Professional Documents
Culture Documents
DiscountedCashFlowValuation
B40.3331
AswathDamodaran
Aswath Damodaran
DiscountedCashflowValuation:BasisforApproach
CF1
CF2
CF3
CF4
CFn
Value of asset =
.....
1
2
3
4
(1 + r) (1 + r)
(1 + r)
(1 + r)
(1 + r) n
whereCFtistheexpectedcashflowinperiodt,risthediscountrateappropriate
giventheriskinessofthecashflowandnisthelifeoftheasset.
Proposition1:Foranassettohavevalue,theexpectedcashflowshavetobe
positivesometimeoverthelifeoftheasset.
Proposition2:Assetsthatgeneratecashflowsearlyintheirlifewillbeworth
morethanassetsthatgeneratecashflowslater;thelattermayhowever
havegreatergrowthandhighercashflowstocompensate.
Aswath Damodaran
DCFChoices:EquityValuationversusFirmValuation
FirmValuation:Valuetheentirebusiness
A ssets
E x is tin g In v e s tm e n ts
G e n e ra te c a s h flo w s to d a y
In c lu d e s lo n g liv e d (fix e d ) a n d
s h o rt-liv e d (w o rk in g
c a p ita l) a s s e ts
E x p e c te d V a lu e th a t w ill b e
c re a te d b y fu tu re in v e s tm e n ts
L ia b i li ti es
A s s e ts in P la c e
D ebt
G ro w th A s s e ts
E q u ity
F ix e d C la im o n c a s h flo w s
L ittle o r N o ro le in m a n a g e m e n t
F i x e d M a tu r i ty
T a x D e d u c ti b l e
R e s id u a l C la im o n c a s h flo w s
S ig n ific a n t R o le in m a n a g e m e n t
P e r p e tu a l L i v e s
Equityvaluation:Valuejustthe
equityclaiminthebusiness
Aswath Damodaran
EquityValuation
F i g u r e 5 .5 : E q u i ty V a l u a ti o n
A ssets
C a s h flo w s c o n s id e re d a re
c a s h flo w s fro m a s s e ts ,
a fte r d e b t p a y m e n ts a n d
a fte r m a k in g re in v e s tm e n ts
n e e d e d fo r fu tu re g ro w th
L ia b i l i ti es
A s s e ts in P la c e
G ro w th A s s e ts
D ebt
E q u ity
D is c o u n t ra te re fle c ts o n ly th e
c o s t o f ra is in g e q u ity fin a n c in g
P r e s e n t v a lu e is v a lu e o f ju s t th e e q u ity c la im s o n th e f ir m
Aswath Damodaran
FirmValuation
F i g u r e 5 .6 : F i r m V a l u a ti o n
A ssets
C a s h flo w s c o n s id e re d a re
c a s h flo w s fro m a s s e ts ,
p rio r to a n y d e b t p a y m e n ts
b u t a fte r firm h a s
re in v e s te d to c re a te g ro w th
a s s e ts
L ia b i l i ti es
A s s e ts in P la c e
G ro w th A s s e ts
D ebt
E q u ity
D is c o u n t ra te re fle c ts th e c o s t
o f ra is in g b o th d e b t a n d e q u ity
fin a n c in g , in p ro p o rtio n to th e ir
use
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FirmValueandEquityValue
A.
B.
C.
D.
A.
B.
C.
Togetfromfirmvaluetoequityvalue,whichofthefollowingwouldyou
needtodo?
Subtractoutthevalueoflongtermdebt
Subtractoutthevalueofalldebt
Subtractthevalueofanydebtthatwasincludedinthecostofcapital
calculation
Subtractoutthevalueofallliabilitiesinthefirm
Doingso,willgiveyouavaluefortheequitywhichis
greaterthanthevalueyouwouldhavegotinanequityvaluation
lesserthanthevalueyouwouldhavegotinanequityvaluation
equaltothevalueyouwouldhavegotinanequityvaluation
Aswath Damodaran
CashFlowsandDiscountRates
Assumethatyouareanalyzingacompanywiththefollowingcashflowsfor
thenextfiveyears.
Year
CFtoEquity
InterestExp(1taxrate)
CFtoFirm
1
$50
$40
$90
2
$60
$40
$100
3
$68
$40
$108
4
$76.2
$40
$116.2
5
$83.49
$40
$123.49
TerminalValue
$1603.0
$2363.008
Assumealsothatthecostofequityis13.625%andthefirmcanborrowlong
termat10%.(Thetaxrateforthefirmis50%.)
Thecurrentmarketvalueofequityis$1,073andthevalueofdebtoutstanding
is$800.
Aswath Damodaran
EquityversusFirmValuation
Method1:DiscountCFtoEquityatCostofEquitytogetvalueofequity
CostofEquity=13.625%
ValueofEquity=50/1.13625+60/1.136252+68/1.136253+76.2/1.136254+
(83.49+1603)/1.136255=$1073
Method2:DiscountCFtoFirmatCostofCapitaltogetvalueoffirm
CostofDebt=Pretaxrate(1taxrate)=10%(1.5)=5%
WACC
=13.625%(1073/1873)+5%(800/1873)=9.94%
PVofFirm=90/1.0994+100/1.09942+108/1.09943+116.2/1.09944+
(123.49+2363)/1.09945=$1873
ValueofEquity=ValueofFirmMarketValueofDebt
=$1873$800=$1073
Aswath Damodaran
FirstPrincipleofValuation
Nevermixandmatchcashflowsanddiscountrates.
Thekeyerrortoavoidismismatchingcashflowsanddiscountrates,since
discountingcashflowstoequityattheweightedaveragecostofcapitalwill
leadtoanupwardlybiasedestimateofthevalueofequity,whilediscounting
cashflowstothefirmatthecostofequitywillyieldadownwardbiased
estimateofthevalueofthefirm.
Aswath Damodaran
TheEffectsofMismatchingCashFlowsandDiscountRates
Error1:DiscountCFtoEquityatCostofCapitaltogetequityvalue
PVofEquity=50/1.0994+60/1.09942+68/1.09943+76.2/1.09944+
(83.49+1603)/1.09945=$1248
Valueofequityisoverstatedby$175.
Error2:DiscountCFtoFirmatCostofEquitytogetfirmvalue
PVofFirm=90/1.13625+100/1.136252+108/1.136253+116.2/1.136254+
(123.49+2363)/1.136255=$1613
PVofEquity=$1612.86$800=$813
ValueofEquityisunderstatedby$260.
Error3:DiscountCFtoFirmatCostofEquity,forgettosubtractoutdebt,and
gettoohighavalueforequity
ValueofEquity=$1613
ValueofEquityisoverstatedby$540
Aswath Damodaran
10
DiscountedCashFlowValuation:TheSteps
Estimatethediscountrateorratestouseinthevaluation
Discountratecanbeeitheracostofequity(ifdoingequityvaluation)oracostof
capital(ifvaluingthefirm)
Discountratecanbeinnominaltermsorrealterms,dependinguponwhetherthe
cashflowsarenominalorreal
Discountratecanvaryacrosstime.
Estimatethecurrentearningsandcashflowsontheasset,toeitherequity
investors(CFtoEquity)ortoallclaimholders(CFtoFirm)
Estimatethefutureearningsandcashflowsonthefirmbeingvalued,
generallybyestimatinganexpectedgrowthrateinearnings.
Estimatewhenthefirmwillreachstablegrowthandwhatcharacteristics
(risk&cashflow)itwillhavewhenitdoes.
ChoosetherightDCFmodelforthisassetandvalueit.
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GenericDCFValuationModel
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VALUING A FIRM
Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF
Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)
Beta
- Measures market risk
Type of
Business
Aswath Damodaran
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
15
DiscountedCashFlowValuation:TheInputs
AswathDamodaran
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I.EstimatingDiscountRates
DCFValuation
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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
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CostofEquity
Thecostofequityshouldbehigherforriskierinvestmentsandlowerforsafer
investments
Whileriskisusuallydefinedintermsofthevarianceofactualreturnsaround
anexpectedreturn,riskandreturnmodelsinfinanceassumethattheriskthat
shouldberewarded(andthusbuiltintothediscountrate)invaluationshould
betheriskperceivedbythemarginalinvestorintheinvestment
Mostriskandreturnmodelsinfinancealsoassumethatthemarginalinvestor
iswelldiversified,andthattheonlyriskthatheorsheperceivesinan
investmentisriskthatcannotbediversifiedaway(I.e,marketornon
diversifiablerisk)
Aswath Damodaran
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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
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TheCAPM:CostofEquity
Considerthestandardapproachtoestimatingcostofequity:
CostofEquity=RiskfreeRate+EquityBeta*(EquityRiskPremium)
Inpractice,
Aswath Damodaran
Goverrnmentsecurityratesareusedasriskfreerates
Historicalriskpremiumsareusedfortheriskpremium
Betasareestimatedbyregressingstockreturnsagainstmarketreturns
21
ARiskfreeRate
Onariskfreeasset,theactualreturnisequaltotheexpectedreturn.Therefore,
thereisnovariancearoundtheexpectedreturn.
Foraninvestmenttoberiskfree,then,ithastohave
1.
2.
Nodefaultrisk
Noreinvestmentrisk
Timehorizonmatters:Thus,theriskfreeratesinvaluationwilldependupon
whenthecashflowisexpectedtooccurandwillvaryacrosstime.
Notallgovernmentsecuritiesareriskfree:Somegovernmentsfacedefaultrisk
andtheratesonbondsissuedbythemwillnotberiskfree.
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Test1:AriskfreerateinUSdollars!
a)
b)
c)
d)
Invaluation,weestimatecashflowsforever(oratleastforverylongtime
periods).TherightriskfreeratetouseinvaluingacompanyinUSdollars
wouldbe
AthreemonthTreasurybillrate
AtenyearTreasurybondrate
AthirtyyearTreasurybondrate
ATIPs(inflationindexedtreasury)rate
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Test2:ARiskfreeRateinEuros
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Test3:ARiskfreeRateinIndianRupees
a)
b)
c)
d)
TheIndiangovernmenthad10yearRupeebondsoutstanding,witha
yieldtomaturityofabout8%onJanuary1,2011.
InJanuary2011,theIndiangovernmenthadalocalcurrency
sovereignratingofBa1.Thetypicaldefaultspread(overadefaultfree
rate)forBa1ratedcountrybondsinearly2010was2.4%.
TheriskfreerateinIndianRupeesis
Theyieldtomaturityonthe10yearbond(8%)
Theyieldtomaturityonthe10yearbond+Defaultspread(10.4%)
Theyieldtomaturityonthe10yearbondDefaultspread(5.6%)
Noneoftheabove
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SovereignDefaultSpread:Twopathstothesame
destination
Sovereigndollaroreurodenominatedbonds:Findsovereignbonds
denominatedinUSdollars,issuedbyemergingmarkets.Thedifference
betweentheinterestrateonthebondandtheUStreasurybondrateshouldbe
thedefaultspread.Forinstance,inJanuary2011,theUSdollardenominated
10yearbondissuedbytheBraziliangovernment(withaBaa3rating)hadan
interestrateof5.1%,resultinginadefaultspreadof1.8%overtheUS
treasuryrateof3.3%atthesamepointintime.
CDSspreads:ObtainthedefaultspreadsforsovereignsintheCDSmarket.In
January2011,theCDSspreadforBrazilinthatmarketwas1.51%.
Aswath Damodaran
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SovereignDefaultSpreads:January2011
Rating Default spread in basis points
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
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0
25
50
70
85
100
115
150
175
200
240
275
325
400
500
600
700
850
1000
27
Test4:ARealRiskfreeRate
Insomecases,youmaywantariskfreerateinrealterms(inreal
terms)ratherthannominalterms.
Togetarealriskfreerate,youwouldlikeasecuritywithnodefault
riskandaguaranteedrealreturn.Treasuryindexedsecuritiesofferthis
combination.
InJanuary2011,theyieldona10yearindexedtreasurybondwas
1.5%.Whichofthefollowingstatementswouldyousubscribeto?
a) This(1.5%)istherealriskfreeratetouse,ifyouarevaluingUS
companiesinrealterms.
b) This(1.5%)istherealriskfreeratetouse,anywhereintheworld
Explain.
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Nodefaultfreeentity:Choiceswithriskfreerates.
Estimatearangefortheriskfreerateinlocalterms:
Approach1:Subtractdefaultspreadfromlocalgovernmentbondrate:
GovernmentbondrateinlocalcurrencytermsDefaultspreadforGovernmentinlocal
currency
Approach2:Useforwardratesandtherisklessrateinanindexcurrency(sayEuros
ordollars)toestimatetherisklessrateinthelocalcurrency.
Dotheanalysisinrealterms(ratherthannominalterms)usingarealriskfree
rate,whichcanbeobtainedinoneoftwoways
fromaninflationindexedgovernmentbond,ifoneexists
setequal,approximately,tothelongtermrealgrowthrateoftheeconomyinwhich
thevaluationisbeingdone.
Dotheanalysisinacurrencywhereyoucangetariskfreerate,sayUSdollars
orEuros.
Aswath Damodaran
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Test5:Matchingupriskfreerates
YouarevaluingEmbraer,aBraziliancompany,inU.S.dollarsandare
attemptingtoestimateariskfreeratetouseintheanalysis(inAugust2004).
Theriskfreeratethatyoushoulduseis
A. TheinterestrateonaBrazilianReaisdenominatedlongtermbondissuedbythe
BrazilianGovernment(11%)
B. TheinterestrateonaUS$denominatedlongtermbondissuedbytheBrazilian
Government(6%)
C. TheinterestrateonadollardenominatedbondissuedbyEmbraer(9.25%)
D. TheinterestrateonaUStreasurybond(3.75%)
E. Noneoftheabove
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Whydoriskfreeratesvaryacrosscurrencies?
January2011Riskfreerates
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Onemoretestonriskfreerates
a)
b)
c)
InJanuary2009,the10yeartreasurybondrateintheUnitedStates
was2.2%,ahistoriclow.Assumethatyouwerevaluingacompanyin
USdollarsthen,butwerewaryabouttheriskfreeratebeingtoolow.
Whichofthefollowingshouldyoudo?
Replacethecurrent10yearbondratewithamorereasonable
normalizedriskfreerate(theaverage10yearbondrateoverthelast5
yearshasbeenabout4%)
Usethecurrent10yearbondrateasyourriskfreeratebutmakesure
thatyourotherassumptions(aboutgrowthandinflation)are
consistentwiththeriskfreerate
Somethingelse
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Everyoneuseshistoricalpremiums,but..
Thehistoricalpremiumisthepremiumthatstockshavehistoricallyearned
overrisklesssecurities.
Practitionersneverseemtoagreeonthepremium;itissensitiveto
Howfarbackyougoinhistory
WhetheryouuseT.billratesorT.Bondrates
Whetheryouusegeometricorarithmeticaverages.
Forinstance,lookingattheUS:
Aswath Damodaran
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Theperilsoftrustingthepast.
