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Valuation Models

AswathDamodaran

Aswath Damodaran

Misconceptions about Valuation

Myth1:Avaluationisanobjectivesearchfortruevalue
Truth1.1:Allvaluationsarebiased.Theonlyquestionsarehowmuchand
inwhichdirection.
Truth1.2:Thedirectionandmagnitudeofthebiasinyourvaluationis
directlyproportionaltowhopaysyouandhowmuchyouarepaid.

Myth2.:Agoodvaluationprovidesapreciseestimateofvalue
Truth2.1:Therearenoprecisevaluations
Truth2.2:Thepayofftovaluationisgreatestwhenvaluationisleast
precise.

Myth3:.Themorequantitativeamodel,thebetterthevaluation
Truth3.1:Onesunderstandingofavaluationmodelisinversely
proportionaltothenumberofinputsrequiredforthemodel.
Truth3.2:Simplervaluationmodelsdomuchbetterthancomplexones.

Aswath Damodaran

Approaches to Valuation
ValuationModels

AssetBased
Valuation

DiscountedCashflow
Models

RelativeValuation

Liquidation
Value

Equity
Stable

Current

ContingentClaim
Models

Sector

Twostage
Threestage
ornstage

EquityValuation
Models

Normalized

Earnings

Book Revenues
Value

Sector
specific

Patent

Aswath Damodaran

Optionto
liquidate

Young
firms

Equityin
troubled
firm

Undeveloped
land

FirmValuation
Models

Dividends

FreeCashflow
toFirm

Optionto
expand

Firm
Market

Replacement
Cost

Optionto
delay

Costofcapital
approach

APV
approach

Undeveloped
Reserves

ExcessReturn
Models

Basis for all valuation approaches

Theuseofvaluationmodelsininvestmentdecisions(i.e.,indecisions
onwhichassetsareundervaluedandwhichareovervalued)arebased
upon
aperceptionthatmarketsareinefficientandmakemistakesinassessing
value
anassumptionabouthowandwhentheseinefficiencieswillgetcorrected

Inanefficientmarket,themarketpriceisthebestestimateofvalue.
Thepurposeofanyvaluationmodelisthenthejustificationofthis
value.

Aswath Damodaran

Discounted Cash Flow Valuation

Whatisit:Indiscountedcashflowvaluation,thevalueofanassetis
thepresentvalueoftheexpectedcashflowsontheasset.
PhilosophicalBasis:Everyassethasanintrinsicvaluethatcanbe
estimated,baseduponitscharacteristicsintermsofcashflows,growth
andrisk.
InformationNeeded:Tousediscountedcashflowvaluation,youneed
toestimatethelifeoftheasset
toestimatethecashflowsduringthelifeoftheasset
toestimatethediscountratetoapplytothesecashflowstogetpresentvalue

MarketInefficiency:Marketsareassumedtomakemistakesinpricing
assetsacrosstime,andareassumedtocorrectthemselvesovertime,as
newinformationcomesoutaboutassets.

Aswath Damodaran

Discounted Cashflow Valuation: Basis for


Approach
t = n CF
t
Value =
t
t = 1 (1+ r)

whereCFtisthecashflowinperiodt,risthediscountrateappropriate
giventheriskinessofthecashflowandtisthelifeoftheasset.
Proposition1:Foranassettohavevalue,theexpectedcashflows
havetobepositivesometimeoverthelifeoftheasset.
Proposition2:Assetsthatgeneratecashflowsearlyintheirlifewill
beworthmorethanassetsthatgeneratecashflowslater;the
lattermayhoweverhavegreatergrowthandhighercashflowsto
compensate.

Aswath Damodaran

Equity Valuation versus Firm Valuation

Valuejusttheequitystakeinthebusiness
Valuetheentirebusiness,whichincludes,besidesequity,theother
claimholdersinthefirm

Aswath Damodaran

I.Equity Valuation

Thevalueofequityisobtainedbydiscountingexpectedcashflowstoequity,i.e.,the
residualcashflowsaftermeetingallexpenses,taxobligationsandinterestandprincipal
payments,atthecostofequity,i.e.,therateofreturnrequiredbyequityinvestorsinthe
firm.
t=n CFtoEquity

ValueofEquity =
t=1

(1+ k e )

where,
CFtoEquityt=ExpectedCashflowtoEquityinperiodt
ke=CostofEquity

Forms:Thedividenddiscountmodelisaspecializedcaseofequityvaluation,andthe
valueofastockisthepresentvalueofexpectedfuturedividends.Inthemoregeneral
version,youcanconsiderthecashflowsleftoverafterdebtpaymentsandreinvestment
needsasthefreecashflowtoequity.

