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1he L|tt|e 8ook of Va|uat|on

Aswath Bamouaian
Stein School of Business
44 West Fouith Stieet, 9-96
New Yoik, NY 1uu12
Email: auamouaiÇstein.nyu.euu
Phone: 212-998-uS4u

I|rst draft: Cctober 14, 2010
Knowing the value of an asset may not be a pieiequisite foi investing oi a
guaiantee foi success, but it uoes help us make moie infoimeu juugments. Foi most
investois, though, valuing an asset seems to be a task that is fai too complex anu
complicateu foi theii skill sets. Consequently, they eithei uepenu upon those that
they iegaiu as piofessionals (equity ieseaich analysts, appiaiseis) foi theii
valuations oi ignoie value entiiely when investing.
In this book, I hope to show that valuation, at its coie, is simple anu that
anyone who is willing to spenu some time collecting infoimation anu analyzing it,
can value an asset. I also hope to stiip the mystique away fiom valuation piactices
anu pioviue ways in which we can look at valuation juugments maue by analysts
anu appiaiseis anu ueciue whethei they make sense oi not.
valuation mouels, in theii full foim, aie filleu with uetails. In fact, I have
wiitten othei books foi piactitioneis who uo valuation foi a living that aie
immeiseu in these uetails. Bowevei, heie is an aumission. Not all of the uetails in a
valuation aie equally impoitant anu some mattei moie than otheis. In fact, most
valuations iest on one of two key uiiveis, though these uiiveis may vaiy fiom
company to company. If you can iuentify these value uiiveis anu estimate them with
any success, you can value a company. That is what I hope to uo in this book anu I
will leave it to you to juuge whethei I succeeu.
!"#$% '( )'*+%*+,
1he L|tt|e 8ook of Va|uat|on.........................................................................................1
I|rst draft: Cctober 14, 2010 ........................................................................................1
Þreface ........................................................................................................................2
Chapter 1: Introduct|on to Va|ue..................................................................................6
What is value...............................................................................................................................................................6
Estimating value: Intiinsic veisus Relative value.......................................................................................7
Why shoulu we caie.................................................................................................................................................7
The Accountant ........................................................................................................................................................ 1u
Some tiuths about valuation.............................................................................................................................. 11
Conclusion.................................................................................................................................................................. 16
Sect|on 1: Lay|ng the groundwork ..............................................................................17
Chapter 2: 1he 1oo|s of the trade...............................................................................18
valuation Tools: An oveiview........................................................................................................................... 18
The Time value of Noney.................................................................................................................................... 19
Risk Neasuiement .................................................................................................................................................. 2S
Accounting uata ....................................................................................................................................................... 27
Statistics ...................................................................................................................................................................... SS
Looking foi Relationships in the Bata............................................................................................................ S7
Conclusion.................................................................................................................................................................. 4u
Chapter 3: Intr|ns|c Va|ue...........................................................................................41
Biscounteu Cash flow (BCF) valuation.......................................................................................................... 41
What uo intiinsic valuation mouels tell us. ................................................................................................ 6S
Conclusion.................................................................................................................................................................. 6S
Chapter 4: ke|at|ve Va|uat|on.....................................................................................66
What is ielative valuation. ................................................................................................................................. 66
Stanuaiuizeu values anu Nultiples................................................................................................................. 68
The Foui Basic Keys to 0sing Nultiples ........................................................................................................ 69
Reconciling Relative anu Intiinsic valuations............................................................................................ 8S
Conclusion.................................................................................................................................................................. 86
Sect|on 2: Va|u|ng across the ||fe cyc|e .......................................................................87
Chapter S: Va|u|ng young growth compan|es and bus|nesses .....................................88
What is a young giowth company. ................................................................................................................. 88
Chaiacteiistics of young giowth companies............................................................................................... 89
valuation Issues....................................................................................................................................................... 9u
valuation Solutions ................................................................................................................................................ 9S
value Plays.............................................................................................................................................................. 1u8
Conclusion............................................................................................................................................................... 11u
Chapter 6: Va|u|ng growth compan|es......................................................................112
What is a giowth company. ............................................................................................................................ 112
Chaiacteiistics of giowth companies.......................................................................................................... 114
valuation Issues.................................................................................................................................................... 11S
valuation Solutions ............................................................................................................................................. 12u
value Plays.............................................................................................................................................................. 1S9
Conclusion............................................................................................................................................................... 14u
Chapter 7: Va|u|ng Mature Compan|es.....................................................................142
What is a matuie company. ............................................................................................................................ 142
Chaiacteiistics of Natuie Companies ......................................................................................................... 14S
valuation Issues.................................................................................................................................................... 14S
valuation Solutions ............................................................................................................................................. 1S1
value Plays.............................................................................................................................................................. 176
Conclusion............................................................................................................................................................... 177
Chapter 8: Va|u|ng Dec||n|ng and D|stressed Compan|es ..........................................179
What is a ueclining company. ........................................................................................................................ 179
Chaiacteiistics of Beclining Companies..................................................................................................... 18u
valuation Issues.................................................................................................................................................... 181
Relative valuation................................................................................................................................................ 18S
valuation Solutions ............................................................................................................................................. 186
value Plays.............................................................................................................................................................. 2u9
Conclusion............................................................................................................................................................... 211
Sect|on 3: Spec|a| S|tuat|ons |n Va|uat|on.................................................................213
Chapter 9: Va|u|ng I|nanc|a| Serv|ce Compan|es.......................................................214
What is a financial seivice fiim..................................................................................................................... 214
Chaiacteiistics of financial seivice fiims................................................................................................... 21S
valuation Issues.................................................................................................................................................... 217
valuation Solutions ............................................................................................................................................. 219
value Plays.............................................................................................................................................................. 2S8
Conclusion............................................................................................................................................................... 2S9
Chapter 10: Va|u|ng Cyc||ca| and Commod|ty Compan|es..........................................241
What makes commouity anu cyclical companies uiffeient. ............................................................. 241
Chaiacteiistics of commouity & cyclical fiims ........................................................................................ 242
valuation Issues.................................................................................................................................................... 24S
valuation Solutions ............................................................................................................................................. 244
value Plays.............................................................................................................................................................. 262
Conclusion............................................................................................................................................................... 264
Chapter 12: Va|u|ng compan|es w|th |ntang|b|e assets: 1echno|ogy, 8rand name and
Þatents ....................................................................................................................26S
What aie intangible assets.............................................................................................................................. 26S
Chaiacteiistics of fiims with intangible assets ....................................................................................... 266
valuation Issues.................................................................................................................................................... 267
valuation Solutions ............................................................................................................................................. 269
value Plays.............................................................................................................................................................. 296
Conclusion............................................................................................................................................................... 298
Sect|on 4: Mopp|ng up .............................................................................................299
Chapter 12: Va|uat|on Lessons .................................................................................300
Enlightening Piopositions................................................................................................................................ Suu
Conclusion............................................................................................................................................................... S11
Chapter 1: Introduct|on to Va|ue
It was 0scai Wilue who uefineu a cynic as one who "knows the piice of
eveiything anu the value of nothing". That chaiacteiization woulu fit many
investois who iegaiu investing as a game anu uefine winning as staying aheau of the
pack. In this chaptei, we will uefine value anu follow up by uiawing a uistinction
between the intiinsic anu ielative value of an asset. We will also establish a
iationale foi why estimating value is an integial pait of success foi all investois, no
mattei what theii philosophy.
What |s va|ue?
A postulate of sounu investing is that an investoi uoes not pay moie foi an
asset than it is woith. This statement may seem logical anu obvious, but it is
foigotten anu ieuiscoveieu at some time in eveiy geneiation anu in eveiy maiket.
Theie aie those who aie uisingenuous enough to aigue that value is in the eyes of
the beholuei, anu that any piice can be justifieu if theie aie othei investois willing
to pay that piice. That is patently absuiu. Peiceptions may be all that mattei when
the asset is a painting oi a sculptuie, but you uo not anu shoulu not buy most assets
foi aesthetic oi emotional ieasons; you buy financial assets foi the cash flows you
expect to ieceive fiom them. Consequently, peiceptions of value have to be backeu
up by ieality, which implies that the piice you pay foi any asset shoulu ieflect the
cashflows it is expecteu to geneiate. The mouels of valuation uesciibeu in this book
attempt to ielate value to the level of, unceitainty about anu expecteu giowth in
these cashflows.
Theie aie many aspects of valuation wheie we can agiee to uisagiee,
incluuing estimates of tiue value anu how long it will take foi piices to aujust to that
tiue value. But theie is one point on which theie can be no uisagieement. Asset
piices cannot be justifieu by meiely using the aigument that theie will be othei
investois aiounu who will pay a highei piice in the futuie. That is the equivalent of
playing a veiy expensive game of musical chaiis, wheie eveiy investoi has to
answei the question, "Wheie will I be when the music stops." befoie playing. The
pioblem with investing with the expectation that theie will be a biggei fool aiounu
to sell an asset to, when the time comes, is that you might enu up being the biggest
fool of all.
Lst|mat|ng Va|ue: Intr|ns|c versus ke|at|ve Va|ue
In intiinsic valuation, we begin with a simple pioposition. The value of an
asset is a function of the expecteu cash flows on that asset. Put simply, assets with
high anu pieuictable cash flows shoulu be woith moie than assets with low anu
volatile cash flows. In its most wiuely useu veision, the intiinsic value of an asset is
estimateu in a uiscounteu cash flow (BCF) mouel, wheie the value is set equal to the
expecteu cash flows on the asset.
While the focus in theoiy iemains on uiscounteu cash flow valuation, the
ieality is that most assets aie valueu on a ielative basis. In ielative valuation, we
value an asset by looking at how the maiket piices similai assets. Thus, when
ueteimining what to pay foi a house, we look at what similai houses in the
neighboihoou solu foi iathei than uoing an intiinsic valuation. Extenuing this
analogy to stocks, investois often ueciue whethei a stock is cheap oi expensive by
compaiing its piicing to that of similai stocks, usually in its peei gioup.
While theie aie puiists in each camp who aigue that the othei appioach is
useless, we will take the miuule giounu. While intiinsic valuation often allows us to
get a fullei sense of what uiives the value of a business oi stock, theie aie times
when ielative valuation will yielu a moie iealistic estimate of value. In geneial, theie
is no ieason to choose, since nothing stops us fiom using both appioaches on the
same investment. If investing is a game of ouus, we can impiove oui ouus
significantly by investing in stocks that aie unuei valueu not only on an intiinsic
basis but also on a ielative one.
Why shou|d we care?
Investois come to the maiket with a wiue iange of investment philosophies.
Some aie maiket timeis, while otheis believe in picking stocks. Some poie ovei
piice chaits anu classify themselves as technicians, wheieas otheis compute
financial iatios anu sweai by funuamental analysis. Some invest foi shoit-teim
piofits anu othei foi long teim gains. We believe that knowing how to value assets
is useful to all of these investois, though its place in the piocess will vaiy.
1he Market t|mer
Naiket timeis note, with some legitimacy, that the payoff to calling tuins in
maikets is much gieatei than the ietuins fiom stock picking. They aigue that it is
easiei to pieuict maiket movements than to select stocks anu that these pieuictions
can be baseu upon factois that aie obseivable. While valuation of inuiviuual stocks
may not be of much uiiect use to a maiket timei, maiket-timing stiategies can use
valuation in one of at least two ways:
(a) The oveiall maiket itself can be valueu, eithei on an intiinsic oi ielative
basis, anu compaieu to the cuiient level.
(b) valuation mouels can be useu to value a laige numbei of stocks, anu the
iesults fiom the cioss-section can be useu to ueteimine whethei the maiket
is ovei oi unuei valueu. Foi example, as the numbei of stocks that aie
oveivalueu, using the valuation mouel, incieases ielative to the numbei that
aie unueivalueu, theie may be ieason to believe that the maiket is
In effect, maiket timeis can use valuation mouels to ueteimine when to entei a
maiket (stocks, bonus, ieal estate) anu how much of theii poitfolio to allocate to an
asset class.
1he fundamenta||st
Stock pickeis believe that while timing the maiket is a fiuitless exeicise, picking
the iight stocks to invest in can geneiate piofits ovei the long teim, especially when
the choices aie baseu upon "funuamentals". The unueilying theme in "funuamental"
stock picking is that the tiue value of the fiim can be ielateu to its financial
chaiacteiistics -- its giowth piospects, its iisk piofile anu its cashflows. Any
ueviation fiom this tiue value is a sign that a stock is unuei oi oveivalueu.
Funuamental analysts can incluue both value anu giowth investois. The key
uiffeience between the two is in wheie the valuation focus lies. value investois aie
piimaiily inteiesteu in valuing a fiim's existing asset base anu acquiiing it at less
than its tiue value. uiowth investois, on the othei hanu, aie fai moie focuseu on
valuing a fiim's giowth potential anu buying these giowth assets at a uiscount.
While valuation is the cential focus in funuamental analysis, some analysts use
uiscounteu cashflow mouels to value fiims, while otheis use multiples anu
compaiable fiims.
1he chart|st
Chaitists believe that piices aie uiiven as much by investoi psychology as by
any unueilying financial vaiiables. The infoimation available fiom tiauing measuies
-- piice movements, tiauing volume, shoit sales anu othei inuicatois -- gives an
inuication of investoi psychology anu futuie piice movements. The assumptions
heie aie that piices move in pieuictable patteins anu that the aveiage investoi in
the maiket is uiiven moie by emotion than by iational analysis. While valuation
uoes not play as much of a iole in chaiting as it uoes in funuamental analysis, theie
aie ways in which an enteipiising chaitist can incoipoiate valuation views into
analysis. Foi instance, valuation can be useu to ueteimine suppoit anu iesistance
lines on piice chaits

It can be also useful in ueteimining when bubbles will buist
anu how much iisk theie is in a momentum investing stiategies.
1he |nformat|on trader
Piices move on infoimation about the fiim. Infoimation tiaueis attempt to
tiaue in auvance of new infoimation oi shoitly aftei it is ievealeu to financial
maikets. The unueilying assumption is that these tiaueis can anticipate
infoimation announcements anu gauge the maiket ieaction to them bettei than the
aveiage investoi in the maiket. Foi an infoimation tiauei, the focus is on the
ielationship between infoimation anu changes in value, iathei than on value, pei se.
Thus an infoimation tiauei may buy an 'oveivalueu' fiim if he believes that the next

0n a chait, the suppoit line usually iefeis to a lowei bounu below which piices aie unlikely to move
anu the iesistance line iefeis to the uppei bounu above which piices aie unlikely to ventuie. While
these levels aie usually estimateu using past piices, the iange of values obtaineu fiom a valuation
mouel can be useu to ueteimine these levels, i.e., the maximum value will become the iesistance level
anu the minimum value will become the suppoit line.
infoimation announcement is going to cause the piice to go up, because it contains
bettei than expecteu news. If theie is a ielationship between how unueivalueu oi
oveivalueu a company is, anu how its stock piice ieacts to new infoimation, then
valuation coulu play a iole in investing foi an infoimation tiauei.
1he corporate manager
Theie is a iole foi valuation at eveiy stage of a fiim's life cycle. Foi small
piivate businesses thinking about expanuing, valuation plays a key iole when they
appioach ventuie capital anu piivate equity investois foi moie capital. The shaie of
a fiim that a ventuie capitalist will uemanu in exchange foi a capital infusion will
uepenu upon the value she estimates foi the fiim. As the companies get laigei anu
ueciue to go public, valuations ueteimine the piices at which they aie offeieu to the
maiket in the public offeiing. 0nce establisheu, uecisions on wheie to invest, how
much to boiiow anu how much to ietuin to the owneis will be all uecisions that aie
affecteu by valuation. If the objective in coipoiate finance is to maximize fiim value
the ielationship between financial uecisions, coipoiate stiategy anu fiim value has
to be uelineateu.
1he Accountant
The most significant tienu in accounting stanuaius globally is the shift
towaius faii value accounting, wheie assets aie valueu on balance sheets at theii
faii values iathei than at theii oiiginal cost. This shift, which we view with
tiepiuation, has iequiieu accountants to hone theii valuation skills, as they aie
chaigeu with valuing bianu name, customei lists anu othei intangible assets. In
auuition, both 0S anu inteinational accounting stanuaius now iequiie that
acquisitions be followeu immeuiately by a ieassessment of the values of the assets
of the taiget company anu evaluation of goouwill "impaiiment" in futuie peiious;
the lattei task iequiies that the taiget company be ievalueu on a continuing basis,
with any uecline in value below the oiiginal puichase piice being iecoiueu as

Nost coipoiate financial theoiy is constiucteu on this piemise.
Some truths about va|uat|on
Befoie you uelve into some of the uetails of valuation, it is woith noting some tiuths
about valuation in geneial that will not only pioviue you with peispective when
looking at valuations uone by otheis but also some comfoit, when uoing youi own.
A|| va|uat|ons are b|ased
You almost nevei stait valuing a company with a blank slate. All too often,
uoui views on a company aie foimeu befoie you stait inputting the numbeis into
the mouels anu metiics that you use anu not suipiisingly, youi conclusions tenu to
ieflect youi biases. The souices of the biases can be manifolu:
a. The bias in valuation staits with the companies you choose to value. These
choices aie almost nevei ianuom, anu how you make them can stait laying
the founuation foi bias. It may be that you have ieau something in the piess
(goou oi bau) about the company oi heaiu fiom an expeit that it was unuei
oi ovei valueu. Thus, you alieauy begin with a peiception about the
company that you aie about to value. You auu to the bias when you collect
the infoimation you neeu to value the fiim. The annual iepoit anu othei
financial statements incluue not only the accounting numbeis but also
management uiscussions of peifoimance, often putting the best possible spin
on the numbeis. With many laigei companies, it is easy to access what othei
analysts following the stock think about these companies. Zacks, I¡B¡E¡S anu
Fiist Call, to name thiee seivices among many, pioviue summaiies of how
many analysts aie bullish anu beaiish about the stock. Finally, you have the
maiket's own estimate of the value of the company- the maiket piice -
auuing to the mix. valuations that stiay too fai fiom this numbei make
investois uncomfoitable.
b. Theie aie institutional factois that auu to this alieauy substantial bias. Foi
instance, it is an acknowleugeu fact that equity ieseaich analysts aie moie
likely to issue buy iathei than sell iecommenuations, i.e., that they aie moie
likely to finu fiims to be unueivalueu than oveivalueu.
This can be tiaceu
paitly to the uifficulties analysts face in obtaining access anu collecting
infoimation on fiims that they have issueu sell iecommenuations on, anu
paitly to piessuie that they face fiom poitfolio manageis, some of whom
might have laige positions in the stock, anu fiom theii own fiim's investment
banking aims which have othei piofitable ielationships with the fiims in
c. The iewaiu anu punishment stiuctuie associateu with finuing companies to
be unuei anu ovei valueu is also a contiibutoi to bias. An analyst whose
compensation is uepenuent upon whethei she finus a fiim is unuei oi ovei
valueu will be biaseu in hei conclusions. This shoulu explain why acquisition
valuations aie so often biaseu upwaius. The analysis of the ueal, which is
usually uone by the acquiiing fiim's investment bankei, who also happens to
be iesponsible foi caiiying the ueal to its successful conclusion, can come to
one of two conclusions. 0ne is to finu that the ueal is seiiously ovei piiceu
anu iecommenu iejection, in which case the analyst ieceives the eteinal
giatituue of the stockholueis of the acquiiing fiim but little else. The othei is
to finu that the ueal makes sense (no mattei what the piice) anu to ieap the
ample financial winufall fiom getting the ueal uone.
Theie aie thiee ways in which youi views on a company (anu the biases we
have) can manifest themselves in value.
a. The fiist is in the inputs that you use in the valuation. When you value
companies, you constantly come to foiks in the ioau wheie you have to
make assumptions to move on. These assumptions can be optimistic oi
pessimistic. Foi a company with high opeiating maigins now, you can
eithei assume that competition will uiive the maigins uown to inuustiy
aveiages veiy quickly (pessimistic) oi that the company will be able to
maintain its maigins foi an extenueu peiiou (optimistic). The path you

Theie aie appioximately five times as many buy iecommenuations issueu by analysts on Wall
Stieet as theie aie sell iecommenuations.
choose will ieflect oui piioi biases. It shoulu come as no suipiise then
that the enu value that you aiiive at is ieflective of the optimistic oi
pessimistic choices we maue along the way.
b. The seconu is in what we will call post-valuation gainishing, wheie
analysts ievisit assumptions aftei a valuation in an attempt to get a value
closei to what they hau expecteu to obtain staiting off. Thus, an analyst
who values a company at $ 1S pei shaie, when the maiket piice is $ 2S,
may ievise his giowth iates upwaius anu his iisk uownwaius to come up
a highei value, if she believeu that the company was unuei valueu to
begin with.
c. The thiiu is to leave the value as is but attiibute the uiffeience between
the value you estimate anu the value you think is the iight one to a
qualitative factoi such as syneigy oi stiategic consiueiations. This is a
common uevice in acquisition valuation wheie analysts aie often calleu
upon to justify the unjustifiable.
Bias cannot be iegulateu oi legislateu out of existence. Analysts aie human anu
biing theii biases to the table. As investois, what aie the lessons you can uiawn
fiom this uiscussion. If you aie valuing companies, tiy to be honest about youi own
biases; in fact, put them uown on papei, if possible, befoie you stait. In auuition,
confine youi backgiounu ieseaich on the company to infoimation souices iathei
than opinion souices; in othei woius, spenu moie time looking at a company's
financial statements than ieauing equity ieseaich iepoits about the company. If you
aie looking at someone else's valuation of a company, always consiuei the souice of
the valuation anu potential biases that may affect theii juugments. As a geneial iule,
the moie bias theie is in the piocess, the less weight you shoulu attach to the
A|| va|uat|ons are wrong, but |t |s not a|ways your fau|t
Staiting eaily in life, you aie taught that if you uo the iight things, you will get
the iight answeis. In othei woius, the piecision of the answei is useu as a measuie
of the quality of the piocess that yielueu the answei. While this may be appiopiiate
in mathematics oi physics, it is a pooi measuie of quality in valuation. Baiiing a
veiy small subset of assets, theie will always be unceitainty associateu with
valuations, anu even the best valuations come with a substantial maigin foi eiioi.
When valuing an asset at any point in time, you make foiecasts foi the futuie.
Since none of us possess ciystal balls, you have to make youi best estimates, given
the infoimation that you have at the time of the valuation. 0ui estimates of value
can be wiong foi a numbei of ieasons, anu you can categoiize these ieasons into
thiee gioups.
a. Estimation 0nceitainty: Even if oui infoimation souices aie impeccable, you have
to conveit iaw infoimation into inputs anu use these inputs in mouels. Any mistakes
that we make at eithei stage of this piocess will cause estimation eiioi.
b. Fiim-specific 0nceitainty: The path that you envision foi a fiim can piove to be
hopelessly wiong. The fiim may uo much bettei oi much woise than you expecteu it
to peifoim, anu the iesulting eainings anu cash flows will be veiy uiffeient fiom
youi estimates.
c. Nacioeconomic 0nceitainty: Even if a fiim evolves exactly the way you expecteu
it to, the macio economic enviionment can change in unpieuictable ways. Inteiest
iates can go up oi uown anu the economy can uo much bettei oi woise than
expecteu. These macio economic changes will affect value.
The contiibution of each type of unceitainty to the oveiall unceitainty associateu
with a valuation can vaiy acioss companies. When valuing a matuie cyclical oi
commouity company, it may be macioeconomic unceitainty that is the biggest
factoi causing actual numbeis to ueviate fiom expectations. valuing a young
technology company can expose you to fai moie estimation anu fiim-specific
Even if you feel comfoitable with youi estimates of an asset's values at any
point in time, that value itself will change ovei time, as a consequence of new
infoimation that comes out both about the fiim anu about the oveiall maiket.. uiven
the constant flow of infoimation into financial maikets, a valuation uone on a fiim
ages quickly, anu has to be upuateu to ieflect cuiient infoimation. Thus, technology
companies that weie valueu highly in late 1999, on the assumption that the high
giowth fiom the nineties woulu continue into the futuie, woulu have been valueu
much less in eaily 2uu1, as the piospects of futuie giowth uimmeu. With the benefit
of hinusight, the valuations of these companies (anu the analyst iecommenuations)
maue in 1999 can be ciiticizeu, but they may well have been ieasonable, given the
infoimation available at that time.
The auvantage of bieaking unceitainty uown into estimation unceitainty,
fiim-specific anu macioeconomic unceitainty is that it gives us a winuow on what
you can manage, what you can contiol anu what you shoulu just let pass thiough
into the valuation. Builuing bettei mouels anu accessing supeiioi infoimation will
ieuuce estimation unceitainty but will uo little to ieuuce exposuie to fiim-specific
oi macio-economic iisk. Even the best-constiucteu mouel will be susceptible to
these unceitainties.
More deta|| and comp|ex|ty does not a|ways resu|t |n better va|uat|ons
valuation mouels have become moie anu moie complex ovei the last two
uecaues, as a consequence of two uevelopments. 0n the one siue, computeis anu
calculatois have become fai moie poweiful anu accessible in the last few uecaues.
With technology as oui ally, tasks that woulu have taken us uays in the pie-
computei uays can be accomplisheu in minutes. 0n the othei siue, infoimation is
both moie plentiful, anu easiei to access anu use. We can uownloau uetaileu
histoiical uata on thousanus of companies anu use them as we see fit. The
complexity, though, has come at a cost.
A funuamental question that we all face when uoing valuations is how much
uetail we shoulu bieak a valuation uown into. Theie aie some who believe that
moie uetail is always bettei than less uetail anu that the iesulting valuations aie
moie piecise. We uisagiee. The tiaue off on auuing uetail is a simple one. 0n the one
hanu, moie uetail gives you a chance to use specific infoimation to make bettei
foiecasts on each inuiviuual item. 0n the othei hanu, moie uetail cieates the neeu
foi moie inputs, with the potential foi eiioi on each one, anu geneiates moie
complicateu mouels. In the physical sciences, the piinciple of paisimony uictates
that we tiy the simplest possible explanation foi a phenomenon befoie we move on
to moie complicateu ones. We woulu be well seiveu auopting a similai piinciple in
valuation. When valuing an asset, use the simplest mouel that you can get away
with. In othei woius, if you can value an asset with thiee inputs, you shoulu not be
using five. If you can value a company with S yeais of cash flow foiecasts,
foiecasting ten yeais of cash flows is asking foi tiouble.
When faceu with the question of whethei to invest in a stock, a bonu oi any
asset, you can eithei choose to make youi uecisions baseu upon the actions oi
iecommenuations of otheis that you view as moie infoimeu oi make youi own
assessment of value. Nost investois choose not to uo the lattei anu offei a vaiiety of
excuses: that valuation mouels aie too complex, that theie is insufficient
infoimation oi that theie is too much unceitainty about the futuie. While all of these
ieasons have a coie of tiuth to them, theie is no ieason why they shoulu stop you
fiom valuing assets. valuation mouels can be simplifieu, you can make uo with the
infoimation that you have (iathei than wish you hau) anu you can make youi best
estimates about an unceitain futuie. Will you be wiong. 0f couise, but so will
eveiyone else. Success in investing comes not fiom being iight but fiom being less
wiong than eveiyone else playing the game.

Sect|on 1: Lay|ng the groundwork
Chapter 2: 1he 1oo|s of the trade
Theie aie a few basic tools that shoulu be pait of eveiy valuation toolkit.
While all of these tools have common sense unueipinnings, they can take complex
foims in some analyses. In this chaptei, we will navigate oui way thiough the basics
of these tools, while steeiing away fiom the complexities that may oi may not
impiove valuations at the maigin.
Va|uat|on 1oo|s: An overv|ew
Befoie we stait looking at valuation mouels anu metiics, theie aie foui tools
that we focus on as essential foi oui puisuit:
a. Estimating time value of money: An investment geneiates cash flows ovei
many yeais anu a uollai touay is woith moie than a uollai in the futuie. Tiue,
but to conveit this common sense pioposition to value, we have to fiist
unueistanu why time has value anu then uevelop ways in which we can make
this notion specific.
b. Neasuiing iisk anu estimating expecteu ietuin: When investing, we face
unceitainty about futuie cash flows. The basic piinciple that moie iisky oi
unceitainty cash flows shoulu be woith less than less iisky cash flows is
intuitive. To put this piinciple to woik in valuation, we neeu to be cleai about
what compiises iisk, how to measuie that iisk anu how we aujust value foi
that iisk.
c. Naking sense of accounting uata: When valuing companies, much of the
infoimation that we use comes fiom financial statements. To the extent that
this uata is misieau, oui valuations will iun off couise. We look at the
questions that we woulu like accounting statements to auuiess anu how we
might be able to eke out answeis fiom the numbeis.
u. 0nueistanuing ielationships between uata: The biggest pioblem that we face
in investing touay is not that we have too little infoimation but that we have
too much. The uata is often contiauictoiy anu pulls us in uiffeient uiiections
on whethei an asset is unuei oi ovei valueu. Statistical measuies such as
stanuaiu ueviation can help us consoliuate uata anu unueistanu
1he 1|me Va|ue of Money
The simplest tools in finance aie often the most poweiful. The notion that a
uollai touay is piefeiable to a uollai some time in the futuie is intuitive enough foi
most people to giasp without the use of mouels anu mathematics. The piinciples of
piesent value enable us to calculate exactly how much a uollai some time in the
futuie is woith in touay's uollais anu to move cash flows acioss time.
Why money has t|me va|ue
Theie aie thiee ieasons why a cash flow in the futuie is woith less than a
similai cash flow touay.
1. !"#$%$#&'() +,-.-, +,-)-"/ 01")&2+/$1" /1 .&/&,- 01")&2+/$1"3 People woulu
have to be offeieu moie in the futuie to give up piesent consumption. If the
piefeience foi cuiient consumption incieases, inuiviuuals will have to be offeieu
much moie in teims of futuie consumption to give up cuiient consumption, a
tiaue-off that is captuieu by a high "ieal" iate of ietuin oi uiscount iate.
2. 45-" /5-,- $) 21"-/',6 $".('/$1"7 /5- %'(&- 1. 0&,,-"06 #-0,-')-) 1%-, /$2-3
As inflation iises, the puichasing powei of a cuiiency uecieases. To compensate,
we will value ieuuce the value that we attiibute to cash flows in the futuie.
S. 8 +,12$)-# 0')5 .(19 2$:5/ "1/ ;- #-($%-,-# .1, ' "&2;-, 1. ,-')1")< Any
unceitainty (iisk) associateu with the cash flow in the futuie ieuuces the value of
the cash flow.
The piocess by which futuie cash flows aie aujusteu to ieflect these factois is calleu
uiscounting, anu the magnituue of these factois is ieflecteu in the uiscount iate. The
uiscount iate can be vieweu as a composite of the expecteu ieal ietuin (ieflecting
consumption piefeiences in the aggiegate ovei the investing population), the
expecteu inflation iate (to captuie the ueteiioiation in the puichasing powei of the
cash flow), anu a piemium foi the unceitainty associateu with the cash flow.
now we compute t|me va|ue?
The piocess of uiscounting conveits futuie cash flows into cash flows in
touay's teims. Theie aie five types of cash flows÷simple cash flows, annuities,
giowing annuities, peipetuities, anu giowing peipetuities÷which we uiscuss next.
!"#$%& ()*+ ,%-.*
A simple cash flow is a single cash flow in a specifieu futuie time peiiou; it
can be uepicteu on a time line as in Figuie 2.1.

Biscounting a cash flow conveits it into piesent value uollais anu enables the usei
to uo seveial things. Fiist, once cash flows aie conveiteu into piesent value uollais,
they can be aggiegateu anu compaieu. Seconu, if piesent values aie estimateu
coiiectly, the usei shoulu be inuiffeient between the futuie cash flow anu the
piesent value of that cash flow. The piesent value of a cash flow can be wiitten as
Piesent value of Simple Cash Flow =
(1+Discount Rate)

Thus, the piesent value of $ 1uuu in ten yeais, with a uiscount iate of 8% can be
wiitten as:
Piesent value of $ 1uuu in ten yeais Ç 8% =
= $463.19
0thei things iemaining equal, the piesent value of a cash flow will ueciease as the
uiscount iate incieases anu the fuithei into the futuie the cash flow occuis.
An "##$%&' is a constant cash flow that occuis at iegulai inteivals foi a fixeu
peiiou of time. Befining A to be the constant cash flow, the time line foi an annuity
may be uiawn as follows:
0 8
Cash inflow: CF
Figure 2.1: Present Value of a Cash Flow
1 2 3 4 5 6 7 Year
Discounting converts future casfflow into cash flow today
| | | |
u 1 2 S 4

The value of an annuity can be calculateu by uiscounting each cash flow back to
touay anu then auuing up the piesent values. Alteinatively, an equation can be useu
in the calculation.
PV of an Annuity = Annual Cash flow
1 -
(1+Discount Rate)
No of periods
Discount Rate
To illustiate, assume again that you aie have a choice of buying a cai foi $1u,uuu
cash uown oi paying $S,uuu a yeai, at the enu of each yeai, foi five yeais foi the
same cai. If the uiscount iate is 12 peicent, which woulu you iathei uo.
PV of $3000 each year for next 5 years = $3000
1 -
= $10,814

The piesent value of the installment payments exceeus the cash-uown piice;
theiefoie, you woulu want to pay the $1u,uuu in cash now.
34-."05 /001"2"&*
A ()*+%#( "##$%&' is a cash flow that giows at a constant iate foi a specifieu
peiiou of time. If A is the cuiient cash flow, anu ( is the expecteu giowth iate, the
time line foi a giowing annuity appeais as follows:

Note that to qualify as a giowing annuity, the giowth iate in each peiiou has to be
the same as the giowth iate in the piioi peiiou. In most cases, the piesent value of a
giowing annuity can be estimateu by using the following foimula:

The piesent value of a giowing annuity can be estimateu in all cases, but one÷wheie the giowth
iate is equal to the uiscount iate. In that case, the piesent value is equal to the nominal sums of the
annuities ovei the peiiou, since the giowth effect will exactly offset the uiscounting effect.
0 1 2 3
n A(1+g)
n ...........
PV of a Growing Annuity = Cashflow(1+Growth rate)
1 -
(1+Growth rate)
(1+Discount rate)
Discount rate - Growth rate

To illustiate a giowing annuity, suppose you have the iights to a golu mine foi the
next twenty yeais, ovei which time you plan to extiact S,uuu ounces of golu eveiy
yeai. The cuiient piice pei ounce is $Suu, but it is expecteu to inciease S peicent a
yeai. The appiopiiate uiscount iate is 1u peicent. The piesent value of the golu that
will be extiacteu fiom this mine can be estimateu as follows:
PV of extracted gold = $300* 5000* (1.03)
1 -
.10 - .03
= $16,145, 980
The piesent value of the golu expecteu to be extiacteu fiom this mine is $16.146
million; it is an incieasing function of the expecteu giowth iate in golu piices.
6&4$&21"2"&* )07 34-."05 6&4$&21"2"&*
A ,-),-&$%&' is a constant cash flow at iegulai inteivals foievei. The piesent
value of a peipetuity can be wiitten as
PV of Perpetuity =
Annual Cash flow
Discount Rate

The most common example offeieu foi a peipetuity is a console bonu. A console
bonu is a bonu that has no matuiity anu pays a fixeu coupon. Assume that you have
a 6 peicent coupon console bonu. The value of this bonu, if the inteiest iate is 9
peicent, is as follows:
value of Console Bonu = $6u¡u.u9 = $667
The value of a console bonu will be equal to its face value (which is usually $1,uuu)
only if the coupon iate is equal to the inteiest iate.
A ()*+%#( ,-),-&$%&' is a cash flow that is expecteu to giow at a constant iate
foievei. The piesent value of a giowing peipetuity can be wiitten as:
PV of Growing Perpetuity =
Expected Cash flow next year
(Discount Rate - Expected growth rate in perpetuity)

Although a giowing peipetuity anu a giowing annuity shaie seveial featuies, the
fact that a giowing peipetuity lasts foievei puts constiaints on the giowth iate. It
has to be less than the uiscount iate foi this foimula to woik but an even tightei
constiaint is that it has to be lowei than the nominal giowth iate of the economy.
Consiuei a simple example. In 1992, Southwestein Bell paiu uiviuenus pei shaie of
$2.7S. Its eainings anu uiviuenus hau giown at 6 peicent a yeai between 1988 anu
1992 anu weie expecteu to giow at the same iate in the long iun. The iate of ietuin
iequiieu by investois on stocks of equivalent iisk was 12.2S peicent. With these
inputs, we can value the stock using a peipetual giowth mouel:
value of Stock = $2.7S * 1.u6¡(u.122S - u.u6) = $46.4S
As an asiue, the stock was actually tiauing at $7u pei shaie. This piice coulu be
justifieu by using a highei giowth iate (of about 8%). This giowth iate is often
iefeiieu to as an %.,/%-0 ()*+&1 )"&-.
1he 8ottom L|ne
Almost eveiy investment that we value is come combination of the five cash
flows outlineu above. Take, foi instance, a coipoiate oi goveinment bonu, wheie the
cash flows take the foim of fixeu coupons eveiy peiiou foi the life of the bonu anu
the face value of the bonu is paiu out at matuiity. This bonu can be wiitten as the
sum of the piesent values of an annuity (coupon) anu a single cash flow (face value
of bonu). Equity in a matuie company, illustiateu with the valuation of
Southwestein Bell, will offei cash flows (uiviuenus) giowing at a constant iate
foievei anu can be valueu as a giowing peipetuity. Equity in a high giowth
company, wheie cash flows aie expecteu to giow at a high iate foi a initial peiiou,
befoie subsiuing to a stable iate foievei is the sum of the piesent values of a
giowing annuity (uiviuenus uuiing high giowth) anu a giowing peipetuity
(uiviuenus afteiwaius).
k|sk Measurement
When stocks weie fiist tiaueu in the 16
anu 17
centuiy, theie was little access
to infoimation anu few ways of piocessing even that limiteu infoimation. 0nly the
veiy wealthy investeu in stocks, anu even they weie leau uown the pioveibial
gaiuen path. The iesulting scams anu scanuals of that uay aie well uesciibeu by
Chailes Nackey in his book on bubbles titleu, "The Extiaoiuinaiy Populai Belusions
anu the Nauness of Ciowus". As new investois enteieu into the financial maikets at
the stait of the twentieth centuiy, the uemanu foi iisk measuies also suigeu. In
iesponse, seivices weie alieauy staiting to collect ietuin anu piice uata on
inuiviuual secuiities anu computing basic statistics such as the expecteu ietuin anu
stanuaiu ueviation in ietuins. By 191S, seivices incluuing the Stanuaiu Statistics
Buieau (the piecuisoi to Stanuaiu anu Pooi's), Fitch anu Noouy's weie piocessing
accounting infoimation to pioviue bonu iatings as measuies of cieuit iisk in
companies. Concuiiently, theie weie othei seivices that pioviueu iisk measuies foi
inuiviuual stocks that useu a combination of accounting uata, maiket uata (stock
piice volatility) anu qualitative infoimation on the company (piouucts, management
etc.) to foim assessments of iisk.
1he Markow|tz kevo|ut|on: D|vers|f|cat|on and k|sk
Baiiy Naikowitz ievolutionizeu both how we think about iisk anu how we
measuie that iisk in the eaily 19Sus by wiestling with a conunuium as a uoctoial
stuuent in the 0niveisity of Chicago. Naikowitz noteu that if the value of a stock is
the piesent value of its expecteu uiviuenus anu an investoi weie intent on only
maximizing ietuins, he oi she woulu invest in the one stock that hau the highest
expecteu uiviuenus, a piactice that was cleaily at ouus with both piactice anu
theoiy at that time, which iecommenueu investing in uiveisifieu poitfolios. So, what
weie we missing.
Naikowitz ieasoneu that investois must uiveisify because they caie about iisk,
anu the iisk of a uiveisifieu poitfolio must theiefoie be lowei than the iisk of the
inuiviuual secuiities that went into it. Bis key insight was that the vaiiance of a
poitfolio coulu be wiitten as a function not only of how much was investeu in each
secuiity anu the vaiiances of the inuiviuual secuiities but also of the coiielation
between the secuiities. Naikowitz then went one step fuithei. If investois aie
uiveisifieu, the iisk in any inuiviuual investment (stock, bonu oi ieal asset) has to be
the iisk auueu to the uiveisifieu poitfolio. Consequently, iisks that aie specific to a
fiim (anu thus affect only that fiim) will be aveiageu out in the poitfolio. To
illustiate this concept, consiuei the vaiiety of iisks that any mouein business is
exposeu to in figuie 2.2:
2%($)- 3435 6)-"7%#( 0*+# )%878 %# " 9*.,"#'

At one extieme, theie aie some iisks that affect only the fiim wheieas at the othei,
theie aie iisks that affect all oi most fiims at the same time. When you invest all
youi money in one stock, you aie exposeu to all of these iisks. When you spieau
youi money out acioss many stocks, the iisks that affect one oi a few fiims will get
aveiageu out in youi poitfolio: foi eveiy company, wheie something woise than
expecteu happens on a pioject, theie will be anothei company, wheie something
bettei than expecteu will happen. Risk that affects many oi most fiims cannot be
uiveisifieu away. In the Naikowitz woilu, this is the only iisk that you shoulu
consiuei, as an investoi in a publicly tiaueu company.
I|nance enters the m|x: k|sk and keturn Mode|s
If we accept the Naikowtiz pioposition that the only iisk that we caie about
in an investment is the iisk that you cannot uiveisify away, the question then
becomes one of measuiement. Bow uo you measuie this non-uiveisifiable iisk. This
is wheie uiffeient mouels pait ways.
Actions/Risk that
affect only one
Actions/Risk that
affect all investments
Firm-specific Market
Projects may
do better or
worse than
may be stronger
or weaker than
Entire Sector
may be affected
by action
Exchange rate
and Political
Interest rate,
Inflation &
news about
Affects few
Affects many
These risks will decrease or
disappear as your diversify
These risks cannot be
diversified away because all
investments are affected
The most wiuely useu anu ciitiqueu mouel in piactice is the capital asset piicing
mouel oi the CAPN. In this mouel, we assume that investois face no tiansactions
costs anu have no way of sepaiating goou investments fiom bau ones. Consequently,
they enu up holuing supiemely uiveisifieu composeu of all tiaueu assets (calleu the
maiket poitfolio). The iisk of any asset then becomes the iisk auueu to this "maiket
poitfolio" anu that is what a beta measuies. The beta has the useful piopeity of
being stanuaiuizeu aiounu one; a stock with a beta above one is above aveiage iisk
anu one with a beta below one is below aveiage. The expecteu ietuin on the
investment can then be wiitten as:
Expecteu ietuin = Risk fiee iate + Beta (Risk piemium foi an aveiage iisk
In the yeais since the intiouuction of the CAPN, two classes of mouels have
uevelopeu as alteinatives:
a. Nulti beta mouels: Foi the most pait, though, these mouels (the aibitiage piicing
mouel anu the multi factoi mouel) expanu on the basic theme of the CAPN anu
measuie the iisk auueu by an investment to a uiveisifieu poitfolio, with multiple
betas (iathei than the single beta) measuiing exposuie to uiffeient types of
maiket iisk.
b. Pioxy mouels: In pioxy mouels, we look at the chaiacteiistics of companies that
have histoiically geneiateu high ietuins foi stockholueis anu use them as iisk
measuies. 0ne of the eailiest stuuies in this vein, foi instance, founu that small
maiket capitalization companies anu companies that tiaueu at low maiket
values, ielative to accounting book values, geneiateu highei ietuins than laige
maiket capitalization companies anu companies that tiaue at high maiket
values, ielative to book value.
Theie aie many piactitioneis anu some acauemics who aigue that all iisk anu
ietuin mouels in finance aie flaweu, eithei because of uniealistic assumptions maue
to aiiive at the mouels oi because the paiameteis foi these mouels cannot be
estimateu piecisely.
8ottom L|ne
We agiee with ciitics of conventional iisk anu ietuin mouels that these mouels
aie flaweu, but we shoulu also be able to agiee on coie piopositions about iisk:
1. Risk matteis: We can take issue with whethei beta is a goou measuie of iisk but
theie shoulu be no uebate that "iiskiei" investments neeu to eain highei ietuins,
to pass mustei, than safei investments.
2. Not all investments aie equally iisky: Some investments aie iiskiei than otheis.
0ne of the auvantages of beta is that it pioviues a measuie of ielative iisk, but
even in its absence, we neeu a measuie of ielative iisk in an investment. That
measuie of ielative iisk can be obtaineu by looking at stock piices (like betas),
eainings vaiiability oi even be subjective.
S. The piice of iisk matteis: Investois set piices foi taking iisk, in both equity anu
bonu maikets anu these piices vaiy acioss time. In goou times, piices tenu to
uiift uown anu in bau times, they tenu to uiift up. Boluing the iisk fiee iate anu
ielative iisk (beta) constant, we shoulu expect to see iequiieu ietuins move
Thus, whatevei oui views on the efficacy oi otheiwise of conventional iisk anu
ietuin mouels, we have to uevise ways in which we captuie all thiee factois in oui
iequiieu ietuins.
Account|ng data
Financial statements pioviue the funuamental infoimation that we use to
analyze anu answei valuation questions. Theiefoie, it is impoitant that we
unueistanu the piinciples goveining these statements by looking at thiee questions:
• Bow valuable aie the assets of a fiim.
• Bow uiu the fiim iaise the funus to finance these assets. In paiticulai, how much
of the funuing came fiom owneis' funus (equity) oi boiioweu money (uebt).
• Bow piofitable aie these assets.
As accounting stanuaius have evolveu ovei time, often in iesponse to accounting
scanuals, financial statements have become moie complicateu. Iionically, it has
become moie uifficult to use these statement to answei these questions, iathei than
less uifficult.
1he 8as|c Account|ng Statements
Theie aie thiee basic accounting statements that summaiize infoimation
about a fiim. The fiist is the :"/"#9- 81--&, shown in Figuie 2.S, which summaiizes
the assets owneu by a fiim, the value of these assets, anu the mix of financing, uebt,
anu equity useu to finance these assets at a point in time.

The %#9*.- 8&"&-.-#&, shown in Figuie 2.4, pioviues infoimation on ievenues anu
expenses of the fiim anu the iesulting income maue uuiing a peiiou.

Assets Liabilities
Fixed Assets
Short-term liabilities of the firm
Intangible Assets
Long Lived Real Assets
Assets which are not physical,
like patents & trademarks
Current Assets
Financial Investments Investments in securities &
assets of other firms
Short-lived Assets
Equity investment in firm
Debt obligations of firm
Other long-term obligations
Figure 2.3: The Balance Sheet
Figure 2.4: Income Statement
Gross revenues from sale
of products or services
- Operating Expenses
Expenses associates with
generating revenues
= Operating Income Operating income for the
- Financial Expenses Expenses associated with
borrowing and other financing
- Taxes Taxes due on taxable income
= Net Income before extraordinary items
Earnings to Common &
Preferred Equity for
Current Period
- (+) Extraordinary Losses (Profits) Profits and Losses not
associated with operations
- Income Changes Associated with Accounting Changes Profits or losses associated
with changes in accounting
- Preferred Dividends Dividends paid to preferred
= Net Income to Common Stockholders
The 8&"&-.-#& *; 9"81 ;/*+8, shown in Figuie 2.S, specifies the souices anu uses of
cash of the fiim fiom opeiating, investing, anu financing activities uuiing a peiiou.

The statement of cash flows can be vieweu as an attempt to list the cash flows
uuiing a peiiou anu explain why the cash balance changeu uuiing the peiiou.
Assets Cwned: Measures of asset va|ue
The accounting view of asset value is to a gieat extent giounueu in the notion
of 1%8&*)%9"/ 9*8&, which is the oiiginal cost of the asset, aujusteu upwaiu foi
impiovements maue to the asset since puichase anu uownwaiu foi loss in value
associateu with the aging of the asset. This histoiical cost is calleu the :**7 <"/$-. To
examine how asset value is measuieu on a balance sheet, let us begin with the way
assets aie categoiizeu in the balance sheet.
• Fiist, theie aie the ;%=-0 "88-&8, which incluue the long-teim assets of the fiim,
such as plant, equipment, lanu, anu builuings. ueneially accepteu accounting
piinciples (uAAP) in the 0niteu States iequiie the valuation of fixeu assets at
histoiical cost, aujusteu foi any estimateu gain anu loss in value fiom
impiovements anu the aging, iespectively, of these assets. Although in theoiy the
aujustments foi aging shoulu ieflect the loss of eaining powei of the asset as it
ages, in piactice they aie much moie a piouuct of accounting iules anu
convention, anu these aujustments aie calleu 0-,)-9%"&%*#.
• Next, we have the shoit-teim assets of the fiim, incluuing inventoiy (such as iaw
mateiials, woiks in piogiess, anu finisheu goous), ieceivables (summaiizing
Cash Flows From Operations
+ Cash Flows From Investing
+ Cash Flows from Financing
Net cash flow from operations,
after taxes and interest expenses
Includes divestiture and acquisition
of real assets (capital expenditures)
and disposal and purchase of
financial assets. Also include
acquisition of other firms.
Net cash flow from the issue and
repurchase of equity, from the
issue and repayment of debt and after
dividend payments
= Net Change in Cash Balance
Figure .2.5: Statement of Cash Flows
moneys oweu to the fiim), anu cash; these aie categoiizeu as 9$))-#& "88-&84 It is
in this categoiy accountants aie most amenable to the use of maiket value.
• In the categoiy of %#<-8&.-#&8 "#0 .")7-&":/- 8-9$)%&%-8, accountants consiuei
investments maue by fiims in the secuiities oi assets of othei fiims anu othei
maiketable secuiities. The way these assets aie valueu uepenus on the way the
investment is categoiizeu anu the motive behinu the investment. If the
investment is vieweu as a tiauing investment, as is the case with financial
investments, the value is maikeu to maiket. If the investment is vieweu as a
stiategic anu long-teim investment, the investment is usually iecoiueu at what
was oiiginally paiu foi the asset, with aujustments. In the special case, wheie the
holuings compiise moie than Su% of the value of a subsiuiaiy, the fiim has to
consoliuate, i.e., iecoiu all of the subsiuiaiy's assets anu liabilities on its balance
sheet, with a "minoiity inteiest" item captuiing the peicentage of the subsiuiaiy
that uoes not belong to it.
• Finally, we have what is loosely categoiizeu as %#&"#(%:/- "88-&8. While we woulu
noimally consiuei assets such as bianu names, customei loyalty anu a well-
tiaineu woik foice as intangible assets, the most commonly encounteieu
intangible asset in accounting is goouwill. When a fiim acquiies anothei fiim, the
puichase piice is fiist allocateu to the existing assets of the acquiieu fiim. Any
excess paiu becomes goouwill anu is iecoiueu as an asset. This goouwill has to
be wiitten off, if the accountants ueem it to be impaiieu, i.e., if they ueteimine
that the value of the taiget company has uioppeu since the acquisition.

Iunds ka|sed: Measures of I|nanc|ng M|x
}ust as with the measuiement of asset value, the accounting categoiization of
liabilities anu equity is goveineu by a set of faiily iigiu piinciples. Accountants
categoiize liabilities into cuiient liabilities, long-teim uebt, anu long-teim liabilities

Toi make this juugment, accountants have to value the acquiieu company at iegulai inteivals anu
compaie the value that they get to the piice paiu. If the value is substnatilaly lowei than the piice, the
company has to wiite off an equivalent poition of the goouwill.
that aie neithei uebt noi equity; the last categoiy incluues leases, unueifunueu
pension anu health caie obligations anu uefeiieu taxes.
• >$))-#& /%":%/%&%-8 incluue all obligations that the fiim has coming uue in the next
accounting peiiou. These geneially incluue accounts payable (iepiesenting
cieuit ieceiveu fiom supplieis anu othei venuois to the fiim), shoit teim
boiiowing (iepiesenting shoit-teim loans taken to finance the opeiations oi
cuiient asset neeus of the business) anu the shoit-teim poition of long-teim
boiiowing (iepiesenting the poition of the long-teim uebt oi bonus that is
coming uue in the next yeai). As with cuiient assets, these items aie usually
iecoiueu at close to theii cuiient maiket value.
• ?*#(@&-). 0-:& foi fiims can take one of two foims: long-teim loans fiom banks
oi othei financial institutions, oi long-teim bonus issueu to financial maikets.
These aie geneially iecoiueu at the face value at the time of issue anu aie
geneially not maikeu to maiket.
• In " ,-#8%*# ,/"#, the fiim agiees to pioviue ceitain benefits to its employees,
eithei by specifying a "uefineu contiibution" (wheiein a fixeu contiibution is
maue to the plan each yeai by the employei, without any piomises as to the
benefits to be ueliveieu in the plan) oi a "uefineu benefit" (wheiein the
employei piomises to pay a ceitain benefit to the employee). In the lattei case,
the employei has to put sufficient money into the plan each peiiou to meet the
uefineu benefits. A pension funu whose assets exceeu its liabilities is an
oveifunueu plan, wheieas one whose assets aie less than its liabilities is an
unueifunueu plan, anu uisclosuies to that effect have to be incluueu in financial
statements, geneially in the footnotes.
• Fiims often use uiffeient methous of accounting foi tax anu financial iepoiting
puiposes, leauing to a question of how tax liabilities shoulu be iepoiteu. Because
acceleiateu uepieciation anu favoiable inventoiy valuation methous foi tax
accounting puiposes leau to a uefeiial of taxes, the same piinciples of matching
expenses to income that unueilie acciual accounting iequiie that the 0-;-))-0
%#9*.- &"= be iecognizeu in the financial statements, as a liability (if the fiim
unueipaiu taxes) oi as an asset (if the fiim oveipaiu taxes).
The accounting measuie of equity is a histoiical cost measuie. The value of equity
shown on the balance sheet ieflects the oiiginal pioceeus ieceiveu by the fiim when
it issueu the equity, augmenteu by any eainings maue since then (oi ieuuceu by
losses, if any) anu ieuuceu by any uiviuenus paiu out uuiing the peiiou. A sustaineu
peiiou of negative eainings can make the book value of equity negative.
A I|nanc|a| 8a|ance Sheet
An accounting balance sheet is useful because it pioviues us with
infoimation about a fiim's histoiy of investing anu iaising capital. Bowevei, it is
focuseu on the past. To pioviue a moie foiwaiu-looking pictuie, consiuei an
alteinative, the financial balance sheet, illustiateu in figuie 2.6:
2%($)- 34A5 B 2%#"#9%"/ 6"/"#9- C1--&

While a financial balance sheet beais a supeificial iesemblance to the accounting
balance sheet, it uiffeis on two impoitant counts. The fiist is in the classification of
assets. Rathei than classify assets baseu on asset life oi tangibility, it categoiizes
them into investments alieauy maue by the company (assets in place) anu
investments that you expect the company to make in the futuie (giowth assets). The
seconu is that the values ieflect not what has alieauy been investeu in these assets,
but theii cuiient values, baseu upon expectations foi the futuie. In fact, the entiie
value of giowth assets iests on peiceptions anu expectations. Since the assets aie
iecoiueu at cuiient value, the uebt anu equity values also ieflect that choice. Thus,
the value of equity in a financial balance sheet is an estimate of what the value of the
equity in the fiim is touay anu is uiiectly compaiable to the maiket value.
Assets Liabilities
Assets in Place Debt
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
Growth Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
capital) assets
Expected Value that will be
created by future investments
It shoulu be noteu heie that both 0S anu inteinational accounting stanuaius
aie pushing towaius "faii value" accounting. Put simply, this woulu leau to all assets
being ievalueu at each yeai anu iecoiueu at that value on the balance sheet, iathei
than at oiiginal cost. While this will push accounting balance sheets towaius
financial balance sheets, they will not conveige, since it is unlikely that giowth
assets will evei finu theii iightful place in an accounting balance sheet, even in faii
value teims.
Þrof|tab|||ty: Measures of Larn|ngs
How profitable is a firm? What did it earn on the assets in which it invested?
Two primary principles underlie the measurement of accounting earnings and
profitability. The first is the principle of accrual accounting. In accrual accounting, the
revenue from selling a good or service is recognized in the period in which the good is
sold or the service is performed (in whole or substantially). A corresponding effort is
made on the expense side to match expenses to revenues.
This is in contrast to cash
accounting, wherein revenues are recognized when payment is received and expenses are
recorded when they are paid. Accounting principles require publicly traded companies to
use accrual accounting to record earnings from continuing operations. The second
principle is the categorization of expenses into operating, financing, and capital expenses.
Operating expenses are expenses that at least in theory provide benefits only for the
current period; the cost of labor and materials expended to create products that are sold in
the current period is a good example. Financing expenses are expenses arising from the
non-equity financing used to raise capital for the business; the most common example is
interest expenses. Capital expenses are expected to generate benefits over multiple
periods; for instance, the cost of buying land and buildings is treated as a capital expense.
Nuch of financial analysis is built aiounu the expecteu futuie eainings of a
fiim, anu many of these foiecasts stait with the cuiient eainings. It is theiefoie
impoitant that we know how much of these eainings come fiom the ongoing
opeiations of the fiim anu how much can be attiibuteu to unusual oi extiaoiuinaiy

If a cost (such as an auministiative cost) cannot be easily linkeu with a paiticulai ievenues, it is
usually iecognizeu as an expense in the peiiou in which it is consumeu.
events that aie unlikely to iecui on a iegulai basis. Consequently, accounting
piinciples iequiie that income statements be classifieu into foui sections: income
fiom continuing opeiations, income fiom uiscontinueu opeiations, extiaoiuinaiy
gains oi losses, anu aujustments foi changes in accounting piinciples.
Although the income statement allows us to estimate how piofitable a fiim is
in absolute teims, it is just as impoitant that we gauge the piofitability of the fiim in
compaiison teims oi peicentage ietuins. The simplest anu most useful gauge of
piofitability is ielative to the capital employeu to get a iate of ietuin on investment.
To measuie the oveiall piofitability of a fiim, we can look at the magnituue of
opeiating income ielative to the capital investeu in the fiim, wheie capital is uefineu
as the sum of the book value (Bv) of uebt anu equity, net of cash anu maiketable
secuiities. This is the )-&$)# *# 9",%&"/ (R0C) oi ietuin on investeu capital (R0IC).
After - Tax ROC =
Operating income 1- tax rate ( )
BV of Debt + BV of Equity - Cash

Pre - Tax ROC =
Operating Income
BV of Debt + BV of Equity - Cash

We can also measuie oveiall piofitability ielative to ievenues geneiateu anu the
efficiency of the fiim in using existing capital investeu, anu wiite the ietuin on
capital as a function of the two:
Pre - Tax Operating Margin =
Operating Income
Revenues or Sales

Capital Turnover Ratio =
BV of Debt + BV of Equity - Cash

Pre - Tax ROC = Pre "tax Operating Margin * Capital Turnover Ratio

The ietuin on capital vaiies wiuely acioss fiims in uiffeient businesses, laigely as a
consequence of uiffeiences in piofit maigins anu capital tuinovei iatios.
Although R0C measuies the piofitability of the oveiall fiim, the )-&$)# *#
-D$%&' (R0E) examines piofitability fiom the peispective of the equity investoi by
ielating piofits to the equity investoi (net piofit aftei taxes anu inteiest expenses)
to the book value of the equity investment.
Equity Common of Value Book
Income Net
Because piefeiieu stockholueis have a uiffeient type of claim on the fiim than
common stockholueis, the net income shoulu be estimateu aftei piefeiieu
uiviuenus, anu the book value of common equity shoulu not incluue the book value
of piefeiieu stock.
1he bottom ||ne
While the value of a business is ultimately ueteimineu by expectations about
the futuie, accounting statements pioviue the basis foi these foiecasts. Put anothei
way, to estimate futuie ievenues anu eainings, we have to begin with cuiient
eainings anu ievenues, anu to make sense of cuiient eainings, we have to
unueistanu how accountants measuie eainings. Fuitheimoie, the measuies of
ietuin that we obtain foi a fiim aie cential inputs in ueteimining its value.
The pioblem that we face in financial analysis touay is not having too little
infoimation but too much. Naking sense of laige anu often contiauictoiy
infoimation is pait of what we aie calleu on to uo when analyzing companies. Basic
statistics can make this job easiei. In this appenuix, we consiuei the most
funuamental tools available in uata analysis.
Summar|z|ng Data
Laige amounts of uata aie often compiesseu into moie easily assimilateu
summaiies, which pioviue the usei with a sense of the content, without
oveiwhelming him oi hei with too many numbeis. Theie a numbei of ways uata can
be piesenteu. We will consiuei two heie÷one is to piesent the uata in a
uistiibution, anu the othei is to pioviue summaiy statistics that captuie key aspects
of the uata.
When piesenteu with thousanus of pieces of infoimation, you can bieak the
numbeis uown into inuiviuual values (oi ianges of values) anu inuicate the numbei
of inuiviuual uata items that take on each value oi iange of values. This is calleu a
;)-D$-#9' 0%8&)%:$&%*#. If the uata can only take on specific values, as is the case
when we iecoiu the numbei of goals scoieu in a soccei game, you get a 0%89)-&-
0%8&)%:$&%*#. When the uata can take on any value within the iange, as is the case
with income oi maiket capitalization, it is calleu a 9*#&%#$*$8 0%8&)%:$&%*#.
The auvantages of piesenting the uata in a uistiibution aie twofolu. Foi one
thing, you can summaiize even the laigest uata sets into one uistiibution anu get a
measuie of what values occui most fiequently anu the iange of high anu low values.
The seconu is that the uistiibution can iesemble one of the many common ones
about which we know a gieat ueal in statistics. Consiuei, foi instance, the
uistiibution that we tenu to uiaw on the most in analysis: the noimal uistiibution,
illustiateu in Figuie 2.7.

A noimal uistiibution is symmetiic, has a peak centeieu aiounu the miuule of the
uistiibution, anu tails that aie not fat anu stietch to incluue infinite positive oi
negative values. Not all uistiibutions aie symmetiic, though. Some aie weighteu
towaius extieme positive values anu aie positively skeweu, anu some towaius
extieme negative values anu aie negatively skeweu. Figuie 2.8 illustiates positively
anu negatively skeweu uistiibutions.
Figure 2.7: Normal Distribution

The simplest way to measuie the key chaiacteiistics of a uata set is to estimate
the summaiy statistics foi the uata. Foi any uata seiies, the most wiuely useu
summaiy statistics aie as follows:
- The mean is the simple aveiage of the uata points in a sample.
- The meuian is the miupoint of the seiies; half the uata in the seiies is highei than
the meuian anu half is lowei.
- The vaiiance measuies how fai inuiviuual obseivations fall fiom the aveiage
anu the stanuaiu ueviation is the squaie ioot of the vaiiance.
The mean anu the stanuaiu ueviation aie the calleu the fiist two moments of any
uata uistiibution.
Look|ng for ke|at|onsh|ps |n the Data
When theie aie two seiies of uata, theie aie a numbei of statistical measuies
that can be useu to captuie how the seiies move togethei ovei time. A positive
9*))-/"&%*# between two vaiiables inuicates that the vaiiables move togethei anu a
negative sign that they move in opposite uiiections. The coiielation can nevei be
gieatei than one oi less than negative one; the closei the value is to one, the
stiongei the coiielation. A coiielation close to zeio inuicates that the two vaiiables
aie unielateu. Two vaiiables that aie peifectly positively coiielateu essentially
Figure 2.8: Skewed Distributions
Negatively skewed
Positively skewed
move in peifect piopoition in the same uiiection, wheieas two vaiiables that aie
peifectly negatively coiielateu move in peifect piopoition in opposite uiiections.
The covaiiance is a closely ielateu measuie to coiielation, measuiing how much
two vaiiables move togethei but is not stanuaiuizeu (to fall between -1 anu +1).
A 8%.,/- )-()-88%*# is an extension of the coiielation¡covaiiance concept. It
attempts to explain one vaiiable, the uepenuent vaiiable, using the othei vaiiable,
the inuepenuent vaiiable. Keeping with statistical tiauition, let E be the uepenuent
vaiiable anu F be the inuepenuent vaiiable. If the two vaiiables aie plotteu against
each othei with each paii of obseivations iepiesenting a point on the giaph, you
have a 89"&&-),/*&, with E on the veitical axis anu F on the hoiizontal axis. Figuie 2.9
illustiates a scattei plot.
2%($)- 34G5 C9"&&-) H/*& *; E <-)8$8 F

In a iegiession, we attempt to fit a stiaight line thiough the points that best fits the
uata. In its simplest foim, this is accomplisheu by finuing a line that minimizes the
sum of the squaieu uistance of the points fiom the line. Consequently, it is calleu an
*)0%#")' /-"8& 8D$")-8 (0LS) iegiession. When such a line is fit, two paiameteis
emeige÷one is the point at which the line cuts thiough the E-axis, calleu the
inteicept of the iegiession, anu the othei is the slope of the iegiession line:
E = " + :F
The slope (:) of the iegiession measuies both the uiiection anu the magnituue of
the ielationship between the uepenuent vaiiable (E) anu the inuepenuent vaiiable
(F). When the two vaiiables aie positively coiielateu, the slope will also be positive,
wheieas when the two vaiiables aie negatively coiielateu, the slope will be
negative. The magnituue of the slope of the iegiession can be ieau as follows: Foi
eveiy unit inciease in the uepenuent vaiiable (F), the inuepenuent vaiiable will
change by : (slope). Although iegiessions miiioi coiielation coefficients anu
covaiiances in showing the stiength of the ielationship between two vaiiables, they
also seive anothei useful puipose. The iegiession equation uesciibeu in the last
section can be useu to estimate pieuicteu values foi the uepenuent vaiiable, baseu
on assumeu oi actual values foi the inuepenuent vaiiable. In othei woius, foi any
given E, we can estimate what F shoulu be:
F = " + :(Y)
Bow goou aie these pieuictions. That will uepenu entiiely on the stiength of the
ielationship measuieu in the iegiession. When the inuepenuent vaiiable explains a
high piopoition of the vaiiation in the uepenuent vaiiable (R
is high), the
pieuictions will be piecise. When the R
is low, the pieuictions will have a much
wiuei iange.
The iegiession that measuies the ielationship between two vaiiables
becomes a .$/&%,/- )-()-88%*# when it is extenueu to incluue moie than one
inuepenuent vaiiable in tiying to explain a uepenuent vaiiable. Although the
giaphical piesentation becomes moie uifficult, the multiple iegiession yielus output
that is an extension of the simple iegiession. The I
still measuies the stiength of
the ielationship, but an auuitional I
statistic calleu the aujusteu I
is computeu to
countei the bias that will inuuce the I
to keep incieasing as moie inuepenuent
vaiiables aie auueu to the iegiession. If theie aie k inuepenuent vaiiables in the
iegiession, the aujusteu I
is computeu as follows:
Theie aie implicit statistical assumptions behinu eveiy multiple iegiession
that we ignoie at oui own peiil. Foi the coefficients on the inuiviuual inuepenuent
vaiiables to make sense, the inuepenuent vaiiable neeus to be uncoiielateu with
each othei, a conuition that is often uifficult to meet. When inuepenuent vaiiables
aie coiielateu with each othei, the statistical hazaiu that is cieateu is calleu
.$/&%9*//%#-")%&'. In its piesence, the coefficients on inuepenuent vaiiables can take
on unexpecteu signs (positive insteau of negative, foi instance) anu unpieuictable
values. Theie aie simple uiagnostic statistics that allow us to measuie how fai the
uata may be ueviating fiom oui iueal.
The tools in this chaptei aie inuispensable aius to the piocess of valuation.
We can use time value concepts to move cash flows acioss time on investments, to
aiiive at a value. The measuies that aie pait of "iisk anu ietuin" mouels in finance
can be useu to ueiive costs of equity anu capital, anu by extension, to value
companies in uiffeient maikets. We ueiive much of the eainings anu cash flow uata
fiom financial statement; it behooves us to keep in touch with FASB iequiiements
on leases. Finally, given the quantity anu quality of infoimation that we have to
access, statistical tools that compiess the uata anu pioviue a sense of the
ielationships between uata items can all make us bettei investois.
Chapter 3: Intr|ns|c Va|ue
What is intiinsic value. Consiuei it the value that woulu be attacheu to an
asset by an all-knowing analyst with access to all infoimation available iight now
anu a peifect valuation mouel. No such analyst exists, of couise, but we all aspiie to
be as close as we can to this peifect analyst. Eveiy asset that has an intiinsic value
that ieflects its cash flow potential anu its iisk. While estimating this value poses
challenges, we believe that it is impoitant that we look past maiket peiceptions anu
gauge the intiinsic value of a business oi asset.
D|scounted Cash f|ow (DCI) Va|uat|on
In uiscounteu cash flow valuation, we begin with a simple pioposition. The
value of an asset is not what someone peiceives it to be woith but it is a function of
the expecteu cash flows on that asset. Put simply, assets with high anu pieuictable
cash flows shoulu have highei values than assets with low anu volatile cash flows.
Putting this piinciple into piactice iequiies us to giapple with how to uefine cash
flows anu what we mean by iisk.
Lqu|ty versus I|rm Va|uat|on
While theie aie many appioaches foi aujusting foi iisk in uiscounteu cash
flow valuation, the most common one is the iisk aujusteu uiscount iate appioach,
wheie we use highei uiscount iates to uiscount expecteu cash flows when valuing
iiskiei assets, anu lowei uiscount iates when valuing safei assets. Theie aie two
ways in which we can appioach uiscounteu cash flow valuation. The fiist is to value
the entiie business, with both existing assets (assets-in-place) anu giowth assets;
this is often teimeu fiim oi enteipiise valuation. The best way to fiame this choice
is to think in teims of a financial balance sheet, which we intiouuceu in chaptei 2.

