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Aswath Damodaran

Aswath Damodaran

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First Principles

n

**Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
**

• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

n

n

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

**Objective: Maximize the Value of the Firm
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Aswath Damodaran 2

**Discounted Cashflow Valuation: Basis for Approach
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t = n CF t Value = ∑ t t = 1 (1+ r)

• where, • n = Life of the asset • CFt = Cashflow in period t • r = Discount rate reflecting the riskiness of the estimated cashflows

Aswath Damodaran

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Equity Valuation

n

The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm.

t=n

Value of Equity =

CF to Equity t ∑ (1+ k )t t=1 e

**where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity
**

n

The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends.

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Aswath Damodaran

Firm Valuation

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The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions.

t=n

Value of Firm =

CF to Firm t ∑ (1+ WACC)t t=1

where, CF to Firmt = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital

Aswath Damodaran

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**Generic DCF Valuation Model
**

DISCOUNTED CASHFLOW VALUATION

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

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

Firm is in stable growth: Grows at constant rate forever

Terminal Value Value Firm: Value of Firm Equity: Value of Equity Length of Period of High Growth CF1 CF2 CF3 CF4 CF5 CFn ......... Forever

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

Aswath Damodaran

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the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. The cost of capital is the rate at which we discount free cash flows to the firm. Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. Aswath Damodaran 7 . Discount Rates n n n Critical ingredient in discounted cashflow valuation. At an intutive level. The cost of equity is the rate at which we discount cash flows to equity (dividends or free cash flows to equity).Estimating Inputs: I.

The Cost of Equity: A Recap Preferably. and firm’s own financial leverage Cost of Equity = Riskfree Rate + Beta * (Risk Premium) Has to be in the same currency as cash flows. Mature Equity Market Premium: Average premium earned by stocks over T.S.Bonds in U. based upon other firms in the business. a bottom-up beta. 2. Country risk premium = Country Default Spread* ( σEquity/σCountry bond) or Implied Premium Based on how equity market is priced today and a simple valuation model Aswath Damodaran 8 . and defined in same terms (real or nominal) as the cash flows Historical Premium 1.

reflecting tax benefits of debt (Debt/(Debt + Equity)) Cost of equity based upon bottom-up beta Weights should be market value weights Aswath Damodaran 9 .Estimating the Cost of Capital Cost of borrowing should be based upon (1) synthetic or actual bond rating (2) default spread Cost of Borrowing = Riskfree rate + Default spread Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + Cost of Borrowing (1-t) Marginal tax rate.

Costs of Equity.51% InfoSoft 1.62% 12. Debt and Capital Boeing 1.38% A 3.19% 93.77% 4.55% 9.45% A+ 3.58% 79.09% 9.91% AA 3.78% 95.49 13.17% The Home Depot 0.01 10.55% Beta (Bottom-up) Cost of Equity Equity/(Debt + Equity) Rating After-tax Cost of Debt Debt/(Debt + Equity) Cost of Capital Aswath Damodaran 10 .48% 6.58% 20.87 9.

Estimating Cash Flows Cash Flows To Equity To Firm The Strict View Dividends + Stock Buybacks The Broader View Net Income .Change in Working Capital = Free Cashflow to Firm Aswath Damodaran 11 .Chg WC (1 .Net Cap Ex (1-Debt Ratio) .II.( Cap Ex .Debt Ratio) = Free Cashflow to Equity EBIT (1-t) .Depreciation) .

The second adjustment is the treatment of some capital expenditures as operating expenses. the most dramatic example is the treatment of research and development expenses. Any expense (or income) that is truly a one-time expense (or income) should be removed from the operating income and should not be used in forecasting future operating income. Here. The most significant example is operating leases. The third adjustment is to correct for the incidence of one-time or irregular income and expenses. Aswath Damodaran 12 .Estimating Operating Income • • • The first adjustment is for financing expenses that accountants treat as operating expenses.

000 $0 $4.815 InfoSoft $2.367 $ $3.382 + Imputed Interest Expense on Operating Leases $ 31 = Adjusted Operating Income $2.Amortization of Research Asset $1.661 $0 $0 $0 $ 154 $2.720 + Special and One-time Charges $0 + Research and Development Expenses $1.Operating Income Estimates Boeing Operating Income $1.633 - Aswath Damodaran 13 .264 Home Depot $2.895 .000 $2.

In doing projections. adjust the tax rate towards the marginal tax rate over time. but the after-tax tax operating income is more accurate in later years If you choose to use the effective tax rate. By using the marginal tax rate. we tend to understate the after-tax operating income in the earlier years. Aswath Damodaran 14 .Estimating a Tax Rate n n n The choice is between the effective and the marginal tax rate. it is far safer to use the marginal tax rate since the effective tax rate is really a reflection of the difference between the accounting and the tax books.

83% Average Effective Tax Rate:94-98 20.00% 42% 42% We will use the 35% tax rate to value Boeing and the Home Depot and 42% for InfoSoft.78% 35% InfoSoft 1685 707.19% 38. Aswath Damodaran 15 .7 42.44% Marginal tax rate 35% Home Depot 2654 1040 39.Tax Rate Estimates Boeing Taxable Income 1397 Taxes 277 Effective Tax Rate 19.

The best place to find acquisitions is in the statement of cash flows. The adjusted cap ex will be Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms .Amortization of Research Asset n Acquisitions of other firms. usually categorized under other investment activities Aswath Damodaran 16 . once they have been recategorized as capital expenses. a normalized measure of acquisitions (looking at an average over time) should be used 2.Estimating Capital Expenditures n Research and development expenses. since these are like capital expenditures. Most firms do not do acquisitions every year. The adjusted cap ex will be Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s R&D expenses . Hence.Amortization of such acquisitions Two caveats: 1.

000 $2.686 $1.584 $1.686 InfoSoft $2.633 Capital Expenditures R&D Depreciation Amortization of R&D Net Cap Ex w/o R&D Net Cap Ex with R&D Aswath Damodaran 17 .367 $1.000 $1.382 $67 $580 The Home Depot $2.000 $2.Net Capital Expenditures: 1998 Boeing $1.895 $1.517 $1.000 $4.059 $0 $373 $0 $1.

Therefore. 18 Aswath Damodaran .Estimating Net Working Capital Needs n n n n In accounting terms. cash and accounts receivable) and current liabilities (accounts payables. short term debt and debt due within the next year) A cleaner definition of working capital from a cash flow perspective is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable) Any investment in this measure of working capital ties up cash. and building these effects into the cash flows. the working capital is the difference between current assets (inventory. it is important to forecast the effects of such growth on working capital needs. When forecasting future growth. any increases (decreases) in working capital will reduce (increase) cash flows in that period.

