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B40.3331 Aswath Damodaran

Aswath Damodaran

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Discounted Cashﬂow Valuation: Basis for Approach

Value of asset =

CF1 CF2 CF3 CF4 CFn + + + .....+ (1 + r)1 (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 + r) n

!

where CFt is the expected cash ﬂow in period t, r is the discount rate appropriate given the riskiness of the cash ﬂow and n is the life of the asset. Proposition 1: For an asset to have value, the expected cash ﬂows have to be positive some time over the life of the asset. Proposition 2: Assets that generate cash ﬂows early in their life will be worth more than assets that generate cash ﬂows later; the latter may however have greater growth and higher cash ﬂows to compensate.

Aswath Damodaran

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**DCF Choices: Equity Valuation versus Firm Valuation
**

Firm Valuation: Value the entire business

Assets

Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Expected Value that will be created by future investments Assets in Place Debt

Liabilities

Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible

Growth Assets

Equity

Residual Claim on cash flows Significant Role in management Perpetual Lives

Equity valuation: Value just the equity claim in the business

Aswath Damodaran

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Equity Valuation

**Figure 5.5: Equity Valuation Assets
**

Cash flows considered are cashflows from assets, after debt payments and after making reinvestments needed for future growth Assets in Place Debt

Liabilities

Growth Assets

Equity

Discount rate reflects only the cost of raising equity financing

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

Aswath Damodaran

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Firm Valuation

**Figure 5.6: Firm Valuation Assets
**

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

Liabilities

Growth Assets

Equity

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

Aswath Damodaran

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B.Firm Value and Equity Value A. A. C. will give you a value for the equity which is greater than the value you would have got in an equity valuation lesser than the value you would have got in an equity valuation equal to the value you would have got in an equity valuation Aswath Damodaran 6 . D. B. C. To get from ﬁrm value to equity value. which of the following would you need to do? Subtract out the value of long term debt Subtract out the value of all debt Subtract the value of any debt that was included in the cost of capital calculation Subtract out the value of all liabilities in the ﬁrm Doing so.

) The current market value of equity is $1.2 5 $ 83.49 $ 40 $ 123.0 $ 2363. Aswath Damodaran 7 .625% and the ﬁrm can borrow long term at 10%.073 and the value of debt outstanding is $800. (The tax rate for the ﬁrm is 50%.49 Terminal Value $ 1603. Year CF to Equity Interest Exp (1-tax rate) CF to Firm 1 $ 50 $ 40 $ 90 2 $ 60 $ 40 $ 100 3 $ 68 $ 40 $ 108 4 $ 76.Cash Flows and Discount Rates Assume that you are analyzing a company with the following cashﬂows for the next ﬁve years.2 $ 40 $ 116.008 Assume also that the cost of equity is 13.

49+1603)/1.136253 + 76.Market Value of Debt = $ 1873 .5) = 5% WACC = 13.Equity versus Firm Valuation Method 1: Discount CF to Equity at Cost of Equity to get value of equity • • Cost of Equity = 13.09944 + (123.136255 = $1073 Method 2: Discount CF to Firm at Cost of Capital to get value of ﬁrm Cost of Debt = Pre-tax rate (1.0994 + 100/1.$ 800 = $1073 Aswath Damodaran 8 .49+2363)/1.09945 = $1873 Value of Equity = Value of Firm .09942 + 108/1.2/1.136252 + 68/1.625% (1073/1873) + 5% (800/1873) = 9.94% PV of Firm = 90/1.tax rate) = 10% (1-.2/1.625% Value of Equity = 50/1.13625 + 60/1.136254 + (83.09943 + 116.

while discounting cashﬂows to the ﬁrm at the cost of equity will yield a downward biased estimate of the value of the ﬁrm.First Principle of Valuation Never mix and match cash ﬂows and discount rates. The key error to avoid is mismatching cashﬂows and discount rates. since discounting cashﬂows to equity at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity. Aswath Damodaran 9 .

49+2363)/1.09942 + 68/1.The Effects of Mismatching Cash Flows and Discount Rates Error 1: Discount CF to Equity at Cost of Capital to get equity value PV of Equity = 50/1.2/1.136253 + 116.13625 + 100/1.2/1.09943 + 76.136254 + (123.86 .$800 = $813 Value of Equity is understated by $ 260.09944 + (83.49+1603)/1.09945 = $1248 Value of equity is overstated by $175.136255 = $1613 PV of Equity = $1612.0994 + 60/1. Error 3: Discount CF to Firm at Cost of Equity. forget to subtract out debt.136252 + 108/1. Error 2: Discount CF to Firm at Cost of Equity to get ﬁrm value PV of Firm = 90/1. and get too high a value for equity Value of Equity = $ 1613 Value of Equity is overstated by $ 540 Aswath Damodaran 10 .

Choose the right DCF model for this asset and value it.Discounted Cash Flow Valuation: The Steps Estimate the discount rate or rates to use in the valuation • • • Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the ﬁrm) Discount rate can be in nominal terms or real terms. to either equity investors (CF to Equity) or to all claimholders (CF to Firm) Estimate the future earnings and cash ﬂows on the ﬁrm being valued. generally by estimating an expected growth rate in earnings. Aswath Damodaran 11 . depending upon whether the cash ﬂows are nominal or real Discount rate can vary across time. Estimate when the ﬁrm will reach “stable growth” and what characteristics (risk & cash ﬂow) it will have when it does. Estimate the current earnings and cash ﬂows on the asset.

. Forever Discount Rate Firm:Cost of Capital Equity: Cost of Equity Aswath Damodaran 12 ........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 .

EQUITY VALUATION WITH DIVIDENDS Dividends Net Income * Payout Ratio = Dividends Expected Growth Retention Ratio * Return on Equity Firm is in stable growth: Grows at constant rate forever Value of Equity Dividend 1 Dividend 2 Dividend 3 Dividend 4 Terminal Value= Dividend n+1 /(k e-gn) Dividend 5 Dividend n ..No reinvestment risk ....Premium for average risk investment Type of Business Operating Leverage Financial Leverage Base Equity Premium Country Risk Premium Aswath Damodaran 13 ...No default risk .In same currency and in same terms (real or nominal as cash flows + Beta ..Measures market risk X Risk Premium . Forever Discount at Cost of Equity Cost of Equity Riskfree Rate : ..

.No reinvestment risk ..DR) ..Change in WC (!-DR) = FCFE Expected Growth Retention Ratio * Return on Equity Firm is in stable growth: Grows at constant rate forever Value of Equity FCFE1 FCFE2 FCFE3 FCFE4 Terminal Value= FCFE n+1 /(k e-gn) FCFE5 FCFEn ..Financing Weights Debt Ratio = DR EQUITY VALUATION WITH FCFE Cashflow to Equity Net Income ...No default risk ..(Cap Ex ..In same currency and in same terms (real or nominal as cash flows + Beta .Premium for average risk investment Type of Business Operating Leverage Financial Leverage Base Equity Premium Country Risk Premium Aswath Damodaran 14 .Measures market risk X Risk Premium . Forever Discount at Cost of Equity Cost of Equity Riskfree Rate : .Depr) (1.

.Value of Deb t = Value of Equity Terminal Value= FC FF n+1/(r-g n) FC FF1 FC FF2 FC FF3 FC FF4 FC FF5 FC FFn .(C ap Ex .Premium for average risk investment Typ e of Business Op erating Leverage Financial Leverage Base Equity Premium C ountry Risk Premium Aswath Damodaran 15 .. Forever Discount at W AC C = C ost of Equity (Equity/(Deb t + Equity)) + C ost of Deb t (Deb t/(Deb t+ Equity)) C ost of Equity C ost of Debt (Riskfree Rate + Default Sp read) (1-t) Weights Based on Market Value Riskfree Rate : .Dep r) ..No reinvestment risk .VALUING A FIRM C ashﬂow to Firm EBIT (1-t) .In same currency and in same terms (real or nominal as cash ﬂows + Beta ...No default risk .Measures market risk X Risk Premium ...C hange in W C = FC FF Expected Grow th Reinvestment Rate * Return on C ap ital Firm is in stab le growth: Grows at constant rate forever Value of Op erating Assets + C ash & Non-op Assets = Value of Firm ..

Discounted Cash Flow Valuation: The Inputs Aswath Damodaran Aswath Damodaran 16 .

Estimating Discount Rates DCF Valuation Aswath Damodaran 17 .I.

• Equity versus Firm: If the cash ﬂows being discounted are cash ﬂows to equity. If the cash ﬂows are cash ﬂows to the ﬁrm. Currency: The currency in which the cash ﬂows are estimated should also be the currency in which the discount rate is estimated.Estimating Inputs: Discount Rates Critical ingredient in discounted cashﬂow valuation. Nominal versus Real: If the cash ﬂows being discounted are nominal cash ﬂows (i. the appropriate discount rate is the cost of capital. the appropriate discount rate is a cost of equity. the discount rate should be nominal • • Aswath Damodaran 18 ..e. reﬂect expected inﬂation). Errors in estimating the discount rate or mismatching cashﬂows and discount rates can lead to serious errors in valuation. the discount rate used should be consistent with both the riskiness and the type of cashﬂow being discounted. At an intuitive level.

risk and return models in ﬁnance assume that the risk that should be rewarded (and thus built into the discount rate) in valuation should be the risk perceived by the marginal investor in the investment Most risk and return models in ﬁnance also assume that the marginal investor is well diversiﬁed. market or nondiversiﬁable risk) Aswath Damodaran 19 .Cost of Equity The cost of equity should be higher for riskier investments and lower for safer investments While risk is usually deﬁned in terms of the variance of actual returns around an expected return.e. and that the only risk that he or she perceives in an investment is risk that cannot be diversiﬁed away (I.

.Rf) APM E(R) = Rf + Σj=1 βj (Rj. Betas relative to each factor Factor risk premiums Riskfree Rate.Rf) Multi factor Proxy E(R) = Rf + Σj=1. # of Factors.Rf) E(R) = a + Σj=1. Macro factors Betas relative to macro factors Macro economic risk premiums Proxies Regression coefﬁcients Aswath Damodaran 20 .The Cost of Equity: Competing Models Model CAPM Expected Return E(R) = Rf + β (Rm.N βj (Rj.N bj Yj Inputs Needed Riskfree Rate Beta relative to market portfolio Market Risk Premium Riskfree Rate..

• • • Short term government security rates are used as risk free rates Historical risk premiums are used for the risk premium Betas are estimated by regressing stock returns against market returns Aswath Damodaran 21 .Rf) where.The CAPM: Cost of Equity Consider the standard approach to estimating cost of equity: Cost of Equity = Rf + Equity Beta * (E(Rm) . Rf = Riskfree rate E(Rm) = Expected Return on the Market Index (Diversiﬁed Portfolio) In practice.

On a riskfree asset. it has to have • • No default risk No reinvestment risk Thus. the riskfree rates in valuation will depend upon when the cash ﬂow is expected to occur and will vary across time. Aswath Damodaran 22 . For an investment to be riskfree.Short term Governments are not riskfree in valuation…. the actual return is equal to the expected return. the time horizon is generally inﬁnite. leading to the conclusion that a long-term riskfree rate will always be preferable to a short term rate. there is no variance around the expected return. if you have to pick one. Therefore. In valuation. then.

00% Germany 10year (Euro) Greece 10year (Euro) Italy 10-year (Euro) US 10-year Treasury ($) Brazil 10-year C Bond ($) Mexican 10year (Peso) Japanese 10Year (Yen) Aswath Damodaran 23 .50% 10.42% 4.30% 4.00% 8.00% 11.50% 0.45% 4.Riskfree Rates in 2004 Riskfree Rates: An Exploration $ denominated bonds 12.25% 2.26% 10.00% 4.00% 1.00% 6.00% 10-year Euro Bonds 4.

approximately. if one exists set equal.Default spread for Government in local currency • Approach 2: Use forward rates and the riskless rate in an index currency (say Euros or dollars) to estimate the riskless rate in the local currency. to the long term real growth rate of the economy in which the valuation is being done.Estimating a Riskfree Rate when there are no default free entities…. Do the analysis in a currency where you can get a riskfree rate. Estimate a range for the riskfree rate in local terms: • Approach 1: Subtract default spread from local government bond rate: Government bond rate in local currency terms . which can be obtained in one of two ways – • • from an inﬂation-indexed government bond. say US dollars. Aswath Damodaran 24 . Do the analysis in real terms (rather than nominal terms) using a real riskfree rate.

You are valuing Embraer.30%) The interest rate on a US $ denominated Brazilian Brady bond (which is partially backed by the US Government) (10. in U. D. The riskfree rate that you should use is The interest rate on a Brazilian Real denominated long term bond issued by the Brazilian Government (15%) The interest rate on a US $ denominated long term bond issued by the Brazilian Government (C-Bond) (10.29%) Aswath Damodaran 25 .S.15%) The interest rate on a dollar denominated bond issued by Embraer (9. B. E. dollars and are attempting to estimate a riskfree rate to use in the analysis.25%) The interest rate on a US treasury bond (4. a Brazilian company. C.A Simple Test A.

85% 4.Bonds 1928-2004 7.60% 5.84% 4.Bond rates Whether you use geometric or arithmetic averages.Everyone uses historical premiums.82% 4.92% 6.59% 3. Practitioners never seem to agree on the premium. looking at the US: Arithmetic average Stocks .51% Aswath Damodaran 26 .34% 1994-2004 8.Bills T. For instance.47% 6. The historical premium is the premium that stocks have historically earned over riskless securities.Stocks T.Bills T.bill rates or T.Bonds 6..82% Geometric Average Stocks .53% 1964-2004 5.02% 4. but. it is sensitive to • • • How far back you go in history… Whether you use T.Stocks Historical Period T.

It is closer to how investors think about risk premiums over long periods. A risk premium comes with a standard error.If you choose to use historical premiums…. the premium should be the one over T. Aswath Damodaran 27 . Given the annual standard deviation in stock prices is about 25%. Since we argued for long term bond rates.Bonds Use the geometric risk premium. the standard error in a historical premium estimated over 25 years is roughly: Standard Error in Premium = 25%/√25 = 25%/5 = 5% Be consistent in your use of the riskfree rate. Go back as far as you can.

Risk Premium for a Mature Market? Broadening the sample Aswath Damodaran 28 .

4.01%) = 8.Two Ways of Estimating Country Equity Risk Premiums for other markets.82% (34.76% .94% (The standard deviation in weekly returns from 2002 to 2004 for the Bovespa was 34.30%-4.01%) Aswath Damodaran 29 .82% = 3. Total equity risk premium = Risk PremiumUS* σCountry Equity / σUS Equity Using a 4. Default spread on Country Bond: In this approach.S market.Bond at the end of August 2004 was 6.. (10.29%) Relative Equity Market approach: The country equity risk premium is based upon the volatility of the market in question relative to U. the country equity risk premium is set equal to the default spread of the bond issued by the country (but only if it is denominated in a currency where a default free entity exists.56% whereas the standard deviation in the S&P 500 was 19.82% premium for the US.76% Country equity risk premium for Brazil = 8. • Brazil was rated B2 by Moody’s and the default spread on the Brazilian dollar denominated C. this approach would yield: Total risk premium for Brazil = 4.56%/19.01%.