Aswath Damodaran

II. Firm Valuation

Costofcapitalapproach:Thevalueofthefirmisobtainedby
discountingexpectedcashflowstothefirm,i.e.,theresidualcashflows
aftermeetingalloperatingexpensesandtaxes,butpriortodebt
payments,attheweightedaveragecostofcapital,whichisthecostof
thedifferentcomponentsoffinancingusedbythefirm,weightedby
theirmarketvalueproportions.
t= n
CFtoFirm t
t
t =1 (1+ WACC)

ValueofFirm =

APVapproach:Thevalueofthefirmcanalsobewrittenasthesum
ofthevalueoftheunleveredfirmandtheeffects(goodandbad)of
debt.
FirmValue=UnleveredFirmValue+PVoftaxbenefitsofdebtExpected
BankruptcyCost

Aswath Damodaran

Generic DCF Valuation Model


DISCOUNTED CASHFLOW VALUATION

Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS

Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows

Firm is in stable growth:


Grows at constant rate
forever
Terminal Value

Value
Firm: Value of Firm
Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn
.........
Forever

Length of Period of High Growth


Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity

Aswath Damodaran

10

VALUINGABNAMRO
Retention
Ratio=
41.56%

Dividends
EPS=
1.54Eur
*PayoutRatio58.44%
DPS= 0.90Eur

ValueofEquityper
share=20.48Eur

EPS 1.64Eur
DPS 0.96Eur

ROE=16%
ExpectedGrowth
41.56%*
16%=6.65%

g=4%:ROE=8.95%(=Costofequity)
Beta=1.00
Payout=(14/8.95)=.553

TerminalValue=EPS6*Payout/(rg)
=(2.21*.553)/(.0895.04)=24.69
1.75Eur
1.02Eur

1.87Eur
1.09Eur

1.99Eur
1.16Eur

2.12Eur
1.24Eur
.........
Forever

DiscountatCostofEquity

CostofEquity
4.95%+0.95(4%)=8.75%

RiskfreeRate:
Longtermbondratein
Euros
4.95%

Beta
0.95

AveragebetaforEuropeanbanks=
0.95

Aswath Damodaran

RiskPremium
4%

MatureMarket
4%

CountryRisk
0%

11

Aswath Damodaran

12

Embraer: Status Quo ($)

Avg Reinvestment
rate = 25.08%
Current Cashflow to Firm
EBIT(1-t) :
$ 404
- Nt CpX
23
- Chg WC
9
= FCFF
$ 372
Reinvestment Rate = 32/404= 7.9%

Reinvestment Rate
25.08%

Return on Capital
21.85%

Expected Growth
in EBIT (1-t)
.2185*.2508=.0548
5.48 %

Terminal Value5= 288/(.0876-.0417) = 6272

$ Cashflows
Op. Assets $ 5,272
+ Cash:
795
- Debt
717
- Minor. Int.
12
=Equity
5,349
-Options
28
Value/Share $7.47
R$ 21.75

Year
EBIT(1-t)
- Reinvestment
= FCFF

1
426
107
319

3
474
119
355

4
500
126
374

Term Yr
549
- 261
= 288

5
527
132
395

Discount at$ Cost of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81%

Cost of Equity
10.52 %

Riskfree Rate:
$ Riskfree Rate= 4.17%

Cost of Debt
(4.17%+1%+4%)(1-.34)
= 6.05%

Beta
1.07

Unlevered Beta for


Sectors: 0.95

Aswath Damodaran

2
449
113
336

Stable Growth
g = 4.17%; Beta = 1.00;
Country Premium= 5%
Cost of capital = 8.76%
ROC= 8.76%; Tax rate=34%
Reinvestment Rate=g/ROC
=4.17/8.76= 47.62%

