Valuation

The Big Picture

AswathDamodaran
http://www.damodaran.com

Aswath Damodaran

DCF Choices: Equity Valuation versus Firm

Valuation
FirmValuation:Valuetheentirebusiness
Assets
ExistingInvestments
Generatecashflowstoday
Includeslonglived(fixed)and
shortlived(working
capital)assets
ExpectedValuethatwillbe
createdbyfutureinvestments

Liabilities

AssetsinPlace

Debt

GrowthAssets

Equity

FixedClaimoncashflows
LittleorNoroleinmanagement
FixedMaturity
TaxDeductible

ResidualClaimoncashflows
SignificantRoleinmanagement
PerpetualLives

Equityvaluation:Valuejustthe
equityclaiminthebusiness

Aswath Damodaran

Equity Valuation

Figure5.5:Equity Valuation
Assets
Cashflowsconsideredare
cashflowsfromassets,
afterdebtpaymentsand
aftermakingreinvestments
neededforfuturegrowth

AssetsinPlace

GrowthAssets

Liabilities
Debt

Equity

Discountratereflectsonlythe
costofraisingequityfinancing

Presentvalueisvalueofjusttheequityclaimsonthefirm

Aswath Damodaran

Firm Valuation

Figure5.6:FirmValuation
Assets
Cashflowsconsideredare
cashflowsfromassets,
priortoanydebtpayments
butafterfirmhas
reinvestedtocreategrowth
assets

AssetsinPlace

GrowthAssets

Liabilities
Debt

Equity

Discountratereflectsthecost
ofraisingbothdebtandequity
financing,inproportiontotheir
use

Presentvalueisvalueoftheentirefirm,andreflectsthevalueof
allclaimsonthefirm.

Aswath Damodaran

DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF

Value of Operating Assets

+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity

Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)

Beta
- Measures market risk

Type of
Business

Aswath Damodaran

Firm is in stable growth:

Grows at constant rate
forever

Terminal Value= FCFF n+1 /(r-g n)

FCFF1
FCFF2
FCFF3
FCFF4
FCFF5
FCFFn
.........
Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows

Expected Growth
Reinvestment Rate
* Return on Capital

Operating
Leverage

Weights
Based on Market Value

Risk Premium
- Premium for average
risk investment

Financial
Leverage

Base Equity
Premium

Country Risk
Premium

Embraer: Status Quo ($)

Avg Reinvestment
rate = 25.08%
Current Cashflow to Firm
EBIT(1-t) :
$ 404
- Nt CpX
23
- Chg WC
9
= FCFF
$ 372
Reinvestment Rate = 32/404= 7.9%

Reinvestment Rate
25.08%

Return on Capital
21.85%

Expected Growth
in EBIT (1-t)
.2185*.2508=.0548
5.48 %

Terminal Value5= 288/(.0876-.0417) = 6272

$ Cashflows
Op. Assets $ 5,272
+ Cash:
795
- Debt
717
- Minor. Int.
12
=Equity
5,349
-Options
28
Value/Share $7.47
R$ 21.75

Year
EBIT(1-t)
- Reinvestment
= FCFF

1
426
107
319

3
474
119
355

4
500
126
374

Term Yr
549
- 261
= 288

5
527
132
395

Discount at$ Cost of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81%

Cost of Equity
10.52 %

Riskfree Rate:
$ Riskfree Rate= 4.17%

Cost of Debt
(4.17%+1%+4%)(1-.34)
= 6.05%

Beta
1.07

Unlevered Beta for

Sectors: 0.95

Aswath Damodaran

2
449
113
336

Stable Growth
g = 4.17%; Beta = 1.00;
Country Premium= 5%
Cost of capital = 8.76%
ROC= 8.76%; Tax rate=34%
Reinvestment Rate=g/ROC
=4.17/8.76= 47.62%

On October 6, 2003
Embraer Price = R$15.51

Weights
E = 84% D = 16%

Mature market
premium
4%
Firms D/E
Ratio: 19%

Lambda
0.27

Country Equity Risk

Premium
7.67%

Country Default
Spread
6.01%

Rel Equity
Mkt Vol
1.28

Ambev: Status Quo ($)

Current Cashflow to Firm
EBIT(1-t) :
504
- Nt CpX
146
- Chg WC
124
= FCFF
$ 233
Reinvestment Rate = 270/504= 53.7%

Return on Capital
16.24%

Reinvestment Rate
53.7%

Terminal Value5= 641/(.0994-.047) = 12,249

$ Cashflows
Op. Assets $ 6546
+ Cash:
743
- Debt
1848
- Minor. Int.
137
=Equity
5304
-Options
0
Value/Sh $137.62
R$ 433/sh

Year
EBIT(1t)
Reinvestment
FCFF

1
$548
$294
$253

2
$595
$320
$276

3
$647
$348
$300

4
$704
$378
$326

5
$765
$411
$354

6
$832
$447
$385

7
$904
$486
$419

8
$983
$528
$455

9
10
$1069 $1162
$574 $624
$495 $538

Term Yr
1217
- 576
= 641

Discount at$ Cost of Capital (WACC) = 11.41% (.84) + 7.06% (0.16) = 10.70%

Cost of Equity
11.41 %

Riskfree Rate:
$ Riskfree Rate= 4.70%

Cost of Debt
(4.70%+2%+4%)(1-.34)
= 7.06%

Beta
0.87

Unlevered Beta for

Sectors: 0.77

Aswath Damodaran

Stable Growth
g = 4.70%; Beta = 1.00;
Country Premium= 5%
Cost of capital = 9.94%
ROC= 9.94%; Tax rate=34%
Reinvestment Rate=g/ROC
=4.70/9.94= 47.31%

Expected Growth
in EBIT (1-t)
.537*.1624=.0872
8.72 %

On May 24, 2004

Ambev Common = R$1140
Ambev Pref = 500

Weights
E = 84% D = 16%

Mature market
premium
4%
Firms D/E
Ratio: 19.4%

Lambda
0.41

Country Equity Risk

Premium
7.87%

Country Default
Spread
6.50%

Rel Equity
Mkt Vol
1.21

I. The Cost of Capital

Aswath Damodaran

The Cost of Capital is central to both corporate

finance and valuation

Incorporatefinance,thecostofcapitalisimportantbecause
Itoperatesasthehurdleratewhenconsideringnewinvestments
Itisthemetricthatallowsfirmstochoosetheiroptimalcapitalstructure

Invaluation,itisthediscountratethatweusetovaluetheoperating
assetsofthefirm.

Aswath Damodaran

I. The Cost of Equity

Preferably, a bottom-up beta,

based upon other firms in the
business, and firms own financial
leverage
Cost of Equity =

Riskfree Rate

Has to be in the same

currency as cash flows,
and defined in same terms
(real or nominal) as the
cash flows

Aswath Damodaran

Beta

(Risk Premium)

Historical Premium
1. Mature Equity Market Premium:
Average premium earned by
stocks over T.Bonds in U.S.
2. Country risk premium =
Country Default Spread* ( Equity/Countrybond)

or

Implied Premium
Based on how equity
market is priced today
and a simple valuation
model

10

A Simple Test

YouarevaluingAmbevinU.S.dollarsandareattemptingtoestimate
ariskfreeratetouseintheanalysis.Theriskfreeratethatyoushould
useis
TheinterestrateonanominalrealdenominatedBraziliangovernment
bond
TheinterestrateonaninflationindexedBraziliangovernmentbond
TheinterestrateonadollardenominatedBraziliangovernmentbond
(11.20%)
TheinterestrateonaU.S.treasurybond(4.70%)

Aswath Damodaran

11

Everyone uses historical premiums, but..

Thehistoricalpremiumisthepremiumthatstockshavehistoricallyearned
overrisklesssecurities.
Practitionersneverseemtoagreeonthepremium;itissensitiveto

Howfarbackyougoinhistory
WhetheryouuseT.billratesorT.Bondrates
Whetheryouusegeometricorarithmeticaverages.

Forinstance,lookingattheUS:
Arithmeticaverage
Stocks Stocks
HistoricalPeriod
T.Bills T.Bonds
19282004
7.92% 6.53%
19642004
5.82% 4.34%
19942004
8.60% 5.82%

Aswath Damodaran

GeometricAverage
Stocks Stocks
T.Bills T.Bonds
6.02% 4.84%
4.59% 3.47%
6.85% 4.51%

12

Two Ways of Estimating Country Risk

Premiums September 2003

DefaultspreadonCountryBond:Inthisapproach,thecountryriskpremium
isbaseduponthedefaultspreadofthebondissuedbythecountry(butonlyif
itisdenominatedinacurrencywhereadefaultfreeentityexists.

BrazilwasratedB2byMoodysandthedefaultspreadontheBraziliandollar
denominatedC.BondattheendofSeptember2003was6.01%.(10.18%4.17%)

RelativeEquityMarketapproach:Thecountryriskpremiumisbaseduponthe
volatilityofthemarketinquestionrelativetoU.Smarket.
Countryriskpremium=RiskPremiumUS*CountryEquity/USEquity
Usinga4.53%premiumfortheUS,thisapproachwouldyield:
TotalriskpremiumforBrazil=4.53%(33.37%/18.59%)=8.13%
CountryriskpremiumforBrazil=8.13%4.53%=3.60%
(Thestandarddeviationinweeklyreturnsfrom2001to2003fortheBovespawas
33.37%whereasthestandarddeviationintheS&P500was18.59%)

Aswath Damodaran

13

And a third approach

Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsand
equityriskpremiumsarehighlycorrelated,onewouldexpectequity
spreadstobehigherthandebtspreads.
Anotheristomultiplythebonddefaultspreadbytherelativevolatility
ofstockandbondpricesinthatmarket.Inthisapproach:
Countryriskpremium=Defaultspreadoncountrybond*CountryEquity/
CountryBond
StandardDeviationinBovespa(Equity)=33.37%
StandardDeviationinBrazilCBond=26.15%
DefaultspreadonCBond=6.01%

CountryRiskPremiumforBrazil=6.01%(33.37%/26.15%)=7.67%

Aswath Damodaran

14

Can country risk premiums change? Updating

Brazil in January 2005

Brazilsfinancialstandingandcountryratingimproveddramatically
towardstheendof2004.ItsratingimprovedtoB1.InJanuary2005,
theinterestrateontheBrazilianCBonddroppedto7.73%.TheUS
treasurybondratethatdaywas4.22%,yieldingadefaultspreadof
3.51%forBrazil.

