Many a slip….

Loose Ends in Valuation

Aswath Damodaran

Aswath Damodaran 1
 Some Overriding Thoughts

n The biggest reason for bad valuations is not bad models but bias. Building a
better valuation model is easy, but getting the bias out of valuation is difficult.
n Analysts who fault their models for not being more precise are not only
missing the real reason for imprecision (which is that no one can forecast the
future with certainty) but are also setting themselves up for false alternatives.
n Valuation is simple. We choose to make it complex. Complexity always come
with a cost….

Aswath Damodaran 2
 So, you’ve valued a firm…

Free Cashflow to Firm

EBIT (1- tax rate) Expected Growth
- (Cap Ex - Depreciation)
- Change in non-cash WC during high growth
= Free Cashflow to firm

Length of high growth period: PV of FCFF during high growth

Value of Operating Assets today Stable Growth

Cost of Capital

Cost of Equity Cost of Debt

Aswath Damodaran 3
 But what comes next?

Value of Operating Assets

+ Cash and Marketable Operating versus Non-opeating cash

Securities Should cash be discounted for earning a low return?
+ Value of Cross Holdings How do you value cross holdings in other companies?
What if the cross holdings are in private businesses?
+ Value of Other Assets What about other valuable assets?
How do you consider under utlilized assets?
Should you discount this value for opacity or complexity?
Value of Firm How about a premium for synergy?
What about a premium for intangibles (brand name)?
What should be counted in debt?
- Value of Debt Should you subtract book or market value of debt?
What about other obligations (pension fund and health care?
What about contingent liabilities?
What about minority interests?
= Value of Equity Should there be a premium/discount for control?
Should there be a discount for distress
- Value of Equity Options What equity options should be valued here (vested versus non-vested)?
How do you value equity options?
= Value of Common Stock Should you divide by primary or diluted shares?
/ Number of shares
= Value per share Should there be a discount for illiquidity/ marketability?
Should there be a discount for minority interests?

Aswath Damodaran 4
 1. The Value of Cash

n The simplest and most direct way of dealing with cash and marketable
securities is to keep it out of the valuation - the cash flows should be before
interest income from cash and securities, and the discount rate should not be
contaminated by the inclusion of cash. (Use betas of the operating assets alone
to estimate the cost of equity).
n Once the operating assets have been valued, you should add back the value of
cash and marketable securities.

Aswath Damodaran 5
 How much cash is too much cash?

Cash as % of Firm Value: July 2000

1200

1000

800

600

400

200

0
0-1% 1-2% 2-5% 5-10% 10-15% 15-20% 20-25% 25-30% >30%

Aswath Damodaran 6
 Should you ever discount cash for its low returns?

n There are some analysts who argue that companies with a lot of cash on their
balance sheets should be penalized by having the excess cash discounted to
reflect the fact that it earns a low return.
• Excess cash is usually defined as holding cash that is greater than what the firm
needs for operations.
• A low return is defined as a return lower than what the firm earns on its non-cash
investments.
n This is the wrong reason for discounting cash. If the cash is invested in
riskless securities, it should earn a low rate of return. As long as the return is
high enough, given the riskless nature of the investment, cash does not destroy
value.
n There is a right reason, though, that may apply to some companies…

Aswath Damodaran 7
 The Value of Cash

n Implicitly, we are assuming here that the market will value cash at face value.
Assume now that you are buying a firm whose only asset is marketable
securities worth $ 100 million. Can you ever consider a scenario where you
would not be willing to pay $ 100 million for this firm?
o Yes
o No
n What is or are the scenario(s)?

Aswath Damodaran 8
 The Case of Closed End Funds

n Closed end funds are mutual funds, with a fixed number of shares. Unlike
regular mutual funds, where the shares have to trade at net asset value (which
is the value of the securities in the fund), closed end funds shares can and
often do trade at prices which are different from the net asset value.
n The average closed end fund has always traded at a discount on net asset value
(of between 10 and 20%) in the United States.

Aswath Damodaran 9
 A Simple Explanation for the Closed End Discount

n Assume that you have a closed-end fund that invests in ‘average risk” stocks.
Assume also that you expect the market (average risk investments) to make
11.5% annually over the long term. If the closed end fund underperforms the
market by 0.50%, estimate the discount on the fund.