Noisyestimates:Evenwithlongtimeperiodsofhistory,theriskpremiumthat
youderivewillhavesubstantialstandarderror.Forinstance,ifyougobackto
1928(about80yearsofhistory)andyouassumeastandarddeviationof20%
inannualstockreturns,youarriveatastandarderrorofgreaterthan2%:
StandardErrorinPremium=20%/80=2.26%
(Anaside:Theimpliedstandarddeviationinequitiesrosetoalmost50%during
thelastquarterof2008.Thinkabouttheconsequencesforusinghistoricalrisk
premiums,ifthisvolatilitypersisted)
SurvivorshipBias:UsinghistoricaldatafromtheU.S.equitymarketsoverthe
twentiethcenturydoescreateasamplingbias.Afterall,theUSeconomyand
equitymarketswereamongthemostsuccessfuloftheglobaleconomiesthat
youcouldhaveinvestedinearlyinthecentury.
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RiskPremiumforaMatureMarket?Broadeningthesample
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TwoWaysofEstimatingCountryEquityRiskPremiumsfor
othermarkets..BrazilinAugust2004
DefaultspreadonCountryBond:Inthisapproach,thecountryequityrisk
premiumissetequaltothedefaultspreadofthebondissuedbythecountry
(butonlyifitisdenominatedinacurrencywhereadefaultfreeentityexists.
BrazilwasratedB2byMoodysandthedefaultspreadontheBrazilian
dollardenominatedC.BondattheendofAugust2004was6.01%.
(10.30%4.29%)
RelativeEquityMarketapproach:Thecountryequityriskpremiumisbased
uponthevolatilityofthemarketinquestionrelativetoU.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%
(Thestandarddeviationinweeklyreturnsfrom2002to2004fortheBovespa
was34.56%whereasthestandarddeviationintheS&P500was19.01%)
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Andathirdapproach
Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsandequity
riskpremiumsarehighlycorrelated,onewouldexpectequityspreadstobe
higherthandebtspreads.
Anotheristomultiplythebonddefaultspreadbytherelativevolatilityof
stockandbondpricesinthatmarket.UsingthisapproachforBrazilinAugust
2004,youwouldget:
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%
37
Cancountryriskpremiumschange?UpdatingBrazil
January2007andJanuary2009
InJanuary2007,BrazilsratinghadimprovedtoB1andtheinterestrateon
theBrazilian$denominatedbonddroppedto6.2%.TheUStreasurybondrate
thatdaywas4.7%,yieldingadefaultspreadof1.5%forBrazil.
StandardDeviationinBovespa(Equity)=24%
StandardDeviationinBrazil$Bond=12%
DefaultspreadonBrazil$Bond=1.50%
CountryRiskPremiumforBrazil=1.50%(24/12)=3.00%
OnJanuary1,2009,BrazilsratingwasBa1buttheinterestrateontheBrazilian
$denominatedbondwas6.3%,4.1%higherthantheUStreasurybondrateof
2.2%onthatday.
Aswath Damodaran
StandardDeviationinBovespa(Equity)=33%
StandardDeviationinBrazil$Bond=20%
DefaultspreadonBrazil$Bond=4.1%
CountryRiskPremiumforBrazil=4.10%(33/20)=6.77%
38
Canada
UnitedStates
Argentina
Belize
Bolivia
Brazil
Chile
Colombia
CostaRica
Ecuador
ElSalvador
Guatemala
Honduras
Mexico
Nicaragua
Panama
Paraguay
Peru
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5.00%
5.00%
14.00%
14.00%
11.00%
8.00%
6.05%
8.00%
8.00%
20.00%
20.00%
8.60%
12.50%
7.25%
14.00%
8.00%
11.00%
8.00%
Austria[1]
Belgium[1]
Cyprus[1]
Denmark
Finland[1]
France[1]
Georgia
Germany[1]
Greece[1]
Iceland
Ireland[1]
Italy[1]
Malta[1]
Netherlands[1]
Norway
Portugal[1]
Spain[1]
Sweden
Switzerland
United
Kingdom
Angola
5.00%
5.38%
6.05%
5.00%
5.00%
5.00%
9.88%
5.00%
8.60%
8.00%
7.25%
5.75%
6.28%
5.00%
5.00%
6.28%
5.38%
5.00%
5.00%
5.00%
11.00%
Botswana
6.50%
Egypt
8.60%
Mauritius
7.63%
Morocco
8.60%
SouthAfrica
6.73%
Tunisia
7.63%
Albania
Armenia
Azerbaijan
Belarus
Bosniaand
Herzegovina
Bulgaria
Croatia
Czech
Republic
Estonia
Hungary
Kazakhstan
Latvia
Lithuania
Moldova
Montenegro
Poland
Romania
Russia
Slovakia
Slovenia[1]
Ukraine
Bahrain
Israel
Jordan
Kuwait
Lebanon
Oman
Qatar
SaudiArabia
UnitedArabEmirates
11.00%
9.13%
8.60%
11.00%
12.50%
8.00%
8.00%
6.28%
6.28%
8.00%
7.63%
8.00%
7.25%
14.00%
9.88%
6.50%
8.00%
7.25%
6.28%
5.75%
12.50%
6.73%
6.28%
8.00%
5.75%
11.00%
6.28%
5.75%
6.05%
5.75%
Bangladesh
Cambodia
China
FijiIslands
HongKong
India
Indonesia
Japan
Korea
Macao
Mongolia
Pakistan
PapuaNew
Guinea
Philippines
Singapore
SriLanka
Taiwan
Thailand
Turkey
9.88%
12.50%
6.05%
11.00%
5.38%
8.60%
9.13%
5.75%
6.28%
6.05%
11.00%
14.00%
11.00%
9.88%
5.00%
11.00%
6.05%
7.25%
9.13%
Australia
NewZealand
5.00%
5.00%
39
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
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EstimatingCompanyExposuretoCountryRisk:
Determinants
Sourceofrevenues:Otherthingsremainingequal,acompanyshouldbemore
exposedtoriskinacountryifitgeneratesmoreofitsrevenuesfromthat
country.ABrazilianfirmthatgeneratesthebulkofitsrevenuesinBrazil
shouldbemoreexposedtocountryriskthanonethatgeneratesasmaller
percentofitsbusinesswithinBrazil.
Manufacturingfacilities:Otherthingsremainingequal,afirmthathasallof
itsproductionfacilitiesinBrazilshouldbemoreexposedtocountryriskthan
onewhichhasproductionfacilitiesspreadovermultiplecountries.The
problemwillbeaccentedforcompaniesthatcannotmovetheirproduction
facilities(miningandpetroleumcompanies,forinstance).
Useofriskmanagementproducts:Companiescanusebothoptions/futures
marketsandinsurancetohedgesomeorasignificantportionofcountryrisk.
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EstimatingLambdas:TheRevenueApproach
Theeasiestandmostaccessibledataisonrevenues.Mostcompaniesbreaktheir
revenuesdownbyregion.
%ofrevenuesdomestically firm/%ofrevenuesdomestically avgfirm
Consider,forinstance,EmbraerandEmbratel,bothofwhichareincorporatedandtraded
inBrazil.Embraergets3%ofitsrevenuesfromBrazilwhereasEmbratelgetsalmostall
ofitsrevenuesinBrazil.TheaverageBraziliancompanygetsabout77%ofitsrevenues
inBrazil:
Therearetwoimplications
LambdaEmbraer=3%/77%=.04
LambdaEmbratel=100%/77%=1.30
Acompanysriskexposureisdeterminedbywhereitdoesbusinessandnotbywhereitis
located
Firmsmightbeabletoactivelymanagetheircountryriskexposures
Consider,forinstance,thefactthatSAPgotabout7.5%ofitssalesinEmergingAsia,
wecanestimatealambdaforSAPforAsia(usingtheassumptionthatthetypicalAsian
firmgetsabout75%ofitsrevenuesinAsia)
LambdaSAP,Asia=7.5%/75%=0.10
Aswath Damodaran
42
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%
-1
-10.00%
-1.5
-20.00%
-2
Quarterly EPS
-30.00%
Quarter
Embraer
Aswath Damodaran
Embratel
C Bond
43
EstimatingLambdas:StockReturnsversusCBondReturns
ReturnEmbraer=0.0195+0.2681ReturnCBond
ReturnEmbratel=0.0308+2.0030ReturnCBond
E m b ra e r v e rs u s C B o n d: 2 0 0 0 -2 0 0 3
E m b r a te l v e rs u s C B o n d : 2 0 0 0 - 2 0 0 3
40
100
80
60
R e t u rn o n E m b ra t e l
R e tu r n o n E m b ra e r
20
-2 0
40
20
0
-2 0
-4 0
-4 0
-6 0
-6 0
-8 0
-30
-2 0
-1 0
R e tu r n o n C - B o n d
Aswath Damodaran
10
20
-3 0
-2 0
-1 0
10
20
R e tu r n o n C - B o n d
44
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
45
ValuingEmergingMarketCompanieswithsignificant
exposureindevelopedmarkets
Theconventionalpracticeininvestmentbankingistoaddthecountryequity
riskpremiumontothecostofequityforeveryemergingmarketcompany,
notwithstandingitsexposuretoemergingmarketrisk.Thus,Embraerwould
havebeenvaluedwithacostofequityof17.34%eventhoughitgetsonly3%
ofitsrevenuesinBrazil.Asaninvestor,whichofthefollowingconsequences
doyouseefromthisapproach?
A. Emergingmarketcompanieswithsubstantialexposureindevelopedmarkets
willbesignificantlyovervaluedbyequityresearchanalysts.
B. Emergingmarketcompanieswithsubstantialexposureindevelopedmarkets
willbesignificantlyundervaluedbyequityresearchanalysts.
Canyouconstructaninvestmentstrategytotakeadvantageofthemisvaluation?
Aswath Damodaran
46
ImpliedEquityPremiums
Ifweassumethatstocksarecorrectlypricedintheaggregateandwecan
estimatetheexpectedcashflowsfrombuyingstocks,wecanestimatethe
expectedrateofreturnonstocksbycomputinganinternalrateofreturn.
Subtractingouttheriskfreerateshouldyieldanimpliedequityriskpremium.
Thisimpliedequitypremiumisaforwardlookingnumberandcanbeupdated
asoftenasyouwant(everyminuteofeveryday,ifyouaresoinclined).
Aswath Damodaran
47
ImpliedEquityPremiums:January2008
Wecanusetheinformationinstockpricestobackouthowriskaversethemarketisandhowmuch
ofariskpremiumitisdemanding.
65.08
68.33
71.75
75.34
January 1, 2008
S&P 500 is at 1468.36
4.02% of 1468.36 = 59.03
Ifyoupaythecurrentleveloftheindex,youcanexpecttomakeareturnof8.39%onstocks(which
isobtainedbysolvingforrinthefollowingequation)
1468.36
61.98 65.08
68.33
71.75
75.34
75.35(1.0402)
(1 r) (1 r) 2 (1 r) 3 (1 r) 4 (1 r) 5 (r .0402)(1 r) 5
ImpliedEquityriskpremium=ExpectedreturnonstocksTreasurybondrate=8.39%4.02%=
4.37%
Aswath Damodaran
48
ImpliedRiskPremiumDynamics
Assumethattheindexjumps10%onJanuary2andthatnothingelsechanges.
Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease
Assumethattheearningsjump10%onJanuary2andthatnothingelse
changes.Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease
Assumethattheriskfreerateincreasesto5%onJanuary2andthatnothing
elsechanges.Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease
Aswath Damodaran
49
Ayearthatmadeadifference..Theimpliedpremiumin
January2009
Year
2001
2002
2003
2004
2005
2006
2007
2008
Normalized
Market value of
index
Aswath Damodaran
1148.09
879.82
1111.91
1211.92
1248.29
1418.30
1468.36
903.25
903.25
Dividends
15.74
15.96
17.88
19.01
22.34
25.04
28.14
28.47
28.47
Buybacks
14.34
13.87
13.70
21.59
38.82
48.12
67.22
40.25
24.11
Cash to
equity
30.08
29.83
31.58
40.60
61.17
73.16
95.36
68.72
52.584
Dividend
yield
1.37%
1.81%
1.61%
1.57%
1.79%
1.77%
1.92%
3.15%
3.15%
Buyback
yield
1.25%
1.58%
1.23%
1.78%
3.11%
3.39%
4.58%
4.61%
2.67%
Total yield
2.62%
3.39%
2.84%
3.35%
4.90%
5.16%
6.49%
7.77%
5.82%
50
TheAnatomyofaCrisis:ImpliedERPfromSeptember12,
2008toJanuary1,2009
Aswath Damodaran
51
EquityRiskPremium:AJanuary2011update
ByJanuary1,2011,theworstofthecrisisseemedtobebehindus.Fearsofa
depressionhadrecededandbankslookedliketheywerestrugglingbacktoa
morestablesetting.Defaultspreadsstartedtodropandriskwasnolonger
frontandcenterinpricing.
Aswath Damodaran
52
ImpliedPremiumsintheUS:19602010
Aswath Damodaran
53
ImpliedPremiumversusRiskFreeRate
Aswath Damodaran
54
EquityRiskPremiumsandBondDefaultSpreads
Aswath Damodaran
55
EquityRiskPremiumsandCapRates(RealEstate)
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56
Whyimpliedpremiumsmatter?
Inmanyinvestmentbanks,itiscommonpractice(especiallyincorporate
financedepartments)tousehistoricalriskpremiums(andarithmeticaverages
atthat)asriskpremiumstocomputecostofequity.Ifallanalystsinthe
departmentusedthegeometricaveragepremiumfor19282008of3.9%to
valuestocksinJanuary2009,giventheimpliedpremiumof6.43%,whatwere
theylikelytofind?
Thevaluestheyobtainwillbetoolow(moststockswilllookovervalued)
Thevaluestheyobtainwillbetoohigh(moststockswilllookundervalued)
Thereshouldbenosystematicbiasaslongastheyusethesamepremium
(3.9%)tovalueallstocks.
Aswath Damodaran
57
WhichequityriskpremiumshouldyouusefortheUS?
HistoricalRiskPremium:Whenyouusethehistoricalriskpremium,youare
assumingthatpremiumswillrevertbacktoahistoricalnormandthatthetime
periodthatyouareusingistherightnorm.
CurrentImpliedEquityRiskpremium:Youareassumingthatthemarketis
correctintheaggregatebutmakesmistakesonindividualstocks.Ifyouare
requiredtobemarketneutral,thisisthepremiumyoushoulduse.(What
typesofvaluationsrequiremarketneutrality?)
AverageImpliedEquityRiskpremium:Theaverageimpliedequityrisk
premiumbetween19602010intheUnitedStatesisabout4.25%.Youare
assumingthatthemarketiscorrectonaveragebutnotnecessarilyatapointin
time.
Aswath Damodaran
58
ImpliedpremiumfortheSensex(September2007)
Inputsforthecomputation
Sensexon9/5/07=15446
Dividendyieldonindex=3.05%
Expectedgrowthratenext5years=14%
Growthratebeyondyear5=6.76%(setequaltoriskfreerate)
Solvingfortheexpectedreturn:
15446
(1 r) (1 r) 2 (1 r) 3 (1 r) 4 (1 r) 5 (r .0676)(1 r) 5
Expectedreturnonstocks=11.18%
ImpliedequityriskpremiumforIndia=11.18%6.76%=4.42%
Aswath Damodaran
59
ImpliedEquityRiskPremiumcomparison:
January2008versusJanuary2009
Country
United States
UK
Germany
Japan
India
China
Brazil
Aswath Damodaran
ERP (1/1/08)
4.37%
4.20%
4.22%
3.91%
ERP (1/1/09)
6.43%
6.51%
6.49%
6.25%
4.88%
3.98%
5.45%
9.21%
7.86%
9.06%
60
EstimatingBeta
Thestandardprocedureforestimatingbetasistoregressstockreturns(Rj)
againstmarketreturns(Rm)
Rj=a+bRm
whereaistheinterceptandbistheslopeoftheregression.