Aswath Damodaran

StandardDeviationinBovespa(Equity)=25.09%
StandardDeviationinBrazilCBond=15.12%
DefaultspreadonCBond=3.51%
CountryRiskPremiumforBrazil=3.51%(25.09%/15.12%)=5.82%

15

From Country Spreads to Corporate Risk

premiums

Approach1:Assumethateverycompanyinthecountryisequally
exposedtocountryrisk.Inthiscase,
E(Return)=RiskfreeRate+CountrySpread+Beta(USpremium)
Implicitly,thisiswhatyouareassumingwhenyouusethelocal
Governmentsdollarborrowingrateasyourriskfreerate.

Approach2:Assumethatacompanysexposuretocountryriskis
similartoitsexposuretoothermarketrisk.
E(Return)=RiskfreeRate+Beta(USpremium+CountrySpread)
Approach3:Treatcountryriskasaseparateriskfactorandallow
firmstohavedifferentexposurestocountryrisk(perhapsbasedupon
theproportionoftheirrevenuescomefromnondomesticsales)
E(Return)=RiskfreeRate+(USpremium)+CountrySpread)

Aswath Damodaran

16

Estimating Company Exposure to Country Risk:

Determinants

Sourceofrevenues:Otherthingsremainingequal,acompanyshould
bemoreexposedtoriskinacountryifitgeneratesmoreofits
revenuesfromthatcountry.ABrazilianfirmthatgeneratesthebulk
ofitsrevenuesinBrazilshouldbemoreexposedtocountryriskthan
onethatgeneratesasmallerpercentofitsbusinesswithinBrazil.
Manufacturingfacilities:Otherthingsremainingequal,afirmthathas
allofitsproductionfacilitiesinBrazilshouldbemoreexposedto
countryriskthanonewhichhasproductionfacilitiesspreadover
multiplecountries.Theproblemwillbeaccentedforcompaniesthat
cannotmovetheirproductionfacilities(miningandpetroleum
companies,forinstance).
Useofriskmanagementproducts:Companiescanuseboth
options/futuresmarketsandinsurancetohedgesomeorasignificant
portionofcountryrisk.

Aswath Damodaran

17

Estimating Lambdas: The Revenue Approach

Theeasiestandmostaccessibledataisonrevenues.Mostcompaniesbreak
theirrevenuesdownbyregion.Onesimplisticsolutionwouldbetodothe
following:
%ofrevenuesdomesticallyfirm/%ofrevenuesdomesticallyavgfirm
Consider,forinstance,EmbraerandEmbratel,bothofwhichareincorporated
andtradedinBrazil.Embraergets3%ofitsrevenuesfromBrazilwhereas
EmbratelgetsalmostallofitsrevenuesinBrazil.TheaverageBrazilian
companygetsabout77%ofitsrevenuesinBrazil:

LambdaEmbraer=3%/77%=.04
LambdaEmbratel=100%/77%=1.30

Therearetwoimplications

Aswath Damodaran

Acompanysriskexposureisdeterminedbywhereitdoesbusinessandnotby
whereitislocated
Firmsmightbeabletoactivelymanagetheircountryriskexposures

18

Estimating Lambdas: Earnings Approach

Figure2:EPSchangesversusCountryRisk:EmbraerandEmbratel
1.5

QuarterlyEPS

0.5

0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 2002 2002 2002 2003 2003 2003
0.5

1.5

2
Quarter

Aswath Damodaran

19

Estimating Lambdas: Stock Returns versus CBond Returns

ReturnEmbraer=0.0195+0.2681ReturnCBondReturnEmbratel=0.0308+2.0030ReturnCBond
ReturnAmbev=0.0290+0.4136ReturnCBond ReturnPetrobras=0.0308+0.6600ReturnCBond
ReturnVale=0.02169+0.3760.ReturnCBond

Embraer versus C Bond: 2000-2003

Embratel versus C Bond: 2000-2003

40

100
80
60

Return on Embrat el

Return on Embraer

20

-20

40
20
0
-20
-40

-40

-60
-60
-30

-80
-20

-10

Return on C-Bond

Aswath Damodaran

10

20

-30

-20

-10

10

20

Return on C-Bond

20

Estimating a US Dollar Cost of Equity for

Embraer - September 2003
AssumethatthebetaforEmbraeris1.07,andthattheriskfreerateusedis
4.17%.Thehistoricalriskpremiumfrom19282002fortheUSis4.53%and
thecountryriskpremiumforBrazilis7.67%.
Approach1:Assumethateverycompanyinthecountryisequallyexposedto
countryrisk.Inthiscase,
E(Return)=4.17%+1.07(4.53%)+7.67%=16.69%
Approach2:Assumethatacompanysexposuretocountryriskissimilarto
itsexposuretoothermarketrisk.
E(Return)=4.17%+1.07(4.53%+7.67%)=17.22%
Approach3:Treatcountryriskasaseparateriskfactorandallowfirmsto
havedifferentexposurestocountryrisk(perhapsbasedupontheproportionof
theirrevenuescomefromnondomesticsales)
E(Return)=4.17%+(4.53%)+%)=11.09%

Aswath Damodaran

21

Implied Equity Premiums

Wecanusetheinformationinstockpricestobackouthowriskaversethemarketisandhowmuch
ofariskpremiumitisdemanding.
After year 5, we will assume that

In 2004, dividends & stock

buybacks were 2.90% of
the index, generating 35.15
in cashflows

Analysts expect earnings to grow 8.5% a year for the next 5 years .

38.13

41.37

44.89

48.71

earnings on the index will grow at

4.22%, the same rate as the entire
economy

52.85

January 1, 2005
S&P 500 is at 1211.92

Ifyoupaythecurrentleveloftheindex,youcanexpecttomakeareturnof7.87%onstocks(which
isobtainedbysolvingforrinthefollowingequation)

1211.92

38.13 41.37
44.89
48.71
52.85
52.85(1.0422)

(1 r) (1 r) 2 (1 r) 3 (1 r) 4 (1 r) 5 (r .0422)(1 r) 5

ImpliedEquityriskpremium=ExpectedreturnonstocksTreasurybondrate=7.87%4.22%=
3.65%

Aswath Damodaran

22

2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967
1966
1965
1964
1963
1962
1961
1960

0.00%

23
Aswath Damodaran

4.00%

3.00%
Implied Premium

Implied Premiums in the US

Implied Premium for US Equity Market

7.00%

6.00%

5.00%

2.00%

1.00%

Year

An Intermediate Solution

Thehistoricalriskpremiumof4.84%fortheUnitedStatesistoohigh
apremiumtouseinvaluation.Itismuchhigherthantheactual
impliedequityriskpremiuminthemarket
Thecurrentimpliedequityriskpremiumrequiresustoassumethatthe
marketiscorrectlypricedtoday.(IfIwererequiredtobemarket
neutral,thisisthepremiumIwoulduse)
Theaverageimpliedequityriskpremiumbetween19602004inthe
UnitedStatesisabout4%.Wewillusethisasthepremiumfora
matureequitymarket.

Aswath Damodaran

24

Implied Premium for Brazil: June 2005

LeveloftheIndex=26196
DividendsontheIndex=6.19%of16889
Otherparameters(allinUSdollars)
RiskfreeRate=4.08%
ExpectedGrowth(indollars)
Next5years=8%(UsedexpectedgrowthrateinEarnings)
Afteryear5=4.08%

Solvingfortheexpectedreturn:

Aswath Damodaran

ExpectedreturnonEquity=11.66%
ImpliedEquitypremium=11.66%4.08%=7.58%
ImpliedEquitypremiumforUSonsameday=3.70%
ImpliedcountrypremiumforBrazil=7.58%3.70%=3.88%

25

Estimating Beta

Thestandardprocedureforestimatingbetasistoregressstockreturns
(Rj)againstmarketreturns(Rm)
Rj=a+bRm
whereaistheinterceptandbistheslopeoftheregression.

Theslopeoftheregressioncorrespondstothebetaofthestock,and
measurestheriskinessofthestock.
Thisbetahasthreeproblems:
Ithashighstandarderror
Itreflectsthefirmsbusinessmixovertheperiodoftheregression,not
thecurrentmix
Itreflectsthefirmsaveragefinancialleverageovertheperiodratherthan
thecurrentleverage.

Aswath Damodaran

26

Beta Estimation : The Index Effect

Aswath Damodaran

27

Determinants of Betas
Beta of Equity (Levered Beta)

Beta of Firm (Unlevered Beta)

Nature of product or
service offered by
company :
Other things remaining equal,
the more discretionary the
product or service, the higher
the beta.

Operating Leverage (Fixed

Costs as percent of total
costs):
Other things remaining equal
the greater the proportion of
the costs that are fixed, the
higher the beta of the
company.

Implications
1. Cyclical companies should
have higher betas than noncyclical companies.
2. Luxury goods firms should
have higher betas than basic
goods.
3. High priced goods/service
firms should have higher betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Implications
1. Firms with high infrastructure
needs and rigid cost structures
should have higher betas than
firms with flexible cost structures.
2. Smaller firms should have higher
betas than larger firms.
3. Young firms should have higher
betas than more mature firms.