00% NA 18.95% 12.08% 18.00% Aswath Damodaran 19 .30% InfoSoft 20000 2000 $500 10.154 30219 $1.42% 6.12% 7.71% 4.Net Working Capital Estimates Boeing Revenues: 1998 Non-cash WC: 1998 ∆ Working capital Non-cash WC as % of Revenues Average from 1994-1998 Industry Average The Home Depot $56.360 2028 $667 $190 2.

6 Application Test: Estimating your firm’s FCFF Estimate the FCFF for your firm in its most recent financial year: In general.Capital Expenditures + Capital Expenditures .Change in Non-cash WC + Change in Non-cash WC = FCFF = FCFF Estimate the dollar reinvestment at your firm: Reinvestment = EBIT (1-t) . If using statement of cash flows EBIT (1-t) EBIT (1-t) + Depreciation + Depreciation .FCFF n Aswath Damodaran 20 .

Aswath Damodaran 21 . For Deutsche Bank. Here. it is difficult to estimate free cash flows. For Aracruz. free cash flows to equity become cumbersome to estimate. If a firm’s debt ratio might change over time. If a firm’s debt ratio is not expected to change over time. we will be discounting dividends. we would discount free cash flows to the firm. we will discount free cash flows to equity. the free cash flows to equity can be discounted to yield the value of equity. the only cash flow that you can discount is dividends. For financial service firms. we will discount the free cash flow to the firm. For Disney.Choosing a Cash Flow to Discount n n n When you cannot estimate the free cash fllows to equity or the firm.

Expected Growth Expected Growth Net Income Operating Income Retention Ratio= 1 .Dividends/Net Income X Return on Equity Net Income/Book Value of Equity Reinvestment Rate = (Net Cap Ex + Chg in WC/EBIT(1-t) X Return on Capital = EBIT(1-t)/Book Value of Capital Aswath Damodaran 22 .III.

Aswath Damodaran 23 .Expected Growth in EPS • gEPS = Retained Earningst-1/ NIt-1 * ROE = Retention Ratio * ROE = b * ROE Proposition 1: The expected growth rate in earnings for a company cannot exceed its return on equity in the long term.

should be inversely proportional to the quality of its investments. Aswath Damodaran 24 . for a given growth rate.Expected Growth in EBIT And Fundamentals n n n Reinvestment Rate and Return on Capital gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC Proposition 2: No firm can expect its operating income to grow over time without reinvesting some of the operating income in net capital expenditures and/or working capital. Proposition 3: The net capital expenditure needs of a firm.

793 112.830 102.17% NA 73.686 $ 190 $ 1.85% 88.98% 55.633 $ 500 $ 3.48% The Home Depot $ 1.Estimating Reinvestment Rate Net Cap Ex Change in Non-Cash WC Total Reinvestment EBIT (1-t) Reinvestment Rate Average : 1994-98 Industry Average Boeing $ 580 $ 667 $ 1.133 $ 2.12% Aswath Damodaran 25 .62% InfoSoft $ 2.876 $ 1.53% 131.651 75.247 $ 1.52% 65.

793 $ 11.07% Aswath Damodaran 26 .173 $ 11800 16.957 5.12% 14.38% 23.10% NA 17.20% Adjusted EBIT (1-t) Adjusted BV of capital ROC Average ROC: 1994-1998 6.Estimating Return on Capital Boeing $ 1.59% Industry average ROC 15.830 $ 2.67% 15.651 $ 28.70% The Home Depot InfoSoft $ 1.

55% Return on Capital Reinvestment Rate Expected Growth Rate Boeing: Used average return on capital and reinvestment rate over last 5 years The Home Depot: Used current return on capital and Industry average reinvestment rate InfoSoft: Used current return on capital and reinvestment rate Aswath Damodaran 27 .17% 26.59% 65.Expected Growth Estimates Boeing 6.62% 14.67% 112.38% 88.51% InfoSoft 23.98% 4.35% The Home Depot 16.

based upon these inputs Aswath Damodaran 28 .6 Application Test: Estimating Expected Growth n Estimate the following: • The reinvestment rate for your firm • The after-tax return on capital • The expected growth in operating income.

Getting Closure in Valuation n A publicly traded firm potentially has an infinite life. we estimate cash flows for a “growth period” and then estimate a terminal value.IV. The value is therefore the present value of cash flows forever. t = ∞ CF t Value = ∑ t t = 1 ( 1 +r) n Since we cannot estimate cash flows forever. to capture the value at the end of the period: t = N CF t + Terminal Value Value = ∑ t (1 + r)N t = 1 (1 + r) Aswath Damodaran 29 .

r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate n n n This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates.g) where. they will all approach “stable growth” at some point in time. 30 Aswath Damodaran . While companies can maintain high growth rates for extended periods. the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond. When they do approach stable growth.Stable Growth and Terminal Value n When a firm’s cash flows grow at a “constant” rate forever. the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r .

at the end of which the growth rate will decline gradually to a stable growth rate(3-stage) Aswath Damodaran 31 . at the end of which the growth rate will drop to the stable growth rate (2-stage) • there will be high growth for a period. In general. in which case the firm is already in stable growth • there will be high growth for a period. we can make one of three assumptions: • there is no high growth. and the pattern of growth during that period.Growth Patterns n A key assumption in all discounted cash flow models is the period of high growth.

it becomes much more difficult for them to maintain high growth rates n Current growth rate • While past growth is not always a reliable indicator of future growth. • The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are. Thus. n Barriers to entry and differential advantages • Ultimately. high growth comes from high project returns. how long they will stay up and how strong they will remain. Aswath Damodaran 32 .Determinants of Length of High Growth Period n Size of the firm • Success usually makes a firm larger. there is a correlation between current growth and future growth. As firms become larger. comes from barriers to entry and differential advantages. which. in turn. a firm growing at 30% currently probably has higher growth and a longer expected growth period than one growing 10% a year now.

and competitors are extremely aggressive. In spite of the firm’s competitors to overcome the small size. Aswath Damodaran 33 . but is entering new businesses and new markets (overseas) Current Excess Returns Firm is earning less than its cost of capital. 10 years. Management record over the last few years has been poor. it will be difficult for 5 years.Analyzing the Growth Period Boeing Firm Size/Market Size Firm has the dominant market share of a slow-growing market The Home Depot Firm has dominant market share of domestic market. the competitive nature economies of scale. entirely because of competitive advantages and barriers to entry. and has done so for last 5 years Competitive Advantages Huge capital requirements and technological barriers to new entrants. Has both a good product and good software engineers. InfoSoft Firm is a small firm in a market that is experiencing significant growth. Length of High Growth period 10 years. Significant economies of scale are used to establish cost advantages over rivals. of this market and the lack of barriers to competition make us conservative on our estimate. Competitive advantage is likely to be limited. Firm is earning significant excess returns. Has a management team that is focused on growth and efficiency. since employees can be hired away. Firm is earning substantially more than its cost of capital.