Another is to multiply the bond default spread by the relative volatility of stock and bond prices in that market.56%/26. one would expect equity spreads to be higher than debt spreads.89% Aswath Damodaran 30 .01% • Country Equity Risk Premium = 6.56% – Standard Deviation in Brazil C-Bond = 26.34%) = 7.And a third approach Country ratings measure default risk.01% (34. While default risk premiums and equity risk premiums are highly correlated.34% – Default spread on C-Bond = 6. In this approach: • Country Equity risk premium = Default spread on country bond* σCountry Equity / σ Country Bond – Standard Deviation in Bovespa (Equity) = 34.

Its rating improved to B1.82% Aswath Damodaran 31 .22%. The US treasury bond rate that day was 4. • • • • Standard Deviation in Bovespa (Equity) = 25.51% (25.Can country risk premiums change? Updating Brazil in January 2004 Brazil’s ﬁnancial standing and country rating improved dramatically towards the end of 2004.09%/15. yielding a default spread of 3.09% Standard Deviation in Brazil C-Bond = 15.51% Country Risk Premium for Brazil = 3. In January 2005.12%) = 5.73%. the interest rate on the Brazilian C-Bond dropped to 7.51% for Brazil.12% Default spread on C-Bond = 3.

this is what you are assuming when you use the local Government’s dollar borrowing rate as your riskfree rate. In this case.From Country Equity Risk Premiums to Corporate Equity Risk premiums Approach 1: Assume that every company in the country is equally exposed to country risk. E(Return) = Riskfree Rate + Country ERP + Beta (US premium) Implicitly. Approach 2: Assume that a company’s exposure to country risk is similar to its exposure to other market risk. E(Return) = Riskfree Rate + Beta (US premium + Country ERP) Approach 3: Treat country risk as a separate risk factor and allow ﬁrms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales) E(Return)=Riskfree Rate+ β (US premium) + λ (Country ERP) ERP: Equity Risk Premium Aswath Damodaran 32 .

for instance). Use of risk management products: Companies can use both options/futures markets and insurance to hedge some or a signiﬁcant portion of country risk. a company should be more exposed to risk in a country if it generates more of its revenues from that country.Estimating Company Exposure to Country Risk: Determinants Source of revenues: Other things remaining equal. The problem will be accented for companies that cannot move their production facilities (mining and petroleum companies. Manufacturing facilities: Other things remaining equal. Aswath Damodaran 33 . A Brazilian ﬁrm that generates the bulk of its revenues in Brazil should be more exposed to country risk than one that generates a smaller percent of its business within Brazil. a ﬁrm that has all of its production facilities in Brazil should be more exposed to country risk than one which has production facilities spread over multiple countries.

The average Brazilian company gets about 77% of its revenues in Brazil: • • LambdaEmbraer = 3%/ 77% = .04 LambdaEmbratel = 100%/77% = 1.Estimating Lambdas: The Revenue Approach The easiest and most accessible data is on revenues.30 A company’s risk exposure is determined by where it does business and not by where it is located Firms might be able to actively manage their country risk exposures There are two implications • • Aswath Damodaran 34 . both of which are incorporated and traded in Brazil. Embraer and Embratel. One simplistic solution would be to do the following: λ = % of revenues domesticallyﬁrm/ % of revenues domesticallyavg ﬁrm Consider. for instance. Most companies break their revenues down by region. Embraer gets 3% of its revenues from Brazil whereas Embratel gets almost all of its revenues in Brazil.

00% Quarterly EPS 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 2002 2002 2002 2003 2003 2003 -0.5 40.Estimating Lambdas: Earnings Approach Figure 2: EPS changes versus Country Risk: Embraer and Embratel 1.00% -1.5 20.00% 0.00% Aswath Damodaran % change in C Bond Price 35 .00% 0.5 10.00% -2 Quarter Embraer Embratel C Bond -30.5 -20.00% 1 30.00% -1 -10.

0308 + 2.0030 ReturnC Bond Embraer versus C Bond: 2000-2003 40 100 80 Embratel versus C Bond: 2000-2003 20 60 0 Return on Embrat el -20 -10 0 10 20 Return on Embraer 40 20 0 -20 -40 -60 -20 -40 -60 -30 -80 -30 -20 -10 0 10 20 Return on C-Bond Return on C-Bond Aswath Damodaran 36 .Estimating Lambdas: Stock Returns versus C-Bond Returns ReturnEmbraer = 0.0195 + 0.2681 ReturnC Bond ReturnEmbratel = -0.

Also assume that the risk premium for the US is 4.29 % + 1.29% + 1.89%.27 (7.34% Approach 2: Assume that a company’s exposure to country risk is similar to its exposure to other market risk.29%.82%) + 7.29% + 1.89% Approach 3: Treat country risk as a separate risk factor and allow ﬁrms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales) E(Return)= 4.89% = 17.89%) = 11. In this case. Approach 1: Assume that every company in the country is equally exposed to country risk.89%) = 17.82%+ 7.58% Aswath Damodaran 37 .07 (4. and that the riskfree rate used is 4. E(Return) = 4.82%) + 0.07(4.07.Estimating a US Dollar Cost of Equity for Embraer September 2004 Assume that the beta for Embraer is 1.07 (4.82% and the country risk premium for Brazil is 7. E(Return) = 4.

which of the following consequences do you see from this approach? Emerging market companies with substantial exposure in developed markets will be signiﬁcantly over valued by equity research analysts. The conventional practice in investment banking is to add the country equity risk premium on to the cost of equity for every emerging market company. Can you construct an investment strategy to take advantage of the misvaluation? Aswath Damodaran 38 . B. Embraer would have been valued with a cost of equity of 17. Emerging market companies with substantial exposure in developed markets will be signiﬁcantly under valued by equity research analysts.Valuing Emerging Market Companies with signiﬁcant exposure in developed markets A. Thus.34% even though it gets only 3% of its revenues in Brazil. notwithstanding its exposure to emerging market risk. As an investor.

Subtracting out the riskfree rate should yield an implied equity risk premium.Implied Equity Premiums If we assume that stocks are correctly priced in the aggregate and we can estimate the expected cashﬂows from buying stocks. we can estimate the expected rate of return on stocks by computing an internal rate of return. This implied equity premium is a forward looking number and can be updated as often as you want (every minute of every day. if you are so inclined). Aswath Damodaran 39 .

0422) + + + + + (1+ r) (1+ r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r " .92 If you pay the current level of the index.71 January 1.89 48.4.5% a year for the next 5 years . the same rate as the entire economy 52.71 52.15 in cashflows 38. generating 35.22%.13 41.Treasury bond rate = 7.89 48.13 41.85 52.37 44.90% of the index. Analysts expect earnings to grow 8.22% = 3. dividends & stock buybacks were 2. After year 5.92 = 38. you can expect to make a return of 7. we will assume that earnings on the index will grow at 4.65% ! Aswath Damodaran 40 .0422)(1+ r) 5 Implied Equity risk premium = Expected return on stocks .85(1.87% on stocks (which is obtained by solving for r in the following equation) 1211.37 44.Implied Equity Premiums We can use the information in stock prices to back out how risk averse the market is and how much of a risk premium it is demanding.85 In 2004.87% . 2005 S&P 500 is at 1211.

Implied Risk Premium Dynamics Assume that the index jumps 10% on January 2 and that nothing else changes. What will happen to the implied equity risk premium? Implied equity risk premium will increase Implied equity risk premium will decrease Assume that the riskfree rate increases to 5% on January 2 and that nothing else changes. What will happen to the implied equity risk premium? Implied equity risk premium will increase Implied equity risk premium will decrease Aswath Damodaran 41 . What will happen to the implied equity risk premium? Implied equity risk premium will increase Implied equity risk premium will decrease Assume that the earnings jump 10% on January 2 and that nothing else changes.

Implied Premiums in the US Aswath Damodaran 42 .

Implied Premium versus RiskFree Rate Aswath Damodaran 43 .

Implied Premiums: From Bubble to Bear Market… January 2000 to January 2003 Aswath Damodaran 44 .

15) = 6. After-tax expected return on stocks = 2%(1-.91% Dividend Yield in January 2003 = 2.69% Aswath Damodaran 45 .00% Assuming that dividends were taxed at 30% (on average) on 1/1/03 and that capital gains were taxed at 15%.56% New equity risk premium = 3.January 2003 Expected Return on Stocks (Implied) in Jan 2003 = 7.11 Expected Increase in index due to dividend tax change = 9.42% New Pre-tax required rate of return = 7.Effect of Changing Tax Status of Dividends on Stock Prices .42% If the tax rate on dividends drops to 15% and the after-tax expected return remains the same: 2% (1-.15) + X% (1-.15) = 6.91%(1-.75% Value of the S&P 500 at new equity risk premium = 965.3)+5.

If you are required to be market neutral. You are also more likely to ﬁnd stocks to be overvalued than undervalued (Why?) Current Implied Equity Risk premium: You are assuming that the market is correct in the aggregate but makes mistakes on individual stocks. this is the premium you should use. Aswath Damodaran 46 . You are assuming that the market is correct on average but not necessarily at a point in time. you are assuming that premiums will revert back to a historical norm and that the time period that you are using is the right norm. (What types of valuations require market neutrality?) Average Implied Equity Risk premium: The average implied equity risk premium between 1960-2003 in the United States is about 4%.Which equity risk premium should you use for the US? Historical Risk Premium: When you use the historical risk premium.

5% = 6.Implied Premium for the Indian Market: June 15. 2004 Level of the Index (S&P CNX Index) = 1219 • This is a market cap weighted index of the 500 largest companies in India and represents 90% of the market value of Indian companies Dividends on the Index = 3.51% of 1219 (Simple average is 2.76-5.5% Solving for the expected return: • • Expected return on Equity = 11.50% Expected Growth (in Rs) – Next 5 years = 18% (Used expected growth rate in Earnings) – After year 5 = 5.16% Aswath Damodaran 47 .75%) Other parameters • • Riskfree Rate = 5.76% Implied Equity premium = 11.

95% a year forever after year 5 If you pay the current level of the index.Treasury bond rate = 7. you can expect to make a return of 7.0395)(1 + r) 5 ! Aswath Damodaran 48 . Dividends and stock buybacks were 2.01 160.59 178.13 129.37 178.65 Implied Equity risk premium = Expected return on stocks .36% in earnings over the next 5 years for stocks in the DAX (Source: IBES) Expected dividends and stock buybacks over next 5 years 116.13 129.32 144.01 160.3.83% 3905.Implied Equity Risk Premium for Germany: September 23.78% .59(1.0395) + + + + + (1 + r) (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 + r) 5 (r " .78% on stocks (which is obtained by Buy r in the following equation) solving forthe index for 3905.65 = 116.95% = 3.32 144. 2004 We can use the information in stock prices to back out how risk averse the market is and how much of a risk premium it is demanding.59 Assumed to grow at 3.67% of the index last year Source: Bloomberg Analysts are estimating an expected growth rate of 11.37 178.

The slope of the regression corresponds to the beta of the stock. not the current mix It reﬂects the ﬁrm’s average ﬁnancial leverage over the period rather than the current leverage.Estimating Beta The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) Rj = a + b Rm • where a is the intercept and b is the slope of the regression. and measures the riskiness of the stock. Aswath Damodaran 49 . This beta has three problems: • • • It has high standard error It reﬂects the ﬁrm’s business mix over the period of the regression.

Beta Estimation: The Noise Problem Aswath Damodaran 50 .

Beta Estimation: The Index Effect Aswath Damodaran 51 .

This will require • • understanding the business mix of the ﬁrm estimating the ﬁnancial leverage of the ﬁrm Use an alternative measure of market risk not based upon a regression. which are less noisy than market prices. by bringing in information about the fundamentals of the company the standard deviation in stock prices instead of a regression against an index accounting earnings or revenues. Estimate the beta for the ﬁrm using • • Estimate the beta for the ﬁrm from the bottom up without employing the regression technique.Solutions to the Regression Beta Problem Modify the regression beta by • • changing the index used to estimate the beta adjusting the regression beta estimate. Aswath Damodaran 52 .

22 Bovespa Aswath Damodaran 53 .80% + 1.The Index Game… Aracruz ADR vs S&P 500 80 1 40 1 20 60 1 00 40 80 Aracruz vs Bovespa Aracruz ADR Aracruz -10 0 10 20 60 40 20 0 20 0 -20 -20 -40 -20 -40 -50 -40 -30 -20 -10 0 10 20 30 S&P BOVESPA A r a c r u z ADR = 2.00 S&P A r a c r u z = 2.62% + 0.

2. Cyclical companies should have higher betas than noncyclical companies. Implications 1. 3. 4. 3. Growth firms should have higher betas. Young firms should have Aswath Damodaran 54 .Determinants of Betas Beta of Equity Beta of Firm Nature of product or service offered by company: Other things remaining equal. Luxury goods firms should have higher betas than basic goods. Smaller firms should have higher betas than larger firms. Operating Leverage (Fixed Costs as percent of total costs): Other things remaining equal the greater the proportion of the costs that are fixed. Firms with high infrastructure needs and rigid cost structures shoudl have higher betas than firms with flexible cost structures. High priced goods/service firms should have higher betas than low prices goods/services firms. Implications 1. the higher the beta. Financial Leverage: Other things remaining equal. 2. the higher the beta of the company. the greater the proportion of capital that a firm raises from debt. the more discretionary the product or service.the higher its equity beta will be Implciations Highly levered firms should have highe betas than firms with less debt.

In a perfect world… we would estimate the beta of a ﬁrm by doing the following Start with the beta of the business that the firm is in Adjust the business beta for the operating leverage of the firm to arrive at the unlevered beta for the firm.tax rate) (Debt/Equity)) Aswath Damodaran 55 . Use the financial leverage of the firm to estimate the equity beta for the firm Levered Beta = Unlevered Beta ( 1 + (1.

you can break down the unlevered beta into business and operating leverage components. • Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable costs)) The biggest problem with doing this is informational. we tend to assume that the operating leverage of ﬁrms within a business are similar and use the same unlevered beta for every ﬁrm. If you can compute ﬁxed and variable costs for each ﬁrm in a sector. Aswath Damodaran 56 . In practice.Adjusting for operating leverage… Within any business. It is difﬁcult to get information on ﬁxed and variable costs for individual ﬁrms. ﬁrms with lower ﬁxed costs (as a percentage of total costs) should have lower unlevered betas.

Equity Betas and Leverage Conventional approach: If we assume that debt carries no market risk (has a beta of zero). Aswath Damodaran 57 . the beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio βL = βu (1+ ((1-t)D/E)) In some versions. estimating betas for debt can be difﬁcult to do. Debt Adjusted Approach: If beta carries market risk and you can estimate the beta of debt.βdebt (1-t) (D/E) While the latter is more realistic. the tax effect is ignored and there is no (1-t) in the equation. you can estimate the levered beta as follows: βL = βu (1+ ((1-t)D/E)) .

