Valuation

Aswath Damodaran
http://www.damodaran.com
For the valuations in this presentation, go to 
Seminars/ Presentations

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 Some Initial Thoughts

" One hundred thousand lemmings cannot be wrong"

Graffiti

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 Misconceptions about Valuation

 Myth 1: A valuation is an objective search for “true” value

• Truth 1.1: All valuations are biased. The only questions are how much and in which
direction.
• Truth 1.2: The direction and magnitude of the bias in your valuation is directly
proportional to who pays you and how much you are paid.
 Myth 2.: A good valuation provides a precise estimate of value
• Truth 2.1: There are no precise valuations
• Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
 Myth 3: . The more quantitative a model, the better the valuation
• Truth 3.1: One’s understanding of a valuation model is inversely proportional to
the number of inputs required for the model.
• Truth 3.2: Simpler valuation models do much better than complex ones.

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 Approaches to Valuation

 Discounted cashflow valuation, relates the value of an asset to the present

value of expected future cashflows on that asset.
 Relative valuation, estimates the value of an asset by looking at the pricing of
'comparable' assets relative to a common variable like earnings, cashflows,
book value or sales.
 Contingent claim valuation, uses option pricing models to measure the value
of assets that share option characteristics.

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 Discounted Cash Flow Valuation

 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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 Discounted Cashflow Valuation: Basis for Approach

CF1 CF2 CF3 CF4 CFn

Value of asset = + + + .....+
(1 + r)1 (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 + r) n

where CFt is the expected cash flow in period t, r is the discount rate appropriate
given the riskiness of the cash flow and n 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.

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 DCF Choices: Equity Valuation versus Firm Valuation
Firm Valuation: Value the entire business

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Equity valuation: Value just the

equity claim in the business

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 Equity Valuation

Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

Present value is value of just the equity claims on the firm

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 Firm Valuation

Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets, Discount rate reflects the cost
prior to any debt payments of raising both debt and equity
but after firm has financing, in proportion to their
reinvested to create growth use
assets Growth Assets Equity

Present value is value of the entire firm, and reflects the value of
all claims on the firm.

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 Hyundai Heavy: Status Quo ($) Return on Capital
Reinvestment Rate 30%
50%
Current Cashflow to Firm Stable Growth
EBIT(1-t) : 1,269 Billion Won Expected Growth g = 5%; Beta = 1.20;
- Nt CpX 519 in EBIT (1-t) Country Premium= 0.8%
- Chg WC 135 .50*.30=.15 Cost of capital = 9.42%
= FCFF 615 15% ROC= 9.42%
Reinvestment Rate = 654/1269=51.5% Reinvestment Rate=g/ROC
Return on capital = 1269/3390 =37.45% =5/9.42 = 53.1%

Terminal Value5= 1258(.0942-.05) = 28,471

Wn Cashflows
Op. Assets 20,211
+ Cash: 3,612 Year 1 2 3 4 5 Term Yr
+ Non-0p 3,937 EBIT (1-t) 1,460 1,679 1,931 2,220 2,553 2,681
- Debt 186 - Reinvestment 730 839 965 1,110 1,277 1,423
=Equity 27,574 FCFF 730 839 965 1,110 1,277 =1,258
-Options 0
Value/Share 362.82
(362,820 Won/Sh) Discount at $ Cost of Capital (WACC) = 11.3% (.993) + 4.75% (0.007) = 11.26%

On June 1, 2008
Hyundai Heavy traded at
Cost of Equity Cost of Debt
Weights 350,000 Won/share.
11.30% (5%+0.8%+0.75%)(1-.275)
= 4.75% E = 99.3% D = 0.7%

Riskfree Rate:
Won Riskfree Rate= 5% Beta Mature market Country Equity Risk
+ 1.50 X premium + Lambda X Premium
4% 0.25 1.20%

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.75 Ratio: 26.84% Country Default Mkt Vol
Spread X
0.8% 1.20
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 I. Estimating Discount Rates

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 Cost of Equity

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 A Riskfree Rate

For a rate to be riskfree in valuation, it has to be long term, default free and
currency matched (to the cash flows)
 Assume that you are valuing Hyundai Heavy Industries in Korean Won for a
US institutional investor. Which of the following rates would you use as a
riskfree rate?
 The rate on the US 10-year treasury bond (3.8%)
 The rate on the Korean (Won) 10-year government bond (5.8%)
 Other
How would your answer change if you were valuing Hyundai in US dollars for a
Korean institutional investor?

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 Riskfree Rates - Different Currencies

6.00%
A2
0.80%

5.00%
A1
AAA 0.25%
10-year Govenment bond rate

4.00% AAA

3.00%
5.00%
4.30% 4.30%
2.00% 3.80%
AAA

1.00% 1.70%

0.00%
Japan 10-year US T-bond $ German 10-Year Euro Greece 10-year Euro Korean 10-year Won

Riskfree Rate Default spread

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 Everyone uses historical premiums, but..

 The historical premium is the premium that stocks have historically earned
over riskless securities.
 Practitioners never seem to agree on the premium; it is sensitive to
• How far back you go in history…
• Whether you use T.bill rates or T.Bond rates
• Whether you use geometric or arithmetic averages.
 For instance, looking at the US:
Arithmetic average Geometric Average
Stocks - Stocks - Stocks - Stocks -
Historical Period T.Bills T.Bonds T.Bills T.Bonds
1928-2007 7.78% 6.42% 5.94% 4.79%
1967-2007 5.94% 4.33% 4.75% 3.50%
1997-2007 5.26% 2.68% 4.69% 2.34%

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 Assessing Country Risk Using Currency Ratings: Asia

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 Using Country Ratings to Estimate Equity Spreads

 Country ratings measure default risk. While default risk premiums and equity
risk premiums are highly correlated, one would expect equity spreads to be
higher than debt spreads.
• One way to adjust the country spread upwards is to use information from the US
market. In the US, the equity risk premium has been roughly twice the default
spread on junk bonds.
• Another is to multiply the bond spread by the relative volatility of stock and bond
prices in that market. For example,
– Standard Deviation in KOSPI = 18%
– Standard Deviation in Korean government bond= 12%
– Adjusted Equity Spread = 0.80% (18/12) = 1.20%

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 From Country Risk Premiums to Corporate Risk premiums

 Approach 1: Assume that every company in the country is equally exposed to

country risk. In this case,
E(Return) = Riskfree Rate + Country ERP + Beta (US premium)
 Approach 2: Assume that a company’s exposure to country risk is similar to its
exposure to other market risk.
E(Return) = Riskfree Rate + Beta (US premium + Country ERP)
 Approach 3: Treat country risk as a separate risk factor and allow firms to
have different exposures to country risk (perhaps based upon the proportion of
their revenues come from non-domestic sales)
E(Return)=Riskfree Rate+ β (US premium) + λ (Country ERP)
Country ERP: Additional country equity risk premium

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 Estimating Company Exposure to Country Risk

 Different companies should be exposed to different degrees to country risk.

For instance, a Korean firm that generates the bulk of its revenues in Western
Europe and the US should be less exposed to country risk than one that
generates all its business within Korea.
 The factor “λ” measures the relative exposure of a firm to country risk. One
simplistic solution would be to do the following:
λ = % of revenues domesticallyfirm/ % of revenues domesticallyavg firm
Consider two firms – HyumdaI Heavy Industries and Megastudy, both Korean
companies. The former gets about 20% of its revenues in Korea and the latter
gets 100%. The average Korean firm gets about 80% of its revenues in Korea:
λHyundai = 20%/80% = 0.25
λMegastudy = 100%/80% = 1.25
 There are two implications
• A company’s risk exposure is determined by where it does business and not by
where it is located
• Firms might be able to actively manage their country risk exposures

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 Estimating E(Return) for Hyundai Heavy Industries

 Assume that the beta for Hyundai Heavy is 1.50, and that the riskfree rate used
is 5%. Also assume that the historical premium for the US (4.79%) is a
reasonable estimate of a mature market risk premium.
 Approach 1: Assume that every company in the country is equally exposed to
country risk. In this case,
E(Return) = 5% + 1.2% + 1.5 (4.79%) = 13.39%
 Approach 2: Assume that a company’s exposure to country risk is similar to its
exposure to other market risk.
E(Return) = 5% + 1.5 (4.79%+ 1.2%) = 13.99%
 Approach 3: Treat country risk as a separate risk factor and allow firms to
have different exposures to country risk (perhaps based upon the proportion of
their revenues come from non-domestic sales)
E(Return)= 5% + 1.5(4.79%) + 0.25 (1.2%) + 0.50 (2%) = 13.49%
Reflects revenues in Eastern Europe, China and the
Rest of Asia

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 An alternate view of ERP: Watch what I pay, not what I say..

 You can back out an equity risk premium from stock prices:

After year 5, we will assume that

earnings on the index will grow at
Between 2001 and 2007 Analysts expect earnings to grow 5% a year for the next 5 years. We 4.02%, the same rate as the entire
dividends and stock will assume that dividends & buybacks will keep pace.. economy (= riskfree rate).
buybacks averaged 4.02% Last year’s cashflow (59.03) growing at 5% a year
of the index each year.
61.98 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

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 Solving for the implied premium…

 If we know what investors paid for equities at the beginning of 2007 and we
can estimate the expected cash flows from equities, we can solve for the rate of
return that they expect to make (IRR):
61.98 65.08 68.33 71.75 75.34 75.35(1.0402)
1468.36 = + + + + +
(1+ r) (1+ r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r − .0402)(1+ r) 5
 Expected Return on Stocks = 8.39%
 Implied Equity Risk Premium = Expected Return on Stocks - T.Bond Rate
€ =8.39% - 4.02% = 4.37%

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 Implied Premiums in the US

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 Implied Premium versus RiskFree Rate

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 Equity Risk Premiums and Bond Default Spreads

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 Which equity risk premium should you use for the US?

 Historical Risk Premium: When you use the historical risk premium, you are
assuming that premiums will revert back to a historical norm and that the time
period that you are using is the right norm.
 Current Implied Equity Risk premium: You are assuming that the market is
correct in the aggregate but makes mistakes on individual stocks. If you are
required to be market neutral, this is the premium you should use. (What
types of valuations require market neutrality?)
 Average Implied Equity Risk premium: The average implied equity risk
premium between 1960-2007 in the United States is about 4%. You are
assuming that the market is correct on average but not necessarily at a point in
time.

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 Implied Premium for KOSPI: May 30, 2008

 Level of the Index = 1825

 FCFE on the Index = 3.75% (Estimated FCFE for companies in index as % of
market value of equity)
 Other parameters
• Riskfree Rate = 5% (Won)
• Expected Growth (in Won)
– Next 5 years = 7.5% (Used expected growth rate in Earnings)
– After year 5 = 5%
 Solving for the expected return:
• Expected return on Equity = 9.39%
• Implied Equity premium = 9.39% - 5% = 4.39%
 Effect on valuation
• Hyundai’s value @ historical premium (4%) + country (1.2%) : 350,000 Wn /share
• Hyundai’s value @ implied premium: 352,000 Wn/ share

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 Estimating Beta

 The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns (Rm) -
Rj = a + b Rm
• where a is the intercept and b is the slope of the regression.
 The slope of the regression corresponds to the beta of the stock, and measures
the riskiness of the stock.
 This beta has three problems:
• It has high standard error
• It reflects the firm’s business mix over the period of the regression, not the current
mix
• It reflects the firm’s average financial leverage over the period rather than the
current leverage.

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 Beta Estimation: Amazon

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 Beta Estimation for Hyundai Heavy: The Index Effect

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 Determinants of Betas

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 Bottom-up Betas

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 Hyundai: Breaking down businesses

Value Unlevered
Business Revenues EV/Sales Value Weight beta
Shipbuilding 8341 3.23 26941 63.73% 1.60
Offshore &
Engineering 2563 1.97 5049 11.94% 1.44
Industrial plant 1200 1.55 1860 4.40% 1.29
Engine and
Machinery 2252 1.36 3063 7.24% 1.21
Electro Electric
System 1753 1.8 3155 7.46% 1.19
Construction
Equipment 1823 1.21 2206 5.22% 1.29
42274 100.00% 1.49

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 Bottom up Beta Estimates

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 Small Firm and Other Premiums

 It is common practice to add premiums on to the cost of equity for firm-

specific characteristics. For instance, many analysts add a small stock
premium of 3-3.5% (historical premium for small stocks over the market) to
the cost of equity for smaller companies.
 Adding arbitrary premiums to the cost of equity is always a dangerous
exercise. If small stocks are riskier than larger stocks, we need to specify the
reasons and try to quantify them rather than trust historical averages. (You
could argue that smaller companies are more likely to serve niche
(discretionary) markets or have higher operating leverage and adjust the beta
to reflect this tendency).

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 Is Beta an Adequate Measure of Risk for a Private Firm?

The owners of most private firms are not diversified. Beta measures the risk added
on to a diversified portfolio. Therefore, using beta to arrive at a cost of equity
for a private firm will
a) Under estimate the cost of equity for the private firm
b) Over estimate the cost of equity for the private firm
c) Could under or over estimate the cost of equity for the private firm

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 Total Risk versus Market Risk

 Adjust the beta to reflect total risk rather than market risk. This adjustment is a
relatively simple one, since the R squared of the regression measures the
proportion of the risk that is market risk.
Total Beta = Market Beta / Correlation of the sector with the market
 To estimate the beta for Kristin Kandy, we begin with the bottom-up
unlevered beta of food processing companies:
• Unlevered beta for publicly traded food processing companies = 0.78
• Average correlation of food processing companies with market = 0.333
• Unlevered total beta for Kristin Kandy = 0.78/0.333 = 2.34
• Debt to equity ratio for Kristin Kandy = 0.3/0.7 (assumed industry average)
• Total Beta = 2.34 ( 1- (1-.40)(30/70)) = 2.94
• Total Cost of Equity = 4.50% + 2.94 (4%) = 16.26%

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 When would you use this total risk measure?

 Under which of the following scenarios are you most likely to use the total
risk measure:
 when valuing a private firm for an initial public offering
 when valuing a private firm for sale to a publicly traded firm
 when valuing a private firm for sale to another private investor
 Assume that you own a private business. What does this tell you about the best
potential buyer for your business?

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 From Cost of Equity to Cost of Capital

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 What is debt?

 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.
 As a consequence, debt should include
• Any interest-bearing liability, whether short term or long term.
• Any lease obligation, whether operating or capital.

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 Hyundai’s liabilities…

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 Estimating the Cost of Debt

 If the firm has bonds outstanding, and the bonds are traded, the yield to
maturity on a long-term, straight (no special features) bond can be used as the
interest rate.
 If the firm is rated, use the rating and a typical default spread on bonds with
that rating to estimate the cost of debt.
 If the firm is not rated,
• and it has recently borrowed long term from a bank, use the interest rate on the
borrowing or
• estimate a synthetic rating for the company, and use the synthetic rating to arrive at
a default spread and a cost of debt
 The cost of debt has to be estimated in the same currency as the cost of equity
and the cash flows in the valuation.

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 Estimating Synthetic Ratings

 The rating for a firm can be estimated using the financial characteristics of the
firm. In its simplest form, the rating can be estimated from the interest
coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
 For Hyundai’s interest coverage ratio, we used the interest expenses and EBIT
from 2007.
Interest Coverage Ratio = 1751/ 11 = 153.60
 For Kristin Kandy, we used the interest expenses and EBIT from the most
recent financial year:
Interest Coverage Ratio = 500,000/ 85,000 = 5.88
 Amazon.com has negative operating income; this yields a negative interest
coverage ratio, which should suggest a D rating. We computed an average
interest coverage ratio of 2.82 over the next 5 years.

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 Interest Coverage Ratios, Ratings and Default Spreads

If Interest Coverage Ratio is Bond Rating Default Spread(1/00)`Spread(1/04) Spread (6/08)

> 8.50 (>12.50) AAA 0.20% 0.35% 0.75%
6.50 - 8.50 (9.5-12.5) AA 0.50% 0.50% 1.00%
5.50 - 6.50 (7.5-9.5) A+ 0.80% 0.70% 1.50%
4.25 - 5.50 (6-7.5) A 1.00% 0.85% 1.80%
3.00 - 4.25 (4.5-6) A– 1.25% 1.00% 2.00%
2.50 - 3.00 (3.5-4.5) BBB 1.50% 1.50% 2.25%
2.25 - 2.50 (3.5 -4) BB+ 1.75% 2.00% 3.00%
2.00 - 2.25 ((3-3.5) BB 2.00% 2.50% 3.50%
1.75 - 2.00 (2.5-3) B+ 2.50% 3.25% 4.75%
1.50 - 1.75 (2-2.5) B 3.25% 4.00% 6.50%
1.25 - 1.50 (1.5-2) B– 4.25% 6.00% 8.00%
0.80 - 1.25 (1.25-1.5) CCC 5.00% 8.00% 10.00%
0.65 - 0.80 (0.8-1.25) CC 6.00% 10.00% 11.50%
0.20 - 0.65 (0.5-0.8) C 7.50% 12.00% 12.70%
< 0.20 (<0.5) D 10.00% 20.00% 20.00%
For Hyundai and Kristin Kandy, I used the interest coverage ratio table for smaller/riskier firms (the
numbers in brackets) which yields a lower rating for the same interest coverage ratio.

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 Estimating the cost of debt for a firm

 The synthetic rating for Hyundai is AAA. Using the 2008 default spread of
0.75%, we estimate a cost of debt of 6.55% (using a riskfree rate of 5% and
adding in the country default spread of 0.80%):
Cost of debt = Riskfree rate + Country default spread + Company default spread
=5.00% + 0.80%+ 0.75% = 6.55%
 The synthetic rating for Kristin Kandy is A-. Using the 2004 default spread of
1.00% and a riskfree rate of 4.50%, we estimate a cost of debt of 5.50%.
Cost of debt = Riskfree rate + Default spread =4.50% + 1.00% = 5.50%
 The synthetic rating for Amazon.com in 2000 was BBB. The default spread
for BBB rated bond was 1.50% in 2000 and the treasury bond rate was 6.5%.
Cost of debt = Riskfree Rate + Default spread = 6.50% + 1.50% = 8.00%

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 Weights for the Cost of Capital Computation

 The weights used to compute the cost of capital should be the market value
weights for debt and equity.
 There is an element of circularity that is introduced into every valuation by
doing this, since the values that we attach to the firm and equity at the end of
the analysis are different from the values we gave them at the beginning.
 For private companies, neither the market value of equity nor the market value
of debt is observable. Rather than use book value weights, you should try
• Industry average debt ratios for publicly traded firms in the business
• Target debt ratio (if management has such a target)
• Estimated value of equity and debt from valuation (through an iterative process)

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 Estimating Cost of Capital: Amazon.com

 Equity
• Cost of Equity = 6.50% + 1.60 (4.00%) = 12.90%
• Market Value of Equity = $ 84/share* 340.79 mil shs = $ 28,626 mil (98.8%)
 Debt
• Cost of debt = 6.50% + 1.50% (default spread) = 8.00%
• Market Value of Debt = $ 349 mil (1.2%)
 Cost of Capital
Cost of Capital = 12.9 % (.988) + 8.00% (1- 0) (.012)) = 12.84%

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 Estimating Cost of Capital: Hyundai Heavy

 Equity
• Cost of Equity = 5% + 1.50 (4%) + 0.25 (1.20%) = 11.30%
• Market Value of Equity =27,740 billion Won (99.3%)
 Debt
• Pre-tax Cost of debt = 5% + 0.80% + 0.75%= 6.55%
• Market Value of Debt = 185.58 billion Won (0.7%)
 Cost of Capital
Cost of Capital = 11.30 % (.993) + 6.55% (1- .275) (0.007)) = 11.26%

The book value of equity at Hyundai Heavy is 5,492 billion Won

The book value of debt at Hyundai Heavy is 188 billion Won; Interest expense is
11.4 bil; Average maturity of debt = 3 years
Estimated market value of debt = 11.4 billion (PV of annuity, 3 years, 6.55%) + $
188 billion/1.06553 = 185.58 billion Won

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 Estimating Cost of Capital: Kristin Kandy

 Equity
• Cost of Equity = 4.50% + 2.94 (4%) = 16.26%
• Equity as percent of capital = 70%
 Debt
• Pre-tax Cost of debt = 4.50% + 1.00% = 5.50%
• Marginal tax rate = 40%
• Debt as percent of capital = 30% (Industry average)
 Cost of Capital
Cost of Capital = 16.26% (.70) + 5.50% (1-.40) (.30) = 12.37%

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 II. Estimating Cashflows and Growth

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 Defining Cashflow

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 From Reported to Actual Earnings

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 Dealing with Operating Lease Expenses

 Operating Lease Expenses are treated as operating expenses in computing

operating income. In reality, operating lease expenses should be treated as
financing expenses, with the following adjustments to earnings and capital:
 Debt Value of Operating Leases = Present value of Operating Lease
Commitments at the pre-tax cost of debt
 When you convert operating leases into debt, you also create an asset to
counter it of exactly the same value.
 Adjusted Operating Earnings
Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses -
Depreciation on Leased Asset
• As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of
Operating Leases.

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 Operating Leases at The Gap in 2003

 The Gap has conventional debt of about $ 1.97 billion on its balance sheet and
its pre-tax cost of debt is about 6%. Its operating lease payments in the 2003
were $978 million and its commitments for the future are below:
Year Commitment (millions) Present Value (at 6%)
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 $982.50 each year $1,346.04
Debt Value of leases = $4,396.85 (Also value of leased asset)
 Debt outstanding at The Gap = $1,970 m + $4,397 m = $6,367 m
 Adjusted Operating Income = Stated OI + OL exp this year - Deprec’n
= $1,012 m + 978 m - 4397 m /7 = $1,362 million (7 year life for assets)
 Approximate OI = $1,012 m + $ 4397 m (.06) = $1,276 m

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 The Collateral Effects of Treating Operating Leases as Debt

C o nventional Accounting Operating Leases Treated as Debt

Income Statement Income Statement
EBIT& Leases = 1,990 EBIT& Leases = 1,990
- Op Leases = 978 - Deprecn: OL= 628
EBIT = 1,012 EBIT = 1,362
Interest expense will rise to reflect the conversion
of operating leases as debt. Net income should
not change.
Balance Sheet Balance Sheet
Off balance sheet (Not shown as debt or as an Asset Liability
asset). Only the conventional debt of $1,970 OL Asset 4397 OL Debt 4397
million shows up on balance sheet Total debt = 4397 + 1970 = $6,367 million

Cost of capital = 8.20%(7350/9320) + 4% Cost of capital = 8.20%(7350/13717) + 4%

(1970/9320) = 7.31% (6367/13717) = 6.25%
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) Return on capital = 1362 (1-.35)/(3130+6367)
= 12.90% = 9.30%

Aswath Damodaran 59
 R&D Expenses: Operating or Capital Expenses

 Accounting standards require us to consider R&D as an operating expense

even though it is designed to generate future growth. It is more logical to treat
it as capital expenditures.
 To capitalize R&D,
• Specify an amortizable life for R&D (2 - 10 years)
• Collect past R&D expenses for as long as the amortizable life
• Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5
years, the research asset can be obtained by adding up 1/5th of the R&D expense
from five years ago, 2/5th of the R&D expense from four years ago...:

Aswath Damodaran 60
 Capitalizing R&D Expenses: Cisco in 1999

 R & D was assumed to have a 5-year life.

Year R&D Expense Unamortized portion Amortization this year
1999 (current) 1594.00 1.00 1594.00
1998 1026.00 0.80 820.80 $205.20
1997 698.00 0.60 418.80 $139.60
1996 399.00 0.40 159.60 $79.80
1995 211.00 0.20 42.20 $42.20
1994 89.00 0.00 0.00 $17.80
Total $ 3,035.40 $ 484.60
Value of research asset = $ 3,035.4 million
Amortization of research asset in 1998 = $ 484.6 million
Adjustment to Operating Income = $ 1,594 million - 484.6 million = 1,109.4 million

Aswath Damodaran 61
 The Effect of Capitalizing R&D

C o nventional Accounting R&D treated as capital expenditure

Income Statement Income Statement
EBIT& R&D = 5,049 EBIT& R&D = 5,049
- R&D = 1,594 - Amort: R&D = 485
EBIT = 3,455 EBIT = 4,564 (Increase of 1,109)
EBIT (1-t) = 2,246 EBIT (1-t) = 2,967
Ignored tax benefit = (1594-485)(.35) = 388
Adjusted EBIT (1-t) = 2967 + 388 = 3354
(Increase of $1,109 million)
Net Income will also increase by $1,109 million
Balance Sheet Balance Sheet
Off balance sheet asset. Book value of equity at Asset Liability
$11,722 million is understated because biggest R&D Asset 3035 Book Equity +3035
asset is off the books. Total Book Equity = 11722+3035 = 14757
Capital Expenditures Capital Expenditures
Conventional net cap ex of $98 million Net Cap ex = 98 + 1594 – 485 = 1206
Cash Flows Cash Flows
EBIT (1-t) = 2246 EBIT (1-t) = 3354
- Net Cap Ex = 98 - Net Cap Ex = 1206
FCFF = 2148 FCFF = 2148
Return on capital = 2246/11722 (no debt) Return on capital = 3354/14757
= 19.16% = 22.78%

Aswath Damodaran 62
 What tax rate?