Aswath Damodaran 10
 A Premium for Marketable Securities: Berkshire Hathaway

Berkshire Hathaway

45000 140.00%

40000
120.00%

35000

100.00%

Premium over Book Value

30000
Value Per Share

80.00%
25000 Market Value/Share
Book Value/Share
Premium over Book Value
20000 60.00%

15000
40.00%

10000

20.00%
5000

0 0.00%
1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997
Year

Aswath Damodaran 11
 2. Dealing with Holdings in Other firms

n Holdings in other firms can be categorized into

• Minority passive holdings, in which case only the dividend from the holdings is
shown in the balance sheet
• Minority active holdings, in which case the share of equity income is shown in the
income statements
• Majority active holdings, in which case the financial statements are consolidated.

Aswath Damodaran 12
 How to value holdings in other firms

Fin Statement Valuing What to do…

Not consolidated Equity Value equity in subsidiary and take
share of holding.
Not consolidated Firm Value subsidiary as a firm and add
portion of firm value. Add portion of
debt in subsidiary to the debt in estimating
equity value.
Consolidated Firm Strip operating income of subsidiary
and value subsidiary separately. Add
portion of this value to value of parent firm.

Aswath Damodaran 13
 How some deal with subsidiaries...

n When financial statements are consolidated, some analysts value the firm with
the consolidated operating income and then subtract minority interests from
the firm value to arrive at the value of the equity in the firm. What is wrong
with this approach?

Aswath Damodaran 14
 3. Other Assets that have not been counted yet..

n Unutilized assets: If you have assets or property that are not being utilized
(vacant land, for example), you have not valued it yet. You can assess a
market value for these assets and add them on to the value of the firm.
n Overfunded pension plans: If you have a defined benefit plan and your assets
exceed your expected liabilities, you could consider the over funding with two
caveats:
• Collective bargaining agreements may prevent you from laying claim to these
excess assets.
• There are tax consequences. Often, withdrawals from pension plans get taxed at
much higher rates.
Do not double count an asset. If you count the income from an asset in your
cashflows, you cannot count the market value of the asset in your value.

Aswath Damodaran 15
 4. A Discount for Complexity:
An Experiment

Company A Company B
Operating Income $ 1 billion $ 1 billion
Tax rate 40% 40%
ROIC 10% 10%
Expected Growth 5% 5%
Cost of capital 8% 8%
Business Mix Single Business Multiple Businesses
Holdings Simple Complex
Accounting Transparent Opaque
n Which firm would you value more highly?

Aswath Damodaran 16
 Sources of Complexity

n Accounting Standards
• Inconsistency in applying accounting principles (Operating leases, R&D etc.)
• Fuzzy Accounting Standards (One-time charges, hidden assets)
• Unintended Consequences of Increased Disclosure
n Nature and mix of businesses
• Multiple businesses (Eg. GE)
• Multiple countries (Eg. Coca Cola)
n Structuring of businesses
• Cross Holdings (The Japanese Curse)
• Creative Holding Structures (Enronitis)
n Financing Choices
• Growth of Hybrids
• New Securities (Playing the Ratings Game)

Aswath Damodaran 17
 Reasons for Complexity

n Control
• Complex holding structures were designed to make it more difficult for outsiders
(which includes investors) to know how much a firm is worth, how much it is
making and what assets it holds.
• Multiple classes of shares and financing choices also make it more likely that
incumbents can retain control in the event of a challenge.
n Tax Benefits
• Complex tax law begets complex business mixes and holding structures.
– Different tax rates for different locales and different transactions
– Tax credits
n Deceit

Aswath Damodaran 18
 Reasons for Complexity

n Control
• Complex holding structures were designed to make it more difficult for outsiders
(which includes investors) to know how much a firm is worth, how much it is
making and what assets it holds.
• Multiple classes of shares and financing choices also make it more likely that
incumbents can retain control in the event of a challenge.
n Tax Benefits
• Complex tax law begets complex business mixes and holding structures.
– Different tax rates for different locales and different transactions
– Tax credits
n Deceit

Aswath Damodaran 19
 Measuring Complexity: Volume of Data in Financial
Statements

Company Number of pages in last 10Q Number of pages in last 10K

General Electric 65 410
Microsoft 63 218
Wal-mart 38 244
Exxon Mobil 86 332
Pfizer 171 460
Citigroup 252 1026
Intel 69 215
AIG 164 720
Johnson & Johnson 63 218
IBM 85 353