On October 6, 2003
Embraer Price = R$15.51

Weights
E = 84% D = 16%

Mature market
premium
4%
Firms D/E
Ratio: 19%

Lambda
0.27

Country Equity Risk


Premium
7.67%

Country Default
Spread
6.01%

Rel Equity
Mkt Vol
1.28

13

Current
Revenue
$ 3,804

Current
Margin:
-49.82%
EBIT
-1895m

Cap ex growth slows


and net cap ex
decreases
Revenue
Growth:
13.33%

NOL:
2,076m

Value of Op Assets $ 5,530


+ Cash & Non-op $ 2,260
= Value of Firm
$ 7,790
- Value of Debt
$ 4,923
= Value of Equity $ 2867
- Equity Options
$
14
Value per share
$ 3.22

Stable Growth

EBITDA/Sales
-> 30%

Stable
EBITDA/
Sales
30%

$3,804 $5,326 $6,923 $8,308 $9,139


($95) $0
$346 $831 $1,371
($1,675) ($1,738) ($1,565) ($1,272) $320
($1,675) ($1,738) ($1,565) ($1,272) $320
$1,580 $1,738 $1,911 $2,102 $1,051
$3,431 $1,716 $1,201 $1,261 $1,324
$0
$46
$48
$42
$25
($3,526) ($1,761) ($903) ($472) $22
1
2
3
4
5

$10,053$11,058$11,942$12,659$13,292
$1,809 $2,322 $2,508 $3,038 $3,589
$1,074 $1,550 $1,697 $2,186 $2,694
$1,074 $1,550 $1,697 $2,186 $2,276
$736 $773 $811 $852 $894
$1,390 $1,460 $1,533 $1,609 $1,690
$27
$30
$27
$21
$19
$392 $832 $949 $1,407 $1,461
6
7
8
9
10

Beta
CostofEquity
CostofDebt
DebtRatio
CostofCapital

3.00
16.80%
12.80%
74.91%
13.80%

2.60
15.20%
11.84%
67.93%
12.92%

Riskfree Rate:
T. Bond rate = 4.8%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

2.20
13.60%
10.88%
60.95%
11.94%

Cost of Debt
4.8%+8.0%=12.8%
Tax rate = 0% -> 35%

Beta
3.00> 1.10

Internet/
Retail

Stable
ROC=7.36%
Reinvest
67.93%

Terminal Value= 677(.0736-.05)


=$ 28,683

Revenues
EBITDA
EBIT
EBIT(1t)
+Depreciation
CapEx
ChgWC
FCFF

Cost of Equity
16.80%

Aswath Damodaran

Stable
Revenue
Growth: 5%

Operating
Leverage

1.80
12.00%
9.92%
53.96%
10.88%

1.40
10.40%
8.96%
46.98%
9.72%

Forever

1.00
8.80%
6.76%
40.00%
7.98%

Weights
Debt= 74.91% -> 40%

Global Crossing
November 2001
Stock price = $1.86

Risk Premium
4%

Current
D/E: 441%

Term.Year
$13,902
$4,187
$3,248
$2,111
$939
$2,353
$20
$677

Base Equity
Premium

Country Risk
Premium

14

Valuing Global Crossing with Distress

Probabilityofdistress
Priceof8year,12%bondissuedbyGlobalCrossing=$653
120(1 Distress ) t 1000(1 Distress ) 8

(1.05) t
(1.05) 8
t1

t 8

653

Probabilityofdistress=13.53%ayear

Cumulativeprobabilityofsurvivalover10years=(1.1353)10=23.37%

Distresssalevalueofequity

Bookvalueofcapital=$14,531million
Distresssalevalue=15%ofbookvalue=.15*14531=$2,180million
Bookvalueofdebt=$7,647million
Distresssalevalueofequity=$0

Distressadjustedvalueofequity
ValueofGlobalCrossing=$3.22(.2337)+$0.00(.7663)=$0.75

Aswath Damodaran

15

Adjusted Present Value Model

Intheadjustedpresentvalueapproach,thevalueofthefirmiswritten
asthesumofthevalueofthefirmwithoutdebt(theunleveredfirm)
andtheeffectofdebtonfirmvalue
FirmValue=UnleveredFirmValue+(TaxBenefitsofDebt
ExpectedBankruptcyCostfromtheDebt)
Theunleveredfirmvaluecanbeestimatedbydiscountingthefree
cashflowstothefirmattheunleveredcostofequity
Thetaxbenefitofdebtreflectsthepresentvalueoftheexpectedtax
benefits.Initssimplestform,
TaxBenefit=Taxrate*Debt
Theexpectedbankruptcycostisafunctionoftheprobabilityof
bankruptcyandthecostofbankruptcy(directaswellasindirect)asa
percentoffirmvalue.