2%($)- J4K5 L"/$%#( " 2%). M6$8%#-88N
The cash flows befoie uebt payments anu aftei ieinvestment neeus aie teimeu fiee
cash flows to the fiim, anu the uiscount iate that ieflects the composite cost of
financing fiom all souices of capital is the cost of capital.
The seconu way is to just value the equity stake in the business, anu this is
teimeu equity valuation.
2%($)- J435 L"/$%#( OD$%&'
The cash flows aftei uebt payments anu ieinvestment neeus aie calleu fiee cash
flows to equity, anu the uiscount iate that ieflects just the cost of equity financing is
the cost of equity. With publicly tiaueu fiims, it can be aigueu that the only cash
flow equity investois get fiom the fiim is uiviuenus anu that uiscounting expecteu
uiviuenus back at the cost of equity shoulu yielu the value of equity in the fiim. T
Assets Liabilities
Assets in Place Debt
Discount rate reflects the cost of
raising both debt and equity
financing, in proportion to their
Growth Assets
Firm Valuation
Cash flows considered are
cashflows from assets,
prior to any debt payments
but after firm has
reinvested to create
growth assets
Present value is value of the entire firm, and reflects the value of
all claims on the firm.
Assets Liabilities
Assets in Place Debt
Discount rate reflects only the
cost of raising equity financing
Growth Assets
Equity Valuation
Cash flows considered are
cashflows from assets,
after debt payments and
after making
reinvestments needed for
future growth
Present value is value of just the equity claims on the firm
Note also that we can always get fiom the foimei (fiim value) to the lattei
(equity value) by netting out the value of all non-equity claims fiom fiim value.
Bone iight, the value of equity shoulu be the same whethei it is valueu uiiectly (by
uiscounting cash flows to equity a the cost of equity) oi inuiiectly (by valuing the
fiim anu subtiacting out the value of all non-equity claims).
Inputs to a DCI Va|uat|on
While we can choose to value just the equity oi the entiie business, we have
foui basic inputs that we neeu foi a value estimate, though how we uefine the inputs
will be uiffeient uepenuing upon whethei you uo fiim oi equity valuation. The fiist
input is the cashflow fiom existing assets, uefineu eithei as pie-uebt (anu to the
fiim) oi as post-uebt (anu to equity) eainings, net of ieinvestment to geneiate
futuie giowth. The seconu input is giowth, with giowth in opeiating income being
the key input when valuing the entiie business anu giowth in equity income (net
income oi eainings pei shaie) becoming the focus when valuing equity. The thiiu
input is the uiscount iate, uefineu as the cost of the oveiall capital of the fiim, when
valuing the business, anu as cost of equity, when valuing equity. The final input,
allowing foi closuie, is the teiminal value, uefineu as the estimateu value of fiim
(equity) at the enu of the foiecast peiiou in fiim (equity) valuation.
()*+ ,%-.*
Leauing up to this section, we noteu that cash flows can be estimateu to
eithei just equity investois (cash flows to equity) oi to all supplieis of capital (cash
flows to the fiim). In this section, we will begin with the stiictest measuie of cash
flow to equity, i.e. the uiviuenus ieceiveu by investois, anu then piogiessively move
to moie expansive measuies of cash flows, which geneially iequiie moie
When an investoi buys stock, he geneially expects to get two types of cash
flows - uiviuenus uuiing the holuing peiiou anu an expecteu piice at the enu of the
holuing peiiou. Since this expecteu piice is itself ueteimineu by futuie uiviuenus,
the value of a stock is the piesent value of just expecteu uiviuenus. If we accept this
piemise, the only cash flow to equity that we shoulu be consiueiing in valuation is
the uiviuenu paiu, anu estimating that uiviuenu foi the last peiiou shoulu be a
simple exeicise. Since many fiims uo not pay uiviuenus, this numbei can be zeio,
but it shoulu nevei be negative.
AugmenLed ulvldends
0ne of the limitations of focusing on uiviuenus is that many companies,
especially in the 0niteu States but incieasingly aiounu the woilu, have shifteu fiom
uiviuenus to stock buybacks as theii mechanism foi ietuining cash to stockholueis.
While only those stockholueis who sell theii stock back ieceive cash, it still
iepiesents cash ietuineu to equity investois. In 2uu7, foi instance, fiims in the
0niteu States ietuineu twice as much cash in the foim of stock buybacks than they
uiu in uiviuenus, anu focusing only on uiviuenus will iesult in the unuei valuation of
equity. 0ne simple way of aujusting foi this is to "$(.-#& &1- 0%<%0-#0 with stock
buybacks anu look at the cumulative cash ietuineu to stockholueis.
Augmenteu Biviuenus = Biviuenus + Stock Buybacks
0ne pioblem, though, is that unlike uiviuenus that aie smootheu out ovei time,
stock buybacks can spike in some yeais anu be followeu by yeais of inaction. We
theiefoie will have to noimalize buybacks by using aveiage buybacks ovei a peiiou
of time (say, S yeais) to aiiive at moie ieasonable annualizeu numbeis.
ÞoLenLlal ulvldends (lree Cash flow Lo LqulLy)
With both uiviuenus anu augmenteu uiviuenus, we aie tiusting manageis at
publicly tiaueu fiims to ietuin to pay out to stockholueis any excess cash left ovei
aftei meeting opeiating anu ieinvestment neeus. Bowevei, we uo know that
manageis uo not always follow this piactice, as eviuenceu by the laige cash balances
that you see at most publicly tiaueu fiims. To estimate what manageis coulu have
ietuineu to equity investois, we uevelop a measuie of potential uiviuenus that we
teim the ;)-- 9"81 ;/*+ &* -D$%&'. Intuitively, the fiee cash flow to equity measuies
the cash left ovei aftei taxes, ieinvestment neeus anu uebt cash flows have been
met. It is measuieu as follows:
FCFE = Net Income - Reinvestment Neeus - Bebt Cash flows
= Net Income + (Capital Expenuituies - Bepieciation + Change in non-cash
woiking Capital)- (Piincipal Repayments + New Bebt Issues)
Consiuei the equation in pieces. We begin with net income, since that is the eainings
geneiateu foi equity investois; it is aftei inteiest expenses anu taxes. We compute
what the fiim has to ieinvest in two paits:
a. I-%#<-8&.-#& %# /*#(@/%<-0 "88-&8 is measuieu as the uiffeience between capital
expenuituies (the amount investeu in long liveu assets uuiing the peiiou) anu
uepieciation (the accounting expense geneiateu by capital expenuituies in piioi
peiious). We net the lattei because it is not a cash expense anu hence can be
auueu back to net income.
b. I-%#<-8&.-#& %# 81*)&@/%<-0 "88-&8 is measuieu by the change in non-cash
woiking capital. In effect, incieases in inventoiy anu accounts ieceivable
iepiesent cash tieu up in assets that uo not geneiate ietuins - wasting assets.
The ieason we uone consiuei cash in the computation is because we assume that
companies with laige cash balances geneially invest them in low-iisk,
maiketable secuiities like commeicial papei anu tieasuiy bills; these
investments eain a low but a faii iate of ietuin anu aie theiefoie not wasting
To the extent that they aie offset by the use of suppliei cieuit anu
accounts payable, the effect on cash flows can be muteu. The oveiall change in
non-cash woiking capital theiefoie is investment in shoit-teim assets.
Reinvestment ieuuces cash flow to equity investois, but it pioviues a payoff in
teims of futuie giowth. We will come back anu consiuei whethei the net effect is
positive oi negative aftei we consiuei how best to estimate giowth. The final input
into the piocess aie the negative cash flows associateu with the iepayment of olu
uebt anu the positive cash flows to equity investois fiom iaising new uebt. If olu
uebt is ieplaceu with new uebt of exactly the same magnituue, this teim will be zeio,

Note that we uo not make the uistinction between opeiating anu non-opeiating cash that some
analysts uo (they pioceeu to incluue opeiating cash in woiking capital). 0ui uistinction is between
wasting cash (which woulu incluue cuiiency oi cash eaining below-maiket iate ietuins) anu non-
wasting cash. We aie assuming that the foimei will be a small oi negligible numbei at a publicly
tiaueu company.
but it will geneiate positive (negative) cash flows when uebt issues exceeu (aie less
than) uebt iepayments. A moie conseivative veision of FCFE, which Waiien Buffett
calls "owneis' eainings" ignoies the net cash flow fiom uebt. 0nlike uiviuenus, the
FCFE can be negative foi many ieasons: the fiim may have negative net income, it
may be ieinvesting fai moie than it geneiates in income oi it has significant uebt
iepayments scheuuleu. Since FCFE have to be funueu with new equity, existing
equity investois will see theii stake uiluteu anu have to factoi that into value.
Cash llow Lo Lhe llrm
The cash flow to the fiim is the cash left ovei aftei taxes anu aftei all
ieinvestment neeus have been met. Since a fiim iaises capital fiom uebt anu equity
investois, the cash flow to the fiim shoulu be befoie inteiest anu piincipal payments
on uebt. The cash flow to the fiim can be measuieu in two ways. 0ne is to auu up the
cash flows to all of the uiffeient claim holueis in the fiim. Thus, the cash flows to
equity investois (estimateu using one of the thiee measuies uesciibeu in this
section) aie auueu to the cash flows to uebt holueis (inteiest anu net uebt
payments) to aiiive at the cash flow. The othei appioach is to stait with opeiating
eainings anu to estimate the cash flows to the fiim piioi to uebt payments but aftei
ieinvestment neeus have been met:
Fiee Cash flow to fiim (FCFF) = Aftei-tax 0peiating Income - Reinvestment
= Aftei-tax 0peiating Income- (Capital Expenuituies -
Bepieciation + Change in non-cash Woiking Capital)
It is easiest to unueistanu FCFF by contiasting it with FCFE. Fiist, we begin with
aftei-tax opeiating income insteau of net income; the foimei is befoie inteiest
expenses wheieas the lattei is aftei inteiest expenses. Seconu, we aujust the
opeiating income foi taxes, computeu as if you weie taxeu on the entiie income,
wheieas net income is alieauy an aftei-tax numbei.
Thiiu, while we subtiact out

In effect, when computing taxes on opeiating income, we act like we have no inteiest expenses oi
tax benefits fiom those expenses while computing the cash flow. That is because we will be counting
the tax benefits fiom uebt in the cost of capital (thiough the use of an aftei-tax cost of uebt). If we use
actual taxes paiu oi ieflect the tax benefits fiom inteiest expenses in the cash flows, we will be
uouble counting its effect.
ieinvestment, just as we uiu to aiiive at fiee cash flows to equity, we uo not net out
the effect of uebt cash flows, since we aie now looking at cash flows to all capital anu
not just to equity.
Anothei way of piesenting the same equation is to cumulate the net capital
expenuituies anu woiking capital change into one numbei, anu state it as a
peicentage of the aftei-tax opeiating income. This iatio of ieinvestment to aftei-tax
opeiating income is calleu the ieinvestment iate, anu the fiee cash flow to the fiim
can be wiitten as:
Reinvestment Rate =
Fiee Cash Flow to the Fiim = EBIT (1-t) (1 - Reinvestment Rate)
Note that the ieinvestment iate can exceeu 1uu%
, if the fiim has substantial
ieinvestment neeus. The ieinvestment iate can also be less than zeio, foi fiims that
aie uivesting assets anu shiinking capital.
Bow uiffeient can these estimates of cash flows be. To illustiate, we lookeu
at Ninnesota Nining anu Nanufactuiing (SN, a laige maiket capitalization company,
with opeiations in tianspoitation, health caie, office supplies anu electionics, in
2uu7. Exhibit S.1 pioviues the estimates of uiviuenus, augmenteu uiviuenus, fiee
cash flows to equity anu fiee cash flows to the fiim.

In piactical teims, this fiim will have to iaise exteinal financing, eithei fiom uebt oi equity oi both,
to covei the excess ieinvestment.
(Capital Expenditures - Depreciation + " Working Capital)
After - tax Operating Income

Cash flows that aie iiskiei shoulu be assesseu a lowei value than moie stable
cashflows, but how uo we measuie iisk anu ieflect it in value. In conventional
uiscounteu cash flow valuation mouels, the uiscount iate becomes the vehicle foi
conveying oui conceins about iisk. We use highei uiscount iates on iiskiei cash
flows anu lowei uiscount iates on safei cash flows. In this section, we will begin be
contiasting how the iisk in equity can vaiy fiom the iisk in a business, anu then
consiuei the mechanics of estimating the cost of equity anu capital.
8uslness 8lsk versus LqulLy 8lsk
Befoie we uelve into the uetails of iisk measuiement anu uiscount iates, we
shoulu uiaw a contiast between two uiffeient ways of thinking about iisk that ielate
back to the financial balance sheet that we piesenteu in chaptei 1. In the fiist, we
think about the iisk in a fiim's opeiations oi assets, i.e., the iisk in the business. In
the seconu, we look at the iisk in the equity investment in this business. Figuie S.S
captuies the uiffeiences between the two measuies:
Exhibit 3.1: Estimates of Cash Flows - 3M in 2007
In 2007, the
firm paid
dividends of
Augmented Dividends
The firm bought back $3,239 million of stock.
Adding this to the dividend o $1,380 million
yields an augmented dividend of $ 4,609
Potential Dividends (FCFE)
Net Income = $4,010
- (Capital expenditures - Depreciation) = - $889
- Change in non-cash working capital = - $243
+ Net Debt Issued (paid) = + $1,222
FCFE = $4,100
Net capital expenditures
includes acquisitions
Working capital increase
drained cash flows
Total Equity reinvestment
= 889 + 243 - 1222 = - 90
Equity Reinvstment Rate
= -90/4010 = -2.27%
Free Cash flow to the firm (FCFF)
EBIT (1-t) $3,586
- (Capital expenditures - Depreciation) - $889
- Change in non-cash working capital - $243
Free Cash Flow to the Firm (FCFF) = $2,454
Net capital expenditures
includes acquisitions
Working capital increase
drained cash flows
Total reinvestment
= 889 + 243 = 1132
Equity Reinvstment Rate
= 1132/3474= 36.37%
2%($)- J4J5 I%87 %# 6$8%#-88 <-)8$8 I%87 %# OD$%&'

As with any othei aspect of the balance sheet, this one has to balance has well, with
the weighteu iisk in the assets being equal to the weighteu iisk in the ingieuients to
capital - uebt anu equity. Note that the iisk in the equity investment in a business is
paitly ueteimineu by the iisk of the business the fiim is in anu paitly by its choice
on how much uebt to use to funu that business. The equity in a safe business can be
ienueieu iisky, if the fiim uses enough uebt to funu that business.
In uiscount iate teims, the iisk in the equity in a business is measuieu with
the cost of equity, wheieas the iisk in the business is captuieu in the cost of capital.
The lattei will be a weighteu aveiage of the cost of equity anu the cost of uebt, with
the weights ieflecting the piopoitional use of each souice of funuing.
Measurlng LqulLy 8lsk and Lhe CosL of LqulLy
Neasuiing the iisk in equity investments anu conveiting that iisk measuie
into a cost of equity is ienueieu uifficult by two factois. The fiist is that equity has
an implicit cost, which is unobseivable, unlike uebt, which comes with an explicit
cost in the foim of an inteiest iate. The seconu is that iisk in the eyes of the
beholuei anu uiffeient equity investois in the same business can have veiy uiffeient
peiceptions of iisk in that business anu uemanu uiffeient expecteu ietuins as a
In the iisk anu ietuin mouels that we uesciibeu in chaptei 2, the inputs that
we neeu foi the expecteu ietuin aie stiaightfoiwaiu. We neeu to come up with a
iisk fiee iate anu a piice foi iisk (equity iisk piemium) to use acioss all
investments. 0nce we have these maiket-wiue estimates, we then have to measuie
the ielative iisk in inuiviuual investments. In this section, we will lay out the bioau
Assets Liabilities
Existing Assets Debt
Risk in debt
and cost of
Risk in equity
and cost of
Growth Assets
Risk in the cash
flows from
Risk in
cashflows from
new investments
Risk in a
business and
asset mix
Risk in a firm!s capital
mix has to equate to
the risk in its
business and asset
piinciples that will govein these estimates but we will ietuin in futuie chapteis to
the uetails of how best to make these estimates foi uiffeient types of businesses:
• The iiskfiee iate is the expecteu ietuin on a long-teim investment with
guaianteeu ietuins; in effect, you expecteu ietuin is also youi actual ietuin.
Since only entities that cannot uefault can issue iisk fiee secuiities, we geneially
use ten oi thiity yeai goveinment bonus iates as iisk fiee iates, implicitly
assuming that goveinment uon't uefault, since they can piint cuiiency to pay off
• The equity iisk piemium is the piemium that investois uemanu foi investing in
iisky assets (oi equities) as a class, ielative to the iiskfiee iate. It will be a
function not only of how much iisk investois peiceive in equities, as a class, but
the iisk aveision that they biing to the maiket. It also follows that the equity iisk
piemium can change ovei time, as maiket iisk anu iisk aveision both change.
Nany analysts look at the ietuins stocks have eaineu, ielative to goveinment
bonus, ovei long peiious to estimate a histoiical equity iisk piemium. An
alteinative is to back out a foiwaiu looking piemium (calleu an implieu equity
iisk piemium) fiom cuiient stock piice levels anu expecteu futuie cash flows.
• To estimate the ielative iisk (beta), the stanuaiu appioach foi estimating the
CAPN beta is to iun a iegiession of ietuins on a stock against ietuins on a bioau
equity maiket inuex, with the slope captuiing how much the stock moves, foi
any given maiket move. As a consequence, the beta estimates that we obtain will
always be backwaiu looking (since they aie ueiiveu fiom past uata) anu noisy
(they aie estimateu with eiiois). In auuition, these appioaches cleaily will not
woik foi investments that uo not have a tiauing histoiy (young companies,
uivisions of publicly tiaueu companies). 0ne solution is to ieplace the iegiession
beta with a sectoi-aveiage beta, if the fiim opeiates in only one sectoi oi a
weighteu sum of multiple sectoi betas, if the fiim opeiates in many businesses.
1he CosL of uebL
While equity investois ieceive iesiuual cash flows anu beai the bulk of the
opeiating iisk in most fiims, lenueis to the fiim also face the iisk that they will not
ieceive theii piomiseu payments - inteiest expenses anu piincipal iepayments. It is
to covei this uefault iisk that lenueis auu a "uefault spieau" to the iiskless iate
when they lenu money to fiims; the gieatei the peiceiveu iisk of uefault, the gieatei
the uefault spieau anu the cost of uebt. The othei uimension on which uebt anu
equity can vaiy is in theii tieatment foi tax puiposes, with cashflows to equity
investois (uiviuenus anu stock buybacks) coming fiom aftei-tax cash flows, wheieas
inteiest payments aie tax ueuuctible.
To estimate the cost of uebt foi a fiim, we neeu thiee components. The fiist is
the iiskfiee iate, an input to the cost of equity as well. As a geneial iule, the iiskfiee
iate useu to estimate the cost of equity shoulu be useu to compute the cost of uebt
as well; if the cost of equity is baseu upon a long-teim iiskfiee iate, as it often is, the
cost of uebt shoulu be baseu upon the same iate. The seconu is the uefault spieau
anu theie aie two appioaches that aie useu, uepenuing upon the fiim being
analyzeu. If the fiim has a bonu iating fiom an establisheu iatings agency such as
S&P oi Noouy's, we can estimate a uefault spieau baseu upon the iating. In
Septembei 2uu8, foi instance, the uefault spieau foi BBB iateu bonus was 2% anu
woulu have been useu as the spieau foi any BBB iateu company. If the fiim is
uniateu anu has uebt outstanuing (bank loans), we can estimate a "synthetic" iating
foi the fiim, baseu upon its financial iatios. A simple, albeit effective appioach foi
estimating the synthetic iatio is to base it entiiely on the inteiest coveiage iatio
(EBIT¡ Inteiest expense) of a fiim; highei inteiest coveiage iatios will yielu highei
iatings anu lowei inteiest coveiage iatios.
The final input neeueu to estimate the cost of uebt is the tax iate. Since
inteiest expenses save you taxes at the maigin, the tax iate that is ielevant foi this
calculation is not the effective tax iate but the maiginal tax iate. In the 0niteu States,
wheie the feueial coipoiate tax iate is SS% anu state anu local taxes auu to this, the
maiginal tax iate foi coipoiations in 2uu8 was close to 4u%, much highei than the
aveiage effective tax iate, acioss companies, of 28%. The aftei-tax cost of uebt foi a
fiim is theiefoie:
Aftei-tax cost of uebt = (Riskfiee Rate + Befault Spieau) (1- Naiginal tax iate)
The aftei-tax cost of uebt foi most fiims will be significantly lowei than the cost of
equity foi two ieasons. Fiist, uebt in a fiim is geneially less iisky than its equity,
leauing to lowei expecteu ietuins. Seconu, theie is a tax saving associateu with uebt
that uoes not exist with equity.
uebL 8aLlos and Lhe CosL of CaplLal
0nce we have estimateu the costs of uebt anu equity, we still have to assign
weights foi the two ingieuients. In making this estimate, the values that we shoulu
use aie maiket values, iathei than book values. Foi publicly tiaueu fiims, estimating
the maiket value of equity is usually a tiivial exeicise, wheie we multiply the shaie
piice by the numbei of shaies outstanuing. Estimating the maiket value of uebt is
usually a moie uifficult exeicise, since most fiims have some uebt that is not tiaueu
anu many piactitioneis fall back on book value of uebt.
0nce we have the cuiient maiket value weights foi uebt anu equity foi use in
the cost of capital, we have a follow up juugment to make in teims of whethei these
weights will change oi iemain stable. If we assume that they will change, we have to
specify both what the iight oi taiget mix foi the fiim will be anu how soon the
change will occui. In an acquisition, foi instance, we can assume that the acquiiei
can ieplace the existing mix with the taiget mix instantaneously. As companies
change ovei time, we shoulu expect the cost of capital to change as well.
0sing SN again as oui illustiative example, we estimate the cost of equity,
uebt anu capital foi the fiim in exhibit S.2. To estimate the cost of equity, we useu
the sectoi aveiage betas of the businesses that SN opeiates in anu to estimate the
cost of uebt, we useu a synthetic iating, baseu upon the inteiest coveiage iatio:

PlsLorlcal and lorecasLed CrowLh 8aLes
When confionteu with the task of estimating giowth, it is not suipiising that
analysts tuin to the past. In effect, they use giowth in ievenues oi eainings in the
iecent past as a pieuictoi of giowth in the futuie. Befoie we put this piactice unuei
the micioscope, we shoulu auu that the histoiical giowth iates foi the same
company can yielu uiffeient estimates, uepenuing upon computational choices: how
fai back to go, which measuie of eainings (net income, eainings pei shaie, opeiating
income) to use anu how to compute the aveiage (aiithmetic oi geometiic). A uebate
how best to estimate histoiical giowth makes sense only if it is a goou pieuictoi of
futuie giowth. 0nfoitunately, stuuies that have lookeu at the ielationship have
geneially concluueu that (a) the ielationship between past anu futuie giowth is a
veiy weak one, (b) scaling matteis, with giowth uiopping off significantly as
companies giow anu (c) fiims anu sectois giow thiough giowth cycles, with high
giowth in one peiiou followeu by low giowth in the next.
If histoiical giowth is not a useful pieuictoi of futuie giowth, theie is anothei
souice that we can use foi futuie giowth. We can uiaw on those who know the fiim
bettei than we uo - equity ieseaich analysts who have tiackeu the fiim foi yeais oi
the manageis in the fiim - anu use theii estimates of giowth. 0n the plus siue, these
foiecasts shoulu be baseu upon bettei infoimation than we have available to us.
Aftei all, manageis shoulu have a cleaiei sense of how much they will ieinvest in
theii own businesses anu what the potential ietuins on investments aie when they
uo, anu equity ieseaich analysts have sectoi expeiience anu infoimeu souices that
they can uiaw on foi bettei infoimation. 0n the minus siue, neithei manageis noi
equity ieseaich analysts aie objective about the futuie; manageis aie likely to ovei
estimate theii capacity to geneiate giowth anu analysts have theii own biases. In
auuition, both analysts anu manageis can get caught up in the moou of the moment,
ovei estimating giowth in buoyant times anu unuei estimating giowth in uown
times. As with histoiical giowth, stuuies inuicate that neithei analyst estimates noi
management foiecasts aie goou pieuictois of futuie giowth.
lundamenLal CrowLh 8aLes
If we cannot uiaw on histoiy oi tiust manageis anu analysts, how then uo we
estimate giowth. The answei lies in the funuamentals within a fiim that ultimately
ueteimine its giowth iate. In this section, we will consiuei the two souices foi
giowth - new investments that expanu the business anu impioveu efficiency on
existing investments.
Ctowtb ftom oew lovestmeots
The giowth iate fiom new investments can be wiitten as a function of two
vaiiables - the peicentage of eainings that is ieinvesteu back in the business anu
the ietuin eainings on that investment. While investment anu ietuin on investment
aie geneiic teims, the way in which we uefine them will uepenu upon whethei we
aie looking at equity eainings oi opeiating income. When looking at equity
eainings, oui focus is on the investment in equity anu the ietuin is the ietuin on
equity. When looking at opeiating eainings, the focus is on the investment in capital
anu the ietuin is the ietuin on capital. Cential to any estimate of funuamental
giowth is the estimate of ietuin on capital oi equity, measuies that we intiouuceu
in chaptei 2. Table S.S summaiizes the inputs foi each measuie uepenuing on the
measuie of cash flow that we aie focuseu on:
P":/- J4J5 Q-"8$)%#( R#<-8&.-#& "#0 I-&$)# *# R#<-8&.-#&
S)*+&1 %#
T H)*,*)&%*# *; -")#%#(8 )-%#<-8&-0 F I-&$)# *#
= Reinvestment Rate =

X Retuin on
Capital (R0C
oi R0IC)
= Equity Reinvestment Rate =

X Non-cash
Retuin on
pei shaie
= Retention Ratio =

X Retuin on
Equity (R0E)
It is conventional piactice to use accounting measuies of investment anu ietuin on
investment. Thus, the book values of equity anu investeu capital anu accounting
eainings aie useu to compute ietuins on equity anu capital:

The pioblem with accounting measuies on both uimensions is well uocumenteu,
with accounting choices on iestiuctuiing chaiges, amoitization anu capitalization
all making a uiffeience in the final numbeis.

ífflcleocy Ctowtb
Foi many matuie fiims with limiteu investment oppoitunities, the potential
foi giowth fiom new investments is limiteu. These fiims cannot maintain a high

To get a sense of the pioblems with using accounting numbeis, anu how best to coiiect foi them,
see: Bamouaian, A., 2uu7, Retuin on capital, Retuin on Investeu Capital anu Retuin on Equity:
Neasuiement anu Implications, Woiking Papei, SSRN.
(Cap Ex - Deprec' n + "WC)
EBIT(1- t)
(Cap Ex - Deprec' n + "WC - "Debt)
Net Income
Net Income
Return on Capital (ROIC) =
Operating Income
(1 - tax rate)
Book Value of Invested Capital
t -1

Non - cash Return on Equity(NCROE) =
Net Income
- Interest Income from Cash
(1- tax rate)
Book Value of Equity
t -1
" Cash
t -1
Return on Equity (ROE) =
Net Income

Book Value of Equity
t -1
ieinvestment iate anu uelivei a high ietuin on capital with that ieinvestment.
Bowevei, they can still giow at healthy iates if they can impiove the ietuins that
they eain on existing assets. Thus, a fiim that geneiates a S% ietuin on capital this
yeai can geneiate a giowth iate of 4u% next yeai, if it can impiove that ietuin on
capital to 7%.
Conveisely, ueclines in ietuins on existing assets can tianslate into
uiops in eainings giowth iates.
When valuing companies, efficiency giowth is puie giavy in teims of value
cieateu, since the giowth comes with no concuiient cost. 0nlike giowth fiom new
investments, wheie the positive effects of giowth have to be offset against the
negative effect of moie investment, impioving the ietuin on capital on existing
assets incieases the giowth iate without auveisely affecting the cash flows. It
shoulu as come as no suipiise, then, that analysts who want to inciease the value of
a company uiaw on the efficiency aigument to justify much highei giowth iates
than those estimateu using funuamentals.
While the potential foi efficiency giowth is always theie, we shoulu put some
common sense constiaints on how much we can uiaw on this giowth.
1. Theie is moie potential foi efficiency giowth at matuie fiims, with pooi ietuins
on capital (equity), than theie is at fiims that aie peifoiming well, foi two
ieasons. Fiist, impioving the ietuin on capital is a much moie feasible option foi
a fiim that geneiates a ietuin on capital that is well below the sectoi aveiage
than at a fiim that alieauy outpeifoims the sectoi. Seconu, the effect of an
impiovement in ietuins on giowth is much gieatei when the ietuin on capital is
low than when it is high. A fiim that impioves its ietuin on capital fiom S% to
6% will iepoit a 2u% giowth iate fiom efficiency in that peiiou, wheieas a fiim
that impioves its ietuin on capital fiom 2S% to 26% will geneiate a 4% giowth
iate fiom efficiency in that peiiou.
2. You can uiaw on incieaseu efficiency to justify giowth only foi finite peiious.
Aftei all, a fiim cannot be infinitely inefficient. 0nce the inefficiencies, no mattei

The easiest way to see this is to act like you have $ 1uu investeu in capital in this company. By
impioving its ietuin on capital fiom S% to 7%, the eainings will inciease fiom $S to $7, which is a
4u% inciease.
how significant, aie fixeu, the fiim will have to ieveit back to its sustainable
giowth iate, baseu upon new investments.
In closing, giowth in a specific fiim can come fiom new investments oi impioveu
efficiency, but it has to be eaineu eithei way. None of us has the powei to enuow
companies with highei giowth iates, just because we like the manageis oi want to
make it value inciease.
Figuie S.S pioviues estimates of histoiical, analyst anu funuamental giowth
iates foi SN in Septembei 2uu8. Note that we aie assuming no efficiency giowth foi
SN, because its ietuin on capital is alieauy high anu has been stable ovei time.

:&4#"0)% ;)%1&
Publicly tiaueu fiims uo not have finite lives. uiven that we cannot estimate
cash flows foievei, we geneially impose closuie in valuation mouels by stopping oui
estimation of cash flows sometime in the futuie anu then computing a teiminal
value that ieflects all cash flows beyonu that point. The two legitimate ways of
estimating teiminal value aie to estimate a liquiuation value foi the assets of the
fiim, assuming that the assets aie solu in the teiminal yeai, oi to estimate a going
concein oi a teiminal value. Applying a multiple to estimate teiminal value, a
technique useu by many analysts, is incompatible with intiinsic value anu makes the
valuation a ielative one.
1. LlquldaLlon value
If we assume that the business will be enueu in the teiminal yeai anu that its
assets will be liquiuateu at that time, we can estimate the pioceeus fiom the
liquiuation. This liquiuation value still has to be estimateu, using a combination of
maiket-baseu numbeis (foi assets that have ieauy maikets) anu cashflow-baseu
estimates. Foi fiims that have finite lives anu maiketable assets (like ieal estate),
this iepiesents a faiily conseivative way of estimating teiminal value. Foi othei
fiims, estimating liquiuation value becomes moie uifficult to uo, eithei because the
assets aie not sepaiable (bianu name value in a consumei piouuct company) oi
because theie is no maiket foi the inuiviuual assets. 0ne appioach is to use the
estimateu book value of the assets as a staiting point, anu to estimate the liquiuation
value, baseu upon the book value.
2. Colng Concern or 1ermlnal value
If we tieat the fiim as a going concein at the enu of the estimation peiiou, we
can estimate the value of that concein by assuming that cash flows will giow at a
constant iate foievei afteiwaius. This peipetual giowth mouel uiaws on a simple
piesent value equation to aiiive at teiminal value:

0ui uefinitions of cash flow anu giowth iate have to be consistent with whethei we
aie valuing uiviuenus, cash flows to equity oi cash flows to the fiim; the uiscount
iate will be the cost of equity foi the fiist two anu the cost of capital foi the last. The
peipetual giowth mouel is a poweiful one, but it can be easily misuseu. In fact,
analysts often use it is as a piggy bank that they go to whenevei they feel that the
value that they have ueiiveu foi an asset is too low oi high. Small changes in the
inputs can altei the teiminal value uiamatically. Consequently, theie aie thiee key
constiaints that shoulu be imposeu on its estimation:
a. Cap the growth rate: Small changes in the stable growth rate can change the terminal
value significantly and the effect gets larger as the growth rate approaches the discount
rate used in the estimation. The fact that a stable growth rate is constant forever, however,
Terminal Value
Cashflow in year n +1
(Discount rate "Perpetual growth rate)
puts strong constraints on how high it can be. Since no firm can grow forever at a rate
higher than the growth rate of the economy in which it operates, the constant growth rate
cannot be greater than the overall growth rate of the economy. Setting the stable growth
rate to be less than or equal to the growth rate of the economy is not only the consistent
thing to do but it also ensures that the growth rate will be less than the discount rate. In
fact, a simple rule of thumb on the stable growth rate is that it should not exceed the
riskless rate used in the valuation.

b. Use mature company risk characteristics: As firms move from high growth to stable
growth, we need to give them the characteristics of stable growth firms. A firm in stable
growth is different from that same firm in high growth on a number of dimensions. In
general, you would expect stable growth firms to be less risky and use more debt. In
practice, we should move betas for even high risk firms towards one in stable growth and
give them debt ratios, more consistent with larger, more stable cashflows.
c. Reinvestment and Excess Return Assumptions: Stable giowth fiims tenu to ieinvest
less than high giowth fiims anu it is ciitical that we both captuie the effects of lowei
giowth on ieinvestment anu that we ensuie that the fiim ieinvests enough to
sustain its stable giowth iate in the teiminal phase. uiven the ielationship between
giowth, ieinvestment iate anu ietuins that we establisheu in the section on
expecteu giowth iates, we can estimate the ieinvestment iate that is consistent with
expecteu giowth in table S.S:
P":/- J4U5 I-%#<-8&.-#& %# C&":/- S)*+&1
Model Reinvestment Rate in stable growth


This is because of the ielationship between the iiskless iate that goes into the uiscount iate anu
the giowth iate of the economy. Note that the iiskless iate can be wiitten as:
Nominal iiskless iate = Real iiskless iate + Expecteu inflation iate
In the long teim, the ieal iiskless iate will conveige on the ieal giowth iate of the economy anu the
nominal iiskless iate will appioach the nominal giowth iate of the economy.
Stable Growth rate
Return on Equity in stable growth
Stable Growth rate
Non - cash Return on Equity in stable growth

Linking the reinvestment rate and retention ratio to the stable growth rate also
makes the valuation less sensitive to assumptions about stable growth. While increasing
the stable growth rate, holding all else constant, can dramatically increase value,
changing the reinvestment rate as the growth rate changes will create an offsetting effect.

The gains from increasing the growth rate will be partially or completely offset by the
loss in cash flows because of the higher reinvestment rate. Whether value increases or
decreases as the stable growth increases will entirely depend upon what you assume
about excess returns. If the return on capital is higher than the cost of capital in the stable
growth period, increasing the stable growth rate will increase value. If the return on
capital is equal to the stable period cost of capital, increasing the stable growth rate will
have no effect on value. You could establish the same propositions with equity income
and cash flows and show that the terminal value of equity is a function of the difference
between the return on equity and cost of equity.
In closing, the key assumption in the terminal value computation is not what
growth rate you use in the valuation, but what excess returns accompany that growth rate.
If you assume no excess returns, the growth rate becomes irrelevant. There are some
valuation experts who believe that this is the only sustainable assumption, since no firm
can maintain competitive advantages forever. In practice, though, there may be some
wiggle room, insofar as the firm may become a stable growth firm before its excess
returns go to zero. If that is the case and the competitive advantages of the firm are strong
and sustainable (even if they do not last forever), we may be able to give the firm some
excess returns in perpetuity. As a simple rule of thumb again, these excess returns forever
should be modest (<4-5%) and will affect the terminal value.
Using 3M as the illustrative example again, we assumed that the firm would be in
stable growth after the fifth year and grow 3% a year forever. Table 3.6 lists how we
expect the other inputs to change in stable growth:
Stable growth rate
Return on capital in stable phase
Rate Growth Stable Capital of Cost
Rate) nt Reinvestme - t)(1 (1 EBIT
= Value Terminal
1 + n
P":/- J4A5 L"/$%#( JQ V W%(1 <-)8$8 C&":/- S)*+&1 H1"8-8
Bigh uiowth Stable uiowth
Length of Bigh uiowth
Peiiou = Next S yeais Aftei yeai S
uiowth Rate = 7.Su% S.uu%
Bebt Ratio useu in Cost
of Capital Calculation= 8.48% 2u.uu%
Beta useu foi stock = 1.S6 1.uu
Riskfiee iate = S.72% S.72%
Risk Piemium = 4.uu% 4.uu%
Cost of Bebt = 4.47% 4.47%
Tax Rate = SS.uu% SS.uu%
Cost of capital 8.6S% 6.76%
Retuin on Capital = 2S.uu% 6.76%
Reinvestment Rate = Su.uu% 44.4u%
Note that as the giowth ueclines aftei yeai S, the beta is aujusteu towaius one anu
the uebt iatio is iaiseu to the inuustiy aveiage of 2u% to ieflect the oveiall stability
of the company. Since the cost of uebt is ielatively low, we leave it unchangeu,
iesulting in a uiop in the cost of capital to 6.76%. We uo change the ieinvestment
iate in stable giowth to ieflect the assumption that theie will be no excess ietuins
in stable giowth (ietuin on capital = cost of capital). 0sing the pieuicteu stable
giowth iate of S% anu the ietuin on capital of 6.76% (equal to cost of capital), we
ueiive a ieinvestment iate of 44.4%:
Reinvestment Rate in stable giowth =
:<"05 1$ %--*& &07*
We have coveieu the foui inputs that go into uiscounteu cash flow valuation
mouels - cash flows, uiscount iates, giowth iates anu the teiminal value. The
piesent value we aiiive at, when we uiscount the cash flows at the iisk-aujusteu
iates shoulu yielu an estimate of value, but getting fiom that numbei to what we
Expected Growth
Stable ROC
= 44.40%
woulu be willing to pay pei shaie foi equity uoes iequiie use to consiuei a few othei
a. Cash anu Naiketable Secuiities: Nost companies have cash balances that aie not
insignificant in magnituue. Is this cash balance alieauy incoipoiateu into the
piesent value. The answei uepenus upon how we estimateu cash flows. If the
cash flows aie baseu on opeiating income (fiee cash flow to the fiim) oi non-
cash net income, we have not valueu cash yet anu it shoulu be auueu on to the
piesent value. If, on the othei hanu, we estimate cash flows fiom the cumulative
net income oi use the uiviuenu uiscount mouel, cash alieauy has been implicitly
valueu; the income fiom cash is pait of the final cash flow anu the uiscount iate
piesumably has been aujusteu to ieflect the piesence of cash
b. Cioss Boluings in othei companies: Companies sometimes invest in othei fiims,
anu these cioss holuings can geneially be categoiizeu as eithei minoiity oi
majoiity holuings. With the foimei, the holuings aie usually less than Su%, anu
the income fiom the holuings aie iepoiteu in the income statement below the
opeiating income line. If we use fiee cash flow to the fiim to value the opeiating
assets, we have not valueu these minoiity holuings yet, anu they have to be
valueu explicitly anu auueu to piesent value. With majoiity holuings, which
geneially exceeu Su%, fiims usually consoliuate the entiie subsiuiaiy in theii
financials, anu iepoit 1uu% of the opeiating income anu assets of the subsiuiaiy.
To ieflect the poition of the subsiuiaiy that uoes not belong to them, they iepoit
the book value of that poition as minoiity inteiest in a balance sheet. If we
compute cash flows fiom consoliuateu financial statements, we have to subtiact
out the estimateu maiket value of the minoiity inteiest.
c. Potential liabilities (not tieateu as uebt): Since we aie inteiesteu in the value of
equity in the fiim, we have to consiuei any potential liabilities that we may face
that ieuuce that value. Thus, items like unuei funueu pension obligations anu
health caie obligations may not meet the thiesholu to be categoiizeu as uebt foi
cost of capital puiposes but shoulu be consiueieu when valuing equity. In othei
woius, we woulu subtiact out the values of these anu othei claims (such as
potential costs fiom lawsuits against the fiim) on equity fiom fiim value to
aiiive at equity value.
u. Employee 0ptions: Baving aiiiveu at the value of equity in the fiim, theie is one
final estimate that we have to make, especially if the fiim has maue it a piactice
to giant options to manageis. Since many of these options will be still
outstanuing, we have to consiuei them as anothei (anu uiffeient) claim on
equity. While analysts often use shoit cuts (such as aujusting the numbei of
shaies foi uilution) to ueal with these options, the iight appioach is to value the
options (using an option piicing mouel), ieuuce the value of equity by the option
value anu then uiviue by the actual numbei of shaies outstanuing.
Table S.7 summaiizes the loose enus anu how to ueal with them in the uiffeient
P":/- J4X5 Y-"/%#( +%&1 /**8- -#08 %# <"/$"&%*#
?**8- O#0 Y%<%0-#0 Y%89*$#&
2>2O Q*0-/ 2>22 Q*0-/
Cash anu
Ignoie, since net
income incluues
inteiest income
fiom cash.
Ignoie, if FCFE is
computeu using total
net income. Auu, if
FCFE is computeu using
non-cash net income
Auu. 0peiating
income uoes not
incluue income
fiom cash.
Cioss Boluings Ignoie, since net
income incluues
income fiom
cioss holuings.
Ignoie, since net
income incluues
income fiom cioss
Auu maiket value
of minoiity
holuings anu
subtiact maiket
value of minoiity
0thei Liabilities Ignoie. The
assumption is
that the fiim is
consiueiing costs
when setting
Subtiact out expecteu
litigation costs.
Subtiact out unuei
funueu pension
obligations, health
caie obligations
anu expecteu
litigation costs.
Ignoie. Subtiact out value of
equity options
Subtiact out value
of equity options
Figuie S.4 summaiizes the valuation of SN, biinging togethei all of the key
assumptions on cash flow, giowth anu iisk.

What do |ntr|ns|c va|uat|on mode|s te|| us?
When we estimate intiinsic value, we aie estimating what an asset oi
business is woith, given its cash flows anu the iisk in those cash flows. To the extent
that the value is uepenuent upon the assumptions we make about cash flows,
giowth anu iisk, it iepiesents what we think the intiinsic value is at any point in
time. So, what if the intiinsic value that we ueiive is veiy uiffeient fiom the maiket
piice. Theie aie seveial possible explanations. 0ne is that we have maue eiioneous
oi uniealistic assumptions about a company's futuie giowth potential oi iiskiness.
A seconu anu ielateu explanation is that we have maue incoiiect assessments of iisk
piemiums foi the entiie maiket. A thiiu is that the maiket is, in fact, making a
mistake in its assessment of value.
Even in the last scenaiio, wheie oui assessment of value is iight anu the
maiket piice is wiong, theie is no guaiantee that we can make money of oui
valuations. Foi that to occui, maikets have to coiiect theii mistakes anu that may
not happen in the neai futuie. In fact, we can buy stocks that we believe aie unuei
valueu anu finu them become moie unuei valueu ovei time. That is why a long time
hoiizon is almost a pie-iequisite foi using intiinsic valuation mouels. uiving the
maiket moie time (say S to S yeais) to fix its mistakes pioviues bettei ouus than
hoping that it will happen in the next quaitei oi the next six months.
The intiinsic value of a company ieflects its funuamentals. The piimaiy tool
foi estimating intiinsic value is the uiscounteu cash flow mouel. Theie aie foui
ingieuients that go into estimating this value. The fiist is the cash flows fiom
existing assets, befoie uebt payments (to the fiim) anu aftei uebt payments (to
equity). The seconu is the uiscount iate, with the cost of equity useu to uiscount
cash flows to equity anu the cost of capital to uiscount cash flows to the fiim. The
thiiu is expecteu giowth, which is uiiven by how much anu how well fiims ieinvest.
Finally, we applieu closuie to the mouels by assuming that cash flows will settle into
stable giowth, sometime in the futuie, but imposeu constiaints on what this giowth
iate can be anu the chaiacteiistics of stable giowth companies.
Chapter 4: ke|at|ve Va|uat|on
In uiscounteu cash flow valuation, the objective is to finu the value of an
asset, given its cash flow, giowth anu iisk chaiacteiistics. In ielative valuation, the
objective is to value an asset, baseu upon how similai assets aie cuiiently piiceu by
the maiket. Consequently, there are two components to relative valuation. The first is
that to value assets on a relative basis, prices have to be standardized, usually by
converting prices into multiples of some common variable. While this common variable
will vary across assets, it usually takes the form of earnings, book value or revenues for
publicly traded stocks.. The second is to find similar assets, which is difficult to do since
no two assets are exactly identical. With real assets like antiques and baseball cards, the
differences may be small and easily controlled for when pricing the assets. In the context
of valuing equity in firms, the problems are compounded since firms in the same business
can still differ on risk, growth potential and cash flows.
What |s re|at|ve va|uat|on?
In ielative valuation, we value an asset baseu upon how similai assets aie
piiceu in the maiket. A piospective house buyei ueciues how much to pay foi a
house by looking at the piices paiu foi similai houses in the neighboihoou. A
baseball caiu collectoi makes a juugment on how much to pay foi a Nickey Nantle
iookie caiu by checking tiansactions piices on othei Nickey Nantle iookie caius. In
the same vein, a potential investoi in a stock tiies to estimate its value by looking at
the maiket piicing of "similai" stocks.
Embeuueu in this uesciiption aie the thiee essential steps in ielative
valuation. The fiist step is finuing compaiable assets that aie piiceu by the maiket, a
task that is easiei to accomplish with ieal assets like baseball caius anu houses than
it is with stocks. All too often, analysts use othei companies in the same sectoi as
compaiable, compaiing a softwaie fiim to othei softwaie fiims oi a utility to othei
utilities, but we will question whethei this piactice ieally yielus similai companies
latei in this chaptei. The seconu step is scaling the maiket piices to a common
vaiiable to geneiate stanuaiuizeu piices that aie compaiable. While this may not be
necessaiy when compaiing iuentical assets (Nickey Nantle iookie caius), it is
necessaiy when compaiing assets that vaiy in size oi units. 0thei things iemaining
equal, a smallei house oi apaitment shoulu tiaue at a lowei piice than a laigei
iesiuence. In the context of stocks, this equalization usually iequiies conveiting the
maiket value of equity oi the fiim into multiples of eainings, book value oi
ievenues. The thiiu anu last step in the piocess is aujusting foi uiffeiences acioss
assets when compaiing theii stanuaiuizeu values. Again, using the example of a
house, a newei house with moie upuateu amenities shoulu be piiceu highei than a
similai sizeu oluei house that neeus ienovation. With stocks, uiffeiences in piicing
acioss stocks can be attiibuteu to all of the funuamentals that we talkeu about in
uiscounteu cash flow valuation. Bighei giowth companies, foi instance, shoulu tiaue
at highei multiples than lowei giowth companies in the same sectoi. Nany analysts
aujust foi these uiffeiences qualitatively, making eveiy ielative valuation a stoiy
telling expeiience; analysts with bettei anu moie believable stoiies aie given cieuit
foi bettei valuations.
Theie is a significant philosophical uiffeience between uiscounteu cash flow
anu ielative valuation. In uiscounteu cash flow valuation, we aie attempting to
estimate the intiinsic value of an asset baseu upon its capacity to geneiate cash
flows in the futuie. In ielative valuation, we aie making a juugment on how much an
asset is woith by looking at what the maiket is paying foi similai assets. If the
maiket is coiiect, on aveiage, in the way it piices assets, uiscounteu cash flow anu
ielative valuations may conveige. If, howevei, the maiket is systematically ovei
piicing oi unuei piicing a gioup of assets oi an entiie sectoi, uiscounteu cash flow
valuations can ueviate fiom ielative valuations.
Notwithstanding the focus on discounted cash flow valuation in classrooms and in
theory, there is evidence that most assets are valued on a relative basis for many reasons.
They usually require less information and are easier to do than intrinsic valuations and
are more likely to reflect the market mood of the moment. The strengths of relative
valuation are also its weaknesses. First, the ease with which a relative valuation can be
put together, pulling together a multiple and a group of comparable firms, can also result
in inconsistent estimates of value where key variables such as risk, growth or cash flow
potential are ignored. Second, the fact that multiples reflect the market mood also
implies that using relative valuation to estimate the value of an asset can result in values
that are too high, when the market is over valuing comparable firms, or too low, when it
is under valuing these firms. Third, while there is scope for bias in any type of valuation,
the lack of transparency regarding the underlying assumptions in relative valuations make
them particularly vulnerable to manipulation.
Standard|zed Va|ues and Mu|t|p|es
When comparing identical assets, we can compare the prices of these assets.
Thus, the price of a Tiffany lamp or a Mickey Mantle rookie card can be compared to the
price at which an identical item was bought or sold in the market. However, comparing
assets that are not exactly similar can be a challenge. If we have to compare the prices of
two buildings of different sizes in the same location, the smaller building will look
cheaper unless we control for the size difference by computing the price per square foot.
Things get even messier when comparing publicly traded stocks across
companies. After all, the price per share of a stock is a function both of the value of the
equity in a company and the number of shares outstanding in the firm. Thus, a stock split
that doubles the number of units will approximately halve the stock price. To compare
the values of “similar” firms in the market, we need to standardize the values in some
way by scaling them to a common variable. In general, values can be standardized
relative to the earnings firms generate, to the book value or replacement value of the
firms themselves, to the revenues that firms generate or to measures that are specific to
firms in a sector. Figure 4.1 lists the alternatives:
Figure 4.1: Choices in Standardization

To provide a couple of illustrations, we can divide the market value of equity by the net
income to estimate how much a dollar in earnings today is costing us, as equity investors,
or the enterprise value to EBITDA to get a sense of the market value of operating assets,
relative to operating cash flows. We can even estimate what we are paying as a market
value per subscriber in a cable company or what the market value is relative to the
accounting estimate of value (book value). The central reason for standardizing, though,
does not change. We want to compare these numbers across companies.
1he Iour 8as|c keys to Us|ng Mu|t|p|es
Multiples are easy to use and easy to misuse. There are four basic steps to using
multiples wisely and for detecting misuse in the hands of others. The first step is to
ensure that the multiple is defined consistently and that it is measured uniformly across
the firms being compared. The second step is to be aware of the cross sectional
distribution of the multiple, not only across firms in the sector being analyzed but also
across the entire market. The third step is to analyze the multiple and understand not only
what fundamentals determine the multiple but also how changes in these fundamentals
translate into changes in the multiple. The final step is finding the right firms to use for
comparison and controlling for differences that may persist across these firms.
Def|n|t|ona| 1ests
Even the simplest multiples aie uefineu uiffeiently by uiffeient analysts.
Consiuei, foi instance, the piice eainings iatio (PE), the most wiuely useu valuation
Numerator = What you are paying for the asset
Denominator = What you are getting in return
Market value of equity Market value for the firm
Firm value = Market value of equity
+ Market value of debt
Market value of operating assets of firm
Enterprise value (EV) = Market value of equity
+ Market value of debt
- Cash
a. Accounting
b. Drivers
- # Customers
- # Subscribers
- # units
a. To Equity investors
- Net Income
- Earnings per share
b. To Firm
- Operating income (EBIT)
Book Value
a. Equity
= BV of equity
b. Firm
= BV of debt + BV of equity
c. Invested Capital
= BV of equity + BV of debt - Cash
Multiple =
Cash flow
a. To Equity
- Net Income + Depreciation
- Free CF to Equity
b. To Firm
- Free CF to Firm
multiple in valuation. Analysts uefine it to be the maiket piice uiviueu by the
eainings pei shaie but that is wheie the consensus enus. Theie aie a numbei of
vaiiants on the PE iatio. While the cuiient piice is conventionally useu in the
numeiatoi, theie aie some analysts who use the aveiage piice ovei the last six
months oi a yeai. The eainings pei shaie in the uenominatoi can be the eainings
pei shaie fiom the most iecent financial yeai (yieluing the cuiient PE), the last foui
quaiteis of eainings (yieluing the tiailing PE) anu expecteu eainings pei shaie in
the next financial yeai (iesulting in a foiwaiu PE). In auuition, eainings pei shaie
can be computeu baseu upon piimaiy shaies outstanuing oi fully uiluteu shaies anu
can incluue oi excluue extiaoiuinaiy items. Not only can these vaiiants on eainings
yielu vastly uiffeient values foi the piice eainings iatio but the one that gets useu by
analysts uepenus upon theii biases. Foi instance, in peiious of iising eainings, the
foiwaiu PE will yielu consistently lowei values than the tiailing PE, which, in tuin,
will be lowei than the cuiient PE. A bullish analyst will tenu to use the foiwaiu PE
to make the case that the stock is tiauing at a low multiple of eainings, while a
beaiish analyst will focus on the cuiient PE to make the case that the multiple is too
Every multiple has a numerator and a denominator. The numerator can be either
an equity value (such as market price or value of equity) or a firm value (such as
enterprise value, which is the sum of the values of debt and equity, net of cash). The
denominator can be an equity measure (such as earnings per share, net income or book
value of equity) or a firm measure (such as operating income, EBITDA or book value of
capital). One of the key tests to run on a multiple is to examine whether the numerator
and denominator are defined consistently. If the numerator for a multiple is an equity
value, then the denominator should be an equity value as well. If the numerator is a firm
value, then the denominator should be a firm value as well. To illustrate, the price
earnings ratio is a consistently defined multiple, since the numerator is the price per share
(which is an equity value) and the denominator is earnings per share (which is also an
equity value). So is the Enterprise value to EBITDA multiple, since the numerator and
denominator are both firm value measures; the enterprise value measures the market
value of the operating assets of a company and the EBITDA is the cashflow generated by
the operating assets, prior to taxes and reinvestment needs. In contrast, the price to sales
ratio and price to EBITDA are not consistently defined, since they divide the market
value of equity by a measure of operating revenue or earnings. Using these multiples will
lead you to find any firm with a significant debt burden to be cheap.
In relative valuation, the multiple is computed for all of the firms in a group and
then compared across these firms to make judgments on which firms are over priced and
which are under priced. For this comparison to have any merit, the multiple has to be
defined uniformly across all of the firms in the group. Thus, if the trailing PE is used for
one firm, it has to be used for all of the others as well. In fact, one of the problems with
using the current PE to compare firms in a group is that different firms can have different
fiscal-year ends. This can lead to some firms having their prices divided by earnings from
July 2007 to June 2008, with other firms having their prices divided by earnings from
January 2008 to December 2008. While the differences can be minor in mature sectors,
where earnings do not make quantum jumps over six months, they can be large in high-
growth sectors.
With both earnings and book value measures, there is another component to be
concerned about and that is the accounting standards used to estimate earnings and book
values. Differences in accounting standards can result in very different earnings and book
value numbers for similar firms. This makes comparisons of multiples across firms in
different markets, with different accounting standards, very difficult. Even with the same
accounting standards governing companies, there can be differences in firms that arise
because of discretionary accounting choices. There is also the additional problem posed
by the fact that some firms use different accounting rules (on depreciation and expensing)
for reporting purposes and tax purposes and others do not.
In summary, companies that

Fiims that auopt uiffeient iules foi iepoiting anu tax puiposes geneially iepoit highei eainings to
theii stockholueis than they uo to the tax authoiities. When they aie compaieu on a piice eainings
basis to fiims that uo not maintain uiffeient iepoiting anu tax books, they will look cheapei (lowei
use aggressive assumptions in measuring earnings will look cheaper on earnings
multiples than firms that adopt conservative accounting practices.
@&*=4"$2"A& :&*2*
When using a multiple, it is always useful to have a sense of what a high value, a low
value or a typical value for that multiple is in the market. In other words, knowing the
distributional characteristics of a multiple is a key part of using that multiple to identify
under or over valued firms. In addition, we need to understand the effects of outliers on
averages and unearth any biases in these estimates, introduced in the process of
estimating multiples. In the final part of this section, we will look at how the distributions
of multiples shift over time.
ulsLrlbuLlonal CharacLerlsLlcs
Many analysts who use multiples have a sector focus and have a good sense of
how different firms in their sector rank on specific multiples. What is often lacking,
however, is a sense of how the multiple is distributed across the entire market. Why
should a software analyst care about price earnings ratios of utility stocks? Because both
software and utility stocks are competing for the same investment dollar, they have to, in
a sense, play by the same rules. Furthermore, an awareness of how multiples vary across
sectors can be very useful in detecting when the sector we are analyzing is over or under
What are the distributional characteristics that matter? The standard statistics –
the average and standard deviation – are where we should start, but they represent the
beginning of the exploration. In markets like the United States, characterized by diverse
companies in very different businesses there will be significant variation across
companies on any multiple at any point in time. Table 4.1 summarizes the average and
standard deviation for three widely used multiples -price earnings ratios, price to book
value ratios and enterprise value to EBITDA multiple – in January 2010 in the United
States. In addition, the maximum and minimum values on
Table 4.1:Summary Statistics on Multiples
Current PE Price to Book Equity EV/EBITDA EV/Sales
Mean 29.57 3.81 36.27 13.35
Standard Error 1.34 0.30 17.04 5.70
Median 14.92 1.51 5.86 1.13
Skewness 12.12 41.64 64.64 68.99
Maximum 1570.00 1294.00 5116.05 28846.00
Number of firms 3457 5399.00 5429.00 5130.00
Sample Size 7036 7036.00 7036.00 7036.00
Note that the lowest value that any company can register on any of these multiples is zero
whereas the highest values are unbounded. As a result, the distributions for these
multiples are skewed towards the positive values as evidenced by the distribution of PE
ratios of US companies in January 2010 in figure 4.2:
Figure 4.2: PE Ratio Distribution: US stocks in January 2010

The consequences of skewed distributions for investors and analysts are significant:
a. Average versus Median values: As a result of the positively skewed distributions, the
average values for multiples will be higher than median values
. For instance, the
median PE ratio in January 2010 was about 15, well below the average PE reported in
table 4.1 and this is true for all multiples. The median value is much more
representative of the typical firm in the group and any comparisons should be made to
medians. The standard sales pitch of a stock being cheap because it trades at a

With the meuian, half of all fiims in the gioup fall below this value anu half lie above.


0-4 4-8 8-12 12-
28 -
PE Ratio
PE Ratios for US: January 2010
Current PE
Trailing PE
Forward PE
multiple less than the average for the sector should be retired in favor of one which
compares the stock’s pricing to the median for the sector.
b. Probabilistic statements: As a result of the focus on normal distributions in most
statistics classes, we begin attributing its properties to all distributions. For instance, it
is true that the probability of values in a normal distribution falling more than two
standard deviations away from the mean is very small. In the case of the PE ratio, this
rule would suggest that few companies should have PE ratios that fall below 27.89
(which is the average of 29.57 minus two standard errors) or above 32.25 (the average
plus two standard errors). The reality is that there are thousands of firms that fall
outside this range because the distributions are not normal.
CuLllers and Averages
As noted earlier, multiples are unconstrained on the upper end and firms can trade
at multiples of 500 or 2000 or even 10000. This can occur not only because of high stock
prices but also because earnings at firms can sometime drop to a few cents or even a
fraction of a cent. These outliers will result in averages that are not representative of the
sample. In many cases, data reporting services (such as Value Line and Standard and
Poors) that compute and report average values for multiples either throw out these
outliers when computing the averages or constrain the multiples to be less than or equal
to a fixed number. For instance, any firm that has a price earnings ratio greater than 500
will be assumed to have a price earnings ratio of 500. The consequence is that the
averages reported by two services for the same sector or market will almost never match
up because they deal with outliers differently. In November 2008, for instance, the
average PE reported for the S&P 500 varied widely across services from a low value of
11.5 on Yahoo! Finance to 14.2 on Morningstar. It is incumbent on those investors using
these numbers to be clear about how they are computed and consistent in their
8lases ln LsLlmaLlng MulLlples
With every multiple, there are firms for which the multiple cannot be computed.
Consider again the price-earnings ratio. When the earnings per share are negative, the
price earnings ratio for a firm is not meaningful and is usually not reported. When
looking at the average price earnings ratio across a group of firms, the firms with
negative earnings will all drop out of the sample because the price earnings ratio cannot
be computed. Why should this matter when the sample is large? The fact that the firms
that are taken out of the sample are the firms losing money creates a bias in the selection
process. In fact, the average PE ratio for the group will be biased upwards because of the
elimination of these firms.
There are three solutions to this problem. The first is to be aware of the bias and
build it into the analysis. In practical terms, this will mean adjusting the average PE down
to reflect the elimination of the money-losing firms. The second is to aggregate the
market value of equity and net income (or loss) for all of the firms in the group, including
the money-losing ones, and compute the price earnings ratio using the aggregated values.
The third choice is to use a multiple that can be computed for all of the firms in the
group. The inverse of the price-earning ratio, which is called the earnings yield, can be
computed for all firms, including those losing money and is not exposed to the same
biases as the price earnings ratio is.
1|me Var|at|on |n Mu|t|p|es
As any investoi who has tiackeu the maiket foi any length of time knows,
multiples change ovei time foi the entiie maiket anu foi inuiviuual sectois. To
pioviue a measuie of how much multiples can change ovei time, we have computeu
the aveiage anu meuian PE iatios each yeai fiom 2uuu to 2uu8 foi the 0niteu States
in table 4.2:
P":/- Z435 HO I"&%*8 "9)*88 &%.-5 [C C&*978
B<-)"(- Q-0%"#
% of firms
with PE
}an-uu S2.16 24.SS 65.33%
}an-u1 44.99 14.74 63.00%
}an-u2 4S.44 1S.S 57.06%
}an-uS SS.S6 16.68 49.99%
}an-u4 41.4 2u.76 58.18%
}an-uS 48.12 2S.21 56.43%
}an-u6 44.SS 22.4u 56.89%
}an-u7 4u.77 21.21 57.50%
}an-u8 4S.u2 18.16 56.42%
}an-u9 18.91 9.8u 58.36%
}an-1u 29.S7 14.92 49.13%
In the last column, we note the peicentage of fiims in the oveiall sample foi which
we weie able to compute PE iatios. Note that moie than half of all 0S fiims hau
negative eainings in }anuaiy 2u1u, making the PE iatio not meaningful.
Why uo multiples change ovei time. Some of the change can be attiibuteu to
funuamentals. As inteiest iates anu economic giowth shift ovei time, the piicing of
stocks will change to ieflect these shifts; lowei inteiest iates, foi instance, playeu a
key iole in the iise of eainings multiples thiough the 199us. Some of the change,
though, comes fiom changes in maiket peiception of iisk. As investois become moie
iisk aveise, which tenus to happen uuiing iecessions, multiples paiu foi stocks will
ueciease. This is captuieu in figuie 4.4, which shows eainings yielu
(Eainings¡Piice) iatio foi the S&P Suu anu the T.bonu iate fiom 196u to 2uu9.
2%($)- Z4Z5 O")#%#(8 &* H)%9- I"&%*8 *<-) &%.-5 KGA\@3\\G

EP Ratios and Interest Rates: 1960- 2009
Earnings Yield T.Bond Rate
Note that the eainings yielu iose with the tieasuiy bonu iate in the 197us anu
ueclineu as iates went uown in the 198us anu 199us. Fiom a piactical stanupoint,
what aie the consequences. The fiist is that compaiisons of multiples acioss time
aie fiaught with uangei. Foi instance, the common piactice of bianuing a maiket to
be unuei oi ovei valueu baseu upon compaiing the PE iatio touay to histoiical PE
iatios will leau to misleauing juugments when inteiest iates aie highei oi lowei
than histoiical noims. The seconu is that ielative valuations have shoit shelf lives. A
stock may look cheap ielative to compaiable companies touay but that assessment
can shift uiamatically ovei the next few months. Intiinsic valuations aie inheiently
moie stable than ielative valuations.
Ana|yt|ca| 1ests
In discussing why analysts were so fond of using multiples, we argued that relative
valuations require fewer assumptions than discounted cash flow valuations. While this is
technically true, it is only so on the surface. In reality, we make just as many assumptions
when we do a relative valuation as we do in a discounted cash flow valuation. The
difference is that the assumptions in a relative valuation are implicit and unstated,
whereas those in discounted cash flow valuation are explicit and stated. The two primary
questions that we need to answer before using a multiple are: What are the fundamentals
that determine at what multiple a firm should trade? How do changes in the fundamentals
affect the multiple?
In the introduction to discounted cash flow valuation, we observed that the value
of a firm is a function of three variables – it capacity to generate cash flows, its expected
growth in these cash flows and the uncertainty associated with these cash flows. Every
multiple, whether it is of earnings, revenues or book value, is a function of the same three
variables – risk, growth and cash flow generating potential. Intuitively, then, firms with
higher growth rates, less risk and greater cash flow generating potential should trade at
higher multiples than firms with lower growth, higher risk and less cash flow potential.
The specific measures of growth, risk and cash flow generating potential that are
used will vary from multiple to multiple. To look under the hood, so to speak, of equity
and firm value multiples, we can go back to fairly simple discounted cash flow models
for equity and firm value and use them to derive the multiples.
In the simplest discounted cash flow model for equity, which is a stable growth
dividend discount model, the value of equity is:
Value of Equity =
" g

where DPS
is the expected dividend in the next year, k
is the cost of equity and g
is the
expected stable growth rate. Dividing both sides by the earnings, we obtain the
discounted cash flow equation specifying the PE ratio for a stable growth firm.
= PE =
Payout Ratio* (1+ g
- g

The key determinants of the PE ratio are the expected growth rate in earnings per share,
the cost of equity and the payout ratio. Other things remaining equal, we would expect
higher growth, lower risk and higher payout ratio firms to trade at higher multiples of
earnings than firms without these characteristics.
Dividing both sides by the book value of equity, we can estimate the price/book
value ratio for a stable growth firm.
= PBV =
ROE* Payout Ratio* (1+ g
- g

where ROE is the return on equity and is the only variable in addition to the three that
determine PE ratios (growth rate, cost of equity and payout) that affects price to book
Dividing by the Sales per share, the price/sales ratio for a stable growth firm can
be estimated as a function of its profit margin, payout ratio, risk and expected growth.

= PS =
Profit Margin * Payout Ratio* (1+ g
- g

The net margin is the new variable that is added to the process. While all of these
computations are based upon a stable growth dividend discount model, we will show that
the conclusions hold even when we look at companies with high growth potential and
with other equity valuation models.
We can do a similar analysis to derive the firm value multiples. The value of a
firm in stable growth can be written as:
Value of Firm =
" g

Dividing both sides by the expected free cash flow to the firm yields the Value/FCFF
multiple for a stable growth firm.
" g

The multiple of FCFF that a firm commands will depend upon two variables – its cost of
capital and its expected stable growth rate. Since the free cash flow the firm is the after-
tax operating income netted against the net capital expenditures and working capital
needs of the firm, the multiples of revenues, EBIT and after-tax EBIT can also be
estimated similarly.
(1" t)
(1- Reinvestment Rate)

(1- Reinvestment Rate)(1- t)

After - tax Operating Margin (1- Reinvestment Rate)

Table 4.3 summarizes the multiples and the key variables that determine each multiple,
with the sign of the relationship in brackets next to each variable: ! indicates that an
increase in this variable will increase the multiple, whereas " indicates that an increase
in this variable will decrease the multiple, holding all else constant.
Table 4.3: Fundamentals Determining Multiples
Multiple Fundamental Determinants
Price Earnings Ratio Expected Growth(!), Payout(!), Risk(")
Price to Book Equity Ratio Expected Growth(!), Payout(!), Risk("), ROE(!)
Price to Sales Ratio Expected Growth(!), Payout(!), Risk("), Net
EV to FCFF Cost of capital("), Growth Rate(!)
EV to EBITDA Expected Growth(!), Reinvestment Rate("), Risk("),
ROC(!), Tax rate(")
EV to Capital Ratio Expected Growth(!), Reinvestment Rate("), Risk("),
EV to Sales Expected Growth(!), Reinvestment Rate("), Risk("),
Operating Margin(!)
The point of this analysis is not to suggest that we go back to using discounted cash flow
valuation, but to understand the variables that may cause these multiples to vary across
firms in the same sector. If we ignore these variables, we might conclude that a stock
with a PE of 8 is cheaper than one with a PE of 12 when the true reason may be that the
latter has higher expected growth or we might decide that a stock with a P/BV ratio of 0.7
is cheaper than one with a P/BV ratio of 1.5 when the true reason may be that the latter
has a much higher return on equity.
(-#$)0"-0 ;)4")B%&
While the variables that determine a multiple can be extracted from a discounted
cash flow model and the relationship between each variable and the multiple can be
developed by holding all else constant and asking what-if questions, there is a single
variable that dominates when it comes to explaining each multiple (and it is not the same
variable for every multiple). This variable, which is called the companion variable, is
critical to using multiples wisely in making valuation judgments and can be identified by
looking for the variable that best explain differences across firms using a particular
So, what are the companion variables for the most widely used multiples? To
arrive at this judgment, we looked at which of the variables listed in table 4.2 was most
useful in explaining differences across firms with each multiple and came up with the
listing in table 4.4:
Table 4.4: Valuation Mismatches
Multiple Companion variable Valuation mismatch
PE Ratio Expected Growth Low PE stock with high expected growth rate
in earnings per share
PBV Ratio ROE Low PBV stock with high ROE
PS Ratio Net Margin Low PS stock with high net profit margin.
EV/EBITDA Reinvestment Rate Low EV/EBITDA stock with low reinvestment
EV/Capital Return on Capital Low EV/Capital stock with high return on
EV/Sales After-tax operating
Low EV/Sales ratio with a high after-tax
operating margin.
Knowing the fundamentals that determine a multiple is a useful first step, but
understanding how the multiple changes as the fundamentals change is just as critical to
using the multiple. To illustrate, knowing that higher growth firms have higher PE ratios
is not a sufficient insight if we are called upon to analyze whether a firm with a growth
rate that is twice as high as the average growth rate for the sector should have a PE ratio
that is 1.5 times or 1.8 times or 2 times the average price earnings ratio for the sector. To
make this judgment, we need to know how the PE ratio changes as the growth rate
A surprisingly large number of valuation analyses are based upon the assumption
that there is a linear relationship between multiples and fundamentals. For instance, the
PEG ratio, which is the ratio of the PE to the expected growth rate of a firm and widely
used to analyze high growth firms, implicitly assumes that PE ratios and expected growth
rates are linearly related.
One of the advantages of deriving the multiples from a discounted cash flow
model, as was done in the last section, is that we can analyze the relationship between
each fundamental variable and the multiple by keeping everything else constant and
changing the value of that variable. When we do this, we will find that there are very few
linear relationships in valuation.
App||cat|on 1ests
When multiples are used, they tend to be used in conjunction with comparable
firms to determine the value of a firm or its equity. But what is a comparable firm? While
the conventional practice is to look at firms within the same industry or business, this is
not necessarily always the correct or the best way of identifying these firms. In addition,
no matter how carefully we choose comparable firms, differences will remain between
the firm we are valuing and the comparable firms. Figuring out how to control for these
differences is a significant part of relative valuation.
C+)2 "* ) =-#$)4)B%& ?"4#D
A comparable firm is one with cash flows, growth potential, and risk similar to
the firm being valued. It would be ideal if we could value a firm by looking at how an
exactly identical firm - in terms of risk, growth and cash flows - is priced. Nowhere in
this definition is there a component that relates to the industry or sector to which a firm
belongs. Thus, a telecommunications firm can be compared to a software firm, if the two
are identical in terms of cash flows, growth and risk. In most analyses, however, analysts
define comparable firms to be other firms in the firm’s business or businesses. If there are
enough firms in the industry to allow for it, this list is pruned further using other criteria;
for instance, only firms of similar size may be considered. The implicit assumption being
made here is that firms in the same sector have similar risk, growth, and cash flow
profiles and therefore can be compared with much more legitimacy. The tiaueoff is
theiefoie a simple one. Befining an inuustiy moie bioauly incieases the numbei of
compaiable fiims, but it also iesults in a moie uiveise gioup of companies.
(-024-%%"05 ?-4 @"??&4&0=&* )=4-** ,"4#*
No matter how carefully we construct our list of comparable firms, we will end up
with firms that are different from the firm we are valuing. The differences may be small
on some variables and large on others and we will have to control for these differences in
a relative valuation. There are three ways of controlling for these differences:
1. Sub[ecLlve Ad[usLmenLs
Relative valuation begins with two choices - the multiple used in the analysis and
the group of firms that comprises the comparable firms. In many relative valuation, the
multiple is calculated for each of the comparable firms and the average is computed. To
evaluate an individual firm, the analyst then compare the multiple it trades at to the
average computed; if it is significantly different, the analyst can make a subjective
judgment about whether the firm’s individual characteristics (growth, risk or cash flows)
may explain the difference. Thus, a firm may have a PE ratio of 22 in a sector where the
average PE is only 15, but the analyst may conclude that this difference can be justified
because the firm has higher growth potential than the average firm in the industry. If, in
the judgment of the analyst, the difference on the multiple cannot be explained by the
fundamentals, the firm will be viewed as over valued (if its multiple is higher than the
average) or undervalued (if its multiple is lower than the average). The weakness in this
approach is not that analysts are called upon to make subjective judgments, but that the
judgments are often based upon little more than guesswork. All too often, these
judgments confirm their biases about companies.
2. Modlfled MulLlples
In this approach, we modify the multiple to take into account the most important
variable determining it – the companion variable. To provide an illustration, analysts who
compare PE ratios across companies with very different growth rates often divide the PE
ratio by the expected growth rate in EPS to determine a growth-adjusted PE ratio or the
PEG ratio. This ratio is then compared across companies with different growth rates to
find under and over valued companies.
There are two implicit assumptions that we make when using these modified
multiples. The first is that these firms are comparable on all the other measures of value,
other than the one being controlled for. In other words, when comparing PEG ratios
across companies, we are assuming that they are all of equivalent risk. The other
assumption generally made is that that the relationship between the multiples and
fundamentals is linear. Again, using PEG ratios to illustrate the point, we are assuming
that as growth doubles, the PE ratio will double; if this assumption does not hold up and
PE ratios do not increase proportional to growth, companies with high growth rates will
look cheap on a PEG ratio basis.
3. SLaLlsLlcal 1echnlques
Subjective adjustments and modified multiples are difficult to use when the
relationship between multiples and the fundamental variables that determine them
becomes complex. There are statistical techniques that offer promise, when this happens.
In a multiple regression, for instance, we attempt to explain a dependent variable by using
independent variables that we believe influence the dependent variable. This mirrors what
we are attempting to do in relative valuation, where we try to explain differences across
firms on a multiple (PE ratio, EV/EBITDA) using fundamental variables (such as risk,
growth and cash flows). Regressions offer three advantages over the subjective approach:
a. The output from the regression gives us a measure of how strong the relationship is
between the multiple and the variable being used. Thus, if we are contending that
higher growth companies have higher PE ratios, the regression should yield clues to
both how growth and PE ratios are related (through the coefficient on growth as an
independent variable) and how strong the relationship is (through the t statistics and R
b. If the relationship between a multiple and the fundamental we are using to explain it
is non-linear, the regression can be modified to allow for the relationship.
c. Unlike the modified multiple approach, where we were able to control for differences
on only one variable, a regression can be extended to allow for more than one
variable and even for cross effects across these variables.
In general, regressions seem particularly suited to our task in relative valuation, which is
to make sense of voluminous and sometimes contradictory data.
Exhibit 4.1 illustrates all three approaches – the subjective comparison, modified
multiples and statistical techniques applied to companies in the beverage sector. Based
just on PE ratios, Hansen Natural, Andres Wine and Todhunter look cheap, trading at less
than ten times earnings. With PEG ratios, Hansen Natural continues to look cheap but
Andres Wine and Todhunter do not. Controlling for differences in risk and growth in a
regression, Hansen Natural looks under valued by about 20%, relative to the sector.

keconc|||ng ke|at|ve and Intr|ns|c Va|uat|ons
The two approaches to valuation – discounted cash flow valuation and relative
valuation – will generally yield different estimates of value for the same firm at the same
point in time. It is even possible for one approach to generate the result that the stock is
under valued while the other concludes that it is over valued. Furthermore, even within
relative valuation, we can arrive at different estimates of value depending upon which
multiple we use and what firms we based the relative valuation on.
The differences in value between discounted cash flow valuation and relative
valuation come from different views of market efficiency, or put more precisely, market
inefficiency. In discounted cash flow valuation, we assume that markets make mistakes,
that they correct these mistakes over time, and that these mistakes can often occur across
entire sectors or even the entire market. In relative valuation, we assume that while
markets make mistakes on individual stocks, they are correct on average. In other words,
when we value a new software company relative to other small software companies, we
are assuming that the market has priced these companies correctly, on average, even
though it might have made mistakes in the pricing of each of them individually. Thus, a
stock may be over valued on a discounted cash flow basis but under valued on a relative
basis, if the firms used for comparison in the relative valuation are all overpriced by the
market. The reverse would occur, if an entire sector or market were underpriced.
In relative valuation, we estimate the value of an asset by looking at how similar
assets are priced. To make this comparison, we begin by converting prices into multiples
– standardizing prices – and then comparing these multiples across firms that we define
as comparable. Prices can be standardized based upon earnings, book value, revenue or
sector-specific variables.
While the allure of multiples remains their simplicity, there are four steps in using
them soundly. First, we have to define the multiple consistently and measure it uniformly
across the firms being compared. Second, we need to have a sense of how the multiple
varies across firms in the market. In other words, we need to know what a high value, a
low value and a typical value are for the multiple in question. Third, we need to identify
the fundamental variables that determine each multiple and how changes in these
fundamentals affect the value of the multiple. Finally, we need to find truly comparable
firms and adjust for differences between the firms on fundamental characteristics.