Aswath Damodaran 20
 Measuring Complexity: A Complexity Score

Item Factors Follow-up Question Answer Complexity score

Operating Income 1. Multiple Businesses Number of businesses (with more than 10% of revenues) = 2 4
2. One-time income and expenses Percent of operating income = 20% 1
3. Income from unspecified sources Percent of operating income = 15% 0.75
4. Items in income statement that are volatile
Percent of operating income = 5% 0.25
Tax Rate 1. Income from multiple locales Percent of revenues from non-domestic locales = 100% 3
2. Different tax and reporting books Yes or No Yes 3
3. Headquarters in tax havens Yes or No Yes 3
4. Volatile effective tax rate Yes or No Yes 2
Capital 1. Volatile capital expenditures Yes or No Yes 2
Expenditures 2. Frequent and large acquisitions Yes or No Yes 4
3. Stock payment for acquisitions and investments Yes or No Yes 4
Working capital 1. Unspecified current assets and current liabilities
Yes or No Yes 3
2. Volatile working capital items Yes or No Yes 2
Expected Growth 1. Off-balance sheet assets and liabilities (operating
rate leases and R&D) Yes or No Yes 3
2. Substantial stock buybacks Yes or No Yes 3
3. Changing return on capital over time Is your return on capital volatile? Yes 5
4. Unsustainably high return Is your firm's ROC much higher than industry average? Yes 5
Cost of capital 1. Multiple businesses Number of businesses (more than 10% of revenues) = 2 2
2. Operations in emerging markets Percent of revenues= 30% 1.5
3. Is the debt market traded? Yes or No Yes 0
4. Does the company have a rating? Yes or No Yes 0
5. Does the company have off-balance sheet debt?
Yes or No No 0
Complexity Score = 51.5

Aswath Damodaran 21
 Dealing with Complexity

n The Aggressive Analyst: Trust the firm to tell the truth and value the firm
based upon the firm’s statements about their value.
n The Conservative Analyst: Don’t value what you cannot see.
n The Compromise: Adjust the value for complexity
• Adjust cash flows for complexity
• Adjust the discount rate for complexity
• Adjust the expected growth rate/ length of growth period
• Value the firm and then discount value for complexity

Aswath Damodaran 22
 Estimate a complexity discount to value

1. One is to develop a rule of thumb, similar to those used by analysts who value private companies to
estimate the effect of illiquidity.
2. A slightly more sophisticated option is to use a complexity scoring system, to measure the
complexity of a firm’s financial statements and to relate the complexity score to the size of the
discount.
3. You could compare the valuations of complex firms to the valuation of simple firms in the same
business, and estimate the discount being applied by markets for complexity. With the hundred
largest market cap firms, for instance:
PBV = 0.65 + 15.31 ROE – 0.55 Beta + 3.04 Expected growth rate – 0.003 # Pages in 10K
Thus, a firm with a 15% return on equity, a beta of 1.15, and expected growth rate of 10% and 350 pages
in the 10K would have a price to book ratio of
PBV = 0.65 + 15.31 (.15) – 0.55 (1.20) + 3.04 (.10) - .003 (350) = 1.54
4. If a firm is in multiple businesses, and some businesses are simple and others are complex, you could
value the company in pieces attaching no discount to the simple pieces and a greater discount to the
more complex parts of the firm.

Aswath Damodaran 23
 4. The Value of Synergy

n Synergy can be valued. In fact, if you want to pay for it, it should be valued.
n To value synergy, you need to answer two questions:
(a) What form is the synergy expected to take? Will it reduce costs as a percentage of
sales and increase profit margins (as is the case when there are economies of
scale)? Will it increase future growth (as is the case when there is increased
market power)? )
(b) When can the synergy be reasonably expected to start affecting cashflows?
(Will the gains from synergy show up instantaneously af ter the takeover? If it will
take time, when can the gains be expected to start showing up? )
n If you cannot answer these questions, you need to go back to the drawing
board…

Aswath Damodaran 24
 A procedure for valuing synergy

(1) the firms involved in the merger are valued independently, by discounting
expected cash flows to each firm at the weighted average cost of capital for
that firm.
(2) the value of the combined firm, with no synergy, is obtained by adding the
values obtained for each firm in the first step.
(3) The effects of synergy are built into expected growth rates and cashflows,
and the combined firm is re-valued with synergy.
Value of Synergy = Value of the combined firm, with synergy - Value of the
combined firm, without synergy

