EstimatingDiscountRates

DCFValuation

Aswath Damodaran

EstimatingInputs:DiscountRates

Criticalingredientindiscountedcashflowvaluation.Errorsinestimatingthe
discountrateormismatchingcashflowsanddiscountratescanleadtoserious
errorsinvaluation.
Atanintuitivelevel,thediscountrateusedshouldbeconsistentwithboththe
riskinessandthetypeofcashflowbeingdiscounted.

Aswath Damodaran

EquityversusFirm:Ifthecashflowsbeingdiscountedarecashflowstoequity,the
appropriatediscountrateisacostofequity.Ifthecashflowsarecashflowstothe
firm,theappropriatediscountrateisthecostofcapital.
Currency:Thecurrencyinwhichthecashflowsareestimatedshouldalsobethe
currencyinwhichthediscountrateisestimated.
NominalversusReal:Ifthecashflowsbeingdiscountedarenominalcashflows
(i.e.,reflectexpectedinflation),thediscountrateshouldbenominal

CostofEquity

Thecostofequityshouldbehigherforriskierinvestmentsandlowerforsafer
investments
Whileriskisusuallydefinedintermsofthevarianceofactualreturnsaround
anexpectedreturn,riskandreturnmodelsinfinanceassumethattheriskthat
shouldberewarded(andthusbuiltintothediscountrate)invaluationshould
betheriskperceivedbythemarginalinvestorintheinvestment
Mostriskandreturnmodelsinfinancealsoassumethatthemarginalinvestor
iswelldiversified,andthattheonlyriskthatheorsheperceivesinan
investmentisriskthatcannotbediversifiedaway(I.e,marketornon
diversifiablerisk)

Aswath Damodaran

TheCostofEquity:CompetingModels

Model
CAPM

APM

Multi

ExpectedReturn
E(R)=Rf+(RmRf)

InputsNeeded
RiskfreeRate

E(R)=Rf+j=1j(RjRf)

Betarelativetomarketportfolio
MarketRiskPremium
RiskfreeRate;#ofFactors;

E(R)=Rf+j=1,,Nj(RjRf)

Betasrelativetoeachfactor
Factorriskpremiums
RiskfreeRate;Macrofactors

E(R)=a+j=1..NbjYj

Betasrelativetomacrofactors
Macroeconomicriskpremiums
Proxies

factor
Proxy

Regressioncoefficients

Aswath Damodaran

TheCAPM:CostofEquity

Considerthestandardapproachtoestimatingcostofequity:
CostofEquity=Rf+EquityBeta*(E(Rm)Rf)

where,
Rf=Riskfreerate
E(Rm)=ExpectedReturnontheMarketIndex(DiversifiedPortfolio)

Inpractice,

Aswath Damodaran

Shorttermgovernmentsecurityratesareusedasriskfreerates
Historicalriskpremiumsareusedfortheriskpremium
Betasareestimatedbyregressingstockreturnsagainstmarketreturns

ShorttermGovernmentsarenotriskfreeinvaluation.

Onariskfreeasset,theactualreturnisequaltotheexpectedreturn.Therefore,
thereisnovariancearoundtheexpectedreturn.
Foraninvestmenttoberiskfree,then,ithastohave

Nodefaultrisk
Noreinvestmentrisk

Thus,theriskfreeratesinvaluationwilldependuponwhenthecashflowis
expectedtooccurandwillvaryacrosstime.
Invaluation,thetimehorizonisgenerallyinfinite,leadingtotheconclusion
thatalongtermriskfreeratewillalwaysbepreferabletoashorttermrate,if
youhavetopickone.

Aswath Damodaran

RiskfreeRatesin2004
Riskfree Rates: An Exploration
$ denominated bonds

12.00%

11.50%

10.26%
10.00%

8.00%

10-year Euro Bonds

6.00%
4.30%

4.45%

4.42%

4.25%

4.00%

2.00%

1.50%

0.00%
Germany 10year (Euro)

Aswath Damodaran

Greece 10year (Euro)

Italy 10-year
(Euro)

US 10-year
Treasury ($)

Brazil 10-year
C Bond ($)

Mexican 10year (Peso)

Japanese 10Year (Yen)

EstimatingaRiskfreeRatewhentherearenodefaultfree
entities.

Estimatearangefortheriskfreerateinlocalterms:

Approach1:Subtractdefaultspreadfromlocalgovernmentbondrate:
GovernmentbondrateinlocalcurrencytermsDefaultspreadforGovernmentinlocal
currency
Approach2:Useforwardratesandtherisklessrateinanindexcurrency(sayEuros
ordollars)toestimatetherisklessrateinthelocalcurrency.