 The tax rate that you should use in computing the after-tax operating income
should be
 The effective tax rate in the financial statements (taxes paid/Taxable income)
 The tax rate based upon taxes paid and EBIT (taxes paid/EBIT)
 The marginal tax rate for the country in which the company operates
 The weighted average marginal tax rate across the countries in which the
company operates
 None of the above
 Any of the above, as long as you compute your after-tax cost of debt using the
same tax rate

Aswath Damodaran 63
 Capital expenditures should include

 Research and development expenses, once they have been re-categorized as

capital expenses. The adjusted net cap ex will be
Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s R&D
expenses - Amortization of Research Asset
 Acquisitions of other firms, since these are like capital expenditures. The
adjusted net cap ex will be
Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms -
Amortization of such acquisitions
Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized measure of
acquisitions (looking at an average over time) should be used
2. The best place to find acquisitions is in the statement of cash flows, usually
categorized under other investment activities

Aswath Damodaran 64
 Cisco’s Net Capital Expenditures in 1999

Cap Expenditures (from statement of CF) = $ 584 mil

- Depreciation (from statement of CF) = $ 486 mil
Net Cap Ex (from statement of CF) = $ 98 mil
+ R & D expense = $ 1,594 mil
- Amortization of R&D = $ 485 mil
+ Acquisitions = $ 2,516 mil
Adjusted Net Capital Expenditures = $3,723 mil

(Amortization was included in the depreciation number)

Aswath Damodaran 65
 Working Capital Investments

 In accounting terms, the working capital is the difference between current

assets (inventory, cash and accounts receivable) and current liabilities
(accounts payables, short term debt and debt due within the next year)
 A cleaner definition of working capital from a cash flow perspective is the
difference between non-cash current assets (inventory and accounts
receivable) and non-debt current liabilities (accounts payable)
 Any investment in this measure of working capital ties up cash. Therefore, any
increases (decreases) in working capital will reduce (increase) cash flows in
that period.
 When forecasting future growth, it is important to forecast the effects of such
growth on working capital needs, and building these effects into the cash
flows.

Aswath Damodaran 66
 Dealing with Negative or Abnormally Low Earnings

Aswath Damodaran 67
 Normalizing Earnings: Amazon

Year Revenues Operating Margin EBIT

Tr12m $1,117 -36.71% -$410
1 $2,793 -13.35% -$373
2 $5,585 -1.68% -$94
3 $9,774 4.16% $407
4 $14,661 7.08% $1,038
5 $19,059 8.54% $1,628
6 $23,862 9.27% $2,212
7 $28,729 9.64% $2,768
8 $33,211 9.82% $3,261
9 $36,798 9.91% $3,646
10 $39,006 9.95% $3,883
TY(11) $41,346 10.00% $4,135 Industry Average

Aswath Damodaran 68
 Estimating FCFF: Hyundai Heavy Industries

 EBIT = 1,751 billion Won

 Tax rate = 27.5%
 Net Capital expenditures =Cap Ex - Depreciation = 911 – 392 = 519 billion W
 Change in Working Capital = - 135 billion Won
Estimating FCFF
Current EBIT * (1 - tax rate) = 1751 (1-.275) = 1,269 billion Won
- (Capital Spending - Depreciation) 519 billion Won
- Change in Working Capital 135 billion Won
Current FCFF 615 billion Won
Reinvestment in 2007 = 519 +135 = 654 billion Won
Reinvestment rate = 654/1269 = 51.52%

Aswath Damodaran 69
 Estimating FCFF: Amazon.com

 EBIT (Trailing 1999) = -$ 410 million

 Tax rate used = 0% (Assumed Effective = Marginal)
 Capital spending (Trailing 1999) = $ 243 million
 Depreciation (Trailing 1999) = $ 31 million
 Non-cash Working capital Change (1999) = - 80 million
 Estimating FCFF (1999)
Current EBIT * (1 - tax rate) = - 410 (1-0) = - $410 million
- (Capital Spending - Depreciation) = $212 million
- Change in Working Capital = -$ 80 million
Current FCFF = - $542 million

Aswath Damodaran 70
 Growth in Earnings

 Look at the past

• The historical growth in earnings per share is usually a good starting point for
growth estimation
 Look at what others are estimating
• Analysts estimate growth in earnings per share for many firms. It is useful to know
what their estimates are.
 Look at fundamentals
• Ultimately, all growth in earnings can be traced to two fundamentals - how much
the firm is investing in new projects, and what returns these projects are making for
the firm.

Aswath Damodaran 71
 Fundamental Growth when Returns are stable

Aswath Damodaran 72
 Measuring Return on Capital (Equity)

Aswath Damodaran 73
 Expected Growth Estimate: Hyundai Heavy

Reinevestment in 2007 Invested Capital in 2006

EBIT (1-t) in 2007: Net Cap Ex = 519 EBIT (1-t) in year 2007 BV of Debt 187
1,269 million Chg in WC = 135 1,269 million + BV of Equity 4479
Total = 654 - Cash 1276
Invested Capital = 3390

Reinvestment Rate = Reinvestment/ EBIT (1-t) X Return on Capital = EBIT (1-t)/ Invested Capital = 19.3%
= 654/1269 = 51/5% =1269/3390 = 37.45%

Normalized Values

Average reinvestment rate over last 5 years X Lower return on capital reflecting increasing scale = 15%
50% 30%

Aswath Damodaran 74
 Fundamental Growth when return on equity (capital) is
changing

 When the return on equity or capital is changing, there will be a second

component to growth, positive if the return is increasing and negative if the
return is decreasing. If ROCt is the return on capital in period t and ROCt+1 is
the return on capital in period t+1, the expected growth rate in operating
income will be:
Expected Growth Rate = ROCt+1 * Reinvestment rate
+(ROCt+1 – ROCt) / ROCt
 For example, assume that you have a firm that is generating a return on capital
of 8% on its existing assets and expects to increase this return to 10% next
year. The efficiency growth for this firm is
Efficiency growth = (10% -8%)/ 8% = 25%
Thus, if this firm has a reinvestment rate of 50% and makes a 10% return on
capital on its new investments as well, its total growth next year will be 30%
Growth rate = .50 * 10% + 25% = 30%
The key difference is that growth from new investments is sustainable whereas
returns from efficiency are short term (or transitory).
Aswath Damodaran 75
 Revenue Growth and Operating Margins

 With negative operating income and a negative return on capital, the

fundamental growth equation is of little use for Amazon.com
 For Amazon, the effect of reinvestment shows up in revenue growth rates and
changes in expected operating margins:
Expected Revenue Growth in $ = Reinvestment (in $ terms) * (Sales/ Capital)
 The effect on expected margins is more subtle. Amazon’s reinvestments
(especially in acquisitions) may help create barriers to entry and other
competitive advantages that will ultimately translate into high operating
margins and high profits.

Aswath Damodaran 76
 Growth in Revenues, Earnings and Reinvestment: Amazon

Year Revenue Chg in Reinvestment Chg Rev/ Chg Reinvestment ROC

Growth Revenue
1 150.00% $1,676 $559 3.00 -76.62%
2 100.00% $2,793 $931 3.00 -8.96%
3 75.00% $4,189 $1,396 3.00 20.59%
4 50.00% $4,887 $1,629 3.00 25.82%
5 30.00% $4,398 $1,466 3.00 21.16%
6 25.20% $4,803 $1,601 3.00 22.23%
7 20.40% $4,868 $1,623 3.00 22.30%
8 15.60% $4,482 $1,494 3.00 21.87%
9 10.80% $3,587 $1,196 3.00 21.19%
10 6.00% $2,208 $736 3.00 20.39%
Assume that firm can earn high returns because of established economies of scale.

Aswath Damodaran 77
 III. The Tail that wags the dog…
Terminal Value

Aswath Damodaran 78
 Getting Closure in Valuation

 A publicly traded firm potentially has an infinite life. The value is therefore the
present value of cash flows forever. CF
t=∞ t
Value = ∑ t
t = 1 (1+ r)

 Since we cannot estimate cash flows forever, we estimate cash flows for a
“growth period” and then estimate a terminal value, to capture the value at the
end of the period:
t = N CFt Terminal Value
Value = ∑ +
t (1 + r)N
t = 1 (1 + r)

Aswath Damodaran 79
 Ways of Estimating Terminal Value

Aswath Damodaran 80
 Stable Growth and Terminal Value

 When a firm’s cash flows grow at a “constant” rate forever, the present value
of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
 This “constant” growth rate is called a stable growth rate and cannot be higher
than the growth rate of the economy in which the firm operates.
 While companies can maintain high growth rates for extended periods, they
will all approach “stable growth” at some point in time.

Aswath Damodaran 81
 1. How high can the stable growth rate be?

 The stable growth rate cannot exceed the growth rate of the economy but it
can be set lower.
• If you assume that the economy is composed of high growth and stable growth
firms, the growth rate of the latter will probably be lower than the growth rate of the
economy.
• The stable growth rate can be negative. The terminal value will be lower and you
are assuming that your firm will disappear over time.
• If you use nominal cashflows and discount rates, the growth rate should be nominal
in the currency in which the valuation is denominated.
 One simple proxy for the nominal growth rate of the economy is the riskfree
rate.
• Riskfree rate = Expected inflation + Expected Real Interest Rate
• Nominal growth rate in economy = Expected Inflation + Expected Real Growth

Aswath Damodaran 82
 2. When will the firm reach stable growth?

 Size of the firm

• Success usually makes a firm larger. As firms become larger, it becomes much
more difficult for them to maintain high growth rates
 Current growth rate
• While past growth is not always a reliable indicator of future growth, there is a
correlation between current growth and future growth. Thus, a firm growing at 30%
currently probably has higher growth and a longer expected growth period than one
growing 10% a year now.
 Barriers to entry and differential advantages
• Ultimately, high growth comes from high project returns, which, in turn, comes
from barriers to entry and differential advantages.
• The question of how long growth will last and how high it will be can therefore be
framed as a question about what the barriers to entry are, how long they will stay up
and how strong they will remain.

Aswath Damodaran 83
 3. What else should change in stable growth?

 In stable growth, firms should have the characteristics of other stable growth
firms. In particular,
• The risk of the firm, as measured by beta and ratings, should reflect that of a stable
growth firm.
– Beta should move towards one
– The cost of debt should reflect the safety of stable firms (BBB or higher)
• The debt ratio of the firm might increase to reflect the larger and more stable
earnings of these firms.
– The debt ratio of the firm might moved to the optimal or an industry average
– If the managers of the firm are deeply averse to debt, this may never happen
• The return on capital generated on investments should move to sustainable levels,
relative to both the sector and the company’s own cost of capital.

Aswath Damodaran 84
 4. What excess returns will you generate in stable growth and
why does it matter?

 Strange though this may seem, the terminal value is not as much a function of
stable growth as it is a function of what you assume about excess returns in
stable growth.
 The key connecting link is the reinvestment rate that you have in stable
growth, which is a function of your return on capital:
Reinvestment Rate = Stable growth rate/ Stable ROC
The terminal value can be written in terms of ROC as follows:
Terminal Value = EBITn+1 (1-t) (1 – g/ ROC)/ (Cost of capital – g)
 In the scenario where you assume that a firm earns a return on capital equal to
its cost of capital in stable growth, the terminal value will not change as the
growth rate changes.
 If you assume that your firm will earn positive (negative) excess returns in
perpetuity, the terminal value will increase (decrease) as the stable growth rate
increases.

Aswath Damodaran 85
 Hyundai and Amazon.com: Stable Growth Inputs

High Growth Stable Growth

 Hyundai Heavy
• Beta 1.50 1.20
• Debt Ratio 0.7% 10%
• Return on Capital 30% 9.42%
• Cost of Capital 11.26% 9.42%
• Expected Growth Rate 15% 5%
• Reinvestment Rate 50% 5%/9.42% = 53.1%
 Amazon.com
• Beta 1.60 1.00
• Debt Ratio 1.20% 15%
• Return on Capital Negative 20%
• Expected Growth Rate NMF 6%
• Reinvestment Rate >100% 6%/20% = 30%

Aswath Damodaran 86
 Hyundai: Terminal Value and Growth

Growth Reinvestment Terminal

Rate Rate FCFF value
0% 0.00% ￦2,681 ￦28,471
1% 10.62% ￦2,396 ￦28,471
2% 21.24% ￦2,112 ￦28,471
3% 31.86% ￦1,827 ￦28,471
4% 42.48% ￦1,542 ￦28,471
5% 53.10% ￦1,258 ￦28,471

As growth increases, value does not change. Why?

Under what conditions will value increase as growth increases?
Under what conditions will value decrease as growth increases?

Aswath Damodaran 87
 Value Enhancement: Back to Basics

Aswath Damodaran 88
 Price Enhancement versus Value Enhancement

Aswath Damodaran 89
 The Paths to Value Creation

 Using the DCF framework, there are four basic ways in which the value of a
firm can be enhanced:
• The cash flows from existing assets to the firm can be increased, by either
– increasing after-tax earnings from assets in place or
– reducing reinvestment needs (net capital expenditures or working capital)
• The expected growth rate in these cash flows can be increased by either
– Increasing the rate of reinvestment in the firm
– Improving the return on capital on those reinvestments
• The length of the high growth period can be extended to allow for more years of
high growth.
• The cost of capital can be reduced by
– Reducing the operating risk in investments/assets
– Changing the financial mix
– Changing the financing composition

Aswath Damodaran 90
 Value Creation 1: Increase Cash Flows from Assets in Place

Aswath Damodaran 91
 Value Creation 2: Increase Expected Growth

Price Leader versus Volume Leader Strategies

Return on Capital = Operating Margin * Capital Turnover Ratio

Aswath Damodaran 92
 Value Creating Growth… Evaluating the Alternatives..

Aswath Damodaran 93
 III. Building Competitive Advantages: Increase length of the
growth period

Aswath Damodaran 94
 Value Creation 4: Reduce Cost of Capital

Aswath Damodaran 95
 Hyundai’s Optimal Financing Mix

Interest
Debt Cost of Bond rate on Cost of Debt Firm
Ratio Beta Equity Rating debt Tax Rate (after-tax) WACC Value (G)
0% 1.49 11.27% AAA 6.55% 27.50% 4.75% 11.27% $26,470
10% 1.61 11.77% A 7.60% 27.50% 5.51% 11.15% $27,021
20% 1.76 12.41% B 12.30% 27.50% 8.92% 11.71% $24,648
30% 1.96 13.23% CC 17.30% 27.04% 12.62% 13.05% $20,313
40% 2.30 14.66% C 18.50% 18.90% 15.00% 14.80% $16,437
50% 2.76 16.59% C 18.50% 15.12% 15.70% 16.15% $14,278
60% 3.47 19.57% D 19.80% 11.74% 17.48% 18.31% $11,727
70% 4.63 24.43% D 19.80% 10.06% 17.81% 19.79% $10,414
80% 6.94 34.14% D 19.80% 8.80% 18.06% 21.27% $9,340
90% 13.88 63.28% D 19.80% 7.83% 18.25% 22.75% $8,445

Aswath Damodaran 96
 IV. Loose Ends in Valuation: From
firm value to value of equity per
share

Aswath Damodaran 97
 But what comes next?

Aswath Damodaran 98
 1. An Exercise in Cash Valuation

Company A Company B Company C

Enterprise Value $ 1 billion $ 1 billion $ 1 billion
Cash $ 100 mil $ 100 mil $ 100 mil
Return on Capital 10% 5% 22%
Cost of Capital 10% 10% 12%
Trades in US US Indonesia

Aswath Damodaran 99
 Cash: Discount or Premium?

Aswath Damodaran 100

 Cash and Trouble?
Cash/
Company Name Primary Industry ROIC Value
Able C&C Co. Ltd. Personal Products 0.49% 38.74%
Varo Vision Co Ltd - 0.85% 76.99%
Raygen Co. Ltd. Semiconductors 1.12% 38.39%
Kodicom Co. Ltd. Consumer Electronics 2.62% 53.35%
Kukyoung Glass Industries Building Products 3.10% 38.75%
DASAN Networks Inc. Communications Equipment 3.45% 49.05%
Tellord Co. Ltd. - 6.89% 45.47%
FRTEK Co. Ltd Communications Equipment 6.98% 45.51%
Ilsung Construction Co., Ltd. Construction and Engineering 7.29% 89.49%
H&T Co., Ltd. Computer Storage and Peripherals 7.76% 42.92%
Feelingk Co. Ltd. Internet Software and Services 8.38% 46.79%
Duck Yang Industry Co. Ltd. Auto Parts and Equipment 8.84% 92.63%
Sewoo Global Co. Ltd. Commodity Chemicals 9.23% 43.88%
D&T, Inc. IT Consulting and Other Services 9.51% 39.31%

Aswath Damodaran 101

 2. Dealing with Holdings in Other firms

 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.
 We tend to be sloppy in practice in dealing with cross holdings. After valuing
the operating assets of a firm, using consolidated statements, it is common to
add on the balance sheet value of minority holdings (which are in book value
terms) and subtract out the minority interests (again in book value terms),
representing the portion of the consolidated company that does not belong to
the parent company.

Aswath Damodaran 102

 How to value holdings in other firms.. In a perfect world..

 In a perfect world, we would strip the parent company from its subsidiaries
and value each one separately. The value of the combined firm will be
• Value of parent company + Proportion of value of each subsidiary
 To do this right, you will need to be provided detailed information on each
subsidiary to estimated cash flows and discount rates.

Aswath Damodaran 103

 Two compromise solutions…

 The market value solution: When the subsidiaries are publicly traded, you
could use their traded market capitalizations to estimate the values of the cross
holdings. You do risk carrying into your valuation any mistakes that the
market may be making in valuation.
 The relative value solution: When there are too many cross holdings to value
separately or when there is insufficient information provided on cross
holdings, you can convert the book values of holdings that you have on the
balance sheet (for both minority holdings and minority interests in majority
holdings) by using the average price to book value ratio of the sector in which
the subsidiaries operate.

Aswath Damodaran 104

 Hyundai’s Cross Holdings

Cross holding % of Total MarketValue of Book P/Book

holding Cap holding Value (Sector)
Hyundai Merchant
Marine 17.60% 4806.00 845.86
Public Hyundai Motors 3.46% 17540.00 606.88
Hyundai Elevator 2.16% 688.00 14.86
Hyundai Corp 0.36% 602.00 2.17
Others ? ? 84.20

Hyundai Oil Bank 19.87% 1825.77 362.78 329.80 1.10

Hyundai Samho 94.92% 2026.23 1923.30 1068.50 1.80
Private Hyundai Finance 67.49% 143.75 97.02 88.20 1.10
Value of Cross
holdings 3937.07

Aswath Damodaran 105

 3. Other Assets that have not been counted yet..

 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.
 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 106

 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
 Which firm would you value more highly?

Aswath Damodaran 107

 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 108

 Measuring Complexity: A Complexity Score
Item Factors Follow-up Question Answer Weighting factor Gerdau Score GE Score
Operating Income 1. Multiple Businesses Number of businesses (with more than 10% of
revenues) = 1 2.00 2 30
2. One-time income and expenses
Percent of operating income = 10% 10.00 1 0.8
3. Income from unspecified sources
Percent of operating income = 0% 10.00 0 1.2
4. Items in income statement that are volatile
Percent of operating income = 15% 5.00 0.75 1
Tax Rate 1. Income from multiple locales
Percent of revenues from non-domestic locales = 70% 3.00 2.1 1.8
2. Different tax and reporting books
Yes or No No Yes=3 0 3
3. Headquarters in tax havens
Yes or No No Yes=3 0 0
4. Volatile effective tax rate
Yes or No Yes Yes=2 2 0
Capital Expenditures 1. Volatile capital expenditures
Yes or No Yes Yes=2 2 2
2. Frequent and large acquisitions
Yes or No Yes Yes=4 4 4
3. Stock payment for acquisitions and
investments Yes or No No Yes=4 0 4
Working capital 1. Unspecified current assets and current
liabilities Yes or No No Yes=3 0 0
2. Volatile working capital items
Yes or No Yes Yes=2 2 2
Expected Growth rate 1. Off-balance sheet assets and liabilities
(operating leases and R&D)
Yes or No No Yes=3 0 3
2. Substantial stock buybacks
Yes or No No Yes=3 0 3
3. Changing return on capital over time
Is your return on capital volatile? Yes Yes=5 5 5
4. Unsustainably high return
Is your firm's ROC much higher than industry average? No Yes=5 0 0
Cost of capital 1. Multiple businesses
Number of businesses (more than 10% of revenues) = 1 1.00 1 20
2. Operations in emerging markets
Percent of revenues= 50% 5.00 2.5 2.5
3. Is the debt market traded?
Yes or No No No=2 2 0
4. Does the company have a rating?
Yes or No Yes No=2 0 0
5. Does the company have off-balance sheet
debt? Yes or No No Yes=5 0 5
No-operating assets Minority holdings as percent of book assets
Minority holdings as percent of book assets 0% 20.00 0 0.8
Firm to Equity value Consolidation of subsidiaries
Minority interest as percent of book value of equity 63% 20.00 12.6 1.2
Per share value Shares with different voting rights
Does the firm have shares with different voting rights? Yes Yes = 10 10 0
Equity options outstanding
Options outstanding as percent of shares 0% 10.00 0 0.25
Complexity Score = 48.95 90.55
Aswath Damodaran 109
 Hyundai: An Enigma wrapped in a Mystery

Aswath Damodaran 110

 Dealing with Complexity

In Discounted Cashflow Valuation

 The Aggressive Analyst: Trust the firm to tell the truth and value the firm
based upon the firm’s statements about their value.
 The Conservative Analyst: Don’t value what you cannot see.
 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
In relative valuation
In a relative valuation, you may be able to assess the price that the market is charging 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

Aswath Damodaran 111

 5. The Value of Synergy

 Synergy can be valued. In fact, if you want to pay for it, it should be valued.
 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 after the takeover? If it will
take time, when can the gains be expected to start showing up? )
 If you cannot answer these questions, you need to go back to the drawing
board…

Aswath Damodaran 112

 Sources of Synergy

Aswath Damodaran 113

 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 114

 Valuing Synergy: P&G + Gillette

P&G Gillette Piglet: No Synergy Piglet: Synergy

Free Cashflow to Equity $5,864.74 $1,547.50 $7,412.24 $7,569.73 Annual operating expenses reduced by $250 million
Growth rate for first 5 years 12% 10% 11.58% 12.50% Slighly higher growth rate
Growth rate after five years 4% 4% 4.00% 4.00%
Beta 0.90 0.80 0.88 0.88
Cost of Equity 7.90% 7.50% 7.81% 7.81% Value of synergy
Value of Equity $221,292 $59,878 $281,170 $298,355 $17,185

Aswath Damodaran 115

 6. Brand name, great management, superb product …Are we
short changing the intangibles?

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

are
• Brand name
• Great management
• Loyal workforce
• Technological prowess
 There are two potential dangers:
• For some assets, the value may already be in your value and adding a premium will
be double counting.
• For other assets, the value may be ignored but incorporating it will not be easy.