Aswath Damodaran 25
 Synergy Effects in Valuation Inputs

If synergy is Valuation Inputs that will be affected are

Economies of Scale Operating Margin of combined firm will be greater
than the revenue-weighted operating margin of individual
firms.
Growth Synergy More projects:Higher Reinvestment Rate (Retention)
Better projects: Higher Return on Capital (ROE)
Longer Growth Period
Again, these inputs will be estimated for the
combined firm.
Synergy can and should be valued…

Aswath Damodaran 26
 5. Brand name, great management, superb product …

n There is often a temptation to add on premiums for intangibles. Among them

are
• Brand name
• Great management
• Loyal workforce
• Technological prowess
n If your discounted cashflow valuation is done right, your inputs should already
reflect these strengths.
n If you add a premium, you will be double counting the strength.

Aswath Damodaran 27
 Valuing Brand Name

Coca Cola Generic Cola Company

AT Operating Margin 18.56% 7.50%
Sales/BV of Capital 1.67 1.67
ROC 31.02% 12.53%
Reinvestment Rate 65.00% (19.35%) 65.00% (47.90%)
Expected Growth 20.16% 8.15%
Length 10 years 10 yea
Cost of Equity 12.33% 12.33%
E/(D+E) 97.65% 97.65%
AT Cost of Debt 4.16% 4.16%
D/(D+E) 2.35% 2.35%
Cost of Capital 12.13% 12.13%
Value $115 $13

Aswath Damodaran 28
 6. Defining Debt

n General Rule: Debt generally has the following characteristics:

• Commitment to make fixed payments in the future
• The fixed payments are tax deductible
• Failure to make the payments can lead to either default or loss of control of the
firm to the party to whom payments are due.
n Defined as such, debt should include
• All interest bearing liabilities, short term as well as long term
• All leases, operating as well as capital
n Debt should not include
• Accounts payable or supplier credit

Aswath Damodaran 29
 Book Value or Market Value

n For some firms that are in financial trouble, the book value of debt can be
substantially higher than the market value of debt. Analysts worry that
subtracting out the market value of debt in this case can yield too high a value
for equity.
n A discounted cashflow valuation is designed to value a going concern. In a
going concern, it is the market value of debt that should count, even if it is
much lower than book value.
n In a liquidation valuation, you can subtract out the book value of debt from the
liquidation value of the assets.
Converting book debt into market debt,,,,,

Aswath Damodaran 30
 But you should consider other potential liabilities

n If you have under funded pension fund or health care plans, you should
consider the under funding at this stage in getting to the value of equity.
• If you do so, you should not double count by also including a cash flow line item
reflecting cash you would need to set aside to meet the unfunded obligation.
• You should not be counting these items as debt in your cost of capital
calculations….
n If you have contingent liabilities - for example, a potential liability from a
lawsuit that has not been decided - you should consider the expected value of
these contingent liabilities
• Value of contingent liability = Probability that the liability will occur * Expected
value of liability

Aswath Damodaran 31
 7. The Value of Control

n The value of the control premium that will be paid to acquire a block of equity
will depend upon two factors -
• Probability that control of firm will change: This refers to the probability that
incumbent management will be replaced. this can be either through acquisition or
through existing stockholders exercising their muscle.
• Value of Gaining Control of the Company: The value of gaining control of a
company arises from two sources - the increase in value that can be wrought by
changes in the way the company is managed and run, and the side benefits and
perquisites of being in control
Value of Gaining Control = Present Value (Value of Company with change in control -
Value of company without change in control) + Side Benefits of Control

Aswath Damodaran 32
 A Simple Example

n Assume that a firm has a value of $ 100 million run by incumbent managers
and $ 150 million run optimally. The firm creates 10 million voting shares and
offers 70% to the public.
n Since the potential for changing management is created by this offering, the
value per share will fall between $10 and $15, depending upon the probability
that is attached to the management change. Thus, if the probability of the
management change is 60%, the value per share will be $13.00.
Value/Shr = (150*.6+100*.4)/10 = $13
n If you have shares with different voting rights, the voting shares will get a
disproportionate share of the value of control…

Aswath Damodaran 33
 Valuing minority interests…

n Assume that this is a private firm(with a status quo value of $ 100 million and
an optimal value of $ 150 million) and that you are buying 49% of this firm,
with the current owner holding on to 51%. How much you would pay for the
49%?

n How would your answer differ if you were buying 51%?