Aswath Damodaran

16

Excess Return Models

Youcanpresentanydiscountedcashflowmodelintermsofexcess
returns,withthevaluebeingwrittenas:
Value=CapitalInvested+Presentvalueofexcessreturnsoncurrent
investments+Presentvalueofexcessreturnsonfutureinvestments

Thismodelcanbestatedintermsoffirmvalue(EVA)orequity
value.

Aswath Damodaran

17

EQUITY VALUATION WITH EQUITY EVA


Current EVA
Net Income =
- Equity cost =
Equity EVA =

Book Equity= 17997


+ PV of EVA= 38334
= Equity EVA=56331
Value/sh = $50.26

Expected Growth
.60 * 20% =12%

$ 3104
$ 1645
$ 1459

Net Income
$3,599
- Equity Cost (see below) $1,908
Excess Equity Return
$1,692

$4,031
$2,137
$1,895

Firm is in stable growth:


Growth rate = 5%
Return on Equity = 15%
Cost of equity =9.40%

Terminal Value= $2220/(.094-.05)=50,459


$4,515
$5,057
$5,664
$2,393
$2,680
$3,002
$2,122
$2,377
$2,662
Forever

Discount atCost of Equity

Cost of Equity
10.60%

Riskfree Rate:
5.00%

Beta
1.40

Risk Premium
4.00%

Base Equity
Premium = 4%

Aswath Damodaran

Country Risk
Premium=0%

18

Choosing the right Discounted Cashflow Model


Can you estimate cash flows?
Yes

No

Is leverage stable or
likely to change over
time?

Use dividend
discount model

Are the current earnings


positive & normal?
Yes

No

Use current
earnings as
base

< Growth rate


of economy

Is the cause
temporary?
Yes

Stable
leverage

Unstable
leverage

FCFE

FCFF

What rate is the firm growing


at currently?

Stable growth
model

Are the firms


competitive
advantges time
limited?

No

Replace current
earnings with
normalized
earnings

Is the firm
likely to
survive?

Yes
2-stage
model

Yes

No
3-stage or
n-stage
model

No

Adjust
margins over
time to nurse
firm to financial
health

Does the firm


have a lot of
debt?

Yes
Value Equity
as an option
to liquidate

Aswath Damodaran

> Growth rate of


economy

No
Estimate
liquidation
value

19

Relative Valuation

Whatisit?:Thevalueofanyassetcanbeestimatedbylookingathowthe
marketpricessimilarorcomparableassets.
PhilosophicalBasis:Theintrinsicvalueofanassetisimpossible(orcloseto
impossible)toestimate.Thevalueofanassetiswhateverthemarketis
willingtopayforit(baseduponitscharacteristics)
InformationNeeded:Todoarelativevaluation,youneed
anidenticalasset,oragroupofcomparableorsimilarassets
astandardizedmeasureofvalue(inequity,thisisobtainedbydividingtheprice
byacommonvariable,suchasearningsorbookvalue)
andiftheassetsarenotperfectlycomparable,variablestocontrolforthe
differences

MarketInefficiency:Pricingerrorsmadeacrosssimilarorcomparable
assetsareeasiertospot,easiertoexploitandaremuchmorequickly
corrected.

Aswath Damodaran

20

Variations on Multiples

EquityversusFirmValue

Scalingvariable

Earnings(EPS,NetIncome,EBIT,EBITDA)
Bookvalue(Bookvalueofequity,Bookvalueofassets,Bookvalueofcapital)
Revenues
Sectorspecificvariables

Baseyear

Equitymultiples(PricepershareorMarketvalueofequity)
Firmvaluemultiplies(FirmvalueorEnterprisevalue)

Mostrecentfinancialyear(Current)
Lastfourquarters(Trailing)
Averageoverlastfewyears(Normalized)
Expectedfutureyear(Forward)

Comparables

Aswath Damodaran

Sector
Market

21

Definitional Tests

Isthemultipleconsistentlydefined?
Proposition1:Boththevalue(thenumerator)andthestandardizing
variable(thedenominator)shouldbetothesameclaimholdersinthe
firm.Inotherwords,thevalueofequityshouldbedividedbyequity
earningsorequitybookvalue,andfirmvalueshouldbedividedby
firmearningsorbookvalue.