Aswath Damodaran

Financial Leverage:
Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
equity beta will be

Implciations
Highly levered firms should have highe betas
than firms with less debt.
Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))

28

The Solution: Bottom-up Betas

Step 1: Find the business or businesses that your firm operates in.
Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
obtain their regression betas. Compute the simple average across
these regression betas to arrive at an average beta for these publicly
traded firms. Unlever this average beta using the average debt to
equity ratio across the publicly traded firms in the sample.
Unlevered beta for business = Average beta across publicly traded
firms/ (1 + (1- t) (Average D/E ratio across firms))

Step 3: Estimate how much value your firm derives from each of
the different businesses it is in.

Step 4: Compute a weighted average of the unlevered betas of the

different businesses (from step 2) using the weights from step 3.
Bottom-up Unlevered beta for your firm = Weighted average of the
unlevered betas of the individual business
Step 5: Compute a levered beta (equity beta) for your firm, using
the market debt to equity ratio for your firm.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

Aswath Damodaran

If you can, adjust this beta for differences

between your firm and the comparable
firms on operating leverage and product
characteristics.

While revenues or operating income

are often used as weights, it is better
to try to estimate the value of each
business.
If you expect the business mix of your
firm to change over time, you can
change the weights on a year-to-year
basis.
If you expect your debt to equity ratio to
change over time, the levered beta will
change over time.

29

Bottom-up Betas: Embraer, Ambev, Vale and

Petrobras

Company
Embraer
Ambev

Vale

Petrobras

Aswath Damodaran

Business
Aerospace
Alcoholic beverages
Soft Drinks
Company
Mining
Aluminum
Steel
Transportation
Other
Company
Integrated Oil

Unlevered beta
0.95
0.75
0.85
0.77
0.98
0.72
0.63
0.73
0.74
0.89
0.60

D/E Ratio
18.95%
19.43%
19.43%
19.43%
25.66%
25.66%
25.66%
25.66%
25.66%
25.66%
49.58%

Weights Levered Beta

100%
1.07
80%
0.85
20%
0.96
0.87
71%
1.15
9%
0.84
14%
0.74
5%
0.85
1%
0.87
100%
1.04
100%
0.79

30

Gross Debt versus Net Debt Approaches:

Embraer in September 2003

NetDebtRatioforEmbraer=(DebtCash)/MarketvalueofEquity
=(19532320)/11,042=3.32%
LeveredBetaforEmbraer=0.95(1+(1.34)(.0332))=0.93
ThecostofEquityusingnetdebtleveredbetaforEmbraerwillbe
muchlowerthanwiththegrossdebtapproach.Thecostofcapitalfor
Embraer,though,willevenoutsincethedebtratiousedinthecostof
capitalequationwillnowbeanetdebtratioratherthanagrossdebt
ratio.

Aswath Damodaran

31

From Cost of Equity to Cost of Capital

Cost of borrowing should be based upon

(1) synthetic or actual bond rating
(2) default spread
Cost of Borrowing = Riskfree rate + Default spread
Cost of Capital =

Cost of Equity (Equity/(Debt + Equity))

Cost of equity
based upon bottom-up
beta

Aswath Damodaran

Cost of Borrowing

(1-t)

Marginal tax rate, reflecting

tax benefits of debt

(Debt/(Debt + Equity))

Weights should be market value weights

32

Estimating Synthetic Ratings

Theratingforafirmcanbeestimatedusingthefinancialcharacteristicsofthe
firm.Initssimplestform,theratingcanbeestimatedfromtheinterest
coverageratio
InterestCoverageRatio=EBIT/InterestExpenses
ForEmbraersinterestcoverageratio,weusedtheinterestexpensesandEBIT
from2002.
InterestCoverageRatio=2166/222=9.74
ForAmbevsinterestcoverageratio,weusedtheinterestexpensesandEBIT
from2003.
InterestCoverageRatio=2213/570=3.88
ForValesinterestcoverageratio,weusedtheinterestexpensesandEBIT
from2003also
InterestCoverageRatio=6371/1989=3.20

Aswath Damodaran

33

Interest Coverage Ratios, Ratings and Default

Spreads
IfInterestCoverageRatiois
EstimatedBondRating
DefaultSpread(2003)
DefaultSpread(2004)
>8.50
(>12.50)
AAA
0.75%
0.35%
6.508.50
(9.512.5)
AA
1.00%
0.50%
5.506.50
(7.59.5)
A+
1.50%
0.70%
4.255.50
(67.5)
A
1.80%
0.85%
3.004.25
(4.56)
A
2.00%
1.00%
2.503.00
(44.5)
BBB
2.25%
1.50%
2.252.50
(3.54)
BB+
2.75%
2.00%
2.002.25
((33.5)
BB
3.50%
2.50%
1.752.00
(2.53)
B+
4.75%
3.25%
1.501.75
(22.5)
B
6.50%
4.00%
1.251.50
(1.52)
B
8.00%
6.00%
0.801.25
(1.251.5)
CCC
10.00%
8.00%
0.650.80
(0.81.25)
CC
11.50%
10.00%
0.200.65
(0.50.8)
C
12.70%
12.00%
<0.20
(<0.5)
D
15.00%
20.00%
Thefirstnumberunderinterestcoverageratiosisforlargermarketcapcompaniesandthesecondinbracketsisfor
smallermarketcapcompanies.ForEmbraerandAmbev,Iusedtheinterestcoverageratiotableforsmaller/riskier
firms(thenumbersinbrackets)whichyieldsalowerratingforthesameinterestcoverageratio.

Aswath Damodaran

34

Estimating the cost of debt

Company

EBIT

Interest

Interest Rating

Company

Country Costof

Expense

Coverage

Spread

Spread Debt($)

Embraer(2003) 2166

222

9.76

AA

1.00%

4%

9.17%

Ambev

2213

570

3.88

BB+

2.00%

4%

10.70%

Vale

6371

1989

3.20

BB

2.50%

4%

11.20%

Petrobras

14974

3195

4.69

1%

4%

9.70%

RiskfreeRate=4.17%forEmbraerin2003,4.70%forallotherfirms
Costofdebt($)=RiskfreeRate+CompanySpread+CountrySpread
(Ihaveassumedthatallofthesecompanieswillhavetobearonlyaportionofthetotal
countrydefaultspreadofBrazilwhichis4.50%)

Aswath Damodaran

35

Weights for the Cost of Capital Computation

Theweightsusedtocomputethecostofcapitalshouldbethemarket
valueweightsfordebtandequity.
Thereisanelementofcircularitythatisintroducedintoevery
valuationbydoingthis,sincethevaluesthatweattachtothefirmand
equityattheendoftheanalysisaredifferentfromthevalueswegave
thematthebeginning.
Asageneralrule,thedebtthatyoushouldsubtractfromfirmvalueto
arriveatthevalueofequityshouldbethesamedebtthatyouusedto
computethecostofcapital.

Aswath Damodaran

36

Estimating Cost of Capital: Embraer

Equity

CostofEquity=4.17%+1.07(4%)+0.27(7.67%)=10.52%
MarketValueofEquity=11,042millionBR($3,781million)

Debt

Costofdebt=4.17%+4.00%+1.00%=9.17%
MarketValueofDebt=2,093millionBR($717million)

CostofCapital
CostofCapital=10.52%(.84)+9.17%(1.34)(0.16))=9.81%
ThebookvalueofequityatEmbraeris3,350millionBR.
ThebookvalueofdebtatEmbraeris1,953millionBR;Interestexpenseis222
mil;Averagematurityofdebt=4years
Estimatedmarketvalueofdebt=222million(PVofannuity,4years,9.17%)+
$1,953million/1.09174=2,093millionBR

Aswath Damodaran

37

Estimating Cost of Capital: Ambev

Equity

CostofEquity=4.7%+0.87(4%)+0.41(7.87%)=11.41%
MarketValueofEquity=29,886millionBR($9,508million)

Debt

Costofdebt=4.7%+4.00%+2.00%=10.70%
MarketValueofDebt=5,808millionBR($1,848million)

CostofCapital
CostofCapital=11.41%(.837)+10.7%(1.34)(0.163))=10.70%
ThebookvalueofequityatAmbevis4,209millionBR.
ThebookvalueofdebtatAmbevis5,980millionBR;Interestexpenseis570
mil;Averagematurityofdebt=3years
Estimatedmarketvalueofdebt=570million(PVofannuity,3years,10.7%)+
$5,980million/1.1073=5,808millionBR

Aswath Damodaran

38

Estimating Cost of Capital: Vale

Equity

CostofEquity=4.7%+1.04(4%)+0.37(7.87%)=11.77%
MarketValueofEquity=56,442millionBR($17,958million)

Debt

Costofdebt=4.7%+4.00%+2.50%=11.20%
MarketValueofDebt=14,484millionBR($4,612million)

CostofCapital
CostofCapital=11.77%(.796)+11.2%(1.34)(0.204))=10.88%
ThebookvalueofequityatValeis15,937millionBR.
ThebookvalueofdebtatValeis13,709millionBR;Interestexpenseis1,989
mil;Averagematurityofdebt=2years
Estimatedmarketvalueofdebt=1,989million(PVofannuity,2years,11.2%)+
13,709million/1.1122=14,484millionBR

Aswath Damodaran

39

Estimating Cost of Capital: Petrobras

Equity

CostofEquity=4.70%+0.79(4%)+0.66(7.87%)=12.58%
MarketValueofEquity=85,218millionBR($27,114million)

Debt

Costofdebt=4.7%+4.00%+1.00%=9.70%
MarketValueofDebt=39,367millionBR($12,537million)

CostofCapital
CostofCapital=12.58%(.684)+9.7%(1.34)(0.316))=10.63%
ThebookvalueofequityatPetrobrasis50.987millionBR.
ThebookvalueofdebtatPetrobrasis42,248millionBR;Interestexpenseis
1,989mil;Averagematurityofdebt=4years
Estimatedmarketvalueofdebt=3,195million(PVofannuity,4years,9.7%)+
42,248million/1.0974=39,367millionBR

Aswath Damodaran

40

If you had to do it.Converting a Dollar Cost of

Capital to a Nominal Real Cost of Capital Ambev

Approach1:UseaBRriskfreerateinallofthecalculationsabove.For
instance,iftheBRriskfreeratewas12%,thecostofcapitalwouldbe
computedasfollows:

CostofEquity=12%+(4%)+%)=18.71%
CostofDebt=12%+2%=14%
(Thisassumestheriskfreeratehasnocountryriskpremiumembeddedinit.)