Firm Characteristics as Growth Changes Variable Risk Dividend Payout Net Cap Ex Return on Capital Leverage High Growth Firms tend to be above-average risk pay little or no dividends have high net cap ex earn high ROC (excess return) have little or no debt Stable Growth Firms tend to be average risk pay high dividends have low net cap ex earn ROC closer to WACC higher leverage Aswath Damodaran 34 .

if they are not. use current leverage. in which case we assume that the firm will stop earning excess returns on its projects as a result of competition. use industry averages) n Use the relationship between growth and fundamentals to estimate payout and net capital expenditures. Aswath Damodaran 35 .Estimating Stable Growth Inputs n Start with the fundamentals: • Profitability measures such as return on equity and capital. it depends upon how entrenched current management is and whether they are stubborn about their policy on leverage (If they are. in stable growth. • Leverage is a tougher call. in which case we assume that this firm in stable growth will look like the average firm in the industry – cost of equity and capital. can be estimated by looking at – industry averages for these measure. While industry averages can be used here as well.

48% 6.62% 8.489 10.92% 12.17% The Home Depot InfoSoft Growth High Growth Stable Growth High Growth Stable 1 0.48% 30.50% 9.Estimating Stable Period Cost of Capital Boeing High Growth Stable Beta 1.60% 3.55% Growth 1.51% 7.00% 6.58% 3.19% 3.58% After-tax Cost of Debt 3.869 1.78% 13.42% 9.2 11.78% 9.77% 3.62% 11.00% 4.55% 30.014 Cost of Equity 10.09% Cost of Capital 9.58% Debt Ratio 20.06% Aswath Damodaran 36 .869 0.58% 3.

Estimating Stable Period Net Cap Ex gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC n Moving terms around.42 = 59.42% (its cost of capital).36% n In other words. assume that Boeing in stable growth will • grow 5% and that • its return on capital in stable growth will be 8. Aswath Damodaran 37 . • the net capital expenditures and working capital investment each year during the stable growth period will be 59. Reinvestment Rate for Boeing in Stable Growth = 5/8. Reinvestment Rate = gEBIT / Return on Capital n For instance.36% of after-tax operating income.

38% 14.62% 35.59% 65.98% 4.17% 5.00% 14.46% 112.20% 29.Stable Period Return on Capital and Reinvestment Rates Boeing High Growth Stable 6.00% 26.00% Return on Capital Reinvestment Rate Expected Growth Rate Aswath Damodaran 38 .42% 16.67% 59.07% 5.35% 88.35% The Home Depot InfoSoft Growth High Growth Stable Growth High Growth Stable 8.51% 5.55% Growth 17.10% 23.

(Use betas of the operating assets alone to estimate the cost of equity). Aswath Damodaran 39 .the cash flows should be before interest income from cash and securities. and the discount rate should not be contaminated by the inclusion of cash. • If you have a particularly incompetent management. markets may discount the value of this cash. Once the firm has been valued. add back the value of cash and marketable securities. with a history of overpaying on acquisitions.Dealing with Cash and Marketable Securities n n The simplest and most direct way of dealing with cash and marketable securities is to keep it out of the valuation .

183 Marketable Securities $279 Non-Operating Assets $0 Excess of Pension Assets $1. Aswath Damodaran 40 .861 Cash and Non-Operating Assets $4.323 The Home Depot $62 $0 $0 $0 $62 InfoSoft $100 $400 $0 $0 $500 Boeing has an overfunded pension plan. We considered only 50% of the overfunding. since the firm will have to pay a tax of 50% if it decides to withdraw the funds.Cash and Marketable Securities: Estimates Boeing Cash $2.

we are assuming here that the market will value cash at face value. Assume now that you are buying a firm whose only asset is marketable securities worth $ 100 million. Can you ever consider a scenario where you would not be willing to pay $ 100 million for this firm? Yes No What is or are the scenario(s)? Aswath Damodaran 41 .The Value of Cash n o o n Implicitly.

Dealing with Holdings in Other firms n Holdings in other firms can be categorized into • Minority passive holdings. Aswath Damodaran 42 . in which case only the dividend from the holdings is shown in the balance sheet • Minority active holdings. in which case the share of equity income is shown in the income statements • Majority active holdings. in which case the financial statements are consolidated.

Value subsidiary as a firm and add portion of firm value. Consolidated Firm Aswath Damodaran 43 .How to value holdings in other firms Fin Statement Not consolidated Not consolidated Valuing Equity Firm What to do… Value equity in subsidiary and take share of holding. Add portion of debt in subsidiary to the debt in estimating equity value. Add portion of this value to value of parent firm. Strip operating income of subsidiary and value subsidiary separately.

. n When financial statements are consolidated.How some deal with subsidiaries. some analysts value the firm with the consolidated operating income and then subtract minority interests from the firm value to arrive at the value of the equity in the firm. What is wrong with this approach? Aswath Damodaran 44 ..

What is the value per share? Aswath Damodaran 45 .Equity Value and Per Share Value: A Test n Assume that you have done an equity valuation of Microsoft. The total value for equity is estimated to be $ 400 billion and there are 5 billion shares outstanding.

Microsoft had 500 million options outstanding. granted to employees over time. Aswath Damodaran 46 . These options had an average exercise price of $ 20 (the current stock price is $ 80). Estimate the value per share.An added fact n In 1999.

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

Warrants n n n A warrant is a security issued by a company that provides the holder with the right to buy a share of stock in the company at a fixed price during the life of the warrant. which has relevance for: • estimating debt and equity for the leverage calculation • estimating per share value from total equity value Aswath Damodaran 48 . Warrants and other equity options issued by the firm are claims on the equity of the firm and have to be treated as equity. A warrant is therefore a long term call option on the equity of the firm and can be valued using option pricing models.