Aswath Damodaran 116

 Categorizing Intangibles

Independent and Cash flow Not independent and cash flow No cash flows now but potential
generating intangibles generating to the firm for cashflows in future
Examples Copyrights, trademarks, licenses, Brand names, Quality and Morale Undeveloped patents, operating or
franchises, professional practices of work force, Technological financial flexibility (to expand into
(medical, dental) expertise, Corporate reputation new products/markets or abandon
existing ones)
Valuation approach Estimate expected cashflows from • C ompare DCF value of firm Option valuation
the product or service and discount with intangible with firm • V a lue the undeveloped patent
back at appropriate discount rate. without (if you can find one) as an option to develop the
• A ssume that all excess returns underlying product.
of firm are due to intangible. • V a lue expansion options as call
• C ompare multiples at which options
firm trades to sector averages. • V a lue abandonment options as
put options.
Challenges • L ife is usually finite and With multiple intangibles (brand • Need exclusivity.
terminal value may be small. name and reputation for service), it • D i f f icult to replicate and
• C a s hflows and value may be becomes difficult to break down arbitrage (making option
person dependent (for individual components. pricing models dicey)
professional practices)

Aswath Damodaran 117

 Valuing Brand Name

Coca Cola With Cott Margins

Current Revenues = $21,962.00 $21,962.00
Length of high-growth period 10 10
Reinvestment Rate = 50% 50%
Operating Margin (after-tax) 15.57% 5.28%
Sales/Capital (Turnover ratio) 1.34 1.34
Return on capital (after-tax) 20.84% 7.06%
Growth rate during period (g) = 10.42% 3.53%
Cost of Capital during period = 7.65% 7.65%
Stable Growth Period
Growth rate in steady state = 4.00% 4.00%
Return on capital = 7.65% 7.65%
Reinvestment Rate = 52.28% 52.28%
Cost of Capital = 7.65% 7.65%
Value of Firm = $79,611.25 $15,371.24

Aswath Damodaran 118

 7. Be circumspect about defining debt for cost of capital
purposes…

 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.
 Defined as such, debt should include
• All interest bearing liabilities, short term as well as long term
• All leases, operating as well as capital
 Debt should not include
• Accounts payable or supplier credit

Aswath Damodaran 119

 Book Value or Market Value

 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.
 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.
 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 120

 But you should consider other potential liabilities when
getting to equity value

 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….
 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 121

 8. The Value of Control

 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 122

 Hyundai Heavy: Status Quo ($) Return on Capital
Reinvestment Rate 30%
50%
Current Cashflow to Firm Stable Growth
EBIT(1-t) : 1,269 Billion Won Expected Growth g = 5%; Beta = 1.20;
- Nt CpX 519 in EBIT (1-t) Country Premium= 0.8%
- Chg WC 135 .50*.30=.15 Cost of capital = 9.42%
= FCFF 615 15% ROC= 9.42%
Reinvestment Rate = 654/1269=51.5% Reinvestment Rate=g/ROC
Return on capital = 1269/3390 =37.45% =5/9.42 = 53.1%

Terminal Value5= 1258(.0942-.05) = 28,471

Wn Cashflows
Op. Assets 20,211
+ Cash: 3,612 Year 1 2 3 4 5 Term Yr
+ Non-0p 3,937 EBIT (1-t) 1,460 1,679 1,931 2,220 2,553 2,681
- Debt 186 - Reinvestment 730 839 965 1,110 1,277 1,423
=Equity 27,574 FCFF 730 839 965 1,110 1,277 =1,258
-Options 0
Value/Share 362.82
(362,820 Won/Sh) Discount at $ Cost of Capital (WACC) = 11.3% (.993) + 4.75% (0.007) = 11.26%

On June 1, 2008
Hyundai Heavy traded at
Cost of Equity Cost of Debt
Weights 350,000 Won/share.
11.30% (5%+0.8%+0.75%)(1-.275)
= 4.75% E = 99.3% D = 0.7%

Riskfree Rate:
Won Riskfree Rate= 5% Beta Mature market Country Equity Risk
+ 1.50 X premium + Lambda X Premium
4% 0.25 1.20%

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.75 Ratio: 26.84% Country Default Mkt Vol
Spread X
0.8% 1.20
Aswath Damodaran 123
 Hyundai Heavy: Restructured($) Return on Capital
Reinvestment Rate 30%
50%
Current Cashflow to Firm Stable Growth
EBIT(1-t) : 1,269 Billion Won Expected Growth g = 5%; Beta = 1.20;
- Nt CpX 519 in EBIT (1-t) Country Premium= 0.8%
- Chg WC 135 .50*.30=.15 Cost of capital = 9.42%
= FCFF 615 15% ROC= 9.42%
Reinvestment Rate = 654/1269=51.5% Reinvestment Rate=g/ROC
Return on capital = 1269/3390 =37.45% =5/9.42 = 53.1%

Terminal Value5= 1932(.0942-.05) = 43,732

Wn Cashflows
Op. Assets 23,112
+ Cash: 3,612 Year 1 2 3 4 5 6 7 8 9 10 Term Yr
+ Non-0p 3,937 EBIT (1-t) 1,460 1,679 1,931 2,220 2,553 2,885 3,203 3,491 3,735 3,922 4,118
- Debt 186 - Reinvestment 730 839 965 1,110 1,277 1,461 1,641 1,810 1,960 2,082 2,186
=Equity 30,481 FCFF 730 839 965 1,110 1,277 1,425 1,562 1,681 1,775 1,840 =1,932
-Options 0
Value/Share 401.06
(401,060 Won/Sh) Discount at $ Cost of Capital (WACC) = 11.3% (.9) + 4.75% (0.1) = 11.16%

On June 1, 2008
Hyundai Heavy traded at
Cost of Equity Cost of Debt
Weights 350,000 Won/share.
11.74% (5%+0.8%+1.8%)(1-.275)
= 5.51% E = 90% D = 10%

Riskfree Rate:
Won Riskfree Rate= 5% Beta Mature market Country Equity Risk
+ 1.61 X premium + Lambda X Premium
4% 0.25 1.20%

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.75 Ratio: 26.84% Country Default Mkt Vol
Spread X
0.8% 1.20

Aswath Damodaran 124

 The Value of Control in a publicly traded firm..

 If the value of a firm run optimally is significantly higher than the value of the
firm with the status quo (or incumbent management), you can write the value
that you should be willing to pay as:
Value of control = Value of firm optimally run - Value of firm with status quo
Value of control at Hyundai Heavy= 401 Won per share – 362 Won per share = 39
Won per share
 Implications:
• In an acquisition, this is the most that you would be willing to pay as a premium
(assuming no other synergy)
• As a stockholder, you will be willing to pay a value between 362 and 401 Wn,
depending upon your views on whether control will change.
• If there are voting and non-voting shares, the difference in prices between the two
should reflect the value of control.

Aswath Damodaran 125

 Minority and Majority interests in a private firm

 When you get a controlling interest in a private firm (generally >51%, but
could be less…), you would be willing to pay the appropriate proportion of the
optimal value of the firm.
 When you buy a minority interest in a firm, you will be willing to pay the
appropriate fraction of the status quo value of the firm.
 For badly managed firms, there can be a significant difference in value
between 51% of a firm and 49% of the same firm. This is the minority
discount.
 If you own a private firm and you are trying to get a private equity or venture
capital investor to invest in your firm, it may be in your best interests to offer
them a share of control in the firm even though they may have well below
51%.

Aswath Damodaran 126

 9. Distress and the Going Concern Assumption

 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.
 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 127

Aswath Damodaran 128
 Valuing Global Crossing with Distress

 Probability of distress
• Price of 8 year,
t= 8 12% πbond issued
120(1− by Global
) t 1000(1− π Crossing
)8 = $ 653
653 = ∑ Distress
t
+ Distress
8
t=1 (1.05) (1.05)

• Probability of distress = 13.53% a year

•€ Cumulative probability of survival over 10 years = (1- .1353)10 = 23.37%
 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
 Distress adjusted value of equity
• Value of Global Crossing = $3.22 (.2337) + $0.00 (.7663) = $0.75

Aswath Damodaran 129

 10. Equity to Employees: Effect on Value

 In recent years, firms have turned to giving employees (and especially top
managers) equity option packages as part of compensation. These options are
usually
• Long term
• At-the-money when issued
• On volatile stocks
 Are they worth money? And if yes, who is paying for them?
 Two key issues with employee options:
• How do options granted in the past affect equity value per share today?
• How do expected future option grants affect equity value today?

Aswath Damodaran 130

 Equity Options and Value

 Options outstanding
• Step 1: List all options outstanding, with maturity, exercise price and vesting status.
• Step 2: Value the options, taking into account dilution, vesting and early exercise
considerations
• Step 3: Subtract from the value of equity and divide by the actual number of shares
outstanding (not diluted or partially diluted).
 Expected future option and restricted stock issues
• Step 1: Forecast value of options that will be granted each year as percent of
revenues that year. (As firm gets larger, this should decrease)
• Step 2: Treat as operating expense and reduce operating income and cash flows
• Step 3: Take present value of cashflows to value operations or equity.

Aswath Damodaran 131

 11. Analyzing the Effect of Illiquidity on Value

 Investments which are less liquid should trade for less than otherwise similar
investments which are more liquid.
 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 132

 Illiquidity Discount: Restricted Stock Studies

 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. Studies of restricted stock over time have
concluded that the discount is between 25 and 35%. Many practitioners use
this as the illiquidity discount for all private firms.
 A more nuanced used of restricted stock studies is to relate the discount to
fundamental characteristics of the company - level of revenues, health of the
company etc.. And to adjust the discount for any firm to reflect its
characteristics:
• The discount will be smaller for larger firms
• The discount will be smaller for healthier firms

Aswath Damodaran 133

 Illiquidity Discounts from Bid-Ask Spreads

 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)
 We could substitute in the revenues of Kristin Kandy ($5 million), the fact that
it has positive earnings and the cash as a percent of revenues held by the firm
(8%):
Spread = 0.145 – 0.0022 ln (Annual Revenues) -0.015 (DERN) – 0.016 (Cash/
Firm Value) – 0.11 ($ Monthly trading volume/ Firm Value)
= 0.145 – 0.0022 ln (5) -0.015 (1) – 0.016 (.08) – 0.11 (0) = .12.52%
 Based on this approach, we would estimate an illiquidity discount of 12.52%
for Kristin Kandy.

Aswath Damodaran 134

 V. Value, Price and Information:
Closing the Deal

Aswath Damodaran 135

Aswath Damodaran 136
 Amazon.com: Break Even at $84?

6% 8% 10% 12% 14%

30% $ (1.94) $ 2.95 $ 7.84 $ 12.71 $ 17.57
35% $ 1.41 $ 8.37 $ 15.33 $ 22.27 $ 29.21
40% $ 6.10 $ 15.93 $ 25.74 $ 35.54 $ 45.34
45% $ 12.59 $ 26.34 $ 40.05 $ 53.77 $ 67.48
50% $ 21.47 $ 40.50 $ 59.52 $ 78.53 $ 97.54
55% $ 33.47 $ 59.60 $ 85.72 $ 111.84 $ 137.95
60% $ 49.53 $ 85.10 $ 120.66 $ 156.22 $ 191.77

Aswath Damodaran 137

Aswath Damodaran 138
 Amazon over time…

Aswath Damodaran 139

 Relative Valuation
Aswath Damodaran

Aswath Damodaran 140

 The Essence of relative valuation?

 In relative valuation, the value of an asset is compared to the values assessed

by the market for similar or comparable assets.
 To do relative valuation then,
• we need to identify comparable assets and obtain market values for these assets
• convert these market values into standardized values, since the absolute prices
cannot be compared This process of standardizing creates price multiples.
• compare the standardized value or multiple for the asset being analyzed to the
standardized values for comparable asset, controlling for any differences between
the firms that might affect the multiple, to judge whether the asset is under or over
valued

Aswath Damodaran 141

 Relative valuation is pervasive…

 Most asset valuations are relative.

 Most equity valuations on Wall Street are relative valuations.
• Almost 85% of equity research reports are based upon a multiple and comparables.
• More than 50% of all acquisition valuations are based upon multiples
• Rules of thumb based on multiples are not only common but are often the basis for
final valuation judgments.
 While there are more discounted cashflow valuations in consulting and
corporate finance, they are often relative valuations masquerading as
discounted cash flow valuations.
• The objective in many discounted cashflow valuations is to back into a number that
has been obtained by using a multiple.
• The terminal value in a significant number of discounted cashflow valuations is
estimated using a multiple.

Aswath Damodaran 142

 The Reasons for the allure…

“If you think I’m crazy, you should see the guy who lives across the hall”
Jerry Seinfeld talking about Kramer in a Seinfeld episode

“ A little inaccuracy sometimes saves tons of explanation”

H.H. Munro

“ If you are going to screw up, make sure that you have lots of company”
Ex-portfolio manager

Aswath Damodaran 143

 The Market Imperative….

 Relative valuation is much more likely to reflect market perceptions and

moods than discounted cash flow valuation. This can be an advantage when it
is important that the price reflect these perceptions as is the case when
• the objective is to sell a security at that price today (as in the case of an IPO)
• investing on “momentum” based strategies
 With relative valuation, there will always be a significant proportion of
securities that are under valued and over valued.
 Since portfolio managers are judged based upon how they perform on a
relative basis (to the market and other money managers), relative valuation is
more tailored to their needs
 Relative valuation generally requires less information than discounted cash
flow valuation (especially when multiples are used as screens)

Aswath Damodaran 144

 The Four Steps to Deconstructing Multiples

 Define the multiple

• In use, the same multiple can be defined in different ways by different users. When
comparing and using multiples, estimated by someone else, it is critical that we
understand how the multiples have been estimated
 Describe the multiple
• Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a
multiple is, it is difficult to look at a number and pass judgment on whether it is too
high or low.
 Analyze the multiple
• It is critical that we understand the fundamentals that drive each multiple, and the
nature of the relationship between the multiple and each variable.
 Apply the multiple
• Defining the comparable universe and controlling for differences is far more
difficult in practice than it is in theory.

Aswath Damodaran 145

 Definitional Tests

 Is the multiple consistently defined?

• Proposition 1: Both the value (the numerator) and the standardizing variable
( the denominator) should be to the same claimholders in the firm. In other
words, the value of equity should be divided by equity earnings or equity book
value, and firm value should be divided by firm earnings or book value.
 Is the multiple uniformly estimated?
• The variables used in defining the multiple should be estimated uniformly across
assets in the “comparable firm” list.
• If earnings-based multiples are used, the accounting rules to measure earnings
should be applied consistently across assets. The same rule applies with book-value
based multiples.

Aswath Damodaran 146

 Example 1: Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share

 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

Aswath Damodaran 147

 Example 2: Enterprise Value /EBITDA Multiple

 The enterprise value to EBITDA multiple is obtained by netting cash out

against debt to arrive at enterprise value and dividing by EBITDA.
Enterprise Value Market Value of Equity + Market Value of Debt - Cash
=
EBITDA Earnings before Interest, Taxes and Depreciation

 Why do we net out cash from firm value?

 What happens if a firm has cross holdings which are categorized as:
• Minority interests?
• Majority active interests?

Aswath Damodaran 148

 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?

Aswath Damodaran 149

 Looking at the distribution…

Aswath Damodaran 150

 PE: Deciphering the Distribution

Aswath Damodaran 151

 PE Ratios in Korea…

Aswath Damodaran 152

 And 8 times EBITDA is not cheap

Aswath Damodaran 153

 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
 How do changes in these fundamentals change the multiple?
• The relationship between a fundamental (like growth) and a multiple (such as PE)
is seldom linear. For example, if firm A has twice the growth rate of firm B, it will
generally not trade at twice its PE ratio
• Proposition 3: It is impossible to properly compare firms on a multiple, if we
do not know the nature of the relationship between fundamentals and the
multiple.

Aswath Damodaran 154

 PE Ratio: Understanding the Fundamentals

 To understand the fundamentals, start with a basic equity discounted cash flow
model.
 With the dividend discount model,
DPS 1
P0 =
r − gn

 Dividing both sides by the current earnings per share,

P0 Payout Ratio * (1 + g n )
= PE =
EPS0 r-gn

 If this had been a FCFE Model,

FCFE1
P0 =
r − gn
P0 (FCFE/Earnings) * (1+ g n )
= PE =
EPS0 r-g n

Aswath Damodaran 155

€
 Using the Fundamental Model to Estimate PE For a High
Growth Firm

 The price-earnings ratio for a high growth firm can also be related to
fundamentals. In the special case of the two-stage dividend discount model,
this relationship can be made explicit fairly simply:
 (1+ g)n 
EPS0 * Payout Ratio *(1+ g)* 1 −
 (1+ r) n  EPS0 * Payout Ratio n *(1+ g)n *(1+ g n )
P0 = +
r-g (r -g n )(1+ r)n

• For a firm that does not pay what it can afford to in dividends, substitute FCFE/
Earnings for the payout ratio.
 Dividing both sides by the earnings per share:
 (1 + g)n 
Payout Ratio * (1 + g) *  1 −
P0  (1+ r) n  Payout Ratio n *(1+ g) n * (1 + gn )
= +
EPS0 r -g (r - g n )(1+ r) n

Aswath Damodaran 156

 A Simple Example

 Assume that you have been asked to estimate the PE ratio for a firm which has
the following characteristics:
Variable High Growth Phase Stable Growth Phase
Expected Growth Rate 25% 8%
Payout Ratio 20% 50%
Beta 1.00 1.00
Number of years 5 years Forever after year 5
 Riskfree rate = T.Bond Rate = 6%
 Required rate of return = 6% + 1(5.5%)= 11.5%

 (1.25) 5 
0.2 * (1.25) * 1− 5 5
 (1.115)  0.5 * (1.25) * (1.08)
PE = + = 28.75
(.115 - .25) (.115 - .08) (1.115) 5

€
Aswath Damodaran 157
 a. PE and Growth: Firm grows at x% for 5 years, 8%
thereafter

Aswath Damodaran 158

 b. PE and Risk: A Follow up Example

Aswath Damodaran 159

 Comparisons of PE across time: PE Ratio for the S&P 500

Aswath Damodaran 160

 Is low (high) PE cheap (expensive)?

 A market strategist argues that stocks are over priced because the PE ratio
today is too high relative to the average PE ratio across time. Do you agree?
 Yes
 No
 If you do not agree, what factors might explain the higher PE ratio today?

Aswath Damodaran 161

 E/P Ratios , T.Bond Rates and Term Structure

Aswath Damodaran 162

 Regression Results

 There is a strong positive relationship between E/P ratios and T.Bond rates, as
evidenced by the correlation of 0.70 between the two variables.,
 In addition, there is evidence that the term structure also affects the PE ratio.
 In the following regression, using 1960-2007 data, we regress E/P ratios
against the level of T.Bond rates and a term structure variable (T.Bond - T.Bill
rate)
E/P = 2.19% + 0.734 T.Bond Rate - 0.335 (T.Bond Rate-T.Bill Rate)
(2.70) (6.80) (-1.41)
R squared = 51.23%

Aswath Damodaran 163

 The Determinants of Multiples…

Aswath Damodaran 164

 Application Tests

 Given the firm that we are valuing, what is a “comparable” firm?

• While traditional analysis is built on the premise that firms in the same sector are
comparable firms, valuation theory would suggest that a comparable firm is one
which is similar to the one being analyzed in terms of fundamentals.
• Proposition 4: There is no reason why a firm cannot be compared with another
firm in a very different business, if the two firms have the same risk, growth
and cash flow characteristics.
 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.

Aswath Damodaran 165

 I. Comparing PE Ratios across a Sector: PE

Company Name PE Growth

PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zealand ADR 11.2 0.11
Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunication Organization SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Satellite Telecom Holdings ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexico ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gilat Communications 22.7 0.31
Deutsche Telekom AG ADR 24.6 0.11
British Telecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomunikasi Indonesia ADR 28.4 0.32
Cable & Wireless PLC ADR 29.8 0.14
APT Satellite Holdings ADR 31 0.33
Telefonica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Italia SPA ADR 42.2 0.14
Nippon Telegraph & Telephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Telecom ADR 71.3 0.44

Aswath Damodaran 166

 PE, Growth and Risk

Dependent variable is: PE

R squared = 66.2% R squared (adjusted) = 63.1%

Variable Coefficient SE t-ratio prob

Constant 13.1151 3.471 3.78 0.0010
Growth rate 121.223 19.27 6.29 ≤ 0.0001
Emerging Market -13.8531 3.606 -3.84 0.0009
Emerging Market is a dummy: 1 if emerging market
0 if not

Aswath Damodaran 167

 Is Telebras under valued?

 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.

Aswath Damodaran 168

 II. Price to Book vs ROE: Korean Consumer Electronics
Stocks in June 2008

Aswath Damodaran 169

 A Risk Adjusted Version?

Most overvalued

Most undervalued

Aswath Damodaran 170

 III. Value/EBITDA Multiple: Trucking Companies

Aswath Damodaran 171

 A Test on EBITDA

 Ryder System looks very cheap on a Value/EBITDA multiple basis, relative to

the rest of the sector. What explanation (other than misvaluation) might there
be for this difference?

Aswath Damodaran 172

 IV. A Case Study: Internet Stocks in early 2000

Aswath Damodaran 173

 PS Ratios and Margins are not highly correlated

 Regressing PS ratios against current margins yields the following

PS = 81.36 - 7.54(Net Margin) R2 = 0.04
(0.49)
 This is not surprising. These firms are priced based upon expected margins,
rather than current margins.

Aswath Damodaran 174

 Solution 1: Use proxies for survival and growth: Amazon in
early 2000

 Hypothesizing that firms with higher revenue growth and higher cash balances
should have a greater chance of surviving and becoming profitable, we ran the
following regression: (The level of revenues was used to control for size)
PS = 30.61 - 2.77 ln(Rev) + 6.42 (Rev Growth) + 5.11 (Cash/Rev)
(0.66) (2.63) (3.49)
R squared = 31.8%
Predicted PS = 30.61 - 2.77(7.1039) + 6.42(1.9946) + 5.11 (.3069) = 30.42
Actual PS = 25.63
Stock is undervalued, relative to other internet stocks.

Aswath Damodaran 175

 Solution 2: Use forward multiples

 Global Crossing lost $1.9 billion in 2001 and is expected to continue to lose money for
the next 3 years. In a discounted cashflow valuation (see notes on DCF valuation) of
Global Crossing, we estimated an expected EBITDA for Global Crossing in five years of
$ 1,371 million.
 The average enterprise value/ EBITDA multiple for healthy telecomm firms is 7.2
currently.
 Applying this multiple to Global Crossing’s EBITDA in year 5, yields a value in year 5
of
• Enterprise Value in year 5 = 1371 * 7.2 = $9,871 million
• Enterprise Value today = $ 9,871 million/ 1.1385 = $5,172 million
(The cost of capital for Global Crossing is 13.80%)
• The probability that Global Crossing will not make it as a going concern is 77%.
• Expected Enterprise value today = 0.23 (5172) = $1,190 million

Aswath Damodaran 176

 Comparisons to the entire market: Why not?

 In contrast to the 'comparable firm' approach, the information in the entire

cross-section of firms can be used to predict PE ratios.
 The simplest way of summarizing this information is with a multiple
regression, with the PE ratio as the dependent variable, and proxies for risk,
growth and payout forming the independent variables.

Aswath Damodaran 177

 PE versus Expected EPS Growth: January 2008

Aswath Damodaran 178

 PE Ratio: Standard Regression for US stocks - January 2008

Aswath Damodaran 179

 Fundamentals hold in every market: PE regressions across
markets…
Region Regression R squared

Europe PE = 14.15 – 2.62 Beta + 7.50 Payout + 29.06 17.9%

Expected growth rate

Japan PE = 13.55 – 1.25 Beta + 26.05 Payout + 11.87 18.4%

Expected growth rate
Emerging PE = 5.63 + 11.35 Beta + 2.71 Payout + 92.72 13.9%
Markets Expected growth rate

Aswath Damodaran 180

 Market Regressions: Korean Market in 2008

Multiple Regression R squared

PBV PBV = 1.28 + 34.1 ROE +0.51 Beta 46.5%

EV/Sales EV/Sales = 1.72 -0.72 Beta + 176.9 Operating 16.0%

Margin
Price/Sales PS = 1.27 – 1.71 Beta + 91.5 Net Profit Margin 12.0%

Aswath Damodaran 181

 Relative Valuation: Some closing propositions

 Proposition 1: In a relative valuation, all that you are concluding is that a stock
is under or over valued, relative to your comparable group.
• Your relative valuation judgment can be right and your stock can be hopelessly
over valued at the same time.
 Proposition 2: In asset valuation, there are no similar assets. Every asset is
unique.
• If you don’t control for fundamental differences in risk, cashflows and growth
across firms when comparing how they are priced, your valuation conclusions will
reflect your flawed judgments rather than market misvaluations.