Aswath Damodaran 34
 Tube Investments: Status Quo (in Rs)
Return on Capital
Current Cashflow to Firm Reinvestment Rate 9.20%
EBIT(1-t) : 4,425 60% Expected Growth Stable Growth
- Nt CpX 843 in EBIT (1-t) g = 5%; Beta = 1.00;
- Chg WC 4,150 .60*.092-= .0552 Debt ratio = 44.2%
= FCFF - 568 5.52 % Country Premium= 3%
Reinvestment Rate =112.82% ROC= 9.22%
Reinvestment Rate=54.35%
Terminal Value 5= 2775/(.1478-.05) = 28,378

Firm Value: 19,578 Term Yr

+ Cash: 13,653 EBIT(1-t) $4,670 $4,928 $5,200 $5,487 $5,790 6,079
- Debt: 18,073 - Reinvestment $2,802 $2,957 $3,120 $3,292 $3,474 3,304
=Equity 15,158 FCFF $1,868 $1,971 $2,080 $2,195 $2,316 2,775
-Options 0
Value/Share 61.57
Discount at Cost of Capital (WACC) = 22.8% (.558) + 9.45% (0.442) = 16.90%

Cost of Equity Cost of Debt

22.80% (12%+1.50%)(1-.30) Weights
= 9.45% E = 55.8% D = 44.2%

Riskfree Rate : Risk Premium

Real riskfree rate = 12% Beta 9.23%
+ 1.17 X

Unlevered Beta for Firm’s D/E Mature risk Country Risk

Sectors: 0.75 Ratio: 79% premium Premium
4% 5.23%

Aswath Damodaran 35
 Tube Investments: Higher Average Return(in Rs) Return on Capital Improvement on existing assets
12.20% { (1+(.122-.092)/.092) 1/5-1}
Current Cashflow to Firm Reinvestment Rate
EBIT(1-t) : 4,425 60% Expected Growth Stable Growth
- Nt CpX 843 60*.122 + g = 5%; Beta = 1.00;
- Chg WC 4,150 .0581 = .1313 Debt ratio = 44.2%
= FCFF - 568 13.13 % Country Premium= 3%
Reinvestment Rate =112.82% ROC=12.22%
Reinvestment Rate= 40.98%
Terminal Value 5= 5081/(.1478-.05) = 51,956

Firm Value: 31,829 Term Yr

+ Cash: 13,653 EBIT(1-t) $5,006 $5,664 $6,407 $7,248 $8,200 8,610
- Debt: 18,073 - Reinvestment $3,004 $3,398 $3,844 $4,349 $4,920 3,529
=Equity 27,409 FCFF $2,003 $2,265 $2,563 $2,899 $3,280 5,081
-Options 0
Value/Share 111.3
Discount at Cost of Capital (WACC) = 22.8% (.558) + 9.45% (0.442) = 16.90%

Cost of Equity Cost of Debt

22.80% (12%+1.50%)(1-.30) Weights
= 9.45% E = 55.8% D = 44.2%

Riskfree Rate : Risk Premium

Real riskfree rate = 12% Beta 9.23%
+ 1.17 X

Unlevered Beta for Firm’s D/E Mature risk Country Risk

Sectors: 0.75 Ratio: 79% premium Premium
4% 5.23%

Aswath Damodaran 36
 Tube Investments : Should there be a corporate governance
discount?

n Stockholders in Asian, Latin American and many European companies have

little or no power over the managers of the firm. In many cases, insiders own
voting shares and control the firm and the potential for conflict of interests is
huge. Would you discount the value that you estimated to allow for this
absence of stockholder power?
q Yes
q No.

Aswath Damodaran 37
 8. Distress and the Going Concern Assumption

n Traditional valuation techniques are built on the assumption of a going

concern, i.e., a firm that has continuing operations and there is no significant
threat to these operations.
• In discounted cashflow valuation, this going concern assumption finds its place
most prominently in the terminal value calculation, which usually is based upon an
infinite life and ever-growing cashflows.
• In relative valuation, this going concern assumption often shows up implicitly
because a firm is valued based upon how other firms - most of which are healthy -
are priced by the market today.
n When there is a significant likelihood that a firm will not survive the
immediate future (next few years), traditional valuation models may yield an
over-optimistic estimate of value.