Isthemultipleuniformallyestimated?
Thevariablesusedindefiningthemultipleshouldbeestimateduniformly
acrossassetsinthecomparablefirmlist.
Ifearningsbasedmultiplesareused,theaccountingrulestomeasure
earningsshouldbeappliedconsistentlyacrossassets.Thesamerule
applieswithbookvaluebasedmultiples.

Aswath Damodaran

22

An Example: Price Earnings Ratio: Definition


PE=MarketPriceperShare/EarningsperShare

ThereareanumberofvariantsonthebasicPEratioinuse.Theyare
baseduponhowthepriceandtheearningsaredefined.
Price:
isusuallythecurrentprice
issometimestheaveragepricefortheyear
EPS:
earningspershareinmostrecentfinancialyear
earningspershareintrailing12months(TrailingPE)
forecastedearningspersharenextyear(ForwardPE)
forecastedearningspershareinfutureyear

Aswath Damodaran

23

Descriptive Tests

Whatistheaverageandstandarddeviationforthismultiple,across
theuniverse(market)?
Whatisthemedianforthismultiple?
Themedianforthismultipleisoftenamorereliablecomparisonpoint.

Howlargearetheoutlierstothedistribution,andhowdowedealwith
theoutliers?
Throwingouttheoutliersmayseemlikeanobvioussolution,butifthe
outliersalllieononesideofthedistribution(theyusuallyarelarge
positivenumbers),thiscanleadtoabiasedestimate.

Aretherecaseswherethemultiplecannotbeestimated?Willignoring
thesecasesleadtoabiasedestimateofthemultiple?
Howhasthismultiplechangedovertime?

Aswath Damodaran

24

PE Ratio: Descriptive Statistics

Aswath Damodaran

25

PE: Deciphering the Distribution

Mean
Standard Error
Median
Standard Deviation
Skewness
Minimum
Maximum
Count
Largest(500)
Smallest(500)

Aswath Damodaran

Current PE
36.04
1.94
18.25
123.36
23.13
0.65
5103.50
4024
48.00
9.38

Trailing PE
34.14
2.93
17.25
176.34
28.40
1.35
6914.50
3627
39.60
9.62

Forward PE
30.79
1.15
18.52
57.56
13.66
3.30
1414.00
2491
34.49
12.94

26

8 Times EBITDA is not cheap

Aswath Damodaran

27

Analytical Tests

Whatarethefundamentalsthatdetermineanddrivethesemultiples?
Proposition2:Embeddedineverymultipleareallofthevariablesthat
driveeverydiscountedcashflowvaluationgrowth,riskandcashflow
patterns.
Infact,usingasimplediscountedcashflowmodelandbasicalgebra
shouldyieldthefundamentalsthatdriveamultiple

Howdochangesinthesefundamentalschangethemultiple?
Therelationshipbetweenafundamental(likegrowth)andamultiple
(suchasPE)isseldomlinear.Forexample,iffirmAhastwicethegrowth
rateoffirmB,itwillgenerallynottradeattwiceitsPEratio
Proposition3:Itisimpossibletoproperlycomparefirmsona
multiple,ifwedonotknowthenatureoftherelationshipbetween
fundamentalsandthemultiple.

Aswath Damodaran

28

Relative Value and Fundamentals


Value of Stock = DPS 1/(ke - g)

PE=Payout Ratio
(1+g)/(r-g)
PE=f(g, payout, risk)

PEG=Payout ratio
(1+g)/g(r-g)

PBV=ROE (Payout ratio)


(1+g)/(r-g)

PEG=f(g, payout, risk)

PBV=f(ROE,payout, g, risk)

PS= Net Margin (Payout ratio)


(1+g)/(r-g)
PS=f(Net Mgn, payout, g, risk)

Equity Multiples

Firm Multiples
V/FCFF=f(g, WACC)
Value/FCFF=(1+g)/
(WACC-g)

V/EBIT(1-t)=f(g, RIR, WACC)


Value/EBIT(1-t) = (1+g)
(1- RIR)/(WACC-g)

V/EBIT=f(g, RIR, WACC, t)


Value/EBIT=(1+g)(1RiR)/(1-t)(WACC-g)

VS=f(Oper Mgn, RIR, g, WACC)


VS= Oper Margin (1RIR) (1+g)/(WACC-g)

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

Aswath Damodaran

29

What to control for...


