Valuation using Capitalization of Income Stream

This method can be used to value a business that generates significant before-tax profits. It takes the net income of the company and capitalizes it at an appropriate rate of return produced by other investments bearing a similar level of risk. The business is valued as an investment opportunity.

You can use this method when a business produces sufficient earnings to result in goodwill value over and above the market value of the company’s assets.

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Valuing "WPP WPP PLC"

Valuation Assumptions

Latest quoted share price	£
Number of ordinary shares

Required annual rate of return	%

Latest reporting financial year
Total cash & cash equivalents	£
Total interest-bearing debts	£

Profit before tax	£
Interest expenses	£
Depreciation & other non-cash expenses	£

Valuation Results

£10.44 Highest price you can pay to get 10% annual return	12.5% Your annual return if you pay at market price £8.33
15.1% Your annual return if you pay at intrinsic value £6.93	-16.8% Value Vs Price variation

Calculations

Profit before tax	£323,666,667
+ Add interest expenses	£377,000,000
+ Add current depreciation & non-cash expenses	£422,000,000
Adjusted profit before tax	£1,122,666,667
Value of company operations (£1,122,666,667 / 10%)	£11,226,666,667
+ Add cash & cash equivalents	£2,218,000,000
- Less total interest-bearing debts	£5,995,000,000
Business intrinsic value	£7,449,666,667
Business intrinsic value per share	£6.93

+Tips & Advice

A company with strong business franchise often has consistent earnings with a long-term upward trend. Consistent earnings are usually a sign that the company is selling products that don’t need to go through the expensive process of change. The upward trend in earnings means that the business’s economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion. Steady earnings make profit projections more reliable. A company in a fiercely competitive industry is prone to booms and busts, and profits are often erratic. Its share price swings wildly, caused by the company’s unpredictable earnings and sometimes can create the illusion of buying opportunities for traditional value investors. Exponential growth in earnings is very hard to sustain. Very few companies have actually maintained high double-digit growth for a decade. Even when growth is well established, there are ceilings in every marketplace. As that ceiling is approached, growth becomes difficult to sustain and eventually fades. Look for businesses that can generate internally funded future long-term average sustainable growth of 15% to 25%.
Depreciation is an allocation of the cost of an asset over a period of time for accounting and tax purposes. It is charged against earnings on the basis that the use of capital assets is a legitimate cost of doing business. Highly competitive capital-intensive business such as car manufacturer often has depreciation expense runs anywhere from 22% to 57% of its gross profits. Companies with strong business franchise such as Coca-Cola and Procter & Gamble depreciation expense runs between 6% to 8%. Depreciation is also a non-cash expense that is added back to net income to determine the company’s cash flow.
The investor’s annual rate of return from investing in the company can be determined in three ways. You can calculate the weighted average cost of capital (WACC) of the firm as the rate of return; the built-up method using inflation, risk-free rate and equity-risk premium as the components in arriving at an appropriate rate of return or simply the minimum hurdle rate you would require for investing in the business. Most venture capital firms demand a compound annual return of 25% to 30% and many leveraged buyouts have been risky enough to warrant interest rate of 20% to 25% on their secured borrowing.
The number of common shares should be almost constant or slowly decreasing may be due to the repurchasing of outstanding shares. This helps to increase earnings per share which in turn drives up the company’s share price. A dramatic increase in the number of shares outstanding over a number of years without an increase in the company’s earnings usually means that the business is selling new shares to increase its capital base to make up for the fact that it is a mediocre business.