Sect|on 2: Va|u|ng across the ||fe cyc|e
Chapter S: Va|u|ng young growth compan|es and bus|nesses
valuing young companies is uifficult to uo, paitly because of the absence of
opeiating histoiy anu paitly because most young fiims uo not make it thiough these
eaily stages to success. 0ntil iecent yeais, these companies weie funueu piimaiily
by ventuie capitalists, but in the last two uecaues, some of these young companies
have become publicly listeu, exposing investois to both oppoitunity anu thieat. In
this chaptei, we begin by looking at chaiacteiistics shaieu by young companies anu
the valuation challenges that they cieate. We follow up by looking at how intiinsic
anu ielative valuation techniques can be auapteu to meet these challenges anu uiaw
fiom these techniques some pointeis that can help investois in finuing goou ueals.
What |s a young growth company?
If eveiy business staits with an iuea, young companies can iange the
spectium fiom iuea companies, that have no ievenues oi piouucts, to stait-up
companies that aie testing out piouuct appeal to seconu stage companies that aie
moving on the path to piofitability. Figuie S.1 illustiates the uiveisity of young,
giowth companies:
2%($)- U4K5 P1- O")/' C&"(-8 *; &1- ?%;- >'9/-

Idea companies
No revenues
Operating losses
Starrt-up ccmpanies
Small revenues
Increasing losses
Second-stage companies
Growing revenues
Move towards profts
Nost young giowth companies tenu to be piivately owneu anu funueu, eithei
entiiely by theii founuei¡ownei oi by ventuie capitalists. In the last two uecaues,
though, companies in some sectois such as technology anu biotechnology have been
able to leap fiog the piocess anu go public.
Character|st|cs of young growth compan|es
Young companies aie uiveise, but they geneially shaie some common attiibutes:
1. No histoiy: At the iisk of stating the obvious, young companies have veiy limiteu
histoiies. Nany of them have only one oi two yeais of uata available on
opeiations anu financing anu some have financials foi only a poition of a yeai,
foi instance.
2. Small oi no ievenues, opeiating losses: The limiteu histoiy that is available foi
young companies is ienueieu even less useful by the fact that theie is little
opeiating uetail in them. Revenues aie small oi non-existent foi iuea companies
anu the expenses often aie associateu with getting the business establisheu,
iathei than geneiating ievenues. In combination, they iesult in significant
opeiating losses.
S. Bepenuent on piivate equity: Foi the most pait, young businesses aie uepenuent
upon equity fiom piivate souices, iathei than public maikets. At the eailiei
stages, the equity is pioviueu almost entiiely by the founuei (anu fiienus anu
family). As the piomise of futuie success incieases, anu with it the neeu foi moie
capital, ventuie capitalists become a souice of equity capital, in ietuin foi a
shaie of the owneiship in the fiim. In iecent yeais, though, some companies
have bypasseu the ventuie capital ioute anu gone uiiectly to public maikets.
4. Nany uon't suivive: Nost young companies uon't suivive the test of commeicial
success anu fail. 0ne stuuy of the Buieau of Laboi Statistics Quaiteily Census of
Employment anu Wages (QCEW) computes suivival statistics acioss fiims.

0sing a seven-yeai uatabase fiom 1998 to 2uuS, the authois concluueu that only

Knaup, Amy E., Nay 2uuS,, "Suivival anu longevity in the Business Employment Bynamics uata," Q*#&1/'
?":*) I-<%-+, pp. Su-S6; Knaup, Amy E. anu NC. Piazza, Septembei 2uu7, Business Employment Bynamics Bata:
Suivival anu Longevity, Nonthly Laboi Review, pp S-1u.
44% of all businesses that weie founueu in 1998 suiviveu at least 4 yeais anu
only S1% maue it thiough all seven yeais. In auuition, they finu that suivival
iates vaiy acioss sectois, with only 2S% of fiims in the infoimation sectoi
(which incluues technology) suiviving 7 yeais, wheieas almost 44% of health
seivice businesses make it thiough that peiiou.
S. Investments aie illiquiu: Since equity investments in young fiims tenu to be
piivately helu anu in non-stanuaiuizeu units, they aie also much moie illiquiu
than investments in theii publicly tiaueu counteipaits.
Va|uat|on Issues
The fact that young companies have limiteu histoiies anu aie paiticulaily
susceptible to failuie all contiibute to making them moie uifficult to value. In this
section, we will begin by consiueiing the estimation issues that we iun into in
uiscounteu cash flow valuations anu we will follow up by evaluating why these same
issues ciop up when we uo ielative valuation.
Intr|ns|c (DCI) Va|uat|on
In chaptei S, we laiu out the foui pieces that make up the intiinsic valuation
puzzle - the cash flows foim existing assets, the expecteu giowth fiom both new
investments anu impioveu efficiency on existing assets, the uiscount iates that
emeige fiom oui assessments of iisk in both the business anu its equity, anu the
assessment of when the fiim will become a stable giowth fiim (allowing us to
estimate teiminal value). 0n each of these measuies, young fiims pose estimation
challenges that can be tiaceu back to theii common chaiacteiistics.
()*+ ?%-.* ?4-# &E"*2"05 )**&2*
When valuing any company, we stait by estimating cash flows fiom existing
investments, not only to pioviue a base figuie, but also to leain something about the
company's business mouel. Theie aie thiee pioblems with estimating cash flows
fiom existing assets foi young fiims.
- The fact that existing assets iepiesent a slivei of the potential value of the fiim
that the ievenues anu income they geneiate aie of little impoit in assessing
oveiall fiim value.
- The absence of histoiical uata makes it uifficult to assess how well the ievenues
fiom existing assets will holu up if macio economic conuitions become less
favoiable. In othei woius, if all you have is one yeai of financial uata, it is moie
uifficult to make a juugment on whethei the ievenues iepiesent a flash in the
pan oi aie sustainable.
- The expenses that young companies incui to geneiate futuie giowth aie often
mixeu in with the expenses associateu with geneiating cuiient ievenues. Foi
instance, it is not unusual to see the Selling, ueneial anu Auministiative (S,u&A)
expenses at some young companies be thiee oi foui times laigei than ievenues,
laigely because they incluue the expenses associateu with lining up futuie
34-.2+ /**&2*
The bulk of a young company's value comes fiom giowth assets, but estimating
theii value comes with its own impeuiments.
- The absence of ievenues in some cases, anu the lack of histoiy on ievenues in
otheis, means that we cannot use past ievenue giowth as an input into the
estimation of futuie ievenues. As a iesult, we aie often uepenuent upon the
fiim's own estimates of futuie ievenues, with all the biases associateu with these
- Even if we weie able to estimate ievenues in futuie yeais, we have to also
estimate how eainings will evolve in futuie yeais, as ievenues change. Beie
again, the fact that young companies tenu to iepoit losses anu have no histoiy on
opeiating income makes it moie uifficult to assess what futuie piofit maigins
will be.
- In chaptei S, we noteu that it is not ievenue oi even eainings giowth pei se that
ueteimines value, but the quality of that giowth. To assess the quality of giowth,
we lookeu at how much the fiim ieinvesteu to geneiate its expecteu giowth,
noting that value cieating giowth aiises only when a fiim geneiates a ietuin on
capital gieatei than its cost of capital on its giowth investments. This intuitive
concept is put to the test with young companies, because theie is little to base
the expecteu ietuin on capital on new investments. Past uata pioviues little
guiuance, because the company has maue so few investments in the past anu
these investments have been in existence foi shoit peiious. The cuiient ietuin
on capital, which is often useu as a staiting point foi estimating futuie ietuins, is
geneially a negative numbei foi young companies.
In summaiy, we have a tough time estimating futuie giowth in ievenues anu
opeiating maigins foi young companies, anu the estimation pioblems aie
accentuateu by the uifficulties we face in coming up with ieinvestment assumptions
that aie consistent with oui giowth estimates.
@"*=-102 8)2&*
The stanuaiu appioaches foi assessing the iisk in a company anu coming up
with uiscount iates aie uepenuent upon the availability of maiket piices foi the
secuiities issueu by the fiim. Thus, we estimate the beta foi equity by iegiessing
ietuins on a stock against ietuins on a maiket inuex, anu the cost of uebt by looking
at the cuiient maiket piices of publicly tiaueu bonus. With young companies, these
assumptions aie open to challenge. Fiist, most young companies aie not publicly
tiaueu anu have no publicly tiaueu bonus outstanuing. Consequently, theie is no
way in which we can iun a iegiession of past ietuins, to get an equity beta, oi use a
maiket inteiest iate on uebt. To auu to the pioblem, a laige piopoition of the equity
in a young company is often helu by investois who aie eithei completely investeu in
the company (founueis) oi only paitially uiveisifieu (ventuie capitalists). As a
iesult, these investois aie unlikely to accept the notion that the only iisk that
matteis is the iisk that cannot be uiveisifieu away anu insteau will uemanu
compensation foi at least some of the fiim specific iisk.
:&4#"0)% ;)%1&
If the teiminal value accounts foi a laige piopoition of the oveiall value of a
typical fiim, it is an even biggei component of the value of a young company. In fact,
it is not unusual foi the teiminal value to account foi 9u%, 1uu% oi even moie than
1uu% of the cuiient value of a young company. Consequently, assumptions about
when a fiim will ieach stable giowth, a pie-iequisite foi estimating teiminal value,
anu its chaiacteiistics in stable giowth can have a substantial impact on the value
that we attach to a young company. 0ui task, though, is complicateu by oui inability
to answei thiee questions:
a. Will the fiim make it to stable giowth. In an eailiei section, we noteu the high
failuie iate among young fiims. In effect, these fiims will nevei make it to stable
giowth anu the teiminal value will not pioviue the laige winufall to value that is
uoes foi a going concein. Estimating the piobability of suivival foi a fiim, eaily
in the life cycle, is theiefoie a ciitical component of value, but not necessaiily an
easy input to estimate.
b. When will the fiim become a stable giowth fiim. Even if we assume that a fiim
will make it to stable giowth in the futuie, estimating when that will occui is a
uifficult exeicise. Aftei all, some fiims ieach steauy state in a couple of yeais,
wheieas otheis have a much longei stietch of high giowth, befoie settling into
matuie giowth. The juugment of when a fiim will become stable is complicateu
by the fact that the actions of competitois can play an impoitant iole in how
giowth evolves ovei time.
c. What will the fiim look like in stable giowth. In chaptei S, we noteu that it is not
just the giowth iate in the stable giowth iate that ueteimines the magnituue of
teiminal value but the concuiient assumptions we make about iisk anu excess
ietuins uuiing the stable phase. In effect, assuming that a fiim will continue to
geneiate excess ietuins foievei will leau to a highei teiminal value than
assuming that excess ietuins will conveige on zeio oi be negative. While this is a
juugment that we have to make foi any fiim, the absence of any histoiical uata
on excess ietuins at young fiims uoes complicate estimation.
;)%1& -? FG1"2< (%)"#*
0nce the cash flows have been estimateu, a uiscount iate computeu anu the
piesent value computeu, we have estimateu the value of the aggiegate equity in the
fiim. If all equity claims in the fiim aie equivalent, as is the case with a publicly
tiaueu fiim with one class of shaies, we uiviue the value of equity piopoitionately
among the claims to get the value pei claim. With young fiims, theie can be laige
uiffeiences acioss equity claims on cash flows anu contiol iights, with some
claimholueis getting piefeiential iights ovei otheis. As a final point, the lack of
liquiuity in equity investments in piivate business have an effect on how much value
we attach to them. In geneial, we shoulu expect moie illiquiu investments to have
less value than moie liquiu investments, but measuiing anu piicing the illiquiuity in
the equity of piivate businesses is fai moie uifficult to uo than in theii publicly
tiaueu counteipaits.
ke|at|ve Va|uat|on
The uifficulties that we have outlineu in valuing young companies in a
uiscounteu cash flow mouel leau some analysts to consiuei using ielative valuation
appioaches to value these companies. In effect, they tiy to value young companies
using multiples anu compaiables. Bowevei, this task is also maue moie uifficult by
the following factois:
1. What uo you scale value to. All valuation multiples have to be scaleu to some
common measuie, anu conventional scaling measuies incluue eainings, book
value anu ievenues. With young companies, each of these measuies can pose
pioblems. Since most of them iepoit losses eaily in the life cycle, multiples such
as piice eainings iatios anu EBITBA multiples cannot be computeu. Since the
fiim has been in opeiation only a shoit peiiou, the book value is likely to be a
veiy small numbei anu not ieflect the tiue capital investeu in the company. Even
ievenues can be pioblematic, since they can be non-existent foi iuea companies
anu miniscule foi companies that have just tiansitioneu into commeicial
2. What aie youi compaiable companies. When ielative valuation is useu to value
a publicly tiaueu company, the compaiable fiims aie usually publicly tiaueu
counteipaits in the same sectoi. With young companies, the compaiison woulu
logically be to othei young companies in the same business but these companies
aie usually not publicly tiaueu anu have no maiket piices (oi multiples that can
be computeu). We coulu look at the multiples at which publicly tiaueu fiims in
the same sectoi tiaue at, but these fiims aie likely to have veiy uiffeient iisk,
cash flow anu giowth chaiacteiistics than the young fiim being valueu.
S. What is the best pioxy foi iisk. Nany of the pioxies useu foi iisk, in ielative
valuation, aie maiket baseu. Thus, beta oi stanuaiu ueviation of equity ietuins
aie often useu as measuies of equity iisk, but these measuies cannot be
computeu foi young companies that have been listeu foi shoit peiious.
4. Bow uo you contiol foi suivival. In the context of uiscounteu cash flow
valuation, we lookeu at the pioblems cieateu by the high failuie iate of young
companies. This is also an issue with using ielative valuation. Intuitively, we
woulu expect the ielative value of a young company (the multiple of ievenues oi
eainings that we assign it) to inciease with its likelihoou of suivival. Bowevei,
putting this intuitive piinciple into piactice is not easy to uo.
S. Bow uo you aujust foi uiffeiences in equity claims. With intiinsic valuation, we
noteu the effect that uiffeiences in cash flows anu contiol claims can have on the
value of equity claims. When uoing ielative valuation, we will have to confiont
the same issues.
In conclusion, the use of ielative valuation may seem like an easy solution, when
faceu with the estimation challenges poseu in intiinsic valuation, but all of the
pioblems that we face in the lattei iemain pioblems when we uo the foimei.
Va|uat|on So|ut|ons
While it is unueistanuable that analysts, when confionteu with the myiiau
unceitainties associateu with valuing young companies, look foi shoit cuts, theie is
no ieason why young companies cannot be valueu systematically. In this section, we
will begin by laying out the founuations foi estimating the intiinsic value of a young
company, move on to consiuei how best to auapt ielative valuation foi the special
chaiacteiistics of young companies anu close with a uiscussion of how ieal options
may be useful, at least foi some small businesses.
D|scounted Cash I|ow Va|uat|on
To applying uiscounteu cash flow mouels to valuing young companies, we
will move systematically thiough the piocess of estimation, consiueiing at each
stage, how best to ueal with the chaiacteiistics of young companies.
HI F*2"#)2"-0 -? ?1214& =)*+ ?%-.*
To estimate cash flows, we stait by estimating the total maiket foi a piouuct oi
seivice anu ueiive the iest of the numbeis fiom that top line. In effect, we estimate
the ievenues fiist anu then consiuei how much we neeu as capacity (anu capital to
cieate this capacity) to sustain these ievenues. The steps involveu in the piocess aie
the following:
• Potential maiket foi the piouuct¡seivice: The fiist step in ueiiving the ievenues
foi the fiim is estimating the total potential maiket foi its piouucts anu seivices.
Theie aie thiee challenges we face at this junctuie.
a. Befining the piouuct¡seivice offeieu by the fiim: If the piouuct oi seivice
offeieu by the fiim is uefineu naiiowly, the potential maiket will be
ciicumsciibeu by that uefinition anu will be smallei. If we use a bioauei
uefinition, the maiket will expanu to fit that uefinition. Foi example,
uefining as a book ietailei, which is what it was in 1998,
woulu have yielueu a total maiket of less than $ 1u billion in that yeai,
iepiesenting total book ietailing sales in 1998. Categoiizing
as a geneial ietailei woulu have yielueu a much laigei potential maiket.
While that might have been uifficult to uefenu in 1998, it uiu become
moie plausible as Amazon expanueu its offeiings in 1999 anu 2uuu.
b. Estimating the maiket size: Baving uefineu the maiket, we face the
challenge of estimating the size of that maiket. Foi a piouuct oi seivice
that is enteiing an establisheu maiket, the best souices of uata tenu to be
tiaue publications anu piofessional foiecasting seivices.
c. Evolution in total maiket ovei time: Since we have to foiecast ievenues
into the futuie, it woulu be useful to get a sense of how the total maiket is
expecteu to change oi giow ovei time. This infoimation is usually also
usually available fiom the same souices that pioviue the numbeis foi the
cuiient maiket size.
2. Naiket Shaie: 0nce we have a sense of the oveiall maiket size anu how it will
changeovei time, we have to estimate the shaie of that maiket that will be captuieu
by the fiim being analyzeu, both in the long teim anu in the time peiious leauing up
to steauy state. Theie aie two othei vaiiables that have to be consiueieu. 0ne is the
capacity of the management of the young company to uelivei on its piomises; many
entiepieneuis have biilliant iueas but uo not have the management anu business
skills to take it to commeicial fiuition. That is pait of the ieason that ventuie
capitalists look foi entiepieneuis who have hau a tiack iecoiu of success in the
past. The othei is the iesouices that the young company can uiaw on to get its
piouuct¡seivice to the uesiieu maiket shaie. 0ptimistic foiecasts foi maiket shaie
have to be coupleu with laige investments in both capacity anu maiketing; piouucts
usually uon't piouuce anu sell themselves.
S. 0peiating expenses¡ maigins: Revenues may be the top line but as investois, but
a fiim can have value only if it ultimately ueliveis eainings. Consequently, the next
step is estimating the opeiating expenses associateu with the estimateu ievenues
anu we woulu sepaiate the estimation piocess into two paits. In the fiist pait, we
woulu focus on estimating the opeiating maigin in steauy state, piimaiily by looking
at moie establisheu companies in the business. 0nce we have the taiget maigin, we
can then look at how we expect the maigin to evolve ovei time; this "pathway to
piofitability" can be iockiei foi some fiims than otheis, with fixeu costs anu
competition playing significant ioles in the estimation.
4. Investments foi giowth: When owneis aie askeu foi foiecasts of ievenues anu
eainings (step 2 anu S), it is natuial that they go foi optimistic values: ievenues
inciease at exponential iates anu maigins quickly move towaius taiget values. In
any competitive business, though, neithei ievenue giowth noi maigin impiovement
is ueliveieu foi fiee. Consequently, it is ciitical that we estimate how much the fiim
is ieinvesting to geneiate the foiecasteu giowth. With a manufactuiing fiim, this
will take the fiim of investments in auuitional piouuction capacity anu with a
technology fiim, it will incluue not only investments in R&B anu new patents, but
also in human capital (hiiing softwaie piogiammeis anu ieseaicheis). Theie aie
two ieasons to pay attention to this step in the piocess. The fiist is that these
investments will iequiie cash outflows anu thus affect the final bottom line, which is
the cash flow that can be ueliveieu to investois. The seconu, anu this is especially so
with young fiims, this ieinvestment will often iesult in negative cash flows, which
will then have to be coveieu with new capital infusions. Thus, existing equity
investois will see theii shaie of the owneiship eithei ieuuceu (when new equity
investois come in) oi be calleu upon to make investments to keep the business
JI F*2"#)2"05 @"*=-102 8)2&*
In chaptei 2, we laiu out the inputs that go into uiscount iates. Summaiizing, we
estimateu the cost of equity by looking at the beta (oi betas) of the company in
question, the cost of uebt fiom a measuie of uefault iisk (an actual oi synthetic
iating) anu applieu the maiket value weights foi uebt anu equity to come up with
the cost of capital. Theie aie both conceptual anu estimation issues that make each
of these ingieuients uifficult to ueal with, when it comes to young companies.
• Beta anu cost of equity: Laige poitions of equity in even publicly tiaueu young
giowth companies is helu by eithei unuiveisifieu founuei owneis oi by paitially
uiveisifieu ventuie capitalists. Consequently, it uoes not make sense to assume
that the only iisk that shoulu be piiceu in is the maiket iisk; the cost of equity
has to incoipoiate some (in the case of ventuie capitalists) oi maybe even all
(foi completely unuiveisifieu owneis) of the fiim specific iisk.
• Cost of uebt: Young fiims almost nevei have bonus outstanuing anu aie insteau
uepenuent on bank loans foi uebt. C. Even though we may be able to use the
piocess uesciibeu in chaptei 2 to estimate a synthetic iating, the iesulting cost
of uebt may not appiopiiately captuie the inteiest iates actually paiu by these
small anu iisky businesses, since banks may chaige them a piemium.
• Bebt iatio: Since the equity anu uebt in young companies is not tiaueu, theie aie
no maiket values that can be useu to weight the uebt anu equity to aiiive at the
cost of capital.
• Bynamic inputs: Even if we aie able to estimate the cuiient costs of uebt anu
equity foi a fiim, each of the numbeis that we use in the cost of capital
computation can anu will change ovei time, as the company evolves.
To estimate the cost of capital, we woulu suggest an appioach that looks past the
company anu at the business the company opeiates in, anu aujusting foi key
uiffeiences. In effect, we use sectoi aveiages foi uiscount iates, aujusteu foi the
highei iisk anu lack of uiveisification of youngei companies. Thus, in the eaily
yeais, costs of equity anu capital will be much highei foi young companies than foi
moie matuie counteipaits in the same business. As we go fuithei into the futuie,
though, we shoulu expect to see the cost of capital move towaius sectoi aveiages, as
the young company giows anu matuies.
KI F*2"#)2"05 ;)%1& 2-7)< )07 )7L1*2"05 ?-4 *14A"A)%
The expecteu cash flows anu uiscount iates, estimateu in the last two steps, aie
key builuing blocks towaius estimating the value of the business anu equity touay.
Bowevei, theie aie thiee moie components that we have to ueal with at this stage in
getting to the value of the fiim. The fiist is ueteimining what happens at the enu of
oui foiecast peiiou, i.e., the assumptions that leau to the value we assign the
business at the enu of the peiiou. The seconu is aujusting foi the likelihoou that the
business will not suivive, an issue that has auueu ielevance with young fiims,
because so many fail eaily in the piocess. The thiiu factoi that we have to ueal with,
at least in businesses that aie uepenuent upon a peison oi a few key people foi theii
success, is how best to incoipoiate into the value the effects of theii loss.
1ermlnal value
The "teiminal value" estimate iepiesents a big chunk of the value of any
business, but is an even biggei component of value foi a young fiim that has small oi
negative cash flows in the neai yeais, accounting foi 8u%, 9u% oi moie than 1uu%
of value touay.
The basic piinciples that govein teiminal value iemain unchangeu:

The "moie than 1uu%" may stiike ieaueis as impossible, but in young companies with substantial
negative cash flows in the eaily yeais, the teiminal value can be moie than 1uu% of value. In effect,
the giowth iate useu has to be less than the giowth iate of the economy, the cost of
capital has to conveige on that of a matuie fiim anu theie has to be enough
ieinvestment to sustain the "stable" giowth. When valuing fiims, wheie success will
tianslate into an initial public offeiing oi sale to a publicly tiaueu fiim, the peipetual
giowth mouel makes the most sense. Foi smallei, less ambitious fiims, wheie
success will be uefineu as suiviving the foiecast peiiou anu ueliveiing cash flows
beyonu, assuming a finite life foi the cash flows anu estimating a liquiuation value
will yielu the most ieasonable value.
Ad[usL for Survlval
Nany young fiims succumb to the competitive piessuies of the maiket place
anu uon't make it. Rathei than tiy to aujust the uiscount iate foi this likelihoou, a
uifficult exeicise, we woulu suggest a two-step appioach. In the fiist step, we woulu
value the fiim on the assumption that it suivives anu makes it to financial heath.
This, in effect, is what we aie assuming when we a teiminal value anu uiscount cash
flows back to touay at a iisk-aujusteu uiscount iate. In the seconu step, we woulu
biing in the likelihoou that the fiim will not suivive. The piobability of failuie can be
assesseu most simply, by using sectoi aveiages. Eailiei in the chaptei we noteu a
stuuy that useu uata fiom the Buieau of Laboi Statistics to estimate the piobability
of suivival foi fiims in uiffeient sectois fiom 1998 to 2uuS. We coulu use the sectoi
aveiages fiom this stuuy as the piobability of suivival foi inuiviuual fiims in the
sectoi. Foi a softwaie fiim that has been in existence foi one yeai, foi instance, the
likelihoou of failuie ovei a five-yeai peiiou woulu be assesseu at S8% (the
uiffeience between the piobability of suiviving 2 yeais - 64.8S% - anu the
piobability of suiviving 7 yeais - 24.78%). These sectoi aveiages can then be
aujusteu foi specifics about the fiim being valueu: the quality of its management, its
access to capital anu its cash balances. 0nce the piobability of failuie has been
assesseu, the value of the fiim can be wiitten as an expecteu value of the two

to make money on youi investment, you have to suivive multiple infusions of new equity (uilution)
along the way.
scenaiios - the intiinsic value (fiom the uiscounteu cash flows) unuei the going
concein scenaiio anu the uistiess value unuei the failuie scenaiio.
key Þerson ulscounLs
Young companies, especially in seivice businesses, aie often uepenuent upon
the ownei oi a few key people foi theii success. Consequently, the value we
estimate foi these businesses can change significantly if one oi moie of these key
people will no longei be associateu with the fiim. To assess a key peison uiscount in
valuations, we woulu suggest that the fiim be fiist valueu, with the status quo (with
key people involveu in the business) anu be valueu again, with the loss of these
inuiviuuals built into ievenues, eainings anu expecteu cash flows. To the extent that
eainings anu cash flows suffei when key people leave, the value of the business will
be lowei with the loss of these inuiviuuals, thus leauing to a "key peison uiscount".
Theie is no simple foimula that will help in ueteimining how much cash flows will
be lost as a iesult of the loss of key peisonnel, since it will vaiy not only acioss
businesses but acioss the peisonnel involveu. 0ne way to assess it is to suivey
existing customeis to see how they will iesponu if the key peisonnel leave anu to
then builu in this impact into opeiating foiecasts.
MI ;)%1"05 FG1"2< (%)"#* "0 2+& B1*"0&**
To estimate the value of equity pei shaie in a publicly tiaueu company, we
uiviue the estimateu value of equity by the numbei of shaies outstanuing. This
woiks if all shaieholueis have the same claims on cash flows anu equivalent voting
iights. In young giowth companies, theie can be uiffeiences in both cash flow anu
contiol claims acioss shaies.
• Cash flow claims: Theie aie two types of piefeiential cash flow iights that can be
embeuueu in equity claims. The fiist allows some equity investois, geneially
holuing piefeiieu shaies, to claim a shaie of the opeiating cash flows, usually in
the foim of piefeiential uiviuenus, befoie othei claimholueis get paiu. The
seconu gives piefeiieu stockholueis fiist claim on the cash flows of the fiim on
liquiuation. 0thei things iemaining equal, the value of common stock in a
company with piefeiieu shaies outstanuing will be lowei than in a company
without piefeiieu shaies outstanuing.
• Contiol claims: In some young publicly tiaueu giowth fiims, the voting iights aie
eithei entiiely oi uispiopoitionately helu by the founueis anu othei insiue
stockholueis, leaving the shaies with lowei voting iights to outsiue investois.
0thei things iemaining equal, voting shaies shoulu tiaue at a piemium ovei
non-voting shaies anu the magnituue of the piemium will ieflect the value of
contiol. Bow much aie voting iights woith. The eailiest stuuies of voting shaie
piemiums weie uone with companies with uiffeient voting shaie classes in the
0niteu States, anu concluueu founu that voting shaies in that maiket tiaue, on
aveiage, at a ielatively small piemium of S-1u% ovei non-voting shaies.
moie upuateu stuuy lookeu at 28 companies In with voting anu non-voting
shaies in 1994 anu 1999 anu concluueu that that the meuian voting shaie
piemium incieaseu fiom 2% in 1994 to 2.8% in 1999.

Theie aie ways in which we can value cash flow anu contiol claims moie piecisely,
but they iequiie substantial infoimation anu some uegiee of sophistication. Even if
you ueciue not to explicitly value these claims, being awaie of theii existence is a
significant step in the iight uiiection.
Exhibit S.1 pioviues an illustiation of a uiscounteu cash flow valuation foi
Eveigieen Solai, a small batteiy manufactuiei, with significant giowth potential anu
iisk in eaily 2uu9. The value that we estimateu, $u.6S pei shaie, was significantly
lowei than the stock piice of $2.7u pei shaie at the time of the valuation.
Note that
this value is not aujusteu foi the iisk that the fiim may not suivive thiough yeai 1u.
If we uiu aujust foi that likelihoou, the value pei shaie will be even lowei.

Lease, R.C., }.}. NcConnell anu W.B. Nikkelson 198S, P1- .")7-& <"/$- *; 9*#&)*/ %# ,$:/%9/'@&)"0-0
9*),*)"&%*#8] }ouinal of Financial Economics, v11, 4S9-471.
Reilly, R.F., 2uuS, ^$"#&%;'%#( &1- L"/$"&%*# Y%89*$#& ;*) ?"97 *; L*&%#( I%(1&8 "#0 H)-.%$.]
Ameiican Bankiuptcy Institute }ouinal.
To get to the piesent value, the cash flows aie uiscounteu back at the cumulateu cost of capital,
ieflecting the changing cost of capital ovei time. Foi instance, the cumulateu cost of capital in yeai 7
is computeu as follows:
Cumulateu cost of capital in yeai 7 = (1.1uS7)
(1.u984) (1.u9S7) = 1.9672

ke|at|ve Va|uat|on
The essence of ielative valuation is that you value a fiim, baseu upon how
much the maiket is paying foi similai fiims. This piemise is cleaily moie
challenging with young fiims that often have little to show in teims of opeiations
anu face substantial iisks in opeiations anu thieats to theii existence. The issues we
face in applying public maiket multiples to young companies, especially eaily in the
life cycle, aie faiily obvious:
a. Life cycle affects funuamentals: If we accept the piemise that only those
young fiims that make it thiough the eaily phase of the life cycle anu succeeu
aie likely to go public, we also have to accept the ieality that public fiims will
have uiffeient funuamentals than piivate fiims. ueneially, public fiims will
be laigei, have less potential foi giowth anu have moie establisheu maikets
than piivate businesses, anu these uiffeiences will manifest themselves in
the multiples investois pay foi public companies.
b. Suivival: A ielateu point is that theie is a high piobability of failuie in young
fiims. Bowevei, this piobability of failuie shoulu ueciease as fiims establish
theii piouuct offeiings anu those fiims that go public shoulu have a gieatei
chance of suiviving than youngei piivate fiims. The foimei shoulu theiefoie
tiaue at highei maiket values, foi any given vaiiable such as ievenues,
eainings oi book value, holuing all else (giowth anu iisk) constant.
c. Scaling vaiiable: Assuming that we aie able to obtain a ieasonable multiple of
ievenues oi eainings fiom oui public company uataset, we face one final
pioblem. Young fiims often have veiy little ievenues to show in the cuiient
yeai anu many will be losing money; the book value is usually meaningless.
Applying a multiple to any one of these measuies will iesult in stiange
u. Liquiuity: Since equity in publicly tiaueu companies is often moie liquiu than
equity in young giowth companies, the value obtaineu by using these
multiples may be too high if applieu to a young company. }ust as we hau to
aujust foi illiquiuity in intiinsic valuation, we have to aujust foi illiquiuity
with ielative valuation.
Theie aie simple piactices that can not only pievent egiegious valuation
eiiois but also leau to bettei valuations:
a. 0se foiwaiu ievenues¡ eainings: 0ne of the pioblems we noteu with using
multiples on young companies is that the cuiient opeiations of the company
uo not pioviue much in teims of tangible iesults: ievenues aie veiy small
anu eainings aie negative. 0ne solution is to foiecast the opeiating iesults of
the fiim fuithei uown the life cycle anu use these foiwaiu ievenues anu
eainings as the basis foi valuation. In effect, we will estimate the value of the
business in five yeais, using ievenues oi eainings fiom that point in time.
b. Aujust the multiple foi youi fiim's chaiacteiistics at time of valuation: If we
aie valuing the fiim five yeais uown the ioau, we have to estimate a multiple
that is appiopiiate foi the fiim at that point in time, iathei than touay.
Consiuei a simple illustiation. Assume that you have a company that is
expecteu to geneiate a compounueu ievenue giowth of Su% a yeai foi the
next five yeais, as it scales fiom being a veiy small fiim to a moie establisheu
enteipiise. Assume that ievenue giowth aftei yeai S will uiop to a moie
moueiate compounueu annual iate of 1u%. The multiple that we apply to
ievenues oi eainings in yeai S shoulu ieflect an expecteu giowth iate of 1u%
(anu not Su%).
c. Aujust foi suivival: When we estimateu the intiinsic value foi young fiims,
we alloweu foi the possibility of failuie by aujusting the value foi the
piobability that the fiim woulu not make it. We shoulu stick with that
piinciple, since the value baseu upon futuie ievenues¡ eainings is implicitly
baseu upon the assumption that the fiim suivives anu succeeus.
u. Aujust foi illiquiuity: In the last section on intiinsic valuation, we piesenteu
uiffeient ways of estimating illiquiuity uiscounts foi equity in piivate
businesses. We coulu auopt the same techniques to aujust the public multiple
value foi illiquiuity.
A kelotlve volootloo of ívetqteeo 5olot
With small ievenues, miniscule book value anu big opeiating losses,
Eveigieen Solai piesents moie of a challenge when it comes to ielative valuation.
To begin with, the only multiple that we can use, with cuiient numbeis, is a ievenue
multiple. We will consiuei two ways in which we can appioach this ielative
valuation anu the pluses anu minuses of each.
a. Similai companies: The simplest way to appioach ielative valuation is to finu
alteinative eneigy companies that aie close to Eveigieen in teims of cuiient
opeiating statistics - ievenues anu maigins - anu compaie the multiples of
ievenues that these fiims tiaue at in compaiison to Eveigieen's numbeis. In
}anuaiy 2uu9, foi instance, we founu foui companies that hau ievenues similai
to Eveigieen (about $ 9u million). Table S.4 summaiizes the Enteipiise
value¡Sales multiples foi these fiims:
P":/- U4Z5 O#&-),)%8- L"/$- &* C"/-85 >*.,")":/- B/&-)#"&%<- O#-)(' >*.,"#%-8
>*.,"#' _".-
L"/$- OLaC"/-8
P*&"/ I-<-#$- Mb..N
1u.7 74.71 1.2S 6u.7
China Winupowei 169.S 174.7S 2.62 66.7
viiiuis Clean
S2.9 29u.4 S.S1 87.8
Teina Eneigy SA S8u.1 S8u.1 S.S1 1uS.S
-.%/"0% 1234
Note that the aveiage Ev¡Sales iatio acioss these fiims is S.17 anu applying this
to Eveigieen Solai's ievenues of $ 9u million in 2uu7 woulu have yielueu an
enteipiise value touay of $28S.S million. In using this sample, we aie implicitly
assuming that these fiims have the same giowth anu piofit potential in steauy
state. Note also how much vaiiation theie is in the Ev¡Sales iatio acioss these
foui fiims.
b. Foiwaiu values: 0ne ieason why we have tiouble using multiples with giowth
companies is that the cuiient numbeis aie not iepiesentative of what we expect
the fiim to look like in the futuie. 0ne way aiounu this pioblem is to use the
foiecasteu ievenues anu othei opeiating numbeis to estimate value. With
Eveigieen, we uiaw on oui estimates of futuie ievenues anu eainings in
illustiation 1u.S. In table 1u.6, we foiecast Eveigieen's ievenues in yeai S to be
$48S million anu its pie-tax opeiating income to be $27.7S million. Looking
acioss the laigei publicly tiaueu fiims that aie listeu unuei alteinative eneigy,
we estimateu an aveiage Ev¡Sales iatio of 1.SS. Applying this to the ievenues in
yeai S yielus an expecteu enteipiise value (in yeai S) of $749 million.
Expecteu Enteipiise value in yeai S = $48S * 1.SS = $749 million
Biscounting this value back at Eveigieen's cost of capital of 1u.S7% foi the fiist
S yeais (see table 1u.8), we estimate an enteipiise value touay of $4S7 million.
Enteipiise value touay = $749 million¡ 1.1uS7
=$4S7 million
This appioach is baseu on thiee piemises. The fiist is that the fiim will suivive
anu make it to yeai S, which may oi may not happen, given opeiating losses anu
the oveilay of uebt. The seconu is that oui foiecasts of ievenues anu opeiating
income in yeai S aie ieasonable numbeis; if we have ovei oi unuei estimateu
these numbeis, the iesulting estimates of values will also be affecteu. The thiiu is
that the fiim being valueu will look like laigei fiims in the inuustiy in five yeais,
thus making it all iight to use the inuustiy aveiage multiple.
Are we m|ss|ng someth|ng?
In both uiscounteu cash flow anu ielative valuation, we builu in oui
expectations of what success foi a young fiim will look like in teims of ievenues anu
eainings. Thus, it can be aigueu that the potential upsiue is alieauy ieflecteu in the
value. The countei to this aigument is that success in one business oi maiket can
sometimes be a stepping-stone to success in othei businesses¡maikets:
a. New piouucts: Success with an existing piouuct oi seivice can sometimes
pioviue an opening foi a fiim to intiouuce a new piouuct. A classic example
woulu be Niciosoft builuing off the opeiating system (NSB0S anu Winuows) it
uevelopeu foi the PC to piouuce Niciosoft 0ffice, an immensely piofitable
auuition to its piouuct line. Apple's intiouuction of the iPhone to take auvantage
of the customei base that it hau uevelopeu with the iPou woulu be anothei
example. While neithei new piouuct (NS 0ffice anu the iPhone) coulu have been
pieuicteu at the time of the oiiginal piouuct's intiouuction, the success of the
initial piouuct was cleaily the launching pau foi these offeiings.
b. New maikets: In some cases, companies that succeeu with a piouuct in one
maiket may be able to expanu into othei maikets, with similai success. The most
obvious example of this is expanuing into foieign maikets to builu on uomestic
maiket success, a pathway auopteu by companies like Coca Cola, NcBonalus anu
many ietail companies. The moie subtle examples aie piouucts that aie uiiecteu
at one maiket that seienuipitously finu new maikets: an ulcei uiug that ieuuces
cholesteiol woulu be a goou example.
Why cannot we builu expectations about new piouucts anu new maikets into oui
cash flows anu value. We can tiy, but theie aie two pioblems. The fiist is that oui
foiecasts about these potential piouuct anu maiket extensions will be veiy hazy at
the time of the initial valuation anu the cash flows will ieflect this unceitainty. In
othei woius, neithei Niciosoft noi Apple woulu have been able to visualize the
potential maikets foi Niciosoft 0ffice oi the iPhone at the time that they weie
intiouucing NSB0S oi the iPou. The seconu is that it is the infoimation gleaneu anu
the lessons leaineu uuiing the initial piouuct launch anu subsequent uevelopment
that allows fiims to take full auvantage of the follow-up offeiings. It is this leaining
anu auaptive behavioi that gives iise to value that auus to the estimateu intiinsic
value. While we will not explicitly value this "ieal option", we shoulu at least
qualitatively consiuei the possible upsiue.
Va|ue Þ|ays
Baving laiu out the challenges that we face when valuing young giowth
companies anu ways to meet those challenges in both intiinsic anu ielative
valuation, we can extiact geneial lessons that can stanu us in goou steau when
investing in these companies.
Consiuei what a young giowth company has to pull off to become a
successful matuie company. In the neai futuie, the fiim has to post high ievenue
giowth, while maigins impiove towaius taiget maigins at a ieasonable clip. Buiing
this peiiou, the company will have to iaise new capital to sustain its ievenue
giowth, while uealing with unceitainty in its opeiations. 0nce it gets past this initial
phase successfully, the company will have to be able to uefenu its maigins anu
piofitability against laigei playeis in the sectoi, while holuing on oi incieasing its
maiket shaie. Now consiuei all the things that can go wiong:
a. The expecteu ievenue giowth may not mateiialize, eithei because the potential
maiket tuins out to be smallei than expecteu oi because customeis aie not as
ieceptive to the piouuct as anticipateu.
b. The ievenue giowth may be spot on, but the taiget maigin may be much lowei
than anticipateu, eithei because expenses oi competition weie unuei estimateu.
In auuition, the pathway to the taiget may tuin out to be iockiei, with laigei
losses foi longei peiious pieceuing piofitability.
c. The ievenue giowth anu maigins may both be in line with expectations, but the
fiim may be unable to iaise the capital it neeus to funu its giowth. In the face of
this constiaint, it will eithei have to shut uown oi sell itself at a baigain
basement piice to competitois.
u. Eveiy pait of the initial phase may woik out, but just as the company hits its
taiget maigin anu staits making money, competitois may swaim the maiket anu
push uown maigins anu ietuins.
e. If theie is a key peison oi peisons that the fiim uepenus on foi its success, theii
absence causeu by iifts within the fiim oi acts of uou can put the fiim to the test.
While theie is no way to insulate youiself against all of these conceins, investois can
impiove theii ouus of success in young, giowth companies by focusing on those that
shaie the following chaiacteiistics
a. Big potential maiket: The potential maiket foi the company's piouucts anu
seivices has to be laige enough to absoib high ievenue giowth foi an extenueu
peiiou, without being oveiwhelmeu. In the piocess, though, you have to be
iealistic about the ieach of the piouucts anu seivices offeieu.
b. Expense tiacking anu contiols: It is easy foi young companies to become
unuisciplineu in tiacking anu contiolling expenses, while chasing high giowth.
As investois, we shoulu be looking foi management that is focuseu on both
giowth anu maigins anu iesults that uelivei the same. Thus, it may make sense,
when investing in young companies, to set taigets foi maigin impiovement anu
view failuie to meet these taigets as ieasons to exit (sell the stock)
c. Access to capital: To suivive anu giow, young fiims neeu to be able to access
capital in the neai futuie. We woulu look at thiee inuicatois of access. Fiist, we
woulu look at the cuiient cash balance anu the iate at with which the company
spenus its cash; this is teimeu the cash buin iatio. Thus, a company with $ 1uu
million in cash that buins thiough$ 1u million each month has about 1u months
of cash on hanu, befoie it has to go back to iaise moie money. Seconu, we woulu
look at who owns anu tiaues the listeu shaies in the company. A company wheie
a laige poition of the shaies aie tiaueu (high float) fiequently by institutional
investois is in a much bettei position to iaise new capital than a company with
low float, light tiauing anu no institutional investois.
u. Bepenuence on key inuiviuuals: Young fiims aie always uepenuent upon key
inuiviuuals to succeeu, but those fiims wheie these inuiviuuals nuituie talent to
succeeu them (anu aie
e. The option bonus; 0ne of the payoffs to investing in a young giowth company is
that success can feeu on itself anu allow it to entei new maikets anu intiouuce
new piouucts. While this may seem completely unpieuictable, it is moie likely to
happen if the company has some exclusivity in its business, aiising eithei fiom a
piopiietaiy technology oi a patent.
f. Risk¡Retuin: Even successful investments in high giowth companies take
investois on wilu iiues, with significant unceitainty along the way. Investois
have to be pioactive anu uemanu highei ietuins foi investing in young giowth
companies, befoie they entei the tumultuous giowth peiiou. Put in simplei
teims, even the best young, giowth company can be a bau investment, at the
wiong piice. At the minimum, theiefoie, investois have to make juugments of
ievenues anu maigins at a futuie uate (at the enu of the initial giowth phase, foi
instance) anu check the cuiient values against these foiwaiu estimates. If the
cuiient maiket value is too high, ielative to these futuie opeiating numbeis, it
makes no sense to invest in the company.
In summaiy, then, you want to invest in young giowth companies that aie enteiing
huge maikets with piopiietaiy technologies, have management that is focuseu on
keeping expenses unuei contiol anu have access to enough capital to funu giowth.
Not easy to uo, but uone iight, it is a high iisk, high ietuin pioposition.
Theie can be no uenying the fact that young companies pose the most
uifficult estimation challenges in valuation. A combination of factois - shoit anu not
veiy infoimative histoiies, opeiating losses anu the possibility that high piobability
of failuie - all feeu into valuation piactices that tiy to avoiu uealing with the
unceitainty by using a combination of foiwaiu multiples anu aibitiaiily high
uiscount iates. We have laiu out piocesses that can be useu to apply conventional
valuation mouels to young companies. While these appioaches iequiie us to
estimate inputs that aie often uifficult to nail uown, they aie still useful insofai as
they foice us to confiont the souices of unceitainty, leain moie about them anu
make oui best estimates. While we may be tempteu to auu piemiums to these
values foi potential oppoitunities that we see in the futuie, the use of ieal option
piemiums shoulu be limiteu to those companies that have some uegiee of
exclusivity in exploiting these oppoitunities.

Chapter 6: Va|u|ng growth compan|es
In the last chaptei, we lookeu at the estimation challenges associateu with
valuing young anu iuea companies. 0ne of the issues that we confionteu was the
question of suivival, since many young companies fail eaily in theii lives. But what
about those fiims that make it thiough the test of competition anu become
successful businesses. In this chaptei, we will look at a sub-set of young fiims that
become giowth companies. Nany of the conceins that we hau with young
companies - shoit anu volatile opeiating histoiies, unceitainty about futuie giowth
anu changing iisk piofiles - iemain pioblems when we value giowth companies,
especially in theii initial phases, though the uata anu tools that we have to ueal with
them uo become bettei. They will be joineu by new conceins about how giowth
iates may change, as companies get laigei, anu how access anu exposuie to public
capital maikets will change financing anu investment uecisions at the fiim.
What |s a growth company?
While investois anu manageis often talk about giowth anu matuie
companies as uistinct gioups, the uistinction is moie uifficult to make in the ieal
woilu. So, what is a giowth company. Theie aie many uefinitions foi giowth
companies useu in piactice but they all tenu to be both subjective anu have
significant flaws.
a. Sectoi baseu measuies: Nany analysts categoiize companies as giowth
companies oi matuie companies, baseu upon the sectoi that they opeiate in.
Thus, technology companies in the 0niteu States aie tieateu as giowth
companies, wheieas steel companies aie consiueieu matuie. This uefinition
cleaily misses the vast uiffeiences in giowth piospects acioss companies
within any given sectoi. Technology companies like Intel anu Niciosoft may
be moie matuie businesses than giowth businesses, at this stage of theii
coipoiate evolution.
b. Analyst uiowth Estimates¡ uiowth histoiy: A seconu categoiization of
companies into giowth anu matuie companies is baseu upon expecteu
giowth in futuie eainings, baseu usually on foiecasts by equity ieseaich
analysts. The limits of this appioach aie that it is ciicumsciibeu by its focus
on eainings, as opposeu to ievenues oi units solu. Aftei all, theie aie many
young high giowth companies that may have exponential giowth in
ievenues, while losing money. Similaily, matuie companies can post healthy
eainings incieases with impioveu efficiency anu ielatively little opeiating
unit giowth.
c. Naiket baseu measuies: Noiningstai, as pait of its mutual funu tiacking
seivice, categoiizes mutual funus into those investing in giowth stocks anu
those investing in matuie companies. They base theii categoiization on the
maiket multiples that companies tiaue at, aiguing that companies that aie
peiceiveu to be giowth companies will tiaue at highei multiples of eainings,
ievenues anu book value than matuie companies.
While we uo not have a peifect alteinative, we woulu suggest using the financial
balance sheet that we intiouuceu in the eailiei chapteis to make this juugment. In
figuie 6.1, we focus on the asset siue of the financial balance sheet, wheie assets aie
bioken uown into existing investments anu giowth assets.

uiowth fiims get a significant poition of theii value fiom giowth assets, i.e.,
investments that they expect to make in the futuie. While this may seem like a
iestatement of the giowth categoiization uesciibeu eailiei, wheie fiims with high
Assets Liabilities
Investments already
Equity Investments yet to
be made
Existing Investments
Generate cashflows today
Expected Value that will be
created by future investments
Figure 6. 1: A Financial Balance Sheet for a Business
Growth companies
derive a significant
[proportion of their
value from growth
Mature companies
get most of their
value from existing
giowth iates aie tieateu as giowth companies, theie is an impoitant uiffeience. As
we noteu in chaptei S, the value of giowth assets is a function of not only how much
giowth is anticipateu but also the quality of that giowth, measuieu in teims of
excess ietuins: ietuins on the investeu capital in these assets, ielative to the cost of
Character|st|cs of growth compan|es
uiowth companies aie uiveise in size, giowth piospects anu can be spieau
out ovei veiy uiffeient businesses but they shaie some common chaiacteiistics that
make an impact on how we value them. In this section, we will look at some of these
shaieu featuies:
1. Bynamic financials: Nuch of the infoimation that we use to value companies
comes fiom theii financial statements (income statements, balance sheets
anu statements of cash flows). 0ne featuie shaieu by giowth companies is
that the numbeis in these statements aie in a state of flux. Not only can the
numbeis foi the latest yeai be veiy uiffeient fiom numbeis in the piioi yeai,
but can change uiamatically even ovei shoitei time peiious.
2. Size uisconnect: The maiket values of giowth companies, if they aie publicly
tiaueu, aie often much highei than the accounting (oi book) values, since the
foimei incoipoiate the value of giowth assets anu the lattei often uo not. In
auuition, the maiket values can seem uiscoiuant with the opeiating numbeis
foi the fiim - ievenues anu eainings. Nany giowth fiims that have maiket
values in the hunuieus of millions oi even in the billions can have small
ievenues anu negative eainings. Again, the ieason lies in the fact that the
opeiating numbeis ieflect the existing investments of the fiim anu these
investments may iepiesent a veiy small poition of the oveiall value of the
S. 0se of uebt: While the usage of uebt can vaiy acioss sectois, giowth fiims in
any business will tenu to caiiy less uebt, ielative to theii value (intiinsic oi
maiket), than moie stable fiims in the same business, simply because they uo
not have the cash flows fiom existing assets to suppoit moie uebt.
4. Naiket histoiy is shoit anu shifting: We aie uepenuent upon maiket piice
inputs foi seveial key components of valuation anu especially so foi
estimating iisk paiameteis (such as betas). Even if giowth companies aie
publicly tiaueu, they tenu to have shoit anu shifting histoiies.
While the uegiee to which these factois affect giowth fiims can vaiy acioss fiims,
they aie pievalent in almost eveiy giowth fiim.
Va|uat|on Issues
The shaieu chaiacteiistics of giowth fiims - uynamic financials, a mix of
public anu piivate equity, uisconnects between maiket value anu opeiating uata, a
uepenuence on equity funuing anu a shoit anu volatile maiket histoiy - have
consequences foi both intiinsic anu ielative valuations.
Intr|ns|c (DCI) Va|uat|on
If the intiinsic value of a company comes fiom its cash flows anu iisk
chaiacteiistics, theie aie pioblems that we will iun into while valuing giowth
companies that can be tiaceu back to wheie they aie in the life cycle. In this section,
we will bieak uown the valuation issues specific to giowth companies by the key
components of intiinsic value - existing asset value, giowth asset value, iisk
(uiscount iates), teiminal value anu equity value pei shaie.
()*+ ?%-.* ?4-# FE"*2"05 /**&2*
To value existing assets, we stait with the cash flows geneiateu by these
assets anu uiscount back at an appiopiiate iisk-aujusteu iate. Theie aie two
consiueiations that come into play that can make this measuiement complicateu.
1. Pooily measuieu eainings: With giowth fiims, existing assets tenu to be a small
pait of oveiall value anu can be easily swampeu by what a fiim expenus to
sustain anu nuituie its giowth assets. Consiuei, foi instance, the stanuaiu
assumption that we make in uiscounteu cash flow valuation that the existing
opeiating income can be attiibuteu to existing assets anu thus be the basis foi
valuing those assets. With any company, the existing opeiating income (oi loss)
will be aftei selling, auveitising anu othei auministiative expenses. While we
assume that these expenses aie associateu with existing assets, that assumption
may not holu up in a giowth company. Aftei all, the sales foice in a giowth
company may be less inteiesteu in pushing existing piouucts anu moie focuseu
on cultivating a customei base foi futuie piouucts. By tieating all sales expenses
as opeiating expenses, we aie unueistating the eainings fiom anu consequently
the value of existing assets.
2. Shifting piofitability: If one of the key inputs into value is the measuie of the
futuie piofitability of the fiim, the fact that maigins anu ietuins at giowth fiims
change significantly ovei time can make it uifficult to make foiecasts. 0nlike
matuie fiims, wheie maigins usually move within a naiiow iange anu ietuins
aie stable, using past maigins anu ietuins to foiecast futuie values foi a giowth
fiim may not yielu ieasonable numbeis.
34-.2+ /**&2*
The bulk of a value foi a giowth company obviously comes fiom giowth
assets, making it impeiative that we assess the value iight. The challenges we face in
attaching a ieasonable value to giowth assets in a giowth company can also be
1. The scaling effect on giowth: 0ne of the biggest questions that we have to
answei about expecteu giowth iates foi a company is how they will be affecteu
by the changing size of the company. Consiuei, foi instance, a company that has
posteu a giowth iate of 8u% ovei the last S yeais. The company touay is
obviously much laigei (by a factoi of 18) than it was five yeais ago.
It is
extiemely unlikely that it will be able to maintain an 8u% giowth iate foi the
next yeai, given its laigei size. In geneial, ueliveiing a given giowth iate will
become moie uifficult as a company gets biggei.
2. Success attiacts competition: A small company can opeiate unuei the iauai anu
sometimes show exceptional piofitability. As the company giows, though, its
success will attiact attention fiom laigei anu moie pieuatoiy competitois, often

Applying a compounueu giowth iate of 8u% foi five yeais to $ 1 iesults in an enu value of of
almost $ 19, an oveiall inciease of 18uu% ovei five yeais.
possessing moie significant iesouices. This competition, in tuin, will iesult in
lowei piofitability anu value foi giowth.
S. Nacio economic effects: While all companies aie susceptible to macio economic
shocks, small companies aie moie exposeu to economic uowntuins because
theii piouucts aie often niche piouucts that aie uiscietionaiy. While customeis
may be inclineu to buy them in goou book economic times, they aie likely to holu
back uuiing iecessions oi economic slowuowns.
Questions about how quickly giowth iates will scale uown, how piofitability will
suivive competitive assaults anu the effects of oveiall economic giowth will have to
be answeieu if we intenu to attach a value to giowth assets.
@"*=-102 8)2&*
The two key ueteiminants of uiscount iates aie the iisk in the unueilying
investments of a business anu the mix of uebt anu equity useu to funu the business.
0n both uimensions, giowth companies pose a challenge in valuation.
1. Risk of existing assets veisus iisk of giowth assets: Since giowth companies
ueiive significant value fiom both giowth assets anu existing assets, uelineating
the iisk in each categoiy can make a big uiffeience in how we value them. In
othei woius, if giowth assets aie iiskiei than existing assets, we shoulu be using
highei uiscount iates foi expecteu cash flows fiom the foimei anu lowei
uiscount iates foi cash flows fiom the lattei.
2. Changing iisk foi the fiim ovei time: If computing the cuiient iisk paiameteis
anu uebt iatio foi a giowth fiim is uifficult, the task is complicateu fuithei by a
simple fact. 0n both uimensions, giowth fiims can be expecteu to change ovei
time, leauing to uiscount iates that vaiy acioss the yeais. To be moie specific, as
a fiim become laigei ovei time (as it will in futuie peiious, with giowth), we
shoulu expect existing assets to become a laigei piopoition of oveiall value anu
iisk measuies to change to ieflect the incieasing (anu moie stable) eainings of
the fiim. Concuiiently, the fiim's capacity to boiiow money will inciease anu if it
exploits this capacity, its uebt iatio will change as well. ueneially speaking, the
uiscount iates useu to value giowth fiims shoulu be highei in the eailiei peiious
anu ueciease in latei peiious towaius matuie company levels.
:&4#"0)% ;)%1&
Two key questions that oveihang the valuation of any fiim ielate to when the
fiim will become a stable giowth fiim anu the chaiacteiistics that it will possess in
this phase. The answei to the fiist question will ueteimine the length of the high
giowth peiiou, with the teiminal value being computeu on the assumption that
giowth beyonu that point will be sustaineu foievei. The answeis to the seconu
question, especially on iisk anu the ietuins geneiateu on new investments, will
influence the value that we assign to the fiim, foi any given level of giowth. Again
while these aie estimation issues that aiise in any valuation, they can be moie
pioblematic foi giowth companies foi the following ieasons:
a. Teiminal value is a biggei piopoition of value: Since giowth companies geneiate
ielatively low cash flows fiom existing assets, the teiminal value will compiise a
much laigei piopoition of theii oveiall value. Thus, the assumptions we make
about teiminal value will mattei moie in any assessment of cuiient value foi a
giowth fiim than at a matuie fiim.
b. Noie unceitainty about teiminal value assumptions: Concuiient with the
teiminal value being a laigei piopoition of the value of a giowth company than
foi a matuie fiim comes the fact that theie is significantly moie unceitainty
about assessing that value foi two ieasons. Fiist, we aie looking at a young anu
often untesteu fiim anu making oui assessments of not only how quickly it will
continue to giow but also how it will iesponu to moie aggiessive competition.
Seconu, the fact that the fiim is evolving makes it uifficult to evaluate what
maiket it is aspiiing to be in oi even who its uiiect competitois aie.
c. Teiminal value chaiacteiistics: Eailiei in this section we noteu the uifficulties we
face in aiiiving at the cuiient cash flows, ietuins anu uiscount iates foi a giowth
fiim. We will be calleu upon to estimate all of these numbeis again, when we put
the fiim into stable giowth, in ten oi fifteen yeais. If we cannot estimate the
cuiient cost of capital foi a giowth fiim, it seems unieasonable to believe that
we can estimate this anu othei numbeis foi the same fiim ten oi fifteen yeais in
the futuie.
The iiony of teiminal value estimation foi giowth fiims is that it is both moie
impoitant that we get it iight anu that we have fai less basis foi making the estimate
in the fiist place. The way we iesolve this contiauiction will play a key iole in
whethei the value we aiiive at foi a giowth fiim is a ieasonable one.
ke|at|ve Va|uat|on
Nany analysts, when confionteu with the pioblems with intiinsic valuation
outlineu in the eailiei section, ueciue that ielative valuation is a much easiei path to
follow with giowth companies. The issues that make uiscounteu cash flow valuation
uifficult also ciop up, not suipiisingly, when we uo ielative valuation.
1. Compaiable fiims: The conventional piactice of using othei publicly tiaueu
companies in the same sectoi can be uangeious with ielative valuation foi a
few ieasons. The fiist is that a giowth company in a matuie sectoi will (anu
shoulu) beai little oi no iesemblance on eithei funuamentals oi piicing
multiples to the iest of the fiims in the sectoi. The seconu is that even if
eveiy fiim in the sectoi has giowth potential, giowth fiims can vaiy wiuely
in teims of iisk anu giowth chaiacteiistics, thus making it uifficult to
geneialize fiom inuustiy aveiages.
2. Base yeai values anu choice of multiples: Nost multiples aie stateu as a
function of base yeai values foi ievenues, eainings anu book value. To
estimate the PE iatio, foi instance, we uiviue the stock piice touay by the
eainings pei shaie in the most iecent fiscal yeai oi foui quaiteis. If a fiim is a
giowth fiim, the cuiient values foi these numbeis will beai little
iesemblance to the futuie potential foi the fiim. 0sing PE iatios to illustiate
this point, this can leau to eithei veiy high PE iatios (since cuiient eainings
pei shaie will be small ielative to stock piices touay) oi not meaningful
values (because eainings cuiiently aie negative anu PE iatios cannot be
computeu), foi many giowth companies. Noving up the income statement to
EBITBA oi ievenues offeis little solace, since the values foi these items will
also be low, ielative to futuie potential.
S. Contiolling foi giowth uiffeiences: Since giowth potential is the key
uimension on which these fiims vaiy, it becomes ciitical that we contiol foi
giowth when compaiing fiims oi extiapolating fiom inuustiy aveiages.
0nfoitunately, the ielationship between giowth anu value is too complex to
lenu itself to the simplistic geneializations that make ielative valuation so
attiactive to both analysts anu investois. Not only uoes the level of giowth
make a uiffeience to value, but so uoes the length of the giowth peiiou anu
the excess ietuins that accompany that giowth iate. Put anothei way, two
companies with the same expecteu giowth iate in eainings can tiaue at veiy
uiffeient multiples of these eainings, because they vaiy on othei uimensions.
4. Contiolling foi iisk uiffeiences: uiowth anu iisk aie twin vaiiables, with
highei values foi one geneially going with highei values foi the othei.
Beteimining how the net tiaue off will affect value is uifficult to uo in any
valuation but becomes uoubly so in ielative valuation, wheie many
companies have both high giowth anu high iisk. Fuitheimoie, as iisk anu
giowth chaiacteiistics change ovei time, as they inevitably will foi any
giowth company, the multiple that we will apply to the company's opeiating
numbeis shoulu also change.
Analysts who use multiples anu compaiables to value giowth fiims may feel a false
sense of secuiity about theii valuations, since theii assumptions aie often implicit
iathei than explicit. The ieality, though, is that ielative valuations yielu valuations
that aie just as subject to eiioi as uiscounteu cash flow valuations.
Va|uat|on So|ut|ons
While giowth companies iaise thoiny estimation pioblems, we can navigate
oui way thiough these pioblems to aiiive at values foi these fiims that aie less
likely to be contaminateu by inteinal inconsistencies. In this section, we will lay out
the steps to follow in uiscounteu cash flow anu ielative valuations of giowth
D|scounted Cash I|ow Va|uat|on
uiven that the objective in uiscounteu cash flow valuation is to aiiive at
ieasonable estimates of the cash flows anu the uiscount iates, we will list out some
of the consiueiations that shoulu entei into the piocess when we aie valuing giowth
(+-"=& -? N-7&%
In chaptei 2, we listeu the choices we face with uiscounteu cash flow mouels,
noting that we can eithei value the entiie business (by uiscounting cash flows to the
fiim at the cost of capital) oi value the equity uiiectly (by uiscounting cash flows to
equity at the cost of equity). While both appioaches shoulu yielu the same value foi
the equity, estimating cash flows to equity, if we expect the uebt iatio to change ovei
time, is much moie uifficult than estimating the cost of capital. The foimei iequiies
us to foiecast new uebt issues, uebt iepayments anu inteiest payments each peiiou,
as the uollai uebt changes, wheieas the lattei is baseu upon changing uebt iatios.
Since many giowth companies have little oi no uebt in theii capital stiuctuie,
analysts often fall back on equity valuation mouels, using the absence of uebt as
justification. Bowevei, this assumes that giowth companies will continue with theii
policy of not using uebt in peipetuity, even as giowth uecieases anu the companies
become moie matuie. If we make the moie ieasonable assumption that giowth
companies will become matuie companies ovei time anu auopt the financing
piactices of the lattei, fiim valuation mouels pioviue analysts with moie flexibility
to ieflect these changes.
Neeuless to say, the uiscounteu cash flow mouels useu neeu to allow foi high
giowth anu even changing opeiating maigins ovei time. As a geneial iule, iigiu
mouels that lock in the cuiient chaiacteiistics of the company uo not peifoim as
well as moie flexible mouels, wheie analysts can change the inputs ovei time, in
valuing giowth companies.
;)%1"05 2+& -$&4)2"05 )**&2*
If we accept the piemise that fiim valuation mouels woik bettei than equity
valuation mouels, when valuing giowth companies, the fiist step in the piocess is
valuing the opeiating assets of the fiim, incoipoiating both existing assets anu
giowth assets.
8evenue growLh raLes
The valuation piocess staits with estimating futuie ievenues. In making
these estimates, many of the consiueiations that we iaiseu in chaptei 9, foi young
companies, come into play. The biggest issue, anu one that we have emphasizeu
iepeateuly in this chaptei, is the scaling factoi. Revenue giowth iates will ueciease
as companies get laigei, anu eveiy giowth company will get laigei ovei time, if oui
foiecasts of giowth come to fiuition. In a test of how giowth iates change as fiims
get laigei, a stuuy examineu the ievenue giowth iate foi high giowth fiims, ielative
to giowth iate in ievenues foi the sectoi in which they opeiate, in the immeuiate
afteimath of theii initial public offeiings.
The iesults aie iepoiteu in Figuie 6.2
2%($)- A435 I-<-#$- ()*+&1 %# '-")8 ";&-) %#%&%"/ ,$:/%9 *;;-)%#(

Netiick, A., 2uu6, ventuie Capital anu the Finance of Innovation, }ohn Wiley & Sons.
At the time of going public, fiims have giowth iates that aie much highei than the
inuustiy aveiage. Note how quickly the ievenue giowth at these high giowth fiims
moves towaius the inuustiy aveiage - fiom a 1S% highei ievenue giowth (then the
inuustiy aveiage) one yeai aftei the IP0 to 7% highei in yeai 2 to 1% highei in yeai
4 to the inuustiy aveiage in yeai S. While we aie not suggesting that this will
happen at eveiy high giowth fiim, the aggiegate eviuence suggests that giowth
fiims that aie able to maintain high giowth iates foi extenueu peiious iemain the
exception iathei than the iule.
The question of how quickly ievenue giowth iates will uecline at a given
company can geneially be auuiesseu by looking at the company's specifics - the size
of the oveiall maiket foi its piouucts anu seivices, the stiength of the competition
anu quality of both its piouucts anu management. Companies in laigei maikets
with less aggiessive competition (oi piotection fiom competition) anu bettei
management can maintain high ievenue giowth iates foi longei peiious.