Aswath Damodaran 38
 Current Current
Revenue Margin: Stable Growth
$ 3,804 -49.82% Cap ex growth slows Stable
and net cap ex Stable Stable ROC=7.36%
decreases Revenue EBITDA/ Reinvest
EBIT Growth: 5% Sales 67.93%
-1895m Revenue EBITDA/Sales 30%
Growth: -> 30%
NOL: 13.33%
2,076m Terminal Value= 677(.0736-.05)
=$ 28,683
Term. Year
Revenues $3,804 $5,326 $6,923 $8,308 $9,139 $10,053 $11,058 $11,942 $12,659 $13,292 $13,902
EBITDA ($95) $ 0 $346 $831 $1,371 $1,809 $2,322 $2,508 $3,038 $3,589 $ 4,187
EBIT ($1,675) ($1,738) ($1,565) ($1,272) $320 $1,074 $1,550 $1,697 $2,186 $2,694 $ 3,248
EBIT (1-t) ($1,675) ($1,738) ($1,565) ($1,272) $320 $1,074 $1,550 $1,697 $2,186 $2,276 $ 2,111
+ Depreciation $1,580 $1,738 $1,911 $2,102 $1,051 $736 $773 $811 $852 $894 $ 939
- Cap Ex $3,431 $1,716 $1,201 $1,261 $1,324 $1,390 $1,460 $1,533 $1,609 $1,690 $ 2,353
- Chg WC $0 $46 $48 $42 $25 $27 $30 $27 $21 $19 $ 20
Value of Op Assets $ 5,530 FCFF ($3,526) ($1,761) ($903) ($472) $22 $392 $832 $949 $1,407 $1,461 $ 677
+ Cash & Non-op $ 2,260 1 2 3 4 5 6 7 8 9 10
= Value of Firm $ 7,790 Forever
- Value of Debt $ 4,923 Beta 3.00 3.00 3.00 3.00 3.00 2.60 2.20 1.80 1.40 1.00
= Value of Equity $ 2867 Cost of Equity 16.80% 16.80% 16.80% 16.80% 16.80% 15.20% 13.60% 12.00% 10.40% 8.80%
- Equity Options $ 14 Cost of Debt 12.80% 12.80% 12.80% 12.80% 12.80% 11.84% 10.88% 9.92% 8.96% 6.76%
Value per share $ 3.22 Debt Ratio 74.91% 74.91% 74.91% 74.91% 74.91% 67.93% 60.95% 53.96% 46.98% 40.00%
Cost of Capital 13.80% 13.80% 13.80% 13.80% 13.80% 12.92% 11.94% 10.88% 9.72% 7.98%

Cost of Equity Cost of Debt Weights

16.80% 4.8%+8.0%=12.8% Debt= 74.91% -> 40%
Tax rate = 0% -> 35%

Riskfree Rate:
T. Bond rate = 4.8%
Risk Premium
Global Crossing
Beta 4% November 2001
+ 3.00> 1.10 X Stock price = $1.86

Internet/ Operating Current Base Equity Country Risk

Retail Leverage D/E: 441% Premium Premium

Aswath Damodaran 39
 Valuing Global Crossing with Distress

n Probability of distress
• Price of 8 year,t=12%
8 bond issued tby Global Crossing =8 $ 653
120(1- p Distress ) 1000(1- p Distress )
653 = Â t
+
t=1
(1.05) (1.05) 8

• Probability of distress = 13.53% a year

• Cumulative probability of survival over 10 years = (1- .1353) 10 = 23.37%
†
n Distress sale value of equity
• Book value of capital = $14,531 million
• Distress sale value = 15% of book value = .15*14531 = $2,180 million
• Book value of debt = $7,647 million
• Distress sale value of equity = $ 0
n Distress adjusted value of equity
• Value of Global Crossing = $3.22 (.2337) + $0.00 (.7663) = $0.75

Aswath Damodaran 40
 9. Equity Value and Per Share Value

n The conventional way of getting from equity value to per share value is to
divide the equity value by the number of shares outstanding. This approach
assumes, however, that common stock is the only equity claim on the firm.
n In many firms, there are other equity claims as well including:
• warrants, that are publicly traded
• management and employee options, that have been granted, but do not trade
• conversion options in convertible bonds
• contingent value rights, that are also publicly traded.
n The value of these non-stock equity claims has to be subtracted from the value
of equity before dividing by the number of shares outstanding.

