATION METHOD

deducted from the asset adjusted value to

arrive at the liquidation value (or net asset
Value).
Since corporate life ends by Year 3, terminal
value will be based on the liquidation value by
end of Year 3.

Cash flows during the remaining operating life

and liquidation value by end of year 3 should be
ILLUSTRATIVE EXAMPLE 2 combined to arrive at the value of Golden
Company now.
Golden Company, which is a company
specifically created for a venture agreement to
extract gold, will end its corporate life in 3 years
Net Cash Flow expected during the years it still
operate is at P 3 000 000 per year At the end of
its life Golden estimates to incur P 10 000 000 ILLUSTRATIVE EXAMPLE 3
for closure and rehabilitation costs for its mining
site and other costs related to the liquidation Diamond Company’s statement of financial
process Cost of capital is set at 10%. Remaining position revealed total assets of P 3 million,
assets by end of the corporate life will be total liabilities of P 1 million, and 100 000 shares
bought by another company for P 30 000 000 of outstanding ordinary shares. Upon checking
and remaining debt of P 4 000 000 will be fully with potential buyers, the assets of Diamond
paid off by then If the valuation happens now, can be sold for P 1 8 million if sold today
compute for the value of Golden Company. Additional P 300 000 will also be incurred to
cover liquidation expenses. How much is the
Since Golden Company will terminate its life liquidation value of Diamond Company per
after 3 years, it is more appropriate to use share?
liquidation value as terminal value input to the
DCF model. For the three years prior to the To compute for the liquidation value in this
closure, Golden Company will continue to example, we need to consider how much the
generate positive Net Cash Flow and this will company will receive from the assets if it will
form part of its value. sell today This money will also be used to pay
for the remaining liabilities and liquidation
expenses.
 NOTES IN VALUATION METHOD

FACTORS TO BE CONSIDERED TO PROPERLY

VALUE AN ASSET

EARNING ACCRETION

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
CHAPTER 3: INCOME-BASED VALUATION operating efficiencies

LECTURE CONTENTS EARNING DILUTION

▪ Economic Value Added reduce value if there future circumstances that

▪ Capitalization of Earnings Method will affect the firm negatively
▪ Discounted Cash Flows Method EQUITY CONTROL PREMIUM
INCOME the amount that is added to the value of the
- based on the amount of money that the firm in order to gain control of it
company or the assets will generate PRECEDENT TRANSACTIONS
over the period of time
- reduced by the costs that they need to previous deals or experiences that can be
incur in order to realize the cash inflows similar with the investment being evaluated
and operate the assets
considered risks that may affect further the
TWO OPPOSING THEORIES ability to realize the projected earnings

DIVIDEND IRRELEVANCE THEORY ▪ In income based approach, a key driver

is the cost of capital or the required
✓ introduced by Modigliani and Miller return for a venture
that supports the belief that the stock ▪ Cost of capital can be computed
prices are not affected by dividends or through
the returns on the stock but more on a) Weighted Average Cost of Capital, or
the ability and sustainability of the asset b) Capital Asset Pricing Method
or company
WEIGHTED AVERAGE COST OF CAPITAL
BIRD-IN-HAND THEORY
▪ can be used in determining the
✓ the dividend or capital gains has an minimum required return
impact on the price of the stock ▪ can be used to determine the
✓ also known as dividend relevance appropriate cost of capital by weighing
theory developed by Myron Gordon and the portion of the asset funded through
John Lintner equity and debt
▪ reflects the expected average future
cost of capital over the long run
 NOTES IN VALUATION METHOD

▪ weighing the cost of each specific type ▪ The excess earnings shall be
of capital accumulated for the firm.
▪ The general concept here is that higher
excess earnings is better for the firm.

ELEMENTS THAT MUST BE CONSIDERED IN

USING EVA

✓ Reasonableness of earnings or returns

✓ Appropriate cost of capital

The earnings can easily determined, especially

for GCBOs based on their historical performance
WACC may also include other sources of of the similarly situated company in terms of
financing like Preferred Stock and Retained the risk appetite.
Earnings, including other sources of financing The EVA is computed using this formula:
will have to require redistributing the weight
based on the contribution to the asset EVA = Earnings – Cost of Capital

The cost of equity may be also derived using Cost of Capital = Investment value x Rate of
Capital Asset Pricing Model or CAPM Cost of Capital

The formula to be used is as follows:

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.

In capitalized earnings method, the value of the

ECONOMIC VALUE ADDED asset or the investment is determined using the
▪ The most conventional way to anticipated earnings of the company divided by
determine the value of the asset capitalization rate (i.e. cost of capital).
▪ In Economics and Financial This method provides for the relationship of the
Management, economic value added
(EVA) is a convenient metric in 1. Estimated earnings of the company
evaluating investment as it quickly 2. Expected yield or the required rate of
measures the ability of the firm to return
support its cost of capital using its 3. Estimated equity value
earnings.
▪ EVA is the excess of the company
earnings after deducting the cost of
capital.
 NOTES IN VALUATION METHOD

The value of the equity can be calculated using ▪ more verifiable since this allows for a
this formula: 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.
• In the capitalization of earnings method,
if earnings are fixed in the future, the The net cash flows may also assume a terminal
capitalization rate will be applied value that would serve as a representative value
directly to the projected fixed earnings. for the cash flows beyond projection.
• 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.

While the capitalization of earnings is simple

and convenient, there are limitations for this
method:

1. This does 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

the most popular method of determining the

value

▪ generally used by the investors,

valuators and analyst because this is the
most sophisticated approach in
determining the corporate value