(144&02 #)45"0* A&4*1* 2)45&2 #)45"0*
To get fiom ievenues to opeiating income, we neeu opeiating maigins ovei
time. The easiest anu most convenient scenaiio is the one wheie the cuiient
maigins of the fiim being valueu aie sustainable anu can be useu as the expecteu
maigins ovei time. In fact, if this is the case, we can uispense with foiecasting
ievenue giowth anu insteau focus on opeiating income giowth, since the two will be
the equivalent. In most giowth fiims, though, it is moie likely that the cuiient
maigin is likely to change ovei time.
Let us stait with the most likely case fiist, which is that the cuiient maigin is
eithei negative oi too low, ielative to the sustainable long-teim maigin. Theie aie
thiee ieasons why this can happen. 0ne is that the fiim has up-fiont fixeu costs that
have to be incuiieu in the initial phases of giowth, with the payoff in teims of
ievenue anu giowth in latei peiious. This is often the case with infiastiuctuie
companies such as eneigy, telecommunications anu cable fiims. The seconu is the

Foi an extenueu uiscussion of this issue, see Bamouaian, A., 2uu8, The 0iigins of uiowth, Woiking
Papei, SSRN.
mingling of expenses incuiieu to geneiate giowth with opeiating expenses; we
noteu eailiei that selling expenses at giowth fiims aie often uiiecteu towaius futuie
giowth iathei than cuiient sales but aie incluueu with othei opeiating expenses. As
the fiim matuies, this pioblem will get smallei, leauing to highei maigins anu
piofits. The thiiu is that theie might be a lag between expenses being incuiieu anu
ievenues being geneiateu; if the expenses incuiieu this yeai aie uiiecteu towaius
much highei ievenues in S yeais, eainings anu maigins will be low touay.
The othei possibility, wheie the cuiient maigin is too high anu will ueciease
ovei time, is less likely but can occui, especially with giowth companies that have a
niche piouuct in a small maiket. In fact, the maiket may be too small to attiact the
attention of laigei, bettei-capitalizeu competitois, thus allowing the fiims to
opeiate unuei the iauai foi the moment, chaiging high piices to a captive maiket.
As the fiim giows, this will change anu maigins will ueciease. In othei cases, the
high maigins may come fiom owning a patent oi othei legal piotection against
competitois, anu as this piotection lapses, maigins will ueciease.
In both of the lattei two scenaiios - low maigins conveiging to a highei value
oi high maigins uiopping back to moie sustainable levels - we have to make
juugment calls on what the taiget maigin shoulu be anu how the cuiient maigin will
change ovei time towaius this taiget. The answei to the fiist question can be usually
be founu by looking at both the aveiage opeiating maigin foi the inuustiy in which
the fiim opeiates anu the maigins commanueu by laigei, moie stable fiims in that
inuustiy. The answei to the seconu will uepenu upon the ieason foi the uiveigence
between the cuiient anu the taiget maigin. With infiastiuctuie companies, foi
instance, it will ieflect how long it will take foi the investment to be opeiational anu
capacity to be fully utilizeu.
8&"0A&*2 2- *1*2)"0 54-.2+
A constant theme in the eailiei chapteis has been the insistence that giowth
is not fiee anu that fiims will have to ieinvest to giowth. As we noteu eailiei in the
chaptei, it is uangeious to base ieinvestment assumptions on a giowth company's
histoiy of ieinvestment. In othei woius, taking the net capital expenuituies anu
woiking capital changes fiom the most iecent yeai anu assuming that these items
will giow at the same iate as ievenues can iesult in ieinvestment numbeis that aie
both uniealistic anu inconsistent with oui assumptions about giowth.
To estimate ieinvestment foi a giowth fiim, we will follow one of thiee
paths, uepenuing laigely upon the chaiacteiistics of the fiim in question:
1. Foi giowth fiims eailiei in the life cycle, we will auopt the same ioaumap we
useu foi young giowth companies, wheie we estimateu ieinvestment baseu
upon the change in ievenues anu the sales to capital iatio. Thus, assuming a sales
to capital iatio of 2.S, in conjunction with a ievenue inciease of $ 2Su million will
iesult in ieinvestment of $ 1uu million. We can builu in lags between the
ieinvestment anu ievenue change into the computation, by using ievenues in a
futuie peiiou to estimate ieinvestment in the cuiient one.
2. With a giowth fiim that has a moie establisheu tiack iecoiu of eainings anu
ieinvestment, we can estimate the giowth iate as a piouuct of the ieinvestment
iate anu the ietuin on capital on these investments. Thus, a fiim that ieinvests
8u% of its aftei-tax opeiating income back into the business anu eain a 2S%
ietuin on capital on its investments, can be expecteu to giow about 2u% a yeai.
Expecteu giowth iate in opeiating income = u.8u*2S% = 2u%
S. uiowth fiims that have alieauy investeu in capacity foi futuie yeais aie in the
unusual position of being able to giow with little oi no ieinvestment foi the neai
teim. Foi these fiims, we can foiecast capacity usage to ueteimine how long the
investment holiuay will last anu when the fiim will have to ieinvest again.
Buiing the investment holiuay, ieinvestment can be minimal oi even zeio,
accompanieu by healthy giowth in ievenues anu opeiating income.
With all thiee classes of fiims, though, the leeway that we have in estimating
ieinvestment neeus uuiing the high giowth phase shoulu uisappeai, once the fiim
has ieacheu its matuie phase. The ieinvestment in the matuie phase shoulu hew
stiictly to funuamentals:
Reinvestment iate in matuie phase =
In fact, even in cases wheie ieinvestment is estimateu inuepenuently of the
opeiating income uuiing the giowth peiiou, anu without iecouise to the ietuin on
capital, we shoulu keep tiack of the imputeu ietuin on capital (baseu on oui
foiecasts of opeiating income anu capital investeu) to ensuie that it stays within
ieasonable bounus. The piocess foi uoing so is uesciibeu in chaptei 9.
8lsk proflle conslsLenL wlLh growLh and operaLlng numbers
While the components of the cost of capital - the beta(s) anu the cost of
equity, the cost of uebt anu the uebt iatio - aie the same foi a giowth company as
they aie foi a matuie company, what sets giowth companies apait is that theii iisk
piofiles will shift ovei time. The key to maintaining balance in giowth company
valuations is to aujust the uiscount iates ovei time to keep them consistent with the
giowth anu maigin assumptions that we aie making in each peiiou. As geneial
• uiowth fiims shoulu have high costs foi equity anu uebt when ievenue giowth is
highest, but the costs of uebt anu equity shoulu uecline as ievenue giowth
moueiates anu maigins impiove.
• As eainings impiove anu giowth uiops, anothei phenomenon will come into
play, which is that the fiim will geneiate moie cash flows than it neeus, which it
can use to not only pay uiviuenus but also to seivice uebt financing. While fiims
aie not iequiieu to use this uebt capacity, anu some of them uo not, the tax
auvantages of uebt will leau some fiims to boiiow, causing uebt iatios to
inciease ovei time.
In summaiy, the cost of capital foi a giowth company shoulu almost nevei be a
numbei that iemains unchangeu ovei the entiie time hoiizon. Insteau, it shoulu be a
yeai-specific numbei that keeps tiack with the iest of the changes that we aie
foiecasting at the fiim.
In teims of estimating iisk paiameteis (betas), we woulu steei as fai as we
can fiom using the limiteu piice uata that is available on giowth companies: the
stanuaiu eiiois on the estimates aie likely to be huge. Insteau, we woulu use
estimates of betas obtaineu by looking at othei publicly tiaueu fiims that shaie the
same iisk, giowth anu cash flow chaiacteiistics as the fiim being valueu. If the case
foi using these bottom up betas (inuustiy aveiage as opposeu to a iegiession beta)
is stiong with any fiim, it is even stiongei with giowth fiims.
!2)B%& 54-.2+ )**1#$2"-0*O C+&0 )07 .+)2 ."%% 2+& ?"4# %--9 %"9&D
The assumptions we make about teiminal value loom laige with a giowth
company, since it will compiise a much laigei poition of the fiim's cuiient value
than is the case with a matuie fiim. When will a giowth fiim become a stable
giowth, matuie fiim. While we have a little moie infoimation than we uiu with
young companies, in making this assessment, it is uifficult to uo, anu akin to looking
at a teenagei anu wonueiing what he oi she will look like oi be uoing, in miuule age.
While no one answei oi appioach will woik with eveiy giowth company, we
will uiaw on the uiscussion both in chaptei 2 anu this one to uevelop the following
geneial piopositions:
• Bo not wait too long to put a fiim into stable giowth: As we noteu in the section
on the uaik siue of valuing giowth companies, analysts often allow foi veiy long
giowth peiious foi giowth fiims anu justify the assumption by pointing to past
giowth. As we noteu in figuie 6.2, both scale anu competition conspiie to lowei
giowth iates quickly at even the most piomising giowth companies. uiowth
peiious that exceeu 1u yeais, especially when accompanieu by high giowth iates
ovei these peiious, aie uifficult to uefenu, since only a hanuful of companies
have been able to accomplish this ovei time.
• When you put youi fiim into stable giowth, give it the chaiacteiistics of a stable
giowth fiim: In keeping with the emphasis on pieseiving inteinal consistency,
we shoulu change the chaiacteiistics of the company to ieflect stable giowth.
With uiscount iates, as we noteu in the last section, this will take the foim of
using lowei costs of uebt anu equity anu a highei uebt iatio. With ieinvestment,
the key assumption will be the ietuin on capital that we assume foi the stable
giowth phase. While some analysts believe that the ietuin on capital shoulu be
set equal to the cost of capital in stable giowth, we woulu pieseive some
company-specific flexibility anu suggest that the uiffeience between ietuin on
capital anu cost of capital shoulu naiiow uuiing stable giowth to a sustainable
level (less than 4 oi S%).
The natuie of the cash flows at giowth companies - low oi negative in the eaily
yeais anu highei latei - will ensuie that the teiminal value is a high piopoition of
value. Some analysts use this as ammunition against using uiscounteu cash flow
valuations, suggesting that assumptions about the high giowth phase will be
uiowneu out by the teiminal value assumptions. This is not tiue, since the base yeai
value foi the teiminal value calculation (eainings anu cash flows in yeai S oi 1u) is a
function of the assumptions uuiing the high giowth phase; changing these
assumptions will have uiamatic effects (as it shoulu) on value.
Irom operat|ng asset va|ue to equ|ty va|ue per share
Navigating the way fiom opeiating asset value to equity value pei shaie foi
giowth companies can be fiaught with uangeis, many of which we outlineu in
eailiei sections. In this section, we will outline piecautions that can piotect, at least
paitially, against some of these uangeis.
()*+ )07 0-0P-$&4)2"05 )**&2*
Eailiei in this chaptei, we noteu how quickly giowth fiims can buin thiough
cash balances anu how using the cash balance fiom the most iecent financial
statements can leau to misleauing values. At least in theoiy, it woulu be useful to
know what the cash balance is touay, when valuing a fiim. While investois in public
equity maikets have no way of accessing this infoimation, an acquiiei (oi at least a
fiienuly acquiiei) shoulu be able to get this infoimation fiom the taiget fiim anu use
it estimate an upuateu value. Even public investois can make juugments about
cuiient cash balances by using two pieces of public infoimation - the cash flows of
the fiim anu any new financing uuiing the peiiou since the last financial statement.
Foi instance, assume that the last cash balance (fiom thiee months ago) is $ 1uu
million foi a fiim that iepoiteu EBITBA of negative $8u million in the most iecent
twelve-month peiiou. If the fiim has not iaiseu any new financing in the last thiee
months (thiough eithei equity issues oi new uebt), the cuiient cash balance foi the
fiim is likely to be closei to $ 8u million than $ 1uu million. (We aie ieuucing the
cash balance by the estimateu EBITBA of -$2u million - one quaitei of -$8u million.)
@&B2 )07 -2+&4 Q-0P&G1"2< (%)"#*
If conveitible uebt is the piefeiieu moue of boiiowing foi a giowth fiim, we
shoulu tieat it foi what it is - a hybiiu secuiity that is pait uebt anu pait equity.
Since the conveision option is equity anu the iest is uebt, the easiest way to
uecompose conveitible uebt into uebt anu equity is to value the conveitible uebt as
if it weie stiaight uebt anu to tieat the iesulting numbei as uebt. Foi instance,
assume that a giowth fiim has S-yeai conveitible uebt outstanuing, with a face
value of $ Su million anu a coupon iate of 4%, anu that the cuiient pie-tax cost of
uebt foi the fiim, assuming it useu conventional uebt, is 1u%. The value of the
conveitible bonu, tieateu like a conventional uebt woulu be:

Bebt value of conveitible bonu =
1- (1.10)
= $38.63 million
Subtiacting this value fiom the maiket value of conveitible bonu will yielu the value
of the conveision option. Thus, if the conveitible uebt is tiauing at $S2 million, the
conveision option (equity) will be valueu at $1S.S7 million.
When valuing this
company, we woulu tieat this pait as equity anu iest as uebt in computing the
cuiient cost of capital. We woulu subtiact out only the uebt poition fiom the value
of the fiim to aiiive at the oveiall value of equity.
Anothei aspect of uebt that is potentially pioblematic is that the uebt iatios
will change ovei time, anu with those changes will come changes in the uebt
outstanuing at the fiim. Since the value of equity is the value of the fiim, net of uebt,
analysts often get caught up in the question of whethei they shoulu subtiact the
uebt outstanuing touay (which may be negligible) oi the expecteu uebt outstanuing
in the futuie (which may be veiy laige). The answei, when valuing the fiim, is that
we shoulu subtiact out only the cuiient uebt outstanuing, even though that value
may be miniscule ielative to futuie uebt issues.

Foi simplicity, we have assumeu annual inteiest payments. This equation can be easily mouifieu to
allow foi semi-annual payments.
If the maiket value of the uebt is not available, an appioximation woulu be to use the face value.
Þost-va|uat|on correct|ons
0nce we have ueiiveu the value of equity in a giowth fiim, the final step is to
allocate the value of equity acioss the shaies outstanuing in the fiim. In making this
final juugment, theie aie thiee consiueiations to keep in minu, all of which we
iaiseu anu auuiesseu in the chaptei on young giowth companies:
• While conceins about whethei a fiim will suivive may abate as the company
ages, they will not uisappeai. Even publicly tiaueu giowth fiims have to shut
uown opeiations, especially if they iun out of cash, anu¡oi access to the maiket
is iestiicteu.
• While a few giowth fiims have laige maiket capitalizations anu consequently
aie heavily tiaueu, most fiims in this phase iemain small, lightly helu by
institutions anu ielatively illiquiu.
• Nany giowth fiims continue to be contiolleu by theii founuei(s), who tiy to
maintain that contiol by holuing on to shaies with uispiopoitionate voting
The coiiections we woulu make foi suivival, illiquiuity anu uiffeient voting iights
miiioi those that we uesciibeu foi young giowth fiims.
Illustration: A DCF valuation of Underarmour
0nuei Aimoui, a company with a veiy successful line of miciofibei appaiel
foi athletes, was founueu by Kevin Plank in 1996, is heauquaiteieu in Baltimoie,
anu capitalizeu on its success by going public in 2uu6. Revenues at the fiim tiipleu
fiom $2uS million in 2uu4 to $6u7 million in 2uu7; ovei the thiee-yeai peiiou, the
company hau a compounueu giowth iate in ievenues of 44% a yeai. Table 6.1
summaiizes the most iecent twelve months of uata foi 0nuei Aimoui (at least as of
}anuaiy 2uu9):
P":/- A4K5 [,0"&-0 &+-/<-@.*#&1 #$.:-)85 [#0-) B).*$)
?"8& K\e
?"8& '-")
&1)$ ^
P1%8 '-")f8
&1)$ ^
P)"%/%#( K3
Cuiient EBIT = $86.27 $S8.u1 $S4.uS $82.S1
EBIT (aujusteu foi leases) $88.28
Cuiient Inteiest Expense = $u.8u $u.SS $u.86 $1.1S
Cuiient Capital Spenuing $SS.96 $26.24 $Su.8S $S8.S7
Cuiient Bepieciation anu
Amoitization = $14.62 $1u.uu $1S.48 $2u.1u
Cuiient Revenues = $6u6.S6 $4S1.72 $S4S.97 $72u.81
The upuateu numbeis ieflect the highei ievenues anu lowei opeiating income at
the fiim ovei the last twelve months, ielative to the last annual iepoit.
Table 6.2 summaiizes oui estimates of cash flows anu cost of capital foi
0nueiaimoui ovei the next 1u yeais:
P":/- A435 >"81 ;/*+8 "#0 >*8&8 *; 9",%&"/ V [#0-)").*$)
E-") I-<-#$-8 I-<-#$-
I-%#<-8&.-#& 2>22 >*8& *;
$721 12.2S% $88 $SS
1 $97S SS.uu% 12.46% $121 $7S $1S8 -$6S 9.27%
2 $1,216 2S.uu% 12.S7% $1SS $92 $1SS -$41 9.27%
S $1,46u 2u.uu% 12.64% $184 $111 $1SS -$22 9.27%
4 $1,679 1S.uu% 12.67% $21S $128 $12u $8 9.27%
S $1,846 1u.uu% 12.69% $2S4 $141 $92 $49 9.27%
6 $1,994 8.uu% 12.71% $2SS $1S2 $81 $71 8.87%
7 $2,114 6.uu% 12.71% $269 $161 $6S $96 8.62%
8 $2,2u9 4.Su% 12.72% $281 $169 $S2 $117 8.S4%
9 $2,27S S.uu% 12.72% $289 $174 $S6 $1S7 7.98%
1u $2,S4S S.uu% 12.72% $298 $179 $S7 $142 7.28%
$2,S96 2.2S% 12.72% $SuS $18S
The key assumptions unueilying these numbeis aie as follows:
a. Revenue uiowth: We expect ievenue giowth to iemain healthy foi the next S
yeais, but lowei than past giowth of 44%. As the company becomes laigei, we
expect giowth iates to ueciease ieflecting both the scaling effect anu
b. 0peiating maigin: We expect maigins to impiove slightly fiom the cuiient level
of 12.2S% to the inuustiy aveiage of 12.72%. The tax iate is assumeu to be 4u%.
c. Reinvestment: The ieinvestment each peiiou is estimateu by assuming that
eveiy uollai of new capital investeu geneiates $1.8S in auuitional ievenues
(again an inuustiy aveiage).
u. Cost of capital: The cost of capital uecieases as the fiim matuies, fiom the
staiting value of 9.27% to a stable peiiou level of 7.28%.
As a final step, we assess what 0nuei Aimoui will look like as a stable giowth fiim.
As a slightly less iisky business, with moie uebt in its capital stiuctuie, it shoulu
have a lowei cost of capital (7.28%). We will assume that the fiim will be able to use
the magic of its bianu name to geneiate ietuins on capital of 9% in peipetuity on
new investments, above the cost of capital. The ieinvestment iate anu teiminal
value foi the fiim aie computeu below:
Reinvestment iate (aftei yeai 1u) = Stable giowth iate¡ Stable Retuin on capital
= 2.2S%¡ 9% = 2S%
Teiminal value =
(1"t)(1"Reinvestment Rate)
(Cost of capital

(.0728 ".0225)
= $2729.50 million
As the final step, we pull togethei the expecteu fiee cash flows to the fiim anu the
costs of capital in table 6.S, with the intent of computing the value of the opeiating
assets of the fiim:
P":/- A4J5 >"81 ;/*+8] 0%89*$#& )"&-8 "#0 <"/$-
Cost of
Cost of
Capital FCFF
1 9.27% 1.u927 -$6S.1S -$S9.6u
2 9.27% 1.19S9 -$41.17 -$S4.48
S 9.27% 1.Su46 -$22.2S -$17.uS
4 9.27% 1.42S4 $8.u1 $S.62
S 9.27% 1.SS7S $48.92 $S1.41
6 8.87% 1.69S7 $71.S1 $42.uS
7 8.62% 1.8418 $9S.8S $S2.u4
8 8.S4% 1.99SS $116.SS $S8.41
9 7.98% 2.1S4S $1S7.4u $6S.77
1u 7.28% 2.S112 $141.S4 $2,729.Su $1,242.22
Sum of Pv of cash flows = $1,S84.4u
The value that we estimate foi the opeiating assets of the fiim is $1.S84 billion.
To get fiom opeiating asset value to equity value foi 0nuei Aimoui poses fewei
challenges than it uiu at Eveigieen Solai. The cash balance of $4u.1S million
iepoiteu by the fiim in its most iecent financial statements in Septembei 2uu8 is
veiy similai to the cash balance of $4u.S9 million it iepoiteu in Becembei 2uu7.
Since the fiim is geneiating positive eainings, we feel comfoitable assuming that the
cash balance is intact at the time of the valuation in }anuaiy 2uu9. With uebt, the
only confounuing uetail is that the bulk of the uebt takes the foim of leases anu
sponsoiship commitments; of the total uebt of $1SS million, $9S.S million
iepiesents the piesent value of futuie commitments. Fiom a valuation peispective,
though, we see no neeu to sepaiate the two types of uebt. Consequently, the value of
equity at 0nuei Aimoui can be estimateu as follows:
value of Equity = value of opeiating assets + Cash - Bebt
= $1,S84 million + $4u million - $1SS million = $1.292 million
To get fiom this value to the value of equity pei shaie, theie aie two final uetails
that we have to take caie of. The fiist is to consiuei the oveihang of equity options
that have been gianteu in the past to management; we estimateu the value of the
2.1S million options outstanuing at the fiim, with an aveiage stiike piice of $8.26
anu an aveiage expiiation of S.7 yeais, to be $ 2S million aftei taxes.
(We will
ietuin to this issue in moie uepth in a latei chaptei, when we look at technology
fiims) The seconu is that the fiim has two classes of shaies - S6.791 million class A
shaies that aie helu by the investing public anu aie tiaueu anu 12.S million class B
shaies that aie helu by Kevin Plank, the founuei of the fiim; class B shaies have 1u
times the voting iights of class A shaies. If we attiibute no value to voting iights the
value pei shaie that we estimate is $2S.7S.
value pei shaie =
Value of Equity
(# Class A shares + # Class B shares)
($1,292 "$23)
= $25.73
Note that contiol component shoulu give class B shaies a piemium but the fact that
the shaies aie not tiaueu will iesult in an illiquiuity uiscount. If we assume that
class B shaies have a 1u% piemium on class A shaies, we can estimate the value of
equity pei shaie foi class A anu class B shaies as follows:

We useu the stanuaiu Black Scholes mouel anu aujusteu foi the potential uilution anu the tax
savings that will acciue to the fiim when the options aie exeiciseu.
value pei class A shaie =
Value of Equity
(# Class A shares + Value premium *# Class B shares )
($1,292 "23)
= $25.09/ share

value pei class B shaie = value of class A shaie * 1.1 = $27.6u
ke|at|ve Va|uat|on
Theie is no ieason why ielative valuation cannot be useu to aiiive at an
inuepenuent estimate of the value of equity in a giowth fiim as long as we keep two
key factois in minu. The fiist is that using multiples anu compaiables cannot ieuuce
the unceitainty inheient in valuing giowth companies. The seconu is that ielative
valuation techniques have to be auapteu to meet the limitations of giowth
companies - the paucity anu unieliability of cuiient opeiating numbeis anu the
shifting iisk¡giowth chaiacteiistics ovei time.
(-#$)4)B%& ?"4#*
0ptimally, we woulu like to assess how a giowth fiim is valueu by the maiket
by compaiing its piicing with that of otheiwise similai giowth fiims. In a business
like softwaie, wheie theie aie giowth fiims aplenty, this can be accomplisheu by
staying within the tiauitional fiamewoik of uefining compaiable fiims as those in
the same inuustiy. In businesses like ietailing oi automotive paits, a giowth fiim
may be the exception in a sectoi wheie the bulk of the fiims aie eithei matuie oi in
uecline. In these cases, we may have to abanuon the conventional piactice anu
uefine giowth fiims in teims of funuamentals iathei than business. The piicing of a
ietail fiim with giowth piospects shoulu be compaieu to how the maiket is piicing
giowth fiims in othei sectois iathei than moie matuie fiims in its own inuustiy;
theie is no ieason why the PE iatio foi a high giowth ietail fiim shoulu not be
compaiable to the PE iatio foi a high giowth softwaie fiim.
(+-"=& -? #1%2"$%&* )07 B)*& <&)4
As we noteu in the section on the uaik siue as it ielates to ielative valuation,
analysts valuing giowth companies tenu to use eithei ievenues in the cuiient yeai
oi estimates of opeiating peifoimance in futuie yeais (foiwaiu eainings oi
ievenues) to compute multiples. Each caiiies some uangei:
• Revenue multiples aie tioubling simply because they gloss ovei the fact that the
company being valueu coulu be losing significant amounts of money.
Consequently, we woulu suggest biinging in the expecteu futuie piofit maigins
(which will be estimates) into the uiscussion of what compiises a ieasonable
multiple of ievenues. 0thei things helu constant, we woulu expect fiims with
highei expecteu piofit maigins (in matuie phase) to tiaue at highei multiples of
cuiient ievenues than fiims with lowei expecteu piofit maigins.
• Foiwaiu eainings multiples implicitly assume that the fiim being valueu will
suivive to the foiwaiu yeai anu that the estimates of eainings foi that yeai aie
ieasonable. If foiwaiu multiples aie useu, contiolling foi suivival becomes a
ciitical component of the analysis. Fiims that have a gieatei chance of suiviving
to the foiwaiu yeai, shoulu tiaue at a highei multiple of eainings than fiims that
have a gieatei chance of failuie.
As a geneial iule, we woulu steei away fiom multiples of eithei cuiient book value
oi cuiient eainings with giowth companies eaily in the giowth cycle, simply
because these numbeis aie likely to be small anu unstable.
/7L1*2"05 ?-4 7"??&4&0=&* "0 54-.2+ )07 4"*9
With giowth fiims, no mattei how caieful we aie about constiucting a set of
compaiable fiims anu picking the iight multiple, theie will be significant uiffeiences
acioss the fiims on both the level anu the quality of expecteu giowth. In chaptei 4,
we maue note of the thiee ways in which analysts aujust foi these uiffeiences: stoiy
telling, aujusteu multiples anu statistical appioaches. Each has its use with giowth
companies, but each comes with limitations:
a. The giowth stoiy: When compaiing the piicing of giowth fiims, analysts
often tiy to explain why a company tiaues at a highei multiple than
compaiables by pointing to its "highei giowth potential".
b. Aujusteu multiples: In the chaptei 4, we intiouuceu the PEu iatio, the PE
iatio uiviueu by expecteu giowth in the futuie, as a giowth-aujusteu veision
of the PE iatio. In effect, a fiim that tiaues at a lowei PEu iatio is cheapei
than one that tiaues at a highei PEu iatio.
c. Statistical appioaches: When fiims vaiy not only on expecteu giowth, but
also on the quality of that giowth anu iisk, the fiist two appioaches become
uifficult to apply. A multiple iegiession, with the multiple as the uepenuent
vaiiable, anu iisk anu giowth as inuepenuent vaiiables, allow us to contiol
foi uiffeiences acioss fiims on these uimensions.
lllosttotloo 10.6. A kelotlve volootloo of uoJet Atmoot
To evaluate how 0nuei Aimoui is being piiceu, ielative to othei fiims in the
sectoi, we extiacteu infoimation on S4 publicly tiaueu appaiel fiims in the 0niteu
States, with eainings giowth iates estimates available foi the next S yeais fiom
analysts following the companies.
Table 6.4 pioviues the PE iatios, expecteu
giowth iates anu two-yeai betas foi these companies:
P":/- A4Z5 HO] S)*+&1 "#0 I%87 V B,,")-/ >*.,"#%-8
Company Name
Capitalization PE
Expected growth rate in EPS
- Next 5 years Beta
Nike Inc. (NYSE:NKE) $22,102.80 11.91 13.10% 1.04 0.91
Kimberly-Clark Corporation
(NYSE:KMB) $21,830.00 12.64 7.33% 0.603 1.72
Avon Products Inc. (NYSE:AVP) $8,896.80 11.53 13.00% 0.966 0.89
VF Corp. (NYSE:VFC) $5,996.90 9.21 10.60% 1.02 0.87
Polo Ralph Lauren Corp. (NYSE:RL) $3,781.30 8.00 13.60% 1.25 0.59
Cintas Corp. (NasdaqGS:CTAS) $3,627.20 11.26 10.80% 0.999 1.04
Guess? Inc. (NYSE:GES) $1,472.40 6.67 16.00% 1.25 0.42
Gildan Activewear Inc. (NYSE:GIL) $1,291.90 8.93 12.50% 1.1 0.71
Tupperware Brands Corporation
(NYSE:TUP) $1,285.10 8.54 12.00% 1.45 0.71
Columbia Sportswear Company
(NasdaqGS:COLM) $1,083.70 8.87 9.70% 0.664 0.91
Warnaco Group Inc. (NYSE:WRC) $969.80 11.21 20.00% 1.91 0.56
Under Armour, Inc. (NYSE:UA) $969.10 20.71 20.90% 1.44 0.99
Phillips-Van Heusen Corp.
(NYSE:PVH) $968.30 6.05 14.00% 1.25 0.43
Carters Inc. (NYSE:CRI) $964.70 12.64 15.00% 1.19 0.84
Wolverine World Wide Inc.
(NYSE:WWW) $929.80 9.56 12.60% 0.693 0.76
Hanesbrands Inc. (NYSE:HBI) $918.00 5.77 15.30% 1.44 0.38
Fossil Inc. (NasdaqGS:FOSL) $814.70 5.62 16.50% 1.35 0.34
Polaris Industries, Inc. (NYSE:PII) $772.50 6.50 11.20% 1.5 0.58
Timberland Co. (NYSE:TBL) $642.50 11.92 12.00% 1.06 0.99

Theie weie 84 companies in the oveiall sample; only S4 hau positive eainings (to compute PE) anu
expecteu giowth iates in eainings foi the next S yeais.
UniFirst Corp. (NYSE:UNF) $551.20 8.69 13.00% 0.906 0.67
Jos. A Bank Clothiers Inc.
(NasdaqGS:JOSB) $529.10 9.71 15.00% 1.11 0.65
Iconix Brand Group, Inc.
(NasdaqGS:ICON) $511.20 7.08 17.00% 1.74 0.42
Bebe Stores, Inc. (NasdaqGS:BEBE) $507.30 8.61 13.00% 1.55 0.66
Raven Industries Inc.
(NasdaqGS:RAVN) $415.40 12.94 14.50% 1.08 0.89
K-Swiss Inc. (NasdaqGS:KSWS) $382.00 11.24 19.00% 1.17 0.59
G&K Services Inc. (NasdaqGS:GKSR) $347.10 9.86 10.70% 0.922 0.92
Ennis Inc. (NYSE:EBF) $301.40 7.32 10.00% 1.21 0.73
True Religion Apparel Inc.
(NasdaqGS:TRLG) $284.30 7.00 17.00% 1.3 0.41
Volcom Inc. (NasdaqGS:VLCM) $225.20 5.99 20.00% 1.9 0.30
Maidenform Brands Inc. (NYSE:MFB) $211.70 7.40 14.50% 1.45 0.51
American Apparel, Inc. (AMEX:APP) $157.10 18.33 30.00% 0 0.61
Cherokee Inc. (NasdaqGS:CHKE) $133.70 9.03 12.00% 1.27 0.75
Oxford Industries Inc. (NYSE:OXM) $104.90 20.61 13.00% 1.54 1.59
G-III Apparel Group, Ltd.
(NasdaqGS:GIII) $85.80 4.47 18.30% 1.32 0.24
Lacrosse Footwear Inc.
(NasdaqGM:BOOT) $64.90 8.78 13.50% 0.283 0.65
Perry Ellis International Inc.
(NasdaqGS:PERY) $60.80 3.27 13.50% 1.57 0.24
Sector Average 2288.25 9.70 15.00% 1.15 0.70
Let us consiuei fiist the two most common appioaches useu by analysts, following
giowth companies.
• Subjective: The PE iatio foi 0nuei Aimoui in }anuaiy 2uu9 is 2u.71, well above
the aveiage PE iatio foi the sectoi (9.7u). An optimistic analyst woulu
unuoubteuly point to 0nuei Aimoui's highei expecteu giowth in eainings
(2u.9u% veisus the inuustiy aveiage of 1S%) as justification foi a highei PE,
though a pessimistic analyst woulu uiaw attention to 0nuei Aimoui's highei
iisk (a beta of 1.44 veisus the inuustiy aveiage of 1.1S) to suggest that the stock
was ovei valueu.
• PEu iatio: A simple way to contiol foi uiffeiences is giowth is to compute the
PEu iatio that we uesciibeu eailiei in the chaptei; lowei PEu iatios aie
consiueieu inuicative of an unuei valueu company. The PEu iatio foi 0nuei
Aimoui is a shaue unuei 1.uu:
PEu0nuei Aimoui =
Expected growth rate in EPS
= 0.99
Since the aveiage PEu iatio foi the sectoi is much lowei at u.7u, this woulu seem
to inuicate that 0nuei Aimoui is oveivalueu.
Since neithei appioach captuies the effects of both giowth anu iisk satisfactoiily,
anu the PEu iatio assumes that PE incieases in lock step with giowth, we fiist
giapheu the PE iatios of appaiel fiims against expecteu EPS giowth in the next S
yeais in figuie 6.S:
2%($)- A4J5 HO <-)8$8 O=,-9&-0 S)*+&1 V B,,")-/ 9*.,"#%-8

Note that 0nuei Aimoui (0A) has the highest PE iatio in the gioup, but it also has a
high giowth iate. We iegiesseu PE iatios against the expecteu giowth iate anu
betas, weighting each fiim, by maiket capitalization. The iesults aie as follows (with
t statistics in biackets below the coefficients):
PE = 1S.78 + S2.u4 (Expecteu uiowth Rate) - 6.6u Beta R
= 2S.9%
(1u.88) (S.49) (1.91)
In keeping with intuition, highei giowth fiims have highei PE iatios anu highei iisk
pushes uown the PE, anu both ielationships aie statistically significant. 0sing the
expecteu giowth in eainings pei shaie of 2u.9% that analysts aie foiecasting foi
0nuei Aimoui foi the next S yeais anu the 2-yeai beta estimate of 1.44, we can
estimate the expecteu PE iatio foi the fiim:
Expecteu PE0nuei Aimoui = 1S.78 + S2.u4 (.2u9) - 6.6u (1.44) = 1u.98
At its existing PE iatio of 2u.71, 0nuei Aimoui looks oveivalueu, on a ielative
valuation basis, by almost 89%.
Va|ue Þ|ays
Investing successfully in giowth companies iequiies skillful navigation
thiough uangeious cuiients - unsustainable oi value uestioying giowth anu high
giowth. Consiuei what you neeu foi a giowth company to succeeu:
a. The capacity to scale up giowth, i.e., be able to maintain high ievenue giowth as
it gets biggei,. Theie aie a few tools that we can use to assess whethei the
assumptions we aie making about ievenue giowth iates in the futuie, foi an
inuiviuual company, aie ieasonable:
• Absolute ievenue changes: Even expeiienceu analysts often unuei estimate the
compounuing effect of giowth anu how much ievenues can balloon out ovei
time with high giowth iates. Computing the absolute change in ievenues, given a
giowth iate in ievenues, can be a sobeiing antiuote to iiiational exubeiance
when it comes to giowth.
• Past histoiy: Looking at past ievenue giowth iates foi the fiim in question
shoulu give us a sense of how giowth iates have changeu as the company size
changeu in the past. To those who aie mathematically inclineu, theie aie clues in
the ielationship that can be useu foi foiecasting futuie giowth.
• Sectoi uata: The final tool is to look at ievenue giowth iates of moie matuie
fiims in the business, to get a sense of what a ieasonable giowth iate will be as
the fiim becomes laigei.
In summaiy, expecteu ievenue giowth iates will tenu to uiop ovei time foi all
giowth companies but the pace of the uiop off will vaiy acioss companies.
b. The ability to geneiate ietuins on capital investeu that exceeu the cost of capital
on new giowth investments. It is not giowth pei se that cieates value, but
giowth with excess ietuins. Fiims that aie able to sustain maigins anu ietuins
on capital, as they giow, aie much bettei investments that fiims that have to
tiaue off lowei maigins anu ietuins foi highei giowth. As a geneialization,
fiims that aie able to maintain oiganic giowth have bettei ouus of pieseiving
excess ietuins than fiims that have to iely on acquisitions to uelivei high
c. Incieasing stability in eainings as the fiim giows anu matuies, accompanieu by a
uecline in iisk: Fiims that aie able to uiveisify theii piouuct offeiings anu catei
to a wiuei customei base, as they giow, will see theii eainings become moie
stable as they scale up.
Finally, as with any investment, a giowth company is woith investing in, only at the
iight piice. While multiples such as PEu iatios have theii limitations, they can be
useu to scieen giowth fiims foi likely baigains. Theie is one factoi that can woik in
youi favoi, in this seaich piocess. Eveiy giowth company (incluuing those that pass
all of the scieens above) will uisappoint its investois at some point, ueliveiing
eainings that uo not match up to lofty expectations. When that happens, theie will
be some giowth investois who ovei ieact, uumping theii shaies anu embaiking on
theii seaich foi the next gieat giowth stoiy. The iesulting uiop in piice may offei
you an oppoitunity to pick up the company at the iight piice.
When valuing a giowth company, we confiont many of the issues that we
faceu with young anu iuea companies, albeit on a lessei scale. Theie aie thiee key
components to valuing giowth companies well, in a uiscounteu cash flow
fiamewoik. The fiist is to ensuie that the assumptions we aie making about giowth
anu maigins ieflect not only maiket potential anu competition, but also change to
ieflect the fiim's changing size ovei time. The seconu is to ieinvest enough back into
the business to sustain the foiecasteu giowth iates. The thiiu is mouify the iisk
piofile of the fiim to match its giowth chaiacteiistics - the costs of equity, uebt anu
capital aie all likely to ueciease as the fiim goes fiom high giowth to stable giowth.
With ielative valuation, contiolling foi uiffeiences in giowth anu iisk when
compaiing companies is essential.

Chapter 7: Va|u|ng Mature Compan|es
Natuie companies shoulu be the easiest ones to value. They have long
peiious of opeiating anu maiket histoiy, allowing us to estimate most of the inputs
foi valuation fiom histoiical uata. They have also settleu into establisheu patteins of
investment anu financing, iesulting in funuamentals (iisk anu ietuins) that aie
stable ovei time, giving us moie confiuence in oui estimates of these numbeis. It is,
howevei, these establisheu patteins that may piesent a pioblem, since not all long
stanuing piactice is goou. Put anothei way, theie aie matuie fiims that make
financing anu investment choices that aie not optimal oi sensible, anu have been
uoing so foi long peiious. It is possible, theiefoie, that these fiims, with new
management in place, coulu be iun uiffeiently (anu bettei) anu have highei values.
Investois valuing matuie companies have to juggle two values - the value with
existing management in place anu a highei value foim new oi uiffeient management
- anu how they ueal with them will in laige pait ueteimine the quality of the
What |s a mature company?
0ne way to categoiize companies as giowth anu matuie companies is to look
at the giowth iate, with lowei giowth companies being tieateu as matuie. Theie aie
two pioblems with this appioach. Fiist, given that giowth is a continuum, any
giowth iate that we auopt as a cut off point will be subjective -we will finu moie
matuie companies, if we auopt a 6% giowth iate cut off than a 4% giowth iate.
Seconu, not all opeiating measuies giow at the same iate; we have to ueciue
whethei the giowth iate that we use foi the categoiization will be giowth in
ievenues, units oi eainings. It is conceivable foi a company with low giowth in
ievenues to uelivei high eainings giowth, at least ovei shoit peiious.
A bettei way of thinking about giowth is to use the financial balance sheet
constiuct that we uevelopeu in the last chaptei. Rathei than focus on opeiating
measuies such as ievenue oi eainings giowth, we can look at the piopoition of a
fiim's value that comes fiom existing investments as opposeu to giowth assets. If
giowth companies get the bulk of theii value fiom giowth as giowth assets, matuie
companies must get the bulk of theii value fiom existing investments (see figuie 7.1

We can use the uistiibution, acioss all companies, of the piopoition of value that
comes fiom matuie assets to ueteimine oui thiesholu foi matuie companies. Thus,
if we uefine matuie companies as the top 2u% of all companies, in teims of
piopoition of value fiom matuie assets, the thiesholu foi being a matuie company
will vaiy acioss maikets (it will be lowei in giowth economies like Inuia an China,
than in the 0S oi Westein Euiope) anu acioss time (the thiesholu will be highei,
when economies slow uown as they uiu in 2uu8 anu 2uu9, anu lowei, when
economies aie booming).
Character|st|cs of Mature Compan|es
Theie aie cleai uiffeiences acioss matuie companies in uiffeient businesses,
but theie aie some common chaiacteiistics that they shaie. In this section, we will
look at what they have in common, with an eye on the consequences foi valuation.
1. Revenue giowth is appioaching giowth iate in economy: In the last section, we
noteu that theie can be a wiue uiveigence between giowth iate in ievenues anu
eainings in many companies. While the giowth iate foi eainings foi matuie
fiims can be high, as a iesult of impioveu efficiencies, the ievenue giowth is
moie uifficult to altei. Foi the most pait, matuie fiims will iegistei giowth iates
Assets Liabilities
Investments already
Equity Investments yet to
be made
Existing Investments
Generate cashflows today
Expected Value that will be
created by future investments
Figure 7.1: A Financial Balance Sheet for a Business
Growth companies
derive a significant
[proportion of their
value from growth
Mature companies
get most of their
value from existing
in ievenues that, if not equal to, will conveige on the nominal giowth iate foi the
2. Naigins aie establisheu: Anothei featuie shaieu by giowth companies is that
they tenu to have stable maigins, with the exceptions being commouity anu
cyclical fiims, wheie maigins will vaiy as a function of the oveiall economy.
While we will ietuin to take a closei look at this sub-gioup latei in the book,
event these fiims will have stable maigins acioss the economic oi commouity
piice cycle.
S. Competitive auvantages. The uimension on which matuie fiims ieveal the most
vaiiation is in the competitive auvantages that they holu on to, manifesteu by the
excess ietuins that they geneiate on theii investments. While some matuie fiims
see excess ietuins go to zeio oi become negative, with the auvent of
competition, othei matuie fiims ietain significant competitive auvantages (anu
excess ietuins). Since value is ueteimineu by excess ietuins, the lattei will
ietain highei values, ielative to the foimei, even as giowth iates become anemic.
4. Bebt capacity: As fiims matuie, piofit maigins anu eainings impiove,
ieinvestment neeus uiop off anu moie cash is available foi seivicing uebt. As a
consequence, uebt iatios shoulu inciease foi all matuie fiims, though theie can
be big uiffeiences in how fiims ieact to this suige in uebt capacity. Some will
choose not to exploit any oi most of the uebt capacity anu stick with financing
policies that they establisheu as giowth companies. 0theis will ovei ieact anu
not just boiiow, but boiiow moie than they can comfoitably hanule, given
cuiient eainings anu cash flows. Still otheis will take a moie ieasoneu miuule
giounu, anu boiiow money to ieflect theii impioveu financial status, while
pieseiving theii financial health.
S. Cash builu up anu ietuin. As eainings impiove anu ieinvestment neeus uiop off,
matuie companies will be geneiating moie cash fiom theii opeiations than they
neeu. If these companies uo not altei theii uebt oi uiviuenu policies, cash
balances will stait accumulating in these fiims. The question of whethei a
company has too much cash, anu, if so, how it shoulu ietuin this cash to stock
holueis becomes a stanuaiu one at almost eveiy matuie company.
6. Acquisition uiiven giowth: The tiansition fiom a giowth company to a matuie
company is not an easy one foi most companies (anu the manageis involveu). As
companies get laigei anu investment oppoitunities inteinally uo not pioviue the
giowth boost that they useu to, it shoulu not be suipiising that many giowth
companies look foi quick fixes that will allow them to continue to maintain high
giowth. 0ne option, albeit an expensive one, is to buy giowth: acquisitions of
othei companies can pioviue boosts to ievenues anu eainings.
0ne final point that neeus to be maue is that not all matuie companies aie laige
companies. Nany small companies ieach theii giowth ceiling quickly anu essentially
stay as small, matuie fiims. A few giowth companies have extenueu peiious of
giowth befoie they ieach stable giowth anu these companies tenu to be the laige
companies that we finu useu as illustiations of typical matuie companies: Coca Cola,
IBN anu veiizon aie all goou examples.
Va|uat|on Issues
As with young businesses anu giowth fiims, the chaiacteiistics of matuie
companies can cieate estimation challenges, uuiing valuations. In this section, we
will fiist focus on the valuation issues in the uiscounteu oi intiinsic valuation of
matuie companies anu then look at manifestations of the same pioblems, when we
uo ielative valuation.
Intr|ns|c (DCI) Va|uat|on
If the intiinsic value of a fiim is the piesent value of the expecteu cash flows
fiom its investments, uiscounteu back at a iisk aujusteu iate, it woulu seem that
matuie fiims shoulu be easiest to value on that basis. While this is geneially tiue,
theie aie still pioblems that can luik unuei the suiface of the long anu seemingly
stable histoiies of these fiims.
FE"*2"05 /**&2*
We categoiizeu matuie companies as those that get the bulk of theii value
fiom existing assets. Consequently, measuiing the value of these assets coiiectly
becomes fai moie ciitical with matuie fiims than it was with the giowth fiims that
we analyzeu in the last two chapteis. Since a key input into valuing existing assets is
estimating the cash flows that they geneiate, theie aie two issues that we encountei
when we value matuie companies.
a. Nanageu Eainings: Natuie companies aie paiticulaily auept at using the
uiscietionaiy powei offeieu in accounting iules to manage eainings. While
they aie not necessaiily committing accounting fiauu oi even being
ueceptive, it uoes imply that the eainings iepoiteu fiom existing assets by
companies that aggiessively appioach accounting choices will be much
highei than the eainings iepoiteu by otheiwise similai conseivative
companies. Failing to factoi in the uiffeiences in "accounting" minuset can
leau us to ovei value the existing assets of the aggiessive companies anu
unuei value them foi conseivative companies.
b. Nanagement inefficiencies: When valuing matuie companies, we aie often
lulleu by the fact that they have long peiious of stable opeiating histoiy into
believing that the numbeis fiom the past (opeiating maigins, ietuins on
capital) aie ieasonable estimates of what existing assets will continue to
geneiate in the futuie. Bowevei, past eainings ieflect how the fiim was
manageu ovei the peiiou. To the extent that manageis may not have maue
the iight investment oi financing choices, the iepoiteu eainings may be
lowei than what the existing assets woulu be able to piouuce unuei bettei oi
optimal management. If theie is the possibility of such a management change
on the hoiizon, we will unuei value existing assets using iepoiteu eainings.
In summaiy, the notion that existing assets can be easily valueu at a matuie
company, because of its long opeiating histoiy, is uefensible only at well-manageu
companies oi at companies wheie existing management is so entiencheu that theie
is no chance of a management change.
34-.2+ /**&2*
Theie aie two ways in which companies can cieate giowth assets. 0ne is to
invest in new assets anu piojects that geneiate excess ietuins: this is geneially
teimeu oiganic giowth. The othei is to acquiie establisheu businesses anu
companies anu thus shoit ciicuit the piocess: this is inoiganic oi acquisition uiiven
giowth. While both options aie available to companies at any stage in the life cycle,
matuie companies aie fai moie likely to take the "acquiieu giowth" ioute foi thiee
ieasons. The fiist is that as companies matuie, inteinal investments stait to become
scaice, ielative to what the fiim has available to invest. The seconu is that as
companies get laigei, the new investments that they make also have to giow in size
to have any impact on oveiall giowth. While it is uifficult to finu multi-billion uollai
inteinal piojects, it is easiei to finu acquisitions that aie of that size anu affect the
giowth iate almost immeuiately. The thiiu applies in businesses wheie theie is a
long leau-time between investment anu payoff. In these businesses, theie will be a
lag between the initial investment in a new asset anu the giowth geneiateu by that
investment. With an acquisition, we aie in effect speeuing up the payoffs.
So what aie the consequences foi intiinsic valuation. As a geneial iule, the
value of acquisition uiiven giowth is much moie uifficult to assess than the value of
oiganic giowth. 0nlike oiganic giowth, wheie fiims take seveial small investments
each peiiou, acquisitions tenu to be infiequent anu lumpy: a multi-billion uollai
acquisition in one yeai may be followeu by two yeais of no investments at all anu
then followeu by anothei acquisition. The consequences of this lumpiness can be
seen ifwe ielate giowth to funuamentals:
Expecteu uiowth Rate = Reinvestment Rate * Retuin on Capital
Since ieinvestment anu ietuins on capital shoulu ieflect both oiganic anu
acquisition uiiven giowth, we think it is fai moie uifficult to estimate these numbeis
foi acquisitive companies. If we follow the stanuaiu piactice of using the
ieinvestment numbeis fiom the most iecent financial statement, we iisk oveistating
the value (if theie was a laige acquisition uuiing the peiiou) oi unueistating it (if it
was a peiiou between acquisitions). Computing the ietuin on capital on investments
is much moie uifficult with acquisitions, paitly because of the accounting tieatment
of the piice paiu anu its allocation to goouwill anu paitly because we have fai fewei
obseivations to base oui juugments on.
@"*=-102 8)2&*
When estimating uiscount iates, we stait fiom a position of moie stiength,
when analyzing matuie companies, because we have moie uata to woik with. Nost
matuie companies have been publicly tiaueu foi extenueu peiious, giving us access
to moie histoiical piice uata, anu have settleu iisk piofiles, which stabilizes the uata.
Thus, estimating equity iisk paiameteis fiom histoiical uata is moie uefensible with
this gioup of companies than it was with the giowth companies that we analyzeu in
the last two chapteis. In auuition, many matuie companies, at least in the 0niteu
States, use the coipoiate bonu ioute to iaise uebt, which yielus two benefits. The
fiist is that we can get upuateu maiket piices anu yielus on these bonus, which aie
an input into the cost of uebt. The seconu is that the bonus aie accompanieu by bonu
iatings, which not only pioviue measuies of uefault iisk but pathways to uefault
spieaus anu costs of uebt.
Theie aie, howevei, thiee estimation issues that can affect uiscount iate
estimates. The fiist is that matuie companies accumulate uebt fiom multiple places,
leauing to a complex mix of uebt - fixeu anu floating iate, in multiple cuiiencies,
senioi anu suboiuinateu, anu with uiffeient matuiities. Since they often caiiy
uiffeient inteiest iates (anu even uiffeient iatings), analysts aie left with the
challenge of how to ueal with this complexity, when computing uebt iatios anu costs
of uebt. The seconu is that uiscount iates (costs of uebt, equity anu capital) aie
affecteu by the fiim's mix of uebt anu equity anu the estimates that we obtain fiom
the cuiient piice uata anu iatings aie ieflective of the cuiient financing mix of the
fiim. If that mix is alteieu, the uiscount iate will have to be ie-estimateu. The thiiu
factoi comes into play foi those fiims that follow the acquisitive ioute to giowth.
Acquiiing a fiim in a uiffeient business oi with a uiffeient iisk piofile can altei the
uiscount iate foi the fiim.
:&4#"0)% ;)%1&
As in any intiinsic valuation, the teiminal value accounts foi a laige shaie of
the oveiall value of a matuie fiim. Since matuie fiims have giowth iates that aie
close to that of the economy, the computation of teiminal value may seem both
moie imminent anu simplei with a matuie company than a giowth company. While
this may be tiue, theie aie two factois that can still cause uistoitions in the
a. Stable giowth iates, unstable iisk anu investment piofile: While many
matuie companies have giowth iates low enough to qualify foi stable giowth
(by being less than the giowth iate of the economy anu the iiskfiee iate), the
othei inputs into the valuation may not ieflect this matuiity. Thus, a fiim
with a 2% giowth iate in ievenues anu eainings woulu qualify as a stable
fiim, baseu upon its giowth iate, but not if its beta is 2.uu anu it is
ieinvesting 9u% of its aftei-tax opeiating income back into the business. To
qualify as a stable giowth fiim that can be valueu using the teiminal value
equation, the fiim shoulu not only have a sustainable giowth iate but also
have a iisk piofile of a stable fiim (close to aveiage iisk) anu behave like a
stable fiim (in teims of ieinvestment).
b. Lock in inefficiencies in peipetuity: The cash flows fiom existing assets anu
the uiscount iates that we obtain fiom past uata will ieflect the choices maue
by the fiim. To the extent that the fiim is not manageu optimally, the cash
flows may be lowei anu the uiscount iate highei than it woulu have been foi
the same fiim with a uiffeient management. If we lock in cuiient values
(maigins, ietuins on investment anu uiscount iates), when estimating
teiminal value, anu the fiim is pooily iun, we aie in effect unuei valuing the
fiim by assuming that the cuiient piactices will continue foievei.
The assumption that a fiim is in stable giowth anu can be valueu using a teiminal
value equation cannot be maue easily, even foi matuie fiims.
ke|at|ve Va|uat|on
With matuie companies, with positive ievenues anu eainings anu book
values that aie meaningful, we have a luxuiy of iiches when it comes to ielative
valuation. We can estimate ievenues, eainings anu book value multiples anu
compaie how a company is piiceu, ielative to othei companies like it.
a. Too many choices. The pioblem, though, is that while finuing a multiple that
woiks anu compaiable companies is easiei with matuie fiims than with the giowth
fiims that we analyzeu in the last two chapteis, the fact that each multiple that we
use gives us a uiffeient estimate of value can be pioblematic. Put anothei way,
ielative valuation is a subjective piocess, wheie the same company can be assigneu
veiy uiffeient values, uepenuing upon whethei we aie using a fiim oi equity
multiple, whethei that multiple is stateu as a function of ievenues, eainings anu
book value anu the companies we pick to be its compaiables. With matuie fiims, the
pioblem we face is not that we cannot estimate a ielative value but that theie aie
too many values to pick between.
b. Nanagement change: The multiples that we compute of ievenues, eainings anu
book value ieflect the matuie fiim as it is manageu touay. To the extent that
changing the management of the fiim coulu change all of these numbeis, we aie
faceu with the same pioblem as we weie with uiscounteu cash flow valuation. Bow
uo we best ieflect, in a ielative valuation, the potential foi management change anu
the consequent inciease in value. The pioblem is magnifieu, though, because the
same issue of how a uiffeient management can affect opeiating numbeis also affects
all of the othei companies that aie useu as a compaiable fiim.
c. Acquisition Noise: Acquisition uiiven giowth, a souice of intiinsic valuation angst,
contaminates ielative valuation. The accounting afteimath of acquisitions - the
cieation of goouwill as an asset anu its subsequent tieatment - can affect both
eainings anu book value, making multiples baseu on eithei numbei uicey.
u. Changing financial leveiage: The othei factoi that can thiow a wiench into
ielative valuations is changing financial leveiage. Natuie companies aie capable of
making laige changes to theii uebt iatios oveinight - uebt foi equity swaps,
iecapitalizations - anu some multiples can be affecteu uiamatically by such actions.
In geneial, equity multiples, such as PE anu Piice to book iatios, will change moie as
financial leveiage changes than enteipiise value oi fiim multiples, that aie baseu
upon the collective value of both uebt anu equity. A stock buyback, using boiioweu
funus, can ieuuce maiket capitalization uiamatically (by ieuucing the shaies
outstanuing), but will have a much smallei impact on enteipiise value (since we aie
ieplacing equity with uebt). Foi the same ieason, equity eainings (eainings pei
shaie, net income) will change when fiims altei uebt iatios.
Va|uat|on So|ut|ons
Looking at both the estimation issues ielateu to valuation anu the uaik siue
as it manifests itself in the valuation of matuie companies, theie aie two aspects of
matuie companies that we have to be able to ueal with well, in oiuei to value them
coiiectly. The fiist is how best to value giowth at matuie companies, especially
when the giowth is geneiateu by acquisitions. The othei is how to assess the impact
on value of changing the way a matuie company is iun - as we noteu eailiei, theie
can be significant opeiating anu financial inefficiencies in matuie fiims that have
enuuieu foi long peiious, unuei existing management.
Growth and Acqu|s|t|ons
Some fiims giow piimaiily thiough acquisitions anu valuing these fiims
poses challenges. If acquisitions aie in the company's past anu aie unlikely to occui
in the futuie, theii effect is alieauy embeuueu in value anu theie is no futuie impact.
If acquisitions aie pait of the long-teim stiategy of the fiim, the task becomes moie
uifficult since we have to assess how much the fiim will spenu on acquisitions in the
futuie anu what ietuin on capital it will geneiate on these acquisitions. To the
extent that acquisitions geneiate a ietuin on capital that is gieatei (lowei) than the
cost of capital, they will auu to (uetiact fiom) value.
Chang|ng management
If the key to valuing matuie companies is assessing the potential change in
value fiom changing the way they aie iun, it is ciitical that we come up with bettei
ways of assessing that effect. In this section, we will begin by looking at the potential
foi enhancing value at any fiim, fiist by focusing on changes in opeiations anu then
examining how financing policy anu stiategy can altei value. We will extenu the
uiscussion by biinging both the potential foi value change anu the possibility of
making that change into a measuie of the expecteu value of contiol. We will close
the section by evaluating the implications of the expecteu value of contiol not only
in valuing matuie companies but also in estimating the piemium that we shoulu pay
foi voting iights.
R$&4)2"05 8&*241=214"05
When valuing a company, oui foiecasts of eainings anu cash flows aie built
on assumptions about how the company will be iun. If these numbeis aie baseu
upon existing financial statements, we aie, in effect, assuming that the fiim will
continue to be iun the way it is now. In this section, we will look at how changes in
opeiations manifest themselves in valuation, using the intiinsic value fiamewoik
that we have alieauy useu extensively in this book. In this appioach, the value of a
fiim is a function of five key inputs. The fiist is the cash flow fiom assets in place oi
investments alieauy maue, the seconu is the expecteu giowth iate in the cash flows
uuiing what we can teim a peiiou of both high giowth anu excess ietuins (wheie
the fiim eains moie than its cost of capital on its investments), the thiiu is the
length of time befoie the fiim becomes a stable giowth fiim anu the fouith is the
uiscount iate ieflecting both the iisk of the investment anu the financing mix useu
to funu it. The final element iepiesents cash, cioss holuings anu othei non-opeiating
assets that the fiim may holu that augment the value of opeiating assets. Figuie 7.2
captuies all five elements:
llqote 7.2. uetetmlooots of voloe

A fiim can inciease its value by incieasing cash flows fiom cuiient opeiations,
incieasing expecteu giowth anu the peiiou of high giowth, by ieuucing its
composite cost of financing anu managing its non-opeiating assets bettei. In this
section, we will focus on all of these inputs, othei than the cost of financing.
HI S0=4&)*& ()*+ ,%-.* ,4-# /**&2* S0 6%)=&
The fiist place to look foi value is in the existing assets of the fiim. These
assets ieflect investments that have alieauy been maue anu that geneiate the fiim's
cuiient opeiating income. To the extent that these investments eain less than the
cost of capital, oi aie eaining less than they coulu, if optimally manageu, theie is
potential foi value enhancement. In geneial, actions taken to inciease cash flows
fiom assets in place can be categoiizeu into the following gioups:
• B88-& I-0-,/*'.-#&: To the extent that the assets of a business aie pooily
investeu, you can inciease the cash flows anu value of the fiim by uivesting
pooily peifoiming assets
oi by moving assets fiom theii existing uses to
ones that geneiate highei value. 0ne example woulu be a ietail fiim that
owns its stoies ueciuing that the stoie spaces woulu be woith moie
uevelopeu as commeicial ieal estate insteau of being useu in ietailing.
• R.,)*<-0 *,-)"&%#( -;;%9%-#9': When a fiim's opeiations aie iiuuleu with
inefficiencies, ieuucing oi eliminating these inefficiencies will tianslate into
an inciease in opeiating cash flows anu value. Thus, a telecommunications
fiim that is oveistaffeu shoulu be able to geneiate value by ieuucing the size
of its woikfoice. A steel company that is losing money because of outuateu
equipment in its plants may be able to inciease its value by ieplacing them
with newei, moie efficient equipment. In iecent yeais, manufactuiing
companies in uevelopeu maikets like the 0niteu States anu Westein Euiope
have been able to geneiate substantial savings in costs by moving theii
opeiations to emeiging maikets wheie laboi costs aie lowei.

At fiist sight, uivesting businesses that aie eaining pooi ietuins oi losing money may seem like the
ticket to value cieation. Bowevei, the ieal test is whethei the uivestituie value exceeus the value of
continuing in the business; if it is, uivestituie makes sense. Aftei all, when a business is eaining pooi
ietuins, it is unlikely that a potential buyei will pay a piemium piice foi it.
• I-0$9- &"= :$)0-#: It is eveiy fiim's obligation to pay its iightful uue in taxes
but not to pay moie than its faii shaie. If a fiim can legally ieuuce its tax
buiuen, it shoulu uo so. A multinational fiim may be able to ieuuce its taxes
by moving moie of its opeiations (anu the ensuing eainings) to lowei tax
locales. Risk management can also play a iole in ieuucing taxes by smoothing
out eainings ovei peiious; spikes in income can subject a fiim to highei
• I-0$9- 9",%&"/ ."%#&-#"#9- "#0 +*)7%#( 9",%&"/ %#<-8&.-#&8: A significant
poition of aftei-tax opeiating income is often ieinvesteu in the fiim not to
geneiate futuie giowth but to maintain existing opeiations. This
ieinvestment incluues capital maintenance (which is capital expenuituie
uesigneu to maintain anu ieplace existing assets) anu investments in
inventoiy oi accounts ieceivable. Nuch of this ieinvestment may be
unavoiuable, because assets age anu fiims neeu woiking capital to geneiate
sales. In some fiims, though, theie may be potential foi savings, especially in
woiking capital. A ietail fiim that maintains inventoiy at 1u% of sales, when
the aveiage foi the sectoi is only S%, can inciease cash flows substantially if
it can biing its inventoiy levels uown to inuustiy stanuaius.
JI S0=4&)*& FE$&=2&7 34-.2+
A fiim with low cuiient cash flows can still have high value if it is able to giow
quickly uuiing the high giowth peiiou. As noteu eailiei, highei giowth can come
eithei fiom new investments oi fiom moie efficiently utilizing existing assets.
• With new investments, highei giowth has to come fiom eithei a highei
ieinvestment iate oi a highei ietuin on capital on new investments oi both.
Bighei giowth uoes not always tianslate into highei value, since the giowth
effect can be offset by changes elsewheie in the valuation. Thus, highei
ieinvestment iates usually iesult in highei expecteu giowth but at the
expense of lowei cash flows, since moie ieinvestment ieuuces fiee cash
flows at least in the neai teim.
To the extent that the ietuin on capital on
the new investments is highei (lowei) than the cost of capital, the value of
the business will inciease (ueciease) as the ieinvestment iate iises.
Similaily, highei ietuins on capital also cause expecteu giowth to inciease,
but value can still go uown if the new investments aie in iiskiei businesses
anu theie is a moie than piopoitionate inciease in the cost of capital.
• With existing assets, the effect is moie unambiguous, with highei ietuins on
capital tianslating into highei giowth anu highei value. A fiim that is able to
inciease its ietuin on capital on existing assets fiom 2% to 8% ovei the next
S yeais will iepoit healthy giowth anu highei value.
Which of these two avenues offeis the most piomise foi value cieation. The answei
will uepenu upon the fiim in question. Foi matuie fiims with low ietuins on capital
(especially when less than the cost of capital), extiacting moie giowth fiom existing
assets is likely to yielu quickei iesults, at least in the shoit teim. Foi smallei fiims
with ielatively few assets in place, geneiating ieasonable ietuins, giowth has to
come fiom new investments that geneiate healthy ietuins.
KI T&052+&0 2+& 6&4"-7 -? U"5+ 34-.2+
As noteu above, eveiy fiim, at some point in the futuie, will become a stable
giowth fiim, giowing at a iate equal to oi less than the economy in which it
opeiates. In auuition, giowth cieates value only if the ietuin on investments
exceeus the cost of capital. Cleaily, the longei high giowth anu excess ietuins last,
othei things iemaining equal, the gieatei the value of the fiim. Note, howevei, that
no fiim shoulu be able to eain excess ietuins foi any length of peiiou in a
competitive piouuct maiket, since competitois will be attiacteu by the excess
ietuins into the business. Thus, implicit in the assumption that theie will be high
giowth, in conjunction with excess ietuins, is also the assumption that theie exist
some baiiieis to entiy that pievent fiims fiom eaining excess ietuins foi extenueu
time peiious.

Acquisitions have to be consiueieu as pait of capital expenuituies foi ieinvestment. Thus, it is
ielatively easy foi fiims to inciease theii ieinvestment iates but veiy uifficult foi these fiims to
maintain high ietuins on capital as they uo so.
uiven this ielationship between how long fiims can giow at above-aveiage iates
anu the existence of baiiieis to entiy, one way fiims can inciease value is by
augmenting existing baiiieis to entiy anu coming up with new baiiieis to entiy.
Anothei way of saying the same thing is to note that companies that eain excess
ietuins have significant competitive auvantages. Nuituiing these auvantages can
inciease value.
MI N)0)5& 0-0P-$&4)2"05 /**&2*
In the fiist thiee components of value cieation, we have focuseu on ways in
which a fiim can inciease its value fiom opeiating assets. A significant chunk of a
fiim's value can ueiive fiom its non-opeiating assets - cash anu maiketable
secuiities anu holuings in othei companies. To the extent that these assets aie
sometimes mismanageu, theie is potential foi value enhancement heie.
• Cash: While cash anu maiketable secuiities aie by themselves neutial
investments, eaining a faii iate of ietuin (a low one, but a faii one given the iisk
anu liquiuity of the investments), theie aie two scenaiios wheie it can be value
uestiuctive. The fiist is when cash is investeu at below maiket iates. A fiim with
$ 2 billion in a cash balance helu in a non-inteiest beaiing checking account is
cleaily huiting its stockholueis. The seconu aiises if investois aie conceineu
that cash will be misuseu by management to make pooi investments oi
acquisitions. In eithei case, theie will be a uiscount applieu to cash to ieflect the
likelihoou that management will misuse the case the consequences of such
misuse. If cash is being uiscounteu, ietuining some oi all of this cash to
stockholueis in the foim of uiviuenus oi stock buybacks will make stockholueis
bettei off.
• Cioss holuings aie uifficult to value, especially when they aie in subsiuiaiy fiims
with uiffeient iisk anu giowth piofiles than the paient company. It is not
suipiising that fiims with substantial cioss holuings in uiveise businesses often
finu these holuings being unueivalueu by the maiket. In some cases, this
unueivaluation can be blameu on infoimation gaps, causeu by the failuie to
convey impoitant uetails on giowth, iisk anu cash flows on cioss holuings to the
maikets. In othei cases, the unueivaluation may ieflect maiket skepticism about
the paient company's capacity to manage its cioss holuing poitfolio; consiuei
this a conglomeiate uiscount.
If such a uiscount applies, the piesciiption foi
incieaseu value is simple. Spinning off oi uivesting the cioss holuings anu thus
exposing theii tiue value shoulu make stockholueis in the paient company
bettei off.
,"0)0=")% 8&*241=214"05
The one element of value that we uiu not auuiess in the last chaptei was the
cost of financing. In this chaptei, we will look at two aspects of financing that affect
the cost of capital, anu thiough it, the value that we ueiive foi a fiim. Fiist, we will
look at how best to ieflect changes the mix of uebt anu equity useu to funu
opeiations in the cost of capital. Seconu, we will look at how the choices of financing
(in teims of senioiity, matuiity, cuiiency anu othei auu-on featuies) may affect the
cost of funuing anu value.
(+)05"05 ?"0)0=")% #"E
The question of whethei changing the mix of uebt anu equity can altei the
value of a business has long been uebateu in finance. While the answei to some may
seem obvious - uebt aftei all is always less expensive than equity - the choice is not
that simple. In this section, we will fiist lay out the tiaue off on uebt veisus equity in
qualitative teims anu then consiuei thiee tools that can be useu to assess the effect
of financing mix on value.
uebL versus LqulLy: 1he Lrade off
Bebt has two key benefits, ielative to equity, as a moue of financing. Fiist, the
inteiest paiu on uebt financing is tax ueuuctible, wheieas cash flows to equity (such
as uiviuenus) aie geneially not.
Theiefoie, the highei the tax iate, the gieatei the
tax benefit of using uebt. This is absolutely tiue in the 0niteu States anu paitially

Stuuies looking at conglomeiates concluue that they tiaue at a uiscount of between S anu 1u% on
the value of the pieces that they aie composeu of.
This is cleaily the case in the 0niteu States. Theie aie othei maikets, such as Biazil, wheie equity
cash flows also pioviue tax auvantages. Even in those maikets, the tax auvantages foi uebt tenu to be
highei than the tax auvantages foi equity.
tiue in most paits of the woilu. The seconu benefit of uebt financing is moie subtle.
The use of uebt, it can be aigueu, inuuces manageis to be moie uisciplineu in pioject
selection. That is, the manageis of a company funueu entiiely by equity, anu with
stiong cash flows, have a tenuency to become lazy. Foi example, if a pioject tuins
soui, the manageis can hiue eviuence of theii failuie unuei laige opeiating cash
flows, anu few investois notice the effect in the aggiegate. But if those same
manageis hau to use uebt to funu piojects, then bau piojects aie less likely to go
unnoticeu. Since uebt iequiies the company to make inteiest payments, investing in
too many bau piojects can leau to financial uistiess oi even bankiuptcy, anu
manageis may lose theii jobs.
Relative to equity, the use of uebt has thiee uisauvantages÷an expecteu
bankiuptcy cost, an agency cost, anu the loss of futuie financing flexibility.
• The expecteu bankiuptcy cost has two components. 0ne is simply that as uebt
incieases, so uoes the piobability of bankiuptcy. The othei component is the
cost of bankiuptcy, which can be sepaiateu into two paits. 0ne is the uiiect cost
of going bankiupt, such as legal fees anu couit costs, which can eat up to a
significant poition of the value of the assets of a bankiupt fiim. The othei (anu
moie uevastating) cost is the effect on opeiations of being peiceiveu as being in
financial tiouble. Thus, when customeis leain that a company is in financial
tiouble, they tenu to stop buying the company's piouucts. Supplieis stop
extenuing cieuit, anu employees stait looking foi moie ieliable employment
elsewheie. Boiiowing too much money can cieate a uownwaiu spiial that enus
in bankiuptcy.
• Agency costs aiise fiom the uiffeient anu competing inteiests of equity investois
anu lenueis in a fiim. Equity investois see moie upsiue fiom iisky investments
than lenueis to. Consequently, left to theii own uevices, equity investois will
tenu to take moie iisk in investments than lenueis woulu want them to anu to
altei financing anu uiviuenu policies to seive theii inteiests as well. As lenueis
become awaie of this potential, they altei the teims of loan agieements to
piotect themselves in two ways. 0ne is by auuing covenants to these
agieements, iestiicting investing, financing anu uiviuenu policies in the futuie;
these covenants cieate legal anu monitoiing costs. The othei is by assuming that
theie will be some game playing by equity investois anu by chaiging highei
inteiest iates to compensate foi expecteu futuie losses. In both instances, the
boiiowei beais the agency costs.
• As fiims boiiow moie money touay, they lose the capacity to tap this boiiowing
capacity in the futuie. The loss of futuie financing flexibility implies that the fiim
may be unable to make investments that it otheiwise woulu have likeu to make,
simply because it will be unable to line up financing foi these investments.
1he effecL of flnanclng mlx on value: 1he cosL of caplLal approach
In the cost of capital appioach, the optimal financing mix is the one that
minimizes a company's cost of capital. In effect, we keep opeiating cash flows fixeu
anu assume that changing uebt changes only the cost of capital. By minimizing the
cost of capital, we aie maximizing fiim value. This appioach has its ioots in the
uiscounteu cash flow mouel foi valuing a fiim, wheie expecteu cash flows to the
fiim (piioi to uebt payments but aftei taxes anu ieinvestment neeus) aie
uiscounteu back at the cost of capital. If a company can keep its cash flows
unchangeu anu lowei its cost of capital, it will inciease its piesent value. Theiefoie,
the optimal uebt iatio is the one at which the cost of capital is minimizeu.
At fiist sight, the answei to what will happen to the cost of capital as the uebt
iatio is incieaseu seems tiivial, given that the cost of uebt is almost always lowei
than the cost of equity foi a business. Bowevei, that solution misses the uynamic
effects of intiouucing uebt into a business. To see these effects, consiuei the two
components that uiive the cost of capital÷ the cost of equity anu cost of uebt. As the
company boiiows moie money, its equity will become iiskiei. Even though it has
the same opeiating assets (anu income), it now has to make inteiest payments, anu
financial leveiage magnifies the iisk in equity eainings. Thus, the cost of equity will
be an incieasing function of the uebt iatio. Fuitheimoie, as boiiowing incieases, so
uoes uefault iisk, which, in tuin, incieases the cost of uebt. The tiaue off on uebt's
effect on the cost of capital can be summaiizeu as follows: ieplacing equity with
uebt has the positive effect of ieplacing a moie expensive moue of funuing with a
less expensive one but in the piocess the incieaseu iisk in both uebt anu equity will
push up the costs of both components, cieating a negative effect. Whethei the cost of
capital incieases oi uecieases will be a function of which effect uominates. Figuie
7.S captuies the tiaue off:
2%($)- X4J5 P)"0- *;; *# >*8& *; >",%&"/ "#0 Y-:&

The cost of capital appioach ielies on sustainable cash flow to ueteimine the
optimal uebt iatio. The moie stable anu pieuictable a company's cash flow anu the
gieatei the magnituue of these cash flows÷as a peicentage of enteipiise value÷the
highei the company's optimal uebt iatio can be. Fuitheimoie, the most significant
benefit of uebt is the tax benefit. Bighei tax iates shoulu leau to highei uebt iatios.
Baseu on the insights offeieu so fai, the best canuiuates foi laige amounts of
financial leveiage will be matuie oi ueclining companies that have laige, ieliable
cash flows. uiowth companies÷companies with theii best uays aheau of them÷aie
not goou canuiuates foi high financial leveiage because such companies have high
maiket values, ielative to cash flows, anu usually neeu to plough these cash flows
back into the business (iathei than pay inteiest expenses) to geneiate futuie
lllosttotloo 7.1. 1be cost of copltol Apptoocb - notmel looJs
In }anuaiy 2uu9, we lookeu at Boimel Foous anu computeu a cost of capital
of 6.79%, baseu upon the existing uebt iatio of 1u.S9%. The cost of capital appioach,
in conjunction with the uefault spieaus in }anuaiy 2uu9, was useu to ueiive the
costs of uebt anu equity foi Boimel at uiffeient uebt iatios, with the iesults
summaiizeu in Table 7.1:
P":/- X4K5 >*8&8 *; OD$%&'] Y-:& "#0 >",%&"/5 W*).-/ 2**08
Ratio Beta
Cost of
iate on uebt
Cost of Bebt
(aftei-tax) WACC
value (u)
u% u.78 7.uu% AAA S.6u% 4u.uu% 2.16% 7.uu% $4,S2S
1u% u.8S 7.S1% AAA S.6u% 4u.uu% 2.16% 6.8u% $4,66S
2u% u.89 7.7u% AAA S.6u% 4u.uu% 2.16% 6.S9% $4,81S
Su% u.97 8.2u% A+ 4.6u% 4u.uu% 2.76% 6.S7% $4,8S4
4u% 1.u9 8.86% A- S.SS% 4u.uu% S.21% 6.6u% $4,8u8
Su% 1.24 9.79% B+ 8.SS% 4u.uu% S.u1% 7.4u% $4,271
6u% 1.47 11.19% B- 1u.8S% 4u.uu% 6.S1% 8.S8% $S,7S7
7u% 1.86 1S.S2% CCC 12.SS% 4u.uu% 7.41% 9.24% $S,S98
8u% 2.7u 18.SS% CC 14.SS% S8.u7% 8.89% 1u.81% $2,892
9u% S.S9 S4.7u% CC 14.SS% SS.84% 9.49% 12.u1% $2,S97
We use the unleveieu beta of u.78 to estimate the leveieu beta at 1u% inciements
on the uebt iatio, up to 9u peicent uebt. . The table also shows the effect of the iising
uebt iatio on the company's bonu iatings, inteiest iate on uebt, tax iate, cost of uebt,
weighteu aveiage cost of capital (WACC), anu fiim value.
The cost of equity anu cost of uebt both iise as uebt incieases, but the cost of
capital uiops anu the fiim value incieases, at least initially. The benefits of uebt
exceeu its costs, until the uebt ieaches Su peicent, at which point, the cost of capital
staits climbing again anu the fiim value begins to uiop. To minimize the cost of
capital foi Boimel, the optimal uebt iatio woulu be about Su peicent, oi $1.4 billion
in uebt.
,"0)0="05 :<$&
The funuamental piinciple in uesigning the financing of a fiim is to ensuie
that the cash flows on the uebt match as closely as possible the cash flows on the
asset. Fiims that mismatch cash flows on uebt anu cash flows on assets (by using
shoit teim uebt to finance long teim assets, uebt in one cuiiency to finance assets in
a uiffeient cuiiency oi floating iate uebt to finance assets whose cash flows tenu to
be auveisely impacteu by highei inflation) will enu up with highei uefault iisk,
highei costs of capital anu lowei fiim values. To the extent that fiims can use
ueiivatives anu swaps to ieuuce these mismatches, fiim value can be incieaseu.
Conveiting this intuitive statement about matching financing to assets anu its
effect on uefault iisk into specifics can be uifficult. In many cases, mismatching
financing to assets shows up only aftei it has cieateu a ciisis: a fiim that has useu
shoit teim funuing to finance long teim assets is unable to iefinance its uebt anu has
to put its assets up foi sale. We woulu suggest that theie is a much simplei lesson
embeuueu in the financing matching piinciple. Companies often use a bewilueiing
aiiay of uebt anu justify this complexity on the basis of cheapness, uefineu puiely in
teims of inteiest payments. Note that, if we follow this path, shoit teim uebt will be
cheapei than long teim uebt in most peiious as will boiiowing money in lowei
inflation cuiiencies (yen, uollai, euio) will be cheapei than boiiowing money in
high inflation cuiiencies (peso, iuble). Rathei than tiying to assign uiffeient costs to
each layei of uebt, we woulu iecommenu a consoliuation of all uebt with a
composite cost of uebt attacheu to it; this composite cost shoulu ieflect the oveiall
uefault iisk of the fiim (iathei than the uefault iisk of a specific bonu oi uebt) anu
the cost of boiiowing long teim (even if the fiim uses shoit teim uebt).
:+& FE$&=2&7 ;)%1& -? (-024-%
By consiueiing the effects of opeiating anu financing changes on value
explicitly, iathei than attaching an aibitiaiy contiol piemium, we can get a much
bettei hanule on the value of contiol. In this section, we will fiist consoliuate anu
summaiize the effects of changing management on value anu then look at the
likelihoou that we can make this change. The piouuct of these analyses will be the
expecteu value of contiol, which we then use to examine a wiue aiiay of valuation
1he value of Changlng ManagemenL
If we consiuei value to be the enu iesult of the investment, financing anu
uiviuenu uecisions maue by a fiim, the value of fiim will be a function of how
optimal (oi sub-optimal) we consiuei a fiim's management to be. If we estimate a
value foi the fiim, assuming that existing management piactices continue, anu call
this a status quo value anu ie-estimate the value of the same fiim, assuming that it is
optimally manageu, anu call this estimate the optimal value, the value of changing
management can be wiitten as:
value of management change = 0ptimal fiim value - Status quo value
The value of changing management will be a uiiect consequence of how much we
can impiove the way the fiim is iun. The value of changing management will be zeio
in a fiim that is alieauy optimally manageu anu substantial foi a fiim that is bauly
Retiacing the steps thiough value, it shoulu also be quite cleai that the
pathway to value enhancement will vaiy foi uiffeient fiims. Sub-optimal
management can manifest itself in uiffeient ways foi uiffeient fiims. Foi fiims
wheie existing assets aie pooily manageu, the inciease in value will be piimaiily
fiom managing those assets moie efficiently - highei cash flows fiom these assets
anu efficiency giowth. Foi fiims wheie investment policy is sounu but financing
policy is not, the inciease in value will come fiom changing the mix of uebt anu
equity anu a lowei cost of capital. Table 7.2 consiueis potential pioblems in existing
management, fixes to these pioblems anu the value consequences:
P":/- X435 h"'8 *; R#9)-"8%#( L"/$-
Potential Pioblem Nanifestations Possible fixes value Consequence
Existing assets aie
pooily manageu
0peiating maigins
aie lowei than peei
gioup anu ietuin on
capital is lowei than
the cost of capital
existing assets
bettei. This
may iequiie
uivesting some
Bighei opeiating
maigin anu ietuin
on capital on
existing assets ->
Bighei opeiating
Efficiency giowth ->
in neai teim as
ietuin on capital
Nanagement is
unuei investing (It
is too conseivative
in exploiting
Low ieinvestment
iate anu high ietuin
on capital in high
giowth peiiou
Reinvest moie
in new
even if it means
lowei ietuin on
capital (albeit >
cost of capital)
Bighei giowth iate
anu highei
ieinvestment iate
uuiing high giowth
peiiou -> Bighei
value because
giowth is value
Nanagement is
ovei investing (It is
investing in value
uestioying new
Bigh ieinvestment
iate anu ietuin on
capital that is lowei
than cost of capital
iate until
maiginal ietuin
on capital is at
Lowei giowth iate
anu lowei
ieinvestment iate
uuiing high giowth
peiiou -> Bighei
least equal to
cost of capital
value because
giowth is no longei
value uestioying
Nanagement is not
exploiting possible
Shoit oi non-existent
high giowth peiiou
with low oi no excess
Builu on
Longei high giowth
peiiou, with laigei
excess ietuins ->
Bighei value
Nanagement is too
conseivative in its
use of uebt
Bebt iatio is lowei
than optimal (oi
inuustiy aveiage)
Inciease uebt
Bighei uebt iatio
anu lowei cost of
capital -> Bighei
fiim value
Nanagement is
ovei using uebt
Bebt iatio is highei
than optimal
Reuuce uebt
Lowei uebt iatio
anu lowei cost of
capital -> Bighei
fiim value
Nanagement is
using wiong type
of financing
Cost of uebt is highei
than it shoulu be,
given the fiim's
eaining powei
Natch uebt up
to assets, using
ueiivatives oi
Lowei cost of uebt
anu cost of capital ->
Bighei fiim value
Nanagement holus
excess cash anu is
not tiusteu by the
maiket with the
Cash anu maiketable
secuiities aie a laige
peicent of fiim value;
Fiim has pooi tiack
iecoiu on
Retuin cash to
eithei as
uiviuenus oi
stock buybacks
Fiim value is
ieuuceu by cash
paiu out, but
stockholueis gain
because the cash
was uiscounteu in
the fiim's hanus.
Nanagement has
maue investments
in unielateu
Substantial cioss
holuings in othei
companies that aie
being unueivalueu
by the maiket.
As a fiist step,
tiy to be moie
about cioss
holuings. If that
is not sufficient,
uivest cioss
Fiim value is
ieuuceu by uivesteu
cioss holuings but
incieaseu by cash
ieceiveu fiom
uivestituies. When
cioss holuings aie
unuei valueu, the
lattei shoulu exceeu
the foimei.