Approach2:Usethedifferentialinflationratetoestimatethecostofcapital.
Forinstance,iftheinflationrateinBRis8%andtheinflationrateintheU.S.
is2%
1 Inflation
BR
(1 CostofCapital$ )

Costofcapital=

1 Inflation$

=1.107(1.08/1.02)1=17.21%

Aswath Damodaran

41

II. Valuing Control and Synergy

Acquisition Valuation
Itisnotwhatyoubuybutwhatyoupayforit.

Aswath Damodaran

42

Issues in Acquisition Valuation

Acquisitionvaluationsarecomplex,becausethevaluationoften
involvedissueslikesynergyandcontrol,whichgobeyondjust
valuingatargetfirm.Itisimportantontherightsequence,including
Whenshouldyouconsidersynergy?
Wheredoesthemethodofpaymententertheprocess.

Cansynergybevalued,andifso,how?

Whatisthevalueofcontrol?Howcanyouestimatethevalue?

Aswath Damodaran

43

The Value of Control

Control has value because you think that you can run a firm better
thantheincumbentmanagement.
ValueofControl=Valueoffirm,runoptimallyValueoffirm,statusquo

Thevalueofcontrolshouldbeinverselyproportionaltothe
perceivedqualityofthatmanagementanditscapacitytomaximize
firmvalue.

Valueofcontrolwillbemuchgreaterforapoorlymanagedfirm
thatoperatesatbelowoptimumcapacitythanitisforawellmanaged
firm.Itshouldbenegligibleorfirmswhichareoperatingatorclose
totheiroptimalvalue

Aswath Damodaran

44

Price Enhancement versus Value

Enhancement

Aswath Damodaran

45

Ambev: Status Quo ($)

Current Cashflow to Firm
EBIT(1-t) :
504
- Nt CpX
146
- Chg WC
124
= FCFF
$ 233
Reinvestment Rate = 270/504= 53.7%

Return on Capital
16.24%

Reinvestment Rate
53.7%

Terminal Value5= 641/(.0994-.047) = 12,249

$ Cashflows
Op. Assets $ 6546
+ Cash:
743
- Debt
1848
- Minor. Int.
137
=Equity
5304
-Options
0
Value/Sh $137.62
R$ 433/sh

Year
EBIT(1t)
Reinvestment
FCFF

1
$548
$294
$253

2
$595
$320
$276

3
$647
$348
$300

4
$704
$378
$326

5
$765
$411
$354

6
$832
$447
$385

7
$904
$486
$419

8
$983
$528
$455

9
10
$1069 $1162
$574 $624
$495 $538

Term Yr
1217
- 576
= 641

Discount at$ Cost of Capital (WACC) = 11.41% (.84) + 7.06% (0.16) = 10.70%

Cost of Equity
11.41 %

Riskfree Rate:
$ Riskfree Rate= 4.70%

Cost of Debt
(4.70%+2%+4%)(1-.34)
= 7.06%

Beta
0.87

Unlevered Beta for

Sectors: 0.77

Aswath Damodaran

Stable Growth
g = 4.70%; Beta = 1.00;
Country Premium= 5%
Cost of capital = 9.94%
ROC= 9.94%; Tax rate=34%
Reinvestment Rate=g/ROC
=4.70/9.94= 47.31%

Expected Growth
in EBIT (1-t)
.537*.1624=.0872
8.72 %

On May 24, 2004

Ambev Common = R$1140
Ambev Pref = 500

Weights
E = 84% D = 16%

Mature market
premium
4%
Firms D/E
Ratio: 19.4%

Lambda
0.41

Country Equity Risk

Premium
7.87%

Country Default
Spread
6.50%

Rel Equity
Mkt Vol
1.21

46

The Paths to Value Creation

UsingtheDCFframework,therearefourbasicwaysinwhichthevalueofa
firmcanbeenhanced:

Thecashflowsfromexistingassetstothefirmcanbeincreased,byeither
increasingaftertaxearningsfromassetsinplaceor
reducingreinvestmentneeds(netcapitalexpendituresorworkingcapital)

Theexpectedgrowthrateinthesecashflowscanbeincreasedbyeither
Increasingtherateofreinvestmentinthefirm
Improvingthereturnoncapitalonthosereinvestments

Thelengthofthehighgrowthperiodcanbeextendedtoallowformoreyearsof
highgrowth.
Thecostofcapitalcanbereducedby
Reducingtheoperatingriskininvestments/assets
Changingthefinancialmix
Changingthefinancingcomposition

Aswath Damodaran

47

I. Ways of Increasing Cash Flows from Assets

in Place
More efficient
operations and
cost cuttting:
Higher Margins
Divest assets that
have negative EBIT
Reduce tax rate
- moving income to lower tax locales
- transfer pricing
- risk management

Aswath Damodaran

Revenues
* Operating Margin
= EBIT
- Tax Rate * EBIT
= EBIT (1-t)
+ Depreciation
- Capital Expenditures
- Chg in Working Capital
= FCFF

Live off past overinvestment

Better inventory
management and
tighter credit policies

48

II. Value Enhancement through Growth

Reinvest more in
projects
Increase operating
margins

Aswath Damodaran

Do acquisitions
Reinvestment Rate
* Return on Capital

Increase capital turnover ratio

= Expected Growth Rate

49

III. Building Competitive Advantages: Increase

length of the growth period
Increase length of growth period
Build on existing
competitive
advantages

Brand
name

Aswath Damodaran

Legal
Protection

Find new
competitive
advantages

Switching
Costs

Cost
advantages

50

Illustration: Valuing a brand name: Coca Cola

ATOperatingMargin
Sales/BVofCapital
ROC
ReinvestmentRate
ExpectedGrowth
Length
CostofEquity
E/(D+E)
ATCostofDebt
D/(D+E)
CostofCapital
Value

Aswath Damodaran

CocaCola
18.56%
1.67
31.02%
65.00%(19.35%)
20.16%
10years
12.33%
97.65%
4.16%
2.35%
12.13%
$115

GenericColaCompany
7.50%
1.67
12.53%
65.00%(47.90%)
8.15%
10yea
12.33%
97.65%
4.16%
2.35%
12.13%
$13

51

Gauging Barriers to Entry

Whichofthefollowingbarrierstoentryaremostlikelytoworkfor
Embraer?
BrandName
PatentsandLegalProtection
SwitchingCosts
CostAdvantages
WhataboutforAmbev?
BrandName
PatentsandLegalProtection
SwitchingCosts
CostAdvantages

Aswath Damodaran

52

Reducing Cost of Capital

Outsourcing

Flexible wage contracts &

cost structure

Reduce operating
leverage

Change financing mix

Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital

Make product or service
less discretionary to
customers
Changing
product
characteristics

Aswath Damodaran

More
effective
advertising

Match debt to
assets, reducing
default risk
Swaps

Derivatives

Hybrids

53

Embraer : Optimal Capital Structure

DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

Beta
0.95
1.02
1.11
1.22
1.37
1.58
1.89
2.42
3.48
6.95

CostofEquity
10.05%
10.32%
10.67%
11.12%
11.72%
12.56%
13.81%
15.90%
20.14%
34.05%

BondRating
AAA
AAA
AA
A
A
B
CCC
CC
CC
CC

Interestrateondebt
8.92%
8.92%
9.17%
9.97%
10.17%
14.67%
18.17%
19.67%
19.67%
19.67%

TaxRate
34.00%
34.00%
34.00%
34.00%
34.00%
34.00%
34.00%
34.00%
33.63%
29.90%

CostofDebt(aftertax)
5.89%
5.89%
6.05%
6.58%
6.71%
9.68%
11.99%
12.98%
13.05%
13.79%

WACC
10.05%
9.88%
9.75%
9.76%
9.72%
11.12%
12.72%
13.86%
14.47%
15.81%

FirmValue(G)
$3,577
$3,639
$3,690
$3,686
$3,703
$3,218
$2,799
$2,562
$2,450
$2,236

54

Ambev: Optimal Capital Structure

DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

Beta
0.85
0.91
0.99
1.09
1.23
1.49
1.95
2.59
3.89
7.78

CostofEquity
11.33%
11.58%
11.89%
12.29%
12.83%
13.87%
15.71%
18.30%
23.49%
39.06%

BondRating
AAA
AA
A
B
CC
C
D
D
D
D

Interestrateondebt
9.20%
9.20%
9.70%
14.70%
18.70%
20.70%
28.70%
28.70%
28.70%
28.70%

TaxRate
34.00%
34.00%
34.00%
34.00%
34.00%
25.24%
14.22%
12.19%
10.67%
9.48%

CostofDebt(aftertax)
6.07%
6.07%
6.40%
9.70%
12.34%
15.48%
24.62%
25.20%
25.64%
25.98%