Multiple

Variablesthatdetermineit

PERatio
PBVRatio
PSRatio
EVV/EBITDA
EV/Sales

ExpectedGrowth,Risk,PayoutRatio
ReturnonEquity,ExpectedGrowth,Risk,Payout
NetMargin,ExpectedGrowth,Risk,PayoutRatio
ExpectedGrowth,Reinvestmentrate,Costofcapital
OperatingMargin,ExpectedGrowth,Risk,Reinvestment

Aswath Damodaran

30

Application Tests

Giventhefirmthatwearevaluing,whatisacomparablefirm?
Whiletraditionalanalysisisbuiltonthepremisethatfirmsinthesame
sectorarecomparablefirms,valuationtheorywouldsuggestthata
comparablefirmisonewhichissimilartotheonebeinganalyzedin
termsoffundamentals.
Proposition4:Thereisnoreasonwhyafirmcannotbecompared
withanotherfirminaverydifferentbusiness,ifthetwofirmshave
thesamerisk,growthandcashflowcharacteristics.

Giventhecomparablefirms,howdoweadjustfordifferencesacross
firmsonthefundamentals?
Proposition5:Itisimpossibletofindanexactlyidenticalfirmtothe
oneyouarevaluing.

Aswath Damodaran

31

Comparing PE Ratios across a Sector


Company Name
PT Indosat ADR
Telebras ADR
Telecom Corporation of New Zealand ADR
Telecom Argentina Stet - France Telecom SA ADR B
Hellenic Telecommunication Organization SA ADR
Telecomunicaciones de Chile ADR
Swisscom AG ADR
Asia Satellite Telecom Holdings ADR
Portugal Telecom SA ADR
Telefonos de Mexico ADR L
Matav RT ADR
Telstra ADR
Gilat Communications
Deutsche Telekom AG ADR
British Telecommunications PLC ADR
Tele Danmark AS ADR
Telekomunikasi Indonesia ADR
Cable & Wireless PLC ADR
APT Satellite Holdings ADR
Telefonica SA ADR
Royal KPN NV ADR
Telecom Italia SPA ADR
Nippon Telegraph & Telephone ADR
France Telecom SA ADR
Korea Telecom ADR

Aswath Damodaran

PE
7.8
8.9
11.2
12.5
12.8
16.6
18.3
19.6
20.8
21.1
21.5
21.7
22.7
24.6
25.7
27
28.4
29.8
31
32.5
35.7
42.2
44.3
45.2
71.3

Growth
0.06
0.075
0.11
0.08
0.12
0.08
0.11
0.16
0.13
0.14
0.22
0.12
0.31
0.11
0.07
0.09
0.32
0.14
0.33
0.18
0.13
0.14
0.2
0.19
0.44

32

PE, Growth and Risk


Dependentvariableis:

PE

Rsquared=66.2%Rsquared(adjusted)=63.1%
Variable
Coefficient SE
tratio
Constant
13.1151
3.471
3.78
Growthrate
121.223
19.27
6.29
EmergingMarket
13.8531
3.606
3.84
EmergingMarketisadummy:1ifemergingmarket
0ifnot

Aswath Damodaran

prob
0.0010
0.0001
0.0009

33

Is Telebras under valued?

PredictedPE=13.12+121.22(.075)13.85(1)=8.35
Atanactualpricetoearningsratioof8.9,Telebrasisslightly
overvalued.

Aswath Damodaran

34

PE Ratio without a constant - US Stocks


Model Summary
Model
1

R
R Square
.856 b
.73 3

Adjusted R
Square
.73 2

Std. Error of the


Estimate
1350.677619313

a. For regression through the origin (the no- intercept


model), R Square measures the proportion of the
variability in the dependent variable about the origin
explained by regression. T his CANNOT be compar ed to R
Square for models which include an intercept.
b. Predictor s: Value Line Beta, Payout Ratio, Expected
Gr owth in EPS: next 5 years
Coeffici entsa,b,c
Unstandardiz ed
Coefficients
Model
1

B
Expected Growth in
EPS: next 5 year s
Payout Ratio
Value Line Beta

Std. Error

Standardized
Coefficients
Beta

95% Confidence Interval for


B
t

Sig.