Aswath Damodaran 49 . conversion becomes a more attractive option as stock prices increase.Convertible Bonds n n n n A convertible bond is a bond that can be converted into a predetermined number of shares. Firms generally add conversions options to bonds to lower the interest rate paid on the bonds. While it generally does not pay to convert at the time of the bond issue. A convertible bond can be considered to be made up of two securities a straight bond and a conversion option. at the option of the bond holder.

and • conversion options are often exercised before expiration. • conversion options result in stock dilution. and factoring in the dilution effect Aswath Damodaran 50 . n These problems can be partially alleviated by using a binomial option pricing model. allowing for shifts in variance and early exercise. making the assumptions about constant variance and constant dividend yields much shakier. making it dangerous to use European option pricing models.Factors in Using Option Pricing Models to Value Convertibles and Warrants n Option pricing models can be used to value the conversion option with three caveats – • conversion options are long term.

23 38.12 Total Value of Options Outstanding at Boeing = Aswath Damodaran 51 .25 $ 47.5 $ 17.543.7 $ 9.1 $ 10.Options Outstanding: Boeing Exercise Price $ $ $ $ $ Number Life (in ‘000s) Black-Scholes Value/option Total Value (in ‘000s) $ 76.75 41.124.466.35 4315 4.34 53.44 1779 7.34 16.4 $ 10.418.40 $ 19.670.32 8480 5 $ 14.37 9481 8.25 4598 7.71 23.223.65 $ 120.72 $ 350.32 $ 86.

021 million Aswath Damodaran 52 .17 Stock Price at time of analysis= $ 37.728 million Standard Deviation of The Home Depot stock = 30% Value of Options Outstanding = $2.00 Average Maturity of Options Outstanding = 7.6 years Number of Options Outstanding = 47.Options Outstanding: The Home Depot n n n n n n Average Exercise Price of Options Outstanding = $20.

Step 3:Subtract out the market value (or estimated market value) of other equity claims: • Value of Warrants = Market Price per Warrant * Number of Warrants : Alternatively estimate the value using OPM • Value of Conversion Option = Market Value of Convertible Bonds Value of Straight Debt Portion of Convertible Bonds n Step 4:Divide the remaining value of equity by the number of shares outstanding to get value per share. 53 Aswath Damodaran . Alternatively. using discounted cash flow or other valuation models. Step 2:Subtract out the value of the outstanding debt to arrive at the value of equity.Steps in Getting to Value Per Share n n n Step 1: Value the firm. skip step 1 and estimate the of equity directly.

00% 8.36% 8.42% 35% Length Growth Inputs .Reinvestment Rate .00% 1.Cost of Debt .Beta .Return on Capital .59%% 4.92% 9.42% 5.50% 30.Boeing: Valuation .35% 1.Summary of Inputs High Growth Phase 10 years 65.Cost of Capital General Information .Expected Growth rate Cost of Capital Inputs .98% 6.50% 19.00 5.Debt Ratio .17% 35% Stable Growth Phase Forever after year 10 59.01 5.Tax Rate Aswath Damodaran 54 .

36% Terminal Value 10 = 1078/(.14 Terminal year EBIT(1-t) .528 $1.Debt: 8.Nt CpX 568 .532 $790 $2.876 $1.58% (0.651 .6598* .0842-.043 $1.496 Firm Value: 17.20) = 9.77% Reinvestment Rate 65.80) + 3.137 $1.323 .Reinv FCFF $1.132 $1.0435 4.00.654 $1.01 X Risk Premium 5.14% Historical US Premium 5.42% Reinvestment Rate=59.17% Cost of Equity 10.500 + Cash: 4.238 $1. Beta = 1.958 $1.ROC=8.723 $1.225 $1.59% Stable Growth g = 5%.630 -Options 350 Value/Share $13.668 $824 $860 $2.92% Riskfree Rate: Government Bond Rate = 5% + Beta 1.407 $725 $2.5% Unlevered Beta for Sectors: 0.Boeing: A Valuation Current Cashflow to Firm EBIT(1-t) : 1.321 $1.08% D = 19.186 $586 $612 $1.58% Cost of Debt (5%+ 0.0659 = .35) = 3.348 $695 $2.194 =Equity 13.078 Discount at Cost of Capital (WACC) = 10.Chg WC 667 = FCFF 417 Reinvestment Rate = 74.598 $1.50%)(1-.468 $757 $2.58% Weights E = 80.422 $2.35% Return on Capital 6.98% Expected Growth in EBIT (1-t) .58% (0.88 Firm’s D/E Ratio: 25.798 $1.576 $1.05) = 31.292 $638 $666 $2. D/(D+E) = 30%.5% Country Risk Premium 0% Aswath Damodaran 55 .

Return on Capital .Debt Ratio .46% 14.80% 4.51% 0.50% 30.00% 0.87 5.Reinvestment Rate .92% 35% Length Growth Inputs .00% 7.87 5.55% 9.The Home Depot: Valuation Inputs High Growth Phase 10 years 88.Beta .Cost of Capital General Information .37% 14.52% 35% Stable Growth Phase Forever after year 10 35.62% 16.Tax Rate Aswath Damodaran 56 .Expected Growth rate Cost of Capital Inputs .10% 5.Cost of Debt .

486 Firm Value: 68.79% (0.The Home Depot: A Valuation Current Cashflow to Firm Reinvestment Rate EBIT(1-t) : 1.75% Expected Growth in EBIT (1-t) .Chg WC 190 = FCFF <160> Reinvestment Rate =108.949 + Cash: 62 .80%)(1-.Nt CpX 1.05) = 164.51% Return on Capital 16.79% Cost of Debt (5%+ 0.86 Firm’s D/E Ratio: 4.76% Historical US Premium 5.799 .77% Weights E = 95. Beta = 0.1637= .5% Country Risk Premium 0% Aswath Damodaran 57 .77% (0.62% .Reinv 1857 FCFF 238 2399 2126 273 2747 2434 313 3146 2788 358 3602 3192 410 4125 3655 469 4723 4186 538 5409 4793 616 6194 5489 705 7092 6285 807 Discount at Cost of Capital (WACC) = 9.45% Riskfree Rate: Government Bond Rate = 5% + Beta 0.52% Cost of Equity 9.35) = 3.5% Unlevered Beta for Sectors: 0.46% Terminal Value 10 = 4806/(. D/(D+E) = 30%.1% Reinvestment Rate=35.0445) = 9.9555) + 3.ROC=14.0792-.081 =Equity 64.930 -Options 2.8862*.Debt: 4.1451 14.87.87 X Risk Premium 5.55 EBIT(1-t) 2095 .021 Value/Share $42.37% Stable Growth g = 5%.829 88.55% D = 4.