WACC
11.33%
11.03%
10.79%
11.52%
12.63%
14.67%
21.05%
23.13%
25.21%
27.29%

FirmValue(G)
$33,840
$35,530
$36,966
$32,873
$28,005
$21,930
$12,721
$11,098
$9,804
$8,748

55

Vale: Optimal Capital Structure

Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

Beta
0.89
0.95
1.04
1.14
1.28
1.48
1.77
2.35
3.90
7.79

Cost of Equity
11.17%
11.43%
11.76%
12.18%
12.73%
13.52%
14.69%
17.01%
23.20%
38.79%

Bond Rating
AAA
AA
A+
ABB
BCC
CC
D
D

Interest rate on debt

9.20%
9.20%
9.40%
9.70%
11.20%
14.70%
18.70%
18.70%
28.70%
28.70%

Tax Rate
34.00%
34.00%
34.00%
34.00%
34.00%
34.00%
34.00%
29.68%
15.46%
13.74%

Cost of Debt (after-tax)

6.07%
6.07%
6.20%
6.40%
7.39%
9.70%
12.34%
13.15%
24.26%
24.76%

WACC
11.17%
10.89%
10.65%
10.44%
10.60%
11.61%
13.28%
14.31%
24.05%
26.16%

Firm Value (G)

$67,576
$70,723
$73,819
$76,537
$74,451
$63,058
$50,122
$44,418
$20,372
$18,043

56

Ambev: Restructured ($)

Current Cashflow to Firm
EBIT(1-t) :
504
- Nt CpX
146
- Chg WC
124
= FCFF
$ 233
Reinvestment Rate = 270/504= 53.7%

Return on Capital
18%

Reinvestment Rate
60%

Expected Growth
in EBIT (1-t)
.60*.18=.108
10.80 %

Terminal Value5= 766/(.0994-.047) = 14.990

$ Cashflows
Op. Assets $ 7567
+ Cash:
743
- Debt
1848
- Minor. Int.
137
=Equity
6277
-Options
0
Value/Sh $162.89
R$ 512/sh

Year
1
EBIT(1t)
$558
Reinvestment$335
FCFF
$223

2
$618
$371
$247

4
$759
$455
$304

5
$841
$505
$336

6
$932
$559
$373

Term Yr
1470
- 704
= 766

7
8
9
10
$1,032$1144$1,267 $1,404
$619 $686 $760 $843
$413 $458 $507 $562

Discount at$ Cost of Capital (WACC) = 11.53% (.80) + 6.40% (0.20) = 10.50%

Cost of Equity
11.53 %

Riskfree Rate:
$ Riskfree Rate= 4.70%

Cost of Debt
(4.70%+1%+4%)(1-.34)
= 6.40%

Beta
0.90

Unlevered Beta for

Sectors: 0.77

Aswath Damodaran

3
$685
$411
$274

Stable Growth
g = 4.70%; Beta = 1.00;
Country Premium= 5%
Cost of capital = 9.94%
ROC= 9.94%; Tax rate=34%
Reinvestment Rate=g/ROC
=4.70/9.94= 47.31%

On May 24, 2004

Ambev Common = R$1140
Ambev Pref = 500

Weights
E = 80% D = 20%

Mature market
premium
4%
Firms D/E
Ratio: 25%

Lambda
0.41

Country Equity Risk

Premium
7.87%

Country Default
Spread
6.50%

Rel Equity
Mkt Vol
1.21

57

Value of stock in a publicly traded firm

Whenafirmisbadlymanaged,themarketstillassessesthe
probabilitythatitwillberunbetterinthefutureandattachesavalue
ofcontroltothestockpricetoday:
Valuepershare =

StatusQuoValue + Probabilityofcontrolchange(Optimal StatusQuoValue)

Numberofsharesoutstanding

Withvotingsharesandnonvotingshares,adisproportionateshareof
thevalueofcontrolwillgotothevotingshares.Intheextreme
scenariowherenonvotingsharesarecompletelyunprotected:
Valuepernon votingshare =

StatusQuoValue
# VotingShares + # Non votingshares

Valuepervotingshare = Valueofnon votingshare +

Aswath Damodaran

Probabilityofcontrolchange(Optimal StatusQuoValue)
# VotingShares

58

Valuing Ambev voting and non-voting shares

StatusQuoValue=$5,304million*3.14=16,655millionBR
OptimalValue=$6,277million*3.14=19,710millionBR
Numberofshares
Voting=15.735
Nonvoting=22.801
Total=38.536

Value/nonvotingshare=16,655/38.536=433BR/share
Value/votingshare=433+(1971016655)/15.735=626BR/share

Aswath Damodaran

59

Sources of Synergy

Synergy is created when two firms are combined and can be

either financial or operating

Operating Synergy accrues to the combined firm as

Strategic Advantages

Higher returns on
new investments

More new
Investments

Higher ROC

Higher Reinvestment

Higher Growth
Rate

Higher Growth Rate

Aswath Damodaran

Economies of Scale

More sustainable
excess returns

Cost Savings in
current operations

Longer Growth
Period

Higher Margin

Financial Synergy

Tax Benefits

Added Debt
Capacity

Lower taxes on
earnings due to
- higher
depreciaiton
- operating loss
carryforwards

Higher debt
May reduce
raito and lower cost of equity
cost of capital for private or
closely held
firm

Diversification?

Higher Baseyear EBIT

60

Aprocedureforvaluingsynergy
(1) the firms involved in the merger are valued independently, by
discountingexpectedcashflowstoeachfirmattheweightedaverage
costofcapitalforthatfirm.
(2) the value of the combined firm, with no synergy, is obtained by
addingthevaluesobtainedforeachfirminthefirststep.
(3) The effects of synergy are built into expected growth rates and
cashflows,andthecombinedfirmisrevaluedwithsynergy.
ValueofSynergy=Valueofthecombinedfirm,withsynergyValueof
thecombinedfirm,withoutsynergy

Aswath Damodaran

61

Aswath Damodaran

62

J.P. Morgans estimate of annual operating

synergies in Ambev/Labatt Merger

Aswath Damodaran

63

J.P. Morgans estimate of total synergies in

Labatt/Ambev Merger

Aswath Damodaran

64

Evidence on Synergy
o

A stronger test of synergy is to evaluate whether merged firms improve their

performance(profitabilityandgrowth),relativetotheircompetitors,aftertakeovers.
o McKinsey and Co. examined 58 acquisition programs between 1972 and 1983 for
evidenceontwoquestions
o Didthereturnontheamountinvestedintheacquisitionsexceedthecostofcapital?
o Didtheacquisitionshelptheparentcompaniesoutperformthecompetition?
o

Theyconcludedthat28ofthe58programsfailedbothtests,and6failedatleastone
test.

KPMG in a more recent study of global acquisitions concludes that most mergers (>80%)
failthemergedcompaniesdoworsethantheirpeergroup.

Large number of acquisitions that are reversed within fairly short time periods. bout
20.2%ofthe acquisitionsmade between 1982and1986 weredivested by1988.Instudies
thathavetrackedacquisitionsforlongertimeperiods(tenyearsormore)thedivestiturerate
ofacquisitionsrisestoalmost50%.

Aswath Damodaran

65

Labatt DCF valuation

LabattistheCanadiansubsidiaryofInterbrewandisamaturefirmwithsold
brandnames.Itcanbevaluedusingastablegrowthfirmvaluationmodel.
BaseYearinputs

Valuation

EBIT(1t)=$411million
ExpectedGrowthRate=3%
Returnoncapital=9%
Costofcapital=7%
ReinvestmentRate=g/ROC=3/9=33.33%
ValueofLabatt=411(1.333)/(.07.03)=$6.85billion

AmbevispayingforLabattwith23.3billionshares(valuedatabout$5.8
billion)andisassuming$1.5billionindebt,resultinginavalueforthefirm
ofabout$7.3billion.

Aswath Damodaran

66

Whogetsthebenefitsofsynergy?
Total Synergy = $ 2 billion

Premium paid to
Labatt Stockholders
= $7.3 billion - $6.85
billion = $ 450 million

Aswath Damodaran

Voting Shares
in Ambev

Non-voting
Shares in Ambev

$1.55 billion to be shared?

67

III. Valuing Equity in Cyclical firms

and firms with negative earnings :
The Search for Normalcy
AswathDamodaran
http://www.damodaran.com

Aswath Damodaran

68

Begin by analyzing why the earnings are not

not normal
A Framework for Analyzing Companies with Negative or Abnormally Low Earnings
Why are the earnings negative or abnormally low?

Temporary
Problems

Cyclicality:
Eg. Auto firm
in recession

Life Cycle related

reasons: Young
firms and firms with
infrastructure
problems

Leverage
Problems: Eg.
An otherwise
healthy firm with
too much debt.

Long-term
Operating
Problems: Eg. A firm
with significant
production or cost
problems.

Normalize Earnings
If firms size has not
changed significantly
over time

Average Dollar
Earnings (Net Income
if Equity and EBIT if
Firm made by
the firm over time

Aswath Damodaran

If firms size has changed

over time

Use firms average ROE (if

valuing equity) or average
ROC (if valuing firm) on current
BV of equity (if ROE) or current
BV of capital (if ROC)

Value the firm by doing detailed cash

flow forecasts starting with revenues and
reduce or eliminate the problem over
time.:
(a) If problem is structural: Target for
operating margins of stable firms in the
sector.
(b) If problem is leverage : Target for a
debt ratio that the firm will be comfortable
with by end of period, which could be its
own optimal or the industry average.
(c) If problem is operating: Target for an
industry-average operating margin.

