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Aswath Damodaran
Aswath Damodaran
Aswath Damodaran
Approaches to Valuation
Valuation Models
Relative Valuation
Equity Firm
Sector
Option to delay
Option to expand
Option to liquidate
Market Normalized
Young firms
Sector specific
Undeveloped land
APV approach
Aswath Damodaran
The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon
a perception that markets are inefficient and make mistakes in assessing value an assumption about how and when these inefficiencies will get corrected
In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.
Aswath Damodaran
What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Information Needed: To use discounted cash flow valuation, you need
to estimate the life of the asset to estimate the cash flows during the life of the asset to estimate the discount rate to apply to these cash flows to get present value
Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.
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where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.
Aswath Damodaran
Value just the equity stake in the business Value the entire business, which includes, besides equity, the other claimholders in the firm
Aswath Damodaran
I.Equity Valuation
The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm.
t=n
Forms: The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. In the more general version, you can consider the cashflows left over after debt payments and reinvestment needs as the free cashflow to equity.
Aswath Damodaran
Value of Firm =
(1+ WACC)
t =1
CF to Firm t
t
APV approach: The value of the firm can also be written as the sum of the value of the unlevered firm and the effects (good and bad) of debt.
Firm Value = Unlevered Firm Value + PV of tax benefits of debt - Expected Bankruptcy Cost
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Cash flows Firm: Pre-debt cash flow Equity: After debt cash flows
Expected Growth Firm: Growth in Operating Earnings Equity: Growth in Net Income/EPS
Terminal Value Value Firm: Value of Firm Equity: Value of Equity Length of Period of High Growth CF 1 CF 2 CF 3 CF 4 CF 5 ......... CF n Forever
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g =4%: ROE = 8.95%(=Cost of equity) Beta = 1.00 Payout = (1- 4/8.95) = .553
Terminal Value= EPS *Payout/(r-g) 6 = (2.21*.553)/(.0895-.04) = 24.69 Value of Equity per share = 20.48 Eur EPS DPS 1.64 Eur 0.96 Eur 1.75 Eur 1.02 Eur 1.87 Eur 1.09 Eur 1.99 Eur 1.16 Eur 2.12 Eur 1.24 Eur ......... Forever Discount at Cost of Equity
Beta 0.95
Risk Premium 4%
Mature Market 4%
Country Risk 0%
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Avg Reinvestment rate = 25.08% Current Cashflow to Firm EBIT(1-t) : $ 404 - Nt CpX 23 - Chg WC 9 = FCFF $ 372 Reinvestment Rate = 32/404= 7.9%
Return on Capital 21.85% Stable Growth g = 4.17%; Beta = 1.00; Country Premium= 5% Cost of capital = 8.76% ROC= 8.76%; Tax rate=34% Reinvestment Rate=g/ROC =4.17/8.76= 47.62% Terminal Value 5 = 288/(.0876-.0417) = 6272
$ Cashflows Op. Assets $ 5,272 + Cash: 795 - Debt 717 - Minor. Int. 12 =Equity 5,349 -Options 28 Value/Share $7.47 R$ 21.75 Year EBIT(1-t) - Reinvestment = FCFF 1 426 107 319 2 449 113 336 3 474 119 355
Beta 1.07
Lambda 0.27
Country Equity Risk Premium 7.67% Rel Equity Mkt Vol 1.28
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Stable Growth Cap ex growth slows and net cap ex decreases Revenue Growth: 13.33% EBITDA/Sales -> 30% Stable Revenue Growth: 5% Stable EBITDA/ Sales 30% Stable ROC=7.36% Reinvest 67.93%
Value of Op Assets $ 5,530 + Cash & Non-op $ 2,260 = Value of Firm $ 7,790 - Value of Debt $ 4,923 = Value of Equity $ 2867 - Equity Options $ 14 Value per share $ 3.22
Forever
Risk Premium 4%
Internet/ Retail
Operating Leverage
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Probability of distress
Price of 8 year, 12% bond issued by Global Crossing = $ 653
t! 8
653 !