Lower Bound

Upper Bound

1.228

.05 5

.514

22.187

.000

1.119

1.336

- 1.1E- 02

.01 4

- .013

- .768

.443

- .039

.017

11. 705

.82 5

.384

14.184

.000

10. 087

13.324

a. Dependent Variable: Current PE


b. Linear Regression through the Origin
c. Weighted Least Squares Regression - Weighted by Market Cap

Aswath Damodaran

35

Relative Valuation: Choosing the Right Model

Aswath Damodaran

36

Contingent Claim (Option) Valuation

Optionshaveseveralfeatures
Theyderivetheirvaluefromanunderlyingasset,whichhasvalue
Thepayoffonacall(put)optionoccursonlyifthevalueofthe
underlyingassetisgreater(lesser)thananexercisepricethatisspecified
atthetimetheoptioniscreated.Ifthiscontingencydoesnotoccur,the
optionisworthless.
Theyhaveafixedlife

Anysecuritythatsharesthesefeaturescanbevaluedasanoption.

Aswath Damodaran

37

Option Payoff Diagrams

StrikePrice

ValueofAsset
PutOption

CallOption

Aswath Damodaran

38

Underlying Theme: Searching for an Elusive


Premium

Traditionaldiscountedcashflowmodelsunderestimatethevalueof
investments,wherethereareoptionsembeddedintheinvestmentsto
Delayordefermakingtheinvestment(delay)
Adjustoralterproductionschedulesaspricechanges(flexibility)
Expandintonewmarketsorproductsatlaterstagesintheprocess,based
uponobservingfavorableoutcomesattheearlystages(expansion)
Stopproductionorabandoninvestmentsiftheoutcomesareunfavorable
atearlystages(abandonment)

Putanotherway,realoptionadvocatesbelievethatyoushouldbe
payingapremiumondiscountedcashflowvalueestimates.

Aswath Damodaran

39

Three Basic Questions

Whenistherearealoptionembeddedinadecisionoranasset?

Whendoesthatrealoptionhavesignificanteconomicvalue?

Therehastobeaclearlydefinedunderlyingassetwhosevaluechangesovertimein
unpredictableways.
Thepayoffsonthisasset(realoption)havetobecontingentonanspecifiedevent
occurringwithinafiniteperiod.
Foranoptiontohavesignificanteconomicvalue,therehastobearestrictionon
competitionintheeventofthecontingency.
Atthelimit,realoptionsaremostvaluablewhenyouhaveexclusivityyouandonly
youcantakeadvantageofthecontingency.Theybecomelessvaluableasthebarriersto
competitionbecomelesssteep.

Canthatvaluebeestimatedusinganoptionpricingmodel?

Aswath Damodaran

Theunderlyingassetistradedthisyieldnotonlyobservablepricesandvolatilityas
inputstooptionpricingmodelsbutallowsforthepossibilityofcreatingreplicating
portfolios
Anactivemarketplaceexistsfortheoptionitself.
Thecostofexercisingtheoptionisknownwithsomedegreeofcertaint

40

Putting Natural Resource Options to the Test

TheOptionTest:

TheExclusivityTest:

Naturalresourcereservesarelimited(atleastfortheshortterm)
Ittakestimeandresourcestodevelopnewreserves

TheOptionPricingTest

UnderlyingAsset:Oilorgoldinreserve
Contingency:Ifvalue>Costofdevelopment:ValueDevCost
Ifvalue<Costofdevelopment:0

UnderlyingAsset:Whilethereserveorminemaynotbetraded,thecommodityis.Ifwe
assumethatweknowthequantitywithafairdegreeofcertainty,youcantradetheunderlying
asset
Option:Oilcompaniesbuyandsellreservesfromeachotherregularly.
CostofExercisingtheOption:Thisisthecostofdevelopingareserve.Giventheexperience
thatcommoditycompanieshavewiththis,theycanestimatethiscostwithafairdegreeof
precision.

BottomLine:Realoptionpricingmodelsworkwellwithnaturalresourceoptions.