Illustration 7.2: A Valuation of Hormel Foods- Status Quo versus Optimal
To value contiol at Boimel, we valueu the fiim twice: the fiist time with
existing management continuing to iun the fiim anu once with an optimal
management team in place. Foi the status quo value, we assumeu that the fiim
woulu stay with its existing financing mix (1u.S% uebt) anu that they will stay with
theii existing investment policy, thus pieseiving cuiient ieinvestment iates anu
ietuins on capital foi the next S yeais. At the enu of the thiiu yeai, we assumeu that
the fiim woulu be in stable giowth anu that excess ietuins woulu faue to zeio. Table
7.S summaiizes the assumptions useu to value Boimel Foous unuei the status quo:
P":/- X4J5 R#,$&8 ;*) L"/$"&%*#5 W*).-/ 2**08 V C&"&$8 ^$*

Bigh uiowth
Stable giowth
Length of Bigh uiowth Peiiou = S Aftei yeai S
uiowth Rate = 2.7S% 2.SS%
Bebt Ratio useu in Cost of Capital
Calculation= 1u.S9% 1u.S9%
Beta useu foi stock = u.8S u.9u
Riskfiee iate = 2.SS% 2.SS%
Risk Piemium = 6.uu% 6.uu%
Cost of Bebt = S.6u% 4.Su%
Tax Rate = 4u.uu% 4u.uu%
Cost of capital = 6.79% 7.2S%
Retuin on Capital = 14.S4% 7.2S%
Reinvestment Rate = 19.14% S2.S2%
Theie aie two things to note about the high giowth phase. The fiist is that the high
giowth peiiou is shoit anu the giowth iate uuiing the peiiou is anemic (2.7S%),
ieflecting the conseivative ieinvestment policy of the existing management; the
ietuins on capital on existing investments is healthy (14.S4%) but the fiim
ieinvests only 19.14% of its aftei-tax opeiating income back. The seconu is that the
low giowth iate that we have estimateu, by itself, is not sufficient to allow us to use
a stable giowth mouel because it is highei than the iisk fiee iate anu the excess
ietuins geneiateu cuiiently (almost 7.4S%) aie not compatible with a stable fiim.
Table 11.1S summaiizes oui estimates of cash flows foi the fiist S yeais anu the
piesent value of these cash flows, foi Boimel Foous:
P":/- KK4KJ5 >"81 2/*+8 "#0 L"/$- P*0"'
Cuiient 1 2 S
EBIT * (1 - tax iate) $S1S $S24 $SSS $S42
- Reinvestment $6u $62 $64 $6S
Fiee Cashflow to Fiim $2SS $262 $269 $276
Cost of capital 6.79% 6.79% 6.79%
Piesent value 5678 5619 5664
In stable giowth, we not only move the giowth iate uown to the iiskfiee iate but
also assume that the ietuin on capital uiops to equal the cost of capital of 7.2S%;
the cost of capital incieases maiginally because we incieaseu the beta in stable
Reinvestment iate =
Teiminal value =
Auuing the piesent value of the teiminal value, uiscounteu back S yeais at
the cuiient cost of capital of 6.79%, to the piesent value of the cash flows foi the
fiist S yeais gives us a value foi the opeiating assets of $4,682 million. Auuing the
cash holuings of the fiim ($1SS million), subtiacting out uebt ($491 million) anu the
value of management options outstanuing ($SS million) yielus the value of equity in
common stock, which when uiviueu by the numbei of shaies outstanuing (1S4.SS
million) geneiates a value pei shaie of $S1.91.
value pei shaie =
To value the fiim unuei optimal management, we maue thiee key changes.
a. Noie uebt baseu financing: Baseu upon oui analysis of Boimel's financing
mix in the last section, we incieaseu the uebt iatio fiom 1u.S6% to 2u%.
Even allowing foi the highei iisk in equity (beta goes up to u.9u), the cost of
capital foi the fiim uecieases to 6.6S% in the high giowth phase anu to
6.74% in stable giowth.
b. Bighei ieinvestment iate: We assumeu that the fiim woulu be moie
aggiessive in seeking out new investments, using a highei ieinvestment iate
of 4u%, but assumeu that the ietuin on capital woulu uiop as a iesult to
c. Longei giowth peiiou: Boimel has seveial key bianu names in its stable anu
we will assume that it can exploit these bianu names to geneiate excess
ietuins foi a longei time peiious - S yeais insteau of S.
The iesulting valuation inputs aie summaiizeu in table 11.14:
P":/- KK4KZ5 L"/$"&%*# R#,$&85 W*).-/ 2**08 V g,&%."/ Q"#"(-.-#&
High Growth Stable growth
Length of Bigh uiowth Peiiou = S Foievei
uiowth Rate = S.6u% 2.SS%
Bebt Ratio useu in Cost of Capital Calculation= 2u.uu% 2u.uu%
Beta useu foi stock = u.9u u.9u
Riskfiee iate = 2.SS% 2.SS%
Risk Piemium = 6.uu% 6.uu%
Cost of Bebt = S.6u% 4.Su%
Tax Rate = 4u.uu% 4u.uu%
Cost of capital u.1u% 6.74%
Retuin on Capital = 14.uu% 6.74%
Reinvestment Rate = 4u.uu% S4.87%
The cash flows, teiminal value anu the value of the fiim touay that emeige fiom
these assumptions aie shown in table 11.1S:
P":/- KK4KU5 >"81;/*+8 "#0 L"/$- &*0"'5 g,&%."/ Q"#"(-.-#&
Cuiient 1 2 S 4 S
EBIT * (1 - tax iate) $S1S $SSS $SS1 $S71 $S92 $414
- Reinvestment $1S1 $1SS $141 $148 $1S7 $16S
Fiee Cashflow to Fiim $184 $2uu $211 $22S $2SS $248
Teiminal value $6282
Cost of capital 6.6S% 6.6S% 6.6S% 6.6S% 6.6S%
Piesent value $187 $18S $184 $182 $S,6SS
value of opeiating assets $S,474
To complete the stoiy, we make the same aujustments foi cash, uebt anu
management options that we uiu in the status quo valuation to aiiive at a value pei
value pei shaie =
The value pei shaie that we obtain foi Boimel Foous, with a uiffeient management
team in place, is $S7.8u, an inciease of $ S.89 ovei the status quo value pei shaie.
That woulu iepiesent the oveiall value of contiol at Boimel Foous.
1he ÞrobablllLy of Changlng ManagemenL
While the value of changing management in a bauly manageu fiim can be
substantial, the incieaseu value will be cieateu only if management policies aie
changeu. While this change can sometimes be accomplisheu by convincing existing
manageis to mouify theii ways, all too often it iequiies ieplacing the manageis
themselves. If the likelihoou of management change happening is low, the expecteu
value of contiol will also be low. In this section, we fiist consiuei the mechanisms
foi changing management, anu then some of the factois that ueteimine the
likelihoou of management change.
Mecboolsms fot cbooqloq moooqemeot
It is uifficult to change the way a company is iun, but in geneial, theie aie
foui ways in which it can be uone.
1. Activist investois: The fiist is a vaiiation of moial oi at least economic suasion,
wheie one oi moie laige institutional investois intiouuce shaieholuei pioposals
uesigneu piimaiily to impiove coipoiate goveinance, holuing the thieat of moie
extieme action ovei the heaus of manageis. A mix of pension funus anu piivate
investois has shown a willingness to confiont incumbent manageis. These
activist investois, with the weight of theii laige stockholuings, aie able to
piesent pioposals to stockholueis to change policies that they feel aie inimical to
shaieholuei inteiests. 0ften, these pioposals aie centeieu on coipoiate
goveinance; changing the way the boaiu of uiiectois is chosen anu iemoving
anti-takeovei clauses in the coipoiate chaitei aie common examples.
2. Pioxy contests: The seconu is a pioxy contest, wheie incumbent manageis aie
challengeu by an investoi who is unhappy with the way the fiim is iun, foi pioxy
votes; with sufficient votes, the investoi can get iepiesentation on the boaiu anu
may be able to change management policy. In most companies, investois vote
with theii feet - selling theii stockholuings when uissatisfieu - anu thus conceue
powei to incumbent manageis. In some companies, howevei, activist investois
compete with incumbent manageis foi the pioxies of inuiviuual investois, with
the intent of getting theii nominees foi the boaiu electeu. While they may not
always succeeu at winning majoiity votes, they uo put manageis on notice that
they aie accountable to stockholueis. Theie is eviuence that pioxy contests
occui moie often in companies that aie pooily iun, anu that they cieate
significant changes in management policy anu impiovements in opeiating
S. Replacing Nanagement The thiiu is to tiy to ieplace the existing manageis in the
fiim with moie competent managei. In publicly tiaueu fiims, this will iequiie a
boaiu of uiiectois that is willing to challenge management. Top management
tuinovei at most fiims is usually a consequence of ietiiement oi ueath anu the
successoi usually follows in the incumbent's footsteps. In some cases, though,
top manageis aie foiceu out by the boaiu, because of uispleasuie ovei theii
peifoimance, anu a new management is biought in to heau the fiim. This
pioviues an opening foi a ieassessment of the fiim's cuiient management
policies anu foi significant changes. While foiceu management tuinovei was
uncommon outsiue the 0niteu States until iecent yeais, it is becoming moie
4. Bostile acquisition: The fouith anu most extieme is a hostile acquisition of the
fiim by an investoi oi anothei fiim; the incumbent management is usually
ieplaceu aftei the acquisition anu management policy is ievampeu. Investoi
piessuie, CE0 tuinovei anu pioxy contests iepiesent inteinal piocesses foi
management uiscipline. When these fail, the only weapon that stockholueis have
left is to hope that the fiim will become the taiget of a hostile acquisition, wheie
the acquiiei will take ovei the company anu change the way it is iun. Foi hostile
acquisitions to be effective as management uisciplining mechanism, seveial
pieces have to fall into place. Fiist, fiims that aie bauly manageu anu iun shoulu
be taigeteu foi acquisitions. Seconu, the system shoulu give potential hostile
acquiieis a ieasonable chance of success; the bias towaius incumbency shoulu
be negligible oi small. Thiiu, the acquiiei has to change both the manageis anu
the management policies of the taiget company aftei the acquisition.
uetetmlooots of Moooqemeot cbooqe
Theie is a stiong bias towaius pieseiving incumbent management at fiims,
even when theie is wiuespieau agieement that the management is incompetent oi
uoes not have the inteiests of stockholueis at heait. Some of the uifficulties aiise
fiom the institutional tilt towaius incumbency anu otheis aie put in place to make
management change uifficult, if not impossible. In geneial, theie aie foui
ueteiminants of whethei management will be changeu at a fiim:
1. Institutional conceins: The fiist gioup of constiaints on challenging incumbent
management in companies that aie peiceiveu to be bauly manageu anu bauly
iun is institutional. Some of these constiaints can be tiaceu to uifficulties
associateu with iaising the capital neeueu to funu the challenge, some to state
iestiictions on takeoveis anu some to ineitia.
2. Fiim-specific constiaints: Theie aie some fiims wheie incumbent manageis, no
mattei how incompetent, aie piotecteu fiom stockholuei piessuie by actions
taken by these fiims. This piotection can take the foim of anti-takeovei
amenuments to the coipoiate chaitei, elaboiate cioss holuing stiuctuies anu the
cieation of shaies with uiffeient voting iights. In some cases, the incumbent
manageis may own laige enough stakes in the fiim to stifle any challenge to
theii leaueiship. The time-honoieu way foi piotecting incumbent management
is to issue shaies with uiffeient voting iights. In its most extieme foim, the
incumbent manageis holu all of the shaies with voting iights anu issue only non-
voting shaies to the public. In effect, this allows the insiueis in these fiims to
contiol theii uestiny with a small peicentage of all outstanuing stock. Noie
geneially, fiims can accomplish the same objective by issuing shaies with
uiffeient voting iights.
S. Coipoiate Boluing Stiuctuies: Contiol can be maintaineu ovei fiims with a
vaiiety of coipoiate stiuctuies incluuing pyiamius anu cioss holuings. In a
pyiamiu stiuctuie, an investoi uses contiol in one company to establish contiol
in othei companies. Foi instance, company X can own Su% of company Y anu
use the assets of company Y to buy Su% of company Z. In effect, the investoi
who contiols company X will enu up contiolling companies Y anu Z, as well.
Stuuies inuicate that pyiamius aie a common appioach to consoliuating contiol
in family iun companies in Asia anu Euiope. In a cioss holuing stiuctuie,
companies own shaies in each othei, thus allowing the gioup's contiolling
stockholueis to iun all of the companies with less than Su% of the outstanuing
stock. The vast majoiity of }apanese companies (keiietsus) anu Koiean
companies (chaebols) in the 199us weie stiuctuieu as cioss holuings,
immunizing management at these companies fiom stockholuei piessuie.
4. Laige Shaieholuei¡Nanageis: In some fiims, the piesence of a laige stockholuei
as a managei is a significant impeuiment to a hostile acquisition oi a
management change. Consiuei, a fiim like 0iacle, wheie the founuei¡CE0, Laiiy
Ellison, owns almost Su% of the outstanuing stock. Even without a uispeision of
voting iights, he can effectively stymie hostile acquiieis. Why woulu such a
stockholuei¡managei mismanage a fiim when it costs him oi hei a significant
poition of maiket value. The fiist ieason can be tiaceu to hubiis anu ego.
Founuei CE0s, with little to feai fiom outsiue investois, tenu to centialize powei
anu can make seiious mistakes. The seconu is that what is goou foi the insiue
stockholuei, who often has all of his oi hei wealth investeu in the fiim may not
be goou foi the othei investois in the fiim.
While the ueteiminants of management change can be listeu, it is fai moie uifficult
to quantitatively estimate the piobability that it will occui. We can howevei make
subjective juugments of this piobability by looking at fiims wheie the top managei
(CE0) is foiceu out by the boaiu. In iecent yeais, ieseaicheis have examineu when
foiceu CE0 tuinovei is most likely to occui.
• The fiist factoi is stock piice anu eainings peifoimance, with foiceu tuinovei
moie likely in fiims that have peifoimeu pooily ielative to theii peei gioup
anu to expectations.
0ne manifestation of pooi management is oveipaying

Wainei, }., R. Watts anu K. Wiuck, 1988, C&*97 H)%9-8 "#0 P*, Q"#"(-.-#& >1"#(-8, }ouinal o
Financial Economics, v2u, 461-492; Nuiphy, K anu }. Zimmeiman, 199S, 2%#"#9%"/ H-);*)."#9-
8$))*$#0%#( >Og P$)#*<-), }ouinal of Accounting anu Economics, v16, 27S-S16; Puffei, S. anu }.B.
on acquisitions, anu theie is eviuence that CE0s of acquiiing fiims that pay
too much on acquisitions aie fai moie likely to be ieplaceu than CE0s who uo
not uo such acquisitions.

• The seconu factoi is the stiuctuie of the boaiu, with foiceu CE0 changes
moie likely to occui when the boaiu is small
, is composeu of outsiueis

anu when the CE0 is not also the chaiiman of the boaiu of uiiectois.

• The thiiu anu ielateu factoi is the owneiship stiuctuie; foiceu CE0 changes
aie moie common in companies with high institutional anu low insiuei
They also seem to occui moie fiequently in fiims that aie moie
uepenuent upon equity maikets foi new capital.

• The final factoi is inuustiy stiuctuie, with CE0s moie likely to be ieplaceu in
competitive inuustiies.

In summaiy, fiims wheie you see foiceu CE0 change shaie some chaiacteiistics
with fiims that aie taigets of hostile acquisitions - they aie pooily manageu anu iun
- but they tenu to have much moie effective boaius of uiiectois anu moie activist
investois who aie able to change management without tuining ovei the fiim to a
hostile acquiiei.

Weintiop, 1991, >*),*)"&- H-);*)."#9- "#0 >Og P$)#*<-)5 P1- I*/- *; H-);*)."#9- O=,-9&"&%*#8,
Auministiative Science Quaiteily, vS6, 1-19;
Lehn, K. anu N. Zhao, 2uu4, >Og P$)#*<-) ";&-) B9D$%8%&%*#8: Y* 6"0 6%00-)8 (-& ;%)-0i, Woiking
Papei, 0niveisity of Pittsbuigh.
Faleye, 0., 2uuS, B)- /")(- :*")08 ,**) .*#%&*)8i O<%0-#9- ;)*. >Og &$)#*<-), Woiking Papei,
SSRN. 0sing a piopoitional hazaiu mouel, he finus that eveiy auuitional uiiectoi on the boaiu
ieuuces the piobability of a foiceu CE0 change by 1S%.
Weisbach, N., 1988, g$&8%0- Y%)-9&*)8 "#0 >Og P$)#*<-), }ouinal of Financial Economics, v2u, 4S1-
uoyal. v.K., anu C.W. Paik, 2uu1, 6*")0 ?-"0-)81%, C&)$9&$)- "#0 >Og P$)#*<-), }ouinal of
Coipoiate Finanee, v8, 49--66.
Bennis, B.}., B.K. Bennis anu A. Saiin, 1997, g+#-)81%, C&)$9&$)- "#0 P*, O=-9$&%<- P$)#*<-),
}ouinal of Financial Economics, v4S, 19S-221.
Billiei, B., S. Linn anu P. NcColgan, 2uuS, OD$%&' R88$"#9-] >*),*)"&- S*<-)#"#9- I-;*). "#0 >Og
P$)#*<-) %# &1- [e, Woiking Papei, SSRN. They finu that CE0 aie moie likely to be foiceu out just
befoie new equity issues oi placings.
BeFonut, N.L. anu C.W. Paik, 1999, P1- -;;-9& *; 9*.,-&%&%*# *# >Og P$)#*<-), }ouinal of
Accounting anu Economics, v27, SS-S6.
Illustration 11.7: The Probability of Control Changing – Hormel Foods
While making a piecise estimate of the piobability of contiol changing may
be uifficult with Boimel Foous, the fact that the Boimel Founuation holus 47.4% of
the outstanuing stock in the company is a key factoi. While the founuation is iun by
inuepenuent tiustees, it ietains stiong links with the incumbent manageis anu is
unlikely to acquiese to a hostile acquisition that will change key paits of the
company. Nanagement change, if it uoes come, will have to be maue with the
agieement of the founuation. Consequently, we will estimate a piobability of only
1u% of the change occuiiing; in effect, the fiim has to be unuei extieme uuiess
befoie the founuation will step in anu agiee to a change.
0nce we have a measuie of the expecteu value of contiol, it is useful not just
to acquiieis who aie to tiying to buy a fiim but to any investoi in the fiim. The
maiket piice that we obseive foi a publicly tiaueu stock shoulu ieflect the expecteu
value of contiol, as shoulu the piemium that we obseive foi voting shaies, ielative
to non-voting shaies.
íxpectotloos ooJ 5tock ltlces
To see how the expecteu value of contiol shows up in stock piices, assume
that you live in a woilu wheie management change nevei happens anu that the
maiket is ieasonably efficient about assessing the values of the fiims that it piices.
In this scenaiio, eveiy company will tiaue at its status quo value, ieflecting both the
stiengths anu weaknesses of existing management. Now assume that you intiouuce
the likelihoou of management change into this maiket, eithei in the foim of hostile
acquisitions oi CE0 changes. If the maiket iemains ieasonably efficient, the stock
piice of eveiy fiim shoulu iise to ieflect this likelihoou:
Naiket value = Status quo value + (0ptimal value - Status quo value)*
Piobability of management changing
The uegiee to which this will affect stock piices will vaiy wiuely acioss fiims, with
the expecteu value of contiol being gieatest foi bauly manageu fiims wheie theie is
a high likelihoou of management tuinovei anu lowest foi well manageu fiims anu
foi fiims wheie theie is little oi no chance of management change.
Theie aie many who will be skeptical about the capacity of maikets to make
these assessments with any uegiee of accuiacy anu whethei investois actually tiy to
estimate the expecteu value of contiol. The eviuence inuicates that while maikets
may not use sophisticateu mouels to make these assessments, they uo tiy to value
anu piice in contiol.
To the extent that the expecteu value of contiol is alieauy built into the maiket
value, theie aie impoitant implications foi acquiieis, investois anu ieseaicheis:
a. H"'%#( " ,)-.%$. *<-) &1- .")7-& ,)%9- 9"# )-8$/& %# *<-) ,"'.-#&: If the cuiient
maiket piice incoipoiates some of all of the value of contiol, the effect of
management change on maiket value (as opposeu to status quo value) will be
small oi non-existent. In a fiim wheie the maiket alieauy assumes that
management will be changeu anu builus it into the stock piice, acquiieis shoulu
be waiy of paying a piemium on the cuiient maiket piice even foi a bauly
manageu fiim. Consiuei an extieme example. Assume that you have a fiim with a
status quo value of $ 1uu million anu an optimally manageu value of $ 1Su
million anu that the maiket is alieauy builuing in a 9u% chance that the
management of the fiim will change in the neai futuie. The maiket value of this
company will be $ 14S million. If an acquiiei ueciues to pay a substantial
piemium (say $ 4u million) foi this fiim, baseu upon the fact that the company is
bauly manageu, he will oveipay substantially; in this example, he will pay $ 18S
million foi a company with a value of $ 1Su million.
b. B#'&1%#( &1"& 9"$8-8 .")7-& ,-)9-,&%*# *; &1- /%7-/%1**0 *; ."#"(-.-#& 91"#(-
&* 81%;& 9"# 1"<- /")(- -;;-9&8 *# "// 8&*978. A hostile acquisition of one company,
foi instance, may leau investois to change theii assessments of the likelihoou of
management change foi all companies anu to an inciease in stock piices. Since
hostile acquisitions often aie clusteieu in a paiticulai sectoi - oil companies in
the 198us, foi instance - it is not suipiising that a hostile acquisition of a single
company often leaus to incieases in stock piices of companies in its peei gioup.
c. H**) 9*),*)"&- (*<-)#"#9- T ?*+-) 8&*97 ,)%9-8: The piice of pooi coipoiate
goveinance can be seen in stock piices. Aftei all, the essence of goou coipoiate
goveinance is that it gives stockholueis the powei to change the management of
bauly manageu companies. Consequently, stock piices in a maiket wheie
coipoiate goveinance is effective will ieflect a high likelihoou of change foi bau
management anu a highei expecteu value foi contiol. In contiast, it is uifficult, if
not impossible, to uislouge manageis in maikets wheie coipoiate goveinance is
weak. Stock piices in these maikets will theiefoie incoipoiate lowei expecteu
values foi contiol. The uiffeiences in coipoiate goveinance aie likely to manifest
themselves most in the woist manageu fiims in the maiket.
Illustration 7.3: Market Prices and the Expected Value of Control
Consiuei the valuation of Boimel Foous in illustiation 11.7. We estimateu
both the status quo anu the optimal value of the equity in the company anu aiiiveu
at the following iesults:
value of Equity value pei shaie
Status Quo $ 4,29S million $ S1.91 pei shaie
0ptimally manageu $ S,u8S million $ S7.8u pei shaie
In illustiation 11.*, we estimateu the piobability of management change happening
at only 1u%. If we assume that these aie all ieasonable estimates, the expecteu
value pei shaie foi Boimel will be:
Expecteu value pei shaie = $S1.91 (.9u) + #S7.8u (.1u) = $S2.S1
If oui assessments aie coiiect, the stock shoulu be tiauing at $S2.S1. The actual
maiket piice at the time of this valuation was about $S2.2S. Assuming that both the
maiket piice anu oui values pei shaie aie coiiect, the maiket piice can be wiitten
in teims of a piobability of contiol changing anu the expecteu value of contiol:
Expecteu value pei shaie = Status Quo value + Piobability of contiol
changing * (0ptimal value - Status Quo value)
$ S2.2S = $ S1.91 + Piobability of contiol changing ($S7.8u - $S1.91)
The maiket is attaching a piobability of S.6% that management policies can be
Va|ue Þ|ays
Theie aie two ways in which investois can piofit fiom investing in matuie
companies. 0ne is to auopt the classic value appioach anu look foi matuie
companies that continue to uelivei high ietuins anu soliu eainings, but which
investois have tuineu soui on, eithei because they aie not the flavoi of the moment
in the maiket oi they aie boiing. These aie the companies that you hope to finu with
tiauitional value scieens - they tiaue at low multiples of eainings anu book value,
have goou management anu still uelivei ieasonable eainings.
The othei is a moie peiveise stiategy. You tiy to finu matuie companies that aie
pooily manageu anu iun, that aie peiceiveu to be so by the maiket, but wheie you
peiceive the possibility of a change in management that can geneiate substantially
highei value. The inuicatoi vaiiables foi these factois incluue:
a. Pooi peifoimance: If pooi management is manifesteu in pooi investment anu
financing choices, it shoulu be ievealeu in a company's piofitability measuies
anu its financing mix. In paiticulai, you coulu look foi fiims that have low
opeiating maigins ielative to the sectoi, low ietuins on capital ielative to cost of
capital anu veiy low uebt iatios that aie not consistent with theii stiong
opeiating cash flows anu matuie company status.
b. Naiket peiception matches peifoimance: The iest of the maiket has to not only
agiee with youi assessment of cuiient management quality but also see little
chance of changing the management. These two factois will contiibute to
keeping the maiket value low.
c. Potential foi laige inciease in value with change in management: Theie has to be
potential foi a significant inciease in value if the fiim weie manageu uiffeiently.
While this may seem a given, if the fiim is cuiiently bauly manageu, it iequiies
two othei pieces to fall into place.
• The assets that aie cuiiently ueployeu pooily (anu eainings low maigins)
can eithei be ieueployeu quickly anu put to moie piofitable use oi can be
solu to buyeis who can put it to that use. Foi example, a ietail fiim that has
stoies occupying valuable ieal estate is in a bettei position to ieueploy those
assets than a manufactuiing company with inefficient factoiies.
• To the extent that the fiim has too little uebt, having ieauy access to faiily
piiceu uebt can make changing the financing mix much easiei. Thus, fiims in
countiies with well uevelopeu capital maikets may be able to tap theii uebt
potential quickei anu moie cheaply than fiims in some emeiging maikets.
u. Change on the hoiizon: If you wait foi the announcement of a hostile acquisition
oi a management change, it will be too late, since the maiket piice will iesponu
anu the stock will no longei be a baigain. Thus, you have to see the potential oi
possibility of management change befoie most othei investois uo. To make this
uifficult juugment, you will want to look at companies that beai the following
- The game is not tilteu unfaiily in favoi of incumbent management. This can
happen if the state iestiicts takeoveis oi management change, incumbent
manageis holu shaies with uispiopoitionate voting iights oi the company has
anti takeovei amenuments on the books.
- If the company has been bauly manageu foi a while, theie has to be a catalyst foi
management change. This catalyst can be an ageing CE0 with long tenuie, a
founuing family that wishes to exit the company anu¡oi inteiest fiom an activist
Assuming that you can finu a pooily manageu company, piiceu as such, with
potential foi change anu a catalyst, youi payoff will occui when the company's
management uoes change. Note that you may not be iight on each one of youi picks,
but if you aie iight on even a small piopoition, youi poitfolio will geneiate high
In geneial, it is easiei to value matuie companies than high giowth
companies, because we have moie ielevant histoiical uata on eainings, cash flows
anu ievenues. That uoes not mean, howevei, that matuie companies pose no
challenges. In this chaptei, we lookeu at two aspects of matuie companies that may
cieate pioblems in valuations, the shift that some matuie fiims make to acquisitions
to jump stait giowth anu the possibility that a change in management coulu cieate a
change in value.
valuing acquisitive companies iequiies us to ueal with two estimation issues
- the lumpiness of acquisitions, wheie a big acquisition in one yeai is followeu by
inactivity in the othei anu the accounting tieatment of acquisitions, which is
inconsistent with the tieatment of inteinal investment, anu skews key measuies
such as ietuin on capital. Rathei than tieat acquisitions sepaiately, we incluueu
them with capital expenuituies, when estimating ieinvestment, anu useu aveiages
ovei extenueu peiious to oveicome the yeai-to-yeai volatility. When measuiing
ietuins, we iemoveu goouwill fiom investeu capital, assuming that it iepiesents a
piemium foi giowth assets.
To ueal with the possibility of management change anu the consequences foi
value, we value a fiim twice, once with the incumbent management (status quo) anu
once with a uiffeient anu bettei management in place (optimal). The uiffeience
between the two numbeis is the oveiall value of contiol anu when multiplieu by the
piobability of management changing, yielus the expecteu value of contiol. This has
consequences not only in acquisitions, but also in valuing any publicly tiaueu
company anu in assigning piemiums to voting shaies.

Chapter 8: Va|u|ng Dec||n|ng and D|stressed Compan|es
In chaptei S, we examineu fiims at the eailiest stages in the life cycle anu
wiestleu with how best to builu in the ieality that most young, iuea fiims uo not
suivive to become healthy business. In chaptei 6, we moveu foiwaiu in the life cycle
to look at giowth fiims, anu oui biggest challenge became estimating giowth iates,
as fiims became laigei anu competition enteieu the business. In chaptei 7, we
continueu fuithei up the life cycle to look at matuie companies, a giouping that
most giowth companies seek to avoiu but inevitably join, anu evaluateu the
valuation consequences of acquisitions anu management changes. In this chaptei,
we will tuin to the final phase of the life cycle, which is uecline anu examine the key
questions that uiive the value of fiims that entei this phase.
What |s a dec||n|ng company?
As we noteu in the chaptei on matuie companies, giowth companies uo not
want to become matuie companies anu matuie companies constantly tiy to
ieuiscovei theii giowth ioots. By the same token, no matuie company wants to go
into uecline, with the accompanying loss of eainings anu value. So, how uo woulu we
uiffeientiate between matuie fiims anu fiims in uecline. We will use the financial
balance sheet, as we uiu in the eailiei chapteis in figuie 8.1, to illustiate the

Theie aie two key aieas wheie matuie companies aie uiffeient fiom companies in
uecline. The fiist is on the asset siue of the balance sheet. If matuie companies get
Assets Liabilities
Investments already
Equity Investments yet to
be made
Existing Investments
Generate cashflows today
Expected Value that will be
created by future investments
Figure 8.1: A Financial Balance Sheet for a Declining Business
Little or no value
from growth. Can
even be negative, if
firm pursues bad
All of the value comes
from existing assets,
but some of these
asset may be woth
more liquidiated.
if the firm has
high debt, there
is the possibility
of distress
the bulk of theii value fiom existing assets anu less fiom giowth assets, ueclining
companies get none (oi close to none) of theii value fiom giowth assets. In fact, it is
not uncommon foi ueclining companies to actually lose value fiom giowth
investments, especially if they ueciue to ieinvest at iates well below theii cost of
capital. Existing assets not only iepiesent all of the value of ueclining fiims but some
fiims may actually get moie fiom liquiuating oi uivesting these assets than fiom
continuing opeiations. 0n the liability siue, ueclining fiims face much moie uiie
consequences fiom being ovei leveieu, since they cannot count on highei eainings
in the futuie to covei uebt obligation. In othei woius, uecline anu uistiess often go
hanu in hanu.
Character|st|cs of Dec||n|ng Compan|es
In this section, we will look at chaiacteiistics that ueclining companies tenu
to shaie, with an eye towaius the pioblems that they cieate foi analysts tiying to
value these fiims. Note again that not eveiy ueclining company possesses all of
these chaiacteiistics but they uo shaie enough of them to make these
1. Stagnant oi ueclining ievenues: Peihaps the most telling sign of a company in
uecline is the inability to inciease ievenues ovei extenueu peiious, even when
times aie goou. Flat ievenues oi ievenues that giow at less than the inflation
iate is an inuicatoi of opeiating weakness. It is even moie telling if these
patteins in ievenues apply not only to the company being analyzeu but to the
oveiall sectoi, thus eliminating the explanation that the ievenue weakness is uue
to pooi management (anu can thus be fixeu by biinging in a new management
2. Shiinking oi negative maigins: The stagnant ievenues at ueclining fiims aie
often accompanieu by shiinking opeiating maigins, paitly because fiims aie
losing piicing powei anu paitly because they aie uiopping piices to keep
ievenues fiom falling fuithei. This combination iesults in ueteiioiating oi
negative opeiating income at these fiims, with occasional spuits in piofits
geneiateu by asset sales oi one time piofits.
S. Asset uivestituies: If one of the featuies of a ueclining fiim is that existing assets
aie sometimes woith moie to otheis, who intenu to put them to uiffeient anu
bettei uses, it stanus to ieason that asset uivestituies will be moie fiequent at
ueclining fiims than at fiims eailiei in the life cycle. If the ueclining fiim has
substantial uebt obligations, the neeu to uivest will become stiongei, uiiven by
the uesiie to avoiu uefault oi to pay uown uebt.
4. Big payouts - uiviuenus anu stock buybacks: Beclining fiims have few oi any
giowth investments that geneiate value, existing assets that may be geneiating
positive cashflows anu asset uivestituies that iesult in cash inflows. If the fiim
uoes not have enough uebt foi uistiess to be a concein, it stanus to ieason that
ueclining fiims not only pay out laige uiviuenus, sometimes exceeuing theii
eainings, but also buy back stock.
S. Financial leveiage - the uownsiue: If uebt is a uouble-eugeu swoiu, ueclining
fiims often aie exposeu to the wiong euge. With stagnant anu ueclining eainings
fiom existing assets anu little potential foi eainings giowth, it is not suipiising
that many ueclining fiims face uebt buiuens that aie oveiwhelming. Note that
much of this uebt was piobably acquiieu when the fiim was in a healthiei phase
of the life cycle anu at teims that cannot be matcheu touay. In auuition to
uifficulties these fiims face in meeting the obligations that they have committeu
to meet, they will face auuitional tiouble in iefinancing the uebt, since lenueis
will uemanu moie stiingent teims.
Va|uat|on Issues
The issues that we face in valuing ueclining companies come fiom theii
common chaiacteiistics. Nost of the valuation techniques we use foi businesses,
whethei intiinsic oi ielative, aie built foi healthy fiims with positive giowth anu
they sometimes bieak uown when a fiim is expecteu to shiink ovei time oi if
uistiess is imminent.
Intr|ns|c (DCI) Va|uat|on
The intiinsic value of a company is the piesent value of the expecteu
cashflows of the company ovei its lifetime. While that piinciple uoes not change
with ueclining fiims, theie aie piactical pioblems that can impeue valuations.
FE"*2"05 /**&2*
When valuing the existing assets of the fiim, we estimate the expecteu cash
flows fiom these assets anu uiscount them back at a iisk-aujusteu uiscount iate.
While this is stanuaiu valuation piactice in most valuations, theie aie two aspects of
ueclining companies that may thiow a wiench in the piocess.
- Eaining less than cost of capital: In many ueclining fiims, existing assets, even if
piofitable, eain less than the cost of capital. The natuial consequence is that
uiscounting the cash flows back at the cost of capital yielus a value that is less
than the capital investeu in the fiim. Fiom a valuation peispective, this is neithei
suipiising noi unexpecteu: assets that geneiate sub-pai ietuins can be value
- Bivestituie effects: If existing assets eain less than the cost of capital, the logical
iesponse is to sell oi uivest these assets anu hope that the best buyei will pay a
high piice foi them. Fiom a valuation peispective, uivestituies of assets cieate
uiscontinuities in past uata anu make foiecasts moie uifficult to make. To see
how uivestituies can affect past numbeis, consiuei a fiim that uivesteu a
significant poition of its assets miuway thiough last yeai. All of the opeiating
numbeis fiom last yeai - ievenues, maigins anu ieinvestment - will be affecteu
by the uivestituie, but the numbeis foi the yeai will ieflect the opeiating iesults
fiom the poition of the yeai piioi to the uivestituie. Similaily, iisk paiameteis
such as betas, wheie we use past piices oi ietuins, can be skeweu by
uivestituies of assets miuway thiough the time peiiou. Foi the foiecasting
consequences, tiy estimating the ievenues anu eainings numbeis foi a fiim that
is expecteu to uivest a laige poition of its assets ovei the next few yeais. Not
only uo we have to pinpoint the assets that will be uivesteu anu the effects of the
uivestituie on opeiating ievenues anu eainings, but we also have to estimate the
pioceeus fiom the uivestituies. Put anothei way, a uivestituie, by itself, uoes not
affect value, but what we expect to ieceive in compaiison foi the uivesteu assets
can affect value.
Thus, what makes the valuation of existing assets of a ueclining fiim uifficult is that
the value you ueiive fiom these assets in cash flows may be lowei than that value
you obtain fiom uivesting the assets.
34-.2+ /**&2*
Beclining fiims ueiive little fiom giowth assets, anu the valuation of these
assets shoulu theiefoie not have a significant impact on value. While this is
geneially tiue, we have to leave open the possibility that some ueclining fiims aie in
uenial about theii status anu continue to invest in new assets, as it they hau giowth
potential. If these assets eain less than the cost of capital, the value of auuing new
assets will be negative anu ieinvestment will lowei the value of the fiim.
We can actually go fuithei. If we vieweu uivestituies as ieuuctions in capital
investeu, the ieinvestment iate foi a ueclining fiim can be negative in futuie yeais,
which will leau to negative giowth iates, at least foi the foieseeable futuie. Analysts
who have leaineu theii valuation funuamentals at healthiei companies often aie
uncomfoitable with the notion of negative eainings giowth iates anu cash flows
that exceeu eainings, but that combination will chaiacteiize many ueclining fiims.
@"*=-102 8)2&*
If the cost of capital is a weighteu aveiage of the costs of uebt anu equity,
what is it about ueclining fiims that makes it uifficult to estimate these numbeis.
Fiist, the laige uiviuenus anu buybacks that chaiacteiize ueclining fiims can have an
effect on the oveiall value of equity anu on the uebt iatios that we use in the
computation. In paiticulai, ietuining laige amounts of cash to stockholueis will
ieuuce the maiket value of equity, thiough the maiket piice, with uiviuenus, anu the
numbei of shaies, with stock buybacks. If uebt is not iepaiu piopoitionately, the
uebt iatio will inciease, which will then affects of costs of uebt, equity anu capital.
Seconu, the piesence of uistiess can have significant effects on both the cost of
equity anu uebt. The cost of uebt will inciease as uefault iisk incieases anu some
iateu fiims will see theii iatings uiop to junk status - BB, B oi lowei. If opeiating
eainings uiop below inteiest expenses, the tax benefits of uebt will also uissipate,
leauing to fuithei piessuie upwaius on the aftei-tax cost of uebt. As uebt to equity
iatios climb, the cost of equity shoulu also inciease, as equity investois will see
much moie volatility in eainings. Fiom a measuiement stanupoint, analysts who use
iegiession betas, which ieflect changes in equity iisk on a laggeu basis, may finu
themselves facing the unusual scenaiio of a cost of equity that is lowei than the pie-
tax cost of uebt.

:&4#"0)% ;)%1&
The stanuaiu pioceuuies foi estimating teiminal value have been examineu
in uetail in piioi chapteis. We fiist estimate a giowth iate that a fiim can sustain
foievei, with the caveat that the giowth cannot exceeu the giowth iate of the
economy, with the iiskfiee iate acting as a pioxy. We follow up by making
ieasonable assumptions about what a fiim can geneiate as excess ietuins in
peipetuity anu use this numbei to foiecast a ieinvestment iate foi the fiim. We
complete the piocess by estimating a uiscount iate foi the teiminal value
computation, with the qualifiei that the iisk paiameteis useu shoulu ieflect the fact
that the company will be a moie stable one.
At each stage of this piocess, ueclining anu uistiesseu fiims pose special
challenges. At the fiist stage, we have to consiuei the possibility, which will be
significant, that the fiim being valueu will not make it to stable giowth; many
uistiesseu fiims will uefault anu go out of business oi be liquiuateu. Even if a fiim is
expecteu to suivive to ieach steauy state, the expecteu giowth iate in peipetuity
will not only be well below the giowth iate of the economy anu inflation, but in
some cases, it can even be negative. Essentially, the fiim will continue to exist but

Theie aie two ieasons why iegiession betas may not auequately captuie the iisk in the equity of a
fiim in financial uistiess. The fiist is that they aie computeu using a long peiiou of histoiical ietuins;
to the extent that the fiim was healthy (oi healthiei than it is touay) ovei some of that peiiou, the
iegiession beta will unueistate the tiue beta. The seconu is that uuiing peiious of uistiess, the stock
piices of companies tenu to be volatile but often with no ielation to the maiket; they may move up an
uown as a function of uebt iestiuctuiing talks oi iumois of impenuing bankiuptcy. Since the
iegiession beta captuies how a stock moves with the maiket, it may actually ueciease uuiing
peiious of financial uistiess.
get piogiessively smallei ovei time, as its maiket shiinks. At the seconu step, the
biggest estimation issues we face will aiise with ueclining fiims that aie eaining
well below theii cost of capital cuiiently, with no ieason foi optimism about the
futuie. In effect, the most ieasonable assumption to make about this fiim may be
that it will continue to eain a ietuin on its capital that is below the cost of capital in
peipetuity. This will have consequences foi both ieinvestment anu the teiminal
value. Finally, the pioblems that we mentioneu in the pievious section ielating to
uiscount iates can spill ovei into the teiminal value computation. In othei woius, a
uistiesseu fiim can have sky-high costs of equity anu uebt at the moment anu
leaving these numbeis at oi even close to cuiient levels can cause teiminal values to
ke|at|ve Va|uat|on
Analysts who fall back on ielative valuation as a solution to the pioblems of
valuing ueclining oi uistiesseu fiims, using intiinsic valuation, will finu themselves
confionting the estimation issues that we listeu in the eailiei sections eithei
explicitly oi implicitly when they use multiples anu compaiables.
a. Scaling vaiiable: All multiples have to be scaleu to common vaiiables, which
can be bioauly categoiizeu into ievenues, eainings, book value oi sectoi
specific measuies. With uistiesseu companies, eainings anu book values can
become inopeiative veiy quickly, the foimei because many fiims in uecline
have negative eainings anu the lattei because iepeateu losses can uiive the
book value of equity uown anu into negative teiiitoiy. We can scale value to
ievenues, but we aie then implicitly assuming that the fiim will be able to
tuin its opeiations aiounu anu uelivei positive eainings.
b. Compaiable fiims: Theie aie two possible scenaiios that we can face when
valuing ueclining fiims. 0ne is when we aie valuing a ueclining fiim in a
business wheie the iemaining fiims aie all healthy anu giowing. Since
maikets value ueclining fiims veiy uiffeiently fiom healthy fiims, the
challenge in this case is woiking out how much of a uiscount the ueclining
fiim shoulu tiaue at, ielative to the values being attacheu to healthy fiims.
We face the seconu scenaiio when we aie valuing a ueclining¡uistiesseu fiim
in a sectoi wheie many oi even all of the fiims shaie the same chaiacteiistic.
In this case, not only uo oui choices of what multiple to use become moie
limiteu, but we have to consiuei how best to aujust foi the uegiee of uecline
in a fiim. Foi instance, in eaily 2uu9, Foiu, uN anu Chiyslei all showeu signs
of uistiess but uN was in the woist shape, followeu by Chiyslei anu Foiu.
c. Incoipoiating Bistiess: While analysts often come up with cieative solutions
to the fiist two pioblems - using multiples of futuie eainings anu contiolling
foi uiffeiences in uecline, foi instance - the piesence of uistiess puts a wilu
caiu in the compaiison. Put anothei way, when fiims aie not only in uecline
but aie vieweu as uistiesseu, we shoulu expect those fiims that have a highei
likelihoou of uistiess to tiaue at lowei values (anu hence at lowei multiples)
than fiims that aie moie likely to make it. 0nless we explicitly contiol foi
uistiess, we will finu ouiselves concluuing, baseu on ielative valuation, that
the fiist gioup of fiims aie unuei valueu anu the seconu giowth ovei valueu.
By now, the message shoulu be cleai. Any issues that skew intiinsic valuations also
skew ielative valuations. The symptoms of uecline - negative giowth iates, pooi oi
negative maigins, flat ievenues- anu the potential foi failuie - causeu by too much
uebt anu ueclining eainings - will not uisappeai as issues just because we base oui
value on a ievenue multiple.
Va|uat|on So|ut|ons
Flat ievenues, ueclining maigins anu the potential foi uistiess makes valuing
uistiesseu companies tiicky. In this section, we will look at how best to navigate the
challenges in both the intiinsic anu ielative valuation fiamewoik.
Intr|ns|c Va|uat|on
We will builu oui analysis of ueclining fiims aiounu two key questions. The
fiist is whethei the uecline that we aie obseiving in a fiim's opeiations is ieveisible
oi peimanent. In some cases, a fiim may be in a tailspin but can pull out of it, with a
new management team in place. The seconu ielates to whethei the fiim faces a
significant possibility of uistiess; not all ueclining fiims aie uistiesseu.
To assess the question of ieveisibility, we can look at a fiim's own histoiy as
well as the state of othei companies in the sectoi. A fiim that has gone thiough
cycles of goou anu bau times, as is often the case with cyclical anu commouity
companies, is moie likely to be able to move back to health than a fiim that has not
been subject to these cycles. Similaily, it can be aigueu that a fiim that is uoing
bauly in a sectoi filleu with healthy fiims has pioblems that aie moie attiibutable to
pooi management than to funuamentals; with bettei management, the fiim may be
able to ieveit back to health, if not giowth. In contiast, a fiim that is uoing bauly in a
sectoi filleu with pooily peifoiming fiims, with no obvious macio economic ieasons
foi the pioblems, has pioblems that will not be iemeuieu by changing manageis.
To evaluate uistiess, the place to stait is the uebt loau that the fiim may have
accumulateu ovei time. Beclining fiims with significant uebt obligations aie moie
likely to face uefault, iesulting in cessation of opeiations anu liquiuation by
cieuitois. If the fiim is iateu by a bonu iatings agency, we woulu expect to see a low
cieuit iating, geneially below investment giaue. Beclining fiims that uo not face
these fixeu obligations shoulu be able to suivive even with pooi eainings anu no oi
even negative giowth. The way we estimate value will be uiffeient, uepenuing upon
the combination of ieveisibility anu uecline that we obseive in a given fiim. We will
consiuei foui possible combinations below:
1. Reveisible uecline, Low uistiess: If a fiim has flat ievenues anu ueclining
maigins, but the pioblems aie fixable, we woulu follow the fiamewoik we
uevelopeu in chaptei 11 foi valuing contiol. We woulu fiist value the fiim, iun
by existing management, with continuing uecline in opeiations; the iesulting
status quo value will be low. We woulu then ievalue the fiim, assuming that
bettei management is in place anu that the uecline is ieveiseu; this optimal
value shoulu be much highei. Finally, we woulu estimate a piobability of
management changing anu compute an expecteu value, baseu up the status quo
anu optimal values.
Expecteu value = Status Quo value (1 - Piobability of Nanagement Change)
+ 0ptimal value (Piobability of Nanagement Change)
2. Iiieveisible uecline, Low uistiess: If a fiim's pooi peifoimance cannot be
attiibuteu to pooi management anu is not easily fixable, we cannot ievalue the
fiim with opeiating impiovements. Bowevei, the assets that aie ueployeu by the
fiim may be put to bettei use by otheis (in othei businesses) anu thus be woith
moie in a uivestituie. Since the fiim is unuei no piessuie to sell its assets to
meet fixeu obligations, it can liquiuate the assets in an oiueily mannei, waiting
foi both the best time anu the highest biuuei foi each asset. The expecteu
pioceeus fiom this oiueily liquiuation will pioviue an alteinate estimate of
value foi the fiim. The final value that we woulu attach to the fiim woulu be the
highei of the two numbeis.

Expecteu value = Naximum (Status Quo value, 0iueily Liquiuation value)
S. Reveisible uecline, Bigh uistiess: Foi fiims wheie theie is a high piobability of
uistiess, we will consiuei two couises of action. In the fiist one, we will tiy to
biing in the piobability of uistiess into the expecteu cash flows anu uiscount
iates, anu ueiive uistiess-aujusteu values. In the seconu one, we will compute
the expecteu values just as we uiu in the low uistiess scenaiio anu then estimate
the piobability of uistiess sepaiately. Following up this with an estimate of the
pioceeus that we can expect to ieceive in a uistiess sale will yielu the uistiess-
aujusteu value of the fiim. The fact that uecline is ieveisible, though, may give
equity investois in this fiim the possibility of laige payoffs, if uistiess is avoiueu
anu the fiim iecoveis its beaiings, that has the chaiacteiistics of an option anu
can auu to equity value.
4. Iiieveisible uecline, Bigh uistiess: When uecline is inevitable anu is oveilaiu
with uistiess, we have a toxic combination foi value. As with the pievious case,
we have to aujust expecteu values foi uistiess, by eithei changing the inputs to
uiscounteu cash flow oi by aujusting the expecteu no-uistiess value foi the
piobability of uistiess. Theie aie two significant uiffeiences, fiom the ieveisible

We aie assuming that since manageis in this fiim will take the iight action anu liquiuate, if that is
the couise that will uelivei highei value. If they uon't, we will have to estimate piobabilities, just as
we uiu foi fiims with management ueficiencies.
uecline scenaiio, that will uepiess value. The fiist is that, if uistiess occuis, the
pioceeus fiom a uistiess sale with iiieveisible uecline will be lowei, both
because the pool of buyeis is thin (if most fiims in the sectoi aie tioubleu) anu
because buyeis uon't see much potential upsiue. The seconu is that equity
investois have less to gain fiom the option to liquiuate, since the best case value
is constiaineu by the pooi quality of the assets.
We summaiize the foui scenaiios in table 8.1 below.
P":/- j4K5 B ;)".-+*)7 ;*) 0-"/%#( +%&1 0-9/%#- "#0a*) 0%8&)-88
No oi low Bistiess
(Not much uebt, investment giaue iating)
Bigh Bistiess
(Bigh uebt commitments, low




1. value the fiim with existing management anu
expecteu uecline (uoing concein value)
2. value the fiim, assuming oiueily liquiuation
of all of its assets.
S. Expecteu value = Naximum (uoing concein
value, 0iueily liquiuation value)
1. Stait with the expecteu value
(iiieveisible, no uistiess)
2. Estimate the piobability of
uistiess anu pioceeus fiom
foiceu liquiuation of fiim.
S. Re-compute the expecteu value,
aujusting foi uistiess.






a. value the fiim with existing management anu
expecteu uecline.
b. value the fiim with bettei management anu
c. Expecteu value = Status Quo value
(Piobability of no management change) +
0ptimum value (Piobability of management
1. Stait with the expecteu value
(ieveisible, no uistiess)
2. Estimate the piobability of
uistiess anu pioceeus fiom
uistiess sale of fiim.
S. Re-compute the expecteu value,
aujusting foi uistiess.
4. If equity investois iun the fiim,
value the option to liquiuate.
SI S44&A&4*"B%& @&=%"0&V T-. 7"*24&**
With some fiims, the symptoms of opeiating uecline - flat ievenues anu
ueclining maigins -have ueep ioots that cannot be easily iemeuieu foi thiee
ieasons. The fiist is that the oveiall maiket foi the fiim's piouucts anu seivices is
shiinking anu is expecteu to keep uoing so ovei time. The seconu is that all of the
fiims in the sectoi shaie some oi many of the same symptoms as the fiim being
valueu. The thiiu is that theie is no macioeconomic factoi that can be pointeu to as
the ieason foi the uecline, as is the case with an economic iecession foi a cyclical
fiim oi the piice cycle foi a commouity company. A goou example woulu the aiiline
business in much of the uevelopeu woilu since ueiegulation; in this business, the
healthy company has been the exception, iathei than the iule, anu most companies
seem to teetei on the euge of bankiuptcy, even in goou economic times.
The fiist step in valuing such companies is to estimate the value as going
conceins, notwithstanuing the fact that the assets, as investeu cuiiently, may be
eaining less than the cost of capital. In effect, we aie valuing the businesses on the
assumption that they will continue to be opeiateu, while uestioying value foi
existing investois. This status quo value may be well below the book value of the
fiim but that is not suipiising given the negative excess ietuins that we aie
piojecting on existing assets. The value will be uepiesseu fuithei, if management
insists on auuing to its asset base with new investments in the same business.
The seconu step is to consiuei a logical alteinative to continuing in business.
If the assets ueployeu by the fiim can be useu elsewheie (in othei businesses oi by
othei fiims) to geneiate highei ietuins, we can consiuei uivesting these assets anu
liquiuating the business ovei time. Since uistiess is not a concein, the fiim can wait
until the iight time anu the iight biuuei, anu extiact the maximum value fiom
uivestituie; hence, we will teim this an oiueily liquiuation, which can occui ovei
many yeais. As foi estimating what the uivestituie pioceeus will be, the answei will
vaiy acioss sectois anu foi uiffeient assets, but theie aie a few geneial piopositions
that we can uevelop. The fiist is that the expecteu pioceeus shoulu be highei than
the piesent value of the cash flows that woulu have been geneiateu by the assets in
the existing use; if this is not the case, the uivestituie woulu not make sense in the
fiist place. Thus, if the asset is expecteu to geneiate $ Su million in peipetuity, in its
existing use, with a iisk-aujusteu uiscount iate of 1u%, the uivestituie pioceeus
shoulu exceeu $ Suu million. The seconu is that theie shoulu be little oi no illiquiuity
uiscount applieu to the uivestituie value, since theie is no uigency associateu with
the sale.
0nce we have both values in hau - the value of the fiim as a going concein
anu the value fiom an oiueily liquiuation of the fiim ovei time - we woulu expect
the fiim to tiaue at the highei of the two values. In fact, theie is an inteimeuiate
solution, wheie a poition of the fiim, composeu of assets that aie moie valuable to
otheis, is liquiuateu, but the iest of the fiim continues as a going concein.
Illustration 8.1: Valuing a company in irreversible decline: Sears in September 2008
Seais, a ietailei with a long anu uistinguisheu histoiy, has seen its foitunes
faue ovei the last 1u yeais, as its coie customei base has abanuoneu it to go to moie
upscale ietaileis like Taiget, at one enu of the spectium, anu to uiscount ietaileis
like Walmait, at the othei enu. In the fiscal yeai enuing in Febiuaiy 2uu8, Seais
iepoiteu ievenues of $Su.7 billion, just S.2% highei than its ievenues in 2uu6, anu
opeiating income of $1.S4 billion, about 17.7% lowei than opeiating income in
2uu6. Buiing the 2uu8 fiscal yeai, Seais ieuuce the numbei of stoies it opeiateu anu
bought back almost $2.9 billion of its own stock. Finally, Seais geneiateu a ietuin on
capital of 4.99% on its ietail opeiations foi the yeai, well below its cost of capital of
7.Su%. In summaiy, Seais has all the hallmaiks of a company in uecline.
We will assume that the fiim, while not unuei any significant thieat of uefault,
will shut uown less piofitable stoies ovei time, liquiuating some of its ieal estate
holuings in the piocess, anu become a smallei fiim, with highei quality assets.
• Revenues will ueciease S% a yeai, each yeai foi the next S yeais, fiom the
cuiient level of $Su.7 billion to $S9.2 billion in the fifth yeai, as the fiim shuts
uown stoies. Aftei yeai S, we will assume that the shiinkage will stop anu that
ievenues will giow 2% a yeai foievei.
• The pie-tax opeiating maigin will impiove fiom S.uS% to 4%, in lineai
inciements ovei the next five yeais, ieflecting both the cost savings fiom
shutting uown unpiofitable stoies anu a ieveisal back to health at the othei
stoies. The tax iate is assumeu to iemain unchangeu at S8%.
• Foi the fiist five yeais, we will use the cuiient cost of capital foi Seais, which we
estimate to be 7.Su%. Buiing the five-yeai peiiou, as stoies aie being closeu anu
assets uivesteu, Seais will be ieuucing its capital investeu anu collecting
pioceeus fiom the uivestituies. To estimate the pioceeus, we fiist assumeu that
the ietuin on capital at Seais will inciease fiom the cuiient level of 4.99% to
7.Su%, in lineai inciements, ovei the next S yeais, anu then backeu out the
capital investeu baseu upon the aftei-tax opeiating income anu the ietuin on
capital estimate. 0sing the change in book capital each yeai as the basis, we then
estimateu the uivestituie pioceeus as a piopoition of the book value. Table 8.2
iepoits the numbeis by yeai:
P":/- j435 Y%<-8&%&$)- H)*9--08 :' '-")
Cuiient 1 2 S 4 S
uiowth iate -S% -S% -S% -S% -S%
Revenues $Su,7uS $48,168 $4S,7S9 $4S,471 $41,298 $S9,2SS
0peiating maigin S.uS% S.24% S.4S% S.62% S.81% 4.uu%
EBIT $1,S48 $1,S62 $1,S7u $1,S74 $1,S74 $1,S69
EBIT * (1 - tax iate) $96u $968 $974 $976 $976 $97S
Retuin on capital 4.99% S.Su% 6.uu% 6.Su% 7.uu% 7.Su%
Capital Investeu $19,2S4 $17,6u6 $16,227 $1S,u1S $1S,9S9 $12,97S
Change in book
capital -$1,628 -$1,S79 -$1,212 -$1,u77 -$96S
Pioceeus¡ Capital S4.u8% S8.9% 61.9% 64.7% 67.2%
Bivestituie Pioceeus
($) $88u $811 $7S1 $697 $649
Since we aie assuming that the most unpiofitable stoies will be closeu fiist, we
also assume that the uivestituies pioceeus, as a peicentage of book value, will be
lowei in the eailiei yeais anu inciease ovei time. Note, though, that we ieceive
well below 1uu% of capital investeu in eveiy yeai, ianging fiom S4% of capital
in yeai 1 to 67% of capital in yeai S, ieflecting the fact that the investments
being solu aie ueliveiing pooi ietuins.