Theslopeoftheregressioncorrespondstothebetaofthestock,andmeasures
theriskinessofthestock.
Thisbetahasthreeproblems:
Aswath Damodaran
Ithashighstandarderror
Itreflectsthefirmsbusinessmixovertheperiodoftheregression,notthecurrent
mix
Itreflectsthefirmsaveragefinancialleverageovertheperiodratherthanthe
currentleverage.
61
BetaEstimation:TheNoiseProblem
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62
BetaEstimation:TheIndexEffect
Aswath Damodaran
63
SolutionstotheRegressionBetaProblem
Modifytheregressionbetaby
Estimatethebetaforthefirmusing
thestandarddeviationinstockpricesinsteadofaregressionagainstanindex
accountingearningsorrevenues,whicharelessnoisythanmarketprices.
Estimatethebetaforthefirmfromthebottomupwithoutemployingthe
regressiontechnique.Thiswillrequire
changingtheindexusedtoestimatethebeta
adjustingtheregressionbetaestimate,bybringingininformationaboutthe
fundamentalsofthecompany
understandingthebusinessmixofthefirm
estimatingthefinancialleverageofthefirm
Useanalternativemeasureofmarketrisknotbaseduponaregression.
Aswath Damodaran
64
TheIndexGame
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65
DeterminantsofBetas
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66
Inaperfectworldwewouldestimatethebetaofafirmby
doingthefollowing
Aswath Damodaran
67
Adjustingforoperatingleverage
Withinanybusiness,firmswithlowerfixedcosts(asapercentageoftotal
costs)shouldhavelowerunleveredbetas.Ifyoucancomputefixedand
variablecostsforeachfirminasector,youcanbreakdowntheunleveredbeta
intobusinessandoperatingleveragecomponents.
Unleveredbeta=Purebusinessbeta*(1+(Fixedcosts/Variablecosts))
Thebiggestproblemwithdoingthisisinformational.Itisdifficulttoget
informationonfixedandvariablecostsforindividualfirms.
Inpractice,wetendtoassumethattheoperatingleverageoffirmswithina
businessaresimilarandusethesameunleveredbetaforeveryfirm.
Aswath Damodaran
68
Adjustingforfinancialleverage
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
69
BottomupBetas
Aswath Damodaran
70
Whybottomupbetas?
Thestandarderrorinabottomupbetawillbesignificantlylowerthanthe
standarderrorinasingleregressionbeta.Roughlyspeaking,thestandarderror
ofabottomupbetaestimatecanbewrittenasfollows:
Stderrorofbottomupbeta= Average Std Error across Betas
Thebottomupbetacanbeadjustedtoreflectchangesinthefirmsbusiness
mixandfinancialleverage.Regressionbetasreflectthepast.
Youcanestimatebottomupbetasevenwhenyoudonothavehistoricalstock
prices.Thisisthecasewithinitialpublicofferings,privatebusinessesor
divisionsofcompanies.
Aswath Damodaran
71
BottomupBeta:FirminMultipleBusinesses
SAPin2004
Approach1:Basedonbusinessmix
SAPisinthreebusiness:software,consultingandtraining.Wewillaggregatethe
consultingandtrainingbusinesses
Business
Revenues EV/Sales
Value
Weights
Beta
Software
$5.3
3.25
17.23
80%
1.30
Consulting $2.2
2.00
4.40
20%
1.05
SAP
$7.5
21.63
1.25
Approach2:CustomerBase
Aswath Damodaran
72
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
73
ComparableFirms?
CananunleveredbetaestimatedusingU.S.andEuropeanaerospacecompanies
beusedtoestimatethebetaforaBrazilianaerospacecompany?
Yes
No
Whatconcernswouldyouhaveinmakingthisassumption?
Aswath Damodaran
74
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
75
TheCostofEquity:ARecap
Aswath Damodaran
76
EstimatingtheCostofDebt
Thecostofdebtistherateatwhichyoucanborrowatcurrently,Itwillreflect
notonlyyourdefaultriskbutalsothelevelofinterestratesinthemarket.
Thetwomostwidelyusedapproachestoestimatingcostofdebtare:
Lookinguptheyieldtomaturityonastraightbondoutstandingfromthefirm.The
limitationofthisapproachisthatveryfewfirmshavelongtermstraightbondsthat
areliquidandwidelytraded
Lookinguptheratingforthefirmandestimatingadefaultspreadbaseduponthe
rating.Whilethisapproachismorerobust,differentbondsfromthesamefirmcan
havedifferentratings.Youhavetouseamedianratingforthefirm
Whenintrouble(eitherbecauseyouhavenoratingsormultipleratingsfora
firm),estimateasyntheticratingforyourfirmandthecostofdebtbasedupon
thatrating.
Aswath Damodaran
77
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
78
InterestCoverageRatios,RatingsandDefaultSpreads:2003
&2004
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
79
CostofDebtcomputations
Companiesincountrieswithlowbondratingsandhighdefaultriskmightbear
theburdenofcountrydefaultrisk,especiallyiftheyaresmallerorhaveallof
theirrevenueswithinthecountry.
Largercompaniesthatderiveasignificantportionoftheirrevenuesinglobal
marketsmaybelessexposedtocountrydefaultrisk.Inotherwords,theymay
beabletoborrowataratelowerthanthegovernment.
ThesyntheticratingforEmbraerisA.Usingthe2004defaultspreadof
1.00%,weestimateacostofdebtof9.29%(usingariskfreerateof4.29%and
addingintwothirdsofthecountrydefaultspreadof6.01%):
Costofdebt
=Riskfreerate+2/3(Brazilcountrydefaultspread)+Companydefaultspread=4.29%+
4.00%+1.00%=9.29%
Aswath Damodaran
80
SyntheticRatings:SomeCaveats
Therelationshipbetweeninterestcoverageratiosandratings,developedusing
UScompanies,tendstotravelwell,aslongasweareanalyzinglarge
manufacturingfirmsinmarketswithinterestratesclosetotheUSinterestrate
Theyaremoreproblematicwhenlookingatsmallercompaniesinmarkets
withhigherinterestratesthantheUS.Onewaytoadjustforthisdifferenceis
modifytheinterestcoverageratiotabletoreflectinterestratedifferences(For
instances,ifinterestratesinanemergingmarketaretwiceashighasratesin
theUS,halvetheinterestcoverageratio.
Aswath Damodaran
81
DefaultSpreads:Theeffectofthecrisisof2008..Andthe
aftermath
Rating
Aaa/AAA
Aa1/AA+
Aa2/AA
Aa3/AAA1/A+
A2/A
A3/ABaa1/BBB+
Baa2/BBB
Baa3/BBBBa1/BB+
Ba2/BB
Ba3/BBB1/B+
B2/B
B3/BCaa/CCC+
ERP
Aswath Damodaran
1-Jan-09
2.00%
2.25%
2.50%
2.75%
3.25%
3.50%
3.75%
5.25%
5.75%
7.25%
9.50%
10.50%
11.00%
11.50%
12.50%
15.50%
16.50%
6.43%
1-Jan-10
0.50%
0.55%
0.65%
0.70%
0.85%
0.90%
1.05%
1.65%
1.80%
2.25%
3.50%
3.85%
4.00%
4.25%
5.25%
5.50%
7.75%
4.36%
1-Jan-11
0.55%
0.60%
0.65%
0.75%
0.85%
0.90%
1.00%
1.40%
1.60%
2.05%
2.90%
3.25%
3.50%
3.75%
5.00%
6.00%
7.75%
5.20%
82
SubsidizedDebt:Whatshouldwedo?
AssumethattheBraziliangovernmentlendsmoneytoEmbraerata
subsidizedinterestrate(say6%indollarterms).Incomputingthecostof
capitaltovalueEmbraer,shouldbeweusethecostofdebtbasedupondefault
riskorthesubisidizedcostofdebt?
Thesubsidizedcostofdebt(6%).Thatiswhatthecompanyispaying.
Thefaircostofdebt(9.25%).Thatiswhatthecompanyshouldrequireits
projectstocover.
Anumberinthemiddle.
Aswath Damodaran
83
WeightsfortheCostofCapitalComputation
Incomputingthecostofcapitalforapubliclytradedfirm,thegeneralrulefor
computingweightsfordebtandequityisthatyouusemarketvalueweights
(andnotbookvalueweights).Why?
Becausethemarketisusuallyright
Becausemarketvaluesareeasytoobtain
Becausebookvaluesofdebtandequityaremeaningless
Noneoftheabove
Aswath Damodaran
84
EstimatingCostofCapital:Embraerin2003
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%)+$1,953
million/1.09294=2,083millionBR
Aswath Damodaran
85
Ifyouhadtodoit.ConvertingaDollarCostofCapitaltoa
NominalRealCostofCapital
Approach1:UseaBRriskfreerateinallofthecalculationsabove.Forinstance,ifthe
BRriskfreeratewas12%,thecostofcapitalwouldbecomputedasfollows:
CostofEquity=12%+(4%)+%)=18.41%
CostofDebt=12%+1%=13%
(Thisassumestheriskfreeratehasnocountryriskpremiumembeddedinit.)
Approach2:Usethedifferentialinflationratetoestimatethecostofcapital.For
instance,iftheinflationrateinBRis8%andtheinflationrateintheU.S.is2%
1 Inflation
Costofcapital=
BR
(1 Cost of Capital$ )
1 Inflation$
=1.0997(1.08/1.02)1=0.1644or16.44%
Aswath Damodaran
86
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
87
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
88
RecappingtheCostofCapital
Aswath Damodaran
89
II.EstimatingCashFlows
DCFValuation
Aswath Damodaran
90
StepsinCashFlowEstimation
Estimatethecurrentearningsofthefirm
Considerhowmuchthefirminvestedtocreatefuturegrowth
Iflookingatcashflowstoequity,lookatearningsafterinterestexpensesi.e.net
income
Iflookingatcashflowstothefirm,lookatoperatingearningsaftertaxes
Iftheinvestmentisnotexpensed,itwillbecategorizedascapitalexpenditures.To
theextentthatdepreciationprovidesacashflow,itwillcoversomeofthese
expenditures.
Increasingworkingcapitalneedsarealsoinvestmentsforfuturegrowth
Iflookingatcashflowstoequity,considerthecashflowsfromnetdebtissues
(debtissueddebtrepaid)
Aswath Damodaran
91
MeasuringCashFlows
Cash fows can bemeasured to
All claimholders in thefrm
EBIT (1- tax rate)
- ( Capital Expenditures - Depreciation)
- Change in non-cash working capital
= Free Cash Flow to Firm (FCFF)
Aswath Damodaran
Net Income
- (Capital Expenditures - Depreciation)
- Change in non-cash Working Capital
- (Principal Repaid - New Debt Issues)
- Preferred Dividend
Dividends
+ Stock Buybacks
92
MeasuringCashFlowtotheFirm
EBIT(1taxrate)
(CapitalExpendituresDepreciation)
ChangeinWorkingCapital
=Cashflowtothefirm
Wherearethetaxsavingsfrominterestpaymentsinthiscashflow?
Aswath Damodaran
93
FromReportedtoActualEarnings
Aswath Damodaran
94
I.UpdateEarnings
Whenvaluingcompanies,weoftendependuponfinancialstatementsfor
inputsonearningsandassets.Annualreportsareoftenoutdatedandcanbe
updatedbyusing
Trailing12monthdata,constructedfromquarterlyearningsreports.
Informalandunofficialnewsreports,ifquarterlyreportsareunavailable.
Updatingmakesthemostdifferenceforsmallerandmorevolatilefirms,as
wellasforfirmsthathaveundergonesignificantrestructuring.
Timesaver:Togetatrailing12monthnumber,allyouneedisone10Kand
one10Q(examplethirdquarter).UsetheYeartodatenumbersfromthe10Q:
Trailing12monthRevenue=Revenues(inlast10K)Revenuesfromfirst3quarters
oflastyear+Revenuesfromfirst3quartersofthisyear.
Aswath Damodaran
95
II.CorrectingAccountingEarnings
Makesurethattherearenofinancialexpensesmixedinwithoperating
expenses
Financialexpense:Anycommitmentthatistaxdeductiblethatyouhavetomeetno
matterwhatyouroperatingresults:Failuretomeetitleadstolossofcontrolofthe
business.
Example:OperatingLeases:Whileaccountingconventiontreatsoperatingleases
asoperatingexpenses,theyarereallyfinancialexpensesandneedtobereclassified
assuch.Thishasnoeffectonequityearningsbutdoeschangetheoperating
earnings
Makesurethattherearenocapitalexpensesmixedinwiththeoperating
expenses
Aswath Damodaran
Capitalexpense:Anyexpensethatisexpectedtogeneratebenefitsovermultiple
periods.
R&DAdjustment:SinceR&Disacapitalexpenditure(ratherthananoperating
expense),theoperatingincomehastobeadjustedtoreflectitstreatment.
96
TheMagnitudeofOperatingLeases
Aswath Damodaran
97
DealingwithOperatingLeaseExpenses
OperatingLeaseExpensesaretreatedasoperatingexpensesincomputing
operatingincome.Inreality,operatingleaseexpensesshouldbetreatedas
financingexpenses,withthefollowingadjustmentstoearningsandcapital:
DebtValueofOperatingLeases=PresentvalueofOperatingLease
Commitmentsatthepretaxcostofdebt
Whenyouconvertoperatingleasesintodebt,youalsocreateanassetto
counteritofexactlythesamevalue.
AdjustedOperatingEarnings
AdjustedOperatingEarnings=OperatingEarnings+OperatingLeaseExpenses
DepreciationonLeasedAsset
Asanapproximation,thisworks:
AdjustedOperatingEarnings=OperatingEarnings+PretaxcostofDebt*PVof
OperatingLeases.
Aswath Damodaran
98
OperatingLeasesatTheGapin2003
TheGaphasconventionaldebtofabout$1.97billiononitsbalancesheetand
itspretaxcostofdebtisabout6%.Itsoperatingleasepaymentsinthe2003
were$978millionanditscommitmentsforthefuturearebelow:
Year
Commitment(millions)
PresentValue(at6%)
1
$899.00
$848.11
2
$846.00
$752.94
3
$738.00
$619.64
4
$598.00
$473.67
5
$477.00
$356.44
6&7 $982.50eachyear
$1,346.04
DebtValueofleases=
$4,396.85(Alsovalueofleasedasset)
DebtoutstandingatTheGap=$1,970m+$4,397m=$6,367m
AdjustedOperatingIncome=StatedOI+OLexpthisyearDeprecn
=$1,012m+978m4397m/7=$1,362million(7yearlifeforassets)
ApproximateOI=$1,012m+$4397m(.06)=$1,276m
Aswath Damodaran
99
TheCollateralEffectsofTreatingOperatingLeasesasDebt
C o nventional Accounting
Income Statement
EBIT& Leases = 1,990
- Op Leases
= 978
EBIT
= 1,012
Balance Sheet
Off balance sheet (Not shown as debt or as an
asset). Only the conventional debt of $1,970
million shows up on balance sheet
Cost of capital = 8.20%(7350/9320) + 4%
(1970/9320) = 7.31%
Cost of equity for The Gap = 8.20%
After-tax cost of debt = 4%
Market value of equity = 7350
Return on capital = 1012 (1-.35)/(3130+1970)
= 12.90%
Aswath Damodaran
100
TheMagnitudeofR&DExpenses
Aswath Damodaran
101
R&DExpenses:OperatingorCapitalExpenses
AccountingstandardsrequireustoconsiderR&Dasanoperatingexpense
eventhoughitisdesignedtogeneratefuturegrowth.Itismorelogicaltotreat
itascapitalexpenditures.