Dotheanalysisinrealterms(ratherthannominalterms)usingarealriskfree
rate,whichcanbeobtainedinoneoftwoways

fromaninflationindexedgovernmentbond,ifoneexists
setequal,approximately,tothelongtermrealgrowthrateoftheeconomyinwhich
thevaluationisbeingdone.

Dotheanalysisinacurrencywhereyoucangetariskfreerate,sayUSdollars.

Aswath Damodaran

ASimpleTest

A.
B.
C.
D.
E.

YouarevaluingEmbraer,aBraziliancompany,inU.S.dollarsandare
attemptingtoestimateariskfreeratetouseintheanalysis.Theriskfreerate
thatyoushoulduseis
TheinterestrateonaBrazilianRealdenominatedlongtermbondissuedby
theBrazilianGovernment(15%)
TheinterestrateonaUS$denominatedlongtermbondissuedbythe
BrazilianGovernment(CBond)(10.30%)
TheinterestrateonaUS$denominatedBrazilianBradybond(whichis
partiallybackedbytheUSGovernment)(10.15%)
TheinterestrateonadollardenominatedbondissuedbyEmbraer(9.25%)
TheinterestrateonaUStreasurybond(4.29%)

Aswath Damodaran

Everyoneuseshistoricalpremiums,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%
10

Ifyouchoosetousehistoricalpremiums.

Gobackasfarasyoucan.Ariskpremiumcomeswithastandarderror.Given
theannualstandarddeviationinstockpricesisabout25%,thestandarderror
inahistoricalpremiumestimatedover25yearsisroughly:
StandardErrorinPremium=25%/25=25%/5=5%
Beconsistentinyouruseoftheriskfreerate.Sincewearguedforlongterm
bondrates,thepremiumshouldbetheoneoverT.Bonds
Usethegeometricriskpremium.Itisclosertohowinvestorsthinkaboutrisk
premiumsoverlongperiods.

Aswath Damodaran

11

RiskPremiumforaMatureMarket?Broadeningthesample

Aswath Damodaran

12

TwoWaysofEstimatingCountryEquityRiskPremiumsfor
othermarkets..

DefaultspreadonCountryBond:Inthisapproach,thecountryequityriskpremiumis
setequaltothedefaultspreadofthebondissuedbythecountry(butonlyifitis
denominatedinacurrencywhereadefaultfreeentityexists.

BrazilwasratedB2byMoodysandthedefaultspreadontheBraziliandollardenominated
C.BondattheendofAugust2004was6.01%.(10.30%4.29%)

RelativeEquityMarketapproach:Thecountryequityriskpremiumisbaseduponthe
volatilityofthemarketinquestionrelativetoU.Smarket.
Totalequityriskpremium=RiskPremiumUS*CountryEquity/USEquity
Usinga4.82%premiumfortheUS,thisapproachwouldyield:
TotalriskpremiumforBrazil=4.82%(34.56%/19.01%)=8.76%
CountryequityriskpremiumforBrazil=8.76%4.82%=3.94%
(Thestandarddeviationinweeklyreturnsfrom2002to2004fortheBovespawas34.56%whereas
thestandarddeviationintheS&P500was19.01%)

Aswath Damodaran

13

Andathirdapproach

Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsandequity
riskpremiumsarehighlycorrelated,onewouldexpectequityspreadstobe
higherthandebtspreads.
Anotheristomultiplythebonddefaultspreadbytherelativevolatilityof
stockandbondpricesinthatmarket.Inthisapproach:

CountryEquityriskpremium=Defaultspreadoncountrybond*CountryEquity/
CountryBond
StandardDeviationinBovespa(Equity)=34.56%
StandardDeviationinBrazilCBond=26.34%
DefaultspreadonCBond=6.01%

Aswath Damodaran

CountryEquityRiskPremium=6.01%(34.56%/26.34%)=7.89%

14

Cancountryriskpremiumschange?UpdatingBrazilin
January2004

Brazilsfinancialstandingandcountryratingimproveddramaticallytowards
theendof2004.ItsratingimprovedtoB1.InJanuary2005,theinterestrate
ontheBrazilianCBonddroppedto7.73%.TheUStreasurybondratethat
daywas4.22%,yieldingadefaultspreadof3.51%forBrazil.

Aswath Damodaran

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

15

FromCountryEquityRiskPremiumstoCorporateEquity
Riskpremiums

Approach1:Assumethateverycompanyinthecountryisequallyexposedto
countryrisk.Inthiscase,
E(Return)=RiskfreeRate+CountryERP+Beta(USpremium)
Implicitly,thisiswhatyouareassumingwhenyouusethelocalGovernmentsdollar
borrowingrateasyourriskfreerate.