• To apply closuie in the valuation, we assume that the uivestituies enu in yeai S
anu that Seais will ieveit back to a moie tiauitional stable giowth fiim aftei
yeai S. In keeping with this assumption, the cost of capital aftei yeai uiops to
7.1S% anu the ietuin on capital will stay at 7.Su% in peipetuity. Finally, we
assume that the aftei-tax opeiating income will giow 2% a yeai in peipetuity,
thus allowing us to estimate a ieinvestment iate anu teiminal value.
Reinvestment iate =
= 26.7%
Teiminal value =
After - tax Operating Income
)(1- Reinvestement Rate)
(Cost of capital
- g

It is possible that we aie being too conseivative in this estimate, since the buyeis of these assets
may have no intention of pieseiving them as ietail stoies.
973 (1.02)(1- .267)
(.0713- .02)
= $14,187
Table 8.S summaiizes the cash flows foi the next S yeais anu the teiminal value at
the enu of the fifth yeai anu the piesent values of these cash flows (uiscounteu back
at the cost of capital of 7.Su%).
P":/- j4J5 O=,-9&-0 >"81 ;/*+8 "#0 L"/$- P*0"'
Cuiient 1 2 S 4 S
EBIT * (1 - tax iate) $96u $968 $974 $976 $976 $97S $992
- Reinvestment -$88u -$811 -$7S1 -$697 -$649 $26S
Fiee Cashflow to
Fiim $1,849 $1,78S $1,727 $1,67S $1,622 $728
Teiminal value $14,187
Piesent value $1,72u $1,S4S $1,S9u $1,2S2 $11,u12
Cost of capital 7.Su% 7.Su% 7.Su% 7.Su% 7.Su% 7.1S%
Summing up the piesent values ovei time yielus a value of $16,918 million foi the
opeiating assets. Auuing cash ($1,622 million), subtiacting out uebt ($7,728 million)
anu uiviuing by the numbei of shaies outstanuing (1S2.u1) yielus a value pei shaie
of $81.91, about 7% highei than the pievailing maiket piice ($76.2S).
value pei shaie =
16,918 +1,622 - 7728
= $81.91/share
SSI 8&A&4*"B%& @&=%"0&V T-. 7"*24&**
The histoiy of the coipoiate woilu has its shaie of iebiiths, wheie fiims that
weie vieweu as in uecline ieveiseu the piocess anu ietuineu to giowth oi matuie
status. 0ne example was Bailey Baviuson, the manufactuiei of a cult classic
motoicycle. The fiim saw sales slip to S2,4uu motoicycles in 1982 anu iepoiteu a
loss of about $ Su million in that yeai. While many analysts weie wiiting its epitaph,,
a new management team ueviseu a stiategy built aiounu an loyal customei base anu
an iconic bianu anu Bailey iebounueu to piofitability anu financial health.
It is woith noting, howevei, that most tioubleu fiims nevei tuin aiounu anu that
iighting the ship is not easy. Consequently, we shoulu be iealistic in oui
assessments of when uecline is ieveisible anu when it is not. Becline is moie likely
to be ieveisible if one oi moie of the following conuitions holu:
• The company being analyzeu has a histoiy of opeiating ups anu uowns, anu has
come back fiom uecline befoie. Cycles in ievenue giowth anu maigins may then
be pait of the company's make up anu shoulu be consiueieu when valuing it.
• The sectoi oi inuustiy to which the company belongs is, foi the most pait,
healthy anu the fiim being analyzeu is moie the exception than the iule. When
most of a fiim's competitois aie giowing anu making ieasonable ietuins, anu
the fiim is not, it seems ieasonable to concluue that uecline is the iesult of
choices maue by the fiim, anu that new management coulu conceivably tuin the
company aiounu.
• The company is in a business that can benefit fiom macio economic tienus. Even
ueclining companies in a veiy cyclical business can see theii opeiating iesults
impiove if the economy booms.
Note that while we may concluue that uecline is likely to be ieveiseu, theie aie no
The fiist step in valuing ueclining companies, wheie ieveisal is possible, is to
estimate a value with existing policies anu stiategies, notwithstanuing past failuies.
Since we aie assuming continuing uecline, it is entiiely possible that the fiim's
ievenues will stay flat, maigins will ueciease ovei time anu the ietuins on capital
investeu on both existing assets anu new investments will be less than the cost of
capital, i.e., aie value uestioying. In effect, we aie valuing the fiim unuei the status
quo, assuming that it is unable to tuin itself aiounu.
The seconu step is to assume that the fiim's foitunes can be tuineu aiounu
eithei by new management¡owneiship oi existing management changing its
policies. Assuming that the fiim will ieveit back to financial health, if not
immeuiately, but in the neai futuie, we can ie-estimate the fiim's value, with the
opeiating impiovements built into the cash flows. If the iest of the sectoi is healthy,
we coulu assume that the fiim's maigins anu ietuins on investeu capital will ieveit
to inuustiy aveiages. If not, we can look at the company's own histoiy to get a sense
of what it will look like, if it ieveits back to health. With these impiovements in
place, we shoulu ueiive a highei value foi the fiim, unuei new oi optimal
management, than we uiu with the status quo.
The thiiu step is estimating a piobability of change occuiiing, using some of
the techniques that we uesciibeu in chaptei 11. 0sing a mix of subjective juugment
anu quantitative techniques, we can compute the likelihoou that management will
change. This estimate, though, will change as a function of the exteinal enviionment,
with the entiance of an activist investoi into the mix changing the assessment. The
expecteu value foi the fiim will then ieflect the weighteu aveiage of the status quo
anu optimal values, baseu upon the piobability of change.
SSSI @"*24&**
uiowth is not inevitable anu fiims may not iemain as going conceins. In fact,
even laige publicly tiaueu fiims sometimes become uistiesseu foi one ieason oi the
othei anu the consequences foi value can be seiious. In this section, we will
consiuei fiist how often fiims become uistiesseu anu follow up by looking at the
costs they face as a consequence. We will close the section by examining why, given
the fiequency with which fiims face uistiess, that we have histoiically not paiu
attention to uistiess in valuation.
ulsLress ln ulscounLed Cashflow valuaLlon
Financial uistiess is fai moie common in the ieal woilu that most of us
assume it to be. In fact, even casual empiiical obseivation suggests that a veiy laige
numbei of fiims uo not suivive anu go out of business. Some will fail because they
boiiow money to funu theii opeiations anu then aie unable to make these uebt
payments. 0thei will fail because they uo not have the cash to covei theii opeiating
Consiuei how we value a fiim in a uiscounteu cash flow woilu. We begin by
piojecting expecteu cash flows foi a peiiou, we estimate a teiminal value at the enu
of the peiiou that captuies what we believe the fiim will be woith at that point in
time anu we then uiscount the cash flows back at a uiscount iate that ieflects the
iiskiness of the fiim's cash flows. This appioach is an extiaoiuinaiily flexible one
anu can be stietcheu to value fiims ianging fiom those with pieuictable eainings
anu little giowth to those in high giowth with negative eainings anu cash flows.
Implicit in this appioach, though, is the assumption that a fiim is a going concein,
with potentially an infinite life. The teiminal value is usually estimateu by assuming
that eainings giow at a constant iate foievei (a peipetual giowth iate). Even when
the teiminal value is estimateu using a multiple of ievenues oi eainings, this
multiple is ueiiveu by looking at publicly tiaueu fiims (usually healthy ones). The
failuie to explicitly consiuei uistiess in uiscounteu cash flow valuation will not have
a mateiial impact in value if any the following conuitions holu:
1. Theie is no possibility of bankiuptcy, eithei because of the fiim's size anu
stanuing oi because of a goveinment guaiantee.
2. Easy access to capital maikets allows fiims with goou investments to iaise uebt
oi equity capital to sustain themselves thiough bau times, thus ensuiing that
these fiims will nevei be foiceu into a uistiess sale.
3. We use expected cash flows that incorporate the likelihood of distress and a discount
rate that is adjusted for the higher risk associated with distress. In addition, we have
to assume that the firm will receive sale proceeds that are equal to the present value of
expected future cash flows as a going concern in the event of a distress sale.
If these conditions do not hold, and it is easy to make an argument that they will
not for some firms at some points in time, discounted cash flow valuations will overstate
firm value.
ulscounLed Cash flow valuaLlon
When will the failuie to consiuei uistiess in uiscounteu cash flow valuation
have a mateiial impact on value. If the likelihoou of uistiess is high, access to capital
is constiaineu (by inteinal oi exteinal factois) anu uistiess sale pioceeus aie
significantly lowei than going concein values, uiscounteu cash flow valuations will
oveistate fiim anu equity value foi uistiesseu fiims, even if the cash flows anu the
uiscount iates aie coiiectly estimateu. An alteinative to the stanuaiu uiscounteu
cash flow mouel is to sepaiate the going concein assumptions anu the value that
emeiges fiom it fiom the effects of uistiess. To value the effects of uistiess, we
estimate the cumulative piobability that the fiim will become uistiesseu ovei the
foiecast peiiou, anu the pioceeus that we estimate we will get fiom the uistiess sale.
The value of the fiim can then be wiitten as:
Fiim value = uoing concein value * (1-!Bistiess )+ Bistiess sale value * !Bistiess
wheie !uistiess is the cumulative piobability of uistiess ovei the valuation peiiou. In
auuition to making valuation simplei, it also allows us to make consistent
assumptions within each valuation.
You may wonuei about the uiffeiences between this appioach anu the fai
moie conventional one of estimating liquiuation value foi ueeply uistiesseu fiims.
You can consiuei the uistiess sale value to be a veision of liquiuation value, anu if
you assume that the piobability of uistiess is one, the fiim value will, in fact,
conveige on liquiuation value. The auvantage of this appioach is that it allows us to
consiuei the possibility that even uistiesseu fiims have a chance of becoming going
Coloq cooceto ucl
To value a fiim as a going concein, we consiuei only those scenaiios wheie
the fiim suivives. The expecteu cash flow is estimateu only acioss these scenaiios
anu thus shoulu be highei than the expecteu cash flow estimateu in the mouifieu
uiscounteu cash flow mouel. When estimating uiscount iates, we make the
assumption that uebt iatios will, in fact, ueciease ovei time, if the fiim is ovei
leveieu, anu that the fiim will ueiive tax benefits fiom uebt as it tuins the coinei on
piofitability. This is consistent with the assumption that the fiim will iemain a going
concein. Nost uiscounteu cash flow valuations that we obseive in piactice aie going
concein valuations, though they may not come with the tag attacheu.
A less piecise albeit easiei alteinative is to value the company as if it weie a
healthy company touay. This woulu iequiie estimating the cashflows that the fiim
woulu have geneiateu if it weie a healthy fiim, a task most easily accomplisheu by
ieplacing the fiim's opeiating maigin by the aveiage opeiating maigin of healthy
fiims in the business. The cost of capital foi the uistiesseu fiim can be set to the
aveiage cost of capital foi the inuustiy anu the value of the fiim can be computeu.
The uangei with this appioach is that it will oveistate fiim value by assuming that
the ietuin to financial health is both painless anu imminent.
ístlmotloq tbe ltoboblllty of ulsttess
A key input to this appioach is the estimate of the cumulative piobability of
uistiess ovei the valuation peiiou. In this section, we will consiuei two ways in
which we can estimate this piobability. The fiist is a statistical appioach, wheie we
ielate the piobability of uistiess to a fiim's obseivable chaiacteiistics - fiim size,
leveiage anu piofitability, foi instance - by contiasting fiims that have gone
bankiupt in piioi yeais with fiims that uiu not. This appioach has been useu
effectively to compute cieuit scoies (like the Altman Z scoie) that pieuict
The seconu is a less uata intensive appioach, wheie we use the bonu iating
foi a fiim, anu the empiiical uefault iates of fiims in that iating class to estimate the
piobability of uistiess. Altman (2uu7) has estimateu the cumulative piobabilities of
uefault foi bonus in uiffeient iatings classes ovei five anu ten-yeai peiious,
following issuance, anu the estimates aie iepiouuceu in table 12.S below
P":/- K34U5 6*#0 I"&%#( "#0 H)*:":%/%&' *; Y-;"$/& V KGXK @ 3\\X
Cumulative Piobability of Bistiess Rating
S yeais 1u yeais
AAA u.u4% u.u7%
AA u.44% u.S1%
A+ u.47% u.S7%
A u.2u% u.66%
A- S.uu% S.uu%
BBB 6.44% 7.S4%
BB 11.9% 19.6S%
B+ 19.2S% 28.2S%
B 27.Su% S6.8u%
B- S1.1u% 42.12%
CCC 46.26% S9.u2%
CC S4.1S% 66.6%
C+ 6S.1S% 7S.16%
C 72.1S% 81.uS%

Altman, E.I.
The iepoiteu opeiating income of $ 16S million was aftei an impaiiment chaige foi
uisposal of assets of $46 million. The aujusteu opeiating income is $ 2u9 million.
C- 8u.uu% 87.16%
As elaboiation, the cumulative uefault piobability foi a bonu iateu BB at the
stait of the peiiou is 19.6S% ovei the next 1u yeais. We can illustiate the use of this
appioach with Belta Aiilines anu Las vegas Sanus, two opeiating companies with
significant piobability of uefault at the stait of 2uu9:
Company Bonu Rating Estimateu piobability of uistiess
Belta Aiilines BBB- 1S.S8%
Las vegas Sanus B+ 28.2S%
ístlmotloq ulsttess 5ole ltoceeJs
0nce we have estimateu the piobability that the fiim will be unable to make
its uebt payments anu cease to exist, we have to consiuei the logical follow-up
question. What happens then. As noteu eailiei in the chaptei, it is not uistiess pei
se that is the pioblem but the fact that fiims in uistiess have to sell theii assets foi
less than the piesent value of the expecteu futuie cash flows fiom existing assets
anu expecteu futuie investments. 0ften, they may be unable to claim even the
piesent value of the cash flows geneiateu even by existing investments.
Consequently, a key input that we neeu to estimate is the expecteu pioceeus in the
event of a uistiess sale. We have thiee choices:
a. Estimate the piesent value of the expecteu cash flows in a uiscounteu cash
flow mouel, anu assume that the uistiess sale will geneiate only a peicentage
(less than 1uu%) of this value. Thus, if the uiscounteu cash flow valuation
yielus $ S billion as the value of the assets, we may assume that the value will
only be $ S billion in the event of a uistiess sale.
b. Estimate the piesent value of expecteu cash flows only fiom existing
investments as the uistiess sale value. Essentially, we aie assuming that a
buyei will not pay foi futuie investments in a uistiess sale. In piactical teims,
we woulu estimate the uistiess sale value by consiueiing the cash flows fiom
assets in place as a peipetuity (with no giowth).
c. The most piactical way of estimating uistiess sale pioceeus is to consiuei the
uistiess sale pioceeus as a peicent of book value of assets, baseu upon the
expeiience of othei uistiesseu fiims.
Note that many of the issues that come up when estimating uistiess sale pioceeus -
the neeu to sell at below faii value, the uigency of the neeu to sell - aie issues that
aie ielevant when estimating liquiuation value.
Illustration 8.2: Valuing Las Vegas Sands with Distress valued separately
To value Las vegas Sanus with uistiess valueu sepaiately, we began with a
going concein valuation of Las vegas Sanus, assuming that the fiim suivives anu
ieveits back to financial health.
• Foi the fiscal yeai enueu Becembei 2uu8, Las vegas Sanus iepoiteu ievenues of
$4,S9u million anu pie-tax opeiating income of $2u9 million, yieluing pie-tax
opeiating maigin of 4.76%.
The capital investeu in the company at the stait of
the yeai was $9,8S2 million, yieluing an abysmal aftei-tax ietuin on capital of
1.44% (assuming the fiim's effective tax iate of 26%)
Retuin on capital =
• To map out a path to iecoveiy, we have to fiist estimate what we believe to be
ieasonable piofitability measuies, if Las vegas Sanus can tuin things aiounu. To
make these estimates, we fiist lookeu at the opeiating maigins anu ietuins on
capital iepoiteu by the fiim ovei the last S yeais in table 8.4:
P":/- j4Z5 I-<-#$-8] Q")(%#8 "#0 I-&$)# *# >",%&"/5 ?LC 3\\J@3\\j
Yeai Revenues 0peiating Income Pie-tax Naigin Capital investeu R0C
2uu4 1197 2SS 19.47% 1S7S 9.17%
2uuS 1741 491 28.2u% 181u 16.82%
2uu6 22S7 S77 2S.79% 2791 12.82%
2uu7 29S1 SS1 11.22% 2u49 1u.u2%
2uu8 4S9u 2u9 4.76% 8974 1.44%
Both the maigins anu ietuins eaineu in 2uu8 iepiesent a bieak fiom a geneially
piofitable past foi Las vegas Sanus. We followeu by estimating the aveiage pie-
tax opeiating maigin (16.96%) anu aftei-tax ietuin on capital (appioximately
1u%) foi casino fiims in the 0niteu States at the stait of 2uu9. Baseu on these
numbeis, we will assume that Las vegas Sanus, assuming it makes it as a healthy
fiim, will have a pie-tax opeiating maigin of 17% anu eain an aftei-tax ietuin on
capital of 1u%.
• To pioject opeiating iesults into the futuie, we will assume that ievenues will
giow only 1% next yeai anu 2% the yeai aftei, we will assume that the ievenue
giowth iate will pick up, especially as two new casinos in uevelopment come
online, picking up to 2u% in yeais S-S, befoie uiopping back to S% a yeai fiom
yeais 6-1u. We will also assume that the iecoveiy to the taigeteu maigin will
occui giauually ovei the next 1u yeais; with pie-tax opeiating maigins
impioving to 1u% by yeai S anu then posting a fuithei inciease to 17% by yeai
1u; the changes in each peiiou occui in lineai inciements. Table 8.S summaiizes
oui foiecasts of ievenues, maigins anu opeiating income each yeai foi the next
1u yeais; we useu a 26% effective tax iate to estimate the aftei-tax opeiating
income foi the fiist S yeais but giauually move that numbei up to the maiginal
tax iate of S8% by yeai 1u.
P":/- j4U5 O=,-9&-0 I-<-#$-8 "#0 g,-)"&%#( R#9*.- V ?LC
Yeai Revenu
$4,S9u 4.76% $2u9 $1SS
1 $4,4S4 1% S.81% $2S8 $191 -$19 $21
2 $4,S2S 2% 6.86% $S1u $229 -$11 $24
S $S,427 2u% 7.9u% $429 $S17 $u $S1
4 $6,S1S 2u% 8.9S% $S8S $4S1 $22 $41
S $7,81S 2u% 1u.uu% $782 $S78 $S8 $S2
6 $8,2u6 S% 11.4u% $9SS $67u $67 $6u
7 $8,616 S% 12.8u% $1,1uS $76S $1SS $61
8 $9,u47 S% 14.2u% $1,28S $8S8 $21S $64
9 $9,499 S% 1S.6u% $1,482 $9S4 $286 $66
1u $9,974 S% 17.uu% $1,696 $1,uS1 $SSu $7u

Since much of the capital foi the new casinos has alieauy been investeu, we will holu
capital expenuituies uown foi much of the high giowth peiiou; in effect, the
company is living off past investments.
As a consequence, the ieinvestment iate
will be negative foi the next two yeais, since theie will be significant cash inflows
fiom uepieciation chaiges, befoie incieasing in the iest of the high giowth peiiou.

We will begin the valuation with a cost of capital foi Las vegas Sanus that
ieflects its tenuous holu on going concein status. 0sing the cuiient uebt iatio of
7S.Su%, we estimate a cost of capital of 9.88% foi Las vegas Sanus:
Cost of capital = Cost of equity (1- Bebt iatio) + Aftei-tax cost of uebt (Bebt iatio)
= 21.82% (.26S) + S.S8% (.7SS) = 9.88%
Bowevei, we will assume that as the fiim becomes healthiei, its uebt iatio will
conveige on the casino inuustiy aveiage of Su% anu that its cost of capital will also
move uown to 7.4S% to ieflect the ietuin to financial health. To complete the
valuation, we will assume that Las vegas Sanus will be in stable giowth aftei yeai
1u, giowing at S% a yeai (set equal to the iiskfiee iate cap) foievei. We will also
assume that the ietuin on capital will be 1u% in peipetuity anu that the stable
peiiou cost of capital is 7.4S% (fiom table 12.9). The teiminal value can then be
Reinvestment iate =
= 30%
Teiminal value =
After - tax Operating Income
)(1- Reinvestement Rate)
(Cost of capital
- g

1051 (1.03)(1- .30)
(.0743- .03)
= $17,129

LvS hau investeu almost $S billion in new uevelopments in }anuaiy 2uu9 that hau still not
commenceu opeiations.

Biinging togethei the fiee cash flows, the teiminal value above anu the cost of
capital, we can compute the value of the opeiating assets in table 8.6:

P":/- j4A5 L"/$- *; *,-)"&%#( "88-&8 V ?LC
Cost of
Cumulated cost of
capital PV
1 $210 9.88% 1.0988 $190.79
2 $241 9.88% 1.2075 $199.54
3 $317 9.88% 1.3268 $239.25
4 $410 9.88% 1.4579 $281.12
5 $520 9.88% 1.6021 $324.88
6 $603 9.79% 1.7590 $342.71
7 $611 9.50% 1.9261 $316.98
8 $644 9.01% 2.0997 $306.52
9 $668 8.32% 2.2744 $293.72
10 $701 $17,129.27 7.43% 2.4433 $7,297.83
Value of operating assets = $9,793.34
Auuing cash ($S,u4u million), subtiacting out the maiket value of uebt ($7,S6S
million) anu uiviuing by the numbei of shaies outstanuing (641.8S9 million) yielus
a value pei shaie of $8.21.
value pei shaie =
9793 + 3040 - 7565
= $8.21/share
Note that the maiket value of uebt is significantly lowei than the face value of
almost $ 1u.47 billion. Bowevei, it is consistent with oui assumption that LvS will
make it as a going concein.
We can now biing in the piobability of uistiess anu the consequences into
oui final estimate of equity value. We estimateu the piobability of uistiess fiom
piobability of uistiess, baseu upon the B+ iating, of 28.2S%, anu concluueu that the
uistiess sale value of the assets woulu be lowei than the uebt outstanuing (making
equity woithless). The expecteu value of equity pei shaie in LvS can then be
Expecteu value pei shaie = value pei shaie as going concein (1- Piobability
of uistiess) + value pei shaie in uistiess (Piobability of uistiess) = $8.21 (1-
.717S) + $u.uu (.282S) = $S.89

Since the cost of capital changes ovei time, we have to compute a cumulateu cost. Foi instance, the
cost of capital in yeai 7 = 1.u988
If we aujust foi the possibility of uistiess, the value pei shaie is only $S.89, about
SS% highei than the stock piice of $4.2S in Febiuaiy 2uu9.
LqulLy as an CpLlon
In most publicly traded firms, equity has two features. The first is that the equity
investors run the firm and can choose to liquidate its assets and pay off other claim
holders at any time. The second is that the liability of equity investors in some private
firms and almost all publicly traded firms is restricted to their equity investments in these
firms. This combination of the option to liquidate and limited liability allows equity to
have the features of a call option. In firms with substantial debt and a significant potential
for bankruptcy, the option value of equity may be in excess of the discounted cash flow
value of equity. When the equity in a firm takes on the characteristics of a call option, we
have to change the way we think about its value and what determines its value. There are
a number of potential implications for equity investors and bondholders in the firm.
• In discounted cash flow valuation, we argue that equity is worthless if what we own
(the value of the firm) is less than what we owe. The first implication of viewing
equity as a call option is that equity will have value, even if the value of the firm falls
well below the face value of the outstanding debt. While the firm will be viewed as
troubled by investors, accountants and analysts, its equity is not worthless. In fact,
just as deep out-of-the-money traded call options command value because of the
possibility that the value of the underlying asset may increase above the strike price in
the remaining lifetime of the option, equity commands value because of the time
premium on the option (the time until the bonds mature and come due) and the
possibility that the value of the assets may increase above the face value of the bonds
before they come due.
• In traditional discounted cash flow valuation, higher risk almost always translates into
lower value for equity investors. When equity takes on the characteristics of a call
option, we should not expect this relationship to continue to hold. Risk can become
our ally, when we are equity investors in a troubled firm. In essence, we have little to
lose and much to gain from swings in firm value.
ke|at|ve Va|uat|on
Nost valuations in piactice, incluuing those of uistiesseu fiims, aie ielative
valuations. In paiticulai, fiims aie valueu using multiples anu gioups of compaiable
fiims. An open question then becomes whethei the effects of uistiess aie ieflecteu
in ielative valuations anu, if not, how best to uo so.
@"*24&** "0 8&%)2"A& ;)%1)2"-0
It is not cleai how uistiess is incoipoiateu into an estimate of ielative value.
Consiuei how ielative valuation is most often uone. We choose a gioup of fiims that
we believe aie compaiable to the fiim that we aie valuing. 0sually, we pick fiims in
the same business that oui fiim is in. We then stanuaiuize piices by computing a
multiple - piice eainings, piice to book, enteipiise value to sales oi enteipiise value
to EBITBA. Finally, we examine how oui fiim measuies up on this multiple, ielative
to the compaiable fiims. While this time honoieu appioach is useu foi uistiesseu
fiims as well, the issues listeu below geneially aie unique to uistiesseu fiims:
1. Revenue anu EBITBA multiples aie useu moie often to value uistiesseu fiims than
healthy fiims. The ieasons aie piagmatic. Nultiple such as piice eainings oi piice to
book value often cannot even be computeu foi a uistiesseu fiim. Analysts theiefoie
move up the income statement looking foi a positive numbei. Foi fiims that make
heavy infiastiuctuie investments, wheie uepieciation anu amoitization is a
significant chaige against opeiating income anu theie aie substantial inteiest
expenses, the EBITBA is often positive while net income is negative. Foi some fiims,
even EBITBA is negative anu ievenue multiples aie only multiples that yielu
positive values.
2. Analysts who aie awaie of the possibility of uistiess often consiuei them
subjectively when they compaie the multiple foi the fiim they aie analyzing to the
inuustiy aveiage. Foi example, assume that the aveiage telecomm fiim tiaues at 2
times ievenues anu that the fiim we aie analyzing tiaues at 1.2S times ievenues.
Assume also that the fiim has substantially highei uefault iisk than the aveiage
telecomm fiim. We may concluue that the fiim is not unueivalueu even though it
tiaues at a significant uiscount on the aveiage, because of the potential foi uefault.
The peiils of subjective aujustment aie obvious. Baiiing the most egiegious
misvaluations, analysts will finu a way to justify theii piioi biases about fiims.
/7)$2"05 8&%)2"A& ;)%1)2"-0 2- @"*24&**
Is theie a way in which ielative valuation can be auapteu to covei uistiesseu
fiims. We believe so, though the aujustments tenu to be much moie appioximate
than those uesciibeu in the uiscounteu cash flow section. We consiuei two ways of
builuing uistiess explicitly into ielative valuations. In the fiist, we compaie a
uistiesseu company's valuation to the valuations of othei uistiesseu companies. In
the seconu, we use healthy companies as compaiable companies, but finu a way to
aujust foi the uistiess that the fiim we aie valuing is facing.
Chooslng Lhe Comparables
To value a uistiesseu fiim, we can finu a gioup of uistiesseu fiims in the
same business anu look at how much the maiket is willing to pay foi them. Foi
instance, we
coulu value a tioubleu telecomm fiim by looking at the enteipiise value to sales (oi
book capital) multiples at which othei tioubleu telecomm fiims tiaue. While theie is
piomise in this appioach, it woiks only if a laige numbei of fiims in a sectoi slip into
financial tiouble at the same time. In auuition, by categoiizing fiims as uistiesseu oi
not uistiesseu fiims, we iun the iisk of lumping togethei fiims that aie uistiesseu to
uiffeient uegiees.
0ne possible way to expanu this appioach is to look at uistiesseu fiims
acioss the whole maiket, iathei than just the sectoi in which the fiim opeiates. This
will allow foi a laigei sample though theie is the possible uisauvantage that a
tioubleu gioceiy stoie may be in a bettei position (in teims of geneiating uistiess
sale pioceeus) than a tioubleu technology company.
lllosttotloo 8.J. cboosloq JlsttesseJ compotobles
To value Las vegas Sanus, we consiueieu only casino fiims with high
financial leveiage (maiket uebt to capital iatios that exceeu 6u%). 0ui objective was
to aiiive at a sample of casino fiims that have a significant likelihoou of uistiess. We
useu the EBITBA in the most iecent tiailing 12 months anu computeu the enteipiise
value by auuing the maiket value of equity to the book value of uebt anu subtiacting
out cash. Table 8.7 summaiizes the iesulting Ev¡EBITBA iatios foi these fiims:
P":/- j4X5 Y%8&)-88-0 >"8%#* 2%).8
Company Market Cap Total Debt Cash EV EBITDA EV/EBITDA
Codere, S.A. 516.6 1072.8 144.1 1445.3 295.2 4.90
Ameristar Casinos Inc. 561.1 1615.7 68.2 2108.6 289.4 7.29
Las Vegas Sands Corp. 2729 10470 1276 11628.9 812.5 14.31
Groupe Partouche SA 139.1 675 146.9 667.2 178.2 3.74
Boyd Gaming Corp. 431.2 2624.1 123.6 2931.7 372.5 7.87
MGM Mirage (NYSE:MGM) 1548.4 13288.3 250.1 14586.6 1959.6 7.44
Wynn Resorts Ltd. 2747 4917.7 1713.7 5951 714.4 8.33
Average across firms = 7.70
Average (without LVS) = 6.60

The aveiage Ev¡EBITBA multiple, not incluuing LvS, acioss these fiims is 6.6u anu
Las vegas Sanus looks cleaily ovei valueu, ielative to the iest of the gioup. Theie
aie, howevei, a couple of caveats that we woulu offei. The fiist is that the use of
book value of uebt cleaily oveistates the enteipiise value computations, anu moie
so foi companies that aie moie uistiesseu. Foi instance, using the estimateu maiket
value of uebt of $7.S7 billion insteau of the book value woulu lowei LvS's multiple to
about 1u times EBITBA.
Conslderlng Lhe ÞosslblllLy of ulsLress LxpllclLly
0ne of the auaptations that we suggesteu foi uiscounteu cash flow valuation
was an explicit assessment of uefault iisk anu a fiim value that was a weighteu
estimate of a going concein value anu a uistiess sale value. Foi a uistiesseu fiim in a
sectoi wheie the aveiage fiim is healthy, this appioach offeis piomise. We can
estimate the value of the uistiesseu fiim using the compaiable fiims anu consiuei it
the going concein value. Foi instance, if healthy fiims in the business tiaue at 2
times ievenues, we woulu multiple the fiim's ievenues by 2 to aiiive at the going
concein value. We coulu then estimate the fiim value as follows:
Fiim value = uoing concein ielative value * (1-!Bistiess )+ Bistiess sale value * !Bistiess
The piobability of uistiess anu the uistiess sale value woulu be estimateu just as
they weie in the last section. This appioach makes the most sense when valuing a
fiim that is uistiesseu in a sectoi containing mostly healthy fiims, since the piioi
two appioaches coulu not be useu heie.
In some cases, we may have to use foiecasteu values foi ievenues anu
opeiating income to aiiive at the going concein value, especially if cuiient ievenues
anu opeiating income aie auveisely impacteu by the oveihang of uistiess.
lllosttotloo 8.4. lotwotJ Moltlples ooJ ulsttess
Consiuei the foiecasts of ievenues anu EBIT maue in table 12.7 foi Las vegas
Sanus. While the fiim is not geneiating a laige opeiating income cuiiently, we aie
anticipating an impiovement in maigins anu giowth in ievenues, iesulting in an
expecteu opeiating income of $1,696 million in yeai 1u; auuing the expecteu
uepieciation chaige of $S72 million to this value yielus an expecteu EBITBA of 2,268
0sing the aveiage enteipiise value¡EBITBA multiple of 8.2S at which
healthy casino fiims tiaue, we can estimate an expecteu enteipiise value in yeai

Expecteu Enteipiise value in yeai 1u = EBITBA1u * Ev¡ EBITBACuiient foi healthy casino
= 2,268 * 8.2S = $18,711 million
We can estimate the piesent value of this estimateu value by uiscounting back at Las
vegas Sanu's cumulateu cost of capital, computeu eailiei in illustiation 12.6 to be
Enteipiise value touay = 18,711¡2.44SS = $7,6S8 million

While we have not explicitly foiecast uepieciation, the uepieciation in the cuiient yeai is $ Su9
million anu the book capital investeu in yeai 1u is about 2S% highei than touay's book capital. We
scaleu up uepieciation by the same piopoition.
We uefineu healthy casino fiims as those with maiket uebt iatios lowei than Su%.
This, of couise, is baseu upon the assumption that Las vegas Sanus will become a
healthy fiim. 0sing the piobability of suivival (71.7S%) anu uistiess (28.2S%)
estimateu eailiei as well as the uistiess sale pioceeus ($2,769 million) we can value
LvS's opeiating assets touay:
Estimated Enterprise Value
= uoing Concein value (!uoing Concein) + Bistiess Sale value (1 - !uoing Concein)
= 7,6S8(.717S) + 2769 (.282S) = $ 6,277 million
By ignoiing the cash flows ovei the next 1u yeais, we aie also significantly
unueistating the value of LvS, as a going concein.
Auuing back the cash balance of
the fiim ($ S,u4u million) anu subtiacting out uebt ($ 7.S6S million) yielus a value
foi the equity:
Enteipiise value = $ 6,277 million
+ Cash & Naiketable Secuiities = $ S,u4u million
- Bebt = $7,S6S million
value of Equity = $1,7S1 million
Biviuing by the 641.8S9 million shaies outstanuing yielus a value of equity pei
shaie of $2.7S.
Va|ue Þ|ays
Nost investois steei instinctively away fiom ueclining fiims, anu aie even
moie aveise when these companies caiiy laige uebt buiuens. While this may be a
sounu stiategy foi a iisk aveise investoi, theie is potential foi investment golu in
these companies, foi investois with longei time hoiizons anu stiong stomachs.
The fiist stiategy is to focus on ueclining fiims that have low uebt buiuens
anu thus face little iisk of bankiuptcy. So, what woulu make these fiims attiactive
• Low piice: If the uecline in the fiim's foitunes is visible to the maiket (flat
ievenues anu ueclining maigins aie tough to hiue), the maiket piice will

We coulu always auu back the piesent value of cash flows, but if we uo, we aie mixing up intiinsic
anu ielative valuations.
geneially uecline as well. Consequently, these fiims will tiaue at low multiples of
eainings anu at below book value.
• Awaie management: A low maiket piice alone uoes not make foi a goou
investment, especially if a company in uecline peisists in tiying to expanu anu
make moie bau investments. Consequently, you neeu manageis at these
companies who aie awaie that they have ieacheu the enu of the giowth ioau
anu aie willing to not just scale uown new investment but liquiuate olu ones.
• Bivestituie potential: As ueclining fiims tiy to liquiuate oi unloau pooily
peifoiming assets, it uoes help to have buyeis who aie willing to pay highei
values foi these assets (than coulu be geneiateu by the fiim). These highei
values may be the iesult of bettei uses that the assets can be put to oi ieflect
iiiational buyeis.
• Bigh cash ietuin: As the management holus back on new investment anu
liquiuates olu ones, it will see its cash balances iise. This cash has to finu its way
back to investois eithei as high uiviuenus oi in the foim of stock buybacks.
The payoff on this poitfolio, assuming that you make the iight choices, will be in the
foim of high cash yielu on the poitfolio anu ielatively low piice appieciation.
The seconu anu iiskiei stiategy is to uiiect youi money to ueclining fiims
with laige uebt buiuens. The auuitional iisk in this stiategy comes fiom the uistiess
potential cieateu by the uebt. To succeeu with this "vultuie" investing stiategy, you
have to finu fiims wheie uistiess is eithei moie uistant oi less likely than the
maiket assessment in the equity maiket. This is a tall oiuei but theie aie potential
• Look foi uistiesseu companies that have both bonus anu stocks that aie tiaueu,
wheie the two maikets aie geneiating uiffeient signals about likely uistiess. If
you aie investing in equity, you want to invest in companies wheie stock piices
have collapseu because of the feai of uefault but bonu piices have iemaineu
ielatively intact.
• If an exteinal entity, such as the goveinment oi an agency, can pioviue backing
foi the uebt, the company may finu the bieathing ioom to pay uown its uebt anu
escape uefault. This will iequiie pinpointing the types of companies wheie this
assistance will be foithcoming, peihaps laigei companies with lots of employees,
wheie the social costs of coipoiate failuie aie vieweu as too laige to allow the
If you uo invest in uistiesseu companies, it is impoitant that iecognize that some oi
many of these companies will fail anu that you may veiy well lose eveiything you
investeu in theii equity. Youi hope is that those companies that manage to tuin
themselves aiounu will offei high enough ietuins to covei youi losses.
Looking acioss the life cycle, it is the fiims at eithei enu of the life cycle that
seem to pose the most valuation challenges, anu sometimes foi the same ieasons. If
the question with young fiims is whethei they will suivive to become piofitable
businesses, a key issue with ueclining fiims is whethei they will suivive
ueteiioiating opeiations anu laige uebt obligations anu emeige as going conceins.
In this chaptei, we lookeu at the inteiplay between uecline anu uistiess to
uevelop a fiamewoik foi valuing ueclining companies. When uecline is iiieveisible,
but uistiess is not imminent, we aigueu foi valuing the fiim twice, once as a going
concein anu once in an oiueily liquiuation, anu using the highei of the two
numbeis. When the uecline is attiibutable to pooi management anu thus ieveisible,
anu no uistiess oveihanging the fiim, we again aigueu foi two valuations, once with
existing management anu once with bettei management, anu estimateu an expecteu
value, baseu upon the piobability of management change.
When uistiess is a uistinct possibility, we have thiee choices. In the fiist, we
can uevelop piobability uistiibutions foi key vaiiables anu iun simulations, with
uistiess built into the piocess. In the seconu, we can tiy to aujust the expecteu cash
flows anu uiscount iates in a valuation to ieflect the piobability of uistiess
occuiiing anu the iesulting cash flows. In the thiiu, we value the fiim as a going
concein anu then aujust foi the likelihoou of uistiess sepaiately. The contiast heie
between ieveisible anu iiieveisible uecline shows up in two places with uistiesseu
fiims. 0ne is that the pioceeus fiom a uistiess sale aie likely to be highei foi the
fiist gioup, wheie buyeis see a potential foi tuinaiounu foi the assets, than foi the
seconu gioup. The othei is that equity in uistiesseu fiims with the potential foi a
tuinaiounu can have option chaiacteiistics.

Sect|on 3: Spec|a| S|tuat|ons |n Va|uat|on
Chapter 9: Va|u|ng I|nanc|a| Serv|ce Compan|es
Banks, insurance companies and other financial service firms pose special
challenges for an analyst attempting to value them, for three reasons. The first is the
nature of their businesses makes it difficult to define both debt and reinvestment, making
the estimation of cash flows much more difficult. The second is that they tend to be
heavily regulated and changes in regulatory requirements can have significant effect on
value. The third is that the accounting rules that govern bank accounting have historically
been very different from the accounting rules for other firms, with assets being marked
to market more frequently for financial service firms.
What |s a f|nanc|a| serv|ce f|rm?
Any firm that provides financial products and services to individuals or other
firms can be categorized as a financial service firm. We would categorize financial
service businesses into four groups from the perspective of how they make their money.
A bank makes money on the spread between the interest it pays to those from whom it
raises funds and the interest it charges those who borrow from it, and from other services
it offers it depositors and its lenders. Insurance companies make their income in two
ways. One is through the premiums they receive from those who buy insurance protection
from them and the other is income from the investment portfolios that they maintain to
service the claims. An investment bank provides advice and supporting products for other
firms to raise capital from financial markets or to consummate deals such as acquisitions
or divestitures. Investment firms provide investment advice or manage portfolios for
clients. Their income comes from advisory fees for the advice and management and sales
fees for investment portfolios. With the consolidation in the financial services sector, an
increasing number of firms operate in more than one of these businesses. For example,
Citigroup, created by the merger of Travelers and Citicorp operates in all four businesses.
At the same time, however, there remain a large number of small banks, boutique
investment banks and specialized insurance firms that still derive the bulk of their income
from one source.
Character|st|cs of f|nanc|a| serv|ce f|rms
Theie aie many uimensions on which financial seivice fiims uiffei fiom
othei fiims in the maiket. In this section, we will focus on foui key uiffeiences anu
look at why these uiffeiences can cieate estimation issues in valuation. The fiist is
that many categoiies (albeit not all) of financial seivice fiims opeiate unuei stiict
iegulatoiy constiaints on how they iun theii businesses anu how much capital they
neeu to set asiue to keep opeiating. The seconu is that accounting iules foi
iecoiuing eainings anu asset value at financial seivice fiims aie at vaiiance with
accounting iules foi the iest of the maiket. The thiiu is that uebt foi a financial
seivice fiim is moie akin to iaw mateiial than to a souice of capital; the notion of
cost of capital anu enteipiise value may be meaningless as a consequence. The final
factoi is that the uefining ieinvestment (net capital expenuituies anu woiking
capital) foi a bank oi insuiance company may be not just uifficult, but impossible,
anu cash flows cannot be computeu.
1he kegu|atory Cver|ay
Financial service firms are heavily regulated all over the world, though the extent
of the regulation varies from country to country. In general, these regulations take three
forms. First, banks and insurance companies are required to maintain regulatory capital
ratios, computed based upon the book value of equity and their operations, to ensure that
they do not expand beyond their means and put their claimholders or depositors at risk.
Second, financial service firms are often constrained in terms of where they can invest
their funds. For instance, until a decade ago, the Glass-Steagall Act in the United States
restricted commercial banks from investment banking activities as well as from taking
active equity positions in non-financial service firms. Third, the entry of new firms into
the business is often controlled by the regulatory authorities, as are mergers between
existing firms.
Why does this matter? From a valuation perspective, assumptions about growth
are linked to assumptions about reinvestment. With financial service firms, these
assumptions have to be scrutinized to ensure that they pass regulatory constraints. There
might also be implications for how we measure risk at financial service firms. If
regulatory restrictions are changing or are expected to change, it adds a layer of
uncertainty (risk) to the future, which can have an effect on value. Put more simply, to
value banks, insurance companies and investment banks, we have to be aware of the
regulatory structure that governs them.
D|fferences |n Account|ng ku|es
The accounting iules useu to measuie eainings anu iecoiu book value aie
uiffeient foi financial seivice fiims than the iest of the maiket, foi two ieasons.
a. Naik to Naiket: The fiist is that the assets of financial seivice fiims tenu to be
financial instiuments (bonus, secuiitizeu obligations). Since the maiket piice is
obseivable foi many of these investments, accounting iules have tilteu towaius
using maiket value (actual of estimateu) foi these assets. To the extent that
some oi a significant poition of the assets of a financial seivice fiims aie maikeu
to maiket, anu the assets of most non-financial seivice fiims aie not, we fact two
pioblems. The fiist is in compaiing iatios baseu upon book value (both maiket
to book iatios like piice to book anu accounting iatios like ietuin on equity)
acioss financial anu non-financial seivice fiims. The seconu is in inteipieting
these iatios, once computeu. While the ietuin on equity foi a non-financial
seivice fiim can be consiueieu a measuie of ietuin eaineu on equity investeu
oiiginally in assets, the same cannot be saiu about ietuin on equity at financial
seivice fiims, wheie the book equity measuies not what was oiiginally investeu
in assets but an upuateu maiket value. The seconu is that the natuie of
opeiations foi a financial seivice fiim is such that long peiious of piofitability
aie inteispeiseu with shoit peiious of laige losses; accounting stanuaius have
been uevelopeu to countei this tenuency anu cieate smoothei eainings.
a. Loss Piovisions anu smoothing out eainings: Consiuei a bank that makes money
the olu fashioneu way - by taking in funus fiom uepositois anu lenuing these
funus out to inuiviuuals anu coipoiations at highei iates. While the iate chaigeu
to lenueis will be highei than that piomiseu to uepositois, the iisk that the bank
faces is that lenueis may uefault, anu the iate at which they uefault will vaiy
wiuely ovei time - low uuiing goou economic times anu high uuiing economic
uowntuins. Rathei than wiite off the bau loans, as they occui, banks usually
cieate piovisions foi losses that aveiage out losses ovei time anu chaige this
amount against eainings eveiy yeai. Though this piactice is logical, theie is a
catch, insofai as the bank is given the iesponsibility of making the loan loss
assessment. A conseivative bank will set asiue moie foi loan losses, given a loan
poitfolio, than a moie aggiessive bank, anu this will leau to the lattei iepoiting
highei piofits uuiing goou times.
Va|uat|on Issues
When valuing financial seivice fiims, theie aie two piimaiy challenges that
unueicut any valuation. The fiist is that uiawing a uistinction between uebt anu
equity, one that we have maue foi all othei fiims, is uifficult to uo foi financial
seivice fiims. The seconu is that estimating cash flows is complicateu because
capital expenuituies anu woiking capital aie not easily measuieu at financial
seivice fiims.
Debt and Lqu|ty
In the financial balance sheet that we used to describe firms, there are only two
ways to raise funds to finance a business – debt and equity. While this is true for both all
firms, financial service firms differ from non-financial service firms on three dimensions:
a. Debt is raw material, not capital: When we talk about capital for non-financial service
firms, we tend to talk about both debt and equity. A firm raises funds from both equity
investor and bondholders (and banks) and uses these funds to make its investments.
When we value the firm, we value the value of the assets owned by the firm, rather than
just the value of its equity. With a financial service firm, debt has a different connotation.
Rather than view debt as a source of capital, most financial service firms seem to view it
as a raw material. In other words, debt is to a bank what steel is to a manufacturing
company, something to be molded into other products which can then be sold at a higher
price and yield a profit. Consequently, capital at financial service firms seems to be
narrowly defined as including only equity capital. This definition of capital is reinforced
by the regulatory authorities, who evaluate the equity capital ratios of banks and
insurance firms.
b. Defining Debt: The definition of what comprises debt also is murkier with a financial
service firm than it is with a non-financial service firm. For instance, should deposits
made by customers into their checking accounts at a bank be treated as debt by that bank?
Especially on interest-bearing checking accounts, there is little distinction between a
deposit and debt issued by the bank. If we do categorize this as debt, the operating
income for a bank should be measured prior to interest paid to depositors, which would
be problematic since interest expenses are usually the biggest single expense item for a
c. Degree of financial leverage: Even if we can define debt as a source of capital and can
measure it precisely, there is a final dimension on which financial service firms differ
from other firms. They tend to use more debt in funding their businesses and thus have
higher financial leverage than most other firms. While there are good reasons that can be
offered for why they have been able to do this historically - more predictable earnings
and the regulatory framework are two that are commonly cited – there are consequences
for valuation. Since equity is a sliver of the overall value of a financial service firm, small
changes in the value of the firm’s assets can translate into big swings in equity value.
Lst|mat|ng cash f|ows |s d|ff|cu|t
We noted earlier that financial service firms are constrained by regulation in both
where they invest their funds and how much they invest. If, as we have so far in this
book, define reinvestment as necessary for future growth, there are problems associated
with measuring reinvestment with financial service firms. Note that, we consider two
items in reinvestment – net capital expenditures and working capital. Unfortunately,
measuring either of these items at a financial service firm can be problematic.
Consider net capital expenditures first. Unlike manufacturing firms that invest in
plant, equipment and other fixed assets, financial service firms invest primarily in
intangible assets such as brand name and human capital. Consequently, their investments
for future growth often are categorized as operating expenses in accounting statements.
Not surprisingly, the statement of cash flows to a bank show little or no capital
expenditures and correspondingly low depreciation. With working capital, we run into a
different problem. If we define working capital as the difference between current assets
and current liabilities, a large proportion of a bank’s balance sheet would fall into one or
the other of these categories. Changes in this number can be both large and volatile and
may have no relationship to reinvestment for future growth.
As a result of this difficulty in measuring reinvestment, we run into two practical
problems in valuing these firms. The first is that we cannot estimate cash flows without
estimating reinvestment. In other words, if we cannot identify how much a company is
reinvesting for future growth, we cannot identify cash flows either. The second is that
estimating expected future growth becomes more difficult, if the reinvestment rate cannot
be measured.
Va|uat|on So|ut|ons
If you cannot cleaily uelineate how much a financial seivice fiim owes anu
what its cash flows aie, how can you evei get an estimate of value. That is the
question we will auuiess in this section.
D|scounted Cash I|ow Mode|s
In a discounted cash flow model, we consider the value of an asset to be the
present value of the expected cash flows generated by that asset. In this section, we will
first lay out the argument that financial service firms should be valued on an equity basis,
rather than as on a firm basis, and that dividends, for better or worse, are often the only
tangible cash flow that we can observe or estimate. Consequently, our focus will be on
variants of the dividend discount model and how they can best be used in valuing banks
and insurance companies.
FG1"2< A&4*1* ,"4# ;)%1)2"-0
Early in this book, we noted the distinction between valuing a firm and valuing
the equity in the firm. We value firms by discounting expected after tax cash flows prior
to debt payments at the weighted average cost of capital. We value equity by discounting
cash flows to equity investors at the cost of equity. Estimating cash flows prior to debt
payments at a weighted average cost of capital is problematic, when debt and debt
payments cannot be easily identified, which, as we argued earlier, is the case with
financial service firms. Equity can be valued directly, however, by discounting cashflows
to equity at the cost of equity. Consequently, we would argue for the latter approach for
financial service firms.
Even with equity valuation, we have a secondary problem. To value the equity in
a firm, we normally estimate the free cashflow to equity. In Chapter 2, we defined the
free cash flow to equity.
Free Cashflow to Equity = Net Income – Net Capital Expenditures – Change in non-cash
working capital – (Debt repaid – New debt issued)
If we cannot estimate net capital expenditures or non-cash working capital, we clearly
cannot estimate the free cashflow to equity. Since this is the case with financial service
firms, we have three choices. The first is to use dividends as cash flows to equity and
assume that firms over time pay out their free cash flows to equity as dividends. Since
dividends are observable, we therefore do not have to confront the question of how much
firms reinvest. The second is to adapt the free cashflow to equity measure to allow for the
types of reinvestment that financial service firms make. For instance, given that banks
operate under a regulatory capital ratio constraint, it can be argued that these firms have
to increase regulatory capital in order to make more loans in the future. The third is to
keep the focus on excess returns, rather than on earnings, dividends and growth rates, and
to value these excess returns.
@"A"7&07 @"*=-102 N-7&%*
In the basic dividend discount model, the value of a stock is the present value of
the expected dividends on that stock. While many analysts view the model as old
fashioned, it retains a strong following among analysts who value financial service
companies, because of the difficulties we face in estimating cash flows. In this section,
we will begin by laying out the basic model and then consider ways in which we can
streamline its usage, when valuing financial service companies.
1he sLandard model
If we start with the assumption that equity in a publicly traded firm has an infinite
life, we arrive at the most general version of the dividend discount model:
Value per share of equity =
" =
) 1 (

= Expected dividend per share in period t
= Cost of equity
In the special case where the expected growth rate in dividends is constant forever, this
model collapses into the Gordon Growth model.
Value per share of equity in stable growth =
" g)

In this equation, g is the expected growth rate in perpetuity and DPS
is the expected
dividends per share next year. In the more general case, where dividends are growing at a
rate which is not expected to be sustainable or constant forever during a period (called the
extraordinary growth period), we can still assume that the growth rate will be constant
forever at some point in the future. This allows us to then estimate the value of a stock, in
the dividend discount model, as the sum of the present values of the dividends over the
extraordinary growth period and the present value of the terminal price, which itself is
estimated using the Gordon growth model.
Value per share of equity in extraordinary growth =
(1+ k
" +
n +1
# g
)(1+ k

The extraordinary growth is expected to last n years, g
is the expected growth rate after n
years and k
is the cost of equity (hg: high growth period and st: stable growth period).
While the dividend discount model is intuitive and has deep roots in equity
valuation, there are dangers in using the model blindly. As we noted in the section on the
dark side, there are many analysts who start with the current dividends of the bank as a
base, apply a growth rate to these earnings, based on either history or analyst forecasts,
and compute a present value. For the model to yield a value that is reasonable, the
assumptions have to be internally consistent, with the expected growth rate numbers
jelling with the dividend forecasts and risk measures.
A Consistent Dividend Discount Model
Looking at the inputs into the uiviuenu uiscount mouel, theie aie thiee sets
of inputs that ueteimine the value of equity. The fiist is the cost of equity that we
use to uiscount cash flows, with the possibility that the cost may vaiy acioss time, at
least foi some fiims. The seconu is the piopoition of the eainings that we assume
will be paiu out in uiviuenus; this is the uiviuenu payout iatio anu highei payout
iatios will tianslate into moie uiviuenus foi any given level of eainings. The thiiu is
the expecteu giowth iate in uiviuenus ovei time, which will be a function of the
eainings giowth iate anu the accompanying payout iatio. In auuition to estimating
each set of inputs well, we also neeu to ensuie that the inputs aie consistent with
each othei.
klsk ooJ cost of ípolty
In keeping with the way we have estimated the cost of equity for firms so far in
this book, the cost of equity for a financial service firm has to reflect the portion of the
risk in the equity that cannot be diversified away by the marginal investor in the stock.
This risk is estimated using a beta (in the capital asset pricing model) or betas (in a multi-
factor or arbitrage pricing model). There are three estimation notes that we need to keep
in mind, when making estimates of the cost of equity for a financial service firm:
a. Use bottom-up betas: In our earlier discussions of betas, we argued against the use
of regression betas because of the noise in the estimates (standard errors) and the
possibility that the firm has changed over the period of the regression. We will
continue to hold to that proposition, when valuing financial service firms. In fact,
the large numbers of publicly traded firm in this domain should make estimating
bottom up betas much easier.
b. Do not adjust for financial leverage: When estimating betas for non-financial
service firms, we emphasized the importance of unlevering betas (whether they be
historical or sector averages) and then relevering them, using a firm’s current debt
to equity ratio. With financial service firms, we would skip this step for two
reasons. First, financial service firms tend to be much more homogeneous in
terms of capital structure – they tend to have similar financial leverage primarily
due to regulations. Second, and this is a point made earlier, debt is difficult to
measure for financial service firms. In practical terms, this will mean that we will
use the average levered beta for comparable firms as the bottom-up beta for the
firm being analyzed.
c. Adjust for regulatory and business risk: If we use sector betas and do not adjust
for financial leverage, we are in effect using the same beta for every company in
the sector. As we noted earlier, there can be significant regulatory differences
across markets, and even within a market, across different classes of financial
service firms. To reflect this, we would define the sector narrowly; thus, we
would look the average beta across large money center banks, when valuing a
large money center bank, and across small regional banks, when valuing one of
these. We would also argue that financial service firms that expand into riskier
businesses – securitization, trading and investment banking – should have
different (and higher betas) for these segments, and that the beta for the company
should be a weighted average. Table 9.1 summarizes the betas for different groups
of financial service companies, categorized by region, in February 2009.
Table 9.1: Betas for financial service businesses
Categoiy 0S Euiope Emeiging Naikets
Laige Noney Centei Banks u.71 u.8u u.9
Small¡Regional Banks u.91 u.98 1.uS
Thiifts u.66 u.7S u.8S
Biokeiage Bouses 1.S7 1.2S 1.S
Investment Banks 1.Su 1.SS 1.9
Life Insuiance 1.17 1.2u 1.1
Piopeity anu Casualty Insuiance Companies u.91 u.9S u.9

d. Consider the relationship between risk and growth: Through the book, we have
emphasized the importance of modifying a company’s risk profile to reflect
changes that we are assuming to its growth rate. As growth companies mature,
betas should move towards one. We see no need to abandon that principle, when
valuing banks. We would expect high growth banks to have higher betas (and
costs of equity) than mature banks. In valuing such banks, we would therefore
start with higher costs of equity but as we reduce growth, we would also reduce
betas and costs of equity.
There is one final point that bears emphasizing here. The average betas that we get across
financial service firms reflect the regulatory constraints that they operated under during
that period. When significant changes are expected to regulation, we should consider the
potential impact on betas across the board. For instance, the crisis of 2008 will cause
banking regulations to be tightened globally and may very well push up the betas for all
banks at least for the foreseeable future.
Ctowtb ooJ loyoot
Theie is an inheient tiaue off between uiviuenus anu giowth. When a
company pays a laigei segment of its eainings as uiviuenus, it is ieinvesting less anu
shoulu thus giow moie slowly. With financial seivice fiims, this link is ieinfoiceu by
the fact that the activities of these fiims aie subject to iegulatoiy capital constiaints;
banks anu insuiance companies have to maintain equity (in book value teims) at
specifieu peicentages of theii activities. When a company is paying out moie in
uiviuenus, it is ietaining less in eainings; the book value of equity incieases by the
ietaineu eainings. In recent years, in keeping with a trend that is visible in other sectors
as well, financial service firms have increased stock buybacks as a way of returning cash
to stockholders. In this context, focusing purely on dividends paid can provide a
misleading picture of the cash returned to stockholders. An obvious solution is to add the
stock buybacks each year to the dividends paid and to compute the composite payout
ratio. If we do so, however, we should look at the number over several years, since stock
buybacks vary widely across time – a buyback of billions in one year may be followed by
three years of relatively meager buybacks, for instance.
To ensuie that assumptions about uiviuenus, eainings anu giowth aie
inteinally consistent, we have to biing in a measuie of how well the ietaineu equity
is ieinvesteu; the ietuin on equity is the vaiiable that ties togethei payout iatios
anu expecteu giowth. In chaptei 2, we intiouuceu a funuamental giowth measuie
foi eainings:
Expecteu giowth in eainings = Retuin on equity * (1 - Biviuenu Payout iatio)
Foi instance, a bank that payout out 6u% of its eainings as uiviuenus anu eains a
ietuin on equity of 12% will have an expecteu giowth iate in eainings of 4.8%.
When we intiouuceu the funuamental equation in chaptei 2, we also noteu that
fiims can uelivei giowth iates that ueviate fiom this expectation, if the ietuin on
equity is changing.
Expected Growth

= 1- Payout Ratio ( ) ROE
t +1
( ) +
t +1

Thus, if the bank is able to impiove the ietuin on equity on existing assets fiom 1u%
to 12%, the efficiency giowth iate in that yeai will be 2u%. Bowevei, efficiency
giowth is tempoiaiy anu all fiims ultimately will ieveit back to the funuamental
giowth ielationship.
The linkage between ietuin on equity, giowth anu uiviuenus is theiefoie
ciitical in ueteimining value in a financial seivice fiim. At the iisk of hypeibole, the
key numbei in valuing a bank is not uiviuenus, eainings oi giowth iate, but what we
believe it will eain as ietuin on equity in the long teim. That numbei, in conjunction
with payout iatios, will help in ueteimining giowth. Alteinatively, the ietuin on
equity, togethei with expecteu giowth iates, can be useu to estimate uiviuenus. This
linkage is paiticulaily useful, when we get to stable giowth, wheie giowth iates can
be veiy uiffeient fiom the initial giowth iates. To pieseive consistency in the
valuation, the payout iatio that we use in stable giowth, to estimate the teiminal
value, shoulu be:
Payout ratio in stable growth
growth stable
- 1 =

The risk of the firm should also adjust to reflect the stable growth assumption. In
particular, if betas are used to estimate the cost of equity, they should converge towards
one in stable growth.
Illustration 9.1: Wells Fargo Banks – February 2009
In illustiation 14.1, we examineu the effects of leaving uiviuenus unchangeu
anu using histoiical uiviuenu giowth to value Wells Faigo in eaily 2uu9 anu
concluueu that we woulu ovei value the fiim foi two ieasons. Fiist, we aie
oveistating the expecteu uiviuenus in the futuie by basing it on the uiviuenus paiu
in 2uu8. Seconu, the giowth iate we weie assuming foi the futuie (4%) may not be
consistent with the payout iatio that we weie assuming in the valuation. Baseu on
the 2uu8 numbeis, wheie uiviuenus pei shaie weie $1.Su pei shaie anu eainings
pei shaie was $1.71, the payout iatio is 76%. To uelivei a giowth iate of 4% a yeai
foievei, the ietuin on equity that Wells Faigo woulu have to uelivei on it's new
investment is 16.67%.
Implieu Retuin on Equity =
(1"Payout ratio)
If we believe that the ietuin on equity, in the futuie, at Wells Faigo will be lowei
than 16.67%, we have to eithei lowei giowth oi ieuuce uiviuenus.
Rathei than base the valuation on the 2uu8 uiviuenu anu eainings numbeis,
which aie unstable anu ieflect the maiket ciisis, we chose a uiffeient path. We
staiteu with the book value of equity of $47,628 million that Wells Faigo iepoiteu at
the enu of 2uu8, anu estimateu what eainings anu uiviuenus woulu be at a
noimalizeu ietuin on equity. Foi instance, take the most the optimistic scenaiio,
wheie the ietuin on equity at Wells Faigo ieveits back quickly to 18.91%, the
aveiage R0E fiom 2uu1 to 2uu7. The noimalizeu net income foi next yeai woulu be
as follows:
Noimalizeu net income = Book value of equity * Noimalizeu R0E
= $47,628 million * .1891 = $9,uu6 million
Assuming that these eainings woulu giow at a stable iate of S% a yeai in peipetuity,
we next estimateu the uiviuenu payout iatio:
Biviuenu Payout iatio =
= .8414 or 84.14%
If we assume that the cost of equity of 9% that we estimateu eailiei is a ieasonable
value, we can estimate the value of equity in Wells Faigo:

value of equity =
Expected Dividends next year
(Cost of equity - Stable growth rate)

Net Income* Payout ratio
(Cost of equity - Stable growth rate)
(.09 ".03)
= $126,293 mil
0nuei the most optimistic scenaiio, Wells Faigo is significantly unuei valueu in
Febiuaiy 2uu9 at its existing maiket value foi equity of $66,64u million.

To get to this cost of equity, we assumeu a beta of one anu an equity iisk piemium of 6%. With a
iiskfiee iate of S%, we obtain a cost of equity = S% + 6% = 9%.
The two inputs that will ueteimine the value of equity at Wells Faigo aie the
ietuin on equity anu the cost of equity. As we lowei the ietuin on equity, the
noimalizeu net income will ueciease anu the payout out iatio will ueciease as well
(foi the given giowth iate of S%). The cost of equity can also change, if we peiceive
that banks have become iiskiei. Following the same pioceuuie that we uiu foi the
most optimistic scenaiio, we valueu equity at Wells Faigo unuei two othei scenaiio
- an inteimeuiate scenaiio wheie the noimalizeu ietuin on equity uiops to 1S%
anu the cost of equity incieases to 1u% anu a pessimistic scenaiio, wheie the ietuin
on equity ieveits to 12% anu the cost of equity incieases to 11%. Table 9.2
summaiizes oui finuings unuei each scenaiio:
P":/- G435 L"/$- *; h-//8 2")(* OD$%&'5 2-:)$")' 3\\G

Income R0E
Cost of
value of
Quick bounce back to
noimalcy $9,uu6.4S 18.91% 84.14% 9% 12629S.S8
Slow bounce back to
noimalcy $7,144.2u 1S.uu% 8u.uu% 1u% $81,648.uu
Long teim change to
lowei piofitability anu
highei iisk $S,71S.S6 12.uu% 7S.uu% 11% $SS,S81.Su
Naiket Cap (2¡2uu9) $66,64S.uu
While Wells Faigo continues to look unuei valueu, if we assume a slow bounce back
to noimalcy, it uoes not look cheap if we assume that banks will be iiskiei anu less
piofitable fiom this point on.
Cashflow to Equity Models
At the beginning of this discussion, we noted the difficulty in estimating
cashflows when net capital expenditures and non-cash working capital cannot be easily
identified. It is possible, however, to estimate cashflows to equity for financial service
firms if we define reinvestment differently. The cashflow to equity is the cashflow left
over for equity investors after debt payments have been made and reinvestment needs
met. With financial service firms, the reinvestment generally does not take the form of
plant, equipment or other fixed assets. Instead, the investment is in regulatory capital; this
is the capital as defined by the regulatory authorities, which, in turn, determines the limits
on future growth.
Financial Service Firm
= Net Income – Reinvestment in Regulatory Capital
To estimating the reinvestment in regulatory capital, we have to define two parameters.
The first is the book equity capital ratio that will determine the investment; this will be
heavily influenced by regulatory requirements but will also reflect the choices made by a
bank. Conservative banks may choose to maintain a higher capital ratio than required by
regulatory authorities whereas aggressive banks may push towards the regulatory
constraints. For instance, a bank that has a 5% equity capital ratio can make $100 in loans
for every $5 in equity capital. When this bank reports net income of $15 million and pays
out only $5 million, it is increasing its equity capital by $10 million. This, in turn, will
allow it to make $200 million in additional loans and presumably increase its growth rate
in future periods. The second is the profitability of the activity, defined in terms of net
income. Staying with the bank example, we have to specify how much net income the
bank will generate with the additional loans; a 0.5% profitability ratio will translate into
additional net income of $1 million on the additional loans.
Excess Return Models
The third approach to valuing financial service firms is to use an excess return
model. In such a model, the value of a firm can be written as the sum of capital invested
currently in the firm and the present value of excess returns that the firm expects to make
in the future. In this section, we will consider how this model can be applied to valuing
equity in a financial service firm.
Basic Model
Given the difficulty associated with defining total capital in a financial service
firm, it makes far more sense to focus on just equity when using an excess return model
to value a financial service firm. The value of equity in a firm can be written as the sum
of the equity invested in a firm’s current investments and the expected excess returns to
equity investors from these and future investments.
Value of Equity = Equity Capital invested currently + Present Value of Expected Excess
Returns to Equity investors
The most interesting aspect of this model is its focus on excess returns. A firm that
invests its equity and earns just the fair-market rate of return on these investments should
see the market value of its equity converge on the equity capital currently invested in it.
A firm that earns a below-market return on its equity investments will see its equity
market value dip below the equity capital currently invested.
The other point that has to be emphasized is that this model considers expected
future investments as well. Thus, it is up to the analyst using the model to forecast not
only where the financial service firm will direct its future investments but also the returns
it will make on those investments.
Inputs to Model
There are two inputs needed to value equity in the excess return model. The first
is a measure of equity capital currently invested in the firm. The second and more
difficult input is the expected excess returns to equity investors in future periods.
The equity capital invested currently in a firm is usually measured as the book
value of equity in the firm. While the book value of equity is an accounting measure and
is affected by accounting decisions, it should be a much more reliable measure of equity
invested in a financial service firm than in a manufacturing firm for two reasons. The first
is that the assets of a financial service firm are often financial assets that are marked up to
market; the assets of manufacturing firms are real assets and deviations between book
and market value are usually much larger. The second is that depreciation, which can be a
big factor in determining book value for manufacturing firms, is often negligible at
financial service firms. Notwithstanding this, the book value of equity can be affected by
stock buybacks and extraordinary or one-time charges. The book value of equity for
financial service firms that have one or both may understate the equity capital invested in
the firm.
The excess returns, defined in equity terms, can be stated in terms of the return on
equity and the cost of equity.
Excess Equity return = (Return on equity – Cost of equity) (Equity capital invested)
Here again, we are assuming that the return on equity is a good measure of the economic
return earned on equity investments. When analyzing a financial service firm, we can
obtain the return on equity from the current and past periods, but the return on equity that
is required is the expected future return. This requires an analysis of the firm’s strengths
and weaknesses as well as the competition faced by the firm
Illustration 9.2: Excess Return Valuation – Goldman Sachs
In February 2009, Goldman Sachs, perhaps the best-regarded investment bank in
the world, was trading at a market capitalization for equity of $48.7 billion, well below its
book value of equity of $60.6 billion. A significant factor underlying the stock price
collapse was the decline in profitability at the firm, which reported $2,322 million in net
income in 2008, well below the $11,599 million it reported as profits in the previous year.
Goldman paid out $850 million in dividends during 2008.
To value Goldman Sachs, we begin with the current cost of equity. Using the
average beta of 1.50, reported by investment banks in 2008, in conjunction with a
treasury bond rate of 3% and an equity risk premium of 6%, yields a cost of equity of
12% for the firm:
Cost of equity = 3% + 1.5 (6%) = 12%
While the return on equity at Goldman Sachs has ranged from 16 to 20% between 2001
and 2007, the expected return on equity, looking forward, will be much lower. For the
next 5 years, we will assume that the return on equity at Goldman will be 9%, well below
not only the historical average return on equity but also its own cost of equity. The
resulting negative excess returns and present value are summarized in table 9.3:
Table 9.3: Excess Returns – High Growth Period
K 3 J Z U
Net Income $S,941.u8 $6,S84.6u $6,861.2S $7,S7S.44 $7,92S.89
- Equity Cost (see below) $7,921.44 $8,S12.8u $9,148.Su $9,8S1.2S $1u,S6S.18
Excess Equity Retuin -$1,98u.S6 -$2,128.2u -$2,287.u8 -$2,4S7.81 -$2,641.Su
Cumulateu Cost of Equity 1.12uuu 1.2S44u 1.4u49S 1.S7SS2 1.762S4
Piesent value -$1,768.18 -$1,696.S9 -$1,627.9u -$1,S61.98 -$1,498.74

Beginning Bv of Equity $66,u12.uu $7u,9S9.98 $76,2SS.86 $81,927.u8 $88,u4S.17
Cost of Equity 12.uu% 12.uu% 12.uu% 12.uu% 12.uu%
Equity Cost $7,921.44 $8,S12.8u $9,148.Su $9,8S1.2S $1u,S6S.18

Retuin on Equity 9.uu% 9.uu% 9.uu% 9.uu% 9.uu%
Net Income $S,941.u8 $6,S84.6u $6,861.2S $7,S7S.44 $7,92S.89
Biviuenu Payout Ratio 17.uS% 17.uS% 17.uS% 17.uS% 17.uS%
Biviuenus paiu $1,u1S.1u $1,u88.7S $1,17u.uu $1,2S7.SS $1,SS1.21
Retaineu Eainings $4,927.98 $S,29S.87 $S,691.22 $6,116.u9 $6,S72.67
The net income each year is computed by multiplying the return on equity each year by
the beginning book value of equity. The book value of equity each year is augmented by
the portion of earnings that is not paid out as dividends; the dividend payout ratio is based
upon current dividends and normalized earnings.
To put closure on this valuation, we have to make assumptions about excess
returns after year 5. We assumed that the net income would grow 3% a year beyond year
5 and that the beta for the stock would decline to 1.20. For Goldman Sachs, we will
assume that the return on equity after year 5 will be 10.20%, set equal to the cost of
equity in stable growth:
Cost of equity in stable growth period = 3% + 1.2(6%) = 10.20%
Net Income
= Book value of equity at start of year 6* Stable ROE
= ($88,043*1.03) *.102 = $9249.82 million
Note that the net income in year 6 is significantly higher than the net income in year 5, as
the return on equity bounces back from 9% to 10.20%. The terminal value of excess
returns to equity investors can then be computed.
Terminal value of excess returns
Net Income
- Cost of equity
( ) BV of Equity
( )
Cost of equity - Expected growth rate
9,249.82 - 90684.47 ( )(0.102)
0.102 "0.03
= $0

Since the firm earns its cost of equity after year 5, there is no value gained or lost after
that year. The value of equity can then be computed as the sum of the three components –
the book value of equity invested today, the present value of excess equity returns over
the next 5 years and the present value of the terminal value of equity.
Book value of Equity Invested currently = $66,012
PV of Equity Excess Return – next 5 years = - $8,154
PV of terminal value of excess returns = 0
Value of Equity = $57,859
Number of shares = 461.874
Value Per Share = $125.29
At the time of this valuation in February 2009, Goldman Sachs was trading at $ 96.45 a
Relative Valuation
In our chapters on relative valuation, we examined a series of multiples that are
used to value firms, ranging from earnings multiples to book value multiples to revenue
multiples. In this section, we consider how relative valuation can be used for financial
service firms.
Choices in Multiples
Firm value multiples such as Value to EBITDA or Value to EBIT cannot be easily
adapted to value financial service firms, because neither value nor operating income can
be easily estimated for banks or insurance companies. In keeping with our emphasis on
equity valuation for financial service firms, the multiples that we will work with to
analyze financial service firms are equity multiples. The three most widely used equity
multiples are price earnings ratios, price to book value ratios and price to sales ratios.
Since sales or revenues are not really measurable for financial service firms, price to sales
ratios cannot be estimated or used for these firms. We will look, in this section, at the use
of price earnings and price to book value ratios for valuing financial service firms.
Price Earnings Ratios
The price earnings ratio for a bank or insurance companies is measured much the
same as it is for any other firm.
Price Earnings Ratio
share per Earnings
share per Price
In Chapter 4, we noted that the price earnings ratio is a function of three variables – the
expected growth rate in earnings, the payout ratio and the cost of equity. As with other
firms, the price earnings ratio should be higher for financial service firms with higher
expected growth rates in earnings, higher payout ratios and lower costs of equity.
An issue that is specific to financial service firms is the use of provisions for
expected expenses. For instance, banks routinely set aside provisions for bad loans. These
provisions reduce the reported income and affect the reported price earnings ratio.
Consequently, banks that are more conservative about categorizing bad loans will report
lower earnings and have higher price earnings ratios, whereas banks that are less
conservative will report higher earnings and lower price earnings ratios.
Another consideration in the use of earnings multiples is the diversification of
financial service firms into multiple businesses. The multiple that an investor is willing to
pay for a dollar in earnings from commercial lending should be very different than the
multiple that the same investor is will to pay for a dollar in earnings from trading. When a
firm is in multiple businesses with different risk, growth and return characteristics, it is
very difficult to find truly comparable firms and to compare the multiples of earnings
paid across firms. In such a case, it makes far more sense to break the firm’s earnings
down by business and assess the value of each business separately.
Illustration 9.3: Comparing PE ratios: Insurance Companies
In Table 9.4, we compare the current price earnings ratios of life insurance
companies in February 2009.
Table 9.4: PE Ratios and Expected Growth Rates – Insurance Companies
Company Name PE Ratio Expected growth in EPS Beta
Torchmark Corp. (NYSE:TMK) 4.11 3.60% 1.87
Odyssey Re Holdings Corp. (NYSE:ORH) 5.15 4.00% 1.53
Manulife Financial Corporation (TSX:MFC) 5.4 5.20% 2.41
MetLife, Inc. (NYSE:MET) 5.45 4.50% 1.96
Assurant Inc. (NYSE:AIZ) 5.56 5.00% 2.16
Principal Financial Group Inc. (NYSE:PFG) 5.85 5.50% 2.15
AFLAC Inc. (NYSE:AFL) 6.01 6.40% 2.4
Unum Group (NYSE:UNM) 6.33 6.00% 1.47
Aon Corporation (NYSE:AOC) 7.04 6.20% 1.7
The Travelers Companies, Inc. (NYSE:TRV) 7.58 6.00% 1.87
HCC Insurance Holdings Inc. (NYSE:HCC) 7.75 7.00% 2.05
The Chubb Corporation (NYSE:CB) 7.94 10.50% 1.67
American Financial Group Inc. (NYSE:AFG) 9.41 11.00% 1.31
ProAssurance Corporation (NYSE:PRA) 10.74 10.30% 0.89
Reinsurance Group of America Inc. (NYSE:RGA) 11.71 11.50% 1.24
W.R. Berkley Corporation (NYSE:WRB) 12.3 12.50% 1.98
Sun Life Financial Inc. (TSX:SLF) 12.8 10.00% 1.16
RLI Corp. (NYSE:RLI) 13.48 13.00% 1.62
Brown & Brown Inc. (NYSE:BRO) 14.36 13.70% 1.44
Arthur J Gallagher & Co. (NYSE:AJG) 20.21 12.67% 1.21
Transatlantic Holdings Inc. (NYSE:TRH) 20.36 15.00% 1.22
Lincoln National Corp. (NYSE:LNC) 30.5 10.20% 0.86
The Hanover Insurance Group Inc. (NYSE:THG) 35.52 15.00% 0.98
The PE ratios vary widely and range from 4.11 for Nationwide Financial to 35.52 for
the Hanover Insurance Group. We also report the consensus estimates by analysts of
the growth rate in earnings per share over the next 5 years and the equity beta for
each of these firms, as a proxy for risk. Some of the variation in PE ratios can be
explained by differences in the expected growth rate – higher growth firms tend to
have higher PE ratios - and some of it is due to differences in risk – more risky firms
have lower PE ratios. Regressing PE ratios against the expected growth rate and the
standard deviation yields the following:
PE Ratio = 12.41 + 109.95 Expected Growth Rate – 6.60 Beta R
(1.61) (2.86) (-2.14)
The regression confirms the intuition that higher growth and lower risk firms have higher
PE ratios than other firms. Table 9.5 uses this regression to estimate predicted PE ratios
for the companies in the table and reports on whether the firms are under or over valued.
Table 9.5: Predicted and Actual PE ratios: Insurance Companies in February 2009
Company Name PE Ratio Pieuicteu PE
% 0nuei oi ovei
Ameiican Financial uioup Inc. (NYSE:AFu) 9.41 1S.86 -4u.66%
PioAssuiance Coipoiation (NYSE:PRA) 1u.74 17.86 -S9.87%
The Chubb Coipoiation (NYSE:CB) 7.94 12.9S -S8.61%
0num uioup (NYSE:0NN) 6.SS 9.S1 -S1.97%
Reinsuiance uioup of Ameiica Inc.
(NYSE:RuA) 11.71 16.87 -Su.S9%
0uyssey Re Boluings Coip. (NYSE:0RB) S.1S 6.71 -2S.2S%
Biown & Biown Inc. (NYSE:BR0) 14.S6 17.97 -2u.u9%
Sun Life Financial Inc. (TSX:SLF) 12.8 1S.7S -18.72%
RLI Coip. (NYSE:RLI) 1S.48 16.u1 -1S.81%
Aon Coipoiation (NYSE:A0C) 7.u4 8.u1 -12.u8%
W.R. Beikley Coipoiation (NYSE:WRB) 12.S 1S.u9 -6.uu%
Tiansatlantic Boluings Inc. (NYSE:TRB) 2u.S6 2u.8S -2.SS%
Toichmaik Coip. (NYSE:TNK) 4.11 4.uS 2.u8%
Aithui } uallaghei & Co. (NYSE:A}u) 2u.21 18.SS 1u.11%
The Tiaveleis Companies, Inc. (NYSE:TRv) 7.S8 6.67 1S.7S%
BCC Insuiance Boluings Inc. (NYSE:BCC) 7.7S 6.S8 17.84%
NetLife, Inc. (NYSE:NET) S.4S 4.42 2S.2S%
Piincipal Financial uioup Inc. (NYSE:PFu) S.8S 4.27 S7.u9%
Assuiant Inc. (NYSE:AIZ) S.S6 S.6S S2.27%
The Banovei Insuiance uioup Inc.
(NYSE:TBu) SS.S2 22.4S S8.SS%
AFLAC Inc. (NYSE:AFL) 6.u1 S.61 66.6S%
Lincoln National Coip. (NYSE:LNC) Su.S 17.9S 69.9S%
Nanulife Financial Coipoiation (TSX:NFC) S.4 2.22 14S.u9%
Based upon this regression, Manulife Financial looks significantly overvalued while
American Financial and ProAssurance look significantly undervalued.
Price to Book Value Ratios
The price to book value ratio for a financial service firm is the ratio of the price
per share to the book value of equity per share.
Price to Book Ratio
share per equity of Book value
share per Price
Other things remaining equal, higher growth rates in earnings, higher payout ratios, lower
costs of equity and higher returns on equity should all result in higher price to book
ratios. Of these four variable, the return on equity has the biggest impact on the price to
book ratio, leading us to identify it as the companion variable for the ratio.
If anything, the strength of the relationship between price to book ratios and
returns on equity should be stronger for financial service firms than for other firms,
because the book value of equity is much more likely to track the market value of equity
invested in existing assets. Similarly, the return on equity is less likely to be affected by
accounting decisions. The strength of the relationship between price to book ratios and
returns on equity can be seen when we plot the two on a scatter plot for U.S. commercial
banks with market capitalization exceeding $ 1 billion, in the United States in February
2009, in figure 9.1.
Figure 9.1: Price to Book Ratios and Returns on Equity: Banks

Regiession line, with 9u% confiuence iange on estimate.
Note that these numbers were extracted in the midst of the biggest crisis in banking since
the Great Depression, and in an environment where most analysts have come to the
conclusion that investors are in crisis mode and that equity values in banks reflect the
panic and irrationality. It is therefore astounding how close the link is between price to
book ratios for banks in February 2009 and the returns on equity, based upon trailing 12-
month earnings. Banks such as Valley National (VLY) and WestAmerica Bancorp
(WABC) that have high price to book value ratios tend to have high returns on equity.
Banks such as Banco Popular (BPOP) and Wachovia (WB) that have low returns on
equity trade at low price to book value ratios. The correlation between price to book
ratios and returns on equity is in excess of 0.70. Put another way, there seems to be a
fundamental order to the chaos that has undercut the banking sector.
While emphasizing the relationship between price to book ratios and returns on
equity, we should not ignore the other fundamentals. For instance, banks vary in terms of
risk, and we would expect for any given return on equity that riskier banks should have
lower price to book value ratios. Similarly, banks with much greater potential for growth
should have much higher price to book ratios, for any given level of the other
fundamentals. In February 2009, one factor that should make a difference is the exposure
that different banks have to toxic securities – mortgage backed bonds and collateralized
debt obligations (CDOs) – on their balance sheets.
Illustration 9.4: Price to Book Value Ratios: Small commercial banks
In figure 9.1, we noted the strong relationship between price to book ratios and
returns on equity at large banks. Does the same apply relationship apply to smaller
banks? To answer to this question, we looked at banks with market capitalizations
between $ 500 million and $ 1 billion in table 9.6:
Table 9.6: Price to Book Ratios and Returns on Equity: Small Commercial Banks
Company Name
Expecteu uiowth in EPS:
next S yeais
Stu ueviation in
stock piices R0E
East West Bancoip u.76 -2.Su% S7.7S% 1S.76%
Webstei Fin'l u.S7 2.uu% S1.u6% 6.44%
NBT Bancoip 2.1S S.uu% S2.72% 12.66%
PacWest Bancoip u.6u S.uu% 4u.u9% 7.9S%
WesBanco 1.u8 S.uu% 41.77% 7.7u%
Chemical Financial 1.12 S.uu% SS.98% 7.67%
CvB Financial 2.uS 6.SS% SS.u2% 14.26%
Fiist Commonwealth 1.S2 6.Su% Su.81% 8.14%
Pacific Cap. Bancoip 1.1S 6.Su% 42.12% 1S.26%
Community Bank Sys. 1.4S 7.Su% 24.1u% 8.96%
Fiist Busey Coip 1.17 8.uu% Su.S4% S.9S%
Tompkins Financial Coip 2.7S 8.uu% 27.89% 1S.S9%
S & T Bancoip 2.7u 9.uu% 2S.69% 16.62%
0mpqua Boluings
Coipoiation u.68 1u.uu% Su.42% S.11%
NB Finl Inc 1.u7 12.uu% 2S.Su% 7.19%
PiivateBancoip Inc 2.17 1S.6u% 41.uS% 2.S7%
Pinnacle Financial
Pitneis Inc 1.S4 16.uu% SS.69% 4.9S%
0CBB Blugs Inc u.61 24.SS% 77.2S% 11.SS%
While the relationship between price to book ratios and returns on equity is weaker for
this sample than it is for commercial banks, higher price to book value ratios tend to go
with higher returns on equity. Since the assumption about all banks being equally risky
was put to the test during this period, we used the standard deviation in stock price as a
proxy for this risk. Regressing the price to book ratios against the return on equity and
standard deviation yields the following:

Price to Book Ratio = 1.527 + 8.63 (Return on Equity) -2.63 ("
Stock price
) R
= 31%
(2.94) (1.93) (2.36)
Using this regression yields predicted price to book ratios for any firm in the sample. For
instance, the predicted price to book ratio for Tompkins Financial, which at 2.75 times
book value of equity looks expensive, would be:
Predicted P/BV for Tompkins Financial = 1.527 + 8.63 (0.1338) – 2.63 (0.2789)= 1.95
Based on how other small banks are priced, Tompkins looks over valued by about 30%.
Va|ue Þ|ays
Investing in financial seivice companies has histoiically been vieweu as a
conseivative stiategy foi investois who want high uiviuenus anu piefei piice
stability. In effect, investois maue a baigain, wheie they accepteu the absence of
tianspaiency anu uifficulties in estimating cash flows in ietuin foi a iegulatoiy
oveilay that pioviueu constiaints on wheie these fiims investeu anu how much iisk
they took. Implicitly, they assumeu that iegulatois woulu pievent banks anu
insuiance companies fiom taking on too much iisk in theii opeiations. The last few
yeais have stiippeu this illusion away, exposing investois to significant iisks even
when investing in laige banks, investment
When investing in financial seivice fiims touay, success iequiies a stiategy
that goes beyonu looking at the uiviuenu yielu anu the cuiient eainings. While the
actual loans anu investments maue by these fiims aie still beyonu oui puiview, we
can look at the following:
1. Regulatoiy buffeis: While iegulatoiy authoiities impose capital
iequiiements foi financial seivice fiims, these iequiiements iepiesent a
flooi anu banks anu insuiance companies can set theii actual oi taiget iatios
above this flooi. 0ne measuie of safety in a bank is how much of a buffei that
bank has in its capital iatios. Thus, a bank with a iegulatoiy capital iatio of
12% can be vieweu as safei than one with a iegulatoiy capital iatio of 8%.