TocapitalizeR&D,
Aswath Damodaran
SpecifyanamortizablelifeforR&D(210years)
CollectpastR&Dexpensesforaslongastheamortizablelife
SumuptheunamortizedR&Dovertheperiod.(Thus,iftheamortizablelifeis5
years,theresearchassetcanbeobtainedbyaddingup1/5thoftheR&Dexpense
fromfiveyearsago,2/5thoftheR&Dexpensefromfouryearsago...:
102
CapitalizingR&DExpenses:SAP
R&Dwasassumedtohavea5yearlife.
Year
R&DExpense
Unamortizedportion
Amortizationthisyear
Current
1020.02
1.00
1020.02
1
993.99
0.80
795.19
198.80
2
909.39
0.60
545.63
181.88
3
898.25
0.40
359.30
179.65
4
969.38
0.20
193.88
193.88
5
744.67
0.00
0.00
148.93
Valueofresearchasset=
2,914million
Amortizationofresearchassetin2004
=
903million
IncreaseinOperatingIncome=1020903=117million
Aswath Damodaran
103
TheEffectofCapitalizingR&DatSAP
C o nventional Accounting
Income Statement
EBIT& R&D = 3045
- R&D
= 1020
EBIT
= 2025
EBIT (1-t)
= 1285 m
Balance Sheet
Off balance sheet asset. Book value of equity at
3,768 million Euros is understated because
biggest asset is off the books.
Capital Expenditures
Conventional net cap ex of 2 million Euros
Cash Flows
EBIT (1-t)
= 1285
- Net Cap Ex
=
2
FCFF
= 1283
Return on capital = 1285/(3768+530)
= 29.90%
Aswath Damodaran
104
III.OneTimeandNonrecurringCharges
Assumethatyouarevaluingafirmthatisreportingalossof$500million,
duetoaonetimechargeof$1billion.Whatistheearningsyouwouldusein
yourvaluation?
Alossof$500million
Aprofitof$500million
Wouldyouranswerbeanydifferentifthefirmhadreportedonetimelosseslike
theseonceeveryfiveyears?
Yes
No
Aswath Damodaran
105
IV.AccountingMalfeasance.
Thoughallfirmsmaybegovernedbythesameaccountingstandards,the
fidelitythattheyshowtothesestandardscanvary.Moreaggressivefirmswill
showhigherearningsthanmoreconservativefirms.
Whileyouwillnotbeabletocatchoutrightfraud,youshouldlookfor
warningsignalsinfinancialstatementsandcorrectforthem:
Aswath Damodaran
Incomefromunspecifiedsourcesholdingsinotherbusinessesthatarenot
revealedorfromspecialpurposeentities.
Incomefromassetsalesorfinancialtransactions(foranonfinancialfirm)
SuddenchangesinstandardexpenseitemsabigdropinS,G&AorR&D
expensesasapercentofrevenues,forinstance.
Frequentaccountingrestatements
Accrualearningsthatrunaheadofcashearningsconsistently
Bigdifferencesbetweentaxincomeandreportedincome
106
V.DealingwithNegativeorAbnormallyLowEarnings
Aswath Damodaran
107
Whattaxrate?
Thetaxratethatyoushoulduseincomputingtheaftertaxoperatingincome
shouldbe
Theeffectivetaxrateinthefinancialstatements(taxespaid/Taxableincome)
ThetaxratebasedupontaxespaidandEBIT(taxespaid/EBIT)
Themarginaltaxrateforthecountryinwhichthecompanyoperates
Theweightedaveragemarginaltaxrateacrossthecountriesinwhichthe
companyoperates
Noneoftheabove
Anyoftheabove,aslongasyoucomputeyouraftertaxcostofdebtusingthe
sametaxrate
Aswath Damodaran
108
TheRightTaxRatetoUse
Thechoicereallyisbetweentheeffectiveandthemarginaltaxrate.Indoing
projections,itisfarsafertousethemarginaltaxratesincetheeffectivetax
rateisreallyareflectionofthedifferencebetweentheaccountingandthetax
books.
Byusingthemarginaltaxrate,wetendtounderstatetheaftertaxoperating
incomeintheearlieryears,buttheaftertaxtaxoperatingincomeismore
accurateinlateryears
Ifyouchoosetousetheeffectivetaxrate,adjustthetaxratetowardsthe
marginaltaxrateovertime.
Aswath Damodaran
Whileanargumentcanbemadeforusingaweightedaveragemarginaltaxrate,it
issafesttousethemarginaltaxrateofthecountry
109
ATaxRateforaMoneyLosingFirm
Assumethatyouaretryingtoestimatetheaftertaxoperatingincomefora
firmwith$1billioninnetoperatinglossescarriedforward.Thisfirmis
expectedtohaveoperatingincomeof$500millioneachyearforthenext3
years,andthemarginaltaxrateonincomeforallfirmsthatmakemoneyis
40%.Estimatetheaftertaxoperatingincomeeachyearforthenext3years.
Year1
Year2
Year3
EBIT
500
500
500
Taxes
EBIT(1t)
Taxrate
Aswath Damodaran
110
NetCapitalExpenditures
Netcapitalexpendituresrepresentthedifferencebetweencapitalexpenditures
anddepreciation.Depreciationisacashinflowthatpaysforsomeoralot(or
sometimesallof)thecapitalexpenditures.
Ingeneral,thenetcapitalexpenditureswillbeafunctionofhowfastafirmis
growingorexpectingtogrow.Highgrowthfirmswillhavemuchhighernet
capitalexpendituresthanlowgrowthfirms.
Assumptionsaboutnetcapitalexpenditurescanthereforeneverbemade
independentlyofassumptionsaboutgrowthinthefuture.
Aswath Damodaran
111
Capitalexpendituresshouldinclude
Researchanddevelopmentexpenses,oncetheyhavebeenrecategorizedas
capitalexpenses.Theadjustednetcapexwillbe
AdjustedNetCapitalExpenditures=NetCapitalExpenditures+CurrentyearsR&D
expensesAmortizationofResearchAsset
Acquisitionsofotherfirms,sincethesearelikecapitalexpenditures.The
adjustednetcapexwillbe
AdjustedNetCapEx=NetCapitalExpenditures+Acquisitionsofotherfirms
Amortizationofsuchacquisitions
Twocaveats:
1.Mostfirmsdonotdoacquisitionseveryyear.Hence,anormalizedmeasureof
acquisitions(lookingatanaverageovertime)shouldbeused
2.Thebestplacetofindacquisitionsisinthestatementofcashflows,usually
categorizedunderotherinvestmentactivities
Aswath Damodaran
112
CiscosAcquisitions:1999
Acquired
GeoTel
Fibex
Sentient
American Internent
Summa Four
Clarity Wireless
Selsius Systems
PipeLinks
Amteva Tech
Aswath Damodaran
Method of Acquisition
Pooling
Pooling
Pooling
Purchase
Purchase
Purchase
Purchase
Purchase
Purchase
Price Paid
$1,344
$318
$103
$58
$129
$153
$134
$118
$159
$2,516
113
CiscosNetCapitalExpendituresin1999
CapExpenditures(fromstatementofCF)
Depreciation(fromstatementofCF)
NetCapEx(fromstatementofCF)
+R&Dexpense
AmortizationofR&D
+Acquisitions
AdjustedNetCapitalExpenditures
=$584mil
=$486mil
=$98mil
=$1,594mil
=$485mil
=$2,516mil
=$3,723mil
(Amortizationwasincludedinthedepreciationnumber)
Aswath Damodaran
114
WorkingCapitalInvestments
Inaccountingterms,theworkingcapitalisthedifferencebetweencurrent
assets(inventory,cashandaccountsreceivable)andcurrentliabilities
(accountspayables,shorttermdebtanddebtduewithinthenextyear)
Acleanerdefinitionofworkingcapitalfromacashflowperspectiveisthe
differencebetweennoncashcurrentassets(inventoryandaccounts
receivable)andnondebtcurrentliabilities(accountspayable)
Anyinvestmentinthismeasureofworkingcapitaltiesupcash.Therefore,
anyincreases(decreases)inworkingcapitalwillreduce(increase)cashflows
inthatperiod.
Whenforecastingfuturegrowth,itisimportanttoforecasttheeffectsofsuch
growthonworkingcapitalneeds,andbuildingtheseeffectsintothecash
flows.
Aswath Damodaran
115
WorkingCapital:GeneralPropositions
Changesinnoncashworkingcapitalfromyeartoyeartendtobevolatile.A
farbetterestimateofnoncashworkingcapitalneeds,lookingforward,canbe
estimatedbylookingatnoncashworkingcapitalasaproportionofrevenues
Somefirmshavenegativenoncashworkingcapital.Assumingthatthiswill
continueintothefuturewillgeneratepositivecashflowsforthefirm.While
thisisindeedfeasibleforaperiodoftime,itisnotforever.Thus,itisbetter
thatnoncashworkingcapitalneedsbesettozero,whenitisnegative.
Aswath Damodaran
116
VolatileWorkingCapital?
Revenues
NoncashWC
%ofRevenues
Changefromlastyear
Average:last3years
Average:industry
Amazon
$1,640
419 404
25.53%
$(309)
15.16%
8.71%
AssumptioninValuation
WCas%ofRevenue 3.00%
Aswath Damodaran
Cisco
Motorola
$12,154
$30,931
2547
3.32%
8.23%
($700)
($829)
3.16%
8.91%
2.71%
7.04%
0.00%
8.23%
117
DividendsandCashFlowstoEquity
Inthestrictestsense,theonlycashflowthataninvestorwillreceivefroman
equityinvestmentinapubliclytradedfirmisthedividendthatwillbepaidon
thestock.
Actualdividends,however,aresetbythemanagersofthefirmandmaybe
muchlowerthanthepotentialdividends(thatcouldhavebeenpaidout)
managersareconservativeandtrytosmoothoutdividends
managersliketoholdontocashtomeetunforeseenfuturecontingenciesand
investmentopportunities
Whenactualdividendsarelessthanpotentialdividends,usingamodelthat
focusesonlyondividendswillunderstatethetruevalueoftheequityina
firm.
Aswath Damodaran
118
MeasuringPotentialDividends
Someanalystsassumethattheearningsofafirmrepresentitspotential
dividends.Thiscannotbetrueforseveralreasons:
Earningsarenotcashflows,sincetherearebothnoncashrevenuesandexpensesin
theearningscalculation
Evenifearningswerecashflows,afirmthatpaiditsearningsoutasdividends
wouldnotbeinvestinginnewassetsandthuscouldnotgrow
Valuationmodels,whereearningsarediscountedbacktothepresent,willover
estimatethevalueoftheequityinthefirm
Thepotentialdividendsofafirmarethecashflowsleftoverafterthefirmhas
madeanyinvestmentsitneedstomaketocreatefuturegrowthandnetdebt
repayments(debtrepaymentsnewdebtissues)
Aswath Damodaran
Thecommoncategorizationofcapitalexpendituresintodiscretionaryandnon
discretionarylosesitsbasiswhenthereisfuturegrowthbuiltintothevaluation.
119
EstimatingCashFlows:FCFE
CashflowstoEquityforaLeveredFirm
NetIncome
(CapitalExpendituresDepreciation)
ChangesinnoncashWorkingCapital
(PrincipalRepaymentsNewDebtIssues)
=FreeCashflowtoEquity
Aswath Damodaran
Ihaveignoredpreferreddividends.Ifpreferredstockexist,preferreddividendswill
alsoneedtobenettedout
120
EstimatingFCFEwhenLeverageisStable
NetIncome
(1)(CapitalExpendituresDepreciation)
(1)WorkingCapitalNeeds
=FreeCashflowtoEquity
=Debt/CapitalRatio
Forthisfirm,
Proceedsfromnewdebtissues=PrincipalRepayments+(CapitalExpenditures
Depreciation+WorkingCapitalNeeds)
IncomputingFCFE,thebookvaluedebttocapitalratioshouldbeusedwhen
lookingbackintimebutcanbereplacedwiththemarketvaluedebttocapital
ratio,lookingforward.
Aswath Damodaran
121
EstimatingFCFE:Disney
NetIncome=$1533Million
Capitalspending=$1,746Million
DepreciationperShare=$1,134Million
Increaseinnoncashworkingcapital=$477Million
DebttoCapitalRatio=23.83%
EstimatingFCFE(1997):
NetIncome
(Cap.ExpDepr)*(1DR)
Chg.WorkingCapital*(1DR)
=FreeCFtoEquity
$1,533Mil
$465.90
[(17461134)(1.2383)]
$363.33
[477(1.2383)]
$704Million
DividendsPaid
$345Million
Aswath Damodaran
122
FCFEandLeverage:Isthisafreelunch?
1400
1200
FCFE
1000
800
600
400
200
0
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Debt Ratio
Aswath Damodaran
123
FCFEandLeverage:TheOtherShoeDrops
7.00
6.00
Beta
5.00
4.00
3.00
2.00
1.00
0.00
0%
1 0%
20 %
3 0%
40 %
5 0%
60 %
7 0%
80%
90 %
Debt Ratio
Aswath Damodaran
124
Leverage,FCFEandValue
Inadiscountedcashflowmodel,increasingthedebt/equityratiowill
generallyincreasetheexpectedfreecashflowstoequityinvestorsoverfuture
timeperiodsandalsothecostofequityappliedindiscountingthesecash
flows.Whichofthefollowingstatementsrelatingleveragetovaluewouldyou
subscribeto?
Increasingleveragewillincreasevaluebecausethecashfloweffectswill
dominatethediscountrateeffects
Increasingleveragewilldecreasevaluebecausetheriskeffectwillbegreater
thanthecashfloweffects
Increasingleveragewillnotaffectvaluebecausetheriskeffectwillexactly
offsetthecashfloweffect
Anyoftheabove,dependinguponwhatcompanyyouarelookingatand
whereitisintermsofcurrentleverage
Aswath Damodaran
125
III.EstimatingGrowth
DCFValuation
Aswath Damodaran
126
WaysofEstimatingGrowthinEarnings
Lookatthepast
Lookatwhatothersareestimating
Thehistoricalgrowthinearningspershareisusuallyagoodstartingpointfor
growthestimation
Analystsestimategrowthinearningspershareformanyfirms.Itisusefultoknow
whattheirestimatesare.