Approach2:Assumethatacompanysexposuretocountryriskissimilarto
itsexposuretoothermarketrisk.
E(Return)=RiskfreeRate+Beta(USpremium+CountryERP)
Approach3:Treatcountryriskasaseparateriskfactorandallowfirmsto
havedifferentexposurestocountryrisk(perhapsbasedupontheproportionof
theirrevenuescomefromnondomesticsales)
E(Return)=RiskfreeRate+(USpremium)+CountryERP)
ERP:EquityRiskPremium

Aswath Damodaran

16

EstimatingCompanyExposuretoCountryRisk:
Determinants

Sourceofrevenues:Otherthingsremainingequal,acompanyshouldbemore
exposedtoriskinacountryifitgeneratesmoreofitsrevenuesfromthat
country.ABrazilianfirmthatgeneratesthebulkofitsrevenuesinBrazil
shouldbemoreexposedtocountryriskthanonethatgeneratesasmaller
percentofitsbusinesswithinBrazil.
Manufacturingfacilities:Otherthingsremainingequal,afirmthathasallof
itsproductionfacilitiesinBrazilshouldbemoreexposedtocountryriskthan
onewhichhasproductionfacilitiesspreadovermultiplecountries.The
problemwillbeaccentedforcompaniesthatcannotmovetheirproduction
facilities(miningandpetroleumcompanies,forinstance).
Useofriskmanagementproducts:Companiescanusebothoptions/futures
marketsandinsurancetohedgesomeorasignificantportionofcountryrisk.

Aswath Damodaran

17

EstimatingLambdas:TheRevenueApproach
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

EstimatingLambdas:EarningsApproach

1.5

40.00%

30.00%

0.5

20.00%

10.00%
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

0.00%

10.00%

1.5

20.00%

30.00%

Embraer

Aswath Damodaran

Embratel

CBond

19

EstimatingLambdas:StockReturnsversusCBondReturns
ReturnEmbraer=0.0195+0.2681ReturnCBond
ReturnEmbratel=0.0308+2.0030ReturnCBond

Aswath Damodaran

20

EstimatingaUSDollarCostofEquityforEmbraer
September2004
AssumethatthebetaforEmbraeris1.07,andthattheriskfreerateusedis4.29%.Also
assumethattheriskpremiumfortheUSis4.82%andthecountryriskpremiumfor
Brazilis7.89%.
Approach1:Assumethateverycompanyinthecountryisequallyexposedtocountry
risk.Inthiscase,
E(Return)=4.29%+1.07(4.82%)+7.89%=17.34%
Approach2:Assumethatacompanysexposuretocountryriskissimilartoitsexposure
toothermarketrisk.
E(Return)=4.29%+1.07(4.82%+7.89%)=17.89%
Approach3:Treatcountryriskasaseparateriskfactorandallowfirmstohavedifferent
exposurestocountryrisk(perhapsbasedupontheproportionoftheirrevenuescome
fromnondomesticsales)
E(Return)=4.29%+(4.82%)+%)=11.58%

Aswath Damodaran

21

ValuingEmergingMarketCompanieswithsignificant
exposureindevelopedmarkets

A.
B.

Theconventionalpracticeininvestmentbankingistoaddthecountryequity
riskpremiumontothecostofequityforeveryemergingmarketcompany,
notwithstandingitsexposuretoemergingmarketrisk.Thus,Embraerwould
havebeenvaluedwithacostofequityof17.34%eventhoughitgetsonly3%
ofitsrevenuesinBrazil.Asaninvestor,whichofthefollowingconsequences
doyouseefromthisapproach?
Emergingmarketcompanieswithsubstantialexposureindevelopedmarkets
willbesignificantlyovervaluedbyequityresearchanalysts.
Emergingmarketcompanieswithsubstantialexposureindevelopedmarkets
willbesignificantlyundervaluedbyequityresearchanalysts.
Canyouconstructaninvestmentstrategytotakeadvantageofthe
misvaluation?

Aswath Damodaran

22

ImpliedEquityPremiums

Ifweassumethatstocksarecorrectlypricedintheaggregateandwecan
estimatetheexpectedcashflowsfrombuyingstocks,wecanestimatethe
expectedrateofreturnonstocksbycomputinganinternalrateofreturn.
Subtractingouttheriskfreerateshouldyieldanimpliedequityriskpremium.
Thisimpliedequitypremiumisaforwardlookingnumberandcanbeupdated
asoftenasyouwant(everyminuteofeveryday,ifyouaresoinclined).