Tax Rate Aswath Damodaran 58 .62% 12.62% 11.07% 17.55% 1.67% 26.Reinvestment Rate .05% 42% Length Growth Inputs .2% 5.Expected Growth rate Cost of Capital Inputs .Debt Ratio .Cost of Debt .Beta .00% 6.Return on Capital .InfoSoft: Valuation Estimates High Growth Phase 5 years 112.00% 1.17% 23.00% 6.20 6.54% 42% Stable Growth Phase Forever after year 5 29.49 6.Cost of Capital General Information .

633 .2367 = .17% .2% Reinvestment Rate=29.55% Return on Capital 23.Chg WC 500 = FCFF <340> Reinvestment Rate = 112.42) = 3.38% D = 6.583 =Equity 55.2655 26.55% Cost of Equity 13.ROC=17.Nt CpX 2.20% Cost of Debt (5%+ 1.05) = 111.07% Terminal Value 10 = 6753/(.49 X Risk Premium 5.InfoSoft: A Valuation Current Cashflow to Firm Reinvestment Rate EBIT(1-t) : 2.67% Stable Growth g = 5%.17% Expected Growth in EBIT (1-t) 1.20.36% (0.2% (0. D/(D+E) = 6.36% Weights E = 93.9338) + 3.1217*.62% Riskfree Rate: Government Bond Rate = 5% + Beta 1.135 EBIT(1-t) .09% Historical US Premium 5.43 Firm’s D/E Ratio: 7.1106-.Reinv FCFF 3535 3965 -430 4474 5029 -545 5661 6350 -689 7165 7937 -872 9067 10071 -1104 9520 2773 6753 Discount at Cost of Capital (WACC) = 13.5% Country Risk Premium 0% Aswath Damodaran 59 .5% Unlevered Beta for Sectors: 1.384 Firm Value: 59.62%.0662) = 12.Debt: 4.00%)(1-.793 112.218 + Cash: 500 . Beta = 1.

the value of an asset is derived from the pricing of 'comparable' assets. cashflows. standardized using a common variable such as earnings. book value or revenues. Cash Flow multiples) • Price/Book (P/BV) ratios – and variants (Tobin's Q) • Price/Sales ratios Aswath Damodaran 60 . Examples include -• Price/Earnings (P/E) ratios – and variants (EBIT multiples. EBITDA multiples.Relative Valuation n In relative valuation.

gn BV 0 = PBV = r . Payout Ratio *(1 + g n ) P0 = PE = EPS 0 r .Equity Multiples: Determinants n n Gordon Growth Model: P 0 = rDPS1 − gn Dividing both sides by the earnings. Profit Margin*Payout Ratio(1 + g n ) * P0 = PS = Sales 0 r-g n Aswath Damodaran 61 . If the return on equity is written in terms of the retention ratio and the expected growth rate P 0 R O E .gn ROE*Payout Ratio (1 + g n ) * P0 = PBV = BV 0 r-g n n n Dividing by the Sales per share.gn n Dividing both sides by the book value of equity.

Firm Value Multiples n The value of a firm in stable growth can be written as: Value of Firm = n Dividing both sides by the expected free cash flow to the firm yields the Value/FCFF multiple for a stable growth firm: The value/EBITDA multiple. for instance. can be written as follows: n Aswath Damodaran 62 .

Risk Growth. Payout. Risk. Risk Value/Sales Growth. Risk and ROC Companion variable is in italics. Risk.Determinants of Multiples Multiple Price/Earnings Ratio Price/Book Value Ratio Price/Sales Ratio Value/EBITDA Determining Variables Growth. Operating Margin Value/Book Capital Growth. Aswath Damodaran 63 . Net Margin Growth. Payout. Leverage. Risk. Leverage. Payout. ROE Growth. Net Capital Expenditure needs. Net Capital Expenditure needs. Leverage.

the average multiple is adjusted using one variable. and the regression is used to estimate the value any firm.Using Multiples based upon Comparables n n n Simple Averages: The average multiple of comparable firms is used to value any firm. Aswath Damodaran 64 . the multiple is regressed against one or more variables. Adjusted Averages: Here. For instance. Regression Estimates: Here. the PE ratio may be divided by growth to arrive at a PEG ratio. This works only if the firm is similar to the average firm in the sector.

56 16.57 12.33 9.75 0.00 15.02 0.54 23.04 12.14 153.43 0.43 0.53 1.PE Ratios and Growth Rates: Software Firms Company Name Spanlink Communications Expert Software Applied Microsystems Tripos MathSoft Comshare Eagle Point Software TSR Computer Outsourcing Services Data Research Associates Mecon Forsoft HIE CFI ProServices Adept Technology TechForce InVision Technologies American Software A Viasoft Micrografx Orcad MySoftware Integrated Measurement Systems Jetform Aladdin Knowledge Systems Average PE 51.06 46.40 Aswath Damodaran 65 .14 46.55 0.00 11.41 Expected Growth 50% 15% 20% 25% 30% 10% 5% 20% 40% 15% 30% 25% 38% 22% 19% 15% 23% 30% 17% 35% 16% 30% 11% 20% 18% 23% PEG 1.26 1.67 1.04 0.61 9.86 39.53 28.53 13.96 23.13 5.05 122.54 0.74 9.28 0.83 8.31 0.53 3.14 6.54 0.18 10.63 0.54 0.40 0.55 16.39 0.81 1.47 0.73 14.71 10.49 1.10 1.15 9.62 1.17 18.87 9.

03 = $ 37.300 million * 1.03% • Value of Equity = $977.Valuing InfoSoft n Using Simple Average Value of Equity = InfoSoft Net Earnings in 1998* Average PE ratio for sector = $977.40 • Expected Growth Rate for InfoSoft= 27.40 * 27.300 * 28.056 million Aswath Damodaran 66 .765 million n Using Average Adjusted for Growth • PEG Ratio = 1.41 = $27.