Lookatfundamentals
Aswath Damodaran
Ultimately,allgrowthinearningscanbetracedtotwofundamentalshowmuch
thefirmisinvestinginnewprojects,andwhatreturnstheseprojectsaremakingfor
thefirm.
127
I.HistoricalGrowthinEPS
Historicalgrowthratescanbeestimatedinanumberofdifferentways
Historicalgrowthratescanbesensitiveto
ArithmeticversusGeometricAverages
SimpleversusRegressionModels
theperiodusedintheestimation
Inusinghistoricalgrowthrates,thefollowingfactorshavetobeconsidered
Aswath Damodaran
howtodealwithnegativeearnings
theeffectofchangingsize
128
Motorola:ArithmeticversusGeometricGrowthRates
Aswath Damodaran
129
ATest
YouaretryingtoestimatethegrowthrateinearningspershareatTime
Warnerfrom1996to1997.In1996,theearningspersharewasadeficitof
$0.05.In1997,theexpectedearningspershareis$0.25.Whatisthegrowth
rate?
600%
+600%
+120%
Cannotbeestimated
Aswath Damodaran
130
DealingwithNegativeEarnings
Whentheearningsinthestartingperiodarenegative,thegrowthratecannot
beestimated.(0.30/0.05=600%)
Therearethreesolutions:
Usethehigherofthetwonumbersasthedenominator(0.30/0.25=120%)
Usetheabsolutevalueofearningsinthestartingperiodasthedenominator
(0.30/0.05=600%)
Usealinearregressionmodelanddividethecoefficientbytheaverageearnings.
Whenearningsarenegative,thegrowthrateismeaningless.Thus,whilethe
growthratecanbeestimated,itdoesnottellyoumuchaboutthefuture.
Aswath Damodaran
131
TheEffectofSizeonGrowth:CallawayGolf
Year
NetProfit
GrowthRate
1990
1.80
1991
6.40
255.56%
1992
19.30
201.56%
1993
41.20
113.47%
1994
78.00
89.32%
1995
97.70
25.26%
1996
122.30
25.18%
GeometricAverageGrowthRate=102%
Aswath Damodaran
132
ExtrapolationanditsDangers
Year
NetProfit
1996
$122.30
1997
$247.05
1998
$499.03
1999
$1,008.05
2000
$2,036.25
2001
$4,113.23
Ifnetprofitcontinuestogrowatthesamerateasithasinthepast6years,the
expectednetincomein5yearswillbe$4.113billion.
Aswath Damodaran
133
II.AnalystForecastsofGrowth
Whilethejobofananalystistofindunderandovervaluedstocksinthe
sectorsthattheyfollow,asignificantproportionofananalyststime(outside
ofselling)isspentforecastingearningspershare.
Mostofthistime,inturn,isspentforecastingearningspershareinthenext
earningsreport
Whilemanyanalystsforecastexpectedgrowthinearningspershareoverthenext5
years,theanalysisandinformation(generally)thatgoesintothisestimateisfar
morelimited.
Analystforecastsofearningspershareandexpectedgrowtharewidely
disseminatedbyservicessuchasZacksandIBES,atleastforU.Scompanies.
Aswath Damodaran
134
Howgoodareanalystsatforecastinggrowth?
AnalystsforecastsofEPStendtobeclosertotheactualEPSthansimpletime
seriesmodels,butthedifferencestendtobesmall
Study
Collins&Hopwood
Brown&Rozeff
Fried&Givoly
AnalystForecastError
31.7%
28.4%
16.4%
TimeSeriesModel
34.1%
32.2%
19.8%
Theadvantagethatanalystshaveovertimeseriesmodels
TimePeriod
ValueLineForecasts
ValueLineForecasts
EarningsForecaster
tendstodecreasewiththeforecastperiod(nextquarterversus5years)
tendstobegreaterforlargerfirmsthanforsmallerfirms
tendstobegreaterattheindustrylevelthanatthecompanylevel
Forecastsofgrowth(andrevisionsthereof)tendtobehighlycorrelatedacross
analysts.
Aswath Damodaran
135
Aresomeanalystsmoreequalthanothers?
AstudyofAllAmericaAnalysts(chosenbyInstitutionalInvestor)foundthat
Aswath Damodaran
ThereisnoevidencethatanalystswhoarechosenfortheAllAmericaAnalyst
teamwerechosenbecausetheywerebetterforecastersofearnings.(Theirmedian
forecasterrorinthequarterpriortobeingchosenwas30%;themedianforecast
errorofotheranalystswas28%)
However,inthecalendaryearfollowingbeingchosenasAllAmericaanalysts,
theseanalystsbecomeslightlybetterforecastersthantheirlessfortunatebrethren.
(ThemedianforecasterrorforAllAmericaanalystsis2%lowerthanthemedian
forecasterrorforotheranalysts)
EarningsrevisionsmadebyAllAmericaanalyststendtohaveamuchgreater
impactonthestockpricethanrevisionsfromotheranalysts
TherecommendationsmadebytheAllAmericaanalystshaveagreaterimpacton
stockprices(3%onbuys;4.7%onsells).Fortheserecommendationstheprice
changesaresustained,andtheycontinuetoriseinthefollowingperiod(2.4%for
buys;13.8%forthesells).
136
TheFiveDeadlySinsofanAnalyst
TunnelVision:Becomingsofocusedonthesectorandvaluationswithinthe
sectorthatyoulosesightofthebiggerpicture.
Lemmingitis:Strongurgefelttochangerecommendations&reviseearnings
estimateswhenotheranalystsdothesame.
StockholmSyndrome:Referstoanalystswhostartidentifyingwiththe
managersofthefirmsthattheyaresupposedtofollow.
Factophobia(generallyiscoupledwithdelusionsofbeingafamousstory
teller):Tendencytobasearecommendationonastorycoupledwitha
refusaltofacethefacts.
Dr.Jekyll/Mr.Hyde:Analystwhothinkshisprimaryjobistobringin
investmentbankingbusinesstothefirm.
Aswath Damodaran
137
PropositionsaboutAnalystGrowthRates
Proposition1:Thereiffarlessprivateinformationandfarmorepublic
informationinmostanalystforecaststhanisgenerallyclaimed.
Proposition2:Thebiggestsourceofprivateinformationforanalystsremains
thecompanyitselfwhichmightexplain
whytherearemorebuyrecommendationsthansellrecommendations(information
biasandtheneedtopreservesources)
whythereissuchahighcorrelationacrossanalystsforecastsandrevisions
whyAllAmericaanalystsbecomebetterforecastersthanotheranalystsafterthey
arechosentobepartoftheteam.
Proposition3:Thereisvaluetoknowingwhatanalystsareforecastingas
earningsgrowthforafirm.Thereis,however,dangerwhentheyagreetoo
much(lemmingitis)andwhentheyagreetolittle(inwhichcasethe
informationthattheyhaveissonoisyastobeuseless).
Aswath Damodaran
138
III.FundamentalGrowthRates
Aswath Damodaran
139
GrowthRateDerivations
Aswath Damodaran
140
I.ExpectedLongTermGrowthinEPS
Whenlookingatgrowthinearningspershare,theseinputscanbecastasfollows:
ReinvestmentRate=RetainedEarnings/CurrentEarnings=RetentionRatio
ReturnonInvestment=ROE=NetIncome/BookValueofEquity
InthespecialcasewherethecurrentROEisexpectedtoremainunchanged
gEPS
=RetainedEarningst1/NIt1*ROE
=RetentionRatio*ROE
=b*ROE
Proposition 1: The expected growth rate in earnings for a company cannot
exceeditsreturnonequityinthelongterm.
Aswath Damodaran
141
EstimatingExpectedGrowthinEPS:WellsFargoin2008
Returnonequity(basedon2008earnings)=17.56%
RetentionRatio(basedon2008earningsanddividends)=45.37%
ExpectedgrowthrateinearningspershareforWellsFargo,ifitcanmaintain
thesenumbers.
ExpectedGrowthRate=0.4537(17.56%)=7.97%
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142
RegulatoryEffectsonExpectedEPSgrowth
Assumenowthatthebankingcrisisof2008willhaveanimpactonthecapital
ratiosandprofitabilityofbanks.Inparticular,youcanexpectthatthebook
capital(equity)neededbybankstodobusinesswillincrease30%,starting
now.AssumingthatWellscontinueswithitsexistingbusinesses,estimatethe
expectedgrowthrateinearningspershareforthefuture.
NewReturnonEquity=
Expectedgrowthrate=
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143
OnewaytopumpupROE:Usemoredebt
ROE=ROC+D/E(ROCi(1t))
where,
ROC=EBITt(1taxrate)/BookvalueofCapitalt1
D/E=BVofDebt/BVofEquity
i=InterestExpenseonDebt/BVofDebt
t=Taxrateonordinaryincome
NotethatBookvalueofcapital=BookValueofDebt+Bookvalueof
Equity.
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144
DecomposingROE:Brahmain1998
Brahma(nowAmbev)hadanextremelyhighreturnonequity,partlybecause
itborrowedmoneyataratewellbelowitsreturnoncapital
ReturnonCapital=19.91%
Debt/EquityRatio=77%
AftertaxCostofDebt=5.61%
ReturnonEquity=ROC+D/E(ROCi(1t))
19.91%+0.77(19.91%5.61%)=30.92%
Thisseemslikeaneasywaytodeliverhighergrowthinearningsper
share.What(ifany)isthedownside?
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145
DecomposingROE:TitanWatches(India)
ReturnonCapital=9.54%
Debt/EquityRatio=191%(bookvalueterms)
AftertaxCostofDebt=10.125%
ReturnonEquity=ROC+D/E(ROCi(1t))
9.54%+1.91(9.54%10.125%)=8.42%
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146
II.ExpectedGrowthinNetIncome
ThelimitationoftheEPSfundamentalgrowthequationisthatitfocuseson
pershareearningsandassumesthatreinvestedearningsareinvestedin
projectsearningthereturnonequity.
Amoregeneralversionofexpectedgrowthinearningscanbeobtainedby
substitutingintheequityreinvestmentintorealinvestments(netcapital
expendituresandworkingcapital):
EquityReinvestmentRate=(NetCapitalExpenditures+ChangeinWorkingCapital)
(1DebtRatio)/NetIncome
ExpectedGrowthNetIncome=EquityReinvestmentRate*ROE
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147
III.ExpectedGrowthinEBITAndFundamentals:Stable
ROCandReinvestmentRate
Whenlookingatgrowthinoperatingincome,thedefinitionsare
ReinvestmentRate=(NetCapitalExpenditures+ChangeinWC)/EBIT(1t)
ReturnonInvestment=ROC=EBIT(1t)/(BVofDebt+BVofEquity)
ReinvestmentRateandReturnonCapital
gEBIT =(NetCapitalExpenditures+ChangeinWC)/EBIT(1t)*ROC
ReinvestmentRate*ROC
Proposition:Thenetcapitalexpenditureneedsofafirm,foragiven
growthrate,shouldbeinverselyproportionaltothequalityofits
investments.
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148
EstimatingGrowthinEBIT:CiscoversusMotorola1999
CiscosFundamentals
ReinvestmentRate=106.81%
ReturnonCapital=34.07%
ExpectedGrowthinEBIT=(1.0681)(.3407)=36.39%
MotorolasFundamentals
ReinvestmentRate=52.99%
ReturnonCapital=12.18%
ExpectedGrowthinEBIT=(.5299)(.1218)=6.45%
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149
IV.OperatingIncomeGrowthwhenReturnonCapitalis
Changing
Whenthereturnoncapitalischanging,therewillbeasecondcomponentto
growth,positiveifthereturnoncapitalisincreasingandnegativeifthereturn
oncapitalisdecreasing.
IfROCtisthereturnoncapitalinperiodtandROCt+1isthereturnoncapital
inperiodt+1,theexpectedgrowthrateinoperatingincomewillbe:
ExpectedGrowthRate=ROCt+1*Reinvestmentrate
+(ROCt+1ROCt)/ROCt
Ifthechangeisovermultipleperiods,thesecondcomponentshouldbespread
outovereachperiod.
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150
MotorolasGrowthRate
Motorolascurrentreturnoncapitalis12.18%anditsreinvestmentrateis
52.99%.
WeexpectMotorolasreturnoncapitaltoriseto17.22%overthenext5years
(whichishalfwaytowardstheindustryaverage)
ExpectedGrowthRate
=ROCNewInvestments*ReinvestmentRatecurrent+{[1+(ROCIn5yearsROCCurrent)/ROCCurrent]1/51}
=.1722*.5299+{[1+(.1722.1218)/.1218]1/51}
=.1629or16.29%
OnewaytothinkaboutthisistodecomposeMotorolasexpectedgrowthinto
Growthfromnewinvestments:.1722*5299=9.12%
Growthfrommoreefficientlyusingexistinginvestments:16.29%9.12%=7.17%
{Note that I am assuming that the new investments start making 17.22%
immediately,whileallowingforexistingassetstoimprovereturnsgradually}
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151
TheValueofGrowth
Expectedgrowth=Growthfromnewinvestments+Efficiencygrowth
=ReinvRate*ROC
+(ROCtROCt1)/ROCt1
Assumethatyourcostofcapitalis10%.Asaninvestor,rankthese
firmsintheorderofmostvaluegrowthtoleastvaluegrowth.
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152
V.EstimatingGrowthwhenOperatingIncomeisNegative
orMarginsarechanging
Whenoperatingincomeisnegativeormarginsareexpectedtochangeover
time,weuseathreestepprocesstoestimategrowth:
Estimategrowthratesinrevenuesovertime
Usehistoricalrevenuegrowthtogetestimatesofrevenuegrowthinthenearfuture
Decreasethegrowthrateasthefirmbecomeslarger
Keeptrackofabsoluterevenuestomakesurethatthegrowthisfeasible
Estimateexpectedoperatingmarginseachyear
Setatargetmarginthatthefirmwillmovetowards
Adjustthecurrentmargintowardsthetargetmargin
Estimatethecapitalthatneedstobeinvestedtogeneraterevenuegrowthand
expectedmargins
Estimateasalestocapitalratiothatyouwillusetogeneratereinvestmentneedseach
year.