Aswath Damodaran 182

 Choosing Between the Multiples

 As presented in this section, there are dozens of multiples that can be

potentially used to value an individual firm.
 In addition, relative valuation can be relative to a sector (or comparable firms)
or to the entire market (using the regressions, for instance)
 Since there can be only one final estimate of value, there are three choices at
this stage:
• Use a simple average of the valuations obtained using a number of different
multiples
• Use a weighted average of the valuations obtained using a nmber of different
multiples
• Choose one of the multiples and base your valuation on that multiple

Aswath Damodaran 183

 Picking one Multiple

 This is usually the best way to approach this issue. While a range of values can
be obtained from a number of multiples, the “best estimate” value is obtained
using one multiple.
 The multiple that is used can be chosen in one of two ways:
• Use the multiple that best fits your objective. Thus, if you want the company to be
undervalued, you pick the multiple that yields the highest value.
• Use the multiple that has the highest R-squared in the sector when regressed against
fundamentals. Thus, if you have tried PE, PBV, PS, etc. and run regressions of
these multiples against fundamentals, use the multiple that works best at explaining
differences across firms in that sector.
• Use the multiple that seems to make the most sense for that sector, given how value
is measured and created.

Aswath Damodaran 184

 A More Intuitive Approach

 Managers in every sector tend to focus on specific variables when analyzing

strategy and performance. The multiple used will generally reflect this focus.
Consider three examples.
• In retailing: The focus is usually on same store sales (turnover) and profit margins.
Not surprisingly, the revenue multiple is most common in this sector.
• In financial services: The emphasis is usually on return on equity. Book Equity is
often viewed as a scarce resource, since capital ratios are based upon it. Price to
book ratios dominate.
• In technology: Growth is usually the dominant theme. PEG ratios were invented in
this sector.

Aswath Damodaran 185

 In Practice…

 As a general rule of thumb, the following table provides a way of picking a

multiple for a sector
Sector Multiple Used Rationale
Cyclical Manufacturing PE, Relative PE Often with normalized earnings
High Tech, High Growth PEG Big differences in growth across
firms
High Growth/No Earnings PS, VS Assume future margins will be good
Heavy Infrastructure EV/EBITDA Losses/ Big depreciation charges
Financial Services PBV Book value often marked to market
Retailing PS If leverage is similar across firms
VS If leverage is different

Aswath Damodaran 186

 Reviewing: The Four Steps to Understanding Multiples

 Define the multiple

• Check for consistency
• Make sure that they are estimated uniformly
 Describe the multiple
• Multiples have skewed distributions: The averages are seldom good indicators of
typical multiples
• Check for bias, if the multiple cannot be estimated
 Analyze the multiple
• Identify the companion variable that drives the multiple
• Examine the nature of the relationship
 Apply the multiple

Aswath Damodaran 187

 Real Options: Fact and Fantasy
Aswath Damodaran

Aswath Damodaran 188

 Underlying Theme: Searching for an Elusive Premium

 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.

Aswath Damodaran 189

 A Real Option Premium

 In the last few years, there are some who have argued that discounted cashflow
valuations under valued some companies and that a real option premium
should be tacked on to DCF valuations. To understanding its moorings,
compare the two trees below:
A bad investment………………….. Becomes a good one..

1. Learn at relatively low cost

2. Make better decisions based on learning

Aswath Damodaran 190

 Three Basic Questions

 When is there a real option embedded in a decision or an asset?

 When does that real option have significant economic value?
 Can that value be estimated using an option pricing model?

Aswath Damodaran 191

 When is there an option embedded in an action?

 An option provides the holder with the right to buy or sell a specified quantity
of an underlying asset at a fixed price (called a strike price or an exercise
price) at or before the expiration date of the option.
 There has to be a clearly defined underlying asset whose value changes over
time in unpredictable ways.
 The payoffs on this asset (real option) have to be contingent on an specified
event occurring within a finite period.

Aswath Damodaran 192

 Payoff Diagram on a Call

Net Payoff
on Call

Strike
Price

Price of underlying asset

Aswath Damodaran 193

 Example 1: Product Patent as an Option

PV of Cash Flows
from Project

Initial Investment in
Project

Present Value of Expected

Cash Flows on Product
Project's NPV turns
Project has negative positive in this section
NPV in this section

Aswath Damodaran 194

 Example 2: Undeveloped Oil Reserve as an option

Net Payoff on
Extraction

Cost of Developing
Reserve

Value of estimated reserve

of natural resource

Aswath Damodaran 195

 Example 3: Expansion of existing project as an option

PV of Cash Flows
from Expansion

Additional Investment
to Expand

Present Value of Expected

Cash Flows on Expansion
Expansion becomes
Firm will not expand in attractive in this section
this section

Aswath Damodaran 196

 When does the option have significant economic value?

 For an option to have significant economic value, there has to be a restriction

on competition in the event of the contingency. In a perfectly competitive
product market, no contingency, no matter how positive, will generate positive
net present value.
 At the limit, real options are most valuable when you have exclusivity - you
and only you can take advantage of the contingency. They become less
valuable as the barriers to competition become less steep.

Aswath Damodaran 197

 Exclusivity: Putting Real Options to the Test

 Product Options: Patent on a drug

• Patents restrict competitors from developing similar products
• Patents do not restrict competitors from developing other products to treat the same
disease.
 Natural Resource options: An undeveloped oil reserve or gold mine.
• Natural resource reserves are limited.
• It takes time and resources to develop new reserves
 Growth Options: Expansion into a new product or market
• Barriers may range from strong (exclusive licenses granted by the government - as
in telecom businesses) to weaker (brand name, knowledge of the market) to
weakest (first mover).

Aswath Damodaran 198

 Determinants of option value

 Variables Relating to Underlying Asset

• Value of Underlying Asset; as this value increases, the right to buy at a fixed price
(calls) will become more valuable and the right to sell at a fixed price (puts) will
become less valuable.
• Variance in that value; as the variance increases, both calls and puts will become
more valuable because all options have limited downside and depend upon price
volatility for upside.
• Expected dividends on the asset, which are likely to reduce the price appreciation
component of the asset, reducing the value of calls and increasing the value of puts.
 Variables Relating to Option
• Strike Price of Options; the right to buy (sell) at a fixed price becomes more (less)
valuable at a lower price.
• Life of the Option; both calls and puts benefit from a longer life.
 Level of Interest Rates; as rates increase, the right to buy (sell) at a fixed price
in the future becomes more (less) valuable.

Aswath Damodaran 199

 The Building Blocks for Option Pricing Models: Arbitrage
and Replication

 The objective in creating a replicating portfolio is to use a combination of

riskfree borrowing/lending and the underlying asset to create the same
cashflows as the option being valued.
• Call = Borrowing + Buying Δ of the Underlying Stock
• Put = Selling Short Δ on Underlying Asset + Lending
• The number of shares bought or sold is called the option delta.
 The principles of arbitrage then apply, and the value of the option has to be
equal to the value of the replicating portfolio.

Aswath Damodaran 200

 The Binomial Option Pricing Model

Aswath Damodaran 201

 The Limiting Distributions….

 As the time interval is shortened, the limiting distribution, as t -> 0, can take
one of two forms.
• If as t -> 0, price changes become smaller, the limiting distribution is the normal
distribution and the price process is a continuous one.
• If as t->0, price changes remain large, the limiting distribution is the poisson
distribution, i.e., a distribution that allows for price jumps.
 The Black-Scholes model applies when the limiting distribution is the
normal distribution , and explicitly assumes that the price process is
continuous and that there are no jumps in asset prices.

Aswath Damodaran 202

 The Black Scholes Model

Value of call = S N (d1) - K e-rt N(d2)

where, 2
S σ
ln  + (r + )t
K 2
d1 =
σ t

• d2 = d1 - σ √t
 The replicating portfolio is embedded in the Black-Scholes model. To
replicate this call, you would need to
• Buy N(d1) shares of stock; N(d1) is called the option delta
• Borrow K e-rt N(d2)

Aswath Damodaran 203

 The Normal Distribution

d N(d) d N(d) d N(d)

-3.00 0.0013 -1.00 0.1587 1.05 0.8531
-2.95 0.0016 -0.95 0.1711 1.10 0.8643
-2.90 0.0019 -0.90 0.1841 1.15 0.8749
-2.85 0.0022 -0.85 0.1977 1.20 0.8849
-2.80 0.0026 -0.80 0.2119 1.25 0.8944
-2.75 0.0030 -0.75 0.2266 1.30 0.9032
-2.70 0.0035 -0.70 0.2420 1.35 0.9115
-2.65 0.0040 -0.65 0.2578 1.40 0.9192
-2.60 0.0047 -0.60 0.2743 1.45 0.9265
-2.55 0.0054 -0.55 0.2912 1.50 0.9332
-2.50 0.0062 -0.50 0.3085 1.55 0.9394
-2.45 0.0071 -0.45 0.3264 1.60 0.9452
-2.40 0.0082 -0.40 0.3446 1.65 0.9505
-2.35 0.0094 -0.35 0.3632 1.70 0.9554
-2.30 0.0107 -0.30 0.3821 1.75 0.9599
-2.25 0.0122 -0.25 0.4013 1.80 0.9641
-2.20 0.0139 -0.20 0.4207 1.85 0.9678
-2.15 0.0158 -0.15 0.4404 1.90 0.9713
-2.10 0.0179 -0.10 0.4602 1.95 0.9744
-2.05 0.0202 -0.05 0.4801 2.00 0.9772
-2.00 0.0228 0.00 0.5000 2.05 0.9798
-1.95 0.0256 0.05 0.5199 2.10 0.9821
-1.90 0.0287 0.10 0.5398 2.15 0.9842
-1.85 0.0322 0.15 0.5596 2.20 0.9861
-1.80 0.0359 0.20 0.5793 2.25 0.9878
-1.75 0.0401 0.25 0.5987 2.30 0.9893
-1.70 0.0446 0.30 0.6179 2.35 0.9906
-1.65 0.0495 0.35 0.6368 2.40 0.9918
-1.60 0.0548 0.40 0.6554 2.45 0.9929
-1.55 0.0606 0.45 0.6736 2.50 0.9938
-1.50 0.0668 0.50 0.6915 2.55 0.9946
-1.45 0.0735 0.55 0.7088 2.60 0.9953
-1.40 0.0808 0.60 0.7257 2.65 0.9960
-1.35 0.0885 0.65 0.7422 2.70 0.9965
-1.30 0.0968 0.70 0.7580 2.75 0.9970
-1.25 0.1056 0.75 0.7734 2.80 0.9974
-1.20 0.1151 0.80 0.7881 2.85 0.9978
-1.15 0.1251 0.85 0.8023 2.90 0.9981
-1.10 0.1357 0.90 0.8159 2.95 0.9984
-1.05 0.1469 0.95 0.8289 3.00 0.9987
-1.00 0.1587 1.00 0.8413

Aswath Damodaran 204

 When can you use option pricing models to value real
options?

 The notion of a replicating portfolio that drives option pricing models makes
them most suited for valuing real options where
• The underlying asset is traded - this yield not only observable prices and volatility
as inputs to option pricing models but allows for the possibility of creating
replicating portfolios
• An active marketplace exists for the option itself.
• The cost of exercising the option is known with some degree of certainty.
 When option pricing models are used to value real assets, we have to accept
the fact that
• The value estimates that emerge will be far more imprecise.
• The value can deviate much more dramatically from market price because of the
difficulty of arbitrage.

Aswath Damodaran 205

 Valuing a Product Patent as an option: Avonex

 Biogen, a bio-technology firm, has a patent on Avonex, a drug to treat multiple

sclerosis, for the next 17 years, and it plans to produce and sell the drug by
itself. The key inputs on the drug are as follows:
PV of Cash Flows from Introducing the Drug Now = S = $ 3.422 billion
PV of Cost of Developing Drug for Commercial Use = K = $ 2.875 billion
Patent Life = t = 17 years Riskless Rate = r = 6.7% (17-year T.Bond rate)
Variance in Expected Present Values =σ2 = 0.224 (Industry average firm variance for
bio-tech firms)
Expected Cost of Delay = y = 1/17 = 5.89%
d1 = 1.1362 N(d1) = 0.8720
d2 = -0.8512 N(d2) = 0.2076
Call Value= 3,422 exp(-0.0589)(17) (0.8720) - 2,875 (exp(-0.067)(17) (0.2076)= $ 907
million

Aswath Damodaran 206

 Valuing an Oil Reserve

 Consider an offshore oil property with an estimated oil reserve of 50 million

barrels of oil, where the cost of developing the reserve is $ 600 million today.
 The firm has the rights to exploit this reserve for the next twenty years and the
marginal value per barrel of oil is $12 per barrel currently (Price per barrel -
marginal cost per barrel). There is a 2 year lag between the decision to exploit
the reserve and oil extraction.
 Once developed, the net production revenue each year will be 5% of the value
of the reserves.
 The riskless rate is 8% and the variance in ln(oil prices) is 0.03.

Aswath Damodaran 207

 Valuing an oil reserve as a real option

 Current Value of the asset = S = Value of the developed reserve discounted

back the length of the development lag at the dividend yield = $12 * 50 /
(1.05)2 = $ 544.22
 (If development is started today, the oil will not be available for sale until two
years from now. The estimated opportunity cost of this delay is the lost
production revenue over the delay period. Hence, the discounting of the
reserve back at the dividend yield)
 Exercise Price = Present Value of development cost = $12 * 50 = $600 million
 Time to expiration on the option = 20 years
 Variance in the value of the underlying asset = 0.03
 Riskless rate =8%
 Dividend Yield = Net production revenue / Value of reserve = 5%

Aswath Damodaran 208

 Valuing the Option

 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
d1 = 1.0359 N(d1) = 0.8498
d2 = 0.2613 N(d2) = 0.6030
 Call Value= 544 .22 exp(-0.05)(20) (0.8498) -600 (exp(-0.08)(20) (0.6030)= $ 97.08
million
 This oil reserve, though not viable at current prices, still is a valuable property
because of its potential to create value if oil prices go up.
 Extending this concept, the value of an oil company can be written as the sum
of three values:
Value of oil company = Value of developed reserves (DCF valuation)
+ Value of undeveloped reserves (Valued as option)

Aswath Damodaran 209

 An Example of an Expansion Option

 Ambev is considering introducing a soft drink to the U.S. market. The drink
will initially be introduced only in the metropolitan areas of the U.S. and the
cost of this “limited introduction” is $ 500 million.
 A financial analysis of the cash flows from this investment suggests that the
present value of the cash flows from this investment to Ambev will be only $
400 million. Thus, by itself, the new investment has a negative NPV of $ 100
million.
 If the initial introduction works out well, Ambev could go ahead with a full-
scale introduction to the entire market with an additional investment of $
1 billion any time over the next 5 years. While the current expectation is that
the cash flows from having this investment is only $ 750 million, there is
considerable uncertainty about both the potential for the drink, leading to
significant variance in this estimate.

Aswath Damodaran 210

 Valuing the Expansion Option

 Value of the Underlying Asset (S) = PV of Cash Flows from Expansion to

entire U.S. market, if done now =$ 750 Million
 Strike Price (K) = Cost of Expansion into entire U.S market = $ 1000 Million
 We estimate the standard deviation in the estimate of the project value by
using the annualized standard deviation in firm value of publicly traded firms
in the beverage markets, which is approximately 34.25%.
• Standard Deviation in Underlying Asset’s Value = 34.25%
 Time to expiration = Period for which expansion option applies = 5 years
Call Value= $ 234 Million

Aswath Damodaran 211

 One final example: Equity as a Liquidatiion Option

Aswath Damodaran 212

 Application to valuation: A simple example

 Assume that you have a firm whose assets are currently valued at $100 million
and that the standard deviation in this asset value is 40%.
 Further, assume that the face value of debt is $80 million (It is zero coupon
debt with 10 years left to maturity).
 If the ten-year treasury bond rate is 10%,
• how much is the equity worth?
• What should the interest rate on debt be?

Aswath Damodaran 213

 Valuing Equity as a Call Option

 Inputs to option pricing model

• Value of the underlying asset = S = Value of the firm = $ 100 million
• Exercise price = K = Face Value of outstanding debt = $ 80 million
• Life of the option = t = Life of zero-coupon debt = 10 years
• Variance in the value of the underlying asset = σ2 = Variance in firm value = 0.16
• Riskless rate = r = Treasury bond rate corresponding to option life = 10%
 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
• d1 = 1.5994 N(d1) = 0.9451
• d2 = 0.3345 N(d2) = 0.6310
 Value of the call = 100 (0.9451) - 80 exp(-0.10)(10) (0.6310) = $75.94 million
 Value of the outstanding debt = $100 - $75.94 = $24.06 million
 Interest rate on debt = ($ 80 / $24.06)1/10 -1 = 12.77%

Aswath Damodaran 214

 The Effect of Catastrophic Drops in Value

 Assume now that a catastrophe wipes out half the value of this firm (the value
drops to $ 50 million), while the face value of the debt remains at $ 80 million.
What will happen to the equity value of this firm?
 It will drop in value to $ 25.94 million [ $ 50 million - market value of debt
from previous page]
 It will be worth nothing since debt outstanding > Firm Value
 It will be worth more than $ 25.94 million

Aswath Damodaran 215

 Valuing Equity in the Troubled Firm

 Value of the underlying asset = S = Value of the firm = $ 50 million

 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Variance in the value of the underlying asset = σ2 = Variance in firm value =
0.16
 Riskless rate = r = Treasury bond rate corresponding to option life = 10%

Aswath Damodaran 216

 The Value of Equity as an Option

 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
• d1 = 1.0515 N(d1) = 0.8534
• d2 = -0.2135 N(d2) = 0.4155
 Value of the call = 50 (0.8534) - 80 exp(-0.10)(10) (0.4155) = $30.44 million
 Value of the bond= $50 - $30.44 = $19.56 million
 The equity in this firm drops by, because of the option characteristics of
equity.
 This might explain why stock in firms, which are in Chapter 11 and essentially
bankrupt, still has value.

Aswath Damodaran 217

 Equity value persists ..

Aswath Damodaran 218

 Obtaining option pricing inputs in the real worlds

Input Estimation Process

Value of the Firm • Cumulate market values of equity and debt (or)
• Value the assets in place using FCFF and WACC (or)
• Use cumulated market value of assets, if traded.
Variance in Firm Value • If stocks and bonds are traded,
σ2firm = we2 σe2 + wd2 σd2 + 2 we wd ρed σe σd

where σe2 = variance in the stock price

we = MV weight of Equity
σd2 = the variance in the bond price w d = MV weight of debt
• If not traded, use variances of similarly rated bonds.
• Use average firm value variance from the industry in which
company operates.
Value of the Debt • If the debt is short term, you can use only the face or book value
of the debt.
• If the debt is long term and coupon bearing, add the cumulated
nominal value of these coupons to the face value of the debt.
Maturity of the Debt • Face value weighted duration of bonds outstanding (or)
• If not available, use weighted maturity

Aswath Damodaran 219

 Valuing Equity as an option - Eurotunnel in early 1998

 Eurotunnel has been a financial disaster since its opening

• In 1997, Eurotunnel had earnings before interest and taxes of -£56 million and net
income of -£685 million
• At the end of 1997, its book value of equity was -£117 million
 It had £8,865 million in face value of debt outstanding
• The weighted average duration of this debt was 10.93 years
Debt Type Face Value Duration
Short term 935 0.50
10 year 2435 6.7
20 year 3555 12.6
Longer 1940 18.2
Total £8,865 mil 10.93 years

Aswath Damodaran 220

 The Basic DCF Valuation

 The value of the firm estimated using projected cashflows to the firm,
discounted at the weighted average cost of capital was £2,312 million.
 This was based upon the following assumptions –
• Revenues will grow 5% a year in perpetuity.
• The COGS which is currently 85% of revenues will drop to 65% of revenues in yr
5 and stay at that level.
• Capital spending and depreciation will grow 5% a year in perpetuity.
• There are no working capital requirements.
• The debt ratio, which is currently 95.35%, will drop to 70% after year 5. The cost
of debt is 10% in high growth period and 8% after that.
• The beta for the stock will be 1.10 for the next five years, and drop to 0.8 after the
next 5 years.
• The long term bond rate is 6%.

Aswath Damodaran 221

 Other Inputs

 The stock has been traded on the London Exchange, and the annualized std
deviation based upon ln (prices) is 41%.
 There are Eurotunnel bonds, that have been traded; the annualized std
deviation in ln(price) for the bonds is 17%.
• The correlation between stock price and bond price changes has been 0.5. The
proportion of debt in the capital structure during the period (1992-1996) was 85%.
• Annualized variance in firm value
= (0.15)2 (0.41)2 + (0.85)2 (0.17)2 + 2 (0.15) (0.85)(0.5)(0.41)(0.17)= 0.0335
 The 15-year bond rate is 6%. (I used a bond with a duration of roughly 11
years to match the life of my option)

Aswath Damodaran 222

 Valuing Eurotunnel Equity and Debt

 Inputs to Model
• Value of the underlying asset = S = Value of the firm = £2,312 million
• Exercise price = K = Face Value of outstanding debt = £8,865 million
• Life of the option = t = Weighted average duration of debt = 10.93 years
• Variance in the value of the underlying asset = σ2 = Variance in firm value =
0.0335
• Riskless rate = r = Treasury bond rate corresponding to option life = 6%
 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
d1 = -0.8337 N(d1) = 0.2023
d2 = -1.4392 N(d2) = 0.0751
 Value of the call = 2312 (0.2023) - 8,865 exp(-0.06)(10.93) (0.0751) = £122
million
 Appropriate interest rate on debt = (8865/2190)(1/10.93)-1= 13.65%

Aswath Damodaran 223

 Back to Lemmings...

Aswath Damodaran 224

 Aswath Damodaran

VALUATION: IT’S NOT THAT

COMPLICATED!
Aswath Damodaran
www.damodaran.com
 The Big Picture
Just because you have a D and a CF does not
mean you have a DCF!

Aswath Damodaran
Some Initial Thoughts

" One hundred thousand lemmings cannot be wrong"

Graffiti

Aswath Damodaran
3
Theme 1: Characterizing Valuation as a
discipline

¨ In a science, if you get the inputs right, you should

get the output right. The laws of physics and
mathematics are universal and there are no
exceptions. Valuation is not a science.
¨ In an art, there are elements that can be taught but
there is also a magic that you either have or you do
not. The essence of an art is that you are either a
great artist or you are not. Valuation is not an art.
¨ A craft is a skill that you learn by doing. The more
you do it, the better you get at it. Valuation is a
craft.
4
Theme 2: Valuing an asset is not the same as
pricing that asset

Drivers of intrinsic value

- Cashflows from existing assets Drivers of price
- Growth in cash flows - Market moods & momentum
- Quality of Growth - Surface stories about fundamentals

Accounting
Estimates THE GAP
Is there one?
INTRINSIC Price PRICE
Value If so, will it close?
VALUE
If it will close, what will
Valuation cause it to close?
Estimates

5
Theme 3: Good valuation = Story + Numbers

Favored Tools Favored Tools

- Accounting statements - Anecdotes
- Excel spreadsheets - Experience (own or others)
- Statistical Measures - Behavioral evidence
- Pricing Data
A Good Valuation

The Numbers People The Narrative People

Illusions/Delusions
Illusions/Delusions
1. Creativity cannot be quantified
1. Precision: Data is precise
2. If the story is good, the
2. Objectivity: Data has no bias
investment will be.
3. Control: Data can control reality
3. Experience is the best teacher

6
Theme 4: If you value something, you should be
willing to act on it..
¨ What theory? There is very little theory in valuation and
I am not sure what an academic valuation would like like
and am not sure that I want to find out.
¨ Pragmatism, not purity: The end game is to estimate a
value for an asset. I plan to get there, even if it means
taking short cuts and making assumptions that would
make purists blanch.
¨ Do you have faith? To act on your valuations, you have to
have faith in
¤ In your own valuation judgments.
¤ In markets: that prices will move towards your value estimates.
That faith will have to be earned.

7
Misconceptions about Valuation

¨ Myth 1: A valuation is an objective search for “true” value

¤ Truth 1.1: All valuations are biased. The only questions are how much and
in which direction.
¤ Truth 1.2: The direction and magnitude of the bias in your valuation is
directly proportional to who pays you and how much you are paid.
¨ Myth 2.: A good valuation provides a precise estimate of value
¤ Truth 2.1: There are no precise valuations
¤ Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
¨ Myth 3: . The more quantitative a model, the better the valuation
¤ Truth 3.1: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
¤ Truth 3.2: Simpler valuation models do much better than complex ones.

Aswath Damodaran
8
Approaches to Valuation

¨ Intrinsic valuation, relates the value of an asset to

the present value of expected future cashflows on
that asset. In its most common form, this takes the
form of a discounted cash flow valuation.
¨ Relative valuation or Pricing, estimates the value of
an asset by looking at the pricing of 'comparable'
assets relative to a common variable like earnings,
cash flows, book value or sales.
¨ Contingent claim valuation, uses option pricing
models to measure the value of assets that share
option characteristics.
Aswath Damodaran
9
Discounted Cash Flow Valuation

¨ 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.