41% 25.32 ROE 11.07% 47.Boeing: Price to Book Ratios for Aerospace/Defense Firms Company AAR Corp.57% 14.77 6.50 3. Northrop Grumman Raytheon Co.28% 25.46% 27.09% 16.07% 34.63% 26.02% 10.03% 11. Orbital Sci Corp CAE Inc.40% 16.23% 19.83 2.95% 15.66 3. 'B' Lockheed Martin Boeing Average Aswath Damodaran PBV 1.46% 36.85% 3.38% 33.83 3.17 1.59 0.12% 19.51% 16.62% 27.00 3.33 2.93 1.16% 39.02% 27.49 7.15% 37.46 2. Sundstrand Corp.10% 13.32 3. Litton Inds.32% 33. 'A' Gen'l Dynamics Bombardier Inc.38% 67 .19% 32.29% 9.48% 22.59% 36.84% Standarad Deviation in Stock Prices 61. Alliant Techsystems Precision Castparts Howmet Intl Cordant Techn.65 4.62% 18.15% 35.22 4.

0909) –6.50 times book value.41) n Using this regression.54 + 12. based upon its return on equity of 9.3432) = 2.69 (.15% (2.54 + 12.97 (.32%: Predicted PBVBoeing = 3.PBV Regression n Regressing price to book ratios against returns on equity and risk (standard deviation).69 ROE –6. Aswath Damodaran 68 .97 Standard Deviation R2 = 76.27 n Boeing. which is trading at 3.35) (2. we get a predicted price to book value ratio for Boeing. we get PBV = 3.97) (3.09% and a standard deviation of 34. looks over valued.

over or correctly valued? Under Valued Over Valued Correctly Valued Will this valuation give you a higher or lower valuation than the discounted cashflow valuation? Higher Lower Aswath Damodaran 69 . is Boeing under.Is Boeing fairly valued? n o o o n o o Based upon the PBV ratio.

Implicitly.Relative Valuation Assumptions n o o o o o o Assume that you are reading an equity research report where a buy recommendation for a company is being based upon the fact that its PE ratio is lower than the average for the industry. on average. fairly priced The earnings of the firms in the group are being measured consistently The firms in the group are all of equivalent risk The firms in the group are all at the same stage in the growth cycle The firms in the group are of equivalent risk and have similar cash flow patterns All of the above Aswath Damodaran 70 . what is the underlying assumption or assumptions being made by this analyst? The sector itself is.

edu/~adamodar Aswath Damodaran 71 .stern.nyu.Value Enhancement: Back to Basics Aswath Damodaran http://www.

Price Enhancement versus Value Enhancement Aswath Damodaran 72 .

there are four basic ways in which the value of a firm can be enhanced: • The cash flows from existing assets to the firm can be increased.The Paths to Value Creation n Using the DCF framework. by either – increasing after-tax earnings from assets in place or – reducing reinvestment needs (net capital expenditures or working capital) • The expected growth rate in these cash flows can be increased by either – Increasing the rate of reinvestment in the firm – Improving the return on capital on those reinvestments • The length of the high growth period can be extended to allow for more years of high growth. • The cost of capital can be reduced by – Reducing the operating risk in investments/assets – Changing the financial mix – Changing the financing composition Aswath Damodaran 73 .

A Basic Proposition n For an action to affect the value of the firm. Aswath Damodaran 74 . future growth. it has to • • • • Affect current cash flows (or) Affect future growth (or) Affect the length of the high growth period (or) Affect the discount rate (cost of capital) n Proposition 1: Actions that do not affect current cash flows. the length of the high growth period or the discount rate cannot affect value.

75 n .Value-Neutral Actions n n Stock splits and stock dividends change the number of units of equity in a firm. Accounting decisions that affect reported earnings but not cash flows should have no effect on value. growth or risk. Decisions that create new securities on the existing assets of the firm (without altering the financial mix) such as tracking stock cannot Aswath Damodaran create value. though they might affect perceptions and hence the price. • Changing inventory valuation methods from FIFO to LIFO or vice versa in financial reports but not for tax purposes • Changing the depreciation method used in financial reports (but not the tax books) from accelerated to straight line depreciation • Major non-cash restructuring charges that reduce reported earnings but are not tax deductible • Using pooling instead of purchase in acquisitions cannot change the value of a target firm. but cannot affect firm value since they do not affect cash flows.

will increase its value.Depreciation) .(Capital Expenditures . To the extent that these investments were poorly made and/or poorly managed. Aswath Damodaran 76 . without significantly impacting future growth or risk.Change in Non-cash Working Capital = Free Cash Flow to Firm n Proposition 2: A firm that can increase its current cash flows. The cash flows discounted in valuation are after taxes and reinvestment needs have been met: EBIT ( 1-t) .Value Creation 1: Increase Cash Flows from Assets in Place n n The assets in place for a firm reflect investments that have been made historically by the firm. it is possible that value can be increased by increasing the after-tax cash flows generated by these assets.

moving income to lower tax locales .Ways of Increasing Cash Flows from Assets in Place More efficient operations and cost cuttting: Higher Margins Divest assets that have negative EBIT Reduce tax rate .Chg in Working Capital = FCFF Live off past overinvestment Better inventory management and tighter credit policies Aswath Damodaran 77 .risk management Revenues * Operating Margin = EBIT .Tax Rate * EBIT = EBIT (1-t) + Depreciation .Capital Expenditures .transfer pricing .

00 $100.2: Boeing: Operating Margin Effect on Value $140.00 $60.00 $0.00 3% 5% 7% 9% After-tax Operating Margin 11% 13% 15% Aswath Damodaran 78 .00 $20.Operating Margin and Value Per Share: Boeing Figure 25.00 $120.00 $40.00 Value/Share $80.

000 $57.000 $56.000 $59.000 $52.000 $58.Tax Rate and Value: InfoSoft Figure 25.3: Tax Rate and InfoSoft Value $60.000 0% 10% 20% 30% 40% 50% Aswath Damodaran 79 .000 $53.000 $54.000 $55.

Working Capital and Value: The Home Depot Figure 25.5: The Home Depot: Working Capital and Value/Share $50.00 0% 5% 10% 15% 20% Non-Cash Working Capital as % of Revenues Aswath Damodaran Value/Share 80 .00 $45.00 $10.00 $30.00 $5.00 $35.00 $15.00 $40.00 $0.00 $20.00 $25.

Value Creation 2: Increase Expected Growth n n Keeping all else constant. The expected growth in earnings of any firm is a function of two variables: • The amount that the firm reinvests in assets and projects • The quality of these investments Aswath Damodaran 81 . increasing the expected growth in earnings will increase the value of a firm.