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SiriusRadio:RevenuesandRevenueGrowth
June2006
Year
Current
1
2
3
4
5
6
7
8
9
10
Aswath Damodaran
Revenue
Growthrate
200.00%
100.00%
80.00%
60.00%
40.00%
25.00%
20.00%
15.00%
10.00%
5.00%
Revenues
$187
$562
$1,125
$2,025
$3,239
$4,535
$5,669
$6,803
$7,823
$8,605
$9,035
Operating
Margin
419.92%
199.96%
89.98%
34.99%
7.50%
6.25%
13.13%
16.56%
18.28%
19.14%
19.57%
Targetmarginbasedupon
ClearChannel
OperatingIncome
$787
$1,125
$1,012
$708
$243
$284
$744
$1,127
$1,430
$1,647
$1,768
154
Sirius:ReinvestmentNeeds
Year
Revenues Change in revenue
Sales/Capital Ratio
Reinvestment
Current
$187
1
$562
$375
1.50
$250
2
$1,125
$562
1.50
$375
3
$2,025
$900
1.50
$600
4
$3,239
$1,215
1.50
$810
5
$4,535
$1,296
1.50
$864
6
$5,669
$1,134
1.50
$756
7
$6,803
$1,134
1.50
$756
8
$7,823
$1,020
1.50
$680
9
$8,605
$782
1.50
$522
10
$9,035
$430
1.50
$287
Capital Invested
Operating Income (Loss)
Imputed ROC
$
1,657
-$787
$
1,907
-$1,125
-67.87%
$
2,282
-$1,012
-53.08%
$
2,882
-$708
-31.05%
$
3,691
-$243
-8.43%
$
4,555
$284
7.68%
$
5,311
$744
16.33%
$
6,067
$1,127
21.21%
$
6,747
$1,430
23.57%
$
7,269
$1,647
17.56%
$
7,556
$1,768
15.81%
Capitalinvestedinyeart+!=
Capitalinvestedinyeart+
Reinvestmentinyeart+1
IndustryaverageSales/CapRatio
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155
Equity Earnings
Analysts
Fundamentals
Operating Income
Historical
Fundamentals
Stable ROC
Changing ROC
ROC *
Reinvestment Rate
ROCt+1*Reinvestment Rate
+ (ROCt+1-ROCt)/ROCt
Stable ROE
Changing ROE
Aswath Damodaran
ROEt+1*Retention Ratio
+ (ROEt+1-ROEt)/ROEt
ROE * Equity
Reinvestment Ratio
Negative Earnings
1. Revenue Growth
2. Operating Margins
3. Reinvestment Needs
Net Income
Stable ROE
Historical
Changing ROE
156
IV.ClosureinValuation
DiscountedCashflowValuation
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157
GettingClosureinValuation
Apubliclytradedfirmpotentiallyhasaninfinitelife.Thevalueistherefore
thepresentvalueofcashflowsforever.
t = CFt
Value =
t
t = 1 (1+ r)
Sincewecannotestimatecashflowsforever,weestimatecashflowsfora
growthperiodandthenestimateaterminalvalue,tocapturethevalueatthe
endoftheperiod:
t = N CF
t Terminal Value
Value =
N
t
(1 + r)
t = 1 (1 + r)
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158
WaysofEstimatingTerminalValue
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159
GettingTerminalValueRight
1.Obeythegrowthcap
Whenafirmscashflowsgrowataconstantrateforever,thepresentvalueofthose
cashflowscanbewrittenas:
Value=ExpectedCashFlowNextPeriod/(rg)
where,
r=Discountrate(CostofEquityorCostofCapital)
g=Expectedgrowthrate
Thestablegrowthratecannotexceedthegrowthrateoftheeconomybutitcanbeset
lower.
Ifyouassumethattheeconomyiscomposedofhighgrowthandstablegrowthfirms,the
growthrateofthelatterwillprobablybelowerthanthegrowthrateoftheeconomy.
Thestablegrowthratecanbenegative.Theterminalvaluewillbelowerandyouareassuming
thatyourfirmwilldisappearovertime.
Ifyouusenominalcashflowsanddiscountrates,thegrowthrateshouldbenominalinthe
currencyinwhichthevaluationisdenominated.
Onesimpleproxyforthenominalgrowthrateoftheeconomyistheriskfreerate.
Aswath Damodaran
160
GettingTerminalValueRight
2.Dontwaittoolong
Assumethatyouarevaluingayoung,highgrowthfirmwithgreatpotential,just
afteritsinitialpublicoffering.Howlongwouldyousetyourhighgrowth
period?
<5years
5years
10years
>10years
Whathighgrowthperiodwouldyouuseforalargerfirmwithaproventrack
recordofdeliveringgrowthinthepast?
5years
10years
15years
Longer
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161
Someevidenceongrowthatsmallfirms
Whileanalystsroutinelyassumeverylonghighgrowthperiods(with
substantialexcessreturnsduringtheperiods),theevidencesuggeststhatthey
aremuchtoooptimistic.AstudyofrevenuegrowthatfirmsthatmakeIPOsin
theyearsaftertheIPOshowsthefollowing:
Aswath Damodaran
162
Dontforgetthatgrowthhastobeearned..
3.Thinkaboutwhatyourfirmwillearnasreturnsforever..
Inthesectiononexpectedgrowth,welaidoutthefundamentalequationfor
growth:
Growthrate=ReinvestmentRate*Returnoninvestedcapital
+Growthratefromimprovedefficiency
Instablegrowth,youcannotcountonefficiencydeliveringgrowth(why?)
andyouhavetoreinvesttodeliverthegrowthratethatyouhaveforecast.
Consequently,yourreinvestmentrateinstablegrowthwillbeafunctionof
yourstablegrowthrateandwhatyoubelievethefirmwillearnasareturn
oncapitalinperpetuity:
ReinvestmentRate=Stablegrowthrate/StableperiodReturnoncapital
Akeyissueinvaluationiswhetheritokaytoassumethatfirmscanearn
morethantheircostofcapitalinperpetuity.Therearesome(McKinsey,for
instance)whoarguethatthereturnoncapital=costofcapitalinstable
growth
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163
Therearesomefirmsthatearnexcessreturns..
Whilegrowthratesseemtofadequicklyasfirmsbecomelarger,well
managedfirmsseemtodomuchbetteratsustainingexcessreturnsforlonger
periods.
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164
Anddontfallforsleightofhand
AtypicalassumptioninmanyDCFvaluations,whenitcomesto
stablegrowth,isthatcapitalexpendituresoffsetdepreciationandthere
arenoworkingcapitalneeds.Stablegrowthfirms,wearetold,just
havetomakemaintenancecapex(replacingexistingassets)to
delivergrowth.Ifyoumakethisassumption,whatexpectedgrowth
ratecanyouuseinyourterminalvaluecomputation?
Whatifthestablegrowthrate=inflationrate?Isitokaytomakethis
assumptionthen?
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165
GettingTerminalValueRight
4.Beinternallyconsistent..
Riskandcostsofequityandcapital:Stablegrowthfirmstendto
Havebetasclosertoone
Havedebtratiosclosertoindustryaverages(ormaturecompanyaverages)
Countryriskpremiums(especiallyinemergingmarketsshouldevolveovertime)
Theexcessreturnsatstablegrowthfirmsshouldapproach(orbecome)zero.
ROC>CostofcapitalandROE>Costofequity
Thereinvestmentneedsanddividendpayoutratiosshouldreflectthelower
growthandexcessreturns:
Aswath Damodaran
Stableperiodpayoutratio=1g/ROE
Stableperiodreinvestmentrate=g/ROC
166
V.BeyondInputs:ChoosingandUsingthe
RightModel
DiscountedCashflowValuation
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167
SummarizingtheInputs
Insummary,atthisstageintheprocess,weshouldhaveanestimateofthe
thecurrentcashflowsontheinvestment,eithertoequityinvestors(dividendsor
freecashflowstoequity)ortothefirm(cashflowtothefirm)
thecurrentcostofequityand/orcapitalontheinvestment
theexpectedgrowthrateinearnings,baseduponhistoricalgrowth,analysts
forecastsand/orfundamentals
Thenextstepintheprocessisdeciding
Aswath Damodaran
whichcashflowtodiscount,whichshouldindicate
whichdiscountrateneedstobeestimatedand
whatpatternwewillassumegrowthtofollow
168
WhichcashflowshouldIdiscount?
UseEquityValuation
(a)forfirmswhichhavestableleverage,whetherhighornot,and
(b)ifequity(stock)isbeingvalued
UseFirmValuation
(a)forfirmswhichhaveleveragewhichistoohighortoolow,andexpecttochange
theleverageovertime,becausedebtpaymentsandissuesdonothavetobefactored
inthecashflowsandthediscountrate(costofcapital)doesnotchange
dramaticallyovertime.
(b)forfirmsforwhichyouhavepartialinformationonleverage(eg:interestexpenses
aremissing..)
(c)inallothercases,whereyouaremoreinterestedinvaluingthefirmthantheequity.
(ValueConsulting?)
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169
Givencashflowstoequity,shouldIdiscountdividendsor
FCFE?
UsetheDividendDiscountModel
(a)Forfirmswhichpaydividends(andrepurchasestock)whichareclosetothe
FreeCashFlowtoEquity(overaextendedperiod)
(b)ForfirmswhereFCFEaredifficulttoestimate(Example:BanksandFinancial
Servicecompanies)
UsetheFCFEModel
Aswath Damodaran
(a)Forfirmswhichpaydividendswhicharesignificantlyhigherorlowerthanthe
FreeCashFlowtoEquity.(Whatissignificant?...Asaruleofthumb,ifdividends
arelessthan80%ofFCFEordividendsaregreaterthan110%ofFCFEovera5
yearperiod,usetheFCFEmodel)
(b)Forfirmswheredividendsarenotavailable(Example:PrivateCompanies,
IPOs)
170
WhatdiscountrateshouldIuse?
CostofEquityversusCostofCapital
Whatcurrencyshouldthediscountrate(riskfreerate)bein?
Ifdiscountingcashflowstoequity >CostofEquity
Ifdiscountingcashflowstothefirm
>CostofCapital
Matchthecurrencyinwhichyouestimatetheriskfreeratetothecurrencyofyour
cashflows
ShouldIuserealornominalcashflows?
Aswath Damodaran
Ifdiscountingrealcashflows
>realcostofcapital
Ifnominalcashflows
>nominalcostofcapital
Ifinflationislow(<10%),stickwithnominalcashflowssincetaxesarebasedupon
nominalincome
Ifinflationishigh(>10%)switchtorealcashflows
171
WhichGrowthPatternShouldIuse?
Ifyourfirmis
largeandgrowingatarateclosetoorlessthangrowthrateoftheeconomy,or
constrainedbyregulationfromgrowingatratefasterthantheeconomy
hasthecharacteristicsofastablefirm(averagerisk&reinvestmentrates)
UseaStableGrowthModel
Ifyourfirm
islarge&growingatamoderaterate(Overallgrowthrate+10%)or
hasasingleproduct&barrierstoentrywithafinitelife(e.g.patents)
Usea2StageGrowthModel
Ifyourfirm
issmallandgrowingataveryhighrate(>Overallgrowthrate+10%)or
hassignificantbarrierstoentryintothebusiness
hasfirmcharacteristicsthatareverydifferentfromthenorm
Usea3StageornstageModel
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172
TheBuildingBlocksofValuation
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173
6.TyingupLooseEnds
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174
Butwhatcomesnext?
Aswath Damodaran
175
1.TheValueofCash
Thesimplestandmostdirectwayofdealingwithcashandmarketable
securitiesistokeepitoutofthevaluationthecashflowsshouldbebefore
interestincomefromcashandsecurities,andthediscountrateshouldnotbe
contaminatedbytheinclusionofcash.(Usebetasoftheoperatingassetsalone
toestimatethecostofequity).
Oncetheoperatingassetshavebeenvalued,youshouldaddbackthevalueof
cashandmarketablesecurities.
Inmanyequityvaluations,theinterestincomefromcashisincludedinthe
cashflows.Thediscountratehastobeadjustedthenforthepresenceofcash.
(Thebetausedwillbeweighteddownbythecashholdings).Unlesscash
remainsafixedpercentageofoverallvalueovertime,thesevaluationswill
tendtobreakdown.
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176
AnExerciseinCashValuation
CompanyC
EnterpriseValue
Cash
ReturnonCapital
CostofCapital
Tradesin
Aswath Damodaran
$1billion
$100mil
10%
10%
US
CompanyA
CompanyB
$1billion
$100mil
5%
10%
US
$1billion
$100mil
22%
12%
Argentina
177
Shouldyoueverdiscountcashforitslowreturns?
Therearesomeanalystswhoarguethatcompanieswithalotofcashontheir
balancesheetsshouldbepenalizedbyhavingtheexcesscashdiscountedto
reflectthefactthatitearnsalowreturn.
Excesscashisusuallydefinedasholdingcashthatisgreaterthanwhatthefirm
needsforoperations.
Alowreturnisdefinedasareturnlowerthanwhatthefirmearnsonitsnoncash
investments.
Thisisthewrongreasonfordiscountingcash.Ifthecashisinvestedin
risklesssecurities,itshouldearnalowrateofreturn.Aslongasthereturnis
highenough,giventherisklessnatureoftheinvestment,cashdoesnotdestroy
value.
Thereisarightreason,though,thatmayapplytosomecompanies
Managerscandostupidthingswithcash(overpricedacquisitions,pieinthe
skyprojects.)andyouhavetodiscountforthispossibility.
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178
Cash:DiscountorPremium?
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179
TheCaseofClosedEndFunds:PriceandNAV
D i s c o u n ts /P r e m i u m s o n C l o s e d E n d F u n d s - J u n e 2 0 0 2
70
60
50
40
30
20
10
0
D is c o u n t
> 15%
Aswath Damodaran
D is c o u n t: D is c o u n t: D is c o u n t: D is c o u n t: D is c o u n t: P re m iu m : P re m iu m : P r e m iu m : P re m iu m : P re m iu m : P re m iu m
1 0 -1 5 %
7 .5 -1 0 %
5 - 7 .5 %
2 .5 -5 %
0 - 2 .5 %
0 - 2 .5 %
2 .5 -5 %
5 - 7 .5 %
7 .5 -1 0 %
1 0 -1 5 %
> 15%
D is c o u n t o r P re m iu m o n N A V
180
ASimpleExplanationfortheClosedEndDiscount
Assumethatyouhaveaclosedendfundthatinvestsinaverageriskstocks.
Assumealsothatyouexpectthemarket(averageriskinvestments)tomake
11.5%annuallyoverthelongterm.Iftheclosedendfundunderperformsthe
marketby0.50%,estimatethediscountonthefund.
Aswath Damodaran
181
APremiumforMarketableSecurities:BerkshireHathaway
Aswath Damodaran
182
2.DealingwithHoldingsinOtherfirms
Holdingsinotherfirmscanbecategorizedinto
Aswath Damodaran
Minoritypassiveholdings,inwhichcaseonlythedividendfromtheholdingsis
showninthebalancesheet
Minorityactiveholdings,inwhichcasetheshareofequityincomeisshowninthe
incomestatements
Majorityactiveholdings,inwhichcasethefinancialstatementsareconsolidated.
183
AnExerciseinValuingCrossHoldings
AssumethatyouhavevaluedCompanyAusingconsolidatedfinancialsfor$1billion
(usingFCFFandcostofcapital)andthatthefirmhas$200millionindebt.Howmuch
istheequityinCompanyAworth?
NowassumethatyouaretoldthatCompanyAowns10%ofCompanyBandthatthe
holdingsareaccountedforaspassiveholdings.IfthemarketcapofcompanyBis$500
million,howmuchistheequityinCompanyAworth?
NowaddontheassumptionthatCompanyAowns60%ofCompanyCandthatthe
holdingsarefullyconsolidated.TheminorityinterestincompanyCisrecordedat$40
millioninCompanyAsbalancesheet.HowmuchistheequityinCompanyAworth?
Aswath Damodaran
184
MoreonCrossHoldingValuation
Buildingonthepreviousexample,assumethat
YouhavevaluedequityincompanyBat$250million(whichishalfthemarkets
estimateofvaluecurrently)
CompanyAisasteelcompanyandthatcompanyCisachemicalcompany.
