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

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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.
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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

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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

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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.

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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

¨ 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.
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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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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.

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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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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

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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

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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

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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

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Fertiglobe: Operating History

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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.

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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.

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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%.

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 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
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And across time…

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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%).
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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
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Aswath Damodaran
Aswath Damodaran
IV. Betas do not come from regressions… and
are noisy…

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 But should not be trusted, even when they
look great…
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 And subject to game playing
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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.

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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))

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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
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 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

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 But in the future..
39

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 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

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The Price of Risk: The 2008 Crisis

42
The Price of Risk: The COVID crisis

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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%

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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

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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.

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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

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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.
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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

Aswath Damodaran
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

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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

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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?

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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)

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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.

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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.

Aswath Damodaran
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.

Aswath Damodaran
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

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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.

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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

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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

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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.

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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

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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

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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

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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?

Aswath Damodaran
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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193
 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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194
 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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195
4. Simplistic rules almost always break down…6
times EBITDA was not cheap in the US in 2010

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196
 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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197
 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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199
 A Simple Analytical device
200

Aswath Damodaran
200
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 )
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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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