Value Enhancement through Growth

Reinvest more in projects Increase operating margins

Do acquisitions Reinvestment Rate * Return on Capital = Expected Growth Rate Increase capital turnover ratio

Aswath Damodaran

82

**Reviewing the Valuation Inputs
**

Boeing 9.17% 6.59% 65.98% 5.72% $13.14 The Home Depot 9.51% 16.38% 88.62% 14.51% $42.55 InfoSoft 12.55% 23.67% 112.17% 27.03% $55.15

Cost of Capital Return on Capital Reinvestment Rate Expected Growth Rate Value Per Share

Aswath Damodaran

83

**Changing the Reinvestment Rate
**

Figure 25.6: Effect of Changes in the Reinvestment Rate on the Value of Equity 30.00%

20.00%

Change in Value of Equity

10.00%

0.00% -20% -10% 10% 20%

-10.00%

-20.00%

-30.00% Change in Reinvestment Rate Boeing The Home Depot InfoSoft

Aswath Damodaran

84

Reinvestment Rate and Value n Increasing the reinvestment rate increases value per share at The Home Depot and InfoSoft. Why? Aswath Damodaran 85 . but reduces it at Boeing.

The high growth period refers to the period over which a firm is able to sustain a growth rate greater than this “stable” growth rate. it will increase value. If a firm is able to increase the length of its high growth period. at some point in the future. other things remaining equal. will become a stable growth firm. The length of the high growth period is a direct function of the competitive advantages that a firm brings into the process. growing at a rate equal to or less than the economy in which it operates.Value Creation 3: Increase Length of High Growth Period n n n n Every firm. Creating new competitive advantage or augmenting existing ones can create value. Aswath Damodaran 86 .

3. thus increasing value. Firms that are able to improve their brand name value over time can increase both their growth rate and the period over which they can expect to grow at rates above the stable growth rate.1: The Brand Name Advantage n n Some firms are able to sustain above-normal returns and growth because they have well-recognized brand names that allow them to charge higher prices than their competitors and/or sell more than their competitors. Aswath Damodaran 87 .

90%) 8.16% 2.16% 2.35% 12.00% (19.Illustration: Valuing a brand name: Coca Cola AT Operating Margin Sales/BV of Capital ROC Reinvestment Rate Expected Growth Length Cost of Equity E/(D+E) AT Cost of Debt D/(D+E) Cost of Capital Value Aswath Damodaran Coca Cola 18.00% (47.13% $13 88 .33% 97.35% 12.35%) 20.67 12.02% 65.15% 10 yea 12.50% 1.33% 97.65% 4.13% $115 Generic Cola Company 7.65% 4.67 31.56% 1.53% 65.16% 10 years 12.

are monopolies but are regulated when it comes to price increases and returns.2: Patents and Legal Protection n n n The most complete protection that a firm can have from competitive pressure is to own a patent. Licenses and government-sanctioned monopolies also provide protection against competition. for instance. Aswath Damodaran 89 . copyright or some other kind of legal protection allowing it to be the sole producer for an extended period.3. utilities in the United States. since they cannot protect a firm against a competitive product that meets the same need but is not covered by the patent protection. come with restrictions on excess returns. Note that patents only provide partial protection. They may. however.

the more difficult it is for competitors to come in and compete away excess returns. Aswath Damodaran 90 . while reducing the costs of switching from competitor products to their own will be able to increase their expected length of growth. Firms that devise ways to increase the cost of switching from their products to competitors’ products. The greater the switching costs.3: Switching Costs n n n Another potential barrier to entry is the cost associated with switching from one firm’s products to another.3.

• Owning or having the rights to extract a natural resource which is in restricted supply (The undeveloped reserves of an oil or mining company. where scale can be used to reduce costs.4: Cost Advantages n There are a number of ways in which firms can establish a cost advantage over their competitors. economies of scale can give bigger firms advantages over smaller firms • Owning or having exclusive rights to a distribution system can provide firms with a cost advantage over its competitors. Aswath Damodaran 91 . and use this cost advantage as a barrier to entry: • In businesses. but have a much higher operating margin. • The firm may charge lower prices than its competitors and have a much higher capital turnover ratio. for instance) n These cost advantages will show up in valuation in one of two ways: • The firm may charge the same price as its competitors.3.

7: Value of InfoSoft and Expected Growth Period 120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 Aswath Damodaran 92 .Growth Period and Value: InfoSoft Figure 25.

Gauging Barriers to Entry n p p p p Which of the following barriers to entry are most likely to work for the firm that you are analyzing? Brand Name Patents and Legal Protection Switching Costs Cost Advantages Aswath Damodaran 93 .

n The cash flows generated over time are discounted back to the present at the cost of capital. Holding the cash flows constant. given current interest rates and its own default risk. ke = Cost of Equity for the firm kd = Borrowing rate (1 .tax rate) n The cost of equity reflects the rate of return that equity investors in the firm would demand to compensate for risk.Value Creation 4: Reduce Cost of Capital The cost of capital for a firm can be written as: Cost of Capital = ke (E/(D+E)) + kd (D/(D+E)) Where. while the borrowing rate reflects the current long-term rate at which the firm can borrow. n Aswath Damodaran 94 . reducing the cost of capital will increase the value of the firm.

reducing default risk Swaps Derivatives Hybrids Aswath Damodaran 95 ./(D+E)) = Cost of Capital Make product or service less discretionary to customers Changing product characteristics More effective advertising Match debt to assets.Reducing Cost of Capital Outsourcing Flexible wage contracts & cost structure Change financing mix Reduce operating leverage Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D.

17% 30% 9.09% 9.23% 6.16% 4.55% 20% 12.55% 12.28% Boeing The Home Depot InfoSoft Aswath Damodaran 96 .51% 20% 9.Actual versus Optimal Debt Ratios Current Optimal Cost of Capital Debt Ratio Cost of Capital Debt Ratio 20.55% 9.

and increases value. higher costs of capital and lower firm value. Aswath Damodaran 97 . Firms which mismatch cash flows on debt and cash flows on assets by using • Short term debt to finance long term assets • Dollar debt to finance non-dollar assets • Floating rate debt to finance assets whose cash flows are negatively or not affected by inflation will end up with higher default risk. a firm reduces its risk of default and increases its capacity to carry debt. By matching cash flows on debt to cash flows on the asset. in turn. which.Changing Financing Type n n n The fundamental principle in designing the financing of a firm is to ensure that the cash flows on the debt should match as closely as possible the cash flows on the asset. reduces its cost of capital.