Furthermore,assumethatyouhavevaluedtheequityincompanyCat$250
million.
EstimatethevalueofequityincompanyA.
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185
Ifyoureallywanttovaluecrossholdingsright.
Step1:Valuetheparentcompanywithoutanycrossholdings.Thiswill
requireusingunconsolidatedfinancialstatementsratherthanconsolidated
ones.
Step2:Valueeachofthecrossholdingsindividually.(Ifyouusethemarket
valuesofthecrossholdings,youwillbuildinerrorsthemarketmakesin
valuingthemintoyourvaluation.
Step3:ThefinalvalueoftheequityintheparentcompanywithNcross
holdingswillbe:
Valueofunconsolidatedparentcompany
Debtofunconsolidatedparentcompany
+
j N
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186
Ifyouhavetosettleforanapproximation,trythis
Formajorityholdings,withfullconsolidation,converttheminorityinterest
frombookvaluetomarketvaluebyapplyingapricetobookratio(basedupon
thesectoraverageforthesubsidiary)totheminorityinterest.
Estimatedmarketvalueofminorityinterest=Minorityinterestonbalancesheet*
PricetoBookratioforsector(ofsubsidiary)
Subtractthisfromtheestimatedvalueoftheconsolidatedfirmtogettovalueofthe
equityintheparentcompany.
Forminorityholdingsinothercompanies,convertthebookvalueofthese
holdings(whicharereportedonthebalancesheet)intomarketvalueby
multiplyingbythepricetobookratioofthesector(s).Addthisvalueontothe
valueoftheoperatingassetstoarriveattotalfirmvalue.
Aswath Damodaran
187
3.OtherAssetsthathavenotbeencountedyet..
Unutilizedassets:Ifyouhaveassetsorpropertythatarenotbeingutilizedtogenerate
cashflows(vacantland,forexample),youhavenotvaluedityet.Youcanassessa
marketvaluefortheseassetsandaddthemontothevalueofthefirm.
Overfundedpensionplans:Ifyouhaveadefinedbenefitplanandyourassetsexceed
yourexpectedliabilities,youcouldconsidertheoverfundingwithtwocaveats:
Collectivebargainingagreementsmaypreventyoufromlayingclaimtotheseexcessassets.
Therearetaxconsequences.Often,withdrawalsfrompensionplansgettaxedatmuchhigher
rates.
Donotdoublecountanasset.Ifanassetiscontributingtoyour
cashflows,youcannotcountthemarketvalueoftheassetinyour
value.
Aswath Damodaran
188
4.ADiscountforComplexity:
AnExperiment
OperatingIncome $1billion
Taxrate
40%
ROIC
10%
ExpectedGrowth 5%
Costofcapital
8%
BusinessMix
SingleBusiness
Holdings
Simple
Accounting
Transparent
Whichfirmwouldyouvaluemorehighly?
Aswath Damodaran
CompanyA CompanyB
$1billion
40%
10%
5%
8%
MultipleBusinesses
Complex
Opaque
189
MeasuringComplexity:VolumeofDatainFinancial
Statements
Company
General Electric
Microsoft
Wal-mart
Exxon Mobil
Pfizer
Citigroup
Intel
AIG
Johnson & Johnson
IBM
Aswath Damodaran
190
MeasuringComplexity:AComplexityScore
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191
DealingwithComplexity
InDiscountedCashflowValuation
TheAggressiveAnalyst:Trustthefirmtotellthetruthandvaluethefirmbasedupon
thefirmsstatementsabouttheirvalue.
TheConservativeAnalyst:Dontvaluewhatyoucannotsee.
TheCompromise:Adjustthevalueforcomplexity
Adjustcashflowsforcomplexity
Adjustthediscountrateforcomplexity
Adjusttheexpectedgrowthrate/lengthofgrowthperiod
Valuethefirmandthendiscountvalueforcomplexity
Inrelativevaluation
Inarelativevaluation,youmaybeabletoassessthepricethatthemarketischargingforcomplexity:
Withthehundredlargestmarketcapfirms,forinstance:
PBV=0.65+15.31ROE0.55Beta+3.04Expectedgrowthrate0.003#Pagesin10K
Aswath Damodaran
192
5.Becircumspectaboutdefiningdebtforcostofcapital
purposes
GeneralRule:Debtgenerallyhasthefollowingcharacteristics:
Definedassuch,debtshouldinclude
Commitmenttomakefixedpaymentsinthefuture
Thefixedpaymentsaretaxdeductible
Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrolofthefirm
tothepartytowhompaymentsaredue.
Allinterestbearingliabilities,shorttermaswellaslongterm
Allleases,operatingaswellascapital
Debtshouldnotinclude
Aswath Damodaran
Accountspayableorsuppliercredit
193
BookValueorMarketValue
Youarevaluingadistressedtelecomcompanyandhavearrivedatanestimate
of$1billionfortheenterprisevalue(usingadiscountedcashflowvaluation).
Thecompanyhas$1billioninfacevalueofdebtoutstandingbutthedebtis
tradingat50%offacevalue(becauseofthedistress).Whatisthevalueofthe
equity?
Theequityisworthnothing(EVminusFaceValueofDebt)
Theequityisworth$500million(EVminusMarketValueofDebt)
Wouldyouranswerbedifferentifyouweretoldthattheliquidationvalueofthe
assetsofthefirmtodayis$1.2billionandthatyouwereplanningtoliquidate
thefirmtoday?
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194
Butyoushouldconsiderotherpotentialliabilitieswhen
gettingtoequityvalue
Ifyouhaveunderfundedpensionfundorhealthcareplans,youshould
considertheunderfundingatthisstageingettingtothevalueofequity.
Ifyoudoso,youshouldnotdoublecountbyalsoincludingacashflowlineitem
reflectingcashyouwouldneedtosetasidetomeettheunfundedobligation.
Youshouldnotbecountingtheseitemsasdebtinyourcostofcapital
calculations.
Ifyouhavecontingentliabilitiesforexample,apotentialliabilityfroma
lawsuitthathasnotbeendecidedyoushouldconsidertheexpectedvalueof
thesecontingentliabilities
Aswath Damodaran
Valueofcontingentliability=Probabilitythattheliabilitywilloccur*Expected
valueofliability
195
6.EquityOptionsissuedbythefirm..
Anyoptionsissuedbyafirm,whethertomanagementoremployeesorto
investors(convertiblesandwarrants)createclaimsontheequityofthefirm.
Bycreatingclaimsontheequity,theycanaffectthevalueofequitypershare.
Failingtofullytakeintoaccountthisclaimontheequityinvaluationwill
resultinanoverstatementofthevalueofequitypershare.
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196
Whydooptionsaffectequityvaluepershare?
Itistruethatoptionscanincreasethenumberofsharesoutstandingbut
dilutionperseisnottheproblem.
Optionsaffectequityvalueatexercisebecause
Sharesareissuedatbelowtheprevailingmarketprice.Optionsgetexercisedonly
whentheyareinthemoney.
Alternatively,thecompanycanusecashflowsthatwouldhavebeenavailableto
equityinvestorstobuybackshareswhicharethenusedtomeetoptionexercise.
Thelowercashflowsreduceequityvalue.
Optionsaffectequityvaluebeforeexercisebecausewehavetobuildinthe
expectationthatthereisaprobabilityandacosttoexercise.
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197
Asimpleexample
XYZcompanyhas$100millioninfreecashflowstothefirm,growing3%a
yearinperpetuityandacostofcapitalof8%.Ithas100millionshares
outstandingand$1billionindebt.Itsvaluecanbewrittenasfollows:
Valueoffirm=100/(.08.03)
=2000
Debt
=1000
=Equity
=1000
Valuepershare
=1000/100=$10
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198
Nowcometheoptions
XYZdecidestogive10millionoptionsatthemoney(withastrikepriceof
$10)toitsCEO.Whateffectwillthishaveonthevalueofequitypershare?
a) None.Theoptionsarenotinthemoney.
b) Decreaseby10%,sincethenumberofsharescouldincreaseby10million
c) Decreasebylessthan10%.Theoptionswillbringincashintothefirmbutthey
havetimevalue.
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199
DealingwithEmployeeOptions:TheBludgeonApproach
Thesimplestwayofdealingwithoptionsistotrytoadjustthedenominator
forsharesthatwillbecomeoutstandingiftheoptionsgetexercised.
Intheexamplecited,thiswouldimplythefollowing:
Valueoffirm=100/(.08.03)
=2000
Debt
=1000
=Equity
=1000
Numberofdilutedshares =110
Valuepershare
=1000/110=$9.09
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200
Problemwiththedilutedapproach
Thedilutedapproachfailstoconsiderthatexercisingoptionswillbringin
cashintothefirm.Consequently,theywilloverestimatetheimpactofoptions
andunderstatethevalueofequitypershare.
Thedegreetowhichtheapproachwillunderstatevaluewilldependuponhow
hightheexercisepriceisrelativetothemarketprice.
Incaseswheretheexercisepriceisafractionoftheprevailingmarketprice,
thedilutedapproachwillgiveyouareasonableestimateofvaluepershare.
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201
TheTreasuryStockApproach
Thetreasurystockapproachaddstheproceedsfromtheexerciseofoptionsto
thevalueoftheequitybeforedividingbythedilutednumberofshares
outstanding.
Intheexamplecited,thiswouldimplythefollowing:
Valueoffirm=100/(.08.03)
=2000
Debt
=1000
=Equity
=1000
Numberofdilutedshares
=110
Proceedsfromoptionexercise
=10*10=100(Exerciseprice=10)
Valuepershare
=(1000+100)/110=$10
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202
Problemswiththetreasurystockapproach
Thetreasurystockapproachfailstoconsiderthetimepremiumontheoptions.
Intheexampleused,weareassumingthatanatthemoneyoptionis
essentiallyworthnothing.
Thetreasurystockapproachalsohasproblemswithoutofthemoneyoptions.
Ifconsidered,theycanincreasethevalueofequitypershare.Ifignored,they
aretreatedasnonexistent.
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203
Dealingwithoptionstherightway
Step1:Valuethefirm,usingdiscountedcashfloworothervaluationmodels.
Step2:Subtractoutthevalueoftheoutstandingdebttoarriveatthevalueof
equity.Alternatively,skipstep1andestimatetheofequitydirectly.
Step3:Subtractoutthemarketvalue(orestimatedmarketvalue)ofother
equityclaims:
ValueofWarrants=MarketPriceperWarrant*NumberofWarrants
:
Alternativelyestimatethevalueusingoptionpricingmodel
ValueofConversionOption=MarketValueofConvertibleBondsValueof
StraightDebtPortionofConvertibleBonds
ValueofemployeeOptions:Valueusingtheaverageexercisepriceandmaturity.
Step4:Dividetheremainingvalueofequitybythenumberofshares
outstandingtogetvaluepershare.
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204
ValuingEquityOptionsissuedbyfirmsTheDilution
Problem
Optionpricingmodelscanbeusedtovalueemployeeoptionswithfour
caveats
Employeeoptionsarelongterm,makingtheassumptionsaboutconstantvariance
andconstantdividendyieldsmuchshakier,
Employeeoptionsresultinstockdilution,and
Employeeoptionsareoftenexercisedbeforeexpiration,makingitdangeroustouse
Europeanoptionpricingmodels.
Employeeoptionscannotbeexerciseduntiltheemployeeisvested.
Theseproblemscanbepartiallyalleviatedbyusinganoptionpricingmodel,
allowingforshiftsinvarianceandearlyexercise,andfactoringinthedilution
effect.Theresultingvaluecanbeadjustedfortheprobabilitythatthe
employeewillnotbevested.
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205
BacktothenumbersInputsforOptionvaluation
StockPrice=$10
StrikePrice=$10
Maturity=10years
Standarddeviationinstockprice=40%
RisklessRate=4%
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206
ValuingtheOptions
UsingadilutionadjustedBlackScholesmodel,wearriveatthefollowing
inputs:
N(d1)=0.8199
N(d2)=0.3624
Valuepercall=$9.58(0.8199)$10exp(0.04)(10)(0.3624)=$5.42
DilutionadjustedStockprice
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207
ValueofEquitytoValueofEquitypershare
Usingthevaluepercallof$5.42,wecannowestimatethevalueofequityper
shareaftertheoptiongrant:
Valueoffirm=100/(.08.03)
Debt
=Equity
Valueofoptionsgranted
=ValueofEquityinstock =$945.8
/Numberofsharesoutstanding
=Valuepershare
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=2000
=1000
=1000
=$54.2
/100
=$9.46
208
Totaxadjustornottotaxadjust
Intheexampleabove,wehaveassumedthattheoptionsdonotprovideany
taxadvantages.Totheextentthattheexerciseoftheoptionscreatestax
advantages,theactualcostoftheoptionswillbelowerbythetaxsavings.
Onesimpleadjustmentistomultiplythevalueoftheoptionsby(1taxrate)
togetanaftertaxoptioncost.
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209
Optiongrantsinthefuture
Assumenowthatthisfirmintendstocontinuegrantingoptionseachyeartoits
topmanagementaspartofcompensation.Theseexpectedoptiongrantswill
alsoaffectvalue.
Thesimplestmechanismforbringinginfutureoptiongrantsintotheanalysis
istodothefollowing:
Aswath Damodaran
Estimatethevalueofoptionsgrantedeachyearoverthelastfewyearsasapercent
ofrevenues.
Forecastoutthevalueofoptiongrantsasapercentofrevenuesintofutureyears,
allowingforthefactthatasrevenuesgetlarger,optiongrantsasapercentof
revenueswillbecomesmaller.
Considerthislineitemaspartofoperatingexpenseseachyear.Thiswillreducethe
operatingmarginandcashfloweachyear.
210
Whenoptionsaffectequityvaluepersharethemost
Optiongrantsaffectvaluemore
Thelowerthestrikepriceissetrelativetothestockprice
Thelongerthetermtomaturityoftheoption
Themorevolatilethestockprice
Theeffectonvaluewillbemagnifiedifcompaniesareallowedtorevisit
optiongrantsandresettheexercisepriceifthestockpricemovesdown.
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211
Valuations
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212
CompaniesValued
Company
ModelUsed
Keyemphasis
1.ConEd
2a.ABNAmro
2b.Goldman
2c.WellsFargo
2d.DeutscheBank
3.S&P500
4.Tsingtao
5.Toyota
6.TubeInvest.
7.KRKA
8.TataGroup
9.Amazon.com
10.Amgen
11.Sears
12.LVS
StableDDM
2StageDDM
3StageDDM
2stageDDM
2stageFCFE
2StageDDM
3StageFCFE
StableFCFF
2stageFCFF
2stageFCFF
2stageFCFF
nstageFCFF
3stageFCFF
2stageFCFF
2stageFCFF
Stablegrowthinputs;Impliedgrowth
Breakingdownvalue;Macrorisk?
Regulatoryoverlay?
Effectsofamarketmeltdown?
Estimatingcashflowsforabank
DividendsvsFCFE;Riskpremiums
HighGrowth&Changingfundamentals
NormalizedEarnings
Thecostofcorporategovernance
Multiplecountryrisk..
CrossHoldingmess
TheDarkSideofValuation
CapitalizingR&D
NegativeGrowth?