Aswath Damodaran
10
Risk Adjusted Value: Three Basic Propositions

¨ The value of a risky asset can be estimated by discounting the

expected cash flows on the asset over its life at a risk-adjusted
discount rate:

1. The IT Proposition: If “it” does not affect the cash flows or alter
risk (thus changing discount rates), “it” cannot affect value.
2. The DUH Proposition: For an asset to have value, the expected
cash flows have to be positive some time over the life of the
asset.
3. The DON’T FREAK OUT Proposition: 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
11
DCF Choices: Equity Valuation versus Firm
Valuation
Firm Valuation: Value the entire business

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Equity valuation: Value just the

equity claim in the business

Aswath Damodaran
12
The Drivers of Value…

Growth from new investments Efficiency Growth

Growth created by making new Growth generated by
investments; function of amount and using existing assets
quality of investments better
Terminal Value of firm (equity)
Current Cashflows
These are the cash flows from Expected Growth during high growth period
existing investment,s, net of any Stable growth firm,
reinvestment needed to sustain with no or very
future growth. They can be limited excess returns
computed before debt cashflows (to
the firm) or after debt cashflows (to Length of the high growth period
equity investors). Since value creating growth requires excess returns,
this is a function of
- Magnitude of competitive advantages
- Sustainability of competitive advantages

Cost of financing (debt or capital) to apply to

discounting cashflows
Determined by
- Operating risk of the company
- Default risk of the company
- Mix of debt and equity used in financing

Aswath Damodaran
13
Aswath Damodaran
 Cap Ex = Acc net Cap Ex(255) +
Acquisitions (3975) + R&D (2216) Amgen: Status Quo
Return on Capital
Current Cashflow to Firm Reinvestment Rate 16%
EBIT(1-t)= :7336(1-.28)= 6058 60%
- Nt CpX= 6443 Expected Growth
in EBIT (1-t) Stable Growth
- Chg WC 37 g = 4%; Beta = 1.10;
.60*.16=.096
= FCFF - 423 9.6% Debt Ratio= 20%; Tax rate=35%
Reinvestment Rate = 6480/6058 Cost of capital = 8.08%
=106.98% ROC= 10.00%;
Return on capital = 16.71% Reinvestment Rate=4/10=40%
Growth decreases Terminal Value10 = 7300/(.0808-.04) = 179,099
First 5 years gradually to 4%
Op. Assets 94214 Year 1 2 3 4 5 6 7 8 9 10 Term Yr
+ Cash: 1283 EBIT $9,221 $10,106 $11,076 $12,140 $13,305 $14,433 $15,496 $16,463 $17,306 $17,998 18718
- Debt 8272 EBIT (1-t) $6,639 $7,276 $7,975 $8,741 $9,580 $10,392 $11,157 $11,853 $12,460 $12,958 12167
=Equity 87226 - Reinvestment $3,983 $4,366 $4,785 $5,244 $5,748 $5,820 $5,802 $5,690 $5,482 $5,183 4867
-Options 479 = FCFF $2,656 $2,911 $3,190 $3,496 $3,832 $4,573 $5,355 $6,164 $6,978 $7,775 7300
Value/Share $ 74.33
Cost of Capital (WACC) = 11.7% (0.90) + 3.66% (0.10) = 10.90%
Debt ratio increases to 20%
Beta decreases to 1.10

On May 1,2007,
Cost of Equity Cost of Debt Amgen was trading
Weights at $ 55/share
11.70% (4.78%+..85%)(1-.35)
= 3.66% E = 90% D = 10%

Riskfree Rate: Risk Premium

Riskfree rate = 4.78% Beta 4%
+ 1.73 X

Unlevered Beta for

Sectors: 1.59 D/E=11.06%
Aswath Damodaran
 Average reinvestment rate
from 2005-09: 179.59%;
Tata Motors: April 2010 without acquisitions: 70% Return on Capital Stable Growth
17.16% g = 5%; Beta = 1.00
Current Cashflow to Firm Reinvestment Rate Country Premium= 3%
EBIT(1-t) : Rs 20,116 70% Cost of capital = 10.39%
- Nt CpX Rs 31,590 Tax rate = 33.99%
- Chg WC Rs 2,732 Expected Growth = ROC= 10.39%;
= FCFF - Rs 14,205 .70*.1716=0.1201 Reinvestment Rate=g/ROC
Reinv Rate = (31590+2732)/20116 =5%/ 10.39%= 48.11%
= 170.61%; Tax rate = 21.00%
Return on capital = 17.16%
Rs Cashflows Terminal Value= 23493/(.1039-.05) = Rs 435,686

Op. Assets 210,813 Year 1 2 3 4 5 6 7 8 9 10

+ Cash: 11418 EBIT (1-t) ₹ 22,533 ₹ 25,240 ₹ 28,272 ₹ 31,668 ₹ 35,472 ₹ 39,236 ₹ 42,848 ₹ 46,192 ₹ 49,150 ₹ 51,607 45278 Move to effective
+ Crosshold 140576 - Reinvestment ₹ 15,773 ₹ 17,668 ₹ 19,790 ₹ 22,168 ₹ 24,830 ₹ 25,242 ₹ 25,138 ₹ 24,482 ₹ 23,264 ₹ 21,503 21785 tax rate causes
- Debt 109198 FCFF ₹ 6,760 ₹ 7,572 ₹ 8,482 ₹ 9,500 ₹ 10,642 ₹ 13,994 ₹ 17,711 ₹ 21,710 ₹ 25,886 ₹ 30,104 23493 EBIT (1-t) to drop in
=Equity 253,628 terminal year

Value/Share Rs 614 Discount at Cost of Capital (WACC) = 14.00% (.747) + 8.09% (0.253) = 12.50%
Growth declines to 5%
and cost of capital moves
to stable period level.
Cost of Equity
14.00% Cost of Debt Weights
E = 74.7% D = 25.3% On April 1, 2010
(5%+ 4.25%+3%)(1-.3399)
Tata Motors price = Rs 781
= 8.09%

Riskfree Rate:
Rs Riskfree Rate= 5% Beta Mature market Country Equity Risk
+ 1.20 X premium + Lambda X Premium
4.5% 0.80 4.50%

Unlevered Beta for Firm’s D/E Country Default Rel Equity

Sectors: 0.98 Ratio: 34% Spread X Mkt Vol
3% 1.50
Aswath Damodaran
Aswath Damodaran
 I. The Nuts and Bolts of D & CF
The details matter, but never as much as you
think they do…

Aswath Damodaran
I. Measure earnings right..

Operating leases R&D Expenses

Firmʼs Comparable - Convert into debt - Convert into asset
history Firms - Adjust operating income - Adjust operating income

Normalize Cleanse operating items of

Earnings - Financial Expenses
- Capital Expenses
- Non-recurring expenses

Measuring Earnings

Update
- Trailing Earnings
- Unofficial numbers

Aswath Damodaran
19
Operating Leases at Amgen in 2007
¨ Amgen has lease commitments and its cost of debt (based on it’s A rating) is 5.63%.
Year Commitment Present Value
1 $96.00 $90.88
2 $95.00 $85.14
3 $102.00 $86.54
4 $98.00 $78.72
5 $87.00 $66.16
6-12 $107.43 $462.10 ($752 million prorated)
¨ Debt Value of leases = $869.55
¨ Debt outstanding at Amgen = $7,402 + $ 870 = $8,272 million
¨ Adjusted Operating Income = Stated OI + Lease expense this year – Depreciation
= 5,071 m + 69 m - 870/12 = $5,068 million (12 year life for assets)
¨ Approximate Operating income= stated OI + PV of Lease commitment * Pre-tax cost of debt
= $5,071 m + 870 m (.0563) = $ 5,120 million

Aswath Damodaran
20
Capitalizing R&D Expenses: Amgen
¨ R & D was assumed to have a 10-year life.
Year R&D Expense Unamortized portion Amortization this year
Current 3366.00 1.00 3366.00
-1 2314.00 0.90 2082.60 $231.40
-2 2028.00 0.80 1622.40 $202.80
-3 1655.00 0.70 1158.50 $165.50
-4 1117.00 0.60 670.20 $111.70
-5 865.00 0.50 432.50 $86.50
-6 845.00 0.40 338.00 $84.50
-7 823.00 0.30 246.90 $82.30
-8 663.00 0.20 132.60 $66.30
-9 631.00 0.10 63.10 $63.10
-10 558.00 0.00 $55.80
Value of Research Asset = $10,112.80 $1,149.90
¨ Adjusted Operating Income = $5,120 + 3,366 - 1,150 = $7,336 million

Aswath Damodaran
21
Fertiglobe: Operating History

Aswath Damodaran
22
II. Get the big picture (not the accounting one)
when it comes to cap ex and working capital

¨ Capital expenditures should include

¤ Research and development expenses, once they have been re-
categorized as capital expenses.
¤ Acquisitions of other firms, whether paid for with cash or stock.
¨ Working capital should be defined not as the difference
between current assets and current liabilities but as the
difference between non-cash current assets and non-
debt current liabilities.
¨ On both items, start with what the company did in the
most recent year but do look at the company’s history
and at industry averages.

Aswath Damodaran
23
Amgen’s Net Capital Expenditures

¨ The accounting net cap ex at Amgen is small:

¤ Accounting Capital Expenditures = $1,218 million
¤ - Accounting Depreciation = $ 963 million
¤ Accounting Net Cap Ex = $ 255 million
¨ We define capital expenditures broadly to include R&D and
acquisitions:
¤ Accounting Net Cap Ex = $ 255 million
¤ Net R&D Cap Ex = (3366-1150) = $2,216 million
¤ Acquisitions in 2006 = $3,975 million
¤ Total Net Capital Expenditures = $ 6,443 million
¨ Acquisitions have been a volatile item. Amgen was quiet on
the acquisition front in 2004 and 2005 and had a significant
acquisition in 2003.

Aswath Damodaran
24
III. The government bond rate is not
always the riskfree rate
¨ When valuing Amgen in US dollars, the US$ ten-year bond
rate of 4.78% was used as the risk free rate. We assumed that
the US treasury was default free.
¨ When valuing Tata Motors in Indian rupees in 2010, the
Indian government bond rate of 8% was not default free.
Using the Indian government’s local currency rating of Ba2
yielded a default spread of 3% for India and a riskfree rate of
5% in Indian rupees.
Risk free rate in Indian Rupees = 8% - 3% = 5%
¨ To value Fertiglobe in March 2022, you need a risk free rate in
UAE Dirham at the time. Assuming that the peg to the US
dollar is sustainable, we switched and valued the company in
US dollars. The risk free rate is the US treasury bond of 4%.

Aswath Damodaran
25
 0.00%
5.00%

-5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
Euro
Swiss Franc
Japanese Yen
Danish Krone
Swedish Krona
Croatian Kuna

Aswath Damodaran
Taiwanese $
Bulgarian Lev
British Pound
Indonesian Rupiah
Israeli Shekel
Canadian $
HK $
US $
Singapore $
Australian $
Norwegian Krone

Riskfree Rate
Thai Baht
Qatari Dinar
Vietnamese Dong
Korean Won
NZ $
Chinese Yuan
Czech Koruna
Malyasian Ringgit
India Rating on 1/1/22 = Baa3

Polish Zloty
Iceland Krona
Default Spread based on rating Hungarian Forint
Phillipine Peso
Romanian Lev
Default spread on Baa3 rating = 1.87%
Indian Govt Bond Rate (1/1/22) = 6.45%

Chilean Peso
Riskfree Rates in January 2022 : Government Bond Rate

Peruvian Sol
Indian Rupee
Mexican Peso
Colombian Peso
Russian Ruble
Riskfree Rate in Rs (1/1/22) = 6.45% - 1.87% =4.58%

South African Rand

Brazilian Reai
Pakistani Rupee
Kenyan Shilling
Nigerian Naira
Risk free rates will vary across currencies!

Turkish Lira
Zambian kwacha
26
And across time…

Aswath Damodaran
27
Risk free Rates in Currencies without a
Government Bond Rate
¨ There are no traded long term Government bonds in some
currencies. Hence, you have to improvise.
¨ One simple technique is to use differential inflation and the
US dollar risk free rate. Using this technique on the Egyptian
pound, here is what you get:
¤ Risk free rate in US dollars on 12/31/15 = 2.27%
¤ Expected inflation rate in the US = 1.50%
¤ Expected inflation rate in Egypt = 9.70% (last year’s estimate)
¤ Risk free rate in EGP = (1.0227) * (1.097/1.015) -1 =10.53%
¨ This is also a good way to check government bond rates that
you do not trust. For instance, the Venezuelan government
bond rate of 19% on January 1, 2019, is pure fiction, since no
rational person would have bought the bonds with the
interest rate (given that inflation was in >5000%).
Aswath Damodaran
28
But valuations should not! Infosys
Valuation in 2018
In Rupees In Dollars
Risk free Rate 5.38% 2.85%
Expected growth rate 10.00% for next 5 years, 7.37% for next 5 years,
scaling down to 5.38% in scaling down to 2.85% in
year 10 (and forever) year 10 (and forever)
Return on Capital Marginal ROIC of 39.70%, Marginal ROIC of 37.68%,
scaling down to 15% scaling down to 12.36%
forever forever.
Cost of capital 11.02% for next 5 years, 8.36% for next 5 years,
scaling down to 9.88% in scaling down to 7.23% in
year 10 (and beyond) year 10 (and beyond)

Value per share Rs 1072.22 per share $16.86 per share about 7%
about 7% below stock below stock price of
price of Rs 1,150/share $18.02/share
Aswath Damodaran
29
Aswath Damodaran
Aswath Damodaran
IV. Betas do not come from regressions… and
are noisy…

Aswath Damodaran
32
 But should not be trusted, even when they
look great…
33

Aswath Damodaran
33
 And subject to game playing
34

Aswath Damodaran
Determinants of Betas
Beta of Equity

Beta of Firm Financial Leverage:

Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
Nature of product or Operating Leverage (Fixed equity beta will be
service offered by Costs as percent of total
company: costs):
Other things remaining equal, Other things remaining equal
the more discretionary the the greater the proportion of Implciations
product or service, the higher the costs that are fixed, the
the beta. higher the beta of the Highly levered firms should have highe betas
than firms with less debt.
company.

Implications Implications
1. Cyclical companies should 1. Firms with high infrastructure
have higher betas than non- needs and rigid cost structures
cyclical companies. shoudl have higher betas than
2. Luxury goods firms should firms with flexible cost structures.
have higher betas than basic 2. Smaller firms should have higher
goods. betas than larger firms.
3. High priced goods/service 3. Young firms should have
firms should have higher betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Aswath Damodaran
35
Bottom-up Betas

Step 1: Find the business or businesses that your firm operates in.

Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
obtain their regression betas. Compute the simple average across
these regression betas to arrive at an average beta for these publicly If you can, adjust this beta for differences
traded firms. Unlever this average beta using the average debt to between your firm and the comparable
equity ratio across the publicly traded firms in the sample. firms on operating leverage and product
Unlevered beta for business = Average beta across publicly traded characteristics.
firms/ (1 + (1- t) (Average D/E ratio across firms))

While revenues or operating income

Step 3: Estimate how much value your firm derives from each of are often used as weights, it is better
the different businesses it is in. to try to estimate the value of each
business.

Step 4: Compute a weighted average of the unlevered betas of the If you expect the business mix of your
different businesses (from step 2) using the weights from step 3. firm to change over time, you can
Bottom-up Unlevered beta for your firm = Weighted average of the change the weights on a year-to-year
unlevered betas of the individual business basis.

If you expect your debt to equity ratio to

Step 5: Compute a levered beta (equity beta) for your firm, using change over time, the levered beta will
the market debt to equity ratio for your firm. change over time.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

Aswath Damodaran
36
Three examples…

¨ Amgen
¤ The unlevered beta for pharmaceutical firms is 1.59. Using Amgen’s debt to equity ratio of 11%, the
bottom up beta for Amgen is
¤ Bottom-up Beta = 1.59 (1+ (1-.35)(.11)) = 1.73
¨ Tata Motors
¤ The unlevered beta for automobile firms is 0.98. Using Tata Motor’s debt to equity ratio of 33.87%,
the bottom up beta for Tata Motors is
¤ Bottom-up Beta = 0.98 (1+ (1-.3399)(.3387)) = 1.20
¤ Fertiglobe
¤ The unlevered beta of global fertilizer companies is 1.04. Using Fertiglobe’s debt to equity ratio of
2.84% and a tax rate of 25%, the bottom up beta is
¤ Bottom up Beta = 1.04 (1 + (1-.25) (.0284)) = 1.06
¨ Almarai
Business Revenue Weight Unlevered Beta
Packaged Food 81% 0.82
Agricultural Products 19% 0.58
Company 0.77
Aswath Damodaran
37
 V. And the past is not always a good indicator of
the future.
Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2021 8.49% 6.71% 6.69% 5.13%
Std Error 2.05% 2.17%
1972-2021 8.04% 5.47% 6.70% 4.47%
Std Error 2.44% 2.76%
2012-2021 16.47% 14.39% 15.89% 14.00%
Std Error 3.88% 4.59%

¨ If you are going to use a historical risk premium, make it

¤ Long term (because of the standard error)
¤ Consistent with your risk free rate
¤ A “compounded” average
¨ No matter which estimate you use, recognize that it is
backward looking, is noisy and may reflect selection bias

Aswath Damodaran
38
 But in the future..
39

Aswath Damodaran
39
 40

2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
Implied ERP for the S&P 500: History

2010
2009
Implied Premium for US Equity Market: 1960-2021

2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992

Year
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967

Aswath Damodaran
1966
1965
1964
1963
1962
1961
1960

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%
Implied Premium

40
Another Perspective on US stocks

Aswath Damodaran
41
The Price of Risk: The 2008 Crisis

42
The Price of Risk: The COVID crisis

43
Implied Premium for India using the Sensex:
April 2010

¨ Level of the Index = 17559

¨ FCFE on the Index = 3.5% (Estimated FCFE for companies
in index as % of market value of equity)
¨ Other parameters
¤ Riskfree Rate = 5% (Rupee)
¤ Expected Growth (in Rupee)
n Next 5 years = 20% (Used expected growth rate in Earnings)
n After year 5 = 5%

¨ Solving for the expected return:

¤ Expected return on Equity = 11.72%
¤ Implied Equity premium for India =11.72% - 5% = 6.72%

Aswath Damodaran
44
Global Equities?

Growth Growth Cost of

Start of PBV PBV ROE ROE US T.Bond Rate Rate Equity Cost of Equity
year (Developed) (Emerging) (Developed) (Emerging) Rate (Developed) (Emerging) (Developed) (Emerging) Differential
2004 2.00 1.19 10.81% 11.65% 4.25% 3.75% 4.75% 7.28% 10.55% 3.27%
2005 2.09 1.27 11.12% 11.93% 4.22% 3.72% 4.72% 7.26% 10.40% 3.14%
2006 2.03 1.44 11.32% 12.18% 4.39% 3.89% 4.89% 7.55% 9.95% 2.40%
2007 1.67 1.67 10.87% 12.88% 4.70% 4.20% 5.20% 8.19% 9.80% 1.60%
2008 0.87 0.83 9.42% 11.12% 4.02% 3.52% 4.52% 10.30% 12.47% 2.17%
2009 1.20 1.34 8.48% 11.02% 2.21% 1.71% 2.71% 7.35% 8.91% 1.56%
2010 1.39 1.43 9.14% 11.22% 3.84% 3.34% 4.34% 7.51% 9.15% 1.64%
2011 1.12 1.08 9.21% 10.04% 3.29% 2.79% 3.79% 8.52% 9.58% 1.05%
2012 1.17 1.18 9.10% 9.33% 1.88% 1.38% 2.38% 7.98% 8.27% 0.29%
2013 1.56 1.63 8.67% 10.48% 1.76% 1.26% 2.26% 6.01% 7.30% 1.29%
2014 1.95 1.50 9.27% 9.64% 3.04% 2.54% 3.54% 5.99% 7.61% 1.62%
2015 1.88 1.56 9.69% 9.75% 2.17% 1.67% 2.67% 5.94% 7.21% 1.27%
2016 1.99 1.59 9.24% 10.16% 2.27% 1.77% 2.77% 5.52% 7.42% 1.89%
2017 1.76 1.48 8.71% 9.53% 2.68% 2.18% 3.18% 5.89% 7.47% 1.58%
2018 1.98 1.66 11.23% 11.36% 2.68% 2.18% 3.18% 6.75% 8.11% 1.36%
2019 1.64 1.31 12.09% 11.35% 2.68% 2.18% 3.18% 8.22% 9.42% 1.19%

45
VI. There is a downside to globalization…

¨ Emerging markets offer growth opportunities but they are also riskier. If we want
to count the growth, we have to also consider the risk.
¨ Two ways of estimating the country risk premium:
¤ Sovereign Default Spread: In this approach, the country equity risk premium is set equal to the
default spread of the bond issued by the country.
n Equity Risk Premium for mature market = 6.00%
n Default Spread for India = 200% (based on rating)
n Equity Risk Premium for India = 6.00% + 2.00% = 8.00%
¤ Adjusted for equity risk: The country equity risk premium is based upon the volatility of the
equity market relative to the government bond rate.
n Country risk premium= Default Spread* Std DeviationCountry Equity / Std DeviationCountry Bond
n Standard Deviation in Sensex = 21%
n Standard Deviation in Indian government bond= 14%
n Default spread on Indian Bond= 2%
n Additional country risk premium for India = 2% (21/14) = 3.00%
n Total equity risk premium = US equity risk premium + CRP for India
= 6.00% + 3.00% = 9.00%

Aswath Damodaran
46
A Template for Estimating the ERP

Aswath Damodaran
47
ERP : July 2022

Blue: Moody’s Rating

Aswath Damodaran
Red: Added Country Risk
Green #: Total ERP
VII. And it is not just emerging market
companies that are exposed to this risk..
¨ The “default” approach in valuation has been to assign
country risk based upon your country of incorporation.
Thus, if you are incorporated in a developed market, the
assumption has been that you are not exposed to
emerging market risks. If you are incorporated in an
emerging market, you are saddled with the entire
country risk.
¨ As companies globalize and look for revenues in foreign
markets, this practice will under estimate the costs of
equity of developed market companies with significant
emerging market risk exposure and over estimate the
costs of equity of emerging market companies with
significant developed market risk exposure.

Aswath Damodaran
49
Fertiglobe: Equity Risk Premium in 2022

Region Revenues ERP Weight

Africa $294 13.37% 8.88%
Asia & Oceania $1,177 7.57% 35.55%
Central and South America $476 11.21% 14.38%
Middle East $61 8.03% 1.84%
North America $356 6.01% 10.75%
Western Europe $947 7.17% 28.60%
Total $3,311 8.33% 100.00%

50
Natural Resource Twists? Royal Dutch

Country Oil & Gas Production % of Total ERP

Denmark 17396 3.83% 6.20%
Italy 11179 2.46% 9.14%
Norway 14337 3.16% 6.20%
UK 20762 4.57% 6.81%
Rest of Europe 874 0.19% 7.40%
Brunei 823 0.18% 9.04%
Iraq 20009 4.40% 11.37%
Malaysia 22980 5.06% 8.05%
Oman 78404 17.26% 7.29%
Russia 22016 4.85% 10.06%
Rest of Asia & ME 24480 5.39% 7.74%
Oceania 7858 1.73% 6.20%
Gabon 12472 2.75% 11.76%
Nigeria 67832 14.93% 11.76%
Rest of Africa 6159 1.36% 12.17%
USA 104263 22.95% 6.20%
Canada 8599 1.89% 6.20%
Brazil 13307 2.93% 9.60%
Rest of Latin America 576 0.13% 10.78%
Royal Dutch Shell 454326 100.00% 8.26%
Aswath Damodaran
51
 An alternate way: Estimating a company’s
exposure to country risk (Lambda)
¨ Just as beta measures exposure to macro economic risk, lambda measures exposure just to
country risk. Like beta, it is scaled around one.
¨ The easiest and most accessible data is on revenues. Most companies break their revenues
down by region. One simplistic solution would be to do the following:
Lambda = % of revenues domestically firm/ % of revenues domestically average firm
¨ In 2008-09, Tata Motors got about 91.37% of its revenues in India and TCS got 7.62%. The
average Indian firm gets about 80% of its revenues in India:
¤ Lambda Tata Motors = 91%/80% = 1.14
¤ The danger of focusing just on revenues is that it misses other exposures to risk
(production and operations).
Tata Motors TCS

% of production/operations in India High High

91.37% (in 2009)
% of revenues in India Estimated 70% (in 2010) 7.62%
Lambda 0.80 0.20
Low. Significant physical
Flexibility in moving operations assets. High. Human capital is mobile.
52
VIII. Growth has to be earned (not endowed or
estimated): Sustainable Growth
Expected Growth

Net Income Operating Income

Retention Ratio= Return on Equity Reinvestment Return on Capital =

1 - Dividends/Net X Net Income/Book Value of Rate = (Net Cap X EBIT(1-t)/Book Value of
Income Equity Ex + Chg in Capital
WC/EBIT(1-t)

1. No free growth: In the long term, to grow, you have to reinvest.

2. Growth Quality: For a given reinvestment, the higher the return
you generate on your reinvestment, the faster you can grow.
3. Scaling up is hard to do: As companies get larger, it gets more
difficult to sustain value-adding growth.