Aswath Damodaran

23

ImpliedEquityPremiums

Wecanusetheinformationinstockpricestobackouthowriskaversethemarketisandhowmuch
ofariskpremiumitisdemanding.

Analystsexpectearningstogrow8.5%ayearforthenext5years.
January1,2005
52.85
48.71
44.89
41.37
38.13
In2004,dividends&stock
Afteryear5,wewillassumethat
S&P500isat1211.92
buybackswere2.90%of
earningsontheindexwillgrowat

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

24

ImpliedRiskPremiumDynamics

Assumethattheindexjumps10%onJanuary2andthatnothingelsechanges.
Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease
Assumethattheearningsjump10%onJanuary2andthatnothingelse
changes.Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease
Assumethattheriskfreerateincreasesto5%onJanuary2andthatnothing
elsechanges.Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease

Aswath Damodaran

25

ImpliedPremiumsintheUS

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Aswath Damodaran

26

ImpliedPremiumversusRiskFreeRate
Implied Premium versus Riskfree Rate
25.00%

Expected Return on Stocks = T.Bond Rate + Equity Risk Premium

20.00%

15.00%

ERP

10.00%

5.00%

T. Bond Rate

0.00%
1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
T.Bond Rate

Aswath Damodaran

Implied Premium (FCFE)

27

ImpliedPremiums:FromBubbletoBearMarketJanuary
2000toJanuary2003

Aswath Damodaran

28

EffectofChangingTaxStatusofDividendsonStockPrices
January2003
ExpectedReturnonStocks(Implied)inJan2003
=
7.91%
DividendYieldinJanuary2003
=
2.00%
Assumingthatdividendsweretaxedat30%(onaverage)on1/1/03andthat
capitalgainsweretaxedat15%.
Aftertaxexpectedreturnonstocks=2%(1.3)+5.91%(1.15)=6.42%
Ifthetaxrateondividendsdropsto15%andtheaftertaxexpectedreturn
remainsthesame:
2%(1.15)+X%(1.15)=6.42%
NewPretaxrequiredrateofreturn=7.56%
Newequityriskpremium=3.75%
ValueoftheS&P500atnewequityriskpremium=965.11
ExpectedIncreaseinindexduetodividendtaxchange=9.69%

Aswath Damodaran

29

WhichequityriskpremiumshouldyouusefortheUS?

HistoricalRiskPremium:Whenyouusethehistoricalriskpremium,youare
assumingthatpremiumswillrevertbacktoahistoricalnormandthatthetime
periodthatyouareusingistherightnorm.Youarealsomorelikelytofind
stockstobeovervaluedthanundervalued(Why?)
CurrentImpliedEquityRiskpremium:Youareassumingthatthemarketis
correctintheaggregatebutmakesmistakesonindividualstocks.Ifyouare
requiredtobemarketneutral,thisisthepremiumyoushoulduse.(What
typesofvaluationsrequiremarketneutrality?)
AverageImpliedEquityRiskpremium:Theaverageimpliedequityrisk
premiumbetween19602003intheUnitedStatesisabout4%.Youare
assumingthatthemarketiscorrectonaveragebutnotnecessarilyatapointin
time.

Aswath Damodaran

30

ImpliedPremiumfortheIndianMarket:June15,2004

LeveloftheIndex(S&PCNXIndex)=1219

Thisisamarketcapweightedindexofthe500largestcompaniesinIndiaand
represents90%ofthemarketvalueofIndiancompanies

DividendsontheIndex=3.51%of1219(Simpleaverageis2.75%)
Otherparameters

RiskfreeRate=5.50%
ExpectedGrowth(inRs)
Next5years=18%(UsedexpectedgrowthrateinEarnings)
Afteryear5=5.5%

Solvingfortheexpectedreturn:

Aswath Damodaran

ExpectedreturnonEquity=11.76%
ImpliedEquitypremium=11.765.5%=6.16%

31

ImpliedEquityRiskPremiumforGermany:September23,
2004

Wecanusetheinformationinstockpricestobackouthowriskaversethemarketisandhowmuchofariskpremium
itisdemanding.

at 3.95%
buybacks
over
the next
awere
year
5 years
2.67%for
of stocks in the DAX (Source: IBES)
forever
the
index
after
lastyear
year5
Source: Bloomberg

Ifyoupaythecurrentleveloftheindex,youcanexpecttomakeareturnof7.78%onstocks(whichisobtainedby
solvingforrinthefollowingequation)

ImpliedEquityriskpremium=ExpectedreturnonstocksTreasurybondrate=7.78%3.95%=3.83%
3905.65 =

116.13 129.32 144.01 160.37 178.59

178.59(1.0395)
+
+
+
+
+
(1+ r) (1 + r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r .0395)(1+ r) 5

Aswath Damodaran

32

EstimatingBeta

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

whereaistheinterceptandbistheslopeoftheregression.