69

1. If the earnings decline or increase is

temporary and will be quickly reversed
Normalize

Youcannormalizeearningsinthreeways:
Companyshistory:Averagingearningsoroperatingmarginsovertime
andestimatinganormalizedearningforthebaseyear
Industryaverage:Youcanapplytheaverageoperatingmarginforthe
industrytothecompanysrevenuesthisyeartogetanormalizedearnings.
Normalizedprices:Ifyourcompanyisacommoditycompany,youcan
normalizethepriceofthecommodityacrossacycleandapplyittothe
productioninthecurrentyear.

Aswath Damodaran

70

Aracruz in 2001: The Effect of Commodity

Prices
AracruzCelulose:Revenues,ProfitsandthePriceofPaper
$1,600.00

115

$1,400.00

110

$1,200.00

100

$800.00

$600.00

95

Priceofpaper(1992:100)

Revenues&OperatingIncome

105
$1,000.00

Revenues
OperatingIncome
Priceofpulp

$400.00
90
$200.00
85

$0.00
1991

1992

1993

1994

1995

1996

$200.00

1997

1998

1999

2000
80

Year

Aswath Damodaran

71

Normalizing Earnings
Revenues Operating Income Operating Margin Price of pulp
1991
$131.19
$19.54
14.89%
100
1992
$447.84
$125.45
28.01%
113.18
1993
$301.93
-$34.86
-11.55%
102.89
1994
$614.05
$131.34
21.39%
112.54
1995
$703.00
$271.00
38.55%
98.71
1996
$493.00
$15.00
3.04%
94.86
1997
$536.83
$39.12
7.29%
92.93
1998
$535.98
-$4.93
-0.92%
99.20
1999
$989.75
$403.35
40.75%
102.09
2000
$1,342.35
$665.85
49.60%
109.39
Normalized 2000 $1,342.35
$324.59
24.18%
Normalized 2000 $1,258.78
$582.28
102.58

Aswath Damodaran

72

Aracruz (2000): Normalized Earnings ($)

Normalized Earnings
Actual EBIT = $665.85 million
Normalized EBIT = $582 million
Tax Rate = 34%

Reinvestment Rate
80%

Expected Growth
in EBIT (1-t)
80% * 10% = 8%

EBIT (1-t)
- Reinvestment
= FCFF

$425
$242
$183

$470
$267
$203

Stable Growth
g = 3%;
Cost of capital = 8.85
ROC= 8.85%
Reinvestment Rate=g/ROC
=3/8.85= 33.90%

Terminal Value5= 457/(.0885-.03) = 7,805

$ Cashflows
Op. Assets $ 5332
+ Cash:
847
- Debt
1395
=Equity
4785

Normalized ROC
10.55%

$519
$295
$224

$574
$326
$248

$635
$361
$274

Term Yr
691
- 234
= 457

Discount at$ Cost of Capital (WACC) = 13.97% (.73) + 4.95% (0.27) = 11.52%

Cost of Equity
13.97 %

Aswath Damodaran

Cost of Debt
(7.50%(1-.34)
= 4.95%

Weights
E = 73% D = 27%

73

2. If the earnings are negative because the firm

is early in its life cycle

Whenoperatingincomeisnegativeormarginsareexpectedtochange
overtime,weuseathreestepprocesstoestimategrowth:
Estimategrowthratesinrevenuesovertime
Usehistoricalrevenuegrowthtogetestimatesofrevenuegrowthinthenear
future
Decreasethegrowthrateasthefirmbecomeslarger
Keeptrackofabsoluterevenuestomakesurethatthegrowthisfeasible

Estimateexpectedoperatingmarginseachyear
Setatargetmarginthatthefirmwillmovetowards
Adjustthecurrentmargintowardsthetargetmargin

Estimatethecapitalthatneedstobeinvestedtogeneraterevenuegrowth
andexpectedmargins
Estimateasalestocapitalratiothatyouwillusetogeneratereinvestment
needseachyear.

Aswath Damodaran

74

Discounted Cash Flow Valuation: High Growth with Negative Earnings

Current
Operating
Margin

Current
Revenue
EBIT

Reinvestment
Stable Growth
Sales Turnover
Ratio

Competitive
Advantages

Revenue
Growth

Tax Rate
- NOLs

Expected
Operating
Margin

FCFF = Revenue* Op Margin (1-t) - Reinvestment

Value of Operating Assets
+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity
- Equity Options
= Value of Equity in Stock

FCFF1

FCFF4

Terminal Value= FCFF n+1/(r-g n)

FCFF5

FCFFn
.........

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)

Beta
- Measures market risk

Type of
Business

Aswath Damodaran

FCFF3

Stable
Stable
Operating Reinvestment
Margin

Forever

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows

FCFF2

Stable
Revenue
Growth

Operating
Leverage

Weights
Based on Market Value

Risk Premium
- Premium for average
risk investment

Financial
Leverage

Base Equity
Premium

Country Risk
Premium

75

Reinvestment:
Current
Revenue
$ 1,117

Current
Margin:
-36.71%
EBIT
-410m

Cap ex includes acquisitions

Working capital is 3% of revenues

Sales Turnover
Ratio: 3.00

Value of Op Assets $ 14,910

+ Cash
$
26
= Value of Firm
$14,936
- Value of Debt
$ 349
= Value of Equity $14,587
- Equity Options
$ 2,892
Value per share
$ 34.32

Revenues
EBIT
EBIT(1t)
Reinvestment
FCFF

CostofEquity
CostofDebt
ATcostofdebt
CostofCapital

$2,793 5,585
$373 $94
$373 $94
$559
$931
$931 $1,024

Riskfree Rate :
T. Bond rate = 6.5%

9,774
$407
$407
$1,396
$989

Terminal Value= 1881/(.0961-.06)

=52,148

14,661 19,059
$1,038 $1,628
$871
$1,058
$1,629 $1,466
$758 $408

Term.Year
$41,346
10.00%
35.00%
$2,688
$807
$1,881

23,862
$2,212
$1,438
$1,601
$163

28,729
$2,768
$1,799
$1,623
$177

33,211
$3,261
$2,119
$1,494
$625

36,798
$3,646
$2,370
$1,196
$1,174

39,006
$3,883
$2,524
$736
$1,788
10

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
6.71%
12.83%

12.90%
8.00%
5.20%
12.81%

12.42%
7.80%
5.07%
12.13%

12.30%
7.75%
5.04%
11.96%

12.10%
7.67%
4.98%
11.69%

11.70%
7.50%
4.88%
11.15%

Cost of Debt
6.5%+1.5%=8.0%
Tax rate = 0% -> 35%

Beta
1.60 -> 1.00

Internet/
Retail

Operating
Leverage

Stable
ROC=20%
Reinvest 30%
of EBIT(1-t)

Expected
Margin:
-> 10.00%

Cost of Equity
12.90%

Aswath Damodaran

Competitive
Advantages

Revenue
Growth:
42%

NOL:
500 m

Stable Growth
Stable
Stable
Operating
Revenue
Margin:
Growth: 6%
10.00%

10.50%
7.00%
4.55%
9.61%

Weights
Debt= 1.2% -> 15%

Amazon.com
January 2000
Stock Price = $ 84

Risk Premium
4%

Current
D/E: 1.21%

Forever

Base Equity
Premium

Country Risk
Premium

76

3. If earnings are negative because the firm has

structural/ leverage problems

SurvivalScenario:Thefirmsurvivesandsolvesitsstructuralproblem
(bringsdownitsfinancialleverage).Inthisscenario,marginsimprove
andthedebtratioreturnstoasustainablelevel.
FailureScenario:Thefirmdoesnotsolveitsstructuralproblemsor
failstomakedebtpayments,leadingtodefaultandliquidation.

Aswath Damodaran

77

Current
Revenue
$ 3,804

Current
Margin:
-49.82%
EBIT
-1895m

Cap ex growth slows

and net cap ex
decreases
Revenue
Growth:
13.33%

NOL:
2,076m

Value of Op Assets $ 5,530

+ Cash & Non-op $ 2,260
= Value of Firm
$ 7,790
- Value of Debt
$ 4,923
= Value of Equity $ 2867
- Equity Options
$
14
Value per share
$ 3.22

Stable Growth

EBITDA/Sales
-> 30%

Stable
EBITDA/
Sales
30%

$3,804 $5,326 $6,923 $8,308 $9,139

($95) $0
$346 $831 $1,371
($1,675) ($1,738) ($1,565) ($1,272) $320
($1,675) ($1,738) ($1,565) ($1,272) $320
$1,580 $1,738 $1,911 $2,102 $1,051
$3,431 $1,716 $1,201 $1,261 $1,324
$0
$46
$48
$42
$25
($3,526) ($1,761) ($903) ($472) $22
1
2
3
4
5

$10,053$11,058$11,942$12,659$13,292
$1,809 $2,322 $2,508 $3,038 $3,589
$1,074 $1,550 $1,697 $2,186 $2,694
$1,074 $1,550 $1,697 $2,186 $2,276
$736 $773 $811 $852 $894
$1,390 $1,460 $1,533 $1,609 $1,690
$27
$30
$27
$21
$19
$392 $832 $949 $1,407 $1,461
6
7
8
9
10

Beta
CostofEquity
CostofDebt
DebtRatio
CostofCapital

3.00
16.80%
12.80%
74.91%
13.80%

2.60
15.20%
11.84%
67.93%
12.92%

Riskfree Rate:
T. Bond rate = 4.8%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

2.20
13.60%
10.88%
60.95%
11.94%

Cost of Debt
4.8%+8.0%=12.8%
Tax rate = 0% -> 35%

Beta
3.00> 1.10

Internet/
Retail

Stable
ROC=7.36%
Reinvest
67.93%

Terminal Value= 677(.0736-.05)

=$ 28,683

Revenues
EBITDA
EBIT
EBIT(1t)
+Depreciation
CapEx
ChgWC
FCFF

Cost of Equity
16.80%

Aswath Damodaran

Stable
Revenue
Growth: 5%

Operating
Leverage

1.80
12.00%
9.92%
53.96%
10.88%

1.40
10.40%
8.96%
46.98%
9.72%

Forever

1.00
8.80%
6.76%
40.00%
7.98%

Weights
Debt= 74.91% -> 40%

Global Crossing
November 2001
Stock price = $1.86

Risk Premium
4%

Current
D/E: 441%

Term.Year
$13,902
$4,187
$3,248
$2,111
$939
$2,353
$20
$677

Base Equity
Premium

Country Risk
Premium

78

The Going Concern Assumption

Traditionalvaluationtechniquesarebuiltontheassumptionofagoing
concern,I.e.,afirmthathascontinuingoperationsandthereisno
significantthreattotheseoperations.
Indiscountedcashflowvaluation,thisgoingconcernassumptionfindsits
placemostprominentlyintheterminalvaluecalculation,whichusuallyis
baseduponaninfinitelifeandevergrowingcashflows.
Inrelativevaluation,thisgoingconcernassumptionoftenshowsup
implicitlybecauseafirmisvaluedbaseduponhowotherfirmsmostof
whicharehealthyarepricedbythemarkettoday.