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53
Measuring Returns: The Quandary

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54
Reinvestment & Return on Capital –
Fertiglobe History

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55
Earn at least your cost of capital! But companies
seem to have trouble in practice

56
A More General Way to Estimate Growth:
Top Down Growth
¨ All of the fundamental growth equations assume that the firm has a
return on equity or return on capital it can sustain in the long term.
¨ When operating income is negative or margins are expected to change
over time, we use a three step process to estimate growth:
¤ Estimate growth rates in revenues over time
n Determine the total market (given your business model) and estimate the
market share that you think your company will earn.
n Decrease the growth rate as the firm becomes larger
n Keep track of absolute revenues to make sure that the growth is feasible
¤ Estimate expected operating margins each year
n Set a target margin that the firm will move towards
n Adjust the current margin towards the target margin
¤ Estimate the capital that needs to be invested to generate revenue growth and
expected margins
n Estimate a sales to capital ratio that you will use to generate reinvestment needs
each year.

Aswath Damodaran
57
IX. All good things come to an end..And the
terminal value is not an ATM…

This tax rate locks in Are you reinvesting enough to sustain your
forever. Does it make stable growth rate?
sense to use an Reinv Rate = g/ ROC
effective tax rate? Is the ROC that of a stable company?
EBITn+1 (1 - tax rate) (1 - Reinvestment Rate)
Terminal Valuen =
Cost of capital - Expected growth
rate
This growth rate should be
This is a mature company. less than the nomlnal
It’s cost of capital should growth rate of the economy
reflect that.

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58
Terminal Value and Growth

Stable Growth Rate Amgen Tata Motors Fertiglobe Heineken

0% $150,652 ₹ 435,686 $55,280 €59,438
1% $154,479 ₹ 435,686 $57,894 €59,438
2% $160,194 ₹ 435,686 $61,069 €59,438
3% $167,784 ₹ 435,686 $65,044
4% $179,099 ₹ 435,686 $70,220

Risk free Rate 4.78% 5.00% 4.00% -0.50%

ROIC 10.00% 10.39% 15.00% 5.00%
Cost of capital 8.08% 10.39% 10.01% 5.00%

Aswath Damodaran
59
 II. The loose ends in valuation…
A premium here, a discount there, and soon
you are where you wanted to be in the first
place..

Aswath Damodaran
Getting from DCF to value per share: The
Loose Ends

The adjustments to
get to firm value Intangible assets
(Brand Name)
+ Cash & Marketable Premium
Securities Control
Discount FCFF Synergy Premium Premium
at Cost of Discount? Premium?
capital =
Operating Asset + + Value of Cross
= Value of Value per
Value
holdings Value of business
(firm) - Debt = Equity share
Book value? Market
value? Underfunded
Complexity Minority Option
+ Value of other non- pension/ Discount Overhang
discount
operating assets health care
obligations? Distress Differences
What should be here? discount in cashflow/
What should not? Lawsuits & voting rights
Contingent Liquidity across
liabilities? discount shares

Aswath Damodaran
61
1. The Value of Cash
An Exercise in Cash Valuation

Company A Company B Company C

Enterprise Value $ 1 billion $ 1 billion $ 1 billion
Cash $ 100 mil $ 100 mil $ 100 mil
Return on Capital 10% 5% 22%
Cost of Capital 10% 10% 12%
Trades in US US Argentina

¨ In which of these companies is cash most likely to

trade at face value, at a discount and at a premium?

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62
Cash: Discount or Premium?

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63
2. Dealing with Holdings in Other firms

¨ 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.
¨ We tend to be sloppy in practice in dealing with cross
holdings. After valuing the operating assets of a firm, using
consolidated statements, it is common to add on the balance
sheet value of minority holdings (which are in book value
terms) and subtract out the minority interests (again in book
value terms), representing the portion of the consolidated
company that does not belong to the parent company.

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64
How to value holdings in other firms.. In a
perfect world..

¨ In a perfect world, we would strip the parent

company from its subsidiaries and value each one
separately. The value of the combined firm will be
¤ Value of parent company + Proportion of value of each
subsidiary
¨ To do this right, you will need to be provided
detailed information on each subsidiary to estimate
cash flows and discount rates.

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65
Two compromise solutions…

¨ The market value solution: When the subsidiaries are

publicly traded, you could use their traded market
capitalizations to estimate the values of the cross
holdings. You do risk carrying into your valuation any
mistakes that the market may be making in valuation.
¨ The relative value solution: When there are too many
cross holdings to value separately or when there is
insufficient information provided on cross holdings, you
can convert the book values of holdings that you have on
the balance sheet (for both minority holdings and
minority interests in majority holdings) by using the
average price to book value ratio of the sector in which
the subsidiaries operate.

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66
Tata Motor’s Cross Holdings

Tata Steel, 13,572₹ Tata Chemicals, 2,431₹

Other publicly held Tata

Companies, 12,335₹

Non-public Tata companies,

112,238₹

Aswath Damodaran
67
3. Other Assets that have not been counted
yet..
¨ 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.
¨ 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 cash flows, you cannot count the market
value of the asset in your value.

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68
 An Uncounted Asset?
69

Price tag: $200 million

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69
The “real estate” play

¨ Assume that Accor Hotels, a hotel company, has real estate

investments underlying its operations. Assume that you estimate a
real estate value of $1.5 billion for the real estate. Can you add this
value on to your DCF value that you get for the hotel business?
a. Yes.
b. No.
c. Depends
¨ What would you do if the value of the land exceeds the present
value that you have estimated for them as operating assets?
a. Nothing
b. Use the higher of the two values
c. Use the lower of the two values
d. Use a weighted average of the two values

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70
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 Multiple Businesses
Holdings Simple Complex
Accounting Transparent Opaque
¨ Which firm would you value more highly?

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71
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
72
 Measuring Complexity: A Complexity Score
Item Factors Follow-up Question Answer Weighting factor Gerdau Score GE Score
Operating Income 1. Multiple Businesses Number of businesses (with more than 10% of
revenues) = 1 2.00 2 30
2. One-time income and expenses Percent of operating income = 10% 10.00 1 0.8
3. Income from unspecified sources Percent of operating income = 0% 10.00 0 1.2
4. Items in income statement that are volatilePercent of operating income = 15% 5.00 0.75 1
Tax Rate 1. Income from multiple locales Percent of revenues from non-domestic locales = 70% 3.00 2.1 1.8
2. Different tax and reporting books Yes or No No Yes=3 0 3
3. Headquarters in tax havens Yes or No No Yes=3 0 0
4. Volatile effective tax rate Yes or No Yes Yes=2 2 0
Capital Expenditures 1. Volatile capital expenditures Yes or No Yes Yes=2 2 2
2. Frequent and large acquisitions Yes or No Yes Yes=4 4 4
3. Stock payment for acquisitions and
investments Yes or No No Yes=4 0 4
Working capital 1. Unspecified current assets and current
liabilities Yes or No No Yes=3 0 0
2. Volatile working capital items Yes or No Yes Yes=2 2 2
Expected Growth rate 1. Off-balance sheet assets and liabilities
(operating leases and R&D)
Yes or No No Yes=3 0 3
2. Substantial stock buybacks Yes or No No Yes=3 0 3
3. Changing return on capital over time Is your return on capital volatile? Yes Yes=5 5 5
4. Unsustainably high return Is your firm's ROC much higher than industry average? No Yes=5 0 0
Cost of capital 1. Multiple businesses Number of businesses (more than 10% of revenues) = 1 1.00 1 20
2. Operations in emerging markets Percent of revenues= 50% 5.00 2.5 2.5
3. Is the debt market traded? Yes or No No No=2 2 0
4. Does the company have a rating? Yes or No Yes No=2 0 0
5. Does the company have off-balance sheet
debt? Yes or No No Yes=5 0 5
No-operating assets Minority holdings as percent of book assets Minority holdings as percent of book assets 0% 20.00 0 0.8
Firm to Equity value Consolidation of subsidiaries Minority interest as percent of book value of equity 63% 20.00 12.6 1.2
Per share value Shares with different voting rights Does the firm have shares with different voting rights? Yes Yes = 10 10 0
Aswath Damodaran Equity options outstanding Options outstanding as percent of shares 0% 10.00 0 73
0.25
Complexity Score = 48.95 90.55
Dealing with Complexity

¨ In Discounted Cashflow Valuation

¤ The Aggressive Analyst: Trust the firm to tell the truth and value the firm
based upon the firm’s statements about their value.
¤ The Conservative Analyst: Don’t value what you cannot see.
¤ The Compromise: Adjust the value for complexity
n Adjust cash flows for complexity
n Adjust the discount rate for complexity
n Adjust the expected growth rate/ length of growth period
n Value the firm and then discount value for complexity
¨ In relative valuation
¤ In a relative valuation, you may be able to assess the price that the market
is charging 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

Aswath Damodaran
74
 5. The Value of Synergy

Synergy is created when two firms are combined and can be

either financial or operating

Operating Synergy accrues to the combined firm as Financial Synergy

Added Debt
Strategic Advantages Economies of Scale Tax Benefits Capacity Diversification?

Higher returns on More new More sustainable Cost Savings in Lower taxes on Higher debt May reduce
new investments Investments excess returns current operations earnings due to raito and lower cost of equity
- higher cost of capital for private or
depreciaiton closely held
- operating loss firm
Higher ROC Higher Reinvestment carryforwards
Longer Growth Higher Margin
Higher Growth Higher Growth Rate Period
Rate Higher Base-
year EBIT

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75
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

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76
Inbev + SAB Miller: Where’s the synergy?

Combined
firm (status Combined firm
Inbev SABMiller quo) (synergy)
Levered Beta 0.85 0.8289 0.84641 0.84641
Pre-tax cost of debt 3.0000% 3.2000% 3.00% 3.00%
Effective tax rate 18.00% 26.36% 19.92% 19.92%
Debt to Equity Ratio 30.51% 23.18% 29.71% 29.71%

Revenues $45,762.00 $22,130.00 $67,892.00 $67,892.00

Operating Margin 32.28% 19.97% 28.27% 30.00%

Operating Income (EBIT) $14,771.97 $4,419.36 $19,191.33 $20.368

After-tax return on capital 12.10% 12.64% 11.68% 12.00%

Reinvestment Rate = 50.99% 33.29% 43.58% 50.00%
Expected Growth Rate 6.17% 4.21% 5.09% 6.00%
77
 The value of synergy

Combined firm Combined firm

Inbev SABMiller (status quo) (synergy)
Cost of Equity = 8.93% 9.37% 9.12% 9.12%
After-tax cost of debt = 2.10% 2.24% 2.10% 2.10%
Cost of capital = 7.33% 8.03% 7.51% 7.51%

After-tax return on capital = 12.10% 12.64% 11.68% 12.00%

Reinvestment Rate = 50.99% 33.29% 43.58% 50.00%

Expected growth rate= 6.17% 4.21% 5.09% 6.00%

Value of firm
PV of FCFF in high growth = $28,733 $9,806 $38,539 $39,151
Terminal value = $260,982 $58,736 $319,717 $340,175
Value of operating assets = $211,953 $50,065 $262,018 $276,610

Value of synergy = 276,610 – 262,018 = 14,592 million 78

6. Brand name, great management, superb
product …Are we short changing intangibles?

¨ There is often a temptation to add on premiums for

intangibles. Here are a few examples.
¤ Brand name
¤ Great management
¤ Loyal workforce
¤ Technological prowess

¨ There are two potential dangers:

¤ For some assets, the value may already be in your value
and adding a premium will be double counting.
¤ For other assets, the value may be ignored but
incorporating it will not be easy.
Aswath Damodaran
79
Valuing Brand Name
Coca Cola With Cott Margins
Current Revenues = $21,962.00 $21,962.00
Length of high-growth period 10 10
Reinvestment Rate = 50% 50%
Operating Margin (after-tax) 15.57% 5.28%
Sales/Capital (Turnover ratio) 1.34 1.34
Return on capital (after-tax) 20.84% 7.06%
Growth rate during period (g) = 10.42% 3.53%
Cost of Capital during period = 7.65% 7.65%
Stable Growth Period
Growth rate in steady state = 4.00% 4.00%
Return on capital = 7.65% 7.65%
Reinvestment Rate = 52.28% 52.28%
Cost of Capital = 7.65% 7.65%
Value of Firm = $79,611.25 $15,371.24

Aswath Damodaran
80
 Valuing a Franchise: Star Wars
Star Wars Franchise Valuation: December 2015

Main Movies Spin Off Movies

World Box office of $1.5 billion, World Box office is 50% of
adjusted for 2% inflation. main movies.
Add on $
per box
office $

Operating Margin
20.14% for movies
15% for non-movies
30% tax rate

Discounted back
@ 7.61% cost of
capital of
entertainment
companies Assumes that revenues from add ons
continue after 2020, growing at 2% a year,
with 15% operating margin

Aswath Damodaran
81
7. Be circumspect about defining debt for cost
of capital purposes…

¨ 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.
¨ Defined as such, debt should include
¤ All interest bearing liabilities, short term as well as long term
¤ All leases, operating as well as capital
¨ Debt should not include
¤ Accounts payable or supplier credit

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82
But should consider other potential liabilities
when getting to equity value…
¨ 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….
¨ 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
83
8. The Value of Control

¨ 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
84
 Increase Cash Flows
Reduce the cost of capital

Make your
More efficient product/service less Reduce
operations and Revenues discretionary Operating
cost cuttting: leverage
Higher Margins * Operating Margin

= EBIT Reduce beta

Divest assets that - Tax Rate * EBIT

have negative EBIT Cost of Equity * (Equity/Capital) +
= EBIT (1-t) Pre-tax Cost of Debt (1- tax rate) *
Live off past over- (Debt/Capital)
Reduce tax rate + Depreciation investment
- moving income to lower tax locales - Capital Expenditures Shift interest
- transfer pricing - Chg in Working Capital expenses to
= FCFF Match your financing
- risk management to your assets: higher tax locales
Reduce your default
risk and cost of debt
Change financing
Better inventory mix to reduce
management and cost of capital
tighter credit policies
Firm Value

Increase Expected Growth Increase length of growth period

Reinvest more in Do acquisitions

projects Build on existing Create new
Reinvestment Rate
competitive competitive
* Return on Capital advantages advantages
Increase operating Increase capital turnover ratio
margins
= Expected Growth Rate

Aswath Damodaran
 Adris Grupa (Status Quo): 4/2010
Average from 2004-09 Average from 2004-09 Stable Growth
Current Cashflow to Firm 70.83% 9.69% g = 4%; Beta = 0.80
EBIT(1-t) : 436 HRK Country Premium= 2%
- Nt CpX 3 HRK Expected Growth
Reinvestment Rate from new inv. Return on Capital Cost of capital = 9.92%
- Chg WC -118 HRK 70.83% 9.69% Tax rate = 20.00%
.7083*.0969 =0.0686
= FCFF 551 HRK ROC=9.92%;
or 6.86%
Reinv Rate = (3-118)/436= -26.35%; Reinvestment Rate=g/ROC
Tax rate = 17.35% =4/9.92= 40.32%
Return on capital = 8.72%
Terminal Value5= 365/(.0992-.04) =6170 HRK
HKR Cashflows
Op. Assets 4312 Year 1 2 3 4 5
+ Cash: 1787 EBIT (1-t) HRK 466 HRK 498 HRK 532 HRK 569 HRK 608
612
- Debt 141 - Reinvestment HRK 330 HRK 353 HRK 377 HRK 403 HRK 431
- Minority int 465 FCFF HRK 136 HRK 145 HRK 155 HRK 166 HRK 177 246
=Equity 5,484 365
/ (Common + Preferred
shares)
Value non-voting share Discount at $ Cost of Capital (WACC) = 10.7% (.974) + 5.40% (0.026) = 10.55%
335 HRK/share

On May 1, 2010
AG Pfd price = 279 HRK
Cost of Equity Cost of Debt AG Common = 345 HRK
10.70% (4.25%+ 0.5%+2%)(1-.20) Weights
= 5.40 % E = 97.4% D = 2.6%

Lambda CRP for Croatia

0.68 X (3%)
Riskfree Rate:
HRK Riskfree Rate= Beta Mature market
4.25% + 0.70 X premium +
4.5% Lambda X CRP for Central Europe
0.42 (3%)

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.68 Ratio: 2.70% Country Default Mkt Vol
Spread X
1.50
2%
Aswath Damodaran
Aswath Damodaran
Value of Control and the Value of Voting Rights

¨ Adris Grupa has two classes of shares outstanding: 9.616

million voting shares and 6.748 million non-voting shares.
¨ To value a non-voting share, we assume that all non-voting shares
essentially have to settle for status quo value. All shareholders, common
and preferred, get an equal share of the status quo value.
Status Quo Value of Equity = 5,484 million HKR
Value for a non-voting share = 5484/(9.616+6.748) = 334 HKR/share
¨ To value a voting share, we first value control in Adris Grup as
the difference between the optimal and the status quo value:
Value of control at Adris Grupa = 5,735 – 5484 = 251 million HKR
Value per voting share =334 HKR + 251/9.616 = 362 HKR

Aswath Damodaran
88
Aswath Damodaran
Value Enhancement at Twitter

¨ When Musk announced his acquisition bid for

Twitter at $54.20/share, he contended that the
company could be worth more, and that the changes
that needed to be made could be done more easily if
Twitter was a private business.
¨ One of the ideas floating around is that Twitter could
adopt a subscription model.
¤ How would adopting that model play out in Twitter’s
valuation?
¤ What argument (if any) is there for going private?

Aswath Damodaran
90
 III. The Dark Side of Valuation
Valuing difficult-to-value companies!

Aswath Damodaran
The fundamental determinants of value…

What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
Firm: Growth in operating earnings/
What are the cashflows
cashflows from When will the firm
existing assets? become a mature
- Equity: Cashflows firm, and what are
after debt payments How risky are the cash flows from both the potential
- Firm: Cashflows existing assets and growth assets? roadblocks?
before debt payments Equity: Risk in equity in the company
Firm: Risk in the firm’s operations

Aswath Damodaran
92
The Dark Side of Valuation…

¨ Valuing stable, money making companies with

consistent and clear accounting statements, a long and
stable history and lots of comparable firms is easy to do.
¨ The true test of your valuation skills is when you have to
value “difficult” companies. In particular, the challenges
are greatest when valuing:
¤ Young companies, early in the life cycle, in young businesses
¤ Companies that don’t fit the accounting mold
¤ Companies that face substantial truncation risk (default or
nationalization risk)

Aswath Damodaran
93
Difficult to value companies…

¨ Across the life cycle:

¤ Young, growth firms: Limited history, small revenues in conjunction with big operating losses
and a propensity for failure make these companies tough to value.
¤ Mature companies in transition: When mature companies change or are forced to change,
history may have to be abandoned and parameters have to be reestimated.
¤ Declining and Distressed firms: A long but irrelevant history, declining markets, high debt loads
and the likelihood of distress make them troublesome.
¨ Across sectors
¤ Financial service firms: Opacity of financial statements and difficulties in estimating basic
inputs leave us trusting managers to tell us what’s going on.
¤ Commodity and cyclical firms: Dependence of the underlying commodity prices or overall
economic growth make these valuations susceptible to macro factors.
¤ Firms with intangible assets: Accounting principles are left to the wayside on these firms.
¨ Across the ownership cycle
¤ Privately owned businesses: Exposure to firm specific risk and illiquidity bedevil valuations.
¤ Venture Capital (VC) and private equity: Different equity investors, with different perceptions
of risk.
¤ Closely held public firms: Part private and part public, sharing the troubles of both.

Aswath Damodaran
94
I. The challenge with young companies…
Figure 5.2: Estimation Issues - Young and Start-up Companies
Making judgments on revenues/ profits difficult becaue
you cannot draw on history. If you have no product/
service, it is difficult to gauge market potential or
profitability. The company's entire value lies in future
growth but you have little to base your estimate on.

Cash flows from existing

assets non-existent or What is the value added by growth
negative. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Different claims on existing assets and growth assets? roadblocks?
cash flows can
affect value of
Limited historical data on earnings, Will the firm make it through
equity at each
stage. and no market prices for securities the gauntlet of market demand
makes it difficult to assess risk. and competition? Even if it
What is the value of does, assessing when it will
equity in the firm? become mature is difficult
because there is so little to go
on.

Aswath Damodaran
95
Upping the ante.. Young companies in young
businesses…
¨ When valuing a business, we generally draw on three sources of information
¤ The firm’s current financial statement
n How much did the firm sell?
n How much did it earn?
¤ The firm’s financial history, usually summarized in its financial statements.
n How fast have the firm’s revenues and earnings grown over time?
n What can we learn about cost structure and profitability from these trends?
n Susceptibility to macro-economic factors (recessions and cyclical firms)
¤ The industry and comparable firm data
n What happens to firms as they mature? (Margins.. Revenue growth… Reinvestment
needs… Risk)
¨ It is when valuing these companies that you find yourself tempted by the dark
side, where
¤ “Paradigm shifts” happen…
¤ New metrics are invented …
¤ The story dominates and the numbers lag…

Aswath Damodaran
96
Aswath Damodaran
Lesson 1: Don’t trust regression betas….

Aswath Damodaran
98
Lesson 2: Work backwards and keep it simple…

Aswath Damodaran
99
Lesson 3: Scaling up is hard to do…

Aswath Damodaran
100
Lesson 4: Don’t forget to pay for growth…

Invested Capital in year t = Invested Capital in year t-1 +

Reinvestment in year t-1

Return on Capital in year t= EBIT (1-t) in year t/ Invested Capital

in year t-1

Aswath Damodaran
101
Lesson 5: There are always scenarios where the
market price can be justified…

Aswath Damodaran
102
Lesson 6: You will be wrong 100% of the time…
and it really is not (always) your fault…
¨ No matter how careful you are in getting your inputs and
how well structured your model is, your estimate of
value will change both as new information comes out
about the company, the business and the economy.
¨ As information comes out, you will have to adjust and
adapt your model to reflect the information. Rather than
be defensive about the resulting changes in value,
recognize that this is the essence of risk.
¨ A test: If your valuations are unbiased, you should find
yourself increasing estimated values as often as you are
decreasing values. In other words, there should be equal
doses of good and bad news affecting valuations (at least
over time).
Aswath Damodaran
103
And the market is often “more wrong”….

Amazon: Value and Price

$90.00

$80.00

$70.00

$60.00

$50.00

Value per share

$40.00 Price per share

$30.00

$20.00

$10.00

$0.00
2000 2001 2002 2003
Time of analysis

Aswath Damodaran
104
Valuing an IPO

¨ Valuation issues:
¤ Use of the proceeds from the offering: The proceeds from the offering
can be held as cash by the firm to cover future investment needs, paid
to existing equity investors who want to cash out or used to pay down
debt.
¤ Warrants/ Special deals with prior equity investors: If venture
capitalists and other equity investors from earlier iterations of fund
raising have rights to buy or sell their equity at pre-specified prices, it
can affect the value per share offered to the public.
¨ Pricing issues:
¤ Institutional set-up: Most IPOs are backed by investment banking
guarantees on the price, which can affect how they are priced.
¤ Follow-up offerings: The proportion of equity being offered at initial
offering and subsequent offering plans can affect pricing.

Aswath Damodaran
105
Aswath Damodaran
II. Dealing with decline and distress…

Historial data often Growth can be negative, as firm sheds assets and
reflects flat or declining shrinks. As less profitable assets are shed, the firm’s
revenues and falling remaining assets may improve in quality.
margins. Investments
often earn less than the What is the value added by growth
cost of capital. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Underfunded pension existing assets and growth assets? roadblocks?
obligations and
litigation claims can
lower value of equity. Depending upon the risk of the There is a real chance,
Liquidation assets being divested and the use of especially with high financial
preferences can affect the proceeds from the divestuture (to leverage, that the firm will not
value of equity pay dividends or retire debt), the risk make it. If it is expected to
in both the firm and its equity can survive as a going concern, it
What is the value of change. will be as a much smaller
equity in the firm? entity.