Theslopeoftheregressioncorrespondstothebetaofthestock,andmeasures
theriskinessofthestock.
Thisbetahasthreeproblems:

Aswath Damodaran

Ithashighstandarderror
Itreflectsthefirmsbusinessmixovertheperiodoftheregression,notthecurrent
mix
Itreflectsthefirmsaveragefinancialleverageovertheperiodratherthanthe
currentleverage.

33

BetaEstimation:TheNoiseProblem

Aswath Damodaran

34

BetaEstimation:TheIndexEffect

Aswath Damodaran

35

SolutionstotheRegressionBetaProblem

Modifytheregressionbetaby

Estimatethebetaforthefirmusing

thestandarddeviationinstockpricesinsteadofaregressionagainstanindex
accountingearningsorrevenues,whicharelessnoisythanmarketprices.

Estimatethebetaforthefirmfromthebottomupwithoutemployingthe
regressiontechnique.Thiswillrequire

changingtheindexusedtoestimatethebeta
adjustingtheregressionbetaestimate,bybringingininformationaboutthe
fundamentalsofthecompany

understandingthebusinessmixofthefirm
estimatingthefinancialleverageofthefirm

Useanalternativemeasureofmarketrisknotbaseduponaregression.

Aswath Damodaran

36

TheIndexGame

A
8

r a c r u z

A D

v s

S &

5 0 0

A
1

r a c r u z

v s

B o v e

s p

R
D
A

z
u
r
c
a
r

z
u
r
c
a
r

A
0

S &

Aracruz ADR = 2.80% + 1.00 S&P

Aswath Damodaran

5 0

4 0

B O

V E S P A

Aracruz = 2.62% + 0.22 Bovespa

37

DeterminantsofBetas
Implciations
Nature
Operating
Financial
Implications
Leverage:
product
Leverage
or(Fixed
Beta ofof
Firm
Beta
of
Equity
service
Costs
Other
1.
Highly
Cyclical
Firms
things
levered
asoffered
with
percent
companies
remaining
high
firms
byinfrastructure
ofshould
total
should
equal,
have
thehighe betas
company
costs):
greater
have
needs
than
firms
higher
and
the:with
rigid
proportion
betas
less
cost
than
debt.
structures
ofnoncapital that
Other
a
cyclical
shoudl
firm things
raises
have
companies.
higher
remaining
from debt,the
betas
equal,
equal
than
higher its
theLuxury
equity
2.
firms
more
greater
with
beta
discretionary
goods
flexible
the
will proportion
be
firms
cost should
structures.
theof
product
the
have
2.
Smaller
costs
higher
orthat
service,
firms
betas
areshould
fixed,
than
the higher
basic
have
the higher
the beta.
higher
goods.
betas
than
the beta
larger
offirms.
the
company.
3.
High priced
Young
firms goods/service
should have
firms should have higher betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Aswath Damodaran

38

Inaperfectworldwewouldestimatethebetaofafirmby
doingthefollowing

Use the
Start
Adjust
with
the
financial
the
business
betaleverage
ofbeta
the business
for
ofthe
theoperating
firm
that
tothe
estimate
leverage
firm isthe
in ofequity
the firm
beta
to for
arrive
the at
firm
the
unlevered
Levered
Beta
beta= for
Unlevered
the firm.Beta ( 1 + (1- tax rate) (Debt/Equity))

Aswath Damodaran

39

Adjustingforoperatingleverage

Withinanybusiness,firmswithlowerfixedcosts(asapercentageoftotal
costs)shouldhavelowerunleveredbetas.Ifyoucancomputefixedand
variablecostsforeachfirminasector,youcanbreakdowntheunleveredbeta
intobusinessandoperatingleveragecomponents.

Unleveredbeta=Purebusinessbeta*(1+(Fixedcosts/Variablecosts))

Thebiggestproblemwithdoingthisisinformational.Itisdifficulttoget
informationonfixedandvariablecostsforindividualfirms.
Inpractice,wetendtoassumethattheoperatingleverageoffirmswithina
businessaresimilarandusethesameunleveredbetaforeveryfirm.

Aswath Damodaran

40

EquityBetasandLeverage

Conventionalapproach:Ifweassumethatdebtcarriesnomarketrisk(hasa
betaofzero),thebetaofequityalonecanbewrittenasafunctionofthe
unleveredbetaandthedebtequityratio
L=u(1+((1t)D/E))
Insomeversions,thetaxeffectisignoredandthereisno(1t)intheequation.