DealingwithDistress
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213
RiskpremiumsinValuation
TheequityriskpremiumsthatIhaveusedinthevaluationsthatfollowreflect
mythinking(andhowithasevolved)ontheissue.
Aswath Damodaran
Pre1998valuations:Inthevaluationspriorto1998,Iuseariskpremiumof5.5%
formaturemarkets(closetoboththehistoricalandtheimpliedpremiumsthen)
Between1998andSept2008:Inthevaluationsbetween1998andSeptember2008,
Iusedariskpremiumof4%formaturemarkets,reflectingmybeliefthatrisk
premiumsinmaturemarketsdonotchangemuchandrevertbacktohistorical
norms(atleastforimpliedpremiums).
Valuationsdonein2009:Afterthe2008crisisandthejumpinequityrisk
premiumsto6.43%inJanuary2008,Ihaveusedahigherequityriskpremium(5
6%)forthenext5yearsandwillassumeareversionbacktohistoricalnorms(4%)
onlyafteryear5.
In2010&2011:In2010,Irevertedbacktoamaturemarketpremiumof4.5%,
reflectingthedropinequityriskpremiumsduring2009.In2011,Iplantouse5%,
reflectingagainthechangeinimpliedpremiumovertheyear.
214
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ConEd:BreakEvenGrowthRates
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216
FollowinguponDCFvaluation
AssumethatyoubelievethatyourvaluationofConEd($42.30)isafair
estimateofthevalue,7.70%isareasonableestimateofConEdscostof
equityandthatyourexpecteddividendsfornextyear(2.32*1.021)isafair
estimate,whatistheexpectedstockpriceayearfromnow(assumingthatthe
marketcorrectsitsmistake?)
Ifyouboughtthestocktodayat$40.76,whatreturncanyouexpecttomake
overthenextyear(assumingagainthatthemarketcorrectsitsmistake)?
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221
PresentValueMechanicswhendiscountratesare
changing
ConsiderthecostsofequityforGoldmanSachsoverthenext10
years.
Year
15
6
7
8
9
10on
Costofequity
10.4% 10.22% 10.04% 9.86% 9.68% 9.50%
Inestimatingtheterminalvalue,weusedthe9.50%costofequityin
stablegrowth,toarriveataterminalvalueof$476.86.Whatisthe
presentvalueofthisterminalvalue?
Intuitively,explainwhy.
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222
TheValueofGrowth
P0 =
Inanyvaluationmodel,itispossibletoextracttheportionofthevaluethat
canbeattributedtogrowth,andtobreakthisdownfurtherintothatportion
attributabletohighgrowthandtheportionattributabletostablegrowth.
Inthecaseofthe2stageDDM,thiscanbeaccomplishedasfollows:
t=n
DPS t + Pn
(1+r)
t
(1+r)n
t=1
- DPS0 *(1+gn )
(r-gn )
DPS0
r
ValueofHighGrowth
ValueofStableGrowth
Assetsin
Place
DPSt=Expecteddividendspershareinyeart
r=CostofEquity
Pn=Priceattheendofyearn
gn=Growthrateforeverafteryearn
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223
ABNAmroandGoldmanSachs:DecomposingValue
Assets in
place
Stable
Growth
Growth
Assets
Total
Aswath Damodaran
Proportio
n
Goldman (2008)
Proportions
0.90/.0835 =
$10.78
39.02%
1.40/.095 =
$14.74
6.62%
0.90*1.04/
(.0835-.04) =
$10.74
38.88%
1.40*1.04/(.095-.04) =
$11.74
5.27%
222.49-14.74-11.74 =
$196.02
88.10%
27.62-10.78-10.74 =
22.10%
$6.10
$27.62
$222.49
224
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226
In2001,stockwas
tradingat10.10Yuan
pershare
WhyFCFE?CompanyhasnegativeFCFE
Why3stage?Highgrowth
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227
DecomposingvalueatTsingtaoBreweries
BreakingdownthevaluetodayofTsingtaoBreweries,youarriveat
thefollowing:
PVofCashflowstoEquityoverfirst10years= 187million
PVofTerminalValueofEquity=
4783million
Valueofequitytoday=
4596million
Morethan100%ofthevalueofequitytodaycomesfromtheterminal
value.
a. Isthisareasonforconcern?
b.
Howwouldyouintuitivelyexplainwhatthismeansforanequity
investorinthefirm?
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228
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CircularReasoninginFCFFValuation
IndiscountingFCFF,weusethecostofcapital,whichiscalculatedusingthe
marketvaluesofequityanddebt.WethenusethepresentvalueoftheFCFF
asourvalueforthefirmandderiveanestimatedvalueforequity.(For
instance,intheToyptavaluation,weusedthecurrentmarketvalueofequity
of3200yen/sharetoarriveatthedebtratioof52.9%whichweusedinthe
costofcapital.However,weconcludedthatthevalueofToyotasequitywas
4735yen/share.Istherecircularreasoninghere?
Yes
No
Ifthereis,canyouthinkofawayaroundthisproblem?
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StableGrowthRateandValue
InestimatingterminalvalueforTubeInvestments,Iusedastablegrowthrate
of5%.IfIuseda7%stablegrowthrateinstead,whatwouldmyterminal
valuebe?(Assumethatthecostofcapitalandreturnoncapitalremain
unchanged.)
Whatarethelessonsthatyoucandrawfromthisanalysisforthekey
determinantsofterminalvalue?
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TubeInvestments:Shouldtherebeacorporategovernance
discount?
StockholdersinAsian,LatinAmericanandmanyEuropeancompanieshave
littleornopoweroverthemanagersofthefirm.Inmanycases,insidersown
votingsharesandcontrolthefirmandthepotentialforconflictofinterestsis
huge.Wouldyoudiscountthevaluethatyouestimatedtoallowforthis
absenceofstockholderpower?
Yes
No.
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236
8.TheTataGroupApril2010
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237
ComparingtheTataCompanies:CostofCapital
Beta
Lambda
Cost of equity
Synthetic rating
Cost of debt
Aswath Damodaran
Tata Motors
1.2
0.8
14.00%
TCS
1.05
0.2
10.63%
BBB
6.60%
A
6.11%
B+
8.09%
AAA
5.61%
Debt Ratio
30.48%
29.59%
25.30%
0.03%
Cost of Capital
11.62%
13.79%
12.50%
10.62%
238
GrowthandValue
Tata Chemicals
Return on capital
Reinvestment Rate
Expected Growth
10.35%
56.50%
5.85%
Cost of capital
11.62%
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12.50%
40.63%
56.73%
23.05%
10.62%
239
TataCompanies:ValueBreakdown
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A LifeCycleViewof Valuation
Idea
Companies
Young
Growth
Mature Growth
Mature
Decline
Revenues
$ Revenues/
Earnings
Earnings
Time
Valuation
players/setting
Revenue/Earnings
Survival Issues
Owners
Angel financiers
Venture Capitalists
IPO
1. What is the
potential market?
2. Will this product
sell and at what
price?
3. What are the
expected margins?
Aswath Damodaran
No history
No financials
Growth investors
Equity analysts
Value investors
Private equity funds
1. Can the
company scale
up? (How will
revenue growth
change as firm
gets larger?)
2. How will
competition
affect margins?
Will the firm
being acquired?
1. As growth
declines, how will
the firms
reinvestment
policy change?
2. Will financing
policy change as
firm matures?
1. Is there the
possibility of the
firm being
restructured?
Revenue Growth
Target Margins
Return on capital
Reinvestment Rate
Length of growth
Low Revenues
Past data reflects
Negative earnings smaller company
Changing margins
Vulture investors
Break-up valuations
Low, as projects dry
up.
Current Earnings
Efficiency growth
Changing cost of
capital
Numbers can change
if management
changes
Asset divestrture
Liquidation
values
Declining revenues
Negative earnings?
241
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Thedarksideofvaluation...
Whenvaluingcompanies,wedrawonthreesourcesofinformation:
Thefirmscurrentfinancialstatement
Thefirmscurrentfinancialstatement
Howmuchdidthefirmsell?
Howmuchdiditearn?
Thefirmsfinancialhistory,usuallysummarizedinitsfinancialstatements.
Howfasthavethefirmsrevenuesandearningsgrownovertime?Whatcanwelearn
aboutcoststructureandprofitabilityfromthesetrends?
Susceptibilitytomacroeconomicfactors(recessionsandcyclicalfirms)
Theindustryandcomparablefirmdata
Whathappenstofirmsastheymature?(Margins..RevenuegrowthReinvestment
needsRisk)
Valuationismostdifficultwhenacompany
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Hasnegativeearningsandlowrevenuesinitscurrentfinancialstatements
Nohistory
Nocomparables(oreveniftheyexist,theyareallatthesamestageofthelifecycleasthefirm
beingvalued)
243
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Whatdoyouneedtobreakevenat$84?
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Amazonovertime
A m a z o n : V a lu e a n d P r ic e
$ 9 0 .0 0
$ 8 0 .0 0
$ 7 0 .0 0
$ 6 0 .0 0
$ 5 0 .0 0
V a lu e p e r s h a r e
P r ic e p e r s h a r e
$ 4 0 .0 0
$ 3 0 .0 0
$ 2 0 .0 0
$ 1 0 .0 0
$ 0 .0 0
2000
2001
2002
2003
T im e o f a n a ly s is
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Amgen:TheR&DEffect?
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Uncertaintyisendemictovaluation.
Assumethatyouhavevaluedyourfirm,usingadiscountedcashflowmodelandwiththeall
theinformationthatyouhaveavailabletoyouatthetime.Whichofthefollowing
statementsaboutthevaluationwouldyouagreewith?
IfIknowwhatIamdoing,theDCFvaluationwillbeprecise
NomatterhowcarefulIam,theDCFvaluationgivesmeanestimate
Ifyousubscribetothelatterstatement,howwouldyoudealwiththeuncertainty?
Collectmoreinformation,sincethatwillmakemyvaluationmoreprecise
Makemymodelmoredetailed
Dowhatifanalysisonthevaluation
Useasimulationtoarriveatadistributionofvalue
Willnotbuythecompany
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Option1:Collectmoreinformation
Therearetwotypesoferrorsinvaluation.Thefirstisestimationerrorandthe
secondisuncertaintyerror.Theformerisamenabletoinformationcollection
butthelatterisnot.
Waysofincreasinginformationinvaluation
Collectmorehistoricaldata(withthecaveatthatfirmschangeovertime)
Lookatcrosssectionaldata(hopingtheindustryaveragesconveyinformationthat
theindividualfirmsfinancialdonot)
Trytoconvertqualitativeinformationintoquantitativeinputs
Proposition1:Moreinformationdoesnotalwaysleadtomorepreciseinputs,
sincethenewinformationcancontradictoldinformation.
Proposition2:Thehumanmindisincapableofhandlingtoomuchdivergent
information.Informationoverloadcanleadtovaluationtrauma.
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Option2:Buildbiggermodels
Whenvaluationsareimprecise,thetemptationoftenistobuildmoredetailintomodels,
hopingthatthedetailtranslatesintomoreprecisevaluations.Thedetailcanvaryand
includes:
Morelineitemsforrevenues,expensesandreinvestment
Breakingtimeseriesdataintosmallerormorepreciseintervals(Monthlycash
flows,midyearconventionsetc.)
Morecomplexmodelscanprovidetheillusionofmoreprecision.
Proposition1:Thereisnopointtobreakingdownitemsintodetail,ifyoudonothave
theinformationtosupplythedetail.
Proposition2:Yourcapacitytosupplythedetailwilldecreasewithforecastperiod
(almostimpossibleafteracoupleofyears)andincreasewiththematurityofthefirm(it
isverydifficulttoforecastdetailwhenyouarevaluingayoungfirm)
Proposition3:Lessisoftenmore
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Option3:BuildWhatifanalyses
Avaluationisafunctionoftheinputsyoufeedintothevaluation.Tothe
degreethatyouarepessimisticoroptimisticonanyoftheinputs,your
valuationwillreflectit.
Therearethreewaysinwhichyoucandowhatifanalyses
Bestcase,Worstcaseanalyses,whereyousetalltheinputsattheirmostoptimistic
andmostpessimisticlevels
Plausiblescenarios:Here,youdefinewhatyoufeelarethemostplausiblescenarios
(allowingfortheinteractionacrossvariables)andvaluethecompanyunderthese
scenarios
Sensitivitytospecificinputs:Changespecificandkeyinputstoseetheeffecton
value,orlookattheimpactofalargeevent(FDAapprovalforadrugcompany,
lossinalawsuitforatobaccocompany)onvalue.
Proposition1:Asageneralrule,whatifanalyseswillyieldlargerangesforvalue,
withtheactualpricesomewherewithintherange.
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Option 4: Simulation
The Inputs for Amgen
Correlation=0.4
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TheSimulatedValuesofAmgen:
WhatdoIdowiththisoutput?
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DealingwithDistress
ADCFvaluationvaluesafirmasagoingconcern.Ifthereisasignificantlikelihoodofthefirm
failingbeforeitreachesstablegrowthandiftheassetswillthenbesoldforavaluelessthanthe
presentvalueoftheexpectedcashflows(adistresssalevalue),DCFvaluationswillunderstatethe
valueofthefirm.
ValueofEquity=DCFvalueofequity(1Probabilityofdistress)+Distresssalevalueofequity
(Probabilityofdistress)
Therearethreewaysinwhichwecanestimatetheprobabilityofdistress:
Usethebondratingtoestimatethecumulativeprobabilityofdistressover10years
Estimatetheprobabilityofdistresswithaprobit
Estimatetheprobabilityofdistressbylookingatmarketvalueofbonds..
Thedistresssalevalueofequityisusuallybestestimatedasapercentofbookvalue(andthisvalue
willbeloweriftheeconomyisdoingbadlyandthereareotherfirmsinthesamebusinessalsoin
distress).
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AdjustingthevalueofLVSfordistress..
InFebruary2009,LVSwasratedB+byS&P.Historically,28.25%ofB+rated
bondsdefaultwithin10years.LVShasa6.375%bond,maturinginFebruary2015
(7years),tradingat$529.Ifwediscounttheexpectedcashflowsonthebondatthe
riskfreerate,wecanbackouttheprobabilityofdistressfromthebondprice:
t 7
Solvingfortheprobabilityofbankruptcy,weget:
t
7
(1.03)
(1.03)
t 1
Distress=Annualprobabilityofdefault=13.54%
IfLVSisbecomesdistressed:
Cumulativeprobabilityofsurviving10years=(1.1354) 10=23.34%
Cumulativeprobabilityofdistressover10years=1.2334=.7666or76.66%
Expecteddistresssaleproceeds=$2,769million<Facevalueofdebt
Expectedequityvalue/share=$0.00
Expectedvaluepershare=$8.12(1.7666)+$0.00(.7666)=$1.92
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Anothertypeoftruncationrisk?
AssumethatyouarevaluingGazprom,theRussianoilcompanyand
haveestimatedavalueofUS$180billionfortheoperatingassets.The
firmhas$30billionindebtoutstanding.Whatisthevalueofequityin
thefirm?
Nowassumethatthefirmhas15billionsharesoutstanding.Estimate
thevalueofequitypershare.
TheRussiangovernmentowns42%oftheoutstandingshares.Would
thatchangeyourestimateofvalueofequitypershare?
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