With 18 fiims in the sample, we aie pushing the limits of allowable inuepenuent vaiiables, with
two. A laigei sample will pioviue moie piecision.
2. Risk in assets: While capital iatios aie one half of the iisk equation, the types
of assets that aie helu by the financial seivice fiim iepiesent the othei half.
Theie is moie iisk in investing in the equity of a bank that specializes in
lenuing to entities with pooi cieuit histoiies oi an insuiance company that
seeks out anu insuies high iisk inuiviuuals.
S. Tianspaiency: Some financial seivice fiims aie moie foithcoming in
pioviuing infoimation both about theii iegulatoiy capital holuings anu the
iisk in theii assets than otheis. To the extent that withhelu infoimation is
likely to contain moie bau news than goou, investing in moie tianspaient
companies is a goou stiategy.
4. Significant iestiictions on new entiants into the business: Like companies in
any othei business, banks, investment banks anu insuiance companies
geneiate highei ietuins on equity foi theii investois when theie aie
significant baiiieis to entiy into that business. Foi instance, iestiictions on
foieign banks inflate the eainings at many emeiging maiket banks anu make
them moie attiactive investments.
In summaiy, then, you woulu like to invest in financial seivice fiims that not only
uelivei high uiviuenus, but also geneiate significant ietuins on equity fiom an asset
base that is not abnoimally iisky, while pieseiving a laige iegulatoiy capital buffei.
The basic principles of valuation apply just as much for financial service firms as
they do for other firms. There are, however, a few aspects relating to financial service
firms that can affect how they are valued. The first is that debt, for a financial service
firm, is difficult to define and measure, making it difficult to estimate firm value or costs
of capital. Consequently, it is far easier to value the equity directly in a financial service
firm, by discounting cash flows to equity at the cost of equity. The second is that capital
expenditures and working capital, which are required inputs to estimating cash flows, are
often not easily estimated at financial service firms. In fact, much of the reinvestment that
occurs at these firms is categorized under operating expenses. To estimate cashflows to
equity, therefore, we either have to use dividends (and assume that what is not paid out as
dividend is the reinvestment) or modify our definition of reinvestment.
Even if we choose to use multiples, we run into many of the same issues. The
difficulties associated with defining debt make equity multiples such as price earnings or
price to book value ratios better suited for comparing financial service firms than value
multiples. In making these comparisons, we have to control for differences in
fundamentals – risk, growth, cash flows, loan quality – that affect value.
Finally, regulatory considerations and constraints overlay financial firm
valuations. In some cases, regulatory restrictions on competition allow financial service
firms to earn excess returns and increase value. In other case, the same regulatory
authorities may restrict the potential excess returns that a firm may be able to make by
preventing the firm from entering a business.
Chapter 10: Va|u|ng Cyc||ca| and Commod|ty Compan|es
0nceitainty anu volatility aie enuemic to valuation, but cyclical anu
commouity companies have volatility thiust upon them by exteinal factois - the ups
anu uowns of the economy with cyclical companies, anu movements in commouity
piices with commouity companies. As a consequence, even matuie cyclical anu
commouity companies have volatile eainings anu cash flows. When valuing these
companies, the uangei of focusing on the most iecent fiscal yeai is that the iesulting
valuation will uepenu in gieat pait on wheie in the cycle (economic oi commouity
piice) that yeai fell. If the most iecent yeai was a boom (uown) yeai, the value will
be high (low).
What makes commod|ty and cyc||ca| compan|es d|fferent?
Theie aie two gioups of companies that we look at in this chaptei. The fiist
gioup incluues cyclical companies, i.e., companies whose foitunes iest in laige pait
on how the economy is uoing. Theie aie two ways of iuentifying these fiims. The
fiist is to categoiize inuustiy sectois into cyclical anu non-cyclical, baseu on
histoiical peifoimance, anu to assume that all fiims in the sectoi shaie the same
chaiacteiistics. Foi instance, the housing anu automobile sectois have histoiically
been consiueieu to be cyclical, anu all fiims in these sectois will shaie that label.
While the appioach is low-cost anu simple, we iun the iisk of taiiing all fiims in a
sectoi with the same biush; thus Walmait anu Abeicombie & Fitch woulu both be
categoiizeu as cyclical fiims because they aie in the ietailing business. The seconu is
to look at a company's own histoiy, in conjunction with oveiall economic
peifoimance, to make a categoiization. Thus, a company that has histoiically
iepoiteu lowei eainings¡ievenues uuiing economic uowntuins anu highei
eainings¡ievenues uuiing economic boom times woulu be vieweu as cyclical.
The seconu gioup of companies aie commouity companies that ueiive theii
eainings fiom piouucing commouities that may become inputs to othei companies
in the economy (oil, iion oie) oi be uesiieu as investments in theii own iight (golu,
platinum, uiamonus). We can categoiize commouity companies into thiee gioups.
The fiist gioup has piouucts that aie inputs to othei businesses, but aie not
consumeu by the geneial public; incluueu in this gioup woulu be mining companies
like vale, Rio Tinto anu BBP Billiton. The seconu gioup geneiates output that is
maiketeu to consumeis, though theie may othei inteimeuiaiies involveu in the
piocess; in this gioup woulu be most of the foou anu giains companies. The thiiu
gioup incluues fiims whose output seives both othei businesses anu consumeis;
the oil anu natuial gas businesses come to minu but golu mining companies can also
be consiueieu pait of this gioup.
Character|st|cs of commod|ty & cyc||ca| f|rms
While commouity companies can iange the spectium fiom foou giains to
piecious metals anu cyclical fiims can be in uiveise businesses, they uo shaie some
common factois that can affect both how we view them anu the values we assign to
1. The Economic¡Commouity piice cycle: Cyclical companies aie at the meicy
of the economic cycle. While it is tiue that goou management anu the iight
stiategic anu business choices can make some cyclical fiims less exposeu to
movements in the economy, the ouus aie high that all cyclical companies will
see ievenues ueciease in the face of a significant economic uowntuin. 0nlike
fiims in many othei businesses, commouity companies aie, foi the most pait,
piice takeis. In othei woius, even the laigest oil companies have to sell theii
output at the pievailing maiket piice. Not suipiisingly, the ievenues of
commouity companies will be heavily impacteu by the commouity piice. In
fact, as commouity companies matuie anu output levels off, almost all of the
vaiiance in ievenues can be tiaceu to wheie we aie in the commouity piice
cycle. When commouity piices aie on the upswing, all companies that
piouuce that commouity benefit, wheieas uuiing a uowntuin, even the best
companies in the business will see the effects on opeiations.
2. Finite iesouices: With commouity companies, theie is one final shaieu
chaiacteiistic. Theie is a finite quantity of natuial iesouices on the planet; if
oil piices inciease, we can exploie foi moie oil but we cannot cieate oil.
When valuing commouity companies, this will not only play a iole in what
oui foiecasts of futuie commouity piices will be but may also opeiate as a
constiaint on oui noimal piactice of assuming peipetual giowth (in oui
teiminal value computations).
In summaiy, then, when valuing commouity anu cyclical companies, we have to
giapple with the consequences of economic anu commouity piice cycles anu how
shifts in these cycles will affect ievenues anu eainings. We also have to come up
with ways of uealing with the possibility of uistiess, inuuceu not by bau
management uecisions oi fiim specific choices, but by macio economic foices.
Va|uat|on Issues
1. volatile eainings anu cash flows: The volatility in ievenues at cyclical anu
commouity companies will be magnifieu at the opeiating income level
because these companies tenu to have high opeiating leveiage (high fixeu
costs). Thus, commouity companies may have to keep mines (mining),
ieseives (oil) anu fielus (agiicultuial) opeiating even uuiing low points in
piice cycles, because the costs of shutting uown anu ieopening opeiations
can be piohibitive.
2. volatility in eainings flows into volatility in equity values anu uebt iatios:
While this uoes not have to apply foi all cyclical anu commouity companies,
the laige infiastiuctuie investments that aie neeueu to get these fiims
staiteu has leu many of them to be significant useis of uebt financing. Thus,
the volatility in opeiating income that we iefeienceu eailiei, manifests itself
in even gieatei swing in net income.
S. Even the healthiest fiims can be put at iisk if macio move is veiy negative:
Builuing on the theme that cyclical anu commouity companies aie exposeu to
cyclical iisk ovei which they have little contiol anu that this iisk can be
magnifieu as we move uown the income statement, iesulting in high volatility
in net income, even foi the healthiest anu most matuie fiims in the sectoi, it
is easy to see why we have to be moie conceineu about uistiess anu suivival
with cyclical anu commouity fiims than with most otheis. An extenueu
economic uowntuin oi a lengthy phase of low commouity piices can put
most of these companies at iisk.
Va|uat|on So|ut|ons
If volatility in eainings is a given at cyclical anu commouity companies, anu
foiecasting the cycles that the cause the volatility is often impossible to uo, how can
we value such companies. In this section, we will examine healthy iesponses to the
volatility in the valuation of these companies.
Intr|ns|c Va|uat|on
In chaptei 2, we noteu that the uiscounteu cash flow value of a company iests
on foui inputs - eainings anu cash flows fiom existing assets, the giowth in these
cash flows in the neai teim, a juugment on when the company will become matuie
anu a uiscount iate to apply to the cash flows. 0sing this fiamewoik, we will uevelop
two ways of auapting uiscounteu cash flow valuations foi cyclical anu commouity
companies. In the fiist, we will noimalize oui estimates foi all foui of these inputs,
using noimalizeu cash flows, giowth iates anu uiscount iates to estimate a
noimalizeu value foi a fiim. In the seconu, we will tiy to aujust the giowth iate in
the cash flows to ieflect wheie we aie in the cycle - setting it to low oi even
negative values at the peak of a cycle (ieflecting the expectation that eainings will
uecline in the futuie) anu high values at the bottom of a cycle.
Q-4#)%"W&7 ;)%1)2"-0*
The easiest way to value cyclical anu commouity companies is to look past
the yeai-to-yeai swings in eainings anu cash flows anu to look foi a smootheu out
numbeiunueineath. In this section, we will begin by uefining what compiises a
noimal value fiist anu then consiuei uiffeient techniques that can be useu to
estimate this numbei.
WhaL are normal numbers?
If the cuiient financial statements of a company answei the questions we
have about how much a company eaineu, ieinvesteu anu geneiateu as cash flows in
the most iecent peiiou, the noimalizeu veisions of these numbeis woulu answei a
uiffeient question: Bow much eainings, ieinvestment anu cash flow woulu this
company have geneiateu in a noimal yeai.
If we aie talking about cyclical companies, a noimal yeai woulu be one that
iepiesents the miu-point of the cycle, wheie the numbeis aie neithei puffeu up noi
ueflateu by economic conuitions. With commouity companies, a noimal yeai woulu
be one wheie commouity piices ieflect the intiinsic piice of the commouity,
ieflecting the unueilying uemanu anu supply. Each of these uefinitions conveys the
subjective component to this piocess, since two analysts looking at the same
economy oi commouity can make veiy uiffeient juugments on what is noimal.
Measurlng normallzed values for cycllcal companles
If we accept the pioposition that noimalizeu eainings anu cash flows have a
subjective component to them, we can begin to lay out pioceuuies foi estimating
them foi inuiviuual companies. With cyclical companies, theie aie usually thiee
stanuaiu techniques that aie employeu foi noimalizing eainings anu cash flows:
1.Absolute aveiage ovei time: The most common appioach useu to noimalize
numbeis is to aveiage them ovei time, though ovei what peiiou iemains in uispute.
At least in theoiy, the aveiaging shoulu occui ovei a peiiou long enough to covei an
entiie cycle. In chaptei 8, we noteu that economic cycles, even in matuie economies
like the 0niteu States, can iange fiom shoit peiious (2-S yeais) to veiy long ones
(moie than 1u yeais). The auvantage of the appioach is its simplicity. The
uisauvantage is that the use of absolute numbeis ovei time can leau to noimalizeu
values being misestimateu foi any fiim that changeu its size ovei the noimalization
peiiou. In othei woius, using the aveiage eainings ovei the last S yeais as the
noimalizeu eainings foi a fiim that uoubleu its ievenues ovei that peiiou will
unueistate the tiue eainings.
2. Relative aveiage ovei time: A simple solution to the scaling pioblem is to compute
aveiages foi a scaleu veision of the vaiiable ovei time. In effect, we can aveiage
piofit maigins ovei time, insteau of net piofits, anu apply the aveiage piofit maigin
to ievenues in the most iecent peiiou to estimate noimalizeu eainings. We can
employ the same tactics with capital expenuituies anu woiking capital, by looking at
iatios of ievenue oi book capital ovei time, iathei than the absolute values.
S. Sectoi aveiages: In the fiist two appioaches to noimalization, we aie uepenuent
upon the company having a long histoiy. Foi cyclical fiims with limiteu histoiy oi a
histoiy of opeiating changes, it may make moie sense to look at sectoi aveiages to
noimalize. Thus, we will compute opeiating maigins foi all steel companies acioss
the cycle anu use the aveiage maigin to estimate opeiating income foi an inuiviuual
steel company. The biggest auvantage of the appioach is that sectoi maigins tenu to
be less volatile than inuiviuual company maigins, but this appioach will also fail to
incoipoiate the chaiacteiistics (opeiating efficiencies oi inefficiencies) that may
leau a fiim to be uiffeient fiom the iest of the sectoi.
Illustration 10.1: Valuing Toyota – Normalized Earnings
By most accounts in eaily 2uu9, Toyota was consiueieu the best-iun
automobile company in the woilu. Bowevei, the fiim was not immune to the ebbs
anu flows of the global economy anu iepoiteu a loss in the last quaitei of 2uu8, a
piecuisoi to much lowei anu peihaps negative eainings in its 2uu8-2uu9 fiscal yeai
(stietching fiom Apiil 2uu8 to Naich 2uu9).
To noimalize Toyota's opeiating income, we look at its opeiating
peifoimance fiom 1998 to 2uu8 in table 1u.1:
P":/- K\4K5 P*'*&"k8 g,-)"&%#( H-);*)."#9- V KGGj@3\\G M%# .%//%*#8 *; E-#N
Yeai Revenues
FY1 1998 Y11,678,4uu Y779,8uu Y1,S82,9Su 6.68% 11.84%
FY1 1999 Y12,749,u1u Y774,947 Y1,41S,997 6.u8% 11.11%
FY1 2uuu Y12,879,S6u Y77S,982 Y1,4Su,982 6.u2% 11.11%
FY1 2uu1 Y1S,424,42u Y87u,1S1 Y1,S42,6S1 6.48% 11.49%
FY1 2uu2 Y1S,1u6,Suu Y1,12S,47S Y1,822,97S 7.44% 12.u7%
FY1 2uuS Y16,uS4,29u Y1,S6S,68u Y2,1u1,78u 8.49% 1S.u9%
FY1 2uu4 Y17,294,76u Y1,666,894 Y2,4S4,994 9.64% 14.2u%
FY1 2uuS Y18,SS1,SSu Y1,672,187 Y2,447,987 9.u1% 1S.2u%
FY1 2uu6 Y21,uS6,91u Y1,878,S42 Y2,769,742 8.9S% 1S.17%
FY1 2uu7 Y2S,948,u9u Y2,2S8,68S YS,18S,68S 9.SS% 1S.Su%
FY1 2uu8 Y26,289,24u Y2,27u,S7S YS,S12,77S 8.64% 12.6u%
FY 2uu9
(Est) Y22,661,S2S Y267,9u4 Y1,S1u,Su4 1.18% S.78%
Aveiage Y1,Su6,867 7.SS%
Each yeai, we iepoit the opeiating income oi loss, the EBITBA anu the maigins
ielative to ievenues. We consiueieu thiee uiffeient noimalization techniques:
• Aveiage income: Aveiaging the opeiating income fiom 1998 to 2uu9 yielus
an value of 1,SS2.9 billion yen. Since the ievenues ovei the peiiou moie than
uoubleu, this will unueistate the noimalizeu opeiating income foi the fiim.
• Inuustiy aveiage maigin: The aveiage pie-tax opeiating maigin of
automobile fiims (global) ovei the same time peiiou (1998-2uu8) is about
6%. In 2uu9, howevei, many of these fiims weie in fai woise shape than
Toyota anu many aie likely to iepoit laige losses. While we coulu apply the
inuustiy aveiage maigin to Toyota's 2uu9 ievenues to estimate a noimalizeu
opeiating income (6% of 22,661 billion yen=1,S6u billion yen), this will also
unueistate the noimalizeu opeiating income, since it will not ieflect the fact
that Toyota has been among the most piofitable fiims in the sectoi.
• Bistoiical maigin: Aveiaging the pie-tax opeiating maigin fiom 1998 to
2uu9 yielus an aveiage opeiating maigin of 7.SS%. Applying this maigin to
the ievenues in 2uu9 yielus a noimalizeu opeiating income of 1,66u.7 billion
yen (7.SS% of 22,661 billion yen), an estimate that captuies both the laigei
scale of the fiim touay anu its success in this business. We will use this value
as oui noimalizeu opeiating income.
To value the fiim, we will also make the following assumptions.
• To estimate Toyota's cost of equity, we will use a bottom up beta (estimateu
fiom the automobile sectoi) of 1.1u. 0sing the ten-yeai }apanese yen
goveinment bonu iate of 1.Su% as the iiskfiee iate anu an equity iisk
piemium of 6.S%, we compute a cost of equity of 8.6S%.

Cost of equity = Riskfiee iate + Beta * Equity Risk Piemium
= 1.Su% + 1.1u (6.S%) = 8.6S%

We aie using a matuie maiket equity iisk piemium of 6.S% foi Toyota. An aigument can be maue
that we shoulu be auuing a countiy iisk piemium to ieflect Toyota's sales exposuie in emeiging
maikets in Asia anu Latin Ameiica.
• In eaily 2uu9, Toyota hau 11,862 billion yen in uebt outstanuing anu the
maiket value of equity foi the fiim was 1u,SS1 billion (S.448 billion shaies
outstanuing at Su6u Yen¡shaie). 0sing a iating of AA anu an associateu
uefault spieau of 1.7S% ovei the iiskfiee iate, we estimateu a pie-tax cost of
uebt of S.2S%. Assuming that the cuiient uebt iatio is a sustainable one, we
estimate a cost of capital of S.u9%; the maiginal tax iate foi }apan in 2uu9
was 4u.7%.
Bebt Ratio = 11,862¡ (11,862+ 1u,SS1) = S2.9%
Cost of capital = 8.6S% (.471) + S.2S% (1-.4u7) (.S29) = S.u9%
We uiu examine the cost of capital foi Toyota ovei time, anu since neithei the
uebt iatio noi the cost of capital has moveu substantially ovei time, we will
use this as the noimalizeu cost of capital.
• Since Toyota is alieauy the laigest automobile fiim in the woilu, in teims of
maiket shaie, we will assume that the fiim is in stable giowth, giowing at
1.Su% (cappeu at the iiskfiee iate) in peipetuity. We will also assume that
the fiim will be able to geneiate a ietuin on capital equal to its cost of capital
on its investments.
The ieinvestment iate that emeiges fiom these two
assumptions is 29.46%:
Stable peiiou ieinvestment iate =
= .2946
Biinging togethei the noimalizeu opeiating income (1,66u.7 billion yen), the
maiginal tax iate foi }apan (4u.7%), the ieinvestment iate (29.46%), the stable
giowth iate of 1.S% anu the cost of capital of S.u9%, we can estimate the value of
the opeiating assets at Toyota:
value0peiating Assets =
Operating Income (1+g) (1- tax rate) (1- Reinvestment Rate)
(Cost of capital - g)

1660.7 (1.015) (1- .407) (1- .2946)
(.0509 - .015)
= 19,64u billion Yen

0ui ieasoning was as follows. By most inuicatois, Toyota is the most efficiently iun automobile
fiim. We aie assuming that it will not geneiate excess ietuins but will be able to bieak even. In fact,
the ietuin on capital that we computeu baseu on the noimalizeu income anu the capital investeu at
the enu of 2uu8 was 4.98%, veiy close to the estimateu value of S.u9%.
Auuing in cash (2,288 billion Yen) anu non-opeiating assets (6,84S billion Yen),
subtiacting out uebt (11,862 billion Yen) anu minoiity inteiests in consoliuateu
subsiuiaiies (S8S billion Yen), anu uiviuing by the numbei of shaies (S.448 billion)
yielus a value pei shaie of 47SS yen¡shaie.

value pei shaie
Operating Assets + Cash + Non - operating Assets - Debt - Minority Interest
Number of shares

19640 + 2288 + 6845 - 11862 - 583
= 4735 Yen/share
Baseu on the noimalizeu income, Toyota looks significantly unueivalueu at its stock
piice of Su6u yen pei shaie in eaily 2uu9.
Measurlng normallzed earnlngs for commodlLy companles
With commouity companies, the vaiiable that causes the volatility is the
piice of the commouity. As it moves up anu uown, it not only impacts ievenues anu
eainings but also ieinvestment anu financing costs. Consequently, noimalization
with commouity companies has to be built aiounu a noimalizeu commouity piice.
NotmollzeJ commoJlty ptlces
What is a noimalizeu piice foi oil. 0i golu. Theie aie two ways of answeiing
this question.
• 0ne is to look at histoiy. Commouities have a long tiauing histoiy anu we can
use the histoiical piice uata to come up with an aveiage, which we can then
aujust foi inflation. Implicitly, we aie assuming that the aveiage inflation-
aujusteu piice ovei a long peiiou of histoiy is the best estimate of the
noimalizeu piice.
• The othei appioach is moie complicateu. Since the piice of a commouity is a
function of uemanu anu supply foi that commouity, we can assess (oi at least

The non-opeiating assets incluue maiketable secuiities anu holuings in othei companies. Absent
uetaileu infoimation, we aie assuming that the book value of these assets is the maiket value. The
minoiity inteiests aie also taken at book value, but the amount is small enough that using a maiket
value woulu have maue little uiffeience in oui final value pei shaie.
tiy to assess the ueteiminants of that uemanu anu supply) anu tiy to come
up with an intiinsic value foi the commouity.
0nce we have noimalizeu the piice of the commouity, we can then assess what the
ievenues, eainings anu cashflows woulu have been foi the company being valueu at
that noimalizeu piice. With ievenues anu eainings, this may just iequiie
multiplying the numbei of units solu at the noimalizeu piice anu making ieasonable
assumptions about costs. With ieinvestment anu cost of financing, it will iequiie
some subjective juugments on how much (if any) the ieinvestment anu cost of
funuing numbeis woulu have changeu at the noimalizeu piice.
Motket-boseJ fotecosts
0sing a noimalizeu commouity piice to value a commouity company uoes
expose us to the ciitique that the valuations we obtain will ieflect oui commouity
piice views as much as they uo oui views on the company. Foi instance, assume that
the cuiient oil piice is $4S anu that we use a noimalizeu oil piice of $1uu to value
an oil company. We aie likely to finu the company to be unueivalueu, simply
because of oui view about the noimalizeu oil piice. If we want to iemove oui views
of commouity piices fiom valuations of commouity companies, the safest way to uo
this is to use maiket-baseu piices foi the commouity in oui foiecasts. Since most
commouities have foiwaiu anu futuies maikets, we can use the piices foi these
maikets to estimate cash flows in the next few yeais. Foi an oil company, then, we
will use touay's oil piices to estimate cash flows foi the cuiient yeai anu the
expecteu oil piices (fiom the foiwaiu anu futuies maikets) to estimate expecteu
cash flows in futuie peiious.
The auvantage of this appioach is that it comes with a built-in mechanism foi
heuging against commouity piice iisk. An investoi who believes that a company is
unuei valueu but is shaky on what will happen to commouity piices in the futuie
can buy stock in the company anu sell oil piice futuies to piotect heiself against
auveise piice movements.
Illustration 10.2: Valuing Exxon Mobil – Normalized commodity prices
Exxon Nobil may be the laigest of the oil companies, with uiveisifieu
opeiations in multiple locations, but it is as uepenuent upon oil piices as the iest of
the companies in its sectoi. In figuie 1u.1, we giaph Exxon's opeiating income as a
function of the aveiage oil piice each yeai fiom 198S to 2uu8.
2%($)- K\4K5 g,-)"&%#( R#9*.- <-)8$8 g%/ H)%9-8 ;*) O==*# Q*:%/5 KGjU@3\\j

The opeiating income cleaily incieases (uecieases) as the oil piice incieases
(uecieases). We iegiesseu the opeiating income against the oil piice pei baiiel ovei
the peiiou anu obtaineu the following:
0peiating Income = -6,S9S + 911.S2 (Aveiage 0il Piice) R
= 9u.2%
(2.9S) (14.S9)
Put anothei way, Exxon Nobil's opeiating income incieases about $9.11 billion foi
eveiy $ 1u inciease in the piice pei baiiel of oil anu 9u% of the vaiiation in Exxon's
eainings ovei time comes fiom movements in oil piices.

To get fiom opeiating income to equity value at Exxon, we maue the
following assumptions:
• We estimateu a bottom-up beta of u.9u foi Exxon Nobil, anu then useu the
tieasuiy bonu iate of 2.S% anu an equity iisk piemium of 6.S% to estimate a
cost of equity.
Cost of equity = 2.S% + u.9u (6.S%) = 8.SS%
Exxon has $9.4 billion of uebt outstanuing anu a maiket capitalization of $S2u.4
billion (4941.6S million shaies, tiauing at $64.8S¡shaie), iesulting in a uebt
iatio of 2.8S%. As a AAA iateu company, its cost of uebt is expecteu to be S.7S%,
ieflecting a uefault spieau of 1.2S% ovei the iisk fiee iate. 0sing a maiginal tax
iate of S8% (iathei than the effective tax iate), we estimate a cost of capital of
8.18% foi the fiim.
Cost of capital = 8.SS% (.971S) + S.7S% (1-.S8) (.u28S) = 8.18%
• Exxon Nobil is in stable giowth with the opeiating income giowing at 2% a yeai
in peipetuity. New investments aie expecteu to geneiate a ietuin on capital that
ieflects the noimalizeu opeiating income anu cuiient capital investeu; this
ietuin on capital is useu to compute a ieinvestment iate.
Exxon iepoiteu pie-tax opeiating income in excess of $6u billion in 2uu8, but that
ieflects the fact that the aveiage oil piice uuiing the yeai was $86.SS. By Naich
2uu9, the piice pei baiiel of oil hau uioppeu to $ 4S anu the opeiating income foi
the coming yeai will be much lowei. 0sing the iegiession iesults, the expecteu
opeiating income at this oil piice is $S4,614 billion:
Noimalizeu 0peiating Income = -6,S9S + 911.S2 ($4S) = $S4,614
This opeiating income tianslates into a ietuin on capital of appioximately 21% anu
a ieinvestment iate of 9.S2%, baseu upon a 2% giowth iate.

The ielationship is veiy stiong at Exxon because it has been a laige anu stable fiim foi uecaues. It
is likely that the ielationship between eainings anu oil piices will be weakei at smallei, evolving oil
Reinvestment Rate = g¡ R0C = 2¡21% = 9.S2%
value of 0peiating Assets
Operating Income (1+g) (1- tax rate) (1-
(Cost of capital - g)

34614 (1.02) (1- .38) (1-
(.0818 - .02)
= $320, 472 million

Auuing the cuiient cash balance ($S2,uu7 million), subtiacting out uebt ($9,4uu
million) anu uiviuing by the numbei of shaies (4,941.6S million) yielus the value pei
value pei shaie =
Operating Assets + Cash - Debt
Number of shares

320472 + 32007 - 9400
= $69.43/ share
At its cuiient stock piice of $64.8S, the stock looks slightly unuei valueu. Bowevei,
that ieflects the assumption that the cuiient oil piice (of $4S) is the noimalizeu
piice. In figuie 1u.2, we giaph out the value of Exxon Nobil as a function of the
noimalizeu oil piice:

To compute the ietuin on capital, we aggiegateu the book value of equity ($126,u44 million), the
book value of uebt ($9,S66 million) anu netteu out cash ($SS,981 million) fiom the enu of 2uu7, to
aiiive at an investeu capital value of $1u1,629 million. The ietuin on capital is computeu as follows:
Retuin on capital = 0peiating Income (1-tax iate)¡ Investeu Capital = S4614 (1-.S8)¡1u1629 =
2%($)- K\435 _*)."/%`-0 g%/ ,)%9- "#0 L"/$- ,-) C1")- VO==*# Q*:%/

As the oil piice changes, the opeiating income anu the ietuin on capital change; we
keep the capital investeu numbei fixeu at $1u,629 million anu ie-estimate the
ietuin on capital with the estimateu opeiating income. If the noimalizeu oil piice is
$42.S2, the value pei shaie is $64.8S, equal to the cuiient stock piice. Put anothei
way, any investoi who believes that the oil piice will stabilize above this level will
finu Exxon Nobil to be unuei valueu.
/7)$2"A& 34-.2+
0ne of the peiils of noimalization, no mattei what appioach you use, is that
we aie ieplacing the cuiient numbeis of a company with what we believe the
company will geneiate as eainings anu cash flows, if the cycle iights itself. Since
cycles can last foi long peiious, the uangei is that noimalization, even if waiianteu,
may be a long time coming. 0ne compiomise solution is to assume noimalization in
the long teim, but to allow eainings to follow the cuiient cycle foi the shoit teim,
anu to use the giowth iate as a mechanism to biing us back to noimalcy.
Consiuei fiist the case of a cyclical company, with the economy miieu in
iecession, oi a commouity company, when the piice is at the low point on the cycle.
The eainings will be negative oi low in the most iecent time peiiou anu may get
woise befoie it gets bettei. We can allow foi the ueteiioiation, by loweiing
ievenues, eainings anu cash flows in the neai teim (the fiist yeai) anu foi the
impiovement by allowing foi highei ievenue giowth anu impioveu maigins in the
meuium teim, as the company takes auvantage of the economic cycle. With a cyclical
company at the peak of the economic cycle oi a commouity company when
commouity companies have peakeu, we ieveise the piocess, allowing foi shoit-teim
piospeiity fiom the cycle, befoie ieuucing ievenues anu piofit maigins as the cycle
ieveits back to histoiic noims.
In effect, we aie splitting the uiffeience between noimalization anu
foiecasting the cycle. We aie assuming that we have enough infoimation to foiecast
how the economic oi commouity piice cycle will play out in the shoit teim (next 6
months to a couple of yeais) but that we uo not have to capacity to foiecast it in the
long teim. 0sing the noimalizeu numbeis as oui long-teim taigets, we estimate the
iest of the numbeis.
Illustration 10.3: Valuing Toyota with adaptive growth
In illustiation 1S.S, we valueu Toyota, using noimalizeu eainings anu aiiiveu
at a value pei shaie of 47SS Yen¡shaie. Implicit in this valuation, howevei, is the
assumption that while Toyota's eainings have been huit by the economic slowuown
that began in 2uu8, they will bounce back veiy quickly to pie-iecession levels. To
the extent that the iecession that staiteu in Septembei 2uu8 was vieweu as ueepei
anu potentially longei-lasting than othei iecessions, we will ovei value the equity as
a consequence.
To geneiate a moie iealistic estimate of the value of equity, we staiteu with
the assumption that the ievenues in the next financial yeai (Apiil 2uu9 - Naich
2u1u) woulu uecline 1u% anu be accompanieu by opeiating losses, anu that the
iecoveiy woulu giauually begin the following yeai befoie picking up steam in the
thiiu yeai. In yeai 4, we will assume that Toyota will ieach the stable state that we
assumeu in illustiation 1u.1 - eaining its histoiical aveiage opeiating maigin of
7.SS% on ievenues anu geneiating a ietuin on capital of S.u9% (equal to the cost of
capital). Table 1u.2 summaiizes the yeai-by-yeai estimates of ievenues, opeiating
income anu cash flows foi the next S yeais anu foi the teiminal yeai (yeai 4):
P":/- K\435 O=,-9&-0 2)-- >"81 2/*+ &* 2%). V P*'*&"
Cuiient 1 2 S Teiminal yeai
Revenue giowth iate -1u% 4% 8% 1.Su%
Revenues Y22,661 Y2u,S9S Y21,211 Y22,9u8 Y2S,2S1
0peiating Naigin 1.18% -S% 1% 4% 7.SS%
0peiating Income Y268 -Y612 Y212 Y916 Y1,7u4
Taxes Y9S Yu Yu Y2uS Y694
Aftei-tax 0peiating Income Y17S -Y612 Y212 Y714 Y1,u11
- Reinvestment -Y79 -Y2uu YSuu Y4uu Y298
FCFF Y2S4 -Y412 -Y88 YS14 Y71S
Teiminal value Y19,8S6
Piesent value -YS92 -Y8u Y17,S78

Capital Investeu Y14,94S Y14,74S Y1S,u4S Y1S,44S
Retuin on Capital 1.79% -4.1S% 1.41% S.9S% S.u9%

Tax iate S4.7S% S6.22% S7.72% S9.21% 4u.7u%
N0L Y611.8S YS99.74
Cost of capital S.u9% S.u9% S.u9% S.u9% S.u9%

value of 0peiating Assets = Y16,9u7
+ Cash & 0thei non-opeiating assets Y9,1SS
- Bebt Y11,862
- Ninoiity Inteiest YS8S
value of Equity = Y1S,S9S
value pei shaie = YS,94S
Capital investeut = Capital investeut-1 + Reinvestmentt
Theie aie seveial things to note about the piojections. The fiist is that ievenue
giowth is negative in yeai 1, but bounces back shaiply in yeais 2 anu S, ieflecting
the climb back to noimalcy. The seconu is that the opeiating loss that we foiecast
foi yeai 1 cieates a Net 0peiating Loss (N0L) caiiy foiwaiu that shelteis the fiim
entiiely fiom taxes in yeai 2 anu paitially in yeai S; the tax iate also climbs fiom the
cuiient effective iate of S4.7S% to the maiginal iate of 4u.7% in yeai 4. The thiiu is
that Toyota pulls back fiom ieinvesting in the fiist yeai, but ietuins stiongly to
ieinvest (again making up foi lost giounu) in yeais 2 anu S, befoie settling into its
steauy state ieinvestment iate of 29.46%.
Stable peiiou ieinvestment iate =
= .2946
We keep the cost of capital unchangeu at S.u9% ovei the peiiou, anu the piesent
value of the cash flows ovei the next S yeais anu the teiminal value yielus a value
foi the opeiating assets of 16,9u7 billion Yen. Naking the iuentical aujustments foi
cash, non-opeiating assets, uebt anu minoiity inteiests that we useu in illustiation
1u.1, we estimate a value of equity pei shaie of S,94S Yen. While this is lowei than
47SS Yen pei shaie we estimateu, with instant noimalization, it is still significantly
highei than the piice pei shaie of S,u6u Yen in Febiuaiy 2uu9.
ke|at|ve Va|uat|on
The two basic appioaches that we uevelopeu in the uiscounteu cash flow
appioach -using noimalizeu eainings oi auapting the giowth iate - aie also the
appioaches we have foi making ielative valuation woik with cyclical anu
commouity companies.
Q-4#)%"W&7 F)40"05* N1%2"$%&*
If the noimalizeu eainings foi a cyclical oi commouity fiim ieflect what it can
make in a noimal yeai, theie has to be consistency in the way the maiket values
companies ielative to these noimalizeu eainings. In the extieme case, wheie theie
aie no giowth anu iisk uiffeiences acioss fiims, all fiims shoulu tiaue at the same
multiple of noimalizeu eainings. In effect, the PE iatios foi these fiims, with
noimalizeu eainings pei shaie, shoulu be iuentical acioss fiims.
In the moie geneial case, wheie giowth anu iisk uiffeiences peisist even
aftei noimalization, we woulu expect to see uiffeiences in the multiples that
companies tiaue at. In paiticulai, we shoulu expect to see fiims that have moie iisky
eainings tiaue at lowei multiples of noimalizeu eainings than fiims with moie
stable eainings. We woulu also expect to see fiims that have highei giowth potential
tiaue at highei multiples of noimalizeu eainings than fiims with lowei giowth
potential. To pioviue a conciete illustiation, Petiobias anu Exxon Nobil aie both oil
companies whose eainings aie affecteu by the piice of oil. Even if we noimalize
eainings, thus contiolling foi the piice of oil, Petiobias shoulu tiaue at a uiffeient
multiple of eainings than Exxon Nobil, because its eainings aie iiskiei (because
they aie ueiiveu almost entiiely fiom Biazilian ieseives) anu also because it has
highei giowth potential.
/7)$2"A& ?107)#&02)%*
Foi those analysts who aie ieluctant to ieplace the cuiient opeiating
numbeis of a company with noimalizeu values, the multiples at which cyclical anu
commouity fiims tiaue at will change as we move thiough the cycle. In paiticulai,
the multiples of eainings foi cyclical anu commouity fiims will bottom out at the
peak of the cycle anu be highest at the bottom of the cycle. While this may seem
countei intuitive, it ieflects the fact that maikets have to value these companies foi
the long teim,
If the eainings of all companies in a sectoi (cyclical anu commouity) move in
lock step, theie aie no seiious consequences to compaiing the multiples of cuiient
eainings that fiims tiaue at. In effect, we may concluue that a steel company with a
PE iatio of 6 is faiily valueu at the peak of the cycle, when steel companies
collectively iepoit high eainings (anu low PE). The same fiim will be faiily valueu at
1S times eainings at an economic tiough, wheie the eainings of othei steel
companies aie also uown.
As with noimalizeu eainings, the piimaiy concein is that we contiol foi
othei factois that affect the PE. When the cycle is woiking in youi favoi (stiong
economy anu high commouity piices), all fiims in a sectoi may iepoit high eainings,
but some fiims may have bettei long-teim piospects anu shoulu tiaue at highei
multiples. By the same token, all oil companies may iepoit lowei eainings, when oil
piices aie uown, but some of these companies may have moie pieuictable eainings
anu theiefoie tiaue at highei multiples of eainings.
Illustration 10.3: PE ratios for oil companies
In Febiuaiy 2uu9, oil companies that hau benefiteu ovei the piioi five yeais
of iising oil piices weie shaken by the suuuen uiop in the piice pei baiiel of oil,
fiom $ 14u a baiiel a yeai piioi to $4S a baiiel. While the maiket piices of oil
companies tumbleu to ieflect the lowei oil piices, the eainings iepoiteu by these
companies foi the pievious yeai ieflecteu the high oil piices ovei that peiiou. In
table 1u.S, we iepoit on the stock piices of oil companies, in conjunction with foui
measuies of eainings pei shaie - eainings in the most iecent (iepoiteu) fiscal yeai,
eainings in the last foui quaiteis, expecteu eainings in the next foui quaiteis anu a
measuie of noimalizeu eainings obtaineu by aveiaging eainings pei shaie ovei the
pievious five yeais. The PE iatios aie estimateu using each measuie of eainings.
P":/- K\4J5 HO I"&%*8 V g%/ >*.,"#%-8 %# 2-:)$")' 3\\G
12 No
Next 4
e EPS _
Last S
t PE
g PE
u PE
u PE
1 $S.84 $8.18 $4.2S $6.2u 9.69 4.SS 8.76 6.uu
Chevion Coip.
2 $S.24
7 $4.uu $7.Su 11.68 S.2S 1S.S1 8.S9
8 $4.78
9 $4.7S $6.2S 7.9S S.SS 8.uu 6.u8
Exxon Nobil
7 $S.1S $8.66 $S.uu $6.Su 12.77 7.S9 1S.1S 1u.12
Fiontiei 0il
7 $u.21 $u.77 $1.SS $1.9u 66.S2 18.14 1u.SS 7.SS
Bess Coip.
7 $u.42 $7.24 $1.uS $S.4u 1S6.12 7.9u S4.4S 16.81
Bolly Coip.
S $S.u6 $2.41 $2.7S $S.Su 7.2u 9.14 8.u1 6.29
Naiathon 0il
9 $2.u4 $4.94 $2.9u $4.2u 11.u7 4.S7 7.79 S.S8
Nuiphy 0il
u $2.88 $8.7S $2.8S $S.Su 14.24 4.7u 14.S9 7.4S
9 $S.18 $8.97 $S.uS $S.Su 17.48 6.2u 18.2S 1u.11
7 $4.uS $4.44 $4.uS $4.1S 7.S2 6.86 7.S2 7.S4
6 $1.48 $S.49 $2.4S $S.7u 1u.6S 4.S2 6.4S 4.26
Royal Butch
Shell 'A'
2 $S.42
S $S.1u $6.4u 7.99 4.27 8.49 6.77
Sunoco Inc.
S $S.68 $7.48 $S.6S $4.Su 4.99 S.79 7.76 6.S9
Tesoio Coip.
7 $2.6u $1.76 $2.1u $2.8u S.26 7.77 6.S1 4.88
Total ABR
S $S.84 $9.16 $S.6S $7.1S 8.S4 S.44 8.82 6.97
As can be seen fiom the table, each veision of the PE iatio tells a uiffeient stoiy.
With cuiient PE (baseu on eainings pei shaie in the most iecent fiscal yeai), the
cheapest stock is Sunoco, with a PE of 4.99 anu Bess is off the chaits with its PE
iatio of 1S6, but the fact that the most iecent fiscal yeai is uiffeient foi uiffeient
fiims - 2uu7 foi some, miuway thiough 2uu8 foi otheis anu the enu of 2uu8 foi a
hanuful - gives us pause. With tiailing PE, the cheapest stock is ConocoPhillips anu
the most expensive is Fiontiei 0il, anu theie aie ielatively few outlieis. If we
assume that all oil companies benefiteu equally fiom the oil piice boom in the last
foui quaitei anu that theie aie no significant uiffeiences in giowth anu iisk acioss
oil companies, this woulu suggest that Conoco Phillips is cheap. Bowevei, peiusing
the expecteu giowth iates in eainings pei shaie, we finu that Conoco has an
expecteu giowth iate of only 4% foi the next S yeais, wheieas analysts aie
foiecasting giowth of 8.S% a yeai foi Petiobias. With foiwaiu PE iatios, theie aie
no stocks that tiaue at PE iatios less than 6, but Repsol uoes have the lowest PE with
6.4S. Finally, with noimalizeu EPS, the cheapest stock iemains Repsol with a PE of
4.26 anu the most expensive is Bess; oui assumption that the aveiage eainings pei
shaie ovei the last S yeais is noimal can be contesteu.
What aie we to make of this mishmash of iecommenuations. Fiist, it is
ciitical that we stay consistent in how we measuie eainings with commouity anu
cylcial companies. If we ueciue to use tiailing eainings, we shoulu uo so foi all
companies. Seconu, the funuamentals that ueteimine multiples - cash flows, giowth
anu iisk - apply just as much to commouity companies as they uo to the iest of the
maiket. To the extent that commouity companies aie becoming moie uiveise, with
laige uiffeiences in giowth potential anu iisk (especially in emeiging maikets), we
shoulu tiy to factoi in these uiffeiences into oui analyses.
1he kea| Cpt|on argument for undeve|oped reserves
0ne ciitique of conventional valuation appioaches is that they fail to consiuei
auequately the inteiielationship between the commouity piice anu the investment
anu financing actions of commouity companies. In othei woius, oil companies
behave veiy uiffeiently (in teims of exploiation anu financing) when oil piices aie
$1uu a baiiel than they uo when oil piices aie only $2u a baiiel. Since the manageis
of commouity companies get to obseive the commouity piice befoie they act, it can
be aigueu that the leaining anu auaptive behavioi that follows gives at least the
semblance of a ieal options aigument in these fiims. If we accept this aigument, the
upshot in valuation is that we shoulu be auuing a piemium to conventional
uiscounteu cash flow valuations, to ieflect this optionality, anu the piemium shoulu
become laigei as commouity piices become moie volatile.
Even if we nevei explicitly use option piicing mouels to value natuial
iesouice ieseives oi fiims, theie aie implications foi othei valuation appioaches:
a. Piice volatility affects value: The value of a commouity company is a function of
not only the piice of the commouity but also the expecteu volatility in that piice.
The piice matteis foi obvious ieasons - highei commouity piices tianslate into
highei ievenues, eainings anu cash flows. The vaiiance in that piice can affect
value by alteiing the option values of unuevelopeu ieseives. Thus, if the piice of
oil goes fiom $2S a baiiel to $4u a baiiel, you woulu expect all oil companies to
become moie valuable. If the piice uiops back to $2S, the values of oil companies
may not uecline to theii olu levels, since the peiceiveu volatility in oil piices may
have changeu.
b. Natuie veisus uiowth commouity companies: As commouity piices become
moie volatile, commouity companies that ueiive moie of theii value fiom
unuevelopeu ieseives will gain in value, ielative to moie matuie companies that
geneiate cash flows fiom uevelopeu ieseives. In the example useu above, wheie
oil piice volatility is peiceiveu to have changeu even though the piice itself has
not changeu, we woulu expect Petiobias to gain in value, ielative to Exxon Nobil.
c. Bevelopment of ieseives: As commouity piice volatility incieases, commouity
companies will become moie ieluctant to uevelop theii ieseives. If we tieat
unuevelopeu ieseives as options, anu ueveloping those ieseives as the
equivalent of exeicising those options, highei volatility in the unueilying
commouity piice will make exeicise less likely (since we will lose the time
piemium on the option).
u. 0ptionality incieases as commouity piice uecieases: The time piemium on an
option becomes smallei (as a peicent of the option value) as it becomes in-the-
money. In the context of natuial iesouice options, this woulu imply that the
option piemium is gieatest when commouity piices aie low (anu the ieseives
aie eithei maiginally viable oi not viable) anu shoulu ueciease as commouity
piices incieases.
In closing, if we iegaiu unuevelopeu ieseives as options, uiscounteu cash flow
valuation will geneially unuei estimate the value of natuial iesouice companies,
because the expecteu piice of the commouity is useu to estimate ievenues anu
opeiating piofits. As a consequence, we miss the option component of value. Again,
the uiffeience will be gieatest foi fiims with significant unuevelopeu ieseives anu
with commouities wheie piice volatility is highest.
Va|ue Þ|ays
When investing in a commouity company, you aie also investing in the
commouity. Investing in an unuei valueu oil company will not pay off, if oil piices
uiop Su% ovei the next few yeais. Theie aie two ways you can incoipoiate this
ieality into youi investing stiategy. In the fiist, you take a stanu on wheie
commouity piices aie going anu then invest in those companies wheie you can
exploit this piice view. In the seconu, you finu the best commouity companies to
invest in, fiom a puie value peispective, anu then use commouity futuies oi options
to heuge commouity piice iisk. To make a commouity piice play, you have to auopt
one of two stiategies. In the fiist, you play off piice momentum anu assume that if a
commouity's piice has iisen in the iecent past, it will continue to iise in the futuie.
In the seconu, you auopt a moie contiaiian view anu assume that long peiious of
piice upswings will followeu by ueclining piices. Theie is empiiical eviuence that
suppoits both stiategies, with momentum stiategies geneiating moie success foi
shoit teim investing anu ieveisal stiategies moie successful in the long teim. If
commouity piices aie low iight now, anu you believe that they will inciease
significantly in the futuie, the value payoff will be highest in companies with the
following chaiacteiistics:
# Significant unuevelopeu ieseives of the commouity: The fact that these ieseives
aie unuevelopeu gives these companies that option of waiting until the
commouity piice incieases to uevelop them.
# Funuing oi capital to suivive the neai teim commouity piice cycle: To the extent
that low commouity piices uepiess cuiient eainings, you want to avoiu
companies that may be pusheu into uistiess oi have to sell theii ieseives to iaise
If you uo not want to biing a commouity view into youi investment stiategy, youi
choice becomes a moie conventional one. You want to invest in those commouity
companies that aie piiceu attiactively anu have significant low cost ieseives of the
When investing in a cyclical company, you aie making a play on oveiall
economic giowth. In othei woius, investing in a goou cyclical company will not pay
off, if economic giowth is anemic. As with commouity companies, theie aie two
investment stiategies you can auopt. In the fiist, you put youi faith in youi foiecasts
of oveiall economic giowth. If you believe that oveiall economic giowth will be
stiongei than the iest of the maiket thinks it will be, you shoulu buy stiong cyclical
companies that will benefit fiom the economic upswing, with stiong uefineu to
incluue the following components:
• A piouuct oi seivice mix that is not only unique but attiacts customei loyalty.
• Noimalizeu ietuins on investments that exceeu the cost of capital;
noimalizeu woulu iequiie looking acioss the economic cycle.
• Low financial leveiage anu a stiong balance sheet that will pioviue
piotection in the event of an extenueu economic uowntuin.
This stiategy is most likely to woik in peiious of economic malaise, wheie investois
aie ovei ieacting to cuiient economic inuicatois - inflation, uBP giowth - anu
selling cyclical stocks. In the seconu, you accept youi inability to foiecast economic
cycles anu focus on buying the best baigains in each cyclical sectoi. The baigains
will be uefineu as companies that tiaue at low piices, ielative to theii noimalizeu
funuamentals; low piice to book iatios anu high noimalizeu R0E, low enteipiise
value to sales iatios with high noimalizeu maigins.
Cyclical anu commouity companies have volatile eainings, with the volatility
coming fiom macio economic factois that aie not in the contiol of these companies.
As the economy weakens anu stiengthens, cyclical companies will see theii eainings
go up anu uown, anu commouity companies will see theii eainings anu cash flows
tiack the commouity piice.
When valuing these companies, analysts make one of two mistakes. They
eithei ignoie the economic anu commouity piice cycles, anu assume that the cuiient
yeai's eainings anu cashflows (which aie a function of wheie we aie in the cycle)
will continue foievei, oi they expenu iesouices tiying to foiecast the cycle in the
long teim. We piesenteu two ways of valuing these fiims. In the fiist, we look past
the cycle at the noimalizeu eainings, giowth anu cash flow foi the fiim. In effect, we
aie assuming that while cycles can cause big swings in the numbeis, we cannot
foiecast the yeai-to-yeai shifts in cycles. In the seconu, we still assume
noimalization, but only in the long teim. In the neai teim, we foiecast ievenues,
eainings anu cash flows, baseu on wheie we aie in the cycle. While the two
appioaches will conveige when fiims aie in the miuule of a cycle, they will uiveige
at the top oi bottom of a cycle.
In the final section of this chaptei, we consiueieu the possibility that the
unuevelopeu ieseives at commouity companies coulu be consiueieu options, insofai
as the company has the iights to uevelop these ieseives but uoes not have to
uevelop them. We aigueu that commouity companies, especially when the
commouity piice is volatile, can tiaue at a piemium on theii uiscounteu cash flow

Chapter 12: Va|u|ng compan|es w|th |ntang|b|e assets:
1echno|ogy, 8rand name and Þatents
In the last twenty yeais, we have seen a shift away fiom manufactuiing fiims
to seivice anu technology fiims in the global economy, with the magnituue of the
change gieatest in the 0niteu States. As we value moie anu moie phaimaceutical,
technology anu seivice companies, we aie faceu with two iealities. The fiist is that
the assets of these fiims aie often intangible anu invisible - patents, know-how anu
human capital. The seconu is that the way in which accounting has uealt with
investments in these assets is inconsistent with its tieatment of investments in
tangible assets at manufactuiing fiims. As a iesult, many of the basic inputs that we
use in valuation - eainings, cash flows anu ietuin on capital - aie contaminateu.
What are |ntang|b|e assets?
Looking at publicly tiaueu fiims, it is obvious that many fiims ueiive the bulk
of theii value fiom intangible assets. Fiom consumei piouuct companies, uepenuent
upon bianu names, to phaimaceutical companies, with blockbustei uiugs piotecteu
by patent, to technology companies that uiaw on theii skilleu technicians anu know-
how, these fiims iange the spectium. In this section, we will begin by looking at
theii place in the maiket anu how it has shifteu ovei time anu follow up by
iuentifying chaiacteiistics that they shaie.
The simplest measuie of how much intangible assets iepiesent of the
economy comes fiom the maiket values of fiims that ueiive the bulk of theii value
fiom these assets as a piopoition of the oveiall maiket. While technology fiims have
fallen back fiom theii peak numbeis in 2uuu, they still iepiesenteu 14% of the
oveiall S&P Suu inuex at the enu of 2uu8. If we auu phaimaceutical anu consumei
piouuct companies to this mix, the piopoition becomes even highei.
Theie have been othei attempts to captuie the impoitance of intangible
assets in th economy. In one stuuy, Leonaiu Nakamuia of the Feueial Reseive Bank
of Philauelphia pioviueu thiee uiffeient measuies of the magnituue of intangible
assets in touay's economy - an accounting estimate of the value of the investments
in R&B, softwaie, bianu uevelopment anu othei intangibles; the wages anu salaiies
paiu to the ieseaicheis, technicians anu othei cieative woikeis who geneiate these
intangible assets; anu the impiovement in opeiating maigins that he attiibutes to
impiovements to intangible factois.
With all thiee appioaches, he estimateu the
investments in intangible assets to be in excess of $ 1 tiillion in 2uuu anu the
capitalizeu value of these intangible assets to be in excess of $ 6 tiillion in the same
Character|st|cs of f|rms w|th |ntang|b|e assets
While fiims with intangible assets aie uiveise, theie aie some chaiacteiistics
that they uo have in common. In this section, we will highlight those shaieu factois,
with the intent of expanuing on the consequences foi valuation in the next section.
1. Inconsistent accounting foi investments maue in intangible assets: Accounting
fiist piinciples suggests a simple iule to sepaiate capital expenses fiom
opeiating expenses. Any expense that cieates benefits ovei many yeais is a
capital expense wheieas expenses that geneiate benefits only in the cuiient yeai
aie opeiating expenses. Accountants hew to this uistinction with manufactuiing
fiims, putting investments in plant, equipment anu builuings in the capital
expense column anu laboi anu iaw mateiial expenses in the opeiating expense
column. Bowevei, they seem to ignoie these fiist piinciples when it comes to
fiims with intangible assets. The most significant capital expenuituies maue by
technology anu phaimaceutical fiims is in R&B, by consumei piouuct companies
in bianu name auveitising anu by consulting fiims in tiaining anu ieciuiting
peisonnel. 0sing the aigument that the benefits aie too unceitain, accountants
have tieateu these expenses as opeiating expenses. As a consequence, fiims with
intangible assets iepoit small capital expenuituies, ielative to both theii size anu
giowth potential.

Nakamuia, L., 1999,. Intangibles: What put the new in the new economy. Feueial Reseive Bank of
Philauephia Business Review }uly¡August: S÷16.
2. ueneially boiiow less money: While this may be a geneialization that uoes not
holu up foi some sub-categoiies of fiims with intangible assets, many of them
tenu to use uebt spaiingly anu have low uebt iatios, ielative to fiims in othei
sectois with similai eainings anu cash flows. Some of the low financial leveiage
can be attiibuteu to the bias that bankeis have towaius lenuing against tangible
assets anu some of it may ieflect the fact that technology anu phaimaceutical
fiims aie eithei in oi have just emeigeu fiom the giowth phase in the life cycle.
S. Equity 0ptions: While the use of equity options in management compensation is
not unique to fiims with intangible assets, they seem to be much heaviei useis of
options anu othei foims of equity compensation. Again, some of this behavioi
can be attiibuteu to wheie these fiims aie in the life cycle (closei to giowth than
matuie), but some of it has to be ielateu to how uepenuent these fiims aie on
ietaining human capital.
Va|uat|on Issues
The miscategoiization of capital expenses, the spaiing use of uebt anu
equity-baseu compensation (options anu iestiicteu stocks) can cieate pioblems
when we value these fiims. In this section, we will lay out some of the issues that
aiise in both uiscounteu cash flow anu ielative valuation.
• We geneially uiaw on the cuiient eainings anu cuiient book value of a fiim to
ueiive a value foi existing assets. The flaweu accounting tieatment of intangible
assets ienueis both numbeis unieliable, since the iepoiteu eainings foi a
technology fiim iepiesent the eainings aftei ieinvestment in R&B, iathei than
tiue opeiating eainings anu the book value of assets (anu equity) will be
unueistateu because the biggest assts foi these fiims aie off the books; if you
expense an item, you cannot show it as an asset. This has consequences not only
foi uiscounteu cash flows valuation, wheie these numbeis become the base fiom
which we foiecast, but also in ielative valuation, wheie we compaie multiples of
accounting eainings anu book values acioss companies.
• If giowth is a function of how much fiims ieinvest anu the quality of that
ieinvestment, the accounting tieatment of expenuituies on intangible assets
makes it uifficult to gauge eithei numbei. The ieinvestment maue by the fiim is
often buiieu in the opeiating expenses (iathei than showing up sepaiately as
capital expenuituies) anu the failuie to iecoiu the book values of intangible
assets makes measuies like ietuin on equity anu capital, wiuely useu to
ueteimine the quality of a fiim's investments, unieliable.
• In auuition to all of the stanuaiu vaiiables that affect iisk in a company, fiims
with intangible assets aie susceptible to an auuitional iisk. Lenueis aie waiy of
lenuing to fiims with intangible assets, since monitoiing these assets can be
uifficult to uo. In auuition, the values of some intangible assets, like human
capital, can uissipate oveinight, if a fiim gets into tiouble oi has its ieputation
• Estimating when a fiim with intangible assets gets to steauy state can iange
fiom simple to complex. Consiuei the simple scenaiio fiist: a biotechnology fiim
that ueiives almost all of its giowth fiom a single blockbustei uiug, with a patent
expiiing in 7 yeais. Baving a competitive auvantage that comes with a time
expiiation stamp uoes make the juugment on when the company will hit stable
giowth veiy simple. A moie complex scenaiio is a fiim with a well-iegaiueu
bianu name. uiven the uuiability of consumei bianu name as a competitive
auvantage, analysts face a much toughei task estimating when to put the fiim
into stable giowth. The final anu most uifficult scenaiio is a fiim, whose biggest
intangible asset is human capital - consultants at NcKinsey oi tiaueis at a
piivate equity funu. Since it is veiy uifficult to lock in human capital, these fiims
can lose theii best assets oveinight to the highest biuuei. Figuiing out how oi
why these fiims manage to holu on to theii best peisonnel is a cential
component to valuing them coiiectly.
The uefense offeieu by some analysts is that the iules, flaweu though they might be,
aie the same foi all fiims within a sectoi. As we will see in the next section, that
uoes not neutialize the pioblem.
Va|uat|on So|ut|ons
To value fiims with intangible assets, it woulu seem to us that we have to
ueal with the two big pioblems that they shaie. Fiist, we have to clean up the
financial statements (income statement anu balance sheet) anu ie-categoiize
opeiating anu capital expenses. The intent is not just to get a bettei measuie of
eainings, though that is a siue benefit, but also to get a cleaiei sense of what the fiim
is investing to geneiate futuie giowth. Seconu, we neeu to ueal moie effectively with
equity options - the ones that have been gianteu in the past as well the ones that we
expect to be gianteu in the futuie.
kega|n|ng Account|ng Cons|stency
While, in theory, income is not computed after capital expenses, the reality is that
there are a number of capital expenses that are treated as operating expenses. A
significant shortcoming of accounting statements is the way in which they treat research
and development expenses. Under the rationale that the products of research are too
uncertain and difficult to quantify, accounting standards have generally required that all
R&D expenses to be expensed in the period in which they occur. This has several
consequences, but one of the most profound is that the value of the assets created by
research does not show up on the balance sheet as part of the total assets of the firm. This,
in turn, creates ripple effects for the measurement of capital and profitability ratios for the
firm. We will consider how to capitalize R&D expenses in the first part of the section and
extend the argument to other capital expenses in the second part of the section.
()$"2)%"W"05 8X@ FE$&0*&*
Research expenses, notwithstanding the uncertainty about future benefits, should
be capitalized. To capitalize and value research assets, we have to make an assumption
about how long it takes for research and development to be converted, on average, into
commercial products. This is called the amortizable life of these assets. This life will vary
across firms and reflect the commercial life of the products that emerge from the
research. To illustrate, research and development expenses at a pharmaceutical company
should have fairly long amortizable lives, since the approval process for new drugs is
long. In contrast, research and development expenses at a software firm, where products
tend to emerge from research much more quickly should be amortized over a shorter
Once the amortizable life of research and development expenses has been
estimated, the next step is to collect data on R&D expenses over past years ranging back
to the amortizable life of the research asset. Thus, if the research asset has an amortizable
life of 5 years, the R&D expenses in each of the five years prior to the current one have to
be obtained. For simplicity, it can be assumed that the amortization is uniform over time,
which leads to the following estimate of the residual value of research asset today.
0 = t
1) - -(n = t
t) + (n
D & R = Asset Research the of Value
Thus, in the case of the research asset with a five-year life, you cumulate 1/5 of the R&D
expenses from four years ago, 2/5 of the R & D expenses from three years ago, 3/5 of the
R&D expenses from two years ago, 4/5 of the R&D expenses from last year and this
year’s entire R&D expense to arrive at the value of the research asset. This augments the
value of the assets of the firm, and by extension, the book value of equity.
Adjusted Book Value of Equity = Book Value of Equity + Value of the Research Asset
Finally, the operating income is adjusted to reflect the capitalization of R&D
expenses. First, the R&D expenses that were subtracted out to arrive at the operating
income are added back to the operating income, reflecting their re-categorization as
capital expenses. Next, the amortization of the research asset is treated the same way that
depreciation is and netted out to arrive at the adjusted operating income.
Adjusted Operating Income = Operating Income + R & D expenses –
Amortization of Research Asset
The adjusted operating income will generally increase for firms that have R&D expenses
that are growing over time. The net income will also be affected by this adjustment:
Adjusted Net Income = Net Income + R & D expenses – Amortization of Research Asset
While we would normally consider only the after-tax portion of this amount, the fact that
R&D is entirely tax deductible eliminates the need for this adjustment.

If only amortization were tax deductible, the tax benefit from R&D expenses would be:
Amortization * tax rate
This extra tax benefit we get from the entire R&D being tax deductible is as follows:
(R&D – Amortization) * tax rate
Illustration 11.1: Capitalizing R&D expenses: Amgen in February 2009
Amgen is a biotechnology/ pharmaceutical firm. Like most such firms, it has a
substantial amount of R&D expenses and we will attempt to capitalize it in this example.
The first step in this conversion is determining an amortizable life for R & D expenses.
How long will it take, on an expected basis, for research to pay off at Amgen? Given the
length of the approval process for new drugs by the Food and Drugs Administration, we
will assume that this amortizable life is 10 years.
The second step in the analysis is collecting research and development expenses
from prior years, with the number of years of historical data being a function of the
amortizable life. Table 11.1 provides this information for the firm.
Table 11.1: Historical R& D Expenses (in millions)
Yeai R& B Expenses
Cuiient SuSu.uu
-1 S266.uu
-2 SS66.uu
-S 2S14.uu
-4 2u28.uu
-S 16SS.uu
-6 1117.uu
-7 864.uu
-8 84S.uu
-9 82S.uu
-1u 66S.uu

The current year’s information reflects the R&D in the most recent financial year (which
was calendar year 2008 in this example).
The portion of the expenses in prior years that would have been amortized already
and the amortization this year from each of these expenses is considered. To make
estimation simpler, these expenses are amortized linearly over time; with a 10-year life,
10% is amortized each year. This allows us to estimate the value of the research asset
created at each of these firms and the amortization of R&D expenses in the current year.
The procedure is illustrated in table 11.2:

If we subtract out (R&D – Amortization) (1- tax rate) and add the differential tax benefit, which is
computed above, (1- tax rate) drops out of the equation.
Table 11.2: Value of Research Asset
E-") IlY O=,-#8- [#".*)&%`-0 ,*)&%*# B.*)&%`"&%*# &1%8 '-")
Cuiient SuSu.uu 1.uu SuSu.uu
-1 S266.uu u.9u 29S9.4u $S26.6u
-2 SS66.uu u.8u 2692.8u $SS6.6u
-S 2S14.uu u.7u 1619.8u $2S1.4u
-4 2u28.uu u.6u 1216.8u $2u2.8u
-S 16SS.uu u.Su 827.Su $16S.Su
-6 1117.uu u.4u 446.8u $111.7u
-7 864.uu u.Su 2S9.2u $86.4u
-8 84S.uu u.2u 169.uu $84.Su
-9 82S.uu u.1u 82.Su $82.Su
-1u 66S.uu u.uu u.uu $66.Su
$1S28S.6u $1,694.1u

Note that none of the current year’s expenditure has been amortized because it is assumed
to occur at the end of the most recent year (which effectively makes it today). The sum of
the dollar values of unamortized R&D from prior years is $13.284 billion. This can be
viewed as the value of Amgen’s research asset and would be also added to the book value
of equity for computing return on equity and capital measures. The sum of the
amortization in the current year for all prior year expenses is $1,694 million.
The final step in the process is the adjustment of the operating income to reflect
the capitalization of research and development expenses. We make the adjustment by
adding back R&D expenses to the operating income (to reflect its reclassification as a
capital expense) and subtracting out the amortization of the research asset, estimated in
the last step. For Amgen, which reported operating income of $5,594 million in its
income statement for 2008, the adjusted operating earnings would be:
Adjusted Operating Earnings
= Operating Earnings + Current year’s R&D expense – Amortization of Research Asset
= 5,594 + 3030 – 1694 = $ 6.930 million
The stated net income of $4,196 million can be adjusted similarly.
Adjusted Net Income
= Net Income + Current year’s R&D expense – Amortization of Research Asset
= 4,196 + 3030 – 1694 = $ 5,532 million
Both the book value of equity and capital are augmented by the value of the research
asset. Since measures of return on capital and equity are based upon the prior year’s
values, we computed the value of the research asset at the end of 2007, using the same
approach that we used in 2008 and obtained a value of $ 11,948 million.