Bottom-up Betas Step 1: Find the business or businesses that your firm operates in. Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity)) Aswath Damodaran 58 . Step 4: Compute a weighted average of the unlevered betas of the different businesses (from step 2) using the weights from step 3.t) (Average D/E ratio across firms)) If you can. Unlever this average beta using the average debt to equity ratio across the publicly traded firms in the sample. While revenues or operating income are often used as weights. If you expect your debt to equity ratio to change over time. it is better to try to estimate the value of each business. Bottom-up Unlevered beta for your firm = Weighted average of the unlevered betas of the individual business If you expect the business mix of your firm to change over time. Compute the simple average across these regression betas to arrive at an average beta for these publicly traded firms. adjust this beta for differences between your firm and the comparable firms on operating leverage and product characteristics. Unlevered beta for business = Average beta across publicly traded firms/ (1 + (1. using the market debt to equity ratio for your firm. you can change the weights on a year-to-year basis. Possible Refinements Step 2: Find publicly traded firms in each of these businesses and obtain their regression betas. Step 5: Compute a levered beta (equity beta) for your firm. Step 3: Estimate how much value your firm derives from each of the different businesses it is in. the levered beta will change over time.

Aswath Damodaran 59 . You can estimate bottom-up betas even when you do not have historical stock ! prices. This is the case with initial public offerings. private businesses or divisions of companies. Roughly speaking. Regression betas reﬂect the past. the standard error of a bottom-up beta estimate can be written as follows: Std error of bottom-up beta = Average Std Error across Betas Number of firms in sample The bottom-up beta can be adjusted to reﬂect changes in the ﬁrm’s business mix and ﬁnancial leverage.Why bottom-up betas? The standard error in a bottom-up beta will be signiﬁcantly lower than the standard error in a single regression beta.

08 21.08% 1.2186 Estimate the unlevered beta for Disney’s businesses Business Media Networks Parks and Resorts Studio Entertainment Consumer Products Disney Revenues in 2002 EV/Sales Estimated Value Firm Value Proportion Unlevered beta $9.00% 1.18% 1.41 $33.085.45% 1.07 25.63 $3.67% 1.329 $70.35 27.23 20. Entertainment software Number of firms Average levered beta Median D/E Unlevered beta Cash/Firm Value Corrected for cash 24 1.88% 0.60 5.96% 1.42 100.32% 1.77% 0.440 1.691 2.75% 1.733 3.376) (.14 14.63 $17.9364 $6.39 Aswath Damodaran 60 .37 $15.0932 $6.0932 9 1.Bottom-up Beta: Firm in Multiple Businesses Disney in 2003 Start with the unlevered betas for the businesses Business Media Networks Parks and Resorts Studio Entertainment Consumer Products Comparable firms Radia and TV broadcasting companies Theme park & Entertainment firms Movie companies Toy and apparel retailers.67 47.76% 0.9364 11 1.162.1258 Estimate a levered beta for Disney Market debt to equity ratio = 37.3310 $2.08% 1.14% 1.618.465 2.2186 $25.07 12..3746)) = 1.63 120.14 9.970.46% Marginal tax rate = 37.08 0.3310 77 1.91 2.60% Levered beta = 1.1258 ( 1 + (1.334.

1895)) = 1.07 Aswath Damodaran 61 .34) (.95% Levered beta 1.95 D/E Ratio 18.Embraer’s Bottom-up Beta Business Unlevered Beta Aerospace 0.95 ( 1 + (1-.tax rate) (D/E Ratio) = 0.07 Levered Beta = Unlevered Beta ( 1 + (1.

S.Comparable Firms? Can an unlevered beta estimated using U. and European aerospace companies be used to estimate the beta for a Brazilian aerospace company? Yes No What concerns would you have in making this assumption? Aswath Damodaran 62 .

will even out since the debt ratio used in the cost of capital equation will now be a net debt ratio rather than a gross debt ratio.042 = -3. Aswath Damodaran 63 .07 Net Debt Ratio for Embraer = (Debt .95% Levered Beta using Gross Debt ratio = 1.95 (1 + (1-.0332)) = 0.042 = 18. The cost of capital for Embraer.32% Levered Beta using Net Debt Ratio = 0.93 The cost of Equity using net debt levered beta for Embraer will be much lower than with the gross debt approach.Cash)/ Market value of Equity = (1953-2320)/ 11. though.34) (-.Gross Debt versus Net Debt Approaches Gross Debt Ratio for Embraer = 1953/11.

2. and defined in same terms (real or nominal) as the cash flows Historical Premium 1.The Cost of Equity: A Recap Preferably.Bonds in U. Mature Equity Market Premium: Average premium earned by stocks over T. a bottom-up beta. and firm’s own financial leverage Cost of Equity = Riskfree Rate + Beta * (Risk Premium) Has to be in the same currency as cash flows. Country risk premium = Country Default Spread* ( !Equity/!Country bond) or Implied Premium Based on how equity market is priced today and a simple valuation model Aswath Damodaran 64 . based upon other firms in the business.S.

It will reﬂect not only your default risk but also the level of interest rates in the market. Aswath Damodaran 65 . The two most widely used approaches to estimating cost of debt are: • Looking up the yield to maturity on a straight bond outstanding from the ﬁrm. different bonds from the same ﬁrm can have different ratings. While this approach is more robust. estimate a synthetic rating for your ﬁrm and the cost of debt based upon that rating.Estimating the Cost of Debt The cost of debt is the rate at which you can borrow at currently. The limitation of this approach is that very few ﬁrms have long term straight bonds that are liquid and widely traded Looking up the rating for the ﬁrm and estimating a default spread based upon the rating. You have to use a median rating for the ﬁrm • When in trouble (either because you have no ratings or multiple ratings for a ﬁrm).

we used the interest expenses from 2003 and the average EBIT from 2001 to 2003. In 2002 and 2003.70 = 3. Embraer reported signiﬁcant drops in operating income) • Interest Coverage Ratio = 462.1 /129.Estimating Synthetic Ratings The rating for a ﬁrm can be estimated using the ﬁnancial characteristics of the ﬁrm.56 Aswath Damodaran 66 . In its simplest form. the rating can be estimated from the interest coverage ratio Interest Coverage Ratio = EBIT / Interest Expenses For Embraer’s interest coverage ratio. (The aircraft business was badly affected by 9/11 and its aftermath.

75 .2.00% 2.5) B 6.00% The ﬁrst number under interest coverage ratios is for larger market cap companies and the second in brackets is for smaller market cap companies.00 .5-4) BB+ 2.50 (1.2.50 .50 (3.5-12.25 (1.80 (0.80% 0.50 (7.50% 4.4.70% 4.5) CCC 10.20 .25 .5) BBB 2.0.00% 1.25% 1.00% 1.3.50 (>12.50) AAA 0.75% 3.5) D 15.5-0.75 (2-2.50% 1.8) C 12.00% 0.50 .25-1.8-1.50% 0.75% 0.50% 10.50 .25.65 .5-3) B+ 4.50 (9.5.00 .35% 6.50% 2.8.00% 20.50 (6-7.5-6) A– 2.Interest Coverage Ratios.80 .5-2) B– 8.2.00% < 0.25 ((3-3.75% 2.5) A 1.20 (<0.25 (4.5) BB 3.1. For Embraer .1.00% 0.5-9.65 (0.00% 8.00% 6. Aswath Damodaran 67 .00% 0.5) AA 1.00 (2.50 .0. I used the interest coverage ratio table for smaller/riskier ﬁrms (the numbers in brackets) which yields a lower rating for the same interest coverage ratio.70% 12. Ratings and Default Spreads If Interest Coverage Ratio is Estimated Bond Rating Default Spread(2003) Default Spread(2004) > 8.00% 0.1.00 (4-4.25% 1.00% 2.5) A+ 1.25 .50% 2.25) CC 11.50% 5.6.85% 3.

Larger companies that derive a signiﬁcant portion of their revenues in global markets may be less exposed to country default risk.00%+ 1.00%. The synthetic rating for Embraer is A-. they may be able to borrow at a rate lower than the government. In other words. especially if they are smaller or have all of their revenues within the country.29% + 4.29% (using a riskfree rate of 4.29% Aswath Damodaran 68 .Cost of Debt computations Companies in countries with low bond ratings and high default risk might bear the burden of country default risk. we estimate a cost of debt of 9.29% and adding in two thirds of the country default spread of 6.00% = 9. Using the 2004 default spread of 1.01%): Cost of debt = Riskfree rate + 2/3(Brazil country default spread) + Company default spread =4.

Aswath Damodaran 69 .Synthetic Ratings: Some Caveats The relationship between interest coverage ratios and ratings. developed using US companies. tends to travel well. as long as we are analyzing large manufacturing ﬁrms in markets with interest rates close to the US interest rate They are more problematic when looking at smaller companies in markets with higher interest rates than the US.

As a general rule.Weights for the Cost of Capital Computation The weights used to compute the cost of capital should be the market value weights for debt and equity. There is an element of circularity that is introduced into every valuation by doing this. Aswath Damodaran 70 . since the values that we attach to the ﬁrm and equity at the end of the analysis are different from the values we gave them at the beginning. the debt that you should subtract from ﬁrm value to arrive at the value of equity should be the same debt that you used to compute the cost of capital.

083 million BR ($713 million) Debt • • Cost of Capital Cost of Capital = 10.350 million BR.97% The book value of equity at Embraer is 3.09294 = 2.29% + 4.29% Market Value of Debt = 2.70% Market Value of Equity =11.00%= 9. The book value of debt at Embraer is 1.07 (4%) + 0.29% + 1.34) (0.16)) = 9.29%) + $1.70 % (. 9.953 million BR.27 (7.00% +1.29% (1.083 million BR Aswath Damodaran 71 .781 million) Cost of debt = 4.. Average maturity of debt = 4 years Estimated market value of debt = 222 million (PV of annuity. Interest expense is 222 mil BR.953 million/1.Estimating Cost of Capital: Embraer Equity • • Cost of Equity = 4.84) + 9.042 million BR ($ 3. 4 years.89%) = 10.

the cost of capital would be computed as follows: • • • Cost of Equity = 12% + 1.41% Cost of Debt = 12% + 1% = 13% (This assumes the riskfree rate has no country risk premium embedded in it.Converting a Dollar Cost of Capital to a Nominal Real Cost of Capital Approach 1: Use a BR riskfree rate in all of the calculations above.44% # ! Aswath Damodaran 72 .27 (7.89%) = 18. if the inﬂation rate in BR is 8% and the inﬂation rate in the U.If you had to do it….0997 (1. For instance. is 2% Cost of capital= " 1+ Inflation % BR (1+ Cost of Capital$ )$ ' = 1.S. if the BR riskfree rate was 12%.08/1.02)-1 =$ & 1+ Inflation 0.) Approach 2: Use the differential inﬂation rate to estimate the cost of capital.1644 or 16.07(4%) + 0. For instance.

for instance). if the preferred stock is less than 5% of the outstanding market value of the ﬁrm. break the security down into debt and equity and allocate the amounts accordingly. The conversion option is equity. Thus. lumping it in with debt will make no signiﬁcant impact on your valuation). Aswath Damodaran 73 . The cost of preferred stock is the preferred dividend yield. if a ﬁrm has $ 125 million in convertible debt outstanding. break the $125 million into straight debt and conversion option components.Dealing with Hybrids and Preferred Stock When dealing with hybrids (convertible bonds. When dealing with preferred stock. (As a rule of thumb. it is better to keep it as a separate component.

• • Straight debt = (4% of $125 million) (PV of annuity.$91. If the ﬁrm has a bond rating of A and the interest rate on A-rated straight bond is 8%.Decomposing a convertible bond… Assume that the ﬁrm that you are analyzing has $125 million in face value of convertible debt with a stated interest rate of 4%.55 million Aswath Damodaran 74 . 10 years. 8%) + 125 million/1. a 10 year maturity and a market value of $140 million.45 million Equity portion = $140 million . you can break down the value of the convertible bond into straight debt and equity portions.0810 = $91.45 million = $48.

Recapping 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. reflecting tax benefits of debt (Debt/(Debt + Equity)) Cost of equity based upon bottom-up beta Weights should be market value weights Aswath Damodaran 75 .

Estimating Cash Flows DCF Valuation Aswath Damodaran 76 .II.

i. net income If looking at cash ﬂows to the ﬁrm. look at earnings after interest expenses . it will be categorized as capital expenditures. it will cover some of these expenditures.debt repaid) Aswath Damodaran 77 . consider the cash ﬂows from net debt issues (debt issued . look at operating earnings after taxes If the investment is not expensed. Increasing working capital needs are also investments for future growth Consider how much the ﬁrm invested to create future growth • • If looking at cash ﬂows to equity. To the extent that depreciation provides a cash ﬂow.e.Steps in Cash Flow Estimation Estimate the current earnings of the ﬁrm • • If looking at cash ﬂows to equity.

Change in non-cash working capital = Free Cash Flow to Firm (FCFF) Just Equity Investors Net Income .Measuring Cash Flows Cash flows can be measured to All claimholders in the firm EBIT (1.Change in non-cash Working Capital .New Debt Issues) .(Principal Repaid .Preferred Dividend Dividends + Stock Buybacks Aswath Damodaran 78 .( Capital Expenditures .(Capital Expenditures .Depreciation) .Depreciation) .tax rate) .

Change in Working Capital = Cash ﬂow to the ﬁrm Where are the tax savings from interest payments in this cash ﬂow? Aswath Damodaran 79 .Measuring Cash Flow to the Firm EBIT ( 1 .Depreciation) .tax rate) .(Capital Expenditures .

Convert into asset .Financial Expenses .Non-recurring expenses Measuring Earnings Update .From Reported to Actual Earnings Firm’s history Comparable Firms Operating leases .Unofficial numbers Aswath Damodaran 80 .Capital Expenses .Trailing Earnings .Convert into debt .Adjust operating income R&D Expenses .Adjust operating income Normalize Earnings Cleanse operating items of .

Update Earnings When valuing companies. all you need is one 10K and one 10Q (example third quarter). we often depend upon ﬁnancial statements for inputs on earnings and assets. Updating makes the most difference for smaller and more volatile ﬁrms.Revenues from ﬁrst 3 quarters of last year + Revenues from ﬁrst 3 quarters of this year. Aswath Damodaran 81 . as well as for ﬁrms that have undergone signiﬁcant restructuring. Use the Year to date numbers from the 10Q: Trailing 12-month Revenue = Revenues (in last 10K) . Time saver: To get a trailing 12-month number.I. if quarterly reports are unavailable. constructed from quarterly earnings reports. Annual reports are often outdated and can be updated by using• • Trailing 12-month data. Informal and unofﬁcial news reports.

the operating income has to be adjusted to reﬂect its treatment. R & D Adjustment: Since R&D is a capital expenditure (rather than an operating expense). they are really ﬁnancial expenses and need to be reclassiﬁed as such. Example: Operating Leases: While accounting convention treats operating leases as operating expenses.II. This has no effect on equity earnings but does change the operating earnings • Make sure that there are no capital expenses mixed in with the operating expenses • • Capital expense: Any expense that is expected to generate beneﬁts over multiple periods. Aswath Damodaran 82 . Correcting Accounting Earnings Make sure that there are no ﬁnancial expenses mixed in with operating expenses • Financial expense: Any commitment that is tax deductible that you have to meet no matter what your operating results: Failure to meet it leads to loss of control of the business.