DebtAdjustedApproach:Ifbetacarriesmarketriskandyoucanestimatethe
betaofdebt,youcanestimatetheleveredbetaasfollows:
L=u(1+((1t)D/E))debt(1t)(D/E)

Whilethelatterismorerealistic,estimatingbetasfordebtcanbedifficultto
do.

Aswath Damodaran

41

BottomupBetas

Possible
While
Step
If
you5:
1:expect
2:
3:
4:
can,
revenues
Find
Estimate
Compute
Refinements
adjust
the
publicly
theor
your
business
business
how
athis
debt
operating
weighted
levered
traded
beta
much
to equity
or
mix
for
beta
firms
value
businesses
income
average
differences
of(equity
ratio
your
in
your
each
to
offirm
beta)
the
that
ofderives
these
unlevered
your
for your
firm
businesses
from
firm,
betas
operates
each
using
ofof
and
the
in.
obtain
between
are
different
the
firm
change
different
market
often
to their
change
over
businesses
your
used
debt
regression
businesses
time,
firm
over
as
toweights,
and
the
equity
time,
(from
levered
the
betas.
itratio
you
is
step
comparable
it in.
iscan
Compute
beta
for
better
2) your
using
will firm.
the
thesimple
weightsaverage
from step
across
3.

Aswath Damodaran

42

Whybottomupbetas?
Thestandarderrorinabottomupbetawillbesignificantlylowerthanthe
standarderrorinasingleregressionbeta.Roughlyspeaking,thestandarderror
ofabottomupbetaestimatecanbewrittenasfollows:
Stderrorofbottomupbeta= AverageStdErroracrossBetas

Numberoffirmsinsample

Thebottomupbetacanbeadjustedtoreflectchangesinthefirmsbusiness
mixandfinancialleverage.Regressionbetasreflectthepast.
Youcanestimatebottomupbetasevenwhenyoudonothavehistoricalstock

prices.Thisisthecasewithinitialpublicofferings,privatebusinessesor
divisionsofcompanies.

Aswath Damodaran

43

BottomupBeta:FirminMultipleBusinesses
Disneyin2003
Startwiththeunleveredbetasforthebusinesses
Business
Media Networks
Parks and Resorts
Studio Entertainment
Consumer Products

Comparable firms
Radia and TV broadcasting companies
Theme park & Entertainment firms
Movie companies
Toy and apparel retailers; Entertainment software

Number of firms Average levered beta

Median D/E Unlevered beta Cash/Firm Value
Corrected for cash
24
1.23
20.45%
1.08
0.75%
1.0932
9
1.63
120.76%
0.91
2.77%
0.9364
11
1.35
27.96%
1.14
14.08%
1.3310
77
1.14
9.18%
1.07
12.08%
1.2186

EstimatetheunleveredbetaforDisneysbusinesses
Business
Media Networks
Parks and Resorts
Studio Entertainment
Consumer Products
Disney

Revenues in 2002
EV/Sales Estimated Value
Firm Value Proportion
Unlevered beta
$9,733
3.41
$33,162.67
47.32%
1.0932
$6,465
2.37
$15,334.08
21.88%
0.9364
$6,691
2.63
$17,618.07
25.14%
1.3310
$2,440
1.63
$3,970.60
5.67%
1.2186
$25,329
$70,085.42
100.00%
1.1258

EstimatealeveredbetaforDisney

Marketdebttoequityratio=37.46%
Marginaltaxrate=37.60%
Leveredbeta=1.1258(1+(1.376)(.3746))=1.39

Aswath Damodaran

44

EmbraersBottomupBeta
Business
UnleveredBeta
Aerospace
0.95

D/ERatio
18.95%

Leveredbeta
1.07

LeveredBeta
=UnleveredBeta(1+(1taxrate)(D/ERatio)
=0.95(1+(1.34)(.1895))=1.07

Aswath Damodaran

45

ComparableFirms?
CananunleveredbetaestimatedusingU.S.andEuropeanaerospacecompanies
beusedtoestimatethebetaforaBrazilianaerospacecompany?
Yes
No
Whatconcernswouldyouhaveinmakingthisassumption?