Reduce the operating risk of the firm. Terminate projects with Liquidation Value > Continuing Value 3. Reduce capital maintenance expenditures on assets in place. Use swaps and derivatives to match debt more closely to firm’s assets 2. 1. Recapitalize to move the firm towards its optimal debt ratio. Use the optimal financing mix to finance new investments. 1. 98 . Divest assets/projects with Divestiture Value > Continuing Value 2. Aswath Damodaran 1.The Value Enhancement Chain Assets in Place Gimme’ 1. Reduce net working capital 1. or by increasing ratio. Use economies of scale or cost advantages to create higher return on capital. Change pricing strategy to requirements. 3. Eliminate operating expenses that generate no current revenues and no growth. Cost of Financing 1. by making products less discretionary to customers. Increase reinvestment rate or marginal return on capital or both in new businesses. Could work if. do so Odds on. Build up brand name 2. Expected Growth Length of High Growth Period Increase reinvestment rate or marginal return on capital or both in firm’s existing businesses. by reducing maximize the product of inventory and accounts profit margins and turnover receivable. Increase the cost of switching from product and reduce cost of switching to it. Make cost structure more flexible to reduce operating leverage. Eliminate new capital expenditures that are expected to earn less than the cost of capital If any of the firm’s products or services can be patented and protected. Change financing type and use innovative securities to reflect the types of assets being financed 2. accounts payable.. 2.

14% Historical US Premium 5.0842-.92% Riskfree Rate: Government Bond Rate = 5% + Beta 1.776 -Options 350 Value/Share $28.254 + Cash: 4.Reinv 1179 FCFF 608 1935 1277 658 2095 1382 713 2267 1496 771 2454 1619 835 2657 1753 904 2876 1898 978 3113 2054 1059 3370 2223 1146 3648 2407 1241 3830 1532 2298 Discount at Cost of Capital (WACC) = 10.05) = 67.Nt CpX 1.85% Cost of Debt (5%+ 0.039 .148 Firm Value: 33.08 8.50%)(1-.01 X Risk Premium 5.5% Unlevered Beta for Sectors: 0.88 Firm’s D/E Ratio: 25.5% Country Risk Premium 0% Aswath Damodaran 99 .73 EBIT(1-t) 1788 .00.ROC=12.298(.123 .80) + 3.50% Expected Growth in EBIT (1-t) .194 =Equity 40. D/(D+E) = 30%.Boeing: A Restructured Valuation Current Cashflow to Firm EBIT(1-t) : 2. Beta = 1.20) = 9.125 = .98% Return on Capital 12.35) = 3.25% Stable Growth g = 5%.Debt: 8.323 .56% (0.Chg WC 667 = FCFF 417 Reinvestment Rate = 80.38% Reinvestment Rate 65.5% Reinvestment Rate=40% Terminal Value 10 = 2.58% Weights E = 80.6598*.16% Cost of Equity 13.08% D = 19.58% (0.

813 .1% Reinvestment Rate=35.76% Expected Growth in EBIT (1-t) 1.146 Firm Value: 89. Beta = 0.0876*.39% Cost of Debt (5%+ 2.1677= .0792-.ROC=14.Debt: 3.850 + Cash: 62 .98 X Risk Premium 5.05) = 228.841 108.76% .24% Return on Capital 16. D/(D+E) = 30%.87.5% Unlevered Beta for Sectors: 0.23% Cost of Equity 10.The Home Depot: A Restructured Valuation Current Cashflow to Firm Reinvestment Rate EBIT(1-t) : 1.021 Value/Share $56.86 Firm’s D/E Ratio: 25% Historical US Premium 5.5% Country Risk Premium 0% Aswath Damodaran 100 .Chg WC 190 = FCFF <161> Reinvestment Rate =108.Nt CpX 1.027 -Options 2.Reinv 2513 FCFF -336 2574 2972 -397 3044 3514 -470 3599 4155 -556 4256 4913 -657 5032 5809 -777 5950 6869 -919 7036 8122 -1086 8320 9604 -1284 9837 11356 -1519 Discount at Cost of Capital (WACC) = 10.885 =Equity 86.55% (0.77% Stable Growth g = 5%.20) = 9.81 EBIT(1-t) 2177 .1824 18.46% Terminal Value 10 = 6666/(.80) + 4.35) = 4.55% Weights E = 80% D = 20% Riskfree Rate: Government Bond Rate = 5% + Beta 0.00%)(1-.39% (0.

5% Country Risk Premium 0% Aswath Damodaran 101 .20) = 12.17% .ROC=17.64 X Risk Premium 5.2% Reinvestment Rate=29.42) = 5.2655 26.20.37% Weights E = 80% D = 20% Riskfree Rate: Government Bond Rate = 5% + Beta 1.80) + 5.Chg WC 500 = FCFF <340> Reinvestment Rate = 112.2367= .583 =Equity 117439 EBIT(1-t) 3535 .Nt CpX 2.1217*.07% Terminal Value 10 = 21918/(.Debt: 4.00%)(1-.1035-.5% Unlevered Beta for Sectors: 1.55% Return on Capital 23.633 .09% Historical US Premium 5.29% Cost of Equity 14. D/(D+E) =20%.05) = 409453 Firm Value: 121522 + Cash: 500 .43 Firm’s D/E Ratio: 7. Beta = 1.37% (0.Reinv 3965 FCFF -430 4474 5018 -544 5661 6350 -689 7165 8047 -872 9067 11474 14521 18376 23255 10170 12871 16288 20613 26086 -1103 -1397 -1767 -2237 -2831 29429 33011 -3582 Discount at Cost of Capital (WACC) = 14.793 112.17% Expected Growth in EBIT (1-t) 1.02% (0.67% Stable Growth g = 5%.InfoSoft: A Restructured Valuation Current Cashflow to Firm Reinvestment Rate EBIT(1-t) : 2.02% Cost of Debt (5%+ 4.

• The form of returns .First Principles n Invest in projects that yield a return greater than the minimum acceptable hurdle rate. they should also consider both positive and negative side effects of these projects.dividends and stock buybacks . return the cash to stockholders.will depend upon the stockholders’ characteristics. If there are not enough investments that earn the hurdle rate. Objective: Maximize the Value of the Firm Aswath Damodaran 102 . n n Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows. • The hurdle rate should be higher for riskier projects and reflect the financing mix used .

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