00% 0.00% 30.00% 40.00% 10.The Magnitude of Operating Leases Operating Lease expenses as % of Operating Income 60.00% Market Apparel Stores Furniture Stores Restaurants Aswath Damodaran 83 .00% 20.00% 50.

Aswath Damodaran 84 . this works: Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of Operating Leases. Adjusted Operating Earnings Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses Depreciation on Leased Asset • As an approximation. you also create an asset to counter it of exactly the same value. operating lease expenses should be treated as ﬁnancing expenses. In reality.Dealing with Operating Lease Expenses Operating Lease Expenses are treated as operating expenses in computing operating income. with the following adjustments to earnings and capital: Debt Value of Operating Leases = Present value of Operating Lease Commitments at the pre-tax cost of debt When you convert operating leases into debt.

397 m = $6.Deprec’n = $1.97 billion on its balance sheet and its pre-tax cost of debt is about 6%.50 each year Debt Value of leases = Debt outstanding at The Gap = $1.44 $1.396.00 3 $738.67 $356.00 6&7 $982.00 5 $477.367 m Adjusted Operating Income = Stated OI + OL exp this year .346.4397 m /7 = $1.Operating Leases at The Gap in 2003 The Gap has conventional debt of about $ 1.00 4 $598. Its operating lease payments in the 2003 were $978 million and its commitments for the future are below: Present Value (at 6%) $848.11 $752.04 $4.012 m + 978 m .276 m Aswath Damodaran 85 .06) = $1.85 (Also value of leased asset) Year Commitment (millions) 1 $899.64 $473.970 m + $4.00 2 $846.362 million (7 year life for assets) Approximate OI = $1.012 m + $ 4397 m (.94 $619.

990 .31% Cost of equity for The Gap = 8.35)/(3130+1970) = 12.367 million Cost of capital = 8.012 Operating Leases Treated as Debt Income Statement EBIT& Leases = 1.362 Interest expense will rise to reflect the conversion of operating leases as debt.35)/(3130+6367) = 9.990 .970 million shows up on balance sheet Cost of capital = 8.90% Return on capital = 1362 (1-.Deprecn: OL= 628 EBIT = 1.The Collateral Effects of Treating Operating Leases as Debt C o nventional Accounting Income Statement EBIT& Leases = 1. Net income should not change. Balance Sheet Asset Liability OL Asset 4397 OL Debt 4397 Total debt = 4397 + 1970 = $6.Op Leases = 978 EBIT = 1. Only the conventional debt of $1.20%(7350/9320) + 4% (1970/9320) = 7.20% After-tax cost of debt = 4% Market value of equity = 7350 Return on capital = 1012 (1-.25% Balance Sheet Off balance sheet (Not shown as debt or as an asset).20%(7350/13717) + 4% (6367/13717) = 6.30% Aswath Damodaran 86 .

00% 30.00% 40.00% Market Petroleum Computers Aswath Damodaran 87 .00% 50.The Magnitude of R&D Expenses R&D as % of Operating Income 60.00% 20.00% 10.00% 0.

• • • Specify an amortizable life for R&D (2 .: Aswath Damodaran 88 . if the amortizable life is 5 years. the research asset can be obtained by adding up 1/5th of the R&D expense from ﬁve years ago. (Thus.R&D Expenses: Operating or Capital Expenses Accounting standards require us to consider R&D as an operating expense even though it is designed to generate future growth. To capitalize R&D. It is more logical to treat it as capital expenditures.. 2/5th of the R&D expense from four years ago.10 years) Collect past R&D expenses for as long as the amortizable life Sum up the unamortized R&D over the period..

20 1997 698.80 Total $ 3.00 $17.80 $139.035. Year R&D Expense Unamortized portion Amortization this year 1999 (current) 1594.00 0.80 $205.60 1996 399.00 0.20 42.00 1.40 $ 484.60 Value of research asset = $ 3.594 million .00 0.109.00 0.035.4 million Amortization of research asset in 1998 = $ 484.4 million Aswath Damodaran 89 .6 million = 1.80 1995 211.00 0.484.60 $79.6 million Adjustment to Operating Income = $ 1.20 $42.00 0.00 1998 1026.00 1594.20 1994 89.Capitalizing R&D Expenses: Cisco in 1999 R & D was assumed to have a 5-year life.40 159.60 418.80 820.

Net Cap Ex = 1206 FCFF = 2148 Return on capital = 3354/14757 = 22.R&D = 1.109) EBIT (1-t) = 2.78% Balance Sheet Off balance sheet asset.564 (Increase of 1.109 million) Net Income will also increase by $1. Book value of equity at $11.Net Cap Ex = 98 FCFF = 2148 Return on capital = 2246/11722 (no debt) = 19.049 .246 R&D treated as capital expenditure Income Statement EBIT& R&D = 5.049 .35) = 388 Adjusted EBIT (1-t) = 2967 + 388 = 3354 (Increase of $1.Amort: R&D = 485 EBIT = 4.16% Aswath Damodaran 90 .109 million Balance Sheet Asset Liability R&D Asset 3035 Book Equity +3035 Total Book Equity = 11722+3035 = 14757 Capital Expenditures Net Cap ex = 98 + 1594 – 485 = 1206 Cash Flows EBIT (1-t) = 3354 . Capital Expenditures Conventional net cap ex of $98 million Cash Flows EBIT (1-t) = 2246 .594 EBIT = 3.The Effect of Capitalizing R&D C o nventional Accounting Income Statement EBIT& R&D = 5.455 EBIT (1-t) = 2.722 million is understated because biggest asset is off the books.967 Ignored tax benefit = (1594-485)(.

III. What is the earnings you would use in your valuation? A loss of $ 500 million A proﬁt of $ 500 million Would your answer be any different if the ﬁrm had reported one-time losses like these once every ﬁve years? Yes No Aswath Damodaran 91 . due to a one-time charge of $ 1 billion. One-Time and Non-recurring Charges Assume that you are valuing a ﬁrm that is reporting a loss of $ 500 million.

you should look for warning signals in ﬁnancial statements and correct for them: • • • • Income from unspeciﬁed sources . for instance. Though all ﬁrms may be governed by the same accounting standards.a big drop in S. Accounting Malfeasance…. More aggressive ﬁrms will show higher earnings than more conservative ﬁrms.IV. Income from asset sales or ﬁnancial transactions (for a non-ﬁnancial ﬁrm) Sudden changes in standard expense items . Frequent accounting restatements Aswath Damodaran 92 . the ﬁdelity that they show to these standards can vary. While you will not be able to catch outright fraud.G &A or R&D expenses as a percent of revenues.holdings in other businesses that are not revealed or from special purpose entities.

An otherwise healthy firm with too much debt. which could be its own optimal or the industry average.: (a) If problem is structural: Target for operating margins of stable firms in the sector. Normalize Earnings If firm’s size has not changed significantly over time If firm’s size has changed over time Average Dollar Earnings (Net Income if Equity and EBIT if Firm made by the firm over time Use firm’s average ROE (if valuing equity) or average ROC (if valuing firm) on current BV of equity (if ROE) or current BV of capital (if ROC) Value the firm by doing detailed cash flow forecasts starting with revenues and reduce or eliminate the problem over time. A firm with significant production or cost problems. Auto firm in recession Life Cycle related reasons: Young firms and firms with infrastructure problems Leverage Problems: Eg.V. (b) If problem is leverage: Target for a debt ratio that the firm will be comfortable with by end of period. Long-term Operating Problems: Eg. Dealing with Negative or Abnormally Low Earnings A Framework for Analyzing Companies with Negative or Abnormally Low Earnings Why are the earnings negative or abnormally low? Temporary Problems Cyclicality: Eg. (c) If problem is operating: Target for an industry-average operating margin. Aswath Damodaran 93 .

as long as you compute your after-tax cost of debt using the same tax rate Aswath Damodaran 94 .What tax rate? The tax rate that you should use in computing the after-tax operating income should be The effective tax rate in the ﬁnancial statements (taxes paid/Taxable income) The tax rate based upon taxes paid and EBIT (taxes paid/EBIT) The marginal tax rate for the country in which the company operates The weighted average marginal tax rate across the countries in which the company operates None of the above Any of the above.

By using the marginal tax rate.The Right Tax Rate to Use The choice really is between the effective and the marginal tax rate. adjust the tax rate towards the marginal tax rate over time. 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. we tend to understate the after-tax operating income in the earlier years. but the after-tax tax operating income is more accurate in later years If you choose to use the effective tax rate. it is safest to use the marginal tax rate of the country Aswath Damodaran 95 . • While an argument can be made for using a weighted average marginal tax rate. In doing projections.

Year 1 Year 2 Year 3 EBIT 500 500 500 Taxes EBIT (1-t) Tax rate Aswath Damodaran 96 . Estimate the after-tax operating income each year for the next 3 years. and the marginal tax rate on income for all ﬁrms that make money is 40%.A Tax Rate for a Money Losing Firm Assume that you are trying to estimate the after-tax operating income for a ﬁrm with $ 1 billion in net operating losses carried forward. This ﬁrm is expected to have operating income of $ 500 million each year for the next 3 years.

Depreciation is a cash inﬂow that pays for some or a lot (or sometimes all of) the capital expenditures. Aswath Damodaran 97 . Assumptions about net capital expenditures can therefore never be made independently of assumptions about growth in the future. High growth ﬁrms will have much higher net capital expenditures than low growth ﬁrms. the net capital expenditures will be a function of how fast a ﬁrm is growing or expecting to grow. In general.Net Capital Expenditures Net capital expenditures represent the difference between capital expenditures and depreciation.

The adjusted net cap ex will be Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other ﬁrms Amortization of such acquisitions Two caveats: 1. The best place to ﬁnd acquisitions is in the statement of cash ﬂows. Most ﬁrms do not do acquisitions every year. The adjusted net cap ex will be Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s R&D expenses . a normalized measure of acquisitions (looking at an average over time) should be used 2.Capital expenditures should include Research and development expenses. once they have been re-categorized as capital expenses.Amortization of Research Asset Acquisitions of other ﬁrms. usually categorized under other investment activities Aswath Damodaran 98 . since these are like capital expenditures. Hence.

Cisco’s Acquisitions: 1999 Acquired GeoTel Fibex Sentient American Internent Summa Four Clarity Wireless Selsius Systems PipeLinks Amteva Tech Method of Acquisition Pooling Pooling Pooling Purchase Purchase Purchase Purchase Purchase Purchase Price Paid $1.344 $318 $103 $58 $129 $153 $134 $118 $159 $2.516 Aswath Damodaran 99 .

Cisco’s Net Capital Expenditures in 1999 Cap Expenditures (from statement of CF) = $ 584 mil .Depreciation (from statement of CF) = $ 486 mil Net Cap Ex (from statement of CF) = $ 98 mil + R & D expense = $ 1.594 mil .Amortization of R&D = $ 485 mil + Acquisitions = $ 2.516 mil Adjusted Net Capital Expenditures = $3.723 mil (Amortization was included in the depreciation number) Aswath Damodaran 100 .

Therefore. and building these effects into the cash ﬂows. the working capital is the difference between current assets (inventory. cash and accounts receivable) and current liabilities (accounts payables. short term debt and debt due within the next year) A cleaner deﬁnition of working capital from a cash ﬂow perspective is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable) Any investment in this measure of working capital ties up cash. any increases (decreases) in working capital will reduce (increase) cash ﬂows in that period.Working Capital Investments In accounting terms. it is important to forecast the effects of such growth on working capital needs. Aswath Damodaran 101 . When forecasting future growth.

While this is indeed feasible for a period of time. when it is negative. Thus. A far better estimate of non-cash working capital needs. looking forward. it is better that non-cash working capital needs be set to zero. Assuming that this will continue into the future will generate positive cash ﬂows for the ﬁrm.Working Capital: General Propositions Changes in non-cash working capital from year to year tend to be volatile. Aswath Damodaran 102 . can be estimated by looking at non-cash working capital as a proportion of revenues Some ﬁrms have negative non-cash working capital. it is not forever.

640 -419 -404 -25.91% 7.Volatile Working Capital? Amazon $ 1.04% 8.00% 8.32% ($700) -3.53% $ (309) -15.23% ($829) 8.23% Motorola $30.16% 8.71% Cisco $12.71% 0.00% Aswath Damodaran 103 .931 Revenues Non-cash WC % of Revenues Change from last year Average: last 3 years Average: industry Assumption in Valuation WC as % of Revenue 3.154 2547 -3.16% -2.

using a model that focuses only on dividends will under state the true value of the equity in a ﬁrm. Aswath Damodaran 104 .Dividends and Cash Flows to Equity In the strictest sense. Actual dividends. the only cash ﬂow that an investor will receive from an equity investment in a publicly traded ﬁrm is the dividend that will be paid on the stock. however. are set by the managers of the ﬁrm and may be much lower than the potential dividends (that could have been paid out) • • managers are conservative and try to smooth out dividends managers like to hold on to cash to meet unforeseen future contingencies and investment opportunities When actual dividends are less than potential dividends.

where earnings are discounted back to the present. since there are both non-cash revenues and expenses in the earnings calculation Even if earnings were cash ﬂows. a ﬁrm that paid its earnings out as dividends would not be investing in new assets and thus could not grow Valuation models. Aswath Damodaran 105 . will over estimate the value of the equity in the ﬁrm The potential dividends of a ﬁrm are the cash ﬂows left over after the ﬁrm has made any “investments” it needs to make to create future growth and net debt repayments (debt repayments . This cannot be true for several reasons: • • • Earnings are not cash ﬂows.Measuring Potential Dividends Some analysts assume that the earnings of a ﬁrm represent its potential dividends.new debt issues) • The common categorization of capital expenditures into discretionary and nondiscretionary loses its basis when there is future growth built into the valuation.

(Principal Repayments . If preferred stock exist.(Capital Expenditures .Changes in non-cash Working Capital . preferred dividends will also need to be netted out Aswath Damodaran 106 .Estimating Cash Flows: FCFE Cash ﬂows to Equity for a Levered Firm Net Income .Depreciation) .New Debt Issues) = Free Cash ﬂow to Equity • I have ignored preferred dividends.