Aswath Damodaran 41
 Amazon: Estimating the Value of Equity Options

n Details of options outstanding

• Average strike price of options outstanding = $ 13.375
• Average maturity of options outstanding = 8.4 years
• Standard deviation in ln(stock price) = 50.00%
• Annualized dividend yield on stock = 0.00%
• Treasury bond rate = 6.50%
• Number of options outstanding = 38 million
• Number of shares outstanding = 340.79 million
n Value of options outstanding (using dilution-adjusted Black-Scholes model)
• Value of equity options = $ 2,892 million

Aswath Damodaran 42
 Reinvestment:
Cap ex includes acquisitions Stable Growth
Current Current Working capital is 3% of revenues
Revenue Margin: Stable Stable
Stable Operating ROC=20%
$ 1,117 -36.71% Revenue
Sales Turnover Competitive Margin: Reinvest 30%
Ratio: 3.00 Advantages Growth: 6% 10.00% of EBIT(1-t)
EBIT
-410m Revenue Expected
Growth: Margin: Terminal Value= 1881/(.0961-.06)
NOL: 42% -> 10.00% =52,148
500 m
Term. Year
$41,346
Revenues $2,793 5,585 9,774 14,661 19,059 23,862 28,729 33,211 36,798 39,006 10.00%
EBIT -$373 -$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 35.00%
EBIT (1-t) -$373 -$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 $2,688
- Reinvestment $559 $931 $1,396 $1,629 $1,466 $1,601 $1,623 $1,494 $1,196 $736 $ 807
FCFF -$931 -$1,024 -$989 -$758 -$408 -$163 $177 $625 $1,174 $1,788 $1,881
Value of Op Assets $ 14,910
+ Cash $ 26 1 2 3 4 5 6 7 8 9 10
= Value of Firm $14,936 Forever
Cost of Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 12.30% 12.10% 11.70% 10.50%
- Value of Debt $ 349 Cost of Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00%
= Value of Equity $14,587 AT cost of debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%
- Equity Options $ 2,892 Cost of Capital 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.96% 11.69% 11.15% 9.61%
Value per share $ 34.32

Cost of Equity Cost of Debt Weights

12.90% 6.5%+1.5%=8.0% Debt= 1.2% -> 15%
Tax rate = 0% -> 35%

Riskfree Rate :
T. Bond rate = 6.5% Amazon.com
Risk Premium
Beta January 2000
4%
+ 1.60 -> 1.00 X Stock Price = $ 84

Internet/ Operating Current Base Equity Country Risk

Aswath Damodaran Retail Leverage D/E: 1.21% Premium Premium 43
 10. Analyzing the Effect of Illiquidity on Value

n Investments which are less liquid should trade for less than otherwise similar
investments which are more liquid.
n The size of the illiquidity discount should depend upon
• Type of Assets owned by the Firm: The more liquid the assets owned by the firm,
the lower should be the liquidity discount for the firm
• Size of the Firm: The larger the firm, the smaller should be size of the liquidity
discount.
• Health of the Firm: Stock in healthier firms should sell for a smaller discount than
stock in troubled firms.
• Cash Flow Generating Capacity: Securities in firms which are generating large
amounts of cash from operations should sell for a smaller discounts than securities
in firms which do not generate large cash flows.
• Size of the Block: The liquidity discount should increase with the size of the
portion of the firm being sold.

Aswath Damodaran 44
 Empirical Evidence on Illiquidity Discounts: Restricted
Stock

n Restricted securities are securities issued by a company, but not registered

with the SEC, that can be sold through private placements to investors, but
cannot be resold in the open market for a two-year holding period, and limited
amounts can be sold after that. Restricted securities trade at significant
discounts on publicly traded shares in the same company.
• Maher examined restricted stock purchases made by four mutual funds in the
period 1969-73 and concluded that they traded an average discount of 35.43% on
publicly traded stock in the same companies.
• Moroney reported a mean discount of 35% for acquisitions of 146 restricted stock
issues by 10 investment companies, using data from 1970.
• In a recent study of this phenomenon, Silber finds that the median discount for
restricted stock is 33.75%.