Aswath Damodaran
107
Dealing with the “downside” of Distress

¨ A DCF valuation values a firm as a going concern. If there is a significant

likelihood of the firm failing before it reaches stable growth and if the
assets will then be sold for a value less than the present value of the
expected cash flows (a distress sale value), DCF valuations will understate
the value of the firm.
¨ Value of Equity= DCF value of equity (1 - Probability of distress) + Distress
sale value of equity (Probability of distress)
¨ There are three ways in which we can estimate the probability of distress:
¤ Use the bond rating to estimate the cumulative probability of distress over 10 years
¤ Estimate the probability of distress with a probit
¤ Estimate the probability of distress by looking at market value of bonds..
¨ The distress sale value of equity is usually best estimated as a percent of
book value (and this value will be lower if the economy is doing badly and
there are other firms in the same business also in distress).

Aswath Damodaran
108
 Reinvestment:
Capital expenditures include cost of Stable Growth
Current Current
new casinos and working capital Stable Stable
Revenue Margin: Stable
$ 4,390 4.76% Operating ROC=10%
Extended Industry Revenue Margin: Reinvest 30%
reinvestment average Growth: 3% 17% of EBIT(1-t)
EBIT break, due ot
$ 209m investment in Expected
past Margin: Terminal Value= 758(.0743-.03)
-> 17% =$ 17,129

Term. Year
Revenues $4,434 $4,523 $5,427 $6,513 $7,815 $8,206 $8,616 $9,047 $9,499 $9,974 $10,273
Oper margin 5.81% 6.86% 7.90% 8.95% 10% 11.40% 12.80% 14.20% 15.60% 17% 17%
EBIT $258 $310 $429 $583 $782 $935 $1,103 $1,285 $1,482 $1,696 $ 1,746
Tax rate 26.0% 26.0% 26.0% 26.0% 26.0% 28.4% 30.8% 33.2% 35.6% 38.00% 38%
EBIT * (1 - t) $191 $229 $317 $431 $578 $670 $763 $858 $954 $1,051 $1,083
- Reinvestment -$19 -$11 $0 $22 $58 $67 $153 $215 $286 $350 $ 325
Value of Op Assets $ 9,793 FCFF $210 $241 $317 $410 $520 $603 $611 $644 $668 $701 $758
+ Cash & Non-op $ 3,040 1 2 3 4 5 6 7 8 9 10
= Value of Firm $12,833 Forever
- Value of Debt $ 7,565 Beta 3.14 3.14 3.14 3.14 3.14 2.75 2.36 1.97 1.59 1.20
= Value of Equity $ 5,268 Cost of equity 21.82% 21.82% 21.82% 21.82% 21.82% 19.50% 17.17% 14.85% 12.52% 10.20%
Cost of debt 9% 9% 9% 9% 9% 8.70% 8.40% 8.10% 7.80% 7.50%
Value per share $ 8.12 Debtl ratio 73.50% 73.50% 73.50% 73.50% 73.50% 68.80% 64.10% 59.40% 54.70% 50.00%
Cost of capital 9.88% 9.88% 9.88% 9.88% 9.88% 9.79% 9.50% 9.01% 8.32% 7.43%

Cost of Equity Cost of Debt Weights

21.82% 3%+6%= 9% Debt= 73.5% ->50%
9% (1-.38)=5.58%

Riskfree Rate:
T. Bond rate = 3% Risk Premium
Las Vegas Sands
Beta 6% Feburary 2009
+ 3.14-> 1.20 X Trading @ $4.25

Aswath Damodaran Casino Current Base Equity Country Risk

1.15 D/E: 277% Premium Premium
Adjusting the value of LVS for distress..
¨ Ratings based approach: In February 2009, Las Vegas Sands was rated B+, and based upon
history (previous ten years), the likelihood of default is 28.25%.
¨ Bond Price based: In February 2009, LVS was rated B+ by S&P. Historically, 28.25% of B+
rated bonds default within 10 years. LVS has a 6.375% bond, maturing in February 2015 (7
years), trading at $529. If we discount the expected cash flows on the bond at the riskfree
rate, we can back out the probability of distress from the bond price:
t =7
63.75(1− ΠDistress )t 1000(1− ΠDistress )7
529 = ∑ t +
t =1 (1.03) (1.03)7
pDistress = Annual probability of default = 13.54%
Cumulative probability of surviving 10 years = (1 - .1354)10 = 23.34%
Cumulative €probability of distress over 10 years = 1 - .2334 = .7666 or 76.66%
¨ If LVS is becomes distressed:
¤ Expected distress sale proceeds = $2,769 million < Face value of debt
¤ Expected equity value/share = $0.00
¨ Expected value per share
¨ With ratings-based approach: $8.12 (.7175) + $ 0 (.2825) = $5.83
¨ With bond-based approach: $8.12 (1 - .7666) + $0.00 (.7666) = $1.92

Aswath Damodaran
110
The “sunny” side of distress: Equity as a call
option to liquidate the firm

Net Payoff
on Equity

Face Value
of Debt

Value of firm

Aswath Damodaran
111
Application to valuation: A simple example

¨ Assume that you have a firm whose assets are

currently valued at $100 million and that the
standard deviation in this asset value is 40%.
¨ Further, assume that the face value of debt is $80
million (It is zero coupon debt with 10 years left to
maturity).
¨ If the ten-year treasury bond rate is 10%,
¤ how much is the equity worth?
¤ What should the interest rate on debt be?

Aswath Damodaran
112
Model Parameters & Valuation

¨ The inputs
¤ Value of the underlying asset = S = Value of the firm = $ 100 million
¤ Exercise price = K = Face Value of outstanding debt = $ 80 million
¤ Life of the option = t = Life of zero-coupon debt = 10 years
¤ Variance in the value of the underlying asset = s2 = Variance in firm value =
0.16
¤ Riskless rate = r = Treasury bond rate corresponding to option life = 10%
¨ The output
¤ The Black-Scholes model provides the following value for the call:
n d1 = 1.5994 N(d1) = 0.9451
n d2 = 0.3345 N(d2) = 0.6310
¤ Value of the call = 100 (0.9451) - 80 exp(-0.10)(10) (0.6310) = $75.94 million
¤ Value of the outstanding debt = $100 - $75.94 = $24.06 million
¤ Interest rate on debt = ($ 80 / $24.06)1/10 -1 = 12.77%

Aswath Damodaran
113
Firm value drops..

¨ Assume now that a catastrophe wipes out half the value of

this firm (the value drops to $ 50 million), while the face value
of the debt remains at $ 80 million.
¨ The inputs
¤ Value of the underlying asset = S = Value of the firm = $ 50 million
¤ All the other inputs remain unchanged
¨ The output
¤ Based upon these inputs, the Black-Scholes model provides the
following value for the call:
n d1 = 1.0515 N(d1) = 0.8534
n d2 = -0.2135 N(d2) = 0.4155
¤ Value of the call = 50 (0.8534) - 80 exp(-0.10)(10) (0.4155) = $30.44 million
¤ Value of the bond= $50 - $30.44 = $19.56 million

Aswath Damodaran
114
Equity value persists .. As firm value declines..

Value of Equity as Firm Value Changes

80

70

60

50
Value of Equity

40

30

20

10

0
100 90 80 70 60 50 40 30 20 10
Value of Firm ($ 80 Face Value of Debt)

Aswath Damodaran
115
Air India: Give Away or Option Value?

¨ In October 2021, the equity in Air India was sold to the

Tatas for $2.4 billion.
¨ At the time of the sale, Air India owed $3.1 billion,
negative shareholder’s equity and had racked up losses
of close to $10 billion in the years leading up to the sale.
¨ While some viewed the sale as a “give away”, there are
two questions:
¤ What was Air India’s value as a going concern?
¤ How much of the price was for its optionality?
¤ How much did sentiment play a role in the pricing?

Aswath Damodaran
116
III. Valuing Financial Service Companies
Defining capital expenditures and working capital is a
Existing assets are challenge.Growth can be strongly influenced by
usually financial regulatory limits and constraints. Both the amount of
assets or loans, often new investments and the returns on these investments
marked to market. can change with regulatory changes.
Earnings do not
provide much What is the value added by growth
information on assets?
underlying risk.
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
existing assets and growth assets? roadblocks?
Preferred stock is a
significant source of
capital. For financial service firms, debt is In addition to all the normal
raw material rather than a source of constraints, financial service
capital. It is not only tough to define firms also have to worry about
What is the value of but if defined broadly can result in maintaining capital ratios that
equity in the firm? high financial leverage, magnifying are acceptable ot regulators. If
the impact of small operating risk they do not, they can be taken
changes on equity risk. over and shut down.

Aswath Damodaran
117
Lesson 1: Debt to a bank is raw material,
not a source of capital
¨ With conventional firms, you often face a choice of
either valuing the entire business (using cash flows
to the firm and a cost of capital) or valuing equity.
Often, valuing the firm is both easier and more
robust, and you subtract out debt to get to value of
equity.
¨ With financial service firms, valuing the firm is often
a non-starter, since debt to a bank is not a source of
capital but raw material.
¨ Status Quo 1: When you value a bank, it is almost
always on an equity basis.
Aswath Damodaran
118
Lesson 2: Estimating cash flows for a bank
is difficult to do..
¨ Assuming that you want to go down the road of valuing
equity using a DCF, the standard definition of cash flows
is
¤ FCFE = Net Income + Depreciation – Cap Ex – Change in Non-
cash Working Capital
¨ Defining cap ex and working capital for a bank is close to
impossible. Consequently, most analysts give up and
make one of the two following choices:
¤ The indefensible: Discount earnings at the cost of equity, which
gives you basically nothing.
¤ The defensible: Discount dividends at the cost of equity
¨ Status Quo 2: The dividend discount model’s last stand
was with financial service companies.
Aswath Damodaran
119
Aswath Damodaran
Lesson 3: For financial service companies, book
value matters…
¨ The book value of assets and equity is mostly irrelevant when valuing
non-financial service companies. After all, the book value of equity is a
historical figure and can be nonsensical. (The book value of equity can be
negative and is so for more than a 1000 publicly traded US companies)
¨ With financial service firms, book value of equity is relevant for two
reasons:
¤ Since financial service firms mark to market, the book value is more likely to reflect
what the firms own right now (rather than a historical value)
¤ The regulatory capital ratios are based on book equity. Thus, a bank with negative
or even low book equity will be shut down by the regulators.
¨ From a valuation perspective, it therefore makes sense to pay heed to
book value. In fact, you can argue that reinvestment for a bank is the
amount that it needs to add to book equity to sustain its growth
ambitions and safety requirements:
¤ FCFE = Net Income – Reinvestment in regulatory capital (book equity)

Aswath Damodaran
121
Aswath Damodaran
IV. Valuing cyclical and commodity companies

Company growth often comes from movements in the

economic cycle, for cyclical firms, or commodity prices,
for commodity companies.

What is the value added by growth

assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Historial revenue and existing assets and growth assets? roadblocks?
earnings data are
volatile, as the
Primary risk is from the economy for For commodity companies, the
economic cycle and
commodity prices cyclical firms and from commodity fact that there are only finite
change. price movements for commodity amounts of the commodity may
companies. These risks can stay put a limit on growth forever.
dormant for long periods of apparent For cyclical firms, there is the
prosperity. peril that the next recession
may put an end to the firm.

Aswath Damodaran
123
Lesson 1: With “macro” companies, it is easy to
get lost in “macro” assumptions…
¨ With cyclical and commodity companies, it is undeniable that
the value you arrive at will be affected by your views on the
economy or the price of the commodity.
¨ Consequently, you will feel the urge to take a stand on these
macro variables and build them into your valuation. Doing so,
though, will create valuations that are jointly impacted by
your views on macro variables and your views on the
company, and it is difficult to separate the two.
¨ The best (though not easiest) thing to do is to separate your
macro views from your micro views. Use current market
based numbers for your valuation, but then provide a
separate assessment of what you think about those market
numbers.

Aswath Damodaran
124
Shell’s Revenues & Oil Prices

Shell: Revenues vs Oil Price

500,000.0 $120.00

450,000.0
$100.00
400,000.0
Revenues = 39,992.77 + 4,039.39 * Average Oil
350,000.0 Price R squared = 96.44%

Average Oil Price during year

Revenues (in millions of $)

$80.00
300,000.0

250,000.0 $60.00

200,000.0
$40.00
150,000.0

100,000.0
$20.00
50,000.0

0 $-
198919901991199219931994199519961997199819992000200120022003200420052006200720082009201020112012201320142015

Revenue Oil price

125
126 Aswath Damodaran
Lesson 2: Use probabilistic tools to assess value
as a function of macro variables…
¨ If there is a key macro variable affecting the value of your
company that you are uncertain about (and who is not), why
not quantify the uncertainty in a distribution (rather than a
single price) and use that distribution in your valuation.
¨ That is exactly what you do in a Monte Carlo simulation,
where you allow one or more variables to be distributions
and compute a distribution of values for the company.
¨ With a simulation, you get not only everything you would get
in a standard valuation (an estimated value for your
company) but you will get additional output (on the variation
in that value and the likelihood that your firm is under or over
valued)

Aswath Damodaran
127
128 Aswath Damodaran
The optionality in commodities: Undeveloped
reserves as an option

Net Payoff on
Extraction

Cost of Developing
Reserve

Value of estimated reserve

of natural resource

Aswath Damodaran
129
Implications

¨ Optionality Premium: Undeveloped reserves have option

value that will give them a premium over their DCF
value. Put simply, even non-viable reserves have value,
because commodity prices can bounce back.
¤ The option premium will be greater when commodity prices are
low, rather than when oil prices are high.
¤ The option premium will increase if commodity prices are
expected to become more volatile.
¨ Level + Variance: The value of a commodity company is
affected by both the level of oil prices, as well as the
volatility in that level. The former affects your DCF and
the latter the optionality.
Aswath Damodaran
130
V. Valuing Companies across the ownership
cycle
Reported income and balance sheet are
heavily affected by tax considerations rather
than information disclosure requirements. The
line between the personal and business
expenses is a fine one.

What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
Firm: Growth in operating earnings/
What are the
cashflows
cashflows from When will the firm
existing assets? become a mature
- Equity: Cashflows fiirm, and what are
after debt payments the potential
How risky are the cash flows from both
- Firm: Cashflows roadblocks?
existing assets and growth assets?
before debt payments
Equity: Risk in equity in the company
Firm: Risk in the firm’s operations
Reversing Many private
investment Different buyers can perceive risk businesses are finite
mistakes is differently in the same private business, life enterprises, not
difficult to do. largely because what they see as risk will expected to last into
The need for be a function of how diversified they are. perpetuity
and the cost of The fall back positions of using market
illiquidity has to prices to extract risk measures does not
be incorporated
into current

Aswath Damodaran
131
 Kristinʼs Kandy: Valuation in March 2006
Return on Capital
Current Cashflow to Firm Reinvestment Rate 13.64%
EBIT(1-t) : 300 46.67% Expected Growth
- Nt CpX 100 in EBIT (1-t) Stable Growth
- Chg WC 40 .4667*.1364= .0636 g = 4%; Beta =3.00;
= FCFF 160 6.36% ROC= 12.54%
Reinvestment Rate = 46.67% Reinvestment Rate=31.90%

Terminal Value5= 289/(.1254-.04) = 3,403

Year 1 2 3 4 5 Term Yr
Firm Value: 2,571 EBIT (1-t) $319 $339 $361 $384 $408 425
+ Cash 125 - Reinvestment $149 $158 $168 $179 $191 136
- Debt: 900 =FCFF $170 $181 $193 $205 $218 289
=Equity 1,796
- Illiq Discount 12.5%
Adj Value 1,571
Discount at Cost of Capital (WACC) = 16.26% (.70) + 3.30% (.30) = 12.37%

Cost of Debt
Cost of Equity (4.5%+1.00)(1-.40)
16.26% = 3.30% Weights
E =70% D = 30%
Synthetic rating = A-

Riskfree Rate:
Riskfree rate = 4.50% Total Beta Risk Premium
(10-year T.Bond rate) 2.94 4.00%
+ X
1/3 of risk is Adjusted for ownrer
market risk non-diversification

Market Beta: 0.98 Mature risk Country Risk

premium Premium
4% 0%
Aswath Damodaran
Unlevered Beta for Firmʼs D/E
Sectors: 0.78 Ratio: 30/70
 Private Owner versus Publicly Traded Company Perceptions of Risk in an Investment

Total Beta measures all risk

= Market Beta/ (Portion of the
total risk that is market risk)

80 units
Is exposed of firm
to all the risk specific
in the firm risk
Private owner of business
with 100% of your weatlth
invested in the business
Market Beta measures just
Demands a market risk
cost of equity
that reflects this
risk
Eliminates firm-
specific risk in
portfolio

20 units Publicly traded company

of market with investors who are diversified
risk
Demands a
cost of equity
that reflects only
market risk

Aswath Damodaran
Total Risk versus Market Risk

¨ Adjust the beta to reflect total risk rather than market risk.
This adjustment is a relatively simple one, since the R squared
of the regression measures the proportion of the risk that is
market risk.
¤ Total Beta = Market Beta / Correlation of the sector with the market
¨ To estimate the beta for Kristin Kandy, we begin with the
bottom-up unlevered beta of food processing companies:
¤ Unlevered beta for publicly traded food processing companies = 0.78
¤ Average correlation of food processing companies with market = 0.333
¤ Unlevered total beta for Kristin Kandy = 0.78/0.333 = 2.34
¤ Debt to equity ratio for Kristin Kandy = 0.3/0.7 (assumed industry
average)
¤ Total Beta = 2.34 ( 1- (1-.40)(30/70)) = 2.94
¤ Total Cost of Equity = 4.50% + 2.94 (4%) = 16.26%

Aswath Damodaran
134
Lesson 2: With financials, trust but verify..

¨ Different Accounting Standards: The accounting statements

for private firms are often based upon different accounting
standards than public firms, which operate under much
tighter constraints on what to report and when to report.
¨ Intermingling of personal and business expenses: In the case
of private firms, some personal expenses may be reported as
business expenses.
¨ Separating “Salaries” from “Dividends”: It is difficult to tell
where salaries end and dividends begin in a private firm,
since they both end up with the owner.
¨ The Key person issue: In some private businesses, with a
personal component, the cashflows may be intertwined with
the owner being part of the business.

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135
Lesson 3: Illiquidity is a clear and present
danger..
¨ In private company valuation, illiquidity is a constant
theme. All the talk, though, seems to lead to a rule of
thumb. The illiquidity discount for a private firm is
between 20-30% and does not vary across private firms.
¨ But illiquidity should vary across:
¤ Companies: Healthier and larger companies, with more liquid
assets, should have smaller discounts than money-losing smaller
businesses with more illiquid assets.
¤ Time: Liquidity is worth more when the economy is doing badly
and credit is tough to come by than when markets are booming.
¤ Buyers: Liquidity is worth more to buyers who have shorter time
horizons and greater cash needs than for longer term investors
who don’t need the cash and are willing to hold the investment.

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136
Estimating an Illiquidity Discount

1. The Bludgeon Approach: Many practitioners use a fixed illiquidity

discount, often around 25%, to reduce the values of all private
business, no matter who the buyer, what the firm looks like or
market conditions.
2. The Refined Bludgeon Approach: Start with a fixed discount, but
alter it (subjectively or numerically) to reflect business, buyer and
market conditions.
3. Illiquidity as an option: In a sense, liquidity provides the option to
an asset’s holder to sell at the prevailing market price, and not
having it therefore can be viewed as the loss of this put option.
4. The Bid Ask Spread Variant: All investments, including the most
liquid publicly traded stock, are illiquid, with the bid ask spread
(as percent of the price) representing the magnitude of the
illiquidity.

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137
And it is not just in private businesses..

¨ Assume that you are valuing a closely held company

in a lightly traded market. Will the possibility of
illiquidity affect your valuation of the company?
a. Yes
b. No
¨ If it will affect your valuation, how will it show up?
¨ If it will not affect your valuation, how would it show
up in your investment process?

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138
NARRATIVE AND NUMBERS:
VALUATION AS A BRIDGE
Work on your weak side…
Valuation = Stories + Numbers

Favored Tools Favored Tools

- Accounting statements - Anecdotes
- Excel spreadsheets - Experience (own or others)
- Statistical Measures - Behavioral evidence
- Pricing Data
A Good Valuation

The Numbers People The Narrative People

Illusions/Delusions
Illusions/Delusions 1. Creativity cannot be quantified
1. Precision: Data is precise 2. If the story is good, the investment will be.
2. Objectivity: Data has no bias 3. Experience is the best teacher
3. Control: Data can control reality

140
From Story to Numbers: The Steps

141
Step 1a: Survey the landscape

¨ Every valuation starts with a narrative, a story that

you see unfolding for your company in the future.
¨ In developing this narrative, you will be making
assessments of
¤ Your company (its products, its management and its
history.
¤ The market or markets that you see it growing in.

¤ The competition it faces and will face.

¤ The macro environment in which it operates.

142
Zomato: The Indian Online Food Delivery
Business
¨ Transaction Fees: The bulk of Zomato's revenues come from the transactions on
its platform, from food ordering and delivery, as the company keeps a percentage
of the total order value for itself. While Zomato's revenue slice varies across
restaurants, decreasing with restaurant profile and reach, it remains about 20-
25% of gross order value.
¨ Advertising: Restaurants that list on Zomato have to pay a fixed fee to get listed,
but they can also spend more on advertising, based upon customer visits and
resetting revenues, to get additional visibility.
¨ Subscriptions to Zomato Gold (Pro): Zomato also offers a subscription service, and
subscribers to Zomato Gold (now Zomato Pro) get discounts on food and faster
deliveries. The service was initiated in 2017 and it had 1.5 million plus members in
2021, delivering subscription revenues of 600 million rupees (a little less than $ 10
million, and less than 5% of overall revenues) in 2021.
¨ Restaurant Raw Material: In 2018, Zomato introduced HyperPure, a service
directed at restaurants, offering groceries and meats that are source-checked for
quality.

144
The Indian Food Delivery Market

145
Indian Market Size, adjusted for income
and digital reach…
Lower per-capita income: Eating out and prosperity don't always
go hand in hand, but you are more likely to eat out, as your
discretionary income rises..
Less digital reach: To use online restaurant services, you first need
to be online, and digital reach in India, in spite of advances in
recent years, lags digital reach in China, and is about half the
reach in the US and the EU.
Eating habits: Looking across the regions, it seems clear that there
is a third factor at play, a pre-disposition to eat out in the populace.

146
Step 1b: Create a narrative for the future

¨ Every valuation starts with a narrative, a story that

you see unfolding for your company in the future.
¨ In developing this narrative, you will be making
assessments of your company (its products, its
management), the market or markets that you see it
growing in, the competition it faces and will face and
the macro environment in which it operates.
¤ Rule 1: Keep it simple.
¤ Rule 2: Keep it focused.

147
The Uber Narrative

In June 2014, my initial narrative for Uber was that it would be

1. An urban car service business: I saw Uber primarily as a
force in urban areas and only in the car service business.
2. Which would expand the business moderately (about 40%
over ten years) by bringing in new users.
3. With local networking benefits: If Uber becomes large
enough in any city, it will quickly become larger, but that will
be of little help when it enters a new city.
4. Maintain its revenue sharing (20%) system due to strong
competitive advantages (from being a first mover).
5. And its existing low-capital business model, with drivers as
contractors and very little investment in infrastructure.

148
The Zomato Narrative

¨ Zomato will continue to maintain a dominant market

share of the Indian food delivery market, as that market
increases in size almost ten-fold over the next decade.
Zomato’s forays in foreign markets in the food delivery
business will provide only supplemental revenues and
will be less profitable than their Indian food delivery
business.
¨ Zomato may be able to expand into the grocery delivery
market, but the revenue take rate in that market will be
significantly lower than in food delivery.
¨ As Zomato scales up, economies of scale will allow the
company’s margins to converge on the high levels
earned by intermediary businesses.