(1.Estimating FCFE when Leverage is Stable Net Income .δ) (Capital Expenditures .Depreciation) . • Proceeds from new debt issues = Principal Repayments + δ (Capital Expenditures Depreciation + Working Capital Needs) In computing FCFE. the book value debt to capital ratio should be used when looking back in time but can be replaced with the market value debt to capital ratio. Aswath Damodaran 107 .δ) Working Capital Needs = Free Cash ﬂow to Equity δ = Debt/Capital Ratio For this ﬁrm. looking forward.(1.

533 Mil $465.Estimating FCFE: Disney Net Income=$ 1533 Million Capital spending = $ 1.90 [(1746-1134)(1-.83% Estimating FCFE (1997): Net Income .2383)] $363.(Cap. Working Capital*(1-DR) = Free CF to Equity Dividends Paid $1.746 Million Depreciation per Share = $ 1. Exp .134 Million Increase in non-cash working capital = $ 477 Million Debt to Capital Ratio = 23.Depr)*(1-DR) Chg.33 [477(1-.2383)] $ 704 Million $ 345 Million Aswath Damodaran 108 .

FCFE and Leverage: Is this a free lunch? Debt Ratio and FCFE: Disney 1600 1400 1200 1000 FCFE 800 600 400 200 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Debt Ratio Aswath Damodaran 109 .

00 Beta 4.00 5.00 2.FCFE and Leverage: The Other Shoe Drops Debt Ratio and Beta 8.00 6.00 0.00 7.00 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Debt Ratio Aswath Damodaran 110 .00 1.00 3.

increasing the debt/equity ratio will generally increase the expected free cash ﬂows to equity investors over future time periods and also the cost of equity applied in discounting these cash ﬂows. depending upon what company you are looking at and where it is in terms of current leverage Aswath Damodaran 111 . FCFE and Value In a discounted cash ﬂow model. Which of the following statements relating leverage to value would you subscribe to? Increasing leverage will increase value because the cash ﬂow effects will dominate the discount rate effects Increasing leverage will decrease value because the risk effect will be greater than the cash ﬂow effects Increasing leverage will not affect value because the risk effect will exactly offset the cash ﬂow effect Any of the above.Leverage.

III. Estimating Growth DCF Valuation Aswath Damodaran 112 .

Ways of Estimating Growth in Earnings

**Look at the past
**

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

**Look at what others are estimating
**

•

Look at fundamentals

•

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I. Historical Growth in EPS

**Historical growth rates can be estimated in a number of different ways
**

• • Arithmetic versus Geometric Averages Simple versus Regression Models the period used in the estimation how to deal with negative earnings the effect of changing size

**Historical growth rates can be sensitive to
**

•

**In using historical growth rates, the following factors have to be considered
**

• •

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**Motorola: Arithmetic versus Geometric Growth Rates
**

Revenues 1994 $ 22,245 1995 $ 27,037 1996 $ 27,973 1997 $ 29,794 1998 $ 29,398 1999 $ 30,931 Arithmetic Average Geometric Average Standard deviation % Change 21.54% 3.46% 6.51% -1.33% 5.21% 7.08% 6.82% 8.61% $ $ $ $ $ $ EBITDA 4,151 4,850 4,268 4,276 3,019 5,398 % Change 16.84% -12.00% 0.19% -29.40% 78.80% 10.89% 5.39% 41.56% $ $ $ $ $ $ EBIT 2,604 2,931 1,960 1,947 822 3,216 % Change 12.56% -33.13% -0.66% -57.78% 291.24% 42.45% 4.31% 141.78%

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Cisco: Linear and Log-Linear Models for Growth

**Year 1991 1992 1993 1994 1995 1996 1997 1998 1999
**

EPS $ $ $ $ $ $ $ $ $

0.01 0.02 0.04 0.07 0.08 0.16 0.18 0.25 0.32

ln(EPS) -4.6052 -3.9120 -3.2189 -2.6593 -2.5257 -1.8326 -1.7148 -1.3863 -1.1394

EPS = -.066 + 0.0383 ( t): EPS grows by $0.0383 a year Growth Rate = $0.0383/$0.13 = 30.5% ($0.13: Average EPS from 91-99) ln(EPS) = -4.66 + 0.4212 (t): Growth rate approximately 42.12%

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A Test

You are trying to estimate the growth rate in earnings per share at Time Warner from 1996 to 1997. In 1996, the earnings per share was a deﬁcit of $0.05. In 1997, the expected earnings per share is $ 0.25. What is the growth rate? -600% +600% +120% Cannot be estimated

Aswath Damodaran

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30/0.05=600%) Use a linear regression model and divide the coefﬁcient by the average earnings.25 = 120%) Use the absolute value of earnings in the starting period as the denominator (0.30/0. When earnings are negative. Thus. the growth rate is meaningless. while the growth rate can be estimated. the growth rate cannot be estimated. Aswath Damodaran 118 .30/-0. (0.05 = -600%) There are three solutions: • • • Use the higher of the two numbers as the denominator (0. it does not tell you much about the future.Dealing with Negative Earnings When the earnings in the starting period are negative.

30 25.The Effect of Size on Growth: Callaway Golf Year Net Proﬁt Growth Rate 1990 1.00 89.70 25.80 1991 6.56% 1992 19.40 255.47% 1994 78.20 113.30 201.56% 1993 41.32% 1995 97.26% 1996 122.18% Geometric Average Growth Rate = 102% Aswath Damodaran 119 .

Aswath Damodaran 120 .113.Extrapolation and its Dangers Year Net Proﬁt 1996 $ 122.113 billion.03 1999 $ 1.25 2001 $ 4.008.05 1998 $ 499.30 1997 $ 247.036. the expected net income in 5 years will be $ 4.05 2000 $ 2.23 If net proﬁt continues to grow at the same rate as it has in the past 6 years.

S companies. in turn.II. is spent forecasting earnings per share in the next earnings report While many analysts forecast expected growth in earnings per share over the next 5 years. a signiﬁcant proportion of an analyst’s time (outside of selling) is spent forecasting earnings per share. Analyst Forecasts of Growth While the job of an analyst is to ﬁnd under and over valued stocks in the sectors that they follow. • • Most of this time. the analysis and information (generally) that goes into this estimate is far more limited. at least for U. Analyst forecasts of earnings per share and expected growth are widely disseminated by services such as Zacks and IBES. Aswath Damodaran 121 .

but the differences tend to be small Time Period Value Line Forecasts Value Line Forecasts Earnings Forecaster Analyst Forecast Error 31.2% 19.1% 32. Aswath Damodaran 122 .4% Time Series Model 34.4% 16.7% 28.How good are analysts at forecasting growth? Analysts forecasts of EPS tend to be closer to the actual EPS than simple time series models.8% Study Collins & Hopwood Brown & Rozeff Fried & Givoly The advantage that analysts have over time series models • • • tends to decrease with the forecast period (next quarter versus 5 years) tends to be greater for larger ﬁrms than for smaller ﬁrms tends to be greater at the industry level than at the company level Forecasts of growth (and revisions thereof) tend to be highly correlated across analysts.

For these recommendations the price changes are sustained.8% for the sells). (Their median forecast error in the quarter prior to being chosen was 30%. 13. • • • Aswath Damodaran 123 .7% on sells).4% for buys. in the calendar year following being chosen as All-America analysts. the median forecast error of other analysts was 28%) However. these analysts become slightly better forecasters than their less fortunate brethren. (The median forecast error for All-America analysts is 2% lower than the median forecast error for other analysts) Earnings revisions made by All-America analysts tend to have a much greater impact on the stock price than revisions from other analysts The recommendations made by the All America analysts have a greater impact on stock prices (3% on buys. and they continue to rise in the following period (2. 4.Are some analysts more equal than others? A study of All-America Analysts (chosen by Institutional Investor) found that • There is no evidence that analysts who are chosen for the All-America Analyst team were chosen because they were better forecasters of earnings.

Jekyll/Mr. Stockholm Syndrome: Refers to analysts who start identifying with the managers of the ﬁrms that they are supposed to follow. Aswath Damodaran 124 .Hyde: Analyst who thinks his primary job is to bring in investment banking business to the ﬁrm. Factophobia (generally is coupled with delusions of being a famous story teller): Tendency to base a recommendation on a “story” coupled with a refusal to face the facts. Lemmingitis:Strong urge felt to change recommendations & revise earnings estimates when other analysts do the same.The Five Deadly Sins of an Analyst Tunnel Vision: Becoming so focused on the sector and valuations within the sector that you lose sight of the bigger picture. Dr.

however. danger when they agree too much (lemmingitis) and when they agree to little (in which case the information that they have is so noisy as to be useless). Aswath Damodaran 125 .Propositions about Analyst Growth Rates Proposition 1: There if far less private information and far more public information in most analyst forecasts than is generally claimed. Proposition 2: The biggest source of private information for analysts remains the company itself which might explain • • • why there are more buy recommendations than sell recommendations (information bias and the need to preserve sources) why there is such a high correlation across analysts forecasts and revisions why All-America analysts become better forecasters than other analysts after they are chosen to be part of the team. There is. Proposition 3: There is value to knowing what analysts are forecasting as earnings growth for a ﬁrm.

Fundamental Growth Rates Investment in Existing Projects $ 1000 X Current Return on Investment on Projects 12% = Current Earnings $120 Investment in Existing Projects $1000 X Next Period’s Return on Investment 12% + Investment in New Projects $100 X Return on Investment on New Projects 12% = Next Period’s Earnings 132 Investment in Existing Projects $1000 X Change in ROI from current to next period: 0% + Investment in New Projects $100 X Return on Investment on New Projects 12% = $ 12 Change in Earnings Aswath Damodaran 126 .III.

Growth Rate Derivations Aswath Damodaran 127 .

Expected Long Term Growth in EPS When looking at growth in earnings per share. Aswath Damodaran 128 .I. these inputs can be cast as follows: Reinvestment Rate = Retained Earnings/ Current Earnings = Retention Ratio Return on Investment = ROE = Net Income/Book Value of Equity In the special case where the current ROE is expected to remain unchanged 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.

Estimating Expected Growth in EPS: ABN Amro Current Return on Equity = 15.1. its expected growth in EPS will be: Expected Growth Rate = 0.79%) = 8.5388 (15.88% If ABN Amro can maintain its current ROE and retention ratio.79% Current Retention Ratio = 1 .51% Aswath Damodaran 129 .DPS/EPS = 1 .45 = 53.13/2.

less than or equal to this estimate? greater than less than equal to Aswath Damodaran 130 .88%.Expected ROE changes and Growth Assume now that ABN Amro’s ROE next year is expected to increase to 17%. while its retention ratio remains at 53. What is the new expected long term growth rate in earnings per share? Will the expected growth rate in earnings per share next year be greater than.

gEPS= b *ROEt+1 +(ROEt+1– ROEt)/ ROEt Proposition 2: Small changes in ROE translate into large changes in the expected growth rate. sustain growth in earnings per share from improvement in ROE. Aswath Damodaran 131 . • Corollary: The higher the existing ROE of the company (relative to the business in which it operates) and the more competitive the business in which it operates.Changes in ROE and Expected Growth When the ROE is expected to change. • The lower the current ROE. Proposition 3: No ﬁrm can. the greater the effect on growth of changes in the ROE. the smaller the scope for improvement in ROE. in the long term.

17)+(.83% Note that 1.5388)(.17-. The expected growth rate in that year will be: gEPS = b *ROEt+1 + (ROEt+1– ROEt)/ ROEt =(.1579)/(. Aswath Damodaran 132 .88%.Changes in ROE: ABN Amro Assume now that ABN’s expansion into Asia will push up the ROE to 17%. while the retention ratio will remain 53.21% improvement in ROE translates into almost a doubling of the growth rate from 8.51% to 16.83%.1579) = 16.

tax rate) / Book value of Capitalt-1 D/E = BV of Debt/ BV of Equity i = Interest Expense on Debt / BV of Debt t = Tax rate on ordinary income Note that Book value of capital = Book Value of Debt + Book value of Equity.i (1-t)) where. Aswath Damodaran 133 .ROE and Leverage ROE = ROC + D/E (ROC . ROC = EBITt (1 .

61% (Real BR) Return on Equity = ROC + D/E (ROC .61%) = 30.Decomposing ROE: Brahma in 1998 Real Return on Capital = 687 (1-.77 After-tax Cost of Debt = 8.92% Aswath Damodaran 134 .91% + 0.25% (1-.91% • This is assumed to be real because both the book value and income are inﬂation adjusted.77 (19.32) / (1326+542+478) = 19.5. Debt/Equity Ratio = (542+478)/1326 = 0.91% .32) = 5.i(1-t)) 19.

125%) = 8.25) = 10.91 (9.i(1-t)) 9.Decomposing ROE: Titan Watches (India) Return on Capital = 713 (1-.54% + 1.5% (1-.10.42% Aswath Damodaran 135 .54% .91 After-tax Cost of Debt = 13.54% Debt/Equity Ratio = (2378 + 1303)/1925 = 1.25)/(1925+2378+1303) = 9.125% Return on Equity = ROC + D/E (ROC .

Expected Growth in Net Income The limitation of the EPS fundamental growth equation is that it focuses on per share earnings and assumes that reinvested earnings are invested in projects earning the return on equity. A more general version of expected growth in earnings can be obtained by substituting in the equity reinvestment into real investments (net capital expenditures and working capital): Equity Reinvestment Rate = (Net Capital Expenditures + Change in Working Capital) (1 .Debt Ratio)/ Net Income Expected GrowthNet Income = Equity Reinvestment Rate * ROE Aswath Damodaran 136 .II.

the deﬁnitions are Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t) Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity) Reinvestment Rate and Return on Capital gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC Reinvestment Rate * ROC Proposition: The net capital expenditure needs of a ﬁrm. should be inversely proportional to the quality of its investments. for a given growth rate. Expected Growth in EBIT And Fundamentals: Stable ROC and Reinvestment Rate When looking at growth in operating income.III. = Aswath Damodaran 137 .

Aswath Damodaran 138 . where the terminal value is based upon the assumption that operating income will grow 3% a year forever. he contends that this is still feasible because the company is becoming more efﬁcient with its existing assets and can be expected to increase its return on capital over time. Is this a reasonable explanation? Yes No Explain.No Net Capital Expenditures and Long Term Growth You are looking at a valuation. When you confront the analyst. but there are no net cap ex or working capital investments being made after the terminal year.

07% Expected Growth in EBIT =(1.39% Motorola’s Fundamentals Reinvestment Rate = 52.45% Aswath Damodaran 139 .5299)(.99% Return on Capital = 12.0681)(.3407) = 36.18% Expected Growth in EBIT = (.1218) = 6.81% Return on Capital =34.Estimating Growth in EBIT: Cisco versus Motorola Cisco’s Fundamentals Reinvestment Rate = 106.

If ROCt is the return on capital in period t and ROCt+1 is the return on capital in period t+1. positive if the return on capital is increasing and negative if the return on capital is decreasing. Operating Income Growth when Return on Capital is Changing When the return on capital is changing. Aswath Damodaran 140 . the second component should be spread out over each period. the expected growth rate in operating income will be: Expected Growth Rate = ROCt+1 * Reinvestment rate +(ROCt+1 – ROCt) / ROCt If the change is over multiple periods.IV. there will be a second component to growth.