Aswath Damodaran

46

GrossDebtversusNetDebtApproaches

GrossDebtRatioforEmbraer=1953/11,042=18.95%
LeveredBetausingGrossDebtratio=1.07
NetDebtRatioforEmbraer=(DebtCash)/MarketvalueofEquity
=(19532320)/11,042=3.32%
LeveredBetausingNetDebtRatio=0.95(1+(1.34)(.0332))=0.93
ThecostofEquityusingnetdebtleveredbetaforEmbraerwillbemuchlower
thanwiththegrossdebtapproach.ThecostofcapitalforEmbraer,though,
willevenoutsincethedebtratiousedinthecostofcapitalequationwillnow
beanetdebtratioratherthanagrossdebtratio.

Aswath Damodaran

47

SmallFirmandOtherPremiums

Itiscommonpracticetoaddpremiumsontothecostofequityforfirm
specificcharacteristics.Forinstance,manyanalystsaddasmallstock
premiumof33.5%(historicalpremiumforsmallstocksoverthemarket)to
thecostofequityforsmallercompanies.
Addingarbitrarypremiumstothecostofequityisalwaysadangerous
exercise.Ifsmallstocksareriskierthanlargerstocks,weneedtospecifythe
reasonsandtrytoquantifythemratherthantrusthistoricalaverages.(You
couldarguethatsmallercompaniesaremorelikelytoserveniche
(discretionary)marketsorhavehigheroperatingleverageandadjustthebeta
toreflectthistendency).

Aswath Damodaran

48

TheCostofEquity:ARecap

or to
Cost
Has
Preferably,
Historical
ImpliedPremium
ofbe
Equity
Premium
ina the
bottom-up
= same
Riskfree
beta, Rate
+
Beta *
currency
based
1.
Basedonhowequity
Mature
upon
as
Equity
cash
otherMarket
flows,
firms inPremium:
the
and defined
business,
Average
marketispricedtoday
premium
and
in firms
same
earned
own
terms
financial
by
(real orover
leverage
stocks
andasimplevaluation
nominal)
T.Bonds
as the
in U.S.
cash
2.
model
Country
flows risk premium =
Country Default Spread* ( Equity/ Countrybond)

Aswath Damodaran

(Risk Premium)

49

EstimatingtheCostofDebt

Thecostofdebtistherateatwhichyoucanborrowatcurrently,Itwillreflect
notonlyyourdefaultriskbutalsothelevelofinterestratesinthemarket.
Thetwomostwidelyusedapproachestoestimatingcostofdebtare:

Lookinguptheyieldtomaturityonastraightbondoutstandingfromthefirm.The
limitationofthisapproachisthatveryfewfirmshavelongtermstraightbondsthat
areliquidandwidelytraded
Lookinguptheratingforthefirmandestimatingadefaultspreadbaseduponthe
rating.Whilethisapproachismorerobust,differentbondsfromthesamefirmcan
havedifferentratings.Youhavetouseamedianratingforthefirm

Whenintrouble(eitherbecauseyouhavenoratingsormultipleratingsfora
firm),estimateasyntheticratingforyourfirmandthecostofdebtbasedupon
thatrating.

Aswath Damodaran

50

EstimatingSyntheticRatings

Theratingforafirmcanbeestimatedusingthefinancialcharacteristicsofthe
firm.Initssimplestform,theratingcanbeestimatedfromtheinterest
coverageratio
InterestCoverageRatio=EBIT/InterestExpenses
ForEmbraersinterestcoverageratio,weusedtheinterestexpensesfrom
2003andtheaverageEBITfrom2001to2003.(Theaircraftbusinesswas
badlyaffectedby9/11anditsaftermath.In2002and2003,Embraerreported
significantdropsinoperatingincome)

Aswath Damodaran

InterestCoverageRatio=462.1/129.70=3.56

51

InterestCoverageRatios,RatingsandDefaultSpreads
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.ForEmbraer,Iusedtheinterestcoverageratiotableforsmaller/riskierfirms(the
numbersinbrackets)whichyieldsalowerratingforthesameinterestcoverageratio.

Aswath Damodaran

52

CostofDebtcomputations

Companiesincountrieswithlowbondratingsandhighdefaultriskmightbear
theburdenofcountrydefaultrisk,especiallyiftheyaresmallerorhaveallof
theirrevenueswithinthecountry.
Largercompaniesthatderiveasignificantportionoftheirrevenuesinglobal
marketsmaybelessexposedtocountrydefaultrisk.Inotherwords,theymay
beabletoborrowataratelowerthanthegovernment.