Whenthereisasignificantlikelihoodthatafirmwillnotsurvivethe
immediatefuture(nextfewyears),traditionalvaluationmodelsmay
yieldanoveroptimisticestimateofvalue.

Aswath Damodaran

79

DCF Valuation + Distress Value

ADCFvaluationvaluesafirmasagoingconcern.Ifthereisa
significantlikelihoodofthefirmfailingbeforeitreachesstable
growthandiftheassetswillthenbesoldforavaluelessthanthe
presentvalueoftheexpectedcashflows(adistresssalevalue),DCF
valuationswillunderstatethevalueofthefirm.
ValueofEquity=DCFvalueofequity(1Probabilityofdistress)+
Distresssalevalueofequity(Probabilityofdistress)

Aswath Damodaran

80

Bond Price to estimate probability of distress

GlobalCrossinghasa12%couponbondwith8yearstomaturitytradingat$653.To
estimatetheprobabilityofdefault(withatreasurybondrateof5%usedastheriskfree
rate):
t 8

120(1 Distress )t 1000(1 Distress )8

653

t
N
(1.05)
(1.05)
t1

Solvingfortheprobabilityofbankruptcy,weget

Witha10yearbond,itisaprocessoftrialanderrortoestimatethisvalue.Thesolver
functioninexcelaccomplishesthesameinfarlesstime.

Distress=Annualprobabilityofdefault=13.53%
Toestimatethecumulativeprobabilityofdistressover10years:
Cumulativeprobabilityofsurviving10years=(1.1353)10=23.37%
Cumulativeprobabilityofdistressover10years=1.2337=.7663or76.63%

Aswath Damodaran

81

Valuing Global Crossing with Distress

Probabilityofdistress
Cumulativeprobabilityofdistress=76.63%

Distresssalevalueofequity

Bookvalueofcapital=$14,531million
Distresssalevalue=25%ofbookvalue=.25*14531=$3,633million
Bookvalueofdebt=$7,647million
Distresssalevalueofequity=$0

Distressadjustedvalueofequity
ValueofGlobalCrossing=$3.22(1.7663)+$0.00(.7663)=$0.75

Aswath Damodaran

82

Real Options: Fact and Fantasy

AswathDamodaran

Aswath Damodaran

83

Underlying Theme: Searching for an Elusive

Premium

Traditionaldiscountedcashflowmodelsunderestimatethevalueof
investments,wherethereareoptionsembeddedintheinvestmentsto
Delayordefermakingtheinvestment(delay)
Adjustoralterproductionschedulesaspricechanges(flexibility)
Expandintonewmarketsorproductsatlaterstagesintheprocess,based
uponobservingfavorableoutcomesattheearlystages(expansion)
Stopproductionorabandoninvestmentsiftheoutcomesareunfavorable
atearlystages(abandonment)

Putanotherway,realoptionadvocatesbelievethatyoushouldbe
payingapremiumondiscountedcashflowvalueestimates.

Aswath Damodaran

84

Three Basic Questions

Whenistherearealoptionembeddedinadecisionoranasset?
Whendoesthatrealoptionhavesignificanteconomicvalue?
Canthatvaluebeestimatedusinganoptionpricingmodel?

Aswath Damodaran

85

When is there an option embedded in an

action?

Anoptionprovidestheholderwiththerighttobuyorsellaspecified
quantityofanunderlyingassetatafixedprice(calledastrikepriceor
anexerciseprice)atorbeforetheexpirationdateoftheoption.
Therehastobeaclearlydefinedunderlyingassetwhosevalue
changesovertimeinunpredictableways.
Thepayoffsonthisasset(realoption)havetobecontingentonan
specifiedeventoccurringwithinafiniteperiod.

Aswath Damodaran

86

Payoff Diagram on a Call

NetPayoff
onCall

Strike
Price
Priceofunderlyingasset

Aswath Damodaran

87

Example 1: Product Patent as an Option

PVofCashFlows
fromProject

InitialInvestmentin
Project
PresentValueofExpected
CashFlowsonProduct
Projecthasnegative
NPVinthissection

Aswath Damodaran

Project'sNPVturns
positiveinthissection

88

Example 2: Undeveloped Oil Reserve as an

option

NetPayoffon
Extraction

CostofDeveloping
Reserve

Valueofestimatedreserve
ofnaturalresource

Aswath Damodaran

89

Example 3: Expansion of existing project as an

option

PVofCashFlows
fromExpansion

AdditionalInvestment
toExpand
PresentValueofExpected
CashFlowsonExpansion
Firmwillnotexpandin
thissection

Aswath Damodaran

Expansionbecomes
attractiveinthissection

90

When does the option have significant

economic value?

Foranoptiontohavesignificanteconomicvalue,therehastobea
restrictiononcompetitionintheeventofthecontingency.Ina
perfectlycompetitiveproductmarket,nocontingency,nomatterhow
positive,willgeneratepositivenetpresentvalue.
Atthelimit,realoptionsaremostvaluablewhenyouhaveexclusivity
youandonlyyoucantakeadvantageofthecontingency.They
becomelessvaluableasthebarrierstocompetitionbecomelesssteep.

Aswath Damodaran

91

Exclusivity: Putting Real Options to the Test

ProductOptions:Patentonadrug
Patentsrestrictcompetitorsfromdevelopingsimilarproducts
Patentsdonotrestrictcompetitorsfromdevelopingotherproductstotreat
thesamedisease.

NaturalResourceoptions:Anundevelopedoilreserveorgoldmine.
Naturalresourcereservesarelimited.
Ittakestimeandresourcestodevelopnewreserves

GrowthOptions:Expansionintoanewproductormarket
Barriersmayrangefromstrong(exclusivelicensesgrantedbythe
governmentasintelecombusinesses)toweaker(brandname,
knowledgeofthemarket)toweakest(firstmover).

Aswath Damodaran

92

Determinants of option value

VariablesRelatingtoUnderlyingAsset

VariablesRelatingtoOption

ValueofUnderlyingAsset;asthisvalueincreases,therighttobuyatafixedprice
(calls)willbecomemorevaluableandtherighttosellatafixedprice(puts)will
becomelessvaluable.
Varianceinthatvalue;asthevarianceincreases,bothcallsandputswillbecome
morevaluablebecausealloptionshavelimiteddownsideanddependuponprice
volatilityforupside.
Expecteddividendsontheasset,whicharelikelytoreducethepriceappreciation
componentoftheasset,reducingthevalueofcallsandincreasingthevalueofputs.
StrikePriceofOptions;therighttobuy(sell)atafixedpricebecomesmore(less)
valuableatalowerprice.
LifeoftheOption;bothcallsandputsbenefitfromalongerlife.

LevelofInterestRates;asratesincrease,therighttobuy(sell)atafixedprice
inthefuturebecomesmore(less)valuable.

Aswath Damodaran

93

When can you use option pricing models to

value real options?

Alloptionpricingmodelsrestontwofoundations.

Asaresult,optionpricingmodelsworkbestwhen

Thefirstisthenotionofareplicatingportfoliowhereyoucombinetheunderlying
assetandborrowing/lendingtocreateaportfoliothathasthesamecashflowsasthe
option.
Thesecondisarbitrage.Sinceboththeoptionandthereplicatingportfoliohavethe
samecashflows,theyshouldtradeatthesamevalue.
Theunderlyingassetistradedthisyieldnotonlyobservablepricesandvolatility
asinputstooptionpricingmodelsbutallowsforthepossibilityofcreating
replicatingportfolios
Anactivemarketplaceexistsfortheoptionitself.

Whenoptionpricingmodelsareusedtovaluerealassetswhereneither
replicationnorarbitrageareusuallyfeasible,wehavetoacceptthefactthat

Aswath Damodaran

Thevalueestimatesthatemergewillbefarmoreimprecise.
Thevaluecandeviatemuchmoredramaticallyfrommarketpricebecauseofthe
difficultyofarbitrage.