1722*.99%.1722*5299= 9.18% and its reinvestment rate is 52.174 or 17.5299 +{ [1+(. while allowing for existing assets to improve returns gradually} Aswath Damodaran 141 .40%-9.22% over the next 5 years (which is half way towards the industry average) Expected Growth Rate = ROCNew Investments*Reinvestment Ratecurrent+ {[1+(ROCIn 5 years-ROCCurrent)/ROCCurrent]1/5-1} = .12%=8.Motorola’s Growth Rate Motorola’s current return on capital is 12.28% {Note that I am assuming that the new investments start making 17. We expect Motorola’s return on capital to rise to 17.1218]1/5-1} = .40% One way to think about this is to decompose Motorola’s expected growth into Growth from new investments: .12% Growth from more efﬁciently using existing investments: 17.22% immediately.1218)/.1722-.

Estimating Growth when Operating Income is Negative or Margins are changing When operating income is negative or margins are expected to change over time.V. we use a three step process to estimate growth: • Estimate growth rates in revenues over time – Use historical revenue growth to get estimates of revenue growth in the near future – Decrease the growth rate as the ﬁrm becomes larger – Keep track of absolute revenues to make sure that the growth is feasible • Estimate expected operating margins each year – Set a target margin that the ﬁrm will move towards – Adjust the current margin towards the target margin • Estimate the capital that needs to be invested to generate revenue growth and expected margins – Estimate a sales to capital ratio that you will use to generate reinvestment needs each year. Aswath Damodaran 142 .

44% $565 9.08% $2.846 13.21% -$438 -13.068 Aswath Damodaran 143 .802 Operating Margin Operating Income -79.00% 60.401 $13.049 11.900 $4.04% $1.00% 10.00% 35.00% Revenues $537 $806 $1.00% 20.62% -$428 -48.611 $2.640 $6.30% $149 6.00% 100.91% -$182 2.Commerce One: Revenues and Revenue Growth Year Current 1 2 3 4 5 6 7 8 9 10 Growth Rate 50.681 $15.510 12.496 $8.00% 5.23% -$384 -3.00% 80.20% $1.17% -$388 -27.00% 30.770 $11.00% 40.049 $15.27% $1.

033 $6.Commerce One: Reinvestment Needs Year Current 1 2 3 4 5 6 7 8 9 10 Revenues $537 $806 $1.681 $15.340 2.452 2.17% 13.76% 3.856 $2.818 2.20 $1.24% 10.20 $586 $3.14% -15.17% 14.20 $1.744 2.049 $15.401 $13.20 $122 $2.196 $7.36% 16.20 $791 $4.30% -11.740 $1.682 ROC -14.368 $752 Sales/Capital Reinvestment Capital $2.20 $366 $3.232 2.900 $4.609 2.496 $8.802 ΔRevenues $269 $806 $1.611 $2.87% -4.682 2.20 $342 $9.289 $1.20 $844 $5.036 $8.718 2.770 $11.640 $6.20 $622 $9.631 $2.486 2.274 $2.866 2.280 $1.39% Industry average = 15% Aswath Damodaran 144 .76% 14.20 $1.

Aswath Damodaran 145 .

IV. Closure in Valuation Discounted Cashﬂow Valuation Aswath Damodaran 146 .

The value is therefore the present value of cash ﬂows forever.Getting Closure in Valuation A publicly traded ﬁrm potentially has an inﬁnite life. t = ! CFt Value = " t t = 1 (1+ r) Since we cannot estimate cash ﬂows forever. we estimate cash ﬂows for a “growth period” and then estimate a terminal value. to capture the value at the end of the period: t = N CFt Terminal Value Value = ! + t (1 + r)N t = 1 (1 + r) Aswath Damodaran 147 .

Ways of Estimating Terminal Value Aswath Damodaran 148 .

they will all approach “stable growth” at some point in time.g) where. While companies can maintain high growth rates for extended periods. the present value of those cash ﬂows can be written as: Value = Expected Cash Flow Next Period / (r . When they do approach stable growth. Aswath Damodaran 149 . the valuation formula above can be used to estimate the “terminal value” of all cash ﬂows beyond.Stable Growth and Terminal Value When a ﬁrm’s cash ﬂows grow at a “constant” rate forever. r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the ﬁrm operates.

The stable growth rate can be negative. Aswath Damodaran 150 . • If you assume that the economy is composed of high growth and stable growth ﬁrms. the growth rate should be nominal in the currency in which the valuation is denominated. The terminal value will be lower and you are assuming that your ﬁrm will disappear over time. If you use nominal cashﬂows and discount rates. the growth rate of the latter will probably be lower than the growth rate of the economy. • • One simple proxy for the nominal growth rate of the economy is the riskfree rate.Limits on Stable Growth The stable growth rate cannot exceed the growth rate of the economy but it can be set lower.

at the end of which the growth rate will decline gradually to a stable growth rate(3-stage) Each year will have different margins and different growth rates (n stage) Aswath Damodaran 151 . and the pattern of growth during that period. 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.Growth Patterns A key assumption in all discounted cash ﬂow models is the period of high growth. In general. we can make one of three assumptions: • • • • there is no high growth. in which case the ﬁrm is already in stable growth there will be high growth for a period.

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. As ﬁrms become larger. 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.Determinants of Growth Patterns Size of the ﬁrm • Success usually makes a ﬁrm larger. which. Thus. Ultimately. there is a correlation between current growth and future growth. Current growth rate • Barriers to entry and differential advantages • • Aswath Damodaran 152 . high growth comes from high project returns. it becomes much more difﬁcult for them to maintain high growth rates While past growth is not always a reliable indicator of future growth. how long they will stay up and how strong they will remain. comes from barriers to entry and differential advantages.

Earn high ROC 3. Have average risk 3. Have high net cap ex 1. the ﬁrm should be given the characteristics of a stable growth ﬁrm. Have lower net cap ex FCFF 2. Pay no or low dividends 1. Have high risk 2. Have high risk 2. As growth rates approach “stability”. Model High Growth Firms usually Stable growth ﬁrms usually DDM 1. Have low leverage 4. Have average risk 3. Earn ROC closer to WACC FCFE/ 1. Earn high ROC 3.how much it reinvests and how high project returns are. Have leverage closer to industry average Aswath Damodaran 153 . Earn ROC closer to WACC 4.Stable Growth and Fundamentals The growth rate of a ﬁrm is driven by its fundamentals . Pay high dividends 2.

g/ ROE = 1 . Based upon its current return on equity of 15..b Aswath Damodaran 154 . At that point.79% and its retention ratio of 53. let us assume that its return on equity will be closer to the average for European banks of 15%.The Dividend Discount Model: Estimating Stable Growth Inputs Consider the example of ABN Amro.51%.67% g = b (ROE) b = g/ROE Payout = 1.88%. Let us assume that ABN Amro will be in stable growth in 5 years.05/. we estimated a growth in earnings per share of 8.15 = 66. and that it will grow at a nominal rate of 5% (Real Growth + Inﬂation Rate in NV) The expected payout ratio in stable growth can then be estimated as follows: Stable Growth Payout Ratio = 1 .

The reinvestment rate in year 13 can be estimated as follows: Reinvestment Rate = 5%/16. Aswath Damodaran 155 . Cisco is expected to be in stable growth 13 years from now. your terminal value will be unaffected by your stable growth assumption. you will ﬁnd that it is not the stable growth rate that drives your value but your excess returns.27% If you are consistent about estimating reinvestment rates.The FCFE/FCFF Models: Estimating Stable Growth Inputs The soundest way of estimating reinvestment rates in stable growth is to relate them to expected growth and returns on capital: Reinvestment Rate = Growth in Operating Income/ROC For instance. If your return on capital is equal to your cost of capital.52% = 30.52% (which is the industry average). growing at 5% a year and earning a return on capital of 16.

Beyond Inputs: Choosing and Using the Right Model Discounted Cashﬂow Valuation Aswath Damodaran 156 .V.

based upon historical growth. which should indicate which discount rate needs to be estimated and what pattern we will assume growth to follow The next step in the process is deciding • • • Aswath Damodaran 157 . at this stage in the process. analysts forecasts and/or fundamentals which cash ﬂow to discount.Summarizing the Inputs In summary. either to equity investors (dividends or free cash ﬂows to equity) or to the ﬁrm (cash ﬂow to the ﬁrm) the current cost of equity and/or capital on the investment the expected growth rate in earnings. we should have an estimate of the • • • the current cash ﬂows on the investment.

(b) for ﬁrms for which you have partial information on leverage (eg: interest expenses are missing. (Value Consulting?) Aswath Damodaran 158 ..) (c) in all other cases. because debt payments and issues do not have to be factored in the cash ﬂows and the discount rate (cost of capital) does not change dramatically over time. where you are more interested in valuing the ﬁrm than the equity. and (b) if equity (stock) is being valued Use Firm Valuation (a) for ﬁrms which have leverage which is too high or too low. whether high or not. and expect to change the leverage over time.Which cash ﬂow should I discount? Use Equity Valuation (a) for ﬁrms which have stable leverage.

As a rule of thumb. if dividends are less than 80% of FCFE or dividends are greater than 110% of FCFE over a 5year period.. use the FCFE model) (b) For ﬁrms where dividends are not available (Example: Private Companies. IPOs) Use the FCFE Model • • Aswath Damodaran 159 .Given cash ﬂows to equity. (What is signiﬁcant? . should I discount dividends or FCFE? Use the Dividend Discount Model • • (a) For ﬁrms which pay dividends (and repurchase stock) which are close to the Free Cash Flow to Equity (over a extended period) (b)For ﬁrms where FCFE are difﬁcult to estimate (Example: Banks and Financial Service companies) (a) For ﬁrms which pay dividends which are signiﬁcantly higher or lower than the Free Cash Flow to Equity..

stick with nominal cash ﬂows since taxes are based upon nominal income If inﬂation is high (>10%) switch to real cash ﬂows What currency should the discount rate (risk free rate) be in? • Should I use real or nominal cash ﬂows? • • • • Aswath Damodaran 160 .What discount rate should I use? Cost of Equity versus Cost of Capital • • If discounting cash ﬂows to equity -> Cost of Equity If discounting cash ﬂows to the ﬁrm -> Cost of Capital Match the currency in which you estimate the risk free rate to the currency of your cash ﬂows If discounting real cash ﬂows -> real cost of capital If nominal cash ﬂows -> nominal cost of capital If inﬂation is low (<10%).

g.Which Growth Pattern Should I use? If your ﬁrm is • • • large and growing at a rate close to or less than growth rate of the economy. patents) If your ﬁrm • • Use a 2-Stage Growth Model If your ﬁrm • • • is small and growing at a very high rate (> Overall growth rate + 10%) or has signiﬁcant barriers to entry into the business has ﬁrm characteristics that are very different from the norm Use a 3-Stage or n-stage Model Aswath Damodaran 161 . or constrained by regulation from growing at rate faster than the economy has the characteristics of a stable ﬁrm (average risk & reinvestment rates) Use a Stable Growth Model is large & growing at a moderate rate (≤ Overall growth rate + 10%) or has a single product & barriers to entry with a ﬁnite life (e.

tax rate) . the greater is the cost of equity.(1. Capital .Change in Work.(Capital Exp.(1.Deprec’n) [! = Debt Ratio] & A Discount Rate Cost of Equity Cost of Capital WACC = ke ( E/ (D+E)) + kd ( D/(D+E)) kd = Current Borrowing Rate (1-t) E. .The Building Blocks of Valuation Choose a Cash Flow Dividends Expected Dividends to Stockholders Cashflows to Equity Net Income Cashflows to Firm EBIT (1. .!) Change in Work. Capital = Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF) . Models: CAPM: Riskfree Rate + Beta (Risk Premium) APM: Riskfree Rate + " Betaj (Risk Premiumj): n factors Stable Growth g g Two-Stage Growth & a growth pattern | t High Growth Stable High Growth | Transition Stable Aswath Damodaran 162 .D: Mkt Val of Equity and Debt Three-Stage Growth g • • Basis: The riskier the investment.Deprec’n) .!) (Capital Exp.

Tying up Loose Ends Aswath Damodaran 163 .6.

with a history of overpaying on acquisitions. add back the value of cash and marketable securities and subtract out gross debt. markets may discount the value of this cash. Aswath Damodaran 164 . Once the ﬁrm has been valued. (This is also equivalent to subtracting out net debt) • If you have a particularly incompetent management.1.the cash ﬂows should be before interest income from cash and securities. Dealing with Cash and Marketable Securities The simplest and most direct way of dealing with cash and marketable securities is to keep it out of the valuation . (Use betas of the operating assets alone to estimate the cost of equity). and the discount rate should not be contaminated by the inclusion of cash.

How much cash is too much cash? Aswath Damodaran 165 .

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 166 .The Value of Cash Implicitly. 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.

Aswath Damodaran 167 . with a ﬁxed number of shares.The Case of Closed End Funds Closed end funds are mutual funds. where the shares have to trade at net asset value (which is the value of the securities in the fund). Unlike regular mutual funds. closed end funds shares can and often do trade at prices which are different from the net asset value. The average closed end fund has always traded at a discount on net asset value (of between 10 and 20%) in the United States.

Closed End Funds: Price and NAV

**Discounts/Premiums on Closed End Funds- June 2002
**

70

60

50

40

30

20

10

0 Discount Discount: Discount: Discount: Discount: Discount: Premium: Premium: Premium: Premium: Premium: Premium > 15% 10-15% 7.5-10% 5-7.5% 2.5-5% 0-2.5% 0-2.5% 2.5-5% 5-7.5% 7.5-10% 10-15% > 15% Discount or Premium on NAV

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A Simple Explanation for the Closed End Discount

Assume that you have a closed-end fund that invests in ‘average risk” stocks. Assume also that you expect the market (average risk investments) to make 11.5% annually over the long term. If the closed end fund underperforms the market by 0.50%, estimate the discount on the fund.

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A Premium for Marketable Securities

Some closed end funds trade at a premium on net asset value. For instance, the Thai closed end funds were trading at a premium of roughly 40% on net asset value and the Indonesian fund at a premium of 80%+ on NAV on December 31, 1997. Why might an investor be willing to pay a premium over the value of the marketable securities in the fund?

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Berkshire Hathaway

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**2. Dealing with Holdings in Other ﬁrms
**

**Holdings in other ﬁrms can be categorized into
**

• • • Minority passive holdings, in which case only the dividend from the holdings is shown in the balance sheet Minority active holdings, in which case the share of equity income is shown in the income statements Majority active holdings, in which case the ﬁnancial statements are consolidated.