Probability of distress = 13.53% a year Cumulative probability of survival over 10 years = (1- .1353)10 = 23.37%
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In the adjusted present value approach, the value of the firm is written as the sum of the value of the firm without debt (the unlevered firm) and the effect of debt on firm value Firm Value = Unlevered Firm Value + (Tax Benefits of Debt Expected Bankruptcy Cost from the Debt)
The unlevered firm value can be estimated by discounting the free cashflows to the firm at the unlevered cost of equity The tax benefit of debt reflects the present value of the expected tax benefits. In its simplest form, Tax Benefit = Tax rate * Debt The expected bankruptcy cost is a function of the probability of bankruptcy and the cost of bankruptcy (direct as well as indirect) as a percent of firm value.
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You can present any discounted cashflow model in terms of excess returns, with the value being written as:
Value = Capital Invested + Present value of excess returns on current investments + Present value of excess returns on future investments
This model can be stated in terms of firm value (EVA) or equity value.
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Firm is in stable growth: Growth rate = 5% Return on Equity = 15% Cost of equity =9.40%
Terminal Value= $2220/(.094-.05)=50,459 Net Income - Equity Cost (see below) Excess Equity Return Book Equity= 17997 + PV of EVA= 38334 = Equity EVA=56331 Value/sh = $50.26 $3,599 $1,908 $1,692 $4,031 $2,137 $1,895 $4,515 $2,393 $2,122 $5,057 $2,680 $2,377 $5,664 $3,002 $2,662 Forever Discount at Cost of Equity
Beta 1.40
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Are the current earnings positive & normal? Yes Use current earnings as base Yes No Is the cause temporary?
Stable leverage
Unstable leverage
FCFE
FCFF
Yes Adjust margins over time to nurse firm to financial health Yes
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Relative Valuation
What is it?: The value of any asset can be estimated by looking at how the market prices similar or comparable assets. Philosophical Basis: The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics) Information Needed: To do a relative valuation, you need
an identical asset, or a group of comparable or similar assets a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value) and if the assets are not perfectly comparable, variables to control for the differences
Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected.
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Variations on Multiples
Scaling variable
Base year
Comparables
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Definitional Tests
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There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined. Price: is usually the current price is sometimes the average price for the year EPS: earnings per share in most recent financial year earnings per share in trailing 12 months (Trailing PE) forecasted earnings per share next year (Forward PE) forecasted earnings per share in future year
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Descriptive Tests
What is the average and standard deviation for this multiple, across the universe (market)? What is the median for this multiple?
The median for this multiple is often a more reliable comparison point.
How large are the outliers to the distribution, and how do we deal with the outliers?
Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on one side of the distribution (they usually are large positive numbers), this can lead to a biased estimate.
Are there cases where the multiple cannot be estimated? Will ignoring these cases lead to a biased estimate of the multiple? How has this multiple changed over time?
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Mean Standard Error Median Standard Deviation Skewness Minimum Maximum Count Largest(500) Smallest(500)
Current PE 36.04 1.94 18.25 123.36 23.13 0.65 5103.50 4024 48.00 9.38
Trailing PE 34.14 2.93 17.25 176.34 28.40 1.35 6914.50 3627 39.60 9.62
Forward PE 30.79 1.15 18.52 57.56 13.66 3.30 1414.00 2491 34.49 12.94
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Analytical Tests
What are the fundamentals that determine and drive these multiples?
Proposition 2: Embedded in every multiple are all of the variables that drive every discounted cash flow valuation - growth, risk and cash flow patterns. In fact, using a simple discounted cash flow model and basic algebra should yield the fundamentals that drive a multiple
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PS= Net Margin (Payout ratio) (1+g)/(r-g) PS=f(Net Mgn, payout, g, risk)
Firm Multiples V/FCFF=f(g, WACC) Value/FCFF=(1+g)/ (WACC-g) V/EBIT(1-t)=f(g, RIR, WACC) Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g) V/EBIT=f(g, RIR, WACC, t) Value/EBIT=(1+g)(1RiR)/(1-t)(WACC-g) VS=f(Oper Mgn, RIR, g, WACC) VS= Oper Margin (1RIR) (1+g)/(WACC-g)
1 /(WACC -g)
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Application Tests
Given the comparable firms, how do we adjust for differences across firms on the fundamentals?