94

Illustrating Replication: The Binomial Option

Pricing Model

OptionDetails
K=$40
t=2
r=11%

100D1.11B=60
50D1.11B=10
D=1,B=36.04
Call=1*7036.04=33.96

Stock
Price

Call

100

60

50

10

25

Call=33.96
70D1.11B=33.96
35D1.11B=4.99
70
D=0.8278,B=21.61
Call=0.8278*5021.61=19.42

50
Call=19.42

35
Call=4.99
50D1.11B=10
25D1.11B=0
D=0.4,B=9.01
Call=0.4*359.01=4.99

Aswath Damodaran

95

The Black Scholes Model

Valueofcall=SN(d1)KertN(d2)
where,
2

S
ln + (r +
)t
K
2
d1 =
t

d2=d1t

ThereplicatingportfolioisembeddedintheBlackScholesmodel.To
replicatethiscall,youwouldneedto
BuyN(d1)sharesofstock;N(d1)iscalledtheoptiondelta
BorrowKertN(d2)

Aswath Damodaran

96

The Normal Distribution

d

N(d 1)

d1

Aswath Damodaran

-3.00
-2.95
-2.90
-2.85
-2.80
-2.75
-2.70
-2.65
-2.60
-2.55
-2.50
-2.45
-2.40
-2.35
-2.30
-2.25
-2.20
-2.15
-2.10
-2.05
-2.00
-1.95
-1.90
-1.85
-1.80
-1.75
-1.70
-1.65
-1.60
-1.55
-1.50
-1.45
-1.40
-1.35
-1.30
-1.25
-1.20
-1.15
-1.10
-1.05
-1.00

N(d)
0.0013
0.0016
0.0019
0.0022
0.0026
0.0030
0.0035
0.0040
0.0047
0.0054
0.0062
0.0071
0.0082
0.0094
0.0107
0.0122
0.0139
0.0158
0.0179
0.0202
0.0228
0.0256
0.0287
0.0322
0.0359
0.0401
0.0446
0.0495
0.0548
0.0606
0.0668
0.0735
0.0808
0.0885
0.0968
0.1056
0.1151
0.1251
0.1357
0.1469
0.1587

d
-1.00
-0.95
-0.90
-0.85
-0.80
-0.75
-0.70
-0.65
-0.60
-0.55
-0.50
-0.45
-0.40
-0.35
-0.30
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
0.55
0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95
1.00

N(d)
0.1587
0.1711
0.1841
0.1977
0.2119
0.2266
0.2420
0.2578
0.2743
0.2912
0.3085
0.3264
0.3446
0.3632
0.3821
0.4013
0.4207
0.4404
0.4602
0.4801
0.5000
0.5199
0.5398
0.5596
0.5793
0.5987
0.6179
0.6368
0.6554
0.6736
0.6915
0.7088
0.7257
0.7422
0.7580
0.7734
0.7881
0.8023
0.8159
0.8289
0.8413

d
1.05
1.10
1.15
1.20
1.25
1.30
1.35
1.40
1.45
1.50
1.55
1.60
1.65
1.70
1.75
1.80
1.85
1.90
1.95
2.00
2.05
2.10
2.15
2.20
2.25
2.30
2.35
2.40
2.45
2.50
2.55
2.60
2.65
2.70
2.75
2.80
2.85
2.90
2.95
3.00

N(d)
0.8531
0.8643
0.8749
0.8849
0.8944
0.9032
0.9115
0.9192
0.9265
0.9332
0.9394
0.9452
0.9505
0.9554
0.9599
0.9641
0.9678
0.9713
0.9744
0.9772
0.9798
0.9821
0.9842
0.9861
0.9878
0.9893
0.9906
0.9918
0.9929
0.9938
0.9946
0.9953
0.9960
0.9965
0.9970
0.9974
0.9978
0.9981
0.9984
0.9987

97

1. Obtaining Inputs for Patent Valuation

Input

EstimationProcess

1.ValueoftheUnderlyingAsset

PresentValueofCashInflowsfromtakingproject
now
Thiswillbenoisy,butthataddsvalue.

2.Varianceinvalueofunderlyingasset

Varianceincashflowsofsimilarassetsorfirms
Varianceinpresentvaluefromcapitalbudgeting
simulation.

3.ExercisePriceonOption

Optionisexercisedwheninvestmentismade.
Costofmakinginvestmentontheproject ;assumed
tobeconstantinpresentvaluedollars.

4.ExpirationoftheOption

Lifeofthepatent

5.DividendYield

Costofdelay
Eachyearofdelaytranslatesintoonelessyearof
valuecreating cashflows
Annualcostofdelay =

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n

98

Valuing a Product Patent as an option: Avonex

Biogen,abiotechnologyfirm,hasapatentonAvonex,adrugtotreat
multiplesclerosis,forthenext17years,anditplanstoproduceand
sellthedrugbyitself.Thekeyinputsonthedrugareasfollows:
PVofCashFlowsfromIntroducingtheDrugNow=S=$3.422billion
PVofCostofDevelopingDrugforCommercialUse=K=$2.875billion
PatentLife=t=17yearsRisklessRate=r=6.7%(17yearT.Bondrate)
VarianceinExpectedPresentValues=2=0.224(Industryaveragefirm
varianceforbiotechfirms)
ExpectedCostofDelay=y=1/17=5.89%
d1=1.1362 N(d1)=0.8720
d2=0.8512 N(d2)=0.2076

CallValue=3,422exp(0.0589)(17)(0.8720)2,875(exp(0.067)(17)(0.2076)=$
907million

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99

2. Valuing an Oil Reserve

Consideranoffshoreoilpropertywithanestimatedoilreserveof50
millionbarrelsofoil,wherethepresentvalueofthedevelopmentcost
is$12perbarrelandthedevelopmentlagistwoyears.
Thefirmhastherightstoexploitthisreserveforthenexttwentyyears
andthemarginalvalueperbarrelofoilis$12perbarrelcurrently
(Priceperbarrelmarginalcostperbarrel).
Oncedeveloped,thenetproductionrevenueeachyearwillbe5%of
thevalueofthereserves.
Therisklessrateis8%andthevarianceinln(oilprices)is0.03.

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100

Valuing an oil reserve as a real option

CurrentValueoftheasset=S=Valueofthedevelopedreserve
discountedbackthelengthofthedevelopmentlagatthedividend
yield=$12*50/(1.05)2=$544.22
(Ifdevelopmentisstartedtoday,theoilwillnotbeavailableforsale
untiltwoyearsfromnow.Theestimatedopportunitycostofthisdelay
isthelostproductionrevenueoverthedelayperiod.Hence,the
discountingofthereservebackatthedividendyield)
ExercisePrice=PresentValueofdevelopmentcost=$12*50=
$600million
Timetoexpirationontheoption=20years
Varianceinthevalueoftheunderlyingasset=0.03
Risklessrate=8%
DividendYield=Netproductionrevenue/Valueofreserve=5%

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101

Valuing Undeveloped Reserves

Inputsforvaluingundevelopedreserves

Valueofunderlyingasset=Valueofestimatedreservesdiscountedbackforperiod
ofdevelopmentlag=3038*($22.38$7)/1.052=$42,380.44
Exerciseprice=Estimateddevelopmentcostofreserves=3038*$10=$30,380
million
Timetoexpiration=Averagelengthofrelinquishmentoption=12years
Varianceinvalueofasset=Varianceinoilprices=0.03
Risklessinterestrate=9%
Dividendyield=Netproductionrevenue/Valueofdevelopedreserves=5%

Basedupontheseinputs,theBlackScholesmodelprovidesthefollowing
valueforthecall:
d1=1.6548
d2=1.0548

N(d1)=0.9510
N(d2)=0.8542

CallValue=42,380.44exp(0.05)(12)(0.9510)30,380(exp(0.09)(12)(0.8542)=$
13,306million

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102

3. An Example of an Expansion Option

AmbevisconsideringintroducingasoftdrinktotheU.S.market.The
drinkwillinitiallybeintroducedonlyinthemetropolitanareasofthe
U.S.andthecostofthislimitedintroductionis$500million.
Afinancialanalysisofthecashflowsfromthisinvestmentsuggests
thatthepresentvalueofthecashflowsfromthisinvestmenttoAmbev
willbeonly$400million.Thus,byitself,thenewinvestmenthasa
negativeNPVof$100million.
Iftheinitialintroductionworksoutwell,Ambevcouldgoaheadwith
afullscaleintroductiontotheentiremarketwithanadditional
investmentof$1billionanytimeoverthenext5years.Whilethe
currentexpectationisthatthecashflowsfromhavingthisinvestment
isonly$750million,thereisconsiderableuncertaintyaboutboththe
potentialforthedrink,leadingtosignificantvarianceinthisestimate.

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103

Valuing the Expansion Option

ValueoftheUnderlyingAsset(S)=PVofCashFlowsfrom
ExpansiontoentireU.S.market,ifdonenow=$750Million
StrikePrice(K)=CostofExpansionintoentireU.Smarket=$1000
Million
Weestimatethestandarddeviationintheestimateoftheprojectvalue
byusingtheannualizedstandarddeviationinfirmvalueofpublicly
tradedfirmsinthebeveragemarkets,whichisapproximately34.25%.
StandardDeviationinUnderlyingAssetsValue=34.25%

Timetoexpiration=Periodforwhichexpansionoptionapplies=5
years
CallValue=$234Million

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104

Opportunities and not Options

Is the first investment necessary for the second investment?
Not necessary

Pre-Requisit

A Zero competitive
advantage on Second Investment

An Exclusive Right to
Second Investment

No option value
Option has no value

100% of option value

Option has high value
Second investment
has large sustainable
excess return

Second Investment has

zero excess returns
FirstMover

Technological
Edge

Brand
Name

Telecom
Licenses

Pharmaceutical
patents

Increasing competitive advantage/ barriers to entry

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105

Key Tests for Real Options

Isthereanoptionembeddedinthisasset/decision?
Canyouidentifytheunderlyingasset?
Canyouspecifythecontigencyunderwhichyouwillgetpayoff?

Isthereexclusivity?
Ifyes,thereisoptionvalue.
Ifno,thereisnone.
Ifinbetween,youhavetoscalevalue.

Canyouuseanoptionpricingmodeltovaluetherealoption?
Istheunderlyingassettraded?
Cantheoptionbeboughtandsold?
Isthecostofexercisingtheoptionknownandclear?

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106