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An Exercise in Valuing Cross Holdings Assume that you have valued Company A using consolidated ﬁnancials for $ 1 billion (using FCFF and cost of capital) and that the ﬁrm has $ 200 million in debt. How much is the equity in Company A worth? Now assume that you are told that Company A owns 10% of Company B and that the holdings are accounted for as passive holdings. The minority interest in company C is recorded at $ 40 million in Company A’s balance sheet. How much is the equity in Company A worth? Aswath Damodaran 173 . how much is the equity in Company A worth? Now add on the assumption that Company A owns 60% of Company C and that the holdings are fully consolidated. If the market cap of company B is $ 500 million.

More on Cross Holding Valuation Building on the previous example. Aswath Damodaran 174 . assume that you have valued the equity in company C at $250 million. Furthermore. Estimate the value of equity in company A. assume that • You have valued equity in company B at $ 250 million (which is half the market’s estimate of value currently) • Company A is a steel company and that company C is a chemical company.

(If you use the market values of the cross holdings. you will build in errors the market makes in valuing them into your valuation. Step 3: The ﬁnal value of the equity in the parent company with N cross holdings will be: Value of un-consolidated parent company – Debt of un-consolidated parent company + j= N "% owned of Company j * (Value of Company j j=1 Debt of Company j) Aswath Damodaran ! 175 .If you really want to value cross holdings right…. This will require using unconsolidated ﬁnancial statements rather than consolidated ones. Step 2: Value each of the cross holdings individually. Step 1: Value the parent company without any cross holdings.

convert the book value of these holdings (which are reported on the balance sheet) into market value by multiplying by the price to book ratio of the sector(s).If you have to settle for an approximation. Aswath Damodaran 176 . with full consolidation. try this… For majority holdings. • • Estimated market value of minority interest = Minority interest on balance sheet * Price to Book ratio for sector (of subsidiary) Subtract this from the estimated value of the consolidated ﬁrm to get to value of the equity in the parent company. convert the minority interest from book value to market value by applying a price to book ratio (based upon the sector average for the subsidiary) to the minority interest. For minority holdings in other companies. Add this value on to the value of the operating assets to arrive at total ﬁrm value.

. Aswath Damodaran 177 . Failing to fully take into account this claim on the equity in valuation will result in an overstatement of the value of equity per share. By creating claims on the equity. they can affect the value of equity per share.3. whether to management or employees or to investors (convertibles and warrants) create claims on the equity of the ﬁrm. Equity Options issued by the ﬁrm. Any options issued by a ﬁrm.

Aswath Damodaran 178 . Options affect equity value because • • Shares are issued at below the prevailing market price. The lower cashﬂows reduce equity value. Options get exercised only when they are in the money. the company can use cashﬂows that would have been available to equity investors to buy back shares which are then used to meet option exercise.Why do options affect equity value per share? It is true that options can increase the number of shares outstanding but dilution per se is not the problem. Alternatively.

Its value can be written as follows: Value of ﬁrm = 100 / (.08-.A simple example… XYZ company has $ 100 million in free cashﬂows to the ﬁrm. It has 100 million shares outstanding and $ 1 billion in debt.Debt = 1000 = Equity = 1000 Value per share = 1000/100 = $10 Aswath Damodaran 179 .03) = 2000 . growing 3% a year in perpetuity and a cost of capital of 8%.

**Now come the options…
**

XYZ decides to give 10 million options at the money (with a strike price of $10) to its CEO. What effect will this have on the value of equity per share?

a) None. The options are not in-the-money. b) Decrease by 10%, since the number of shares could increase by 10 million c) Decrease by less than 10%. The options will bring in cash into the ﬁrm but they have time value.

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**Dealing with Employee Options: The Bludgeon Approach
**

The simplest way of dealing with options is to try to adjust the denominator for shares that will become outstanding if the options get exercised. In the example cited, this would imply the following:

Value of ﬁrm = 100 / (.08-.03) = 2000 - Debt = 1000 = Equity = 1000 Number of diluted shares = 110 Value per share = 1000/110 = $9.09

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**Problem with the diluted approach
**

The diluted approach fails to consider that exercising options will bring in cash into the ﬁrm. Consequently, they will overestimate the impact of options and understate the value of equity per share. The degree to which the approach will understate value will depend upon how high the exercise price is relative to the market price. In cases where the exercise price is a fraction of the prevailing market price, the diluted approach will give you a reasonable estimate of value per share.

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**The Treasury Stock Approach
**

The treasury stock approach adds the proceeds from the exercise of options to the value of the equity before dividing by the diluted number of shares outstanding. In the example cited, this would imply the following:

Value of ﬁrm = 100 / (.08-.03) = 2000 - Debt = 1000 = Equity = 1000 Number of diluted shares = 110 Proceeds from option exercise = 10 * 10 = 100 (Exercise price = 10) Value per share = (1000+ 100)/110 = $ 10

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**Problems with the treasury stock approach
**

The treasury stock approach fails to consider the time premium on the options. In the example used, we are assuming that an at the money option is essentially worth nothing. The treasury stock approach also has problems with out-of-the-money options. If considered, they can increase the value of equity per share. If ignored, they are treated as non-existent.

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Aswath Damodaran 185 .Dealing with options the right way… Step 1: Value the ﬁrm. using discounted cash ﬂow or other valuation models.Value of Straight Debt Portion of Convertible Bonds Value of employee Options: Value using the average exercise price and maturity. Step 4:Divide the remaining value of equity by the number of shares outstanding to get value per share. skip step 1 and estimate the of equity directly. Step 2:Subtract out the value of the outstanding debt to arrive at the value of equity. 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 option pricing model Value of Conversion Option = Market Value of Convertible Bonds . Alternatively.

making the assumptions about constant variance and constant dividend yields much shakier. These problems can be partially alleviated by using an option pricing model. making it dangerous to use European option pricing models. The resulting value can be adjusted for the probability that the employee will not be vested. Employee options result in stock dilution. Aswath Damodaran 186 .Valuing Equity Options issued by ﬁrms… The Dilution Problem Option pricing models can be used to value employee options with four caveats – • • • • Employee options are long term. allowing for shifts in variance and early exercise. and factoring in the dilution effect. Employee options cannot be exercised until the employee is vested. and Employee options are often exercised before expiration.

Back to the numbers… Inputs for Option valuation Stock Price = $ 10 Strike Price = $ 10 Maturity = 10 years Standard deviation in stock price = 40% Riskless Rate = 4% Aswath Damodaran 187 .

58 (0.3624 Value per call = $ 9.8199) . we arrive at the following inputs: • • • N (d1) = 0.04) (10)(0.3624) = $5.Valuing the Options Using a dilution-adjusted Black Scholes model.8199 N (d2) = 0.42 Dilution adjusted Stock price Aswath Damodaran 188 .$10 exp-(0.

08-.46 Aswath Damodaran 189 .2 / 100 = $ 9.8 / Number of shares outstanding = Value per share = 2000 = 1000 = 1000 = $ 54.Value of options granted = Value of Equity in stock = $945.Debt = Equity .03) .42.Value of Equity to Value of Equity per share Using the value per call of $5. we can now estimate the value of equity per share after the option grant: Value of ﬁrm = 100 / (.

To the extent that the exercise of the options creates tax advantages. One simple adjustment is to multiply the value of the options by (1.tax rate) to get an after-tax option cost.To tax adjust or not to tax adjust… In the example above. the actual cost of the options will be lower by the tax savings. we have assumed that the options do not provide any tax advantages. Aswath Damodaran 190 .

Consider this line item as part of operating expenses each year. Forecast out the value of option grants as a percent of revenues into future years. option grants as a percent of revenues will become smaller. allowing for the fact that as revenues get larger. The simplest mechanism for bringing in future option grants into the analysis is to do the following: • • Estimate the value of options granted each year over the last few years as a percent of revenues. This will reduce the operating margin and cashﬂow each year. These expected option grants will also affect value. • Aswath Damodaran 191 .Option grants in the future… Assume now that this ﬁrm intends to continue granting options each year to its top management as part of compensation.

Aswath Damodaran 192 .When options affect equity value per share the most… Option grants affect value more • • • The lower the strike price is set relative to the stock price The longer the term to maturity of the option The more volatile the stock price The effect on value will be magniﬁed if companies are allowed to revisit option grants and reset the exercise price if the stock price moves down.

The Agency problems created by option grants… The Volatility Effect: Options increase in value as volatility increases. The Short-term Effect: To the extent that options can be exercised quickly and proﬁts cashed in. while ﬁrm value and stock price may decrease. For example. Managers who are compensated primarily with options may have an incentive to take on far more risk than warranted. dividends will be viewed with disfavor since the stock price drops on the ex-dividend day. The Price Effect: Managers will avoid any action (even ones that make sense) that reduce the stock price. there can be a temptation to manipulate information for short term price gain (Earnings announcements…) Aswath Damodaran 193 .

Thus.The Accounting Effect… The accounting treatment of options has been abysmal and has led to the misuse of options by corporate boards. Even when the options are exercised. Aswath Damodaran 194 . there is no expense recorded at the time of the option grant (though the footnotes reveal the details of the grant). Some ﬁrms show the difference between the stock price and the exercise price as an expense whereas others reduce the book value of equity. Accountants have treated the granting of options to be a non-issue and kept the focus on the exercise. there is no uniformity in the way that they are are accounted for.

the accounting rules governing options will change dramatically. They will be allowed to revisit these expenses and adjust them for subsequent non-exercise of the options. Aswath Damodaran 195 . they are changing….The times. Firms will be required to value options when granted and show them as expenses when granted. In 2005.

. The managers of technology ﬁrms. have greeted these rule changes with the predictable complaints which include: • • • These options cannot be valued precisely until they are exercised. who happen to be the prime beneﬁciaries of these options. Firms may be unwilling to use options as liberally as they have in the past because they will affect earnings. Aswath Damodaran 196 . Firms will have to go back and restate earnings when options are exercised or expire. Forcing ﬁrms to value options and expense them will just result in in imprecise earnings.Leading to predictable moaning and groaning.

At least initially. who now will be held accountable for the cost of the options. A greater awareness of the option contract details (maturity and strike price) on the part of boards of directors. we can anticipate the following: • • A decline in equity options as a way of compensating employees even in technology ﬁrms and a concurrent increase in the use of conventional stock. we can expect to see ﬁrms report earnings before option expensing and after option expensing to allow investors to compare them to prior periods • Aswath Damodaran 197 .Some predictions about ﬁrm behavior… If the accounting changes go through.

you can expect the stock prices of companies that grant options to drop when options are expensed. relative to their peer groups.And market reaction… A key test of whether markets are already incorporating the effect of options into the stock price will occur when all ﬁrms expense options. The more likely scenario is that the market is already incorporating options into the market value but is not discriminating very well across companies. If markets are blind to the option overhang. should see stock prices decline. Aswath Damodaran 198 . Consequently. companies that use options disproportionately.

Valuations Aswath Damodaran Aswath Damodaran 199 .

Regulated D/E.com Model Used Stable DDM 2-Stage DDM 2-Stage DDM 2-Stage FCFE 3-Stage FCFE Stable FCFF 2-stage FCFF 2-stage FCFF 2-stage FCFF n-stage FCFF Remarks Dividends=FCFE. Low g FCFE=?. High g Dividends≠FCFE.Companies Valued Company Con Ed ABN Amro S&P 500 Nestle Tsingtao DaimlerChrysler Tube Investments Embraer Global Crossing Amazon. market is an investment Dividends≠FCFE. Stable Sector The value of growth? Emerging Market company (not…) Dealing with Distress Varying margins over time Aswath Damodaran 200 . g>Stable Collectively.High g Normalized Earnings. Stable D/E. Stable D/E. Stable D/E.

5%. Aswath Damodaran 201 . For the valuations from 1998 and earlier. I use a risk premium of 5. This is the average implied equity risk premium from 1960 to 2003 as well as the average historical premium across the top 15 equity markets in the twentieth century.General Information The risk premium that I will be using in the latest valuations for mature equity markets is 4%.

It is unlikely that the regulators will allow proﬁts to grow at extraordinary rates. based upon size and the area that it serves. Firm Characteristics are consistent with stable. The ﬁrm is in stable leverage.Con Ed: Rationale for Model The ﬁrm is in stable growth. DDM model ﬁrm • • • The beta is 0.80 and has been stable over time. – Average Annual FCFE between 1999 and 2004 = $635 million – Average Annual Dividends between 1999 and 2004 = $ 624 million – Dividends as % of FCFE = 98% Aswath Damodaran 202 . The ﬁrm pays out dividends that are roughly equal to FCFE. Its rates are also regulated.

42 on December 31. 2004 Earnings per share for 2004 = $ 2.02) = $ 42.80*4% = 7.22% + 0.Con Ed: A Stable Growth DDM: December 31.72 (Fourth quarter estimate used) Dividend Payout Ratio over 2004 = 83.26*1.02 / (.06% Dividends per share for 2004 = $2. 2004 Aswath Damodaran 203 .53 The stock was trading at $ 43.80 (Bottom-up beta estimate) Cost of Equity = 4.26 Expected Growth Rate in Earnings and Dividends =2% Con Ed Beta = 0.0742 -.42% Value of Equity per Share = $2.

Con Ed: Break Even Growth Rates Aswath Damodaran 204 .

• Break even Return on equity = g/ Retention ratio = .0211/. the fundamental growth rate for Con Ed is: Fundamental growth rate = (.45% Aswath Damodaran 205 . and solve for the growth rate: • • Price per share = $ 43.94% and its return on equity in 2003 of 10%.11% Given its retention ratio of 16.Estimating Implied Growth Rate To estimate the implied growth rate in Con Ed’s current stock price.10) = 1.69% You could also frame the question in terms of a break-even return on equity. we set the market price equal to the value.26*(1+g) / (.42 = $2.0742 -g) Implied growth rate = 2.1694*.1694 = 12.

and that you are right and the market is wrong.Implied Growth Rates and Valuation Judgments When you do any valuation. Will you deﬁnitely proﬁt from your investment? Yes No Aswath Damodaran 206 . The ﬁrst is that you are right and the market is wrong. The third is that you are both wrong. The second is that the market is right and that you are wrong. which is the most likely scenario? Assume that you invest in a misvalued ﬁrm. there are three possibilities. In an efﬁcient market.

Con Ed: A Look Back Con Ed: Estimated Value versus Price per shhare 60 50 40 30 Estimated Value Price per share 20 10 0 1997 1998 1999 2000 2001 2002 Aswath Damodaran 207 .

This is higher than what would be a stable growth rate (roughly 4% in Euros) Aswath Damodaran 208 . The expected growth rate based upon the current return on equity of 16% and a retention ratio of 51% is 8.ABN Amro: Rationale for 2-Stage DDM in December 2003 As a ﬁnancial service institution.2%. estimating FCFE or FCFF is very difﬁcult.

35%+0. premium : Netherlands is AAA rated) Current Earnings Per Share = 1.35% Aswath Damodaran 209 .35%+1.35% Risk Premium = 4% (U.00 Cost of Equity 4.35% (Set = Cost of equity) Payout Ratio 48.35% 47.15% = 8..5135=.10% (1 .95 1.4/8.95(4%) 4.90 Eur. Variable High Growth Phase Stable Growth Phase Length 5 years Forever after yr 5 Return on Equity 16.0822 4% (Assumed) Beta 0.35) Expected growth .90% (b=g/ROE=4/8.16*.35) Retention Ratio 51.65% 52.ABN Amro: Summarizing the Inputs Market Inputs • • Long Term Riskfree Rate (in Euros) = 4.00(4%) =8.00% 8.85 Eur.S. Current DPS = 0.