Aswath Damodaran 45
 Cross Sectional Differences : Restricted Stock

n Silber (1991) develops the following relationship between the size of the
discount and the characteristics of the firm issuing the registered stock –
LN(RPRS) = 4.33 +0.036 LN(REV) - 0.142 LN(RBRT) + 0.174 DERN + 0.332
DCUST
where,
RPRS = Relative price of restricted stock (to publicly traded stock)
REV = Revenues of the private firm (in millions of dollars)
RBRT = Restricted Block relative to Total Common Stock in %
DERN = 1 if earnings are positive; 0 if earnings are negative;
DCUST = 1 if there is a customer relationship with the investor; 0 otherwise;
n Interestingly, Silber finds no effect of introducing a control dummy - set equal
to one if there is board representation for the investor and zero otherwise.

Aswath Damodaran 46
 Using the Study Results to Estimate Illiquidity Discounts

n Approach 1: Use the average liquidity discount, based upon past studies, of
25% for private firms. Adjust subjectively for size - make the discount smaller
for larger firms.
n Approach 2: Estimate the discount as a function of the determinants - the size
of the firm, the stability of cash flows, the type of assets and cash flow
generating capacity. Plug in the values for your company into the regression to
estimate the liquidity discount.

Aswath Damodaran 47
 Liquidity Discount and Revenues

Figure 24.1: Illiquidity Discounts: Base Discount of 25% for profitable firm with $ 10 million in revenues

40.00%

35.00%

30.00%
Discount as % of Value

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
5 10 15 20 25 30 35 40 45 50 100 200 300 400 500 1000
Revenues

Profitable firm Unprofitable firm

Aswath Damodaran 48
 An Alternate Approach to the Illiquidity Discount: Bid Ask
Spread

n The bid ask spread is the difference between the price at which you can buy a
security and the price at which you can sell it, at the same point.
n In other words, it is the illiqudity discount on a publicly traded stock.
n Studies have tied the bid-ask spread to
• the size of the firm
• the trading volume on the stock
• the degree
n Regressing the bid-ask spread against variables that can be measured for a
private firm (such as revenues, cash flow generating capacity, type of assets,
variance in operating income) and are also available for publicly traded firms
offers promise.

Aswath Damodaran 49
 A Bid-Ask Spread Regression

n Using data from the end of 2000, for instance, we regressed the bid-ask spread against
annual revenues, a dummy variable for positive earnings (DERN: 0 if negative and 1 if
positive), cash as a percent of firm value and trading volume.
Spread = 0.145 – 0.0022 ln (Annual Revenues) -0.015 (DERN) – 0.016 (Cash/Firm Value) –
0.11 ($ Monthly trading volume/ Firm Value)
n You could plug in the values for a private firm into this regression (with zero trading
volume) and estimate the spread for the firm.
n To estimate the illiquidity discount for a private firm with $209 million in revenues, 3%
in cash as a percent of value and positive earnings.
Spread = 0.145 – 0.0022 ln (Annual Revenues) -0.015 (DERN) – 0.016 (Cash/Firm Value) –
0.11 ($ Monthly trading volume/ Firm Value)
= 0.145 – 0.0022 ln (209) -0.015 (1) – 0.016 (.03) – 0.11 (0) = .1178 or 11.78%

Aswath Damodaran 50
 Returning to the beginning…

Value of Operating Assets

+ Cash and Marketable Operating versus Non-opeating cash

Securities Should cash be discounted for earning a low return?
+ Value of Cross Holdings How do you value cross holdings in other companies?
What if the cross holdings are in private businesses?
+ Value of Other Assets What about other valuable assets?
How do you consider under utlilized assets?
Should you discount this value for opacity or complexity?
Value of Firm How about a premium for synergy?
What about a premium for intangibles (brand name)?
What should be counted in debt?
- Value of Debt Should you subtract book or market value of debt?
What about other obligations (pension fund and health care?
What about contingent liabilities?
What about minority interests?
= Value of Equity Should there be a premium/discount for control?
Should there be a discount for distress
- Value of Equity Options What equity options should be valued here (vested versus non-vested)?
How do you value equity options?
= Value of Common Stock Should you divide by primary or diluted shares?
/ Number of shares
= Value per share Should there be a discount for illiquidity/ marketability?
Should there be a discount for minority interests?

Aswath Damodaran 51