Aswath Damodaran

41

The Real Options Test: Patents and Technology

TheOptionTest:

UnderlyingAsset:Productthatwouldbegeneratedbythepatent
Contingency:
IfPVofCFsfromdevelopment>Costofdevelopment:PVCost
IfPVofCFsfromdevelopment<Costofdevelopment:0

TheExclusivityTest:

ThePricingTest

Patentsrestrictcompetitorsfromdevelopingsimilarproducts
Patentsdonotrestrictcompetitorsfromdevelopingotherproductstotreatthesamedisease.
UnderlyingAsset:Patentsarenottraded.Notonlydoyouthereforehavetoestimatethe
presentvaluesandvolatilitiesyourself,youcannotconstructreplicatingpositionsordo
arbitrage.
Option:Patentsareboughtandsold,thoughnotasfrequentlyasoilreservesormines.
CostofExercisingtheOption:Thisisthecostofconvertingthepatentforcommercial
production.Here,experiencedoeshelpanddrugfirmscanmakefairlypreciseestimatesofthe
cost.

BottomLine:Userealoptionpricingargumentswithcaution.

Aswath Damodaran

42

The Real Options Test for Growth (Expansion)


Options

TheOptionsTest
UnderlyingAsset:ExpansionProject
Contingency
IfPVofCFfromexpansion>ExpansionCost:PVExpansionCost
IfPVofCFfromexpansion<ExpansionCost:0

TheExclusivityTest

ThePricingTest

Barriersmayrangefromstrong(exclusivelicensesgrantedbythegovernment)toweaker
(brandname,knowledgeofthemarket)toweakest(firstmover).
UnderlyingAsset:Aswithpatents,thereisnotradingintheunderlyingassetandyouhaveto
estimatevalueandvolatility.
Option:Licensesaresometimesboughtandsold,butmorediffuseexpansionoptionsarenot.
CostofExercisingtheOption:Notknownwithanyprecisionandmayitselfevolveovertime
asthemarketevolves.

BottomLine:Usingoptionpricingmodelstovalueexpansionoptionswillnotonly
yieldextremelynoisyestimates,butmayattachinappropriatepremiumstodiscounted
cashflowestimates.

Aswath Damodaran

43

Summarizing the Real Options Argument

Therearerealoptionseverywhere.
Mostofthemhavenosignificanteconomicvaluebecausethereisno
exclusivityassociatedwithusingthem.
Whenoptionshavesignificanteconomicvalue,theinputsneededto
valuetheminabinomialmodelcanbeusedinmoretraditional
approaches(decisiontrees)toyieldequivalentvalue.
Therealvaluefromrealoptionsliesin
Recognizingthatbuildinginflexibilityandescapehatchesintolarge
decisionshasvalue
Insightswegetonunderstandinghowandwhycompaniesbehavethe
waytheydoininvestmentanalysisandcapitalstructurechoices.

Aswath Damodaran

44

ValuationModels

AssetBased
Valuation

DiscountedCashflow
Models

RelativeValuation

Liquidation
Value

Equity
Stable

Current

ContingentClaim
Models

Sector

Twostage
Threestage
ornstage

EquityValuation
Models

Normalized

Earnings

Book Revenues
Value

Sector
specific

Dividends
Costofcapital
approach

Aswath Damodaran

Optionto
liquidate

Young
firms

Equityin
troubled
firm

Undeveloped
land

FirmValuation
Models
Patent

FreeCashflow
toFirm

Optionto
expand

Firm
Market

Replacement
Cost

Optionto
delay

APV
approach

Undeveloped
Reserves

ExcessReturn
Models

45

Which approach should you use? Depends


upon the asset being valued..
Asset Marketability and Valuation Approaches
Mature businesses
Separable & marketable assets

Liquidation &
Replacement cost
valuation

Growth businesses
Linked and non-marketable assets

Other valuation models


Cash Flows and Valuation Approaches

Cashflows currently or
expected in near future

Discounted cashflow
or relative valuation
models

Cashflows if a contingency
occurs

Option pricing models

Assets that will never


generate cashflows

Relative valuation models

Uniqueness of Asset and Valuation Approaches


Unique asset or business

Discounted cashflow
or option pricing
models

Aswath Damodaran

Large number of similar


assets that are priced

Relative valuation models

46

And the analyst doing the valuation.


Investor Time Horizon and Valuation Approaches
Very short time horizon

Liquidation value

Long Time Horizon


Relative valuation

Option pricing
models

Discounted Cashflow value

Views on market and Valuation Approaches


Markets are correct on
average but make mistakes
on individual assets

Relative valuation

Asset markets and financial


markets may diverge

Liquidation value

Markets make mistakes but


correct them over time

Discounted Cashflow value


Option pricing models

Aswath Damodaran

47