Proposition 5: It is impossible to find an exactly identical firm to the one you are valuing.
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Variable Coefficient SE t-ratio Constant 13.1151 3.471 3.78 Growth rate 121.223 19.27 6.29 Emerging Market -13.8531 3.606 -3.84 Emerging Market is a dummy: 1 if emerging market 0 if not
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Predicted PE = 13.12 + 121.22 (.075) - 13.85 (1) = 8.35 At an actual price to earnings ratio of 8.9, Telebras is slightly overvalued.
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St d. Er ro r o f th e Es tim a te 13 5 0.6 77 6 1 93 1 3
a. Fo r r eg re ss io n t hr ou gh th e or igin (th e n o - int e rc e pt m od e l), R Squ ar e m e a su r e s t he pr o po rt ion of t he var ia b ility in th e de p e n de n t varia ble a b ou t th e o rig in ex pla ine d b y r e gr es sion . T his CANNOT b e c o m p ar ed to R Sq ua r e fo r m od e ls whic h inc lu d e a n int er c ep t. b . Pr e d ic tor s: Valu e Line Bet a, P ayou t Ratio , Ex pe c te d Gr owt h in EPS: ne x t 5 ye a rs Co e f fici e n ts a,b ,c Uns t an d ar d iz ed Coe f fic ie nt s Mo de l 1 B Exp e ct e d Gro wth in EPS: n e xt 5 ye ar s Pa yo ut Ra tio Va lu e Lin e B ta e 1 .2 28 - 1 .1 E- 0 2 1 1. 70 5 Std . Er r or .05 5 .01 4 .82 5 St a nd a r dize d C oe ffic ie n ts Be t a .51 4 - .01 3 .38 4 t 22 .1 87 - .7 68 14 .1 84 Sig . .0 0 0 .4 4 3 .0 0 0 9 5% Co nf ide n ce Int e rva l f or B Lo wer Bo un d 1 . 1 19 - . 03 9 1 0. 08 7 Up pe r Bo un d 1.3 3 6 .0 1 7 13 .3 24
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Value of Asset
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Traditional discounted cashflow models under estimate the value of investments, where there are options embedded in the investments to
Delay or defer making the investment (delay) Adjust or alter production schedules as price changes (flexibility) Expand into new markets or products at later stages in the process, based upon observing favorable outcomes at the early stages (expansion) Stop production or abandon investments if the outcomes are unfavorable at early stages (abandonment)
Put another way, real option advocates believe that you should be paying a premium on discounted cashflow value estimates.
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Bottom Line: Real option pricing models work well with natural resource options.
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Bottom Line: Using option pricing models to value expansion options will not only yield extremely noisy estimates, but may attach inappropriate premiums to discounted cashflow estimates.
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There are real options everywhere. Most of them have no significant economic value because there is no exclusivity associated with using them. When options have significant economic value, the inputs needed to value them in a binomial model can be used in more traditional approaches (decision trees) to yield equivalent value. The real value from real options lies in
Recognizing that building in flexibility and escape hatches into large decisions has value Insights we get on understanding how and why companies behave the way they do in investment analysis and capital structure choices.
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Valuation Models
Relative Valuation
Equity Firm
Sector
Option to delay
Option to expand
Option to liquidate
Market Normalized
Young firms
Sector specific
Undeveloped land
APV approach
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Which approach should you use? Depends upon the asset being valued..
Asset Marketability and Valuation Approaches Mature businesses Separable & marketable assets Growth businesses Linked and non-marketable assets
Liquidation & Replacement cost valuation Cash Flows and Valuation Approaches Cashflows currently or expected in near future Cashflows if a contingency occurs
Uniqueness of Asset and Valuation Approaches Large number of similar assets that are priced
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Liquidation value
Relative valuation
Views on market and Valuation Approaches Markets are correct on average but make mistakes on individual assets Asset markets and financial markets may diverge Markets make mistakes but correct them over time
Relative valuation
Liquidation value
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