149
 Step 2: Check the narrative against history,
economic first principles & common sense
150

Aswath Damodaran
150
 The Impossible, The Implausible and the
Improbable
151

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151
Uber: Possible, Plausible and Probable

152
 The Impossible: The Runaway Story
The Story The Checks (?)

+ +
+ Money
Step 3: Connect your narrative to key
drivers of value
The Uber narrative (June 2014)

Uber is an urban car service company,

competing against taxis & limos in urban areas,
but it may expand demand for car service.
Total Market The global taxi/limo business is $100 billion in
2013, growing at 6% a year.
X

Market Share Uber will have competitive advantages against

traditional car companies & against newcomers in
=
this business, but no global networking benefits.
Target market share is 10%
Revenues (Sales)

-
Uber will maintain its current model of keeping 20%
Operating Expenses of car service payments, even in the face of
competition, because of its first mover advantages. It
= will maintain its current low-infrastructure cost model,
allowing it to earn high margins.
Operating Income Target pre-tax operating margin is 40%.
-

Taxes

After-tax Operating Income Uber has a low capital intensity model, since it
does not own cars or other infrastructure,
- allowing it to maintain a high sales to capital
ratio for the sector (5.00)
Reinvestment

After-tax Cash Flow The company is young and still trying to establish
a business model, leading to a high cost of
Adjust for time value & risk capital (12%) up front. As it grows, it will become
safer and its cost of capital will drop to 8%.
Adjusted for operating risk
with a discount rate and
VALUE OF
for failure with a
OPERATING
probability of failure.
ASSETS

Uber has cash & capital, but

Cash there is a chance of failure.
10% probability of failure.

154
Zomato: Narrative to Numbers
¨ Total Market:, I find it hard to see the total market exceeding $40 billion, with US $20-$30 billion, in
ten years, being a more likely outcome. (In rupee terms, this will translate into a market that is
roughly 1800-2000 billion INR.)
¨ Market Share: Expecting any company to have a market share that exceeds 40% of this market is a
reach, and I will assume that Zomato will be one of the winners/survivors
¨ Revenue Share: That number was 23.13% in FY 2020, but dropped to 21.03% in FY 2021, as shut
downs put a crimp on business. I will assume a partial bounce back to 22% of GOV, starting in
2022, but the presence of Amazon Food will prevent a return to higher values in the future.
¨ Profitability: I will assume that pre-tax operating margins will trend towards 30%, largely because I
believe that the market will be dominated by a few big players, but with the very real possibility
that one rogue player that is unwilling to play the game can upend profitability.
¨ Reinvestment: One of the advantages of being an intermediary business is that you can grow with
relatively little capital investment, defined in conventional form (as plant, equipment or
manufacturing facilities). That said, reinvestment takes a different form for online intermediaries,
like Zomato, with investments in technology and in acquisitions, driving future growth.
¨ Risk: In terms of operating risk, the company, in spite of its global ambitions, is still primarily an
Indian company, dependent on Indian macroeconomic growth to succeed, and my rupee cost of
capital will incorporate the country risk. Zomato is a money losing company, but it is no start-up,
facing imminent failure. Overall, I will attach a likelihood of failure of 10%, reflecting this balance.

155
 Step 4: Value the company (Uber)
156

Aswath Damodaran
156
Step 5: Keep the feedback loop open

¨ When you tell a story about a company (either explicitly or

implicitly), it is natural to feel attached to that story and to defend
it against all attacks. Nothing can destroy an investor more than
hubris.
¨ Being open to other views about a company is not easy, but here
are some suggestions that may help:
¤ Talk to a diverse audience: We have created workplaces, where these single-subject specialists
often interact entirely with each other, making their isolation almost complete.
¤ Transparency over opacity: I would rather be transparently wrong than opaquely right. When I
value companies, I try to be open about process, data and mechanics, so that anyone can not
just replicate what I did and find their own points of disagreement and reflect those changes in
value.
¤ Listen to those who disagree with you: There are people out there who know more than I do
about some aspect of the company, and I can learn from them.
¤ Be willing to change: The three most freeing words in investing and valuation are “I was
wrong”, and they are not easy to say.

158
 The Uber Feedback Loop: Bill Gurley
159

1. Not just car service company.: Uber is a car company,

not just a car service company, and there may be a day
when consumers will subscribe to a Uber service,
rather than own their own cars. It could also expand
into logistics, i.e., moving and transportation
businesses.
2. Not just urban: Uber can create new demands for car
service in parts of the country where taxis are not used
(suburbia, small towns).
3. Global networking benefits: By linking with technology
and credit card companies, Uber can have global
networking benefits.

Aswath Damodaran
159
Valuing Bill Gurley’s Uber narrative

160
Feedback on Zomato

¨ Indian food delivery: I have learned more about online food delivery and
restaurants in India in the two weeks since I posted my Zomato valuation. I have
learned why Zomato Pro has not caught on as quickly as the company thought it
would, why some of you prefer Swiggy and even what you like to order from
restaurants.
¨ Tax rate: Some of you noted that the corporate tax rate in India is 25%, not 30%,
and while the Indian tax code with its predilection to add in surcharges that seem
to last forever, and exceptions, does still leave me confused, I will concede on this
point (pushing up my value per share marginally from 41 INR/share to about 43
INR/share.
¨ Market size: I have had pushback on my story’s focus on Indian food delivery, with
some pointing to the potential for Zomato to expand its market globally and
others to the expansion possibilities in Indian grocery deliveries and from cloud
kitchens. While I believe that the networking advantage that works to Zomato’s
benefits will stymie them if they try to expand to large foreign markets and that
the grocery delivery market, at least for the moment, offers too small a slice of
revenues to be a game changer for the company, those are legitimate points.

162
Plausible Stories

163
Why narratives change: Because the world
changes around you…

164
 How narratives change
165

Narrative Break/End Narrative Shift Narrative Change

(Expansion or Contraction)
Events, external (legal, Improvement or Unexpected entry/success
political or economic) or deterioration in initial in a new market or
internal (management, business model, changing unexpected exit/failure in
competitive, default), that market size, market share an existing market.
can cause the narrative to and/or profitability.
break or end.
Your valuation estimates Your valuation estimates Valuation estimates have
(cash flows, risk, growth & will have to be modified to to be redone with new
value) are no longer reflect the new data about overall market potential
operative the company. and characteristics.
Estimate a probability that Monte Carlo simulations or Real Options
it will occur & scenario analysis
consequences

Aswath Damodaran
165
 Step 6: Be ready to modify narrative as
events unfold
166

Narrative Break/End Narrative Shift Narrative Change

(Expansion or Contraction)
Events, external (legal, Improvement or Unexpected entry/success
political or economic) or deterioration in initial in a new market or
internal (management, business model, changing unexpected exit/failure in
competitive, default), that market size, market share an existing market.
can cause the narrative to and/or profitability.
break or end.
Your valuation estimates Your valuation estimates Valuation estimates have
(cash flows, risk, growth & will have to be modified to to be redone with new
value) are no longer reflect the new data about overall market potential
operative the company. and characteristics.
Estimate a probability that Monte Carlo simulations or Real Options
it will occur & scenario analysis
consequences

Aswath Damodaran
166
Valuation as a Craft
You can never master a craft… just keep
working on it..
Repeat and Retrace: The Return of
Inflation
q In my early 2021 posts on inflation, I argued that while the higher inflation that we
were just starting to see could be explained away as transitory, prudence required that
policy makes treat it as a long term threat and dealt with quickly. Not only did they not
do so, but the fiscal and monetary actions they took in 2021 exacerbated inflationary
pressures.
q By the start of 2022, the window for early action had closed and for much of this year,
inflation has been the elephant in the room, the force driving markets, forcing central
banks to be reactive, and its presence has induced me to write three posts on its
impact.
q In my first on May 6, 2022, I put the surge in inflation, in 2022, in historical context and argued that it
is unexpected inflation that shakes up the economy and caused damage to financial assets, and that
until we reached a steady state, where expectations and actual inflation converge, markets would
continue to be unsettled.
q In a follow-up post on May 20, I looked at the disparate effects of inflation on individual companies,
positing that safer companies with pricing power are more protected against inflation than riskier
companies in competitive businesses.
q In a third post on July 1, 2022, I pointed to inflation as a key culprit in the retreat of risk capital, i.e.,
capital invested in the riskiest segments of every market, and presented evidence of the impact on
risk premiums (bond default spreads and equity risk premiums) in markets. In terms of content, I am
afraid this post will contain nothing new, but the fresh uncertainties about inflation, and its impact,
that have opened up this summer require at least an updating of the numbers.

168
Inflation: Historical Perspective

169
A Market-implied Expected Inflation

170
Interest Rates in 2022

171
Risk Premiums: Default Spreads

172
Equity Risk Premiums

173
Inflation and Overall Equity Value

174
Determinants of Value

175
A Double Whammy?

¨ There are two things that stand out about equity markets in 2022.
¤ The first is the surge in the equity risk premium from from 4.24% on
January 1, 2022, to 6.05%, on September 23, 2022, an increase on par with
what we have seen during market crises (2001, 2008 and 2020) in the past.
¤ The second is that as equity risk premiums have jumped, the treasury
bond rate has more than doubled, from 1.51% on January 1, 2022, to
3.69% on September 23, 2022.
¨ In contrast to the afore-mentioned crises, where the treasury bond
rate dropped, offsetting some of the impact of the rise in equity
risk premiums, this inflation-induced market reaction has caused
the expected return on stocks to rise from 5.75% on January 1,
2022, to 9.75%, on September 23, 2022; that increase of 4% dwarfs
the increases in expected returns that we witnessed in the last
quarter of 2008 or the first quarter of 2020.

176
Buzz Words and Magic Bullets!

¨ In my four decades in corporate finance and valuation, I have seen

many "new and revolutionary" ideas emerge, marketed as the
solution to all of the problems in business decision making.
¨ Most of the time, these ideas represent either a repackaging of
existing concepts, with a healthy dose of marketing and selling,
usually by consultants and bankers, and their magic fades quickly
once their limitations come to the surface, as they inevitably do.
¨ The latest entrant in this game is ESG (Environmental, Social and
Governance), and the sales pitch is wider and deeper. Companies
that improve their social goodness standing will not only become
more profitable and valuable over time, we are told, but they will
also advance society's best interests, thus resolving one of the
fundamental conflicts of private enterprise, while also enriching
investors.

177
My S&P 500 Story

178
What if?

179
ESG and Value

180
 Aswath Damodaran

RELATIVE VALUATION (PRICING)

Aswath Damodaran
Relative valuation is pervasive…

¨ Most asset valuations are relative.

¨ Most equity valuations on Wall Street are relative valuations.
¤ Almost 85% of equity research reports are based upon a multiple and
comparables.
¤ More than 50% of all acquisition valuations are based upon multiples
¤ Rules of thumb based on multiples are not only common but are often
the basis for final valuation judgments.
¨ While there are more discounted cashflow valuations in
consulting and corporate finance, they are often relative
valuations masquerading as discounted cash flow valuations.
¤ The objective in many discounted cashflow valuations is to back into a
number that has been obtained by using a multiple.
¤ The terminal value in a significant number of discounted cashflow
valuations is estimated using a multiple.

Aswath Damodaran
182
 Why relative valuation?
183

“If you think I’m crazy, you should see the guy who
lives across the hall”
Jerry Seinfeld talking about Kramer in a Seinfeld episode

“A little inaccuracy sometimes saves tons of explanation”

H.H. Munro

“ If you are going to screw up, make sure that you have
lots of company”
Ex-portfolio manager

Aswath Damodaran
183
 Pricing versus Valuation
184

Drivers of intrinsic value

- Cashflows from existing assets Drivers of price
- Growth in cash flows - Market moods & momentum
- Quality of Growth - Surface stories about fundamentals

Accounting
Estimates THE GAP
Is there one?
INTRINSIC Price PRICE
Value If so, will it close?
VALUE
If it will close, what will
Valuation cause it to close?
Estimates

Aswath Damodaran
184
 Test 1: Are you pricing or valuing?
185

Aswath Damodaran
185
 Test 2: Are you pricing or valuing?
186

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186
 The tool for pricing: A multiple
187

Market value of equity Market value for the firm Market value of operating assets of firm
Firm value = Market value of equity Enterprise value (EV) = Market value of equity
+ Market value of debt + Market value of debt
- Cash

Numerator = What you are paying for the asset

Multiple =
Denominator = What you are getting in return

Revenues Earnings Cash flow Book Value

a. Accounting a. To Equity investors a. To Equity a. Equity
revenues - Net Income - Net Income + Depreciation = BV of equity
b. Drivers - Earnings per share - Free CF to Equity b. Firm
- # Customers b. To Firm b. To Firm = BV of debt + BV of equity
- # Subscribers - Operating income (EBIT) - EBIT + DA (EBITDA) c. Invested Capital
= # units - Free CF to Firm = BV of equity + BV of debt - Cash

Aswath Damodaran
187
The Four Steps to Deconstructing Multiples

¨ Define the multiple

¤ In use, the same multiple can be defined in different ways by different
users. When comparing and using multiples, estimated by someone else, it
is critical that we understand how the multiples have been estimated
¨ Describe the multiple
¤ Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a
multiple is, it is difficult to look at a number and pass judgment on
whether it is too high or low.
¨ Analyze the multiple
¤ It is critical that we understand the fundamentals that drive each multiple,
and the nature of the relationship between the multiple and each variable.
¨ Apply the multiple
¤ Defining the comparable universe and controlling for differences is far
more difficult in practice than it is in theory.

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188
Definitional Tests

¨ Is the multiple consistently defined?

¤ Proposition 1: Both the value (the numerator) and the
standardizing variable ( the denominator) should be to the same
claimholders in the firm. In other words, the value of equity
should be divided by equity earnings or equity book value, and
firm value should be divided by firm earnings or book value.
¨ Is the multiple uniformly estimated?
¤ The variables used in defining the multiple should be estimated
uniformly across assets in the “comparable firm” list.
¤ If earnings-based multiples are used, the accounting rules to
measure earnings should be applied consistently across assets.
The same rule applies with book-value based multiples.

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189
Example 1: Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share

¨ 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: EPS in most recent financial year
EPS in trailing 12 months (Trailing PE)
Forecasted EPS for next year (Forward PE)
Forecasted EPS in future year

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190
Example 2: Enterprise Value /EBITDA Multiple

¨ The enterprise value to EBITDA multiple is obtained by

netting cash out against debt to arrive at enterprise
value and dividing by EBITDA.

Enterprise Value Market Value of Equity + Market Value of Debt - Cash

=
EBITDA Earnings before Interest, Taxes and Depreciation

¨ Why do we net out cash from firm value?

¨ What happens if a firm has cross holdings which are
categorized as:
¤ Minority interests?
¤ Majority active interests?

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191
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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192
1. Multiples have skewed distributions…

PE ratios for US Companies in January 2022

600

500

400

300

200

100

0
<4 4-8 8-12 12-16 16-20 20-24 24-28 28-32 32-36 36-40 40-50 50-75 75-100 >100

Current PE Trailing PE Forward PE

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 2. Making statistics “dicey”
194

Current PE Trailing PE Forward PE

Total Number of firms 7082 7082 7082

Firms with PE 2948 2838 2387
Average 60.52 70.85 35.79
Median 18.49 18.28 17.56
10the Percentile 7.09 8.23 9.27
First Quartile 11.98 11.95 12.22
Third Quartile 33.08 32.35 27.74
90th Percentile 67.99 68.4 50
Maximum 9180.91 41200 8643.33

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 3. Markets have a lot in common : Comparing Global PEs
195

PE Ratios, by Geography, in January 2022

18.00%

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
<4 4-8 8-12 12-16 16-20 20-24 24-28 28-32 32-36 36-40 40-50 50-75 75-100 >100

Aus, NZ & Canada Europe Emerging Markets Japan US Global

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4. Simplistic rules almost always break down…6
times EBITDA was not cheap in the US in 2010

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 But it may be in 2022, unless you in Japan or
Russia…
197

EV to EBITDA by sub-group, by region, in January 2022

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
<2 2-4 4-6 6-8 8-10 10-12 12-16 16-20 20-25 25-30 30-35 35-40 40-45 45-50 50-75 75-100 >100

Aus, NZ & Canada Europe Emerging Markets Japan US Global

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 Fertiglobe: A Relative Valuation in
November 2022
Operating
Company Name EV/Sales Margin PBV ROE PE
Nutrien Ltd. (TSX:NTR) 1.53 27.01% 1.58 25.93% 6.10
Yara International ASA (OB:YAR) 0.61 14.71% 1.28 19.58% 6.56
Corteva, Inc. (NYSE:CTVA) 2.49 15.30% 1.63 6.67% 24.51
The Mosaic Company (NYSE:MOS) 1.18 28.17% 1.38 27.70% 4.97
CF Industries Holdings, Inc. (NYSE:CF) 2.00 50.35% 4.26 55.96% 7.61
Yunnan Yuntianhua Co., Ltd. (SHSE:600096) 0.86 12.37% 3.07 42.86% 7.15
ICL Group Ltd (TASE:ICL) 1.43 30.15% 2.13 33.05% 6.44
Israel Corporation Ltd (TASE:ILCO) 0.65 30.17% 1.50 23.43% 6.40
OCI N.V. (ENXTAM:OCI) 1.05 34.64% 3.06 43.98% 6.95
Sociedad Química y Minera de Chile S.A. 3.72 48.44% 6.68 58.93% 11.33
UPL Limited (BSE:512070) 1.42 17.01% 1.99 15.51% 12.80
FMC Corporation (NYSE:FMC) 3.21 22.42% 4.49 22.28% 20.16
ADAMA Ltd. (SZSE:000553) 0.94 7.38% 0.90 2.32% 38.73
Grupa Azoty S.A. (WSE:ATT) 0.33 13.24% 0.28 19.64% 1.43
K+S Aktiengesellschaft (XTRA:SDF) 0.91 27.50% 0.59 39.75% 1.47
Fertiglobe plc (ADX:FERTIGLB) 2.49 46.15% 5.24 56.05% 9.35
Shandong Hualu-Hengsheng Chemical Co., Ltd. 1.79 30.06% 2.26 31.73% 7.13
(SHSE:600426)
SABIC Agri-Nutrients Company 4.33 61.18% 4.59 53.52% 8.59
KG Chemical Corporation (KOSE:A001390) 0.22 9.87% 0.41 26.75% 1.54
The Scotts Miracle-Gro Company 1.47 11.07% 5.73 -63.48% NA
First Quartile 0.90 14.34% 1.35 19.63% 6.25
Median 1.42 27.25% 2.06 27.22% 7.13
Third QuartileDamodaran
Aswath 2.13 31.29% 4.32 43.14% 10.34
198
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
¨ How do changes in these fundamentals change the multiple?
¤ The relationship between a fundamental (like growth) and a multiple
(such as PE) is seldom linear. For example, if firm A has twice the
growth rate of firm B, it will generally not trade at twice its PE ratio
¤ Proposition 3: It is impossible to properly compare firms on a multiple,
if we do not know the nature of the relationship between
fundamentals and the multiple.
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 A Simple Analytical device
200

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PE Ratio: Understanding the Fundamentals

¨ To understand the fundamentals, start with a basic

equity discounted cash flow model.
¨ With the dividend discount model,
DPS1
P0 =
r − gn

¨ Dividing both sides by the current earnings per share,

P0 Payout Ratio * (1 + g n )
= PE =
EPS0 r-gn

¨ If this had been a FCFE Model,

FCFE1
P0 =
r − gn
P0 (FCFE/Earnings) * (1+ g n )
Aswath Damodaran = PE =
EPS0 r-g n 201
The Determinants of Multiples…

Value of Stock = DPS 1/(k e - g)

PE=Payout Ratio PEG=Payout ratio PBV=ROE (Payout ratio) PS= Net Margin (Payout ratio)
(1+g)/(r-g) (1+g)/g(r-g) (1+g)/(r-g) (1+g)/(r-g)

PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)

Equity Multiples

Firm Multiples

V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)

Value/FCFF=(1+g)/ Value/EBIT(1-t) = (1+g) Value/EBIT=(1+g)(1- VS= Oper Margin (1-

(WACC-g) (1- RIR)/(WACC-g) RiR)/(1-t)(WACC-g) RIR) (1+g)/(WACC-g)

Value of Firm = FCFF 1/(WACC -g)

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Application Tests

¨ Given the firm that we are valuing, what is a

“comparable” firm?
¤ While traditional analysis is built on the premise that firms in the
same sector are comparable firms, valuation theory would
suggest that a comparable firm is one which is similar to the one
being analyzed in terms of fundamentals.
¤ Proposition 4: There is no reason why a firm cannot be
compared with another firm in a very different business, if the
two firms have the same risk, growth and cash flow
characteristics.
¨ 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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An Example: Comparing PE Ratios across a
Sector: PE
Company Name PE Growth
PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zealand ADR 11.2 0.11
Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunication Organization SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Satellite Telecom Holdings ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexico ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gilat Communications 22.7 0.31
Deutsche Telekom AG ADR 24.6 0.11
British Telecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomunikasi Indonesia ADR 28.4 0.32
Cable & Wireless PLC ADR 29.8 0.14
APT Satellite Holdings ADR 31 0.33
Telefonica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Italia SPA ADR 42.2 0.14
Nippon Telegraph & Telephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Telecom ADR 71.3 0.44

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PE, Growth and Risk

¨ Dependent variable is: PE

¨ R squared = 66.2% R squared (adjusted) = 63.1%
Variable Coefficient SE t-ratio Probability
Constant 13.1151 3.471 3.78 0.0010
Growth rate 121.223 19.27 6.29 ≤ 0.0001
Emerging Market -13.853 1 3.606 -3.84 0.0009
Emerging Market is a dummy: 1 if emerging market
0 if not
¨ Is Indosat cheap?
PE = 13.13 + 121.22 (.06) -13.85 (1) = 6.55
At 7.8 times earnings, Indosat is over valued.

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Comparisons to the entire market: Why not?

¨ In contrast to the 'comparable firm' approach, the

information in the entire cross-section of firms can
be used to predict PE ratios.
¨ The simplest way of summarizing this information is
with a multiple regression, with the PE ratio as the
dependent variable, and proxies for risk, growth and
payout forming the independent variables.

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 I. PE Ratio versus the market
PE versus Expected EPS Growth: January 2022
207

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 PE Ratio: Standard Regression for US stocks -
January 2022
208

The regression is run with

growth and payout entered as
absolute, i.e., 25% is entered
as 25)

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 PE ratio regressions across markets
209

Region Regression – January 2022 R2

US PE = 33.33 – 7.11 Beta + 7.50 Payout + 49.4 gEPS 5.1%

Europe PE = 30.23 -9.06Beta + 12.60 Payout + 27.40 gEPS 9.4%

Japan PE = 18.17– 3.40 Beta + 7.40 Payout + 59.70 gEPS 12.5%

Emerging PE = 15.08 + 0.40 Beta + 2.60 Payout + 66.90 gEPS 16.7%

Markets
Australia, PE = 16.65 -5.88 Beta + 10.20 Payout + 100.20 gEPS 29.4%
NZ, Canada
Global PE = 28.52 – 5.89 Beta + 6.20 Payout + 51.30 gEPS 7.6%

gEPS=Expected Growth: Expected growth in EPS or Net Income: Next 5 years (decimals)
Beta: Regression or Bottom up Beta
Payout ratio: Dividends/ Net income from most recent year. Set to zero, if net income < 0
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Choosing Between the Multiples

¨ As presented in this section, there are dozens of multiples

that can be potentially used to value an individual firm.
¨ In addition, relative valuation can be relative to a sector (or
comparable firms) or to the entire market (using the
regressions, for instance)
¨ Since there can be only one final estimate of value, there are
three choices at this stage:
¤ Use a simple average of the valuations obtained using a number of
different multiples
¤ Use a weighted average of the valuations obtained using a nmber of
different multiples
¤ Choose one of the multiples and base your valuation on that multiple

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Picking one Multiple

¨ This is usually the best way to approach this issue. While a

range of values can be obtained from a number of multiples,
the “best estimate” value is obtained using one multiple.
¨ The multiple that is used can be chosen in one of two ways:
¤ Use the multiple that best fits your objective. Thus, if you want the
company to be undervalued, you pick the multiple that yields the
highest value.
¤ Use the multiple that has the highest R-squared in the sector when
regressed against fundamentals. Thus, if you have tried PE, PBV, PS,
etc. and run regressions of these multiples against fundamentals, use
the multiple that works best at explaining differences across firms in
that sector.
¤ Use the multiple that seems to make the most sense for that sector,
given how value is measured and created.
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Conventional usage…

Sector Multiple Used Rationale

Cyclical Manufacturing PE, Relative PE Often with normalized
earnings
Growth firms PEG ratio Big differences in growth
rates
Young growth firms w/ Revenue Multiples What choice do you have?
losses
Infrastructure EV/EBITDA Early losses, big DA
REIT P/CFE (where CFE = Net Big depreciation charges
income + Depreciation) on real estate

Financial Services Price/ Book equity Marked to market?

Retailing Revenue multiples Margins equalize sooner
or later

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A closing thought…

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