Value of Research Asset
= $ 11,948 million
Adjusted Book Value of Equity

= Book Value of Equity
+ Value of Research Asset
= 17,869 million + 11,948 million = $29,817 million
Adjusted Book Value of Capital

= Book Value of Capital
+ Value of Research Asset
= $ 21,985 million + 11,948 million = $ 33,933 million
The returns on equity and capital are estimated by dividing the earnings in 2008 by the
capital invested at the end of 2007 and are reported with both the unadjusted and adjusted
numbers below:
Unadjusted Adjusted for R&D
Return on Equity
= 23.48%
Pre-tax Return on Capital
= 25.44%
= 20.42%
While the profitability ratios for Amgen remain impressive even after the adjustment,
they decline significantly from the unadjusted numbers.
()$"2)%"W"05 R2+&4 R$&4)2"05 FE$&0*&*
While R&D expenses are the most prominent example of capital expenses being
treated as operating expenses, there are other operating expenses that arguably should be
treated as capital expenses. Consumer product companies such as Gillette and Coca Cola
could make a case that a portion of advertising expenses should be treated as capital
expenses, since they are designed to augment brand name value. For a consulting firm
like KPMG or McKinsey, the cost of recruiting and training its employees could be

Note that you can aiiive at this value using the table above anu shifting the amoitization numbeis
by one iow. Thus, $ 822.8u million will become the cuiient yeai's R&B, $ 66S.S million will become
the R&B foi yeai -1 anu 9u% of it will be unamoitizeu anu so on.
considered a capital expense, since the consultants who emerge are likely to be the heart
of the firm’s assets and provide benefits over many years. For many new technology
firms, including online retailers such as, the biggest operating expense item
is selling, general and administrative expenses (SG&A). These firms could argue that a
portion of these expenses should be treated as capital expenses since they are designed to
increase brand name awareness and bring in new presumably long term customers.
While this argument has some merit, we should remain wary about using it to
justify capitalizing these expenses. For an operating expense to be capitalized, there
should be substantial evidence that the benefits from the expense accrue over multiple
periods. Does a customer who is enticed to buy from Amazon, based upon an
advertisement or promotion, continue as a customer for the long term? There are some
analysts who claim that this is indeed the case and attribute significant value added to
each new customer. It would be logical, under those circumstances, to capitalize these
expenses using a procedure similar to that used to capitalize R&D expenses.
• Determine the period over which the benefits from the operating expense (such as
SG&A) will flow.
• Estimate the value of the asset (similar to the research asset) created by these
expenses. This amount will be added to the book value of equity/capital and used
to estimate the returns on equity and capital.
• Adjust the operating income for the expense and the amortization of the created
The net effects of the capitalization will be seen most visibly in the reinvestment rates
and returns on capital that we estimate for these firms.
Illustration 11.2: Capitalizing Brand Name Advertising – Coca Cola in 2009
Coca Cola is wiuely iegaiueu as possessing one of the most valuable bianu
names in the woilu. We know that the company has always spent libeially on
auveitising, paitly uiiecteu at builuing up the bianu name. In table 11.S, we iepoit
on selling anu auveitising expenuituies at Coca Cola eveiy yeai foi the last 2S yeais,
which we will assume is the amoitizable life foi bianu name. (In tiuth, we shoulu be
going back a lot longei, but uata limitations get in the way).
P":/- KK4J5 B0<-)&%8%#( O=,-#0%&$)-8 "& >*9" >*/"5 KGjZ@3\\j
Yeai Yeai
Selling anu
Bianu Name
this yeai
1984 1 $2,S14 $1,S4S $771 $Su.8S $u.uu
198S 2 $2,S68 $1,S79 $789 $S1.S7 $S1.S7
1986 S $2,446 $1,6S1 $81S $S2.61 $6S.2S
1987 4 $2,66S $1,777 $888 $SS.SS $1u6.6u
1988 S $S,uS8 $2,u2S $1,u1S $4u.S1 $162.uS
1989 6 $S,S48 $2,2S2 $1,116 $44.64 $22S.2u
199u 7 $4,u76 $2,717 $1,SS9 $S4.SS $S26.u8
1991 8 $4,6u4 $S,u69 $1,SSS $61.S9 $429.71
1992 9 $S,249 $S,499 $1,7Su $69.99 $SS9.89
199S 1u $S,69S $S,797 $1,898 $7S.9S $68S.4u
1994 11 $6,297 $4,198 $2,u99 $8S.96 $8S9.6u
199S 12 $6,986 $4,6S7 $2,S29 $9S.1S $1,u24.61
1996 1S $8,u2u $S,S47 $2,67S $1u6.9S $1,28S.2u
1997 14 $7,8S2 $S,2SS $2,617 $1u4.69 $1,S61.u1
1998 1S $8,284 $S,S2S $2,761 $11u.4S $1,S46.SS
1999 16 $9,814 $6,S4S $S,271 $1Su.8S $1,962.8u
2uuu 17 $8,SS1 $S,7u1 $2,8Su $114.u1 $1,824.21
2uu1 18 $6,149 $4,u99 $2,uSu $81.99 $1,S9S.77
2uu2 19 $7,uu1 $4,667 $2,SS4 $9S.SS $1,68u.24
2uuS 2u $7,488 $4,992 $2,496 $99.84 $1,896.96
2uu4 21 $8,146 $S,4S1 $2,71S $1u8.61 $2,172.27
2uuS 22 $8,7S9 $S,826 $2,91S $116.S2 $2,446.92
2uu6 2S $9,4S1 $6,287 $S,144 $12S.7S $2,766.4S
2uu7 24 $1u,94S $7,297 $S,648 $14S.9S $S,SS6.47
2uu8 2S $11,774 $7,849 $S,92S $1S6.99 $S,767.68
Total $2,1Su.4u $S1,91u.2S

We assume that two-thiius of the S,u anu A expenses aie foi selling anu auveitising
anu that Su% of the selling anu auveitising expenses each yeai aie associateu with
builuing up bianu name, with the balance useu to geneiate ievenues in the cuiient
yeai. In the seconu-to-last column, we compute the amoitization this yeai of piioi
yeai's expenuituie, using stiaight-line amoitization ovei 2S yeais. In the last
column, we keep tiack of the unamoitizeu poition of piioi yeai's expenuituies. The
cumulateu value of this column ($S1.9 billion) can be consiueieu the capital
investeu in the bianu name.
Theie aie potential iefinements that will impiove this estimate. 0ne is to use
a longei amoitizable life anu to go back fuithei in time to obtain auveitising
expenses. The othei is to conveit the past expenuituies into cuiient uollai
expenuituies, baseu upon inflation. In othei woius, an expenuituie of $ 771 million
in 1984 is ieally much laigei if stateu in 2uu8 uollais.
Both of these will inciease
the capital value of the bianu name.
The aujustments to opeiating income, net income anu capital investeu, in
table 11.4, miiioi those maue foi Amgen foi R&B expenses:
P":/- KK4Z5 >",%&"/%`%#( 6)"#0 _".- B0<-)&%8%#(@ >*9" >*/"
Conventional Accounting Capitalizeu Bianu Name
0peiating Income $8,446 $1u,22u
Net Income $S,8u7 $7,S81
Equity investeu $21,744 $SS,6S4
Capital Investeu $S1,u7S $62,98S
R0E 26.71% 14.1S%
Pie-tax R0C 27.18% 16.2S%
Capitalizing bianu name auveitising substantially uecieases both the ietuin on
equity anu capital investeu foi Coca Cola.
Illustration 11.3: Capitalizing Recruitment and Training Expenses: Cyber Health
Cyber Health Consulting (CHC) is a firm that specializes in offering management
consulting services to health care firms. CHC reported operating income (EBIT) of $51.5
million and net income of $23 million in the most recent year. However, the firm’s
expenses include the cost of recruiting new consultants ($ 5.5 million) and the cost of
training ($8.5 million). A consultant who joins CHC stays with the firm, on average, 4
To capitalize the cost of recruiting and training, we obtained these costs from each
of the prior four years. Table 11.5 reports on these expenses and amortizes each of these
expenses over four years.
Table 11.5: Human Capital Expenses: CHC
Year Training & Recruiting Expenses Unamortized Portion Amortization this year
Current $ 14.00 100% $ 14.00
-1 $ 12.00 75% $ 9.00 $ 3.00
-2 $ 10.40 50% $ 5.20 $ 2.60
-3 $ 9.10 25% $ 2.28 $ 2.28
-4 $ 8.30 - $ 0.00 $ 2.08

When we use inflation aujusteu values, the value of bianu name incieases to almost $ 4u billion.
Value of Human Capital Asset = $ 30.48
Amortization this year = $9.95
The adjustments to operating and net income are as follows:
Adjusted Operating Income = Operating Income + Training and Recruiting expenses –
Amortization of Expense this year = $ 51.5 + $ 14 - $ 9.95 = $ 55.55 million
Net Income = Net Income + + Training and Recruiting expenses – Amortization of
Expense this year = $ 23 million + $ 14 million - $ 9.95 million = $ 27.05 million
These adjusted earnings numbers in conjunction with the value of the human capital
asset, estimated in table 11.6, are used to compute the returns on equity and capital.
Table 11.6: Returns on Equity and Capital – Conventional versus Adjusted
Conventional accounting Capitalizeu Tiaining Expenses
Net Income $2S.uu $27.uS
0peiating Income $S1.Su $SS.SS
Book Equity $12S.uu $1SS.48
Book Capital $2Su.uu $28u.48
R0E 18.4u% 17.4u%
Pie-tax R0C 2u.6u% 19.81%
As with Amgen and Coca Cola, capitalizing training expenses decreases the returns on
equity and capital for the company.
(-0*&G1&0=&* ?-4 A)%1)2"-0
When we capitalize R&B, bianu name auveitising anu tiaining expenses,
theie aie significant consequences foi both uiscounteu cash flow anu ielative
valuation. In uiscounteu cash flow valuation, oui estimates of cash flows anu giowth
can be uiamatically alteieu by the use of the aujusteu numbeis. In ielative valuation,
compaiisons of fiims within the same sectoi can be skeweu by wheie they aie in the
life cycle.
lnLrlnslc valuaLlon
When we capitalize the expenses associateu with cieating intangible assets, we
aie in effect ieuoing the financial statements of the fiim anu iestating numbeis that
aie funuamental inputs into valuation - eainings, ieinvestment anu measuies of
a. Eainings: As we have noteu with all thiee examples of capitalization (R&B,
bianu name auveitising anu tiaining¡ieciuiting expenses), the opeiating anu
net income of a fiim will change as a consequence. Since the aujustment
involves auuing back the cuiient yeai's expense anu subtiacting out the
amoitization of past expenses, the effect on eainings will be non-existent if
the expenses have been unchangeu ovei time, anu positive, if expenses have
iisen ovei time. With Amgen, foi instance, wheie R&B expenses incieaseu
fiom $66S million at the stait of the amoitization peiiou to $S.uS billion in
the cuiient yeai, the eainings incieaseu by moie than $1.S billion as a iesult
of the R&B aujustment.
b. Reinvestment: The effect on ieinvestment is iuentical to the effect on
eainings, with ieinvestment incieasing oi uecieasing by exactly the same
amount as eainings.
c. Fiee Cash flow to the equity(fiim): Since fiee cash flow is computeu by
netting ieinvestment fiom eainings, anu the two items change by the same
magnituue, theie will be no effect on fiee cash flows.
u. Reinvestment Rate: While the fiee cash flow is unaffecteu by capitalization of
these expenses, the ieinvestment iate will change. In geneial, if eainings anu
ieinvestment both inciease as a consequence of the capitalization of R&B oi
auveitising expenses, the ieinvestment iate will inciease.
e. Capital Investeu: Since the unamoitizeu poition of piioi yeai's expenses is
tieateu as an asset, it auus to the estimateu equity oi capital investeu in the
fiim. The effect will inciease with the amoitizable life anu shoulu theieifoie
be highei foi phaimaceutical fiims (wheie amoitizable lives tenu to be
longei) than foi softwaie fiims (wheie ieseaich pays off fai moie quickly as
commeicial piouucts).
f. Retuin on equity (capital): Since both eainings anu capital investeu aie both
affecteu by capitalization, the net effects on ietuin on equity anu capital aie
unpieuictable. If the ietuin on equity (capital) incieases aftei the
iecapitalization, it can be consiueieu a iough inuicatoi that the ietuins
eaineu by the fiim on its R&B oi auveitising investments is gieatei than its
ietuins on tiauitional investments.
g. Expecteu giowth iates: Since the expecteu giowth iate is a function of the
ieinvestment iate anu the ietuin on capital, anu both change as a iesult of
capitalization, the expecteu giowth iate will also change. While the highei
ieinvestment iate will woik in favoi of highei giowth, it may be moie than
offset by a uiop in the ietuin on equity oi capital.
In summaiy, the vaiiables that aie most noticeably affecteu by capitalization aie the
ietuin on equity¡capital anu the ieinvestment iate. Since the cost of equity¡capital
is unaffecteu by capitalization, any change in the ietuin on capital will tianslate into
a change in excess ietuins at the fiim, a key vaiiable ueteimining the value of
giowth. In auuition to pioviuing us with moie iealistic estimates of what these
fiims aie investing in theii giowth assets anu the quality of these assets, the
capitalization piocess also iestoies consistency to valuations by ensuiing that
giowth iates aie in line with ieinvestment anu ietuin on capital assumptions. Thus,
technology oi phaimaceutical fiims that want to continue to giow have to keep
investing in R&B, while ensuiing that these investments, at least collectively,
geneiate high ietuins foi the fiim.
Illustration 11.4: Valuing Amgen
In illustiation 11.1, we capitalizeu R&B expenses foi Amgen anu computeu
the aujusteu opeiating income, ieinvestment anu ietuin on capital at the fiim. We
useu the iestateu numbeis to estimate the value of the fiim anu equity pei shaie.
The valuation, wheie we assume ten yeais of high giowth, is summaiizeu in Figuie
2%($)- KK4K5 L"/$%#( B.(-# V Q")91 3\\G

0ui estimate of value of equity pei shaie is $62.97 a shaie, well above the pievailing
stock piice of $ 47.47.
An intiiguing question is how the capitalization of R&B expenses affecteu
value. To investigate, we compaieu the valuation funuamentals foi Amgen, with
conventional accounting, anu with R&B tieateu as capital expenses in table 11.7:
P":/- KK4X5 L"/$"&%*# 2$#0".-#&"/8 V h%&1 "#0 h%&1*$& IlY >",%&"/%`"&%*#
Conventional Capitalizeu R&B
Aftei-tax R0C 14.91% 17.41%
Reinvestment Rate 19.79% SS.2S%
uiowth Rate 2.9S% S.78%
value pei shaie $4S.6S $62.97
We then ievalueu the fiim, using both sets of funuamentals. As the table inuicates,
the value pei shaie woulu have been $4S.6S, if we hau useu conventional accounting
numbeis. Cleaily, capitalization matteis anu the uegiee to which it matteis will vaiy
acioss fiims. In geneial, the effect will be negative foi fiims that invest laige
amounts in R&B, with little to show (yet) in teims of eainings anu cash flows in
Current Cashflow to Firm
EBIT(1-t)= :6967(1-.20)= 6041
- Nt CpX= 1933
- Chg WC 75
= FCFF 4033
Reinvestment Rate = 2008/6041
Return on capital = 17.41%
Expected Growth
in EBIT (1-t)
Stable Growth
g = 3%; Beta = 1.10;
Debt Ratio= 20%; Tax rate=35%
Cost of capital = 8.67%
ROC= 10.00%;
Reinvestment Rate=3/10=30%
Terminal Value10= 5734/(.0867-.03) = 101,081
Cost of Equity
Cost of Debt
= 2.76%
E = 82.4% D = 17.6%
Cost of Capital (WACC) = 13.36% (0.824) + 2.76% (0.176) = 11.80%
Op. Assets 66602
+ Cash: 9552
- Debt 10578
=Equity 87226
-Options 464
Value/Share $ 62.97
Riskfree Rate:
Riskfree rate = 3%
Risk Premium
Unlevered Beta for
Sectors: 1.41
Reinvestment Rate
Return on Capital
Term Yr
On March 5, 2009,
Amgen was trading
at $ 47.47/share
First 5 years
Growth decreases
gradually to 3%
Debt ratio increases to 20%
Beta decreases to 1.10
Cap Ex = Acc net Cap Ex(-401) +
Acquisitions (974) + Net R&D (1336)
Year 1 2 3 4 5 6 7 8 9 10
EBIT 7988 8450 8939 9456 10003 10526 11017 11470 11878 12235
EBIT (1-t) 6390 6760 7151 7565 8002 8420 8814 9176 9503 9788
- Reinvestment 2124 2247 2377 2514 2659 2744 2815 2872 2912 2936
= FCFF 4267 4513 4774 5051 5343 5677 5999 6305 6590 6851
Figure 15.1: Valuing Amgen
subsequent peiious. It can be positive foi fiims that ieinvest laige amounts in R&B
anu iepoit laige incieases in eainings in subsequent peiious. In the case of Amgen,
capitalizing R&B has a positive effect on value pei shaie, because of its tiack iecoiu
of successful R&B.
8elaLlve valuaLlon
It is tiue that all technology anu phaimaceutical companies opeiate unuei
the same flaweu accounting iules, expensing R&B, iathei than capitalizing it. That
uoes not mean, though, that theie aie no consequences foi ielative valuation. As we
noteu in the last section, the effect of capitalizing R&B on eainings anu book value
can vaiy wiuely acioss fiims anu will uepenu upon the following:
a. Age of the fiim anu stage in life cycle: ueneially speaking, the effects of
capitalization will be much gieatei at young fiims than at moie matuie fiims.
Consiuei, foi instance, the capitalization of R&B expenses. Capitalizing these
expenses will inciease eainings fai moie at young fiims foi two ieasons: (a)
R&B expenses will compiise a much laigei piopoition of the total expenses
at these fiims anu (b) R&B expenses aie moie likely to have incieaseu
significantly ovei time.
b. Amoitizable life: The effect of capitalizing expenses will be much gieatei as
we extenu the amoitizable life of R&B, especially on capital investeu. If we
assume that all fiims in a sectoi shaie the same amoitizable life foi R&B, this
will not be an issue, but to the extent that uiffeient fiims within the same
business may conveit ieseaich into commeicial piouucts at uiffeient speeus,
the effect on eainings of capitalizing R&B can vaiy acioss fiims
If we ignoie accounting inconsistencies anu use the iepoiteu eainings anu book
values of fiims in the computation of multiples, we aie likely to finu that youngei
fiims oi fiims that have R&B with longei gestation peiious aie oveivalueu. Theii
eainings anu book value will be unueistateu, leauing to much highei PE, Ev¡EBITBA
anu book value multiples foi these fiims.
Theie aie two ways we can incoipoiate these factois into ielative valuation.
The fiist is to capitalize the expenses associateu with investing in intangible assets
foi each fiim anu to compute consistent measuies of eainings anu book value to use
in multiples. This appioach, while yieluing the most piecision, is also the most time
anu uata intensive. The seconu is to stick with the iepoiteu accounting values foi
eainings anu book value, which contiolling foi the factois listeu above.
Illustration 11.5: Valuing large pharmaceutical firms with PE ratios
To examine the effect of R&B, we estimateu the PE iatios, in Febiuaiy 2uu9,
foi phaimaceutical fiims, using seveial measuies of net income in table 11.8:
P":/- KK4j5 HO I"&%*8 ;*) H1")."9-$&%9"/ >*.,"#%-8 V 2-:)$")' 3\\G
>*.,"#' _".-
>", b
IlY #-& *;
".*)&%`"&%*# HO HaMOmIlYN
Neick & Co. $46,7u2 $7,8u4 $4,8uS $Su2 S.98 S.7u S.76
AstiaZeneca PLC $44,S66 $6,1Su $S,179 $6Su 7.24 S.92 6.S4
ABR $77,S96 $1u,619 $6,7u7 $22S 7.S1 4.48 7.16
Lilly (Eli) $S1,2S2 $S,86S $S,84u $41u 8.u8 4.uS 7.S1
Sanofi-Aventis $67,924 $7,u68 $4,S7S $4Su 9.61 S.8S 9.uS
Novaitis Au ABR $79,9S4 $8,16S $1,8S4 $76 9.79 8.uu 9.7u
Pfizei Inc. $8S,4SS $8,1u4 $7,94S $SSu 1u.S4 S.S2 9.87
Biogen Iuec Inc. $12,7S2 $78S $1,u72 $41S 16.26 6.86 1u.6S
Wyeth $S4,S91 $4,417 $S,S7S $1SS 12.S1 6.98 11.9u
Squibb $SS,u19 $2,16S $S,S8S $71u 16.18 6.u9 12.18
Scheiing-Plough $26,47S $1,9uS $8Su $1SS 1S.91 9.62 12.99
Alleigan Inc. $1u,9u1 $S77 $798 $2SS 18.89 7.9S 1S.1u
Teva Phaimac.
(ABR) $S4,279 $2,S74 $786 $221 14.44 1u.8S 1S.21
uenzyme Coip. $14,S48 $421 $1,Su8 $622 S4.u8 8.Su 1S.76
Novo Noiuisk $28,16S $1,681 $1,S68 $SSS 16.76 9.24 1S.8S
Abbott Labs. $71,SS7 $4,881 $2,689 $2Su 14.62 9.4S 1S.91
uileau Sciences $4u,S1u $2,u11 $721 $S7S 2u.u4 14.7S 16.89
Celgene Coip. $18,Su2 $226 $S99 $21S 8u.84 29.26 41.46

To contiast with the conventional PE iatio, which is baseu on iepoiteu net income,
we computeu two alteinative measuies of eainings. In the fiist, we use the
simplistic aujustment of auuing back R&B expenses to net income to aiiive at a
multiple of the maiket piice to eainings befoie R&B expenses. In the seconu, we
make the full aujustment foi R&B, auuing back the R&B anu subtiacting out the
amoitization of R&B to aiiive at an aujusteu net income.
The iesults aie ievealing. 0n all thiee measuies of PE, Neick looks like it is
the most unueivalueu company in the gioup. As we auu back R&B, the uiffeiences
between the eainings multiples uecieases, with Celgene iemaining the outliei.
Finally, when we compute the multiple of eainings with net R&B auueu back, the
moie matuie phaimaceutical companies with less attiactive giowth piospects
emeige with lowei PE iatios, wheieas the smallei, highei giowth companies tiaue
at highei multiples of eainings.
Dea||ng w|th Lqu|ty Cpt|ons
In the last two uecaues, fiims have incieasing tuineu to compensating
manageis using equity, with options being a key component, foi seveial ieasons.
The fiist is to align management inteiests with stockholueis, i.e, to make manageis
think like stockholueis by giving them an equity stake. The seconu is it alloweu
cash-pooi fiims with significant giowth piospects to compete foi employee talent
against ueep-pocketeu iivals; young technology fiims aie piime useis of options.
The thiiu is that the accounting foi options woefully unueistateu the tiue cost of
these options, allowing these fiims to iepoit much positive eainings, even as they
gave away big chunks of equity to manageis.
Fiims that pay manageis anu otheis with equity options cieate a seconu
claim on the equity on top of the claim that common stockholueis have. Since we aie
calleu up to estimate the value of equity pei common shaie, we have to consiuei
how to allocate the aggiegate equity value acioss the two claimholueis. In this
section, we will fiist examine how to ueal with options that a fiim may have gianteu
to manageis in the past, that have not been exeiciseu yet; this is the option
oveihang. In the seconu section, we will extenu the analysis to look at how best to
ueal with options that may be gianteu in the futuie to employees anu how to biing
the consequences of such giants into the value of equity pei shaie touay.
:+& R$2"-0 RA&4+)05
Theie aie thiee appioaches that aie wiuely useu to ueal with outstanuing
options, issueu in piioi peiious. The ciuuest way is to assume that all oi some of the
options will be exeiciseu in the futuie, aujust the numbei of shaies outstanuing anu
uiviue the value of equity by this numbei to aiiive at value pei shaie; this is the
uiluteu shaies appioach. The seconu anu slightly moie tempeieu appioach is to
incoipoiate the exeicise pioceeus fiom the options in the numeiatoi anu then
uiviue by the numbei of shaies that woulu be outstanuing aftei exeicise; this is the
tieasuiy stock appioach. The thiiu anu piefeiieu appioach foi uealing with options
is to estimate the value of the options touay, given touay's value pei shaie anu the
time piemium on the option. 0nce this value has been estimateu, it is subtiacteu
fiom the estimateu equity value, anu the iemaining amount is uiviueu by the
numbei of shaies outstanuing to aiiive at value pei shaie.
l. use fully dlluLed number of shares Lo esLlmaLe per-share value
The simplest way to incoipoiate the effect of outstanuing options on value pei
shaie is to uiviue the estimateu value of equity fiom a uiscounteu cash flow mouel
by the numbei of shaies that will be outstanuing if all options aie exeiciseu touay -
the fully uiluteu numbei of shaies. While this appioach has the viitue of simplicity,
it will leau to too low of an estimate of value pei shaie foi thiee ieasons:
• It consiueis all options outstanuing, not just ones that aie in the money anu
vesteu. To be faii, theie aie vaiiants of this appioach wheie the shaies
outstanuing aie aujusteu to ieflect only in-the-money anu vesteu options.
• It uoes not incoipoiate the expecteu pioceeus fiom exeicise, which will
compiise a cash inflow to the fiim.
• Finally, this appioach uoes not builu in the time piemium on the options into the
lllosttotloo 11.6. lolly ulloteJ Apptoocb to estlmotloq voloe pet 5bote
To apply the fully uiluteu appioach to estimate the pei shaie value, we will
value a company with a significant option oveihang -uoogle. We begin by valuing
equity in the aggiegate, capitalizing R&B along the way (we useu a foui yeai
amoitizable life foi uoogle's R&B) anu using a ten-yeai high giowth peiiou. Figuie
11.2 summaiizes the value of equity.
2%($)- KK43 L"/$%#( S**(/-k8 OD$%&' V Q")91 3\\G

In Febiuaiy 2uu9, uoogle hau S1S.29 million shaies outstanuing anu 1S.97 millioin
in options outstanuing. To estimate the value of equity pei shaie, we uiviue the
aggiegate value of equity estimateu in figuie 11.2 by the total numbei of shaies
Biluteu value of equity pei shaie
Aggregate Value of Equity
Fully diluted number of shares
(315.29 +13.97)
= $310.83/ share
This value, howevei, ignoies both the pioceeus fiom the exeicise of the options as
well as the time value inheient in the options. At uoogle, foi example, a significant
numbei of the options issueu in past yeais aie out-of-the-money anu may nevei be
A mouifieu veision of this appioach counts only in-the-money options when
computing uiluteu shaies. 0f uoogle's 1S.97 options outstanuing, 4.7S million weie
Terminal Value= 10140(.0895-.03)
=$ 170,415
Cost of Equity
Cost of Debt
4.25% (1-.38)= 2.64%
Debt= 2.22% -> 10%
Value of Op Assets $ 95,748
+ Cash & Non-op $ 8,931
= Value of Firm $104,679
- Value of Debt $ 2,334
= Value of Equity $102,345
Riskfree Rate:
T. Bond rate = 3%
1.30> 1.10
Risk Premium
D/E: 2.3%
Base Equity
Country Risk
$ 21.796
Cap ex includes acquisitions
Sales Turnover
Ratio: 1.20
-> 30%
Stable Growth
Growth: 3%
Reinvest 25%
of EBIT(1-t)
$ 3,380
$ 10,140
Term. Year
2 4 3 1 5 6 8 9 10 7
March 2009
Trading @ $327
Revenues $28,335 $35,419 $42,502 $48,878 $53,765 $58,067 $61,841 $64,933 $67,855 $70,569
EBIT $9,941 $11,676 $13,486 $15,156 $16,446 $17,619 $18,676 $19,556 $20,403 $21,199
EBIT(1-t) $6,163 $7,239 $8,361 $9,397 $10,197 $10,924 $11,579 $12,125 $12,650 $13,143
- Reinvestment $5,449 $5,903 $5,903 $5,313 $4,073 $3,584 $3,145 $2,577 $2,435 $2,262
FCFF $714 $1,336 $2,458 $4,084 $6,123 $7,340 $8,434 $9,548 $10,215 $10,881
Debt Ratio 2.22% 2.22% 2.22% 2.22% 2.22% 3.77% 4.16% 4.81% 6.11% 10.00%
Beta 1.30 1.30 1.30 1.30 1.30 1.26 1.22 1.18 1.14 1.10
Cost of Equity 10.80% 10.80% 10.80% 10.80% 10.80% 10.56% 10.32% 10.08% 9.84% 9.60%
Cost of debt 2.64% 2.64% 2.64% 2.64% 2.64% 2.73% 2.75% 2.79% 2.87% 3.10%
Cost of Capital 10.62% 10.62% 10.62% 10.62% 10.62% 10.26% 10.00% 9.73% 9.41% 8.95%
Figure 15.*: Valuing Google Equity - March 2009
in-the-money, with an exeicise piice < stock piice. If we count only these shaies
outstanuing, the value of equity pei shaie is $S19.79:
Paitially uiluteu valueu of equity pei shaie
Aggregate Value of Equity
Fully diluted number of shares
(315.29 + 4.75)
= $319.79/ share
ll. 1reasury SLock Approach
This appioach is a vaiiant of the fully uiluteu appioach. Beie, the numbei of
shaies is aujusteu to ieflect options that aie outstanuing, but the expecteu pioceeus
fiom the exeicise (the piouuct of the exeicise piice anu the numbei of options) aie
auueu to the value of equity. The limitations of this appioach aie that, like the fully
uiluteu appioach, it uoes not consiuei the time piemium on the options anu theie is
no effective way of uealing with vesting. ueneially, this appioach, by unuei
estimating the value of options gianteu, will ovei estimate the value of equity pei
The biggest auvantage of this appioach is that it uoes not iequiie a value pei
shaie (oi stock piice) to incoipoiate the option value into pei-shaie value. As we
will see with the last (anu iecommenueu) appioach, theie is a ciiculaiity that is
cieateu when the stock piice is an input into the piocess of estimating option value
which, in tuin, is neeueu to obtain the value pei shaie.
lllosttotloo 11.7. 1teosoty 5tock Apptoocb
To use the tieasuiy stock appioach with uoogle, we fiist estimateu the
aveiage exeicise piice acioss all options outstanuing anu auueu the exeicise
pioceeus to the estimateu value of equity, befoie uiviuing by the fully uiluteu
numbei of shaies outstanuing. (We useu the aveiage exeicise piice of $S91.4u
acioss all options in making this estimate.)
Tieasuiy stock value of equity pei shaie
Value of Equity + Options outstanding * Average Exercise Price
Fully diluted number of shares

$102, 345 + 13.97 * $391.40
(315.29 +13.97)
= $327.44 / share
As with the uiluteu appioach, theie aie mouifieu veisions of this appioach
wheie only in-the-money options aie consiueieu. This will ieuuce the value pei
shaie foi uoogle consiueiably since the aveiage exeicise piice foi the in-the-money
options, at $18S, is much lowei than the weighteu aveiage exeicise piice of $S91.4u.
Tieasuiy stock value of equity pei shaie (baseu on in-the-money options)
Value of Equity + Options outstanding * Average Exercise Price
Fully diluted number of shares

$102, 345 + 4.75 * $185
(315.29 +4.75)
= $314.45/ share
SSSI ;)%1"05 R$2"-0*
The pioblem with both the uiluteu stock anu the tieasuiy stock appioaches
is that they miss the essence of options. Aftei all, the value of an option shoulu
incluue not only the cuiient exeicise value (iecognizeu by the tieasuiy stock
appioach) but also the time piemium, ieflecting the fact that the option still has life
anu the unueilying stock is volatile. Nuch of the uebate on uealing with options has
iageu aiounu how well option piicing mouels woik in valuing employee options. In
this section, we will ieview some of this uiscussion anu examine how to auapt
conventional option piicing mouels to value these options.
MeasuremenL lssues
0ption piicing mouels have been wiuely useu, to goou effect, foi almost foui
uecaues now foi valuing listeu anu tiaueu options on the option exchanges. In
valuing employee options, howevei, theie aie five measuiement issues that we have
to confiont.
a. vesting: Fiims gianting employee options usually iequiie that the employee
ieceiving the options stay with the fiim foi a specifieu peiiou, to be able to exeicise
the option (at which point they aie vesteu). When we examine the options
outstanuing at a fiim, we aie looking at a mix of vesteu anu non-vesteu options. The
non-vesteu options shoulu be woith less than the vesteu options, but the piobability
of vesting will uepenu upon how in-the-money the options aie anu the peiiou left
foi an employee to vest.
b. Illiquiuity: Employee options cannot be tiaueu. As a iesult, employee options aie
often exeiciseu befoie matuiity, making them less valuable than otheiwise similai
tiaueu options that aie maiketable. In a compiehensive stuuy of 262,9S1 option
exeicises of employee options between 1996 anu 2uuS by 0.S. companies, Biooks,
Chance anu Cline (citeu above) note that 92.S% exeicise eaily. 0n aveiage, they finu
that exeicise takes place 2.69 yeais aftei vesting, with 4.71 yeais left to expiiation.
Put anothei way, an employee option with a stateu matuiity of 1u yeais is usually
exeiciseu in S.29 yeais.
c. Stock piice oi stock value: While conventional option piicing mouels aie built
aiounu using the cuiient maiket piice as a key input, we uo come up with estimates
of value pei shaie when we value companies, anu these estimates can be veiy
uiffeient fiom cuiient stock piices. We have to consiuei whethei we want to use
oui estimates of value pei shaie, iathei than the maiket piices, to pieseive
valuation consistency.
u. Bilution: 0nlike listeu options on exchanges, wheie the exeicise of the option has
no impact on the numbei of shaies outstanuing oi the shaie piice, the exeicise of
employee options can altei both.
e. Tax consequences: Fiims aie alloweu to ueuuct the uiffeience between the stock
anu the exeicise piice of an option at exeicise anu theie is potential tax saving at the
time of option exeicise. This potential tax benefit ieuuces the uiain on value cieateu
by having options outstanuing.
f. 0nobseivable inputs: The final issue ielates to options gianteu at piivate fiims oi
fiims on the veige of a public offeiing. Key inputs to the option-piicing mouel,
incluuing the stock piice anu the vaiiance, cannot be obtaineu foi these fiims, but
the options have to be valueu neveitheless.
Modlfylng CpLlon Þrlclng Models
With all of these issues affecting valuation, how uo we auapt conventional
option piicing mouels to value employee options. This question has been auuiesseu
both by acauemics who value options anu by FASB, in its attempts to give guiuance
to fiims that have to value these options foi expensing.
MoJlfleJ 8lock 5cboles
The conventional Black Scholes mouel is uesigneu to value Euiopean options
on tiaueu assets anu uoes not explicitly factoi in the uilution inheient in employee
options oi the illiquiuity¡vesting issues specific to these options. Bowevei,
auaptations of the mouel pioviue ieasonable estimates of value:
1. Builu in expecteu uilution into the stock piice: 0ne of the inputs into the Black
Scholes is the cuiient stock piice. To the extent that the exeicise of options
incieases the numbei of shaies outstanuing (at a piice less than the cuiient
stock piice), the stock piice will uiop on exeicise. A simple aujustment to the
stock piice can incoipoiate this effect:
Aujusteu Stock Piice = Cuiient Stock Piice
shares outstanding
shares outstanding
+ n
The iesulting lowei aujusteu stock piice will also ieuuce the option value.

2. Reuuce the life of the option to ieflect illiquiuity anu eaily exeicise: Eailiei in
this papei, we noteu that employees often exeicise options well befoie
matuiity because these options aie illiquiu. Typically, options aie exeiciseu
about half way thiough theii stateu lives. 0sing a ieuuceu life foi the option
will ieuuce its value.
S. Aujust option value foi piobability of vesting: The vesting aujustment can be
maue in the piocess of calculating of the option value. If we can assess the
piobability of vesting, multiplying this piobability by the option value will
yielu an expecteu value foi the option.
While puiist woulu still iesist, the mouel has pioviueu iemaikably iesilient even in
enviionments wheie its basic assumptions aie violateu.

A mouifieu veision of the aujustment allocates the oveiall value of equity acioss all potential
shaies outstanuing:
Aujusteu Stock Piice =
Share Price*n
shares outstanding
+ Value per Option*n
shares outstanding
+ n
8loomlol MoJels
The possibility of eaily exeicise anu non-vesting, which is substantial in
employee options, leaus many piactitioneis to aigue foi the use of Binomial lattice
mouels to value employee options. 0nlike the Black-Scholes, these mouels not only
can mouel foi eaily exeicise, but can be mouifieu to allow foi othei special featuies
specific to employee options, incluuing vesting. In auuition, binomial mouels allow
foi moie flexibility on inputs, with volatility changing fiom peiiou to peiiou iathei
than iemaining constant (which is the assumption in the Black-Scholes mouel). The
limitation of the binomial mouels is that they aie moie infoimation intensive,
iequiiing the usei to input piices at each bianch of the binomial mouel. In any
iealistic veision of the mouel, wheie the time inteivals aie shoit, this coulu
tianslate into hunuieus of potential piices.
The piimaiy benefit of binomial mouels comes fiom the flexibility that they
offei useis to mouel the inteiaction between the stock piice anu eaily exeicise. 0ne
example is the Bull-White Nouel, which pioposes ieuucing the life useu to value
employee options to a moie iealistic level.
This mouel take into account the
employee exit iate uuiing the vesting peiiou (thus taking into account the
piobability that options will enu up unvesteu anu woithless) anu the expecteu life of
the option aftei they get vesteu. To estimate the lattei, the mouel assumes that theie
will be exeicise if the stock piice ieaches a pie-specifieu multiple of the exeicise
piice, thus making exeicise an enuogenous component of the mouel, iathei than an
exogenous component. The iesulting option values aie usually lowei than those
estimateu using the Black-Scholes mouel.
5lmolotloo MoJels
The thiiu choice foi valuing employee options is Nonte Cailo simulation
mouels. These mouels begin with a uistiibution foi stock piices anu a pie-specifieu
exeicise stiategy. The stock piices aie then simulateu to aiiive at the piobabilities
that employee options will be exeiciseu anu an expecteu value foi the options baseu

}. Bull anu A. White, Bow to value Employee Stock 0ptions, Financial Analysts }ouinal 6u (1)
(2uu4), 114{119.
upon the exeicise. The auvantage of simulations is that they offei the most flexibility
foi builuing in the conuitions that may affect the value of employee options. In
paiticulai, the inteiplay between vesting, the stock piice anu eaily exeicise can all
be built into the simulation iathei than specifieu as assumptions. The uisauvantage
is that simulations iequiie fai moie infoimation than othei mouels.
now mocb Joes tbe moJel mottet?
Bow much uoes the mouel useu to value employee options mattei. Aie theie
significant uiffeiences in values when we use alteinative mouels to value employee
options. Foi the most pait, the biggest single component ueteimining employee
option value is the life of the option. 0sing the stateu life of employee options in the
Black-Scholes mouels yielus too high a value foi these options. If we use an expecteu
life foi the option (which takes into account eaily exeicise anu vesting
piobabilities), the values that we aiiive at aie not uissimilai using uiffeient mouels.
Ammann anu Seiz (2uuS) show that the employee option pricing models in use (the
binomial, Black Scholes with adjusted life and Hull White) all yield similar values.
a consequence, they argue we should steer away from models that require difficult to
estimate inputs (such as risk aversion coefficients) and towards simpler models.
Illustration 11.8: Option Value Approach
In Table 11.9, we begin by estimating the value of the options outstanuing at
uoogle, using the Black-Scholes mouel, aujusteu foi uilution anu using half the
stateu matuiity (to allow foi eaily exeicise). To estimate the value of the options, we
fiist estimate the stanuaiu ueviation of Su% in stock piices
ovei the pievious 2
yeais. Weekly stock piices aie useu to make this estimate, anu this estimate is
. All options, vesteu as well as non-vesteu, aie valueu anu theie is no
aujustment foi non-vesting.

Ammann, N., anu R. Seiz, 2uuS, Y*-8 &1- Q*0-/ Q"&&-)i B L"/$"&%*# B#"/'8%8 *; O.,/*'-- C&*97
g,&%*#8, Woiking Ppaei, SSRN.
The vaiiance estimate is actually on the natuial log of the stock piices. This allows you us to cling
to at least the possibility of a noimal uistiibution. Neithei stock piices noi stock ietuins can be
noimally uistiibuteu since piices cannot fall below zeio anu ietuins cannot be lowei than -1uu%.
All of the inputs to the Black Scholes mouel have to be in annual teims. To annualize a weekly
vaiiance, we multiply by S2.
P":/- KK4G5 O8&%."&-0 L"/$- *; g,&%*#8 g$&8&"#0%#(
Numbei of 0ptions 0utstanuing 1S.97
Aveiage Exeicise Piice $S91.41
Estimateu Stanuaiu Beviation (volatility) Su%
Aveiage stateu matuiity 7.uu
Natuiity aujusteu foi eaily exeicise S.Su
Stock Piice at time of analysis $S26.6
value pei option $ 1uS.6
value of options outstanuing $ 1,447
Tax Rate S8.uu%
Aftei-tax value of options outstanuing $ 897
In estimating the after-tax value of the options at these companies, we have used the
marginal tax rate of 38%. Since the tax law allows for tax deductions only at exercise and
only for the exercise value, we are potentially overstating the possible tax benefits (and
understating the costs).
The value per share is computed by subtracting the value of the options
outstanding from the value of equity and then dividing by the primary number of shares
Value of equity per share =
Value of equity - Value of options
Primary shares outstanding

102, 345 - 897
= $321.76
The inconsistency averred to earlier is clear when we compare the value per share that we
have estimated in this table to the price per share that we used in the previous one to
estimate the value of the options. For instance, Google’s value per share is $321.76,
whereas the price per share used in the option valuation is $ 326.60. If we choose to
iterate, we would revalue the options using the estimated value, which would lower the
value of the options (to $1,406 million) and increase the value per share, leading to a
second iteration and a third one and so on. The values converge to yield a consistent
estimate of $321.84, close to our original estimate. That is because we estimated a value
per share close to the current price; as the difference widens, the effect of doing the
iterative process on value per share will also increase.
,1214& R$2"-0 34)02* )07 F??&=2 -0 ;)%1&
}ust as options outstanuing iepiesent potential uilution oi cash outflows to
existing equity investois, expecteu option giants in the futuie will affect value pei
shaie by incieasing the numbei of shaies outstanuing in futuie peiious. The
simplest way of consiueiing why futuie option giants affect value is to tieat them as
employee compensation. The iesulting inciease in opeiating expenses will ueciease
opeiating income anu aftei-tax cash flows in futuie yeais, thus ieuucing the value
that we woulu attach to the fiim touay.
Theie aie two things to note heie. The fiist is that this piocess is on top of
the aujustment maue to equity value pei shaie foi the option oveihang. It uoes not
iepiesent uouble counting, because it captuies two uiffeient uiains on equity value
pei shaie, one fiom past option giants anu one fiom expecteu futuie giants.
Bowevei, if we uo this, we shoulu not also inciease the numbei of shaies
outstanuing to ieflect futuie option exeicise. That woulu be uouble counting. The
seconu is that making this estimate has become immeasuiably easiei, now that the
accounting iules have changeu to iequiie fiims to show option giants as expenses.
The opeiating anu net income foi most fiims now shoulu be aftei the option
expense, anu if we foiecast futuie values baseu on these numbeis we aie
incoipoiating the expenses associateu with futuie giants into oui cash flows. The
only note of caution that we woulu auu is that as fiims become laigei, the option
giants as a peicent of ievenues oi value will tenu to become smallei. Thus, we
shoulu move option giants foi fiims towaius inuustiy aveiages oi matuie fiim
piactices as we foiecast out fuithei into the futuie.

If the fiim is not expensing options, the cuiient eainings of the fiim may alieauy incluue the
expenses associateu with option exeicises in the cuiient peiiou. If the effect on opeiating income of
option exeicise in the cuiient peiiou is less than the expecteu value of new option issues, we have to
allow foi an auuitional expense associateu with option issues. Conveisely, if a uispiopoitionately
laige numbei of options weie exeiciseu in the last peiiou, we have to ieuuce the opeiating expenses
to allow foi the fact that the expecteu effect of option issues in futuie peiious will be smallei.
Illustration 11.9: Valuing with expected option issues
When valuing uoogle, the cuiient opeiating income was a key input. The way the
fiim has uealt with employee option expenses will play a key iole in what opeiating
income we will use in valuation. 0vei the past thiee yeais, the fiim has shifteu to
expensing employee options. In its 2uu8 annual iepoit, foi instance, the fiim
highlights employee option expenses as a piopoition of total ievenues anu table
11.1u summaiizes the numbeis:
P":/- KK4K\5 O.,/*'-- g,&%*# O=,-#8-8 V S**(/-
Yeai value of Employee options gianteu As % of Revenues
2uu6 $4S8.1u 4.Su%
2uu7 $868.6u S.2u%
2uu8 $1,119.8u S.1u%
Note that the expense associateu with employee options is a significant uiain on
income anu shows no signs of abating as uoogle becomes laigei as a company.
ke|at|ve Va|uat|on
}ust as options affect intiinsic valuations, they also affect ielative valuations.
In paiticulai, compaiing multiples acioss companies is complicateu by the fact that
fiims often have vaiying numbeis of employee options outstanuing anu these
options can have veiy uiffeient values. A failuie to explicitly factoi these options
into analysis will iesult in companies with unusually laige oi small (ielative to the
peei gioup) numbeis of options outstanuing looking misvalueu on a ielative basis.
To see the effect of options on eainings multiples, consiuei the most wiuely
useu one, which is the PE iatio. The numeiatoi is usually the cuiient piice pei shaie
anu the uenominatoi is eainings pei shaie. Analysts who use piimaiy eainings pei
shaie aie cleaily biasing theii analysis towaius finuing companies with highei
option oveihang to be unueivalueu. To see why, note that the piice pei shaie
shoulu incoipoiate the effect of options outstanuing - the maiket piice will be lowei
when theie aie moie employee options outstanuing, but the uenominatoi uoes not
since it ieflects actual shaies outstanuing anu uoes not captuie potential uilution.
Note that this bias will not uisappeai when fiims switch to expensing options.
To countei this, analysts often use fully uiluteu eainings pei shaie to
incoipoiate the effect of outstanuing options, thus penalizing companies with laige
numbeis of options outstanuing. The pioblem with this appioach is that it tieats all
options equivalently, with the numbei of shaies incieasing by the same unit
whethei the option is out-of-the-money anu has thiee weeks left to expiiation oi
ueep in-the-money anu has five yeais left to matuiity. Cleaily, fiims that have moie
of the lattei shoulu tiaue at lowei maiket values (foi any given level of eainings)
anu will look cheapei on a uiluteu basis.
What is the solution. The only way to incoipoiate the effect of options into
eainings multiples is to value the options at faii value, using the cuiient stock piice
as the basis, anu auu this value on to the maiket capitalization to aiiive at the total
maiket value of equity.
This total maiket value of equity can be uiviueu by
aggiegate net income to aiiive at a PE iatio that incoipoiates (coiiectly) the
existence of options. This will allow analysts to consiuei all options outstanuing anu
incoipoiate theii chaiacteiistics into the value.
0ption coiiecteu PE =
(Market Capitalization + Estimated value of options oustanding)
Net Income

The net income useu shoulu be the eainings estimateu on the assumption that
employee options aie compensation anu opeiating expenses. With the auoption of
12SR, this has become a little easiei to uo, though many companies still iepoits net
income befoie anu aftei these expenses.
Eveiything that we have saiu about eainings multiples can also be saiu about
book value multiples. Failing to incoipoiate the value of equity options into the
maiket value of equity will make option-heavy companies look cheapei, ielative to
companies that have fewei options outstanuing. The solution is the same as it was
foi eainings multiples. Estimating the value of employee options anu auuing them to
maiket capitalization will almost always eliminate the bias in the compaiison

Baiking back to the last section, the value of options useu shoulu be calculateu baseu upon the
cuiient stock piice (iathei than an estimateu value) anu on a pie-tax basis.
Illustration 11.10: Adjusting PE ratio for options outstanding
To examine the effects of options outstanuing on ielative valuation, we will
compaie uoogle anu Cisco, two technology fiims with a histoiy of using employee
options. In table 11.11, we estimate the conventional PE iatio anu contiast it with
the aujusteu PE iatio, using the appioach uesciibeu above:
P":/- KK4KK5 HO )"&%* <-)8$8 B0n$8&-0 HO )"&%*5 S**(/- "#0 >%89*
uoogle Cisco
Stock piice $S26.6u $16.2S
Piimaiy Shaies outstanuing S1S.29 S986.uu
Numbei of options outstanuing 1S.97 1199.uu
Piimaiy EPS $1S.4u $1.47
Biluteu EPS $12.8S $1.2S
Piimaiy PE 24.S7 11.u4
Biluteu PE 2S.4S 1S.2S
Naiket Capitalization $1u2,97S $97,1SS
value of 0ptions $1,4u6 $S,477
Naiket value of Equity (Naiket
capitalization + value of options) $1u4,S81 $1uu,6Su
Net Income befoie option
expensing $S,S47 $8,8u2
Net Income aftei option expensing $4,227 $8,uS2
Aujusteu PE (Naiket value of
Equity¡ Net income aftei option
exp) 24.69 12.Su
Note that foi uoogle, the effects of incoipoiating options into the maiket value of
equity anu using net income aftei option expensing uoes not have a mateiial impact
on the PE iatio. Foi Cisco, the effects aie much stiongei with the PE ianging fiom 11
to 1S.2S, uepenuing on how we ueal with options.
Va|ue Þ|ays
The biggest huiule when investing in fiims with intangible assets is that the
accounting numbeis, at least as stateu, aie ueceptive. Technology anu
phaimaceutical companies that look goou on papei - have high eainings giowth anu
exceptional ietuins on capital - may not only be much less attiactive, when we
coiiect foi accounting miscategoiization but may be actually be pooily iun anu pooi
long teim investments.
As investois in these companies, we have to coiiect foi these accounting
pioblems anu focus on companies that have the following chaiacteiistics:
a. Intangible assets shoulu geneiate high maigins anu ietuins: The intangible
asset possesseu by the fiim has to be unique anu uifficult to ieplicate. We aie,
in effect, applying the same test to investments in R&B anu bianu name that
we apply to investments in plant anu equipment. If a consulting fiim claims
that its consultants aie the best in the business anu that this is the souice of
theii excess ietuins, ask the question: Bow uo you holu on to these
b. Reasonable piices foi "tiue" eainings: It is unueniable that many fiims with
intangible assets have high giowth potential anu piices that ieflect that.
0sing the mismatch test that we have useu on othei companies, we want to
invest in technology companies that have high giowth in eainings anu tiaue
at low piice eainings iatios. The one caveat we woulu auu is that giowth in
accounting eainings at these fiims can be misleauing, because it is aftei R&B
has been expenseu. Thus, you may want to naiiow youi seaich to finu fiims
that have high giowth in eainings, piioi to R&B expensing, anu tiaue at low
multiples of pie-R&B eainings.
c. Company is spenuing to pieseive anu augment these intangible assets: If a
fiim is being valueu highly because of its intangible assets, you want to keep
tabs on how much it is spenuing to giow the value of it assets ovei time. In
othei woius, you want phaimaceutical fiims that aie continuing to invest in
R&B anu consumei piouuct companies that aie spenuing money on bianu
name auveitising.
d. The spenuing is efficient: While spenuing money on intangible assets is key
to success, just as ciitical is the iequiiement that this spenuing be efficient. If
the investment is R&B, you want to see the ieseaich pay off in new patents,
which aie tuineu into successful commeicial piouucts quickly in the pipeline.
If the investment is bianu name auveitising, you want to see sustaineu high
ievenue giowth anu¡oi high maigins fiom both existing anu new bianu
e. Watch foi othei equity claims: Fiims with intangible assets tenu to be the
biggest useis of equity options as compensation. To the extent that the
iecepient of these options aie manageis who now lay a c
In effect, you want to invest in companies that make goou investments in intangible
assets anu aie able to leveiage these assets to geneiate high ietuins, while selling at
low maiket piices.
In this chaptei, we examine the two key issues that we face when valuing
fiims with substantial intangible assets. The fiist is that the accounting tieatment of
what compiises capital expenuituies at these fiims is inconsistent with the
accounting tieatment of capital expenuituies at manufactuiing fiims. R&B expenses,
bianu name auveitising anu employee ieciuitment anu tiaining expenses aie
tieateu as opeiating, iathei than capital expenses. As a iesult, both the eainings anu
book value numbeis at these fiims aie skeweu anu using them in valuation can leau
to pooi estimates of value. We examineu ways of coiiecting foi this accounting
inconsistency anu the iesulting effect on value. In geneial, fiims that can conveit
R&B expenuituies moie efficiently anu piofitably into commeicial piouucts will see
theii estimateu values inciease, as a iesult of the coiiection, wheieas fiims that
spenu significant amounts on acquiiing intangible assets with little to show foi it in
teims of highei eainings will see theii estimateu values ueciease.
The seconu issue that we consiuei is the use of equity options to compensate
employees. We look at two tiauitional appioaches foi uealing with these options -
the uiluteu stock anu tieasuiy stock appioaches - anu uiscaiu them. Insteau, we
aigue foi valuing these options using mouifieu option piicing mouels anu aujusting
the value of common shaies touay both foi options that have been gianteu in the
past (the option oveihang) anu expecteu futuie option giants.

Sect|on 4: Mopp|ng up
Chapter 12: Va|uat|on Lessons
Through this book, we have emphasized the importance of first principles in
valuation and how they should guide us, when faced with questions. The dark side of
valuation, as we have described it, takes different forms with different types of firms and
the remedies we offer have also varied with each type. In this chapter, we pull together
some of the core ideas that can allow us to combat the pull of the dark side. In the
process, we will very quickly review the foundations of what we would like to portray as
the right “light” side of valuation.
Ln||ghten|ng Þropos|t|ons
When confionteu by unceitainty oi missing infoimation, we aie tempteu to
auopt looseu-backeu iules of thumb anu make inconsistent assumptions about
giowth, iisk anu cash flows. In this section, we will outline a few piopositions that
can guiue us in making bettei juugments, when challengeu, anu iesult in bettei
Þropos|t|on 1: I|rst pr|nc|p|es matter
Theie aie a few basic piinciples in valuation that we shoulu nevei
compiomise on, no mattei what the countei aiguments aie. An analyst who aigues
that fiims can giow foievei without ieinvesting is violating a fiist piinciple, as is
one who says that iisk uoes not mattei in ueteimining value. Lest this be seen as a
sign of iigiuity, we woulu hasten to auu that we shoulu always be willing to
compiomise on anu accept bettei tools, anu be open to alteinative estimates foi
inputs into value. Thus, the capital asset piicing mouel is a tool foi estimating iisk,
which we shoulu be willing to auapt, mouify oi even abanuon, if the uata so uiiects
us. The beta that we come up with foi a fiim, in the context of measuiing iisk, is an
estimate anu theie shoulu be no one appioach that uominates. In summaiy, then,
we will iemain steaufast in oui belief that iisk shoulu affect value, open to new
uevelopments when it comes to mouels foi estimating that iisk anu always be on the
lookout foi bettei anu moie consistent estimates of beta oi othei iisk paiameteis.
Þropos|t|on 2: Þay heed to markets but don't |et markets determ|ne your va|uat|ons.
Nany of the companies that we aie calleu upon to value aie tiaueu in
financial maikets anu have a maiket piice. Without making any juugments about
maikets oi theii efficiency, we believe that theie is valuable infoimation in how the
maiket is piicing assets. In fact, oui estimates of iiskfiee iates, in chaptei 6, anu
equity iisk piemiums, in chaptei 7, came fiom financial maikets - the piicing of the
tieasuiy bonu foi the fiist anu the level of the equity inuices in the lattei. When
valuing a company, it theiefoie behooves us to pay attention to the maiket piice foi
thiee ieasons:
1. The infoimation we extiact fiom maikets on implieu giowth iates, iisk anu
cash flows can be useu to impiove oui valuation.
2. 0ltimately, we make money, not fiom oui intiinsic values, but fiom the
maiket piice moving to those intiinsic values. Thus, we neeu to unueistanu
why maiket piices may ueviate fiom value anu how they will aujust ovei
S. Waiien Buffett is fonu of the auage of Ni. Naiket, wheie we, as long-teim
intiinsic value investois, tiy to take auvantage of an unpieuictable anu
unstable maiket that goes fiom unuei piicing to ovei piicing secuiities.
At the same time, paying too much attention to markets (and prices) can lead to paralysis,
since there is always an alternative set of assumptions under which the market price is
When valuing companies, we face a balancing act, where use market inputs for some
numbers (riskfree rates, equity risk premium, market weights for debt and equity in the
cost of capital) and argue that the market is wrong on other dimensions. To preserve
sanity and derive reasonable values for companies, we have to decide early on in a
valuation, which inputs we will accept market inputs on, and which ones we will contest
the market consensus. In chapters 6 and 7, we argued that when valuing individual
companies, we should accept the market consensus on riskfree rates and equity risk
premiums and focus our attention or estimating the earnings and cash flows of the
company. In chapter 14, when valuing an oil company, we made a case for using market
consensus prices for oil prices (obtained from either the spot or the forward and futures
markets) and limiting our valuation to how much oil the company would produce and its
cost structure.
As a general rule, the areas where you choose to accept the market wisdom and the
points at which you deviate will depend on two key variables. The first is in the
competitive advantages you see yourself having as an analyst and where you think these
advantages will generate the biggest payoff. If your edge is in forecasting
macroeconomic movements and oil prices, you will replace the market prices with your
own and leverage your edge to generate better valuations. If, on the other hand, your
biggest strength is in assessing the internal strengths of a company, you should not be
expending resources on estimating macro parameters. The second factor is your “job
description”. If your job is to assess the value of individual companies and not to assess
the overall market or commodity prices, you will be doing yourself and your clients a
disservice by letting your views on macro economic variables seep into your company
Þropos|t|on 3: k|sk matters
It is tiue that consiueiable iesouices have been investeu both in acauemia
anu piactice in coming up with mouels to assess iisk anu ueiive expecteu ietuins. It
is also tiue that these mouels often make assumptions about the ieal woilu that uo
not withstanu close sciutiny. In the capital asset piicing mouel, foi instance, we
assume no tiansactions costs anu piivate infoimation to ueiive the ielationship
between expecteu ietuins anu betas. Analysts, looking at these mouels, finu
themselves in uisagieement with the assumptions anu that is peifectly
unueistanuable, but jumping fiom that uisagieement to a conclusion that iisk uoes
not mattei in value is not.
Risk affects value, no mattei which appioach you use to ueiive that value. In
uiscounteu cashflow mouels, the iisk is manifesteu eithei in the uiscount iate oi in a
iisk-aujusteu cash flow (which is moie than just an expecteu ietuin). In ielative
valuation, fiims that aie iiskiei shoulu tiaue at lowei multiples of eainings,
ievenues anu book value than fiims that aie safei. If theie is one lesson that we
shoulu take away fiom the last few uecaues of examining iisk, it is that all iisks aie
not equal. Some iisks affect only a fiim oi a few fiims, wheieas othei iisks have
consequences foi a wiuei subset of fiims anu foi the oveiall maiket. When assessing
iisk foi valuation, it is theiefoie impeiative that we fiist iuentify the maiginal
investois in a fiim anu look at iisk thiough theii eyes. If the maiginal investoi is
uiveisifieu, the only iisks that shoulu affect value aie the maiket oi macio iisks that
cannot be uiveisifieu away. In contiast, though, if the maiginal investoi is
unuiveisifieu oi only paitially uiveisifieu, we shoulu be looking at the much bioauei
set of iisks that incluue fiim specific iisks. In chaptei 9, this was the insight we useu
to ueiive total betas anu costs of equity foi entiepieneuis (who tenu not to be
uiveisifieu) anu ventuie capitalists (who aie only paitially uiveisifieu).
Risk can also be categoiizeu baseu into continuous iisk, i.e. iisk that affects
cash flows anu value continuously ovei time (inteiest iate iisk anu exchange iate
iisk, foi example) anu uisciete oi uiscontinuous iisk, i.e., iisk that may lie uoimant
foi long peiious but affect value significantly when it occuis (the iisk of uefault anu
nationalization, foi instance). We aigueu that continuous iisk is best captuieu in
uiscount iates, wheieas uisciete iisk is moie easily measuieu by assessing both the
piobability anu the consequences of the event occuiiing. We useu the lattei
technique the values of young, giowth companies anu uistiesseu companies foi
suivival iisk anu emeiging maiket companies foi nationalization iisk.
As we builu in iisk into valuation mouels, it is also impoitant that we auopt
the following piactices:
1. Isolate the iisk effects: Rathei than let iisk peivaue all of the inputs into a
valuation, the effects of iisk shoulu be in one oi two vaiiables. Thus, the
effect of emeiging maiket iisk is captuieu in the countiy iisk piemium but
uoes not affect iisk fiee iates, betas oi cash flows. Theie aie two ieasons why
this is a goou piactice. The fiist is that it pievents the uouble oi tiiple
counting of iisk. The seconu is that it allows foi moie tianspaiency. Thus,
those who use the valuation can assess the iisk aujustment maue anu ueciue
whethei they agiee with it oi not; if they uisagiee, it is ielatively simple to
make the change anu ie-estimate value.
2. Be consistent: When valuing fiims, especially giowth fiims oi fiims in
tiouble, we have to iecognize that the fiim's iisk piofile will change ovei
time anu aujust the iisk paiameteis accoiuingly. With giowth fiims, foi
instance, the high uiscount iates we use in the eaily yeais (ieflecting the iisk
in those yeais) have to come uown as giowth ueclines. In almost all of the
valuations that we have piesenteu in this book, the betas anu uiscount iates
that we use foi the teiminal value ieflect this juugment.
Þropos|t|on 4: Growth |s not free and |s not a|ways va|ue add|ng.
If theie is a theme to oui uiscussions of giowth acioss the chapteis, it is that
giowth is not fiee. 0ltimately, the expecteu giowth in eainings anu cash flows in a
company have to come eithei fiom new investments oi impioveu efficiency. The
lattei is finite giowth - theie is a limit to how efficient you can become as a fiim -
wheieas new investment giowth is long teim. This is the ieason why giowth in the
teiminal value computation is estimateu puiely fiom new investments in eveiy
valuation uone in this book.
It is also ciitical to iemembei that giowth by itself is not always a plus foi a
company, since the value auueu by giowth is a function of the quality of the
investments that geneiateu that giowth. That is the ieason that we have focuseu so
intensely on excess ietuins, estimateu by compaiing the ietuin on capital to the cost
of capital oi the ietuin on equity to the cost of equity, in oui assessments of giowth.
A fiim that giows by investing in new assets that geneiate a ietuin on capital equal
to its cost of capital will become laigei ovei time but will not auu value to its
investois. A fiim that giows by investing in pooi investments, i.e., the ietuin on
capital (equity) is less than the cost of capital (equity) will become less valuable
ovei time, even as it giows. In fact, a key test of manageis is whethei they aie able to
geneiate high excess ietuins, while ieinvesting significant amounts back into the
In the context of ielative valuation, we may not be uiiectly focuseu on excess
ietuins but we shoulu pay attention to them. Thus, if two companies aie expecteu to
uelivei the same expecteu giowth in eainings in the futuie, the company that has
the highei excess ietuins accompanying this giowth shoulu be valueu moie highly.
Þropos|t|on S: A|| good th|ngs come to an end.
In auuition to looking at the value auueu oi uestioyeu by giowth, we often
have to make estimates of futuie giowth iates foi companies. In making this
assessment, theie aie two key vaiiables that we have to pay attention to. The fiist is
the scaling effect. As companies become biggei, it becomes moie anu moie uifficult
foi them to keep ueliveiing the excess ietuins anu giowth iates that they useu to in
the past. Thus, it is almost a ceitainty that a fiim that has giown 1uu% a yeai foi the
last S yeais will giow at a slowei iate in the next S yeais. With young giowth
companies, in chaptei 9, we ieflecteu this ieality by loweiing expecteu giowth iates
in ievenues anu eainings as we move thiough time. The othei is competition. When
fiims aie successful, they attiact attention, which in tuin leaus to imitation anu
incieaseu competition. While fiims may be successful in keeping this competition at
bay foi extenueu peiious (using legal anu business tools), it will inevitably chip
away at piofitability anu giowth.
0ne way we ieflecteu the inevitability of ueclining giowth was by assuming
that all fiims, no mattei how highly iegaiueu they might be, eventually become
stable giowth fiims (at which point we estimate a teiminal value). We captuieu the
effects of competition ovei time by pushing the maigins of inuiviuual fiims to the
inuustiy aveiage anu the ietuins on capital (equity) towaius the cost of equity
Þropos|t|on 6: Watch out for truncat|on r|sk
In conventional uiscounteu cash flow valuation, we value fiims as going
conceins, with cash flows continuing into peipetuity, often giowing each yeai. While
this may not be an unieasonable assumption foi some fiims, the ieality is that most
fiims uo not make it. Nany young fiims iun out of cash, some matuie fiims become
the taigets of leveiageu acquisitions anu most uistiesseu fiims enu up uefaulting on
uebt (anu going out of business). The optimism that unueilies uiscounteu cash flow
valuation can leau us to ovei estimate the value of fiims, wheie the iisk of not
making it (tiuncation iisk) is high.
In the chapteis wheie we lookeu at fiims acioss the life cycle, we aigueu that
the iisk of tiuncation is gieatest foi fiims at eithei enu of the life cycle - veiy, young
giowth companies anu ueclining oi uistiesseu companies. With these fiims, we
auopt a two-step appioach to valuation. In the fiist, we assume that the fiims woulu
not only suivive but also ieveit to goou financial health ovei time, anu value them
on that basis. In the seconu, we estimate the likelihoou that they woulu not suivival
anu the values that we woulu assign the fiim anu equity, in the event of failuie. 0ui
final estimate of value is a weighteu aveiage of the two numbeis.
Þropos|t|on 7: Look at the Þast, 8ut 1h|nk About the Iuture
0ne of the conunuiums we face in valuation is that although almost all the
uata we have available to us is about the past, ieflecting the company's histoiy (past
financial statements, betas), the sectoi (inuustiy aveiage maigins anu ietuins on
capital), anu macioeconomic vaiiables (inteiest iates, exchange iates, stock
ietuins), all the foiecasts we have to make aie foi the futuie. While we cannot
manufactuie uata foi the futuie, we can follow some simple iules to minimize the
0se histoiical uata, but uo not be bounu by it: 0ne of the key components in valuing
companies well is iecognizing when to use past uata anu when to look at
alteinatives. Thus, foi a piofitable company with little volatility in yeai-to-yeai
numbeis, theie is no haim in builuing off last yeai's numbeis when valuing the
company. Foi the cyclical anu commouity companies we valueu in Chaptei 1S, this
base-yeai fixation can leau to valuations that aie too high (oi low) if the most iecent
yeai iepiesents the peak (oi bottom) of the cycle. Consequently, we noimalizeu
eainings foi these companies using the infoimation in the company's own histoiy as
well as in the commouity piice cycle.
Tiust in mean ieveision, but watch out foi stiuctuial bieaks anu changes:
Whenevei we use histoiical uata to make foiecasts, we aie assuming that mean
ieveision exists. In othei woius, both macioeconomic numbeis, such as inflation
anu inteiest iates, anu company-specific infoimation, such as maigins anu
ieinvestment iates, ieveit to histoiic noims. While mean ieveision has stiong
empiiical suppoit, two uangeis aie associateu with assuming that it will happen.
The fiist is that theie can sometimes be significant bieaks in histoiy, wheie the
ciicumstances change so much that the numbeis aie unlikely to ieveit foi a veiy
long peiiou to past aveiages. This was the case, foi instance, in the 0.S. in the 197us ,
when inflation incieaseu anu pusheu up inteiest iates anu commouity piices foi
almost a uecaue. The seconu uangei is that theie is no consensus on what exactly
the histoiical noim is foi most vaiiables. Biffeient analysts can look at the same
uata anu come to veiy uiffeient juugments about what constitutes noimalcy.
0se foiwaiu estimates as alteinatives oi checks: With a few vaiiables, we may be
able to get foiwaiu-looking estimates that can be useu eithei uiiectly in valuation oi
to check the histoiical uata. With equity iisk piemiums in Chaptei 7, foi instance,
the implieu equity iisk piemium we estimateu, baseu on the cuiient level of the
equity inuex anu the expecteu futuie cash flows, offeis an alteinative to histoiical
iisk piemiums. With oil piices, futuies anu foiwaiu maikets pioviue estimates that
can be useu to value companies, iathei than past uata. We can eithei ieplace the
histoiical estimates with these foiwaiu-looking numbeis oi aujust them to ieflect
In closing, we shoulu be glau that valuation is not just an exeicise in taking last
yeai's numbeis anu putting them thiough a mouel. Aftei all, if this weie the case,
theie woulu be no neeu foi human inteivention, since a computei coulu veiy easily
accomplish this task. 0ui iole in valuation is to look at past uata, assess its
usefulness, anu then make oui best pieuictions foi the futuie.
Þropos|t|on 8: Draw on the Law of Large Numbers
0ne of the issues we have iaiseu as a manifestation of the uaik siue is the use
of iules of thumb in valuations. These iules can iange anywheie fiom a fixeu equity
iisk piemium (obtaineu fiom a seivice) to auuing piemiums to value foi contiol,
syneigy, anu othei "goou" factois anu subtiacting uiscounts foi illiquiuity anu pooi
coipoiate goveinance. In many cases, the numbeis that aie useu in these
aujustments come fiom looking at past uata. The histoiical equity iisk piemium, foi
instance, is estimateu by aveiaging the piemium eaineu by stocks ovei tieasuiies
ovei long time peiious. The contiol piemium (of 2u%) is ioughly what acquiieis
have paiu to acquiie publicly tiaueu taiget fiims ovei an extenueu peiiou. Even if
these estimates aie constantly upuateu anu aie fiom seivices that have impeccable
ieputations, these numbeis cannot be tieateu as facts. They aie estimates, baseu on
samples, anu they come with substantial stanuaiu eiiois. Thus, a histoiical equity
iisk piemium of 4%, estimateu with Su yeais of uata in the 0.S., has a stanuaiu eiioi
of about S% associateu with it, just as the acquisition piemium of 2u% has a
stanuaiu eiioi of about S% attacheu to it.
While making estimates baseu on uata will always be subject to noise, we can uo
some things to make these estimates moie piecise:
0se laigei samples: When we can, we shoulu expanu oui uata to incluue moie uata
points. With histoiical iisk piemiums, foi instance, an equity iisk piemium
estimateu ovei 1uu yeais of uata will have a stanuaiu eiioi of only 2% associateu
with it. This push towaiu laigei sample sizes peimeates much of what we have uone
in this book to combat bau piactices. Fiom bottom-up betas (wheie we ieplace a
single iegiession beta, with a laige stanuaiu eiioi, with an aveiage of many
iegiession betas, with much smallei stanuaiu eiiois) to the use of inuustiy-aveiage
piofitability measuies in foiecasting futuie eainings foi a company, we substitute
aveiages of laige samples foi inuiviuual company uata. In ielative valuation, wheie
we look at the aveiage multiple at which othei fiims in a sectoi tiaue, we suggesteu
ways of loosening the uefinition of compaiable fiims to allow foi laigei samples. In
effect, we woulu iathei have a laigei sample of less compaiable fiims than a sample
of a few fiims that look moie like the fiim we aie valuing.
0se statistical tools to impiove estimates: In many cases, when analysts use
histoiical uata, they settle foi the aveiage. While this is a useful numbei, theie may
be ways in which the uata can be utilizeu to uelivei moie piecise estimates. Thus,
when compaiing a fiim's PE iatio to the iest of the sectoi, using a pieuicteu PE fiom
a sectoi iegiession shoulu yielu a moie piecise estimate than just using the aveiage
PE foi the sectoi.
We shoulu make a final point about the law of laige numbeis. Since the values we
obtain foi inuiviuual companies aie estimates, the likelihoou that we will be wiong
about any one company in any one peiiou is high. Bowevei, if we assess value well,
oui chances of being iight will impiove if we extenu to multiple peiious (longei time
hoiizons) anu acioss multiple stocks (poitfolios).
Þropos|t|on 9: Accept Uncerta|nty, and Dea| w|th It
We noteu eaily in this book that one of the ieasons we aie attiacteu to the
uaik siue of valuation is because we feel oveiwhelmeu by the unceitainties we face
with some gioups of companies. In fact, much of this book has been uiiecteu at
ueveloping healthiei iesponses to unceitainty:
Accept unceitainty: Accept unceitainty as a given, unueistanuing that no mattei
how caiefully we constiuct mouels, we cannot make unceitainty go away. Thus,
auuing moie uetail to mouels oi making mouels moie complicateu, both of which
aie tactics that analysts use to ieuuce unceitainty, often uoes little to alleviate the
pioblem anu may actually make it woise.
Ask what-if questions, but foi the iight ieasons: As access to uata impioves anu
moie sophisticateu tools foi uealing with unceitainty (Nonte Cailo simulations,
uecision tiees) aie intiouuceu, we aie also seeing the potential uownsiue of
allowing analysts to subject theii valuations to these tools. The fiist pioblem is that
these tools often iequiieu complex inputs, anu the quality of the output is a function
of the quality of the inputs. Simulations, foi instance, iequiie us to choose
piobability uistiibutions foi oui inputs anu paiameteis foi the uistiibutions. This is
a uifficult task consiueiing the uata we can access. The seconu pioblem is that some
analysts use these as tools foi iisk aujustment iathei than iisk assessment. In the
piocess, they uouble-count iisk. Consiuei a uiscounteu cash flow valuation of a fiim,
wheie expecteu cash flows aie uiscounteu back at a iisk-aujusteu iate to aiiive at a
value that is highei than the cuiient maiket piices. Assume that you put this mouel
thiough a Nonte Cailo simulation, ueiive a uistiibution of values (which suggests
that theie is a 4u% chance that the stock is oveivalueu), anu ueciue not to invest in
the fiim on this basis. You have uouble-counteu iisk once by using iisk-aujusteu
iates, anu again by uiawing on the iesults of the simulation.
In summaiy, unceitainty anu iisk aie pait of life anu investing. When valuing
companies, we can uemanu a piemium foi taking this iisk in the uiscount iate anu
aiiive at a iisk-aujusteu value, but it will change as ciicumstances change.
Þropos|t|on 10: Convert Stor|es to Numbers
0ne of the ciitiques of uiscounteu cash flow valuation is that it is so focuseu
on numbeis that it misses the qualitative vaiiables. Incluueu in the list of qualitative
vaiiables aie items such as customei loyalty, bianu name, anu goou management.
This can be tiue in some cases, wheie few questions aie askeu about the numbeis
anu the inputs aie mostly exogenous.
We hope that we have auuiesseu this ciiticism uiiectly, as we have valueu
inuiviuual companies. Eveiy numbei in a uiscounteu cash flow valuation shoulu
have an economic iationale a goou economic stoiy behinu it. Thus, when we set a
fiim's ietuin on capital at 1S%, well above its cost of capital, it behooves us to think
about this fiim's competitive auvantages (most of which aie qualitative) anu how
they tianslate into the ietuin on capital. 0n the flip siue, eveiy soliu economic stoiy
shoulu finu a place in the numbeis. Bianu name affects value, but it uoes so by
incieasing maigins anu excess ietuins, not as a piemium at the enu of the piocess.
In ielative valuation, the tenuency towaiu stoiytelling sometimes oveiwhelms the
numbeis. 0ne ieason foi oui use of statistical tools (iegiessions anu coiielations) in
ielative valuation is not only to assess whethei the unueilying stoiy makes sense,
but also to quantify the effects in oui pieuictions. Thus, by iegiessing PE against
expecteu giowth, we can measuie how much the PE iatio incieases foi eveiy 1%
inciease in the giowth iate, at least given how the maiket is piicing stocks in this
We will enu this book how we began it by noting that valuation has only a
few fiist piinciples, anu that the basic stiuctuie of valuation has not changeu much
ovei time. Bowevei, the kinus of fiims we aie calleu on to value pose moie
challenges touay than evei befoie. As fiims anu investois globalize, companies have
become moie complex in teims of both theii opeiations anu the financing choices
they make to funu those opeiations.
When calleu on to value companies, we shoulu iecognize that iigiu iules uo
not seive us well, since valuing inuiviuual companies iequiies us to be flexible anu
uevise new iules when faceu with unusual scenaiios. Rathei than let estimation
issues oveiwhelm us anu foice us into bau choices, we shoulu step back anu assess
commonsense ways, constiaineu by the uata we have available, to ueal with uifficult