ThesyntheticratingforEmbraerisA.Usingthe2004defaultspreadof1.00%,we
estimateacostofdebtof9.29%(usingariskfreerateof4.29%andaddingintwothirds
ofthecountrydefaultspreadof6.01%):
Costofdebt
=Riskfreerate+2/3(Brazilcountrydefaultspread)+Companydefaultspread=4.29%+
4.00%+1.00%=9.29%

Aswath Damodaran

53

SyntheticRatings:SomeCaveats

Therelationshipbetweeninterestcoverageratiosandratings,developedusing
UScompanies,tendstotravelwell,aslongasweareanalyzinglarge
manufacturingfirmsinmarketswithinterestratesclosetotheUSinterestrate
Theyaremoreproblematicwhenlookingatsmallercompaniesinmarkets
withhigherinterestratesthantheUS.

Aswath Damodaran

54

WeightsfortheCostofCapitalComputation

Theweightsusedtocomputethecostofcapitalshouldbethemarketvalue
weightsfordebtandequity.
Thereisanelementofcircularitythatisintroducedintoeveryvaluationby
doingthis,sincethevaluesthatweattachtothefirmandequityattheendof
theanalysisaredifferentfromthevalueswegavethematthebeginning.
Asageneralrule,thedebtthatyoushouldsubtractfromfirmvaluetoarriveat
thevalueofequityshouldbethesamedebtthatyouusedtocomputethecost
ofcapital.

Aswath Damodaran

55

EstimatingCostofCapital:Embraer

Equity

CostofEquity=4.29%+1.07(4%)+0.27(7.89%)=10.70%
MarketValueofEquity=11,042millionBR($3,781million)

Debt

Costofdebt=4.29%+4.00%+1.00%=9.29%
MarketValueofDebt=2,083millionBR($713million)

CostofCapital
CostofCapital=10.70%(.84)+9.29%(1.34)(0.16))=9.97%
ThebookvalueofequityatEmbraeris3,350millionBR.
ThebookvalueofdebtatEmbraeris1,953millionBR;Interestexpenseis222milBR;
Averagematurityofdebt=4years
Estimatedmarketvalueofdebt=222million(PVofannuity,4years,9.29%)+$1,953
million/1.09294=2,083millionBR

Aswath Damodaran

56

Ifyouhadtodoit.ConvertingaDollarCostofCapitaltoa
NominalRealCostofCapital

Approach1:UseaBRriskfreerateinallofthecalculationsabove.Forinstance,ifthe
BRriskfreeratewas12%,thecostofcapitalwouldbecomputedasfollows:

CostofEquity=12%+(4%)+%)=18.41%
CostofDebt=12%+1%=13%
(Thisassumestheriskfreeratehasnocountryriskpremiumembeddedinit.)

Approach2:Usethedifferentialinflationratetoestimatethecostofcapital.For
instance,iftheinflationrateinBRis8%andtheinflationrateintheU.S.is2%
Costofcapital=

1 + Inflation
BR
(1+ CostofCapital$ )

1+
Inflation
=1.0997(1.08/1.02)1=0.1644or16.44%

Aswath Damodaran

57

DealingwithHybridsandPreferredStock

Whendealingwithhybrids(convertiblebonds,forinstance),breakthe
securitydownintodebtandequityandallocatetheamountsaccordingly.
Thus,ifafirmhas$125millioninconvertibledebtoutstanding,breakthe
$125millionintostraightdebtandconversionoptioncomponents.The
conversionoptionisequity.
Whendealingwithpreferredstock,itisbettertokeepitasaseparate
component.Thecostofpreferredstockisthepreferreddividendyield.(Asa
ruleofthumb,ifthepreferredstockislessthan5%oftheoutstandingmarket
valueofthefirm,lumpingitinwithdebtwillmakenosignificantimpacton
yourvaluation).

Aswath Damodaran

58

Decomposingaconvertiblebond

Assumethatthefirmthatyouareanalyzinghas$125millioninfacevalueof
convertibledebtwithastatedinterestrateof4%,a10yearmaturityanda
marketvalueof$140million.IfthefirmhasabondratingofAandthe
interestrateonAratedstraightbondis8%,youcanbreakdownthevalueof
theconvertiblebondintostraightdebtandequityportions.

Aswath Damodaran

Straightdebt=(4%of$125million)(PVofannuity,10years,8%)+125
million/1.0810=$91.45million
Equityportion=$140million$91.45million=$48.55million

59

RecappingtheCostofCapital
Cost of equity
Marginal
Weights
Capital
borrowing
should
tax rate,
=bereflecting
should
market
Cost be
ofvalue
Equity
based
weights
(Equity/(Debt
upon
+ Equity))
(1) synthetic
tax
based
benefits
upon of
bottom-up
ordebt
actual bond rating
(2) default spread
beta
Cost of Borrowing = Riskfree rate + Default spread

Aswath Damodaran

Cost of Borrowing

(1-t)

(Debt/(Debt + Equity))

60