2003 Aswath Damodaran 210 .04) = 2.55 Euros on December 31.0815)5 = 23.0835-.05 0.90 + 0.90 + 23.90 3 2.23 0.ABN Amro: Valuation Year EPS DPS PV of DPS (at 8.20 Eur PV of Terminal Price = 34.49/(.5210=1.14 0.34 0.54 1.34 1.20/(1.90 + 0.90 2 2.97 0.90 Expected EPS in year 6 = 2.86 Eur Expected DPS in year 6 = 2.04) = 34.11Eur Value Per Share = 0.15%) 1 2.90 5 2.75 1.11 = 27.17 1.00 0.90 + 0.90 4 2.90 + 0.49 Eur Terminal Price (in year 5) = 1.75(1.86*0.62 Eur The stock was trading at 18.

75 Eur 1.34Eur 1.86*.95 X Risk Premium 4% Average beta for European banks = 0.22% ROE = 16% g =4%: ROE = 8.85 Eur * Payout Ratio 48.20 2.34 Eur .95 (4%) = 8.23 Eur 2.521)/(..04) = 34.95% + 0.54 Eur 1.35%(=Cost of equity) Beta = 1.4/8.62 Eur EPS 2.05 Eur 2.521 Value of Equity per share = 27..0835-.97 Eur Terminal Value= EPS6*Payout/(r-g) = (2.15% Riskfree Rate: Long term bond rate in Euros 4..00 Eur DPS 0.35% * 16% = 8..95 Mature Market 4% Country Risk 0% Aswath Damodaran 211 .35% Expected Growth 51...65% DPS = 0... Forever Discount at Cost of Equity Cost of Equity 4.35) = .35% + Beta 0.90 Eur Retention Ratio = 51.VALUING ABN AMRO Dividends EPS = 1.17 Eur 1.14 Eur 2.00 Payout = (1.

The Value of Growth In any valuation model. and to break this down further into that portion attributable to “high growth” and the portion attributable to “stable growth”. this can be accomplished as follows: t=n t=1 P0 = DPS Pn ! (1+r)tt + (1+r)n .DPS0 r (r-gn ) + DPS0 r Value of Stable Growth Place DPSt = Expected dividends per share in year t r = Cost of Equity Pn = Price at the end of year n gn = Growth rate forever after year n Value of High Growth Assets in Aswath Damodaran 212 . it is possible to extract the portion of the value that can be attributed to growth.DPS0 *(1+gn ) (r-gn ) + DPS0 *(1+gn ) . In the case of the 2-stage DDM.

78+10.0835-.90 Euros/.90 (1.74 Euros (A more precise estimate would have required us to use the stable growth payout ratio to re-estimate dividends) Value of High Growth = Total Value .62 .(10.ABN Amro: Decomposing Value Value of Assets in Place = Current DPS/Cost of Equity = 0.78 Euros = 10.78 Euros Value of Stable Growth = 0.10.74) = 6.04) .04)/(.10 Euros Aswath Damodaran 213 .(10.0835 = 10.78+ 10.74) = 27.

S. there is reason to believe that the earnings at U. The consensus estimate of growth in earnings (from Zacks) is roughly 8% (with top-down estimates) Though it is possible to estimate FCFE for many of the ﬁrms in the S&P 500. it is not feasible for several (ﬁnancial service ﬁrms).S & P 500: Rationale for Use of Model While markets overall generally do not grow faster than the economies in which they operate. Aswath Damodaran 214 . companies (which have outpaced nominal GNP growth over the last 5 years) will continue to do so in the next 5 years. The dividends during the year should provide a reasonable (albeit conservative) estimate of the cash ﬂows to equity investors from buying the index.

22% (Nominal g) 1.5% 1.S.00 Length Dividend Yield Expected Growth Beta Aswath Damodaran 215 .60% 4.60% 8.00 Stable Growth Phase Forever after year 5 1.S &P 500: Inputs to the Model (12/31/04) General Inputs • • • Long Term Government Bond Rate = 4.22% Risk Premium for U. Equities = 4% Current level of the Index = 1211.92 Inputs for the Valuation High Growth Phase 5 years 1.

86 Expected Dividends = Expected Terminal Value = Present Value = Intrinsic Value of Index = Cost of Equity = 4.06 $19.51 3 $24.0422) = 760.79 $19.18 $760.22% Terminal Value = 29.0422/(.S & P 500: 2-Stage DDM Valuation 1 $21.56 4 $26.46 $609.28 $531.61 5 $29.85 $19.89 $19.18*1.22% + 1(4%) = 8.0822 -.28 Aswath Damodaran 216 .98 2 $22.

This indicates that one or more of the following has to be true. while the model valuation comes in at 610. • • • • The dividend discount model understates the value because dividends are less than FCFE. The expected growth in earnings over the next 5 years will be much higher than 8%. The risk premium used in the valuation (4%) is too high The market is overvalued. Aswath Damodaran 217 .Explaining the Difference The index is at 1212.

29 At a level of 1112.A More Realistic Valuation of the Index We estimated the free cashﬂows to equity for each ﬁrm in the index and averaged the free cashﬂow to equity as a percent of market cap.42 4 $48.38 $35. The average FCFE yield for the index was about 2.104. Aswath Damodaran 218 .80 2 $41.33 3 $44. With these inputs in the model: Expected Dividends & Buybacks = Expected Terminal Value = Present Value = Intrinsic Value of Index = 1 $38.24 $1.71 $35.377.89 $35.02 $963.85 $1.14 $35.51 5 $52.90% in 2004. the market is overvalued by about 10%.

) Like many large European ﬁrms.Nestle: Rationale for Using Model . Nestle has paid less in dividends than it has available in FCFE. Aswath Damodaran 219 . but the fundamentals at the ﬁrm suggest growth in EPS of about 11%. (How do I know? I do not.January 2001 Earnings per share at the ﬁrm has grown about 5% a year for the last 5 years.6% and is unlikely to change that leverage materially. I am just making an assumption. (Analysts are also forecasting a growth rate of 12% a year for the next 5 years) Nestle has a debt to capital ratio of about 37.

Nestle: Summarizing the Inputs General Inputs • Long Term Government Bond Rate (Sfr) = 4% • Current EPS = 108.63%*.2 Sfr.85 0.38% 4.30% (Grow with earnings) Debt Ratio 37.88 Sfr.60% 37.85 Return on Equity 23. Depreciation/Share=73.30% (Existing) 9.820 Sfr • Capital Expenditures/Share=114.10% (Current) NA Expected Growth 23. Current Revenue/share =1.63% 16% Retention Ratio 65.651= 15.60% Cap Ex/Deprecn Current Ratio 150% Aswath Damodaran 220 .8 Sfr High Growth Stable Growth Length 5 years Forever after yr 5 Beta 0.00% WC/Revenues 9.

00% South America 4.26%) = 8.00% Eastern Europe 4 5.00% Italy/Spain 6.82% 4.4 26.00% Total 70.23% 9.4 9. Europe 13 18.00% 5.67% 8.47% Aswath Damodaran 221 .3 6.5 24.00% Germany/France/UK 18.26% Cost of Equity = 4% + 0.1 1.00% Rest of W.Estimating the Risk Premium for Nestle Revenues Weight Risk Premium North America 17.56% 4.10% 4.85 (5.8 8.5 100.08% 5.00% Switzerland 1.50% Asia 5.26% The risk premium that we will use in the valuation is 5.10% 12.44% 4.

8(1.57 .04) = 231.12 + $94.37 $89.0847)5=3011Sf The stock was trading 2906 Sfr on December 31.093)=13.25 $80.78.04)(.0847-.376) .96 $123.63 $29.85(1-.04 2 $144.63 $106.7 + 3890/(1.(Net CpEX)*(1-DR) -Δ WC*(1-DR) Free Cashﬂow to Equity Present Value Earnings per Share in year 6 = 222.07 $16.5 Sfr Chg in WC6 =( Rev6 .04) = 3890.75 $92.79 $142.1538)5(1.65 $24. 1999 Aswath Damodaran 222 .04)(.95 $33.54 $18.5)= 78.78 + $89.16 Sfr Value=$74.93 Sfr Terminal Value per Share = 173.66(1.1538)5(.12 5 $222.Nestle: Valuation 1 $125.66 $51.98 $44.76 + $83.50 =73.13.04 + $78.093) = 1820(1.93/(.70 $21.376)= 173.78 4 $192.52 $28.7 Earnings .5(1-.35 $94.85 Sfr FCFE6 = 231.25 $38.Rev5 )(.67 $78.76 3 $167.31 $74.92 $83.57 Net Capital Ex 6 = Deprecn’n6 * 0.

93/(.78 +$89.85(1-.93 Sfr Terminal Value per Share = 222.376) = 222.91 Sfr Aswath Damodaran 223 .57 . If.Nestle: The Net Cap Ex Assumption In our valuation of Nestle.7 + 4986/(1.76 +$83. the terminal value would have been: FCFE6 = 231.0847 -.04 +$78. we had assumed that net cap ex was zero. as many analysts do. we assumed that cap ex would be 150% of depreciation in steady state.13. instead.12 +$94.04) = 4986 Sfr Value= $74.0847)5= 3740.

.31 Sfr 92.19 ..28 Firm is in stable growth: g=4%. Terminal Value= 173.0847-.DR) 25.6% Value of Equity per Share = 3011 Sfr 80.37 Sfr 142.04) = 3890 Forever Discount at Cost of Equity Cost of Equity 4%+0.67 Sfr 106.(Cap Ex . Cap Ex/Deprec=150% Debt ratio stays 37.79 Market D/E=11% Base Equity Premium: 4% Country Risk Premium:1.26% Bottom-up beta for food= 0.38% Cashflow to Equity Net Income 108.47 % Riskfree Rate: Swiss franc rate = 4% + Beta 0.41 = FCFE 79.92 Sfr 123.35 Sfr . Beta=0.26% Aswath Damodaran 224 .6% A VALUATION OF NESTLE (PER SHARE) Expected Growth Retention Ratio * Return on Equity =.85(5.85 X Risk Premium 4% + 1.Depr) (1..Financing Weights Debt Ratio = 37.26%)=8.651*.2363=15..Change in WC (!-DR) 4...85...88 .93/(.

• Market Wide Information – Interest Rates – Risk Premiums – Economic Growth • Industry Wide Information – Changes in laws and regulations – Changes in technology • Firm Speciﬁc Information – New Earnings Reports – Changes in the Fundamentals (Risk and Return characteristics) Aswath Damodaran 225 .The Effects of New Information on Value No valuation is timeless. Each of the inputs to the model are susceptible to change as new information comes out about the ﬁrm. its competitors and the overall economy.

is expected to shrink to 5.98% in the previous analysis. The drop in earnings will make the projected earnings and cash ﬂows lower. even if the growth rate remains the same The drop in net margin will make the return on equity lower (assuming turnover ratios remain unchanged).8 Sfr. There are two effects on value: • • Aswath Damodaran 226 . which was 5. The after-tax margin.Nestle: Effects of an Earnings Announcement Assume that Nestle makes an earnings announcement which includes two pieces of news: • • The earnings per share come in lower than expected.79%. The base year earnings per share will be 105. Increased competition in its markets is putting downward pressure on the net proﬁt margin. This will reduce expected growth.5 Sfr instead of 108.

.Financing Weights Debt Ratio = 37..6% Value of Equity per Share = 2854 Sfr 76.84/(.85.26% Bottom-up beta for food= 0.50 .90 Firm is in stable growth: g=4%.DR) 25.32 Sfr .48 Sfr 88.47% Riskfree Rate: Swiss franc rate = 4% + Beta 0.68 Sfr 134...6% A RE-VALUATION OF NESTLE (PER SHARE) Expected Growth Retention Ratio * Return on Equity =. Beta=0.(Cap Ex .35 Sfr 116.19 .12% Cashflow to Equity Net Income 105.651*. Terminal Value= 164..Depr) (1.79 Market D/E=11% Base Equity Premium: 4% Country Risk Premium:1.26% Aswath Damodaran 227 .85 X Risk Premium 4% + 1.04) = 3687 Forever Discount at Cost of Equity Cost of Equity 4%+0.0847-..2323=15.41 = FCFE 75.26%)=8..Change in WC (!-DR) 4..04 Sfr 101. Cap Ex/Deprec=150% Debt ratio stays 37.85(5.

in general. and the rest of Asia. The ﬁrm’s current return on equity is low. Why FCFE? Corporate governance in China tends to be weak and dividends are unlikely to reﬂect free cash ﬂow to equity. the ﬁrm consistently funds a portion of its reinvestment needs with new debt issues. As it increases.Tsingtao Breweries: Rationale for Using Model: June 2001 Why three stage? Tsingtao is a small ﬁrm serving a huge and growing market – China. In addition. earnings growth will be pushed up. Aswath Damodaran 228 . and we anticipate that it will improve over the next 5 years. in particular.

giving it a return on equity of 2.204 + 52. Tsingtao Breweries earned 72.588 million CY.94% at the end of 1999 and use it to estimate the normalized equity reinvestment in 2000. The ﬁrm had capital expenditures of 335 million CY and depreciation of 204 million CY during the year. and we normalize the change using non-cash working capital as a percent of revenues in 2000: Normalized change in non-cash working capital = (Non-cash working capital2000/ Revenues 2000) (Revenuess 2000 – Revenues1999) = (180/2253)*( 2253-1598) = 52.3 million CY As with working capital. debt issues have been volatile.Background Information In 2000. We estimate the ﬁrm’s book debt to capital ratio of 40.80%. The working capital changes over the last 4 years have been volatile.3= 183.3 million CY Normalized Reinvestment = Capital expenditures – Depreciation + Normalized Change in non-cash working capital = 335 . Aswath Damodaran 229 .36 million CY(Chinese Yuan) in net income on a book value of equity of 2.

4997 *.028)1/5-1] = 44.next 5 years = Equity reinvestment rate * ROENew+ [1+ (ROE5-ROEtoday)/ROEtoday]1/5-1 = 1.12 + [(1+ (.80 4%+2.Debt Ratio) / Net Income = = 183.97% 44.91% Aswath Damodaran 230 .95% 20% 50% 10% Equity Reinvestment Ratio= Reinvestment (1.28% 2.91% Transition Phase 5 years 0.12-.8%->12% 149.3 (1-.80 --> 12%->20% Moves to 50% Moves to 10% Stable Growth Forever after yr 10 4+0.36 = 149.028)/.Inputs for the 3 Stages Length Beta 0.4094) / 72.75 Risk Premium ROE Equity Reinv.97% Expected growth rate. Expected Growth We wil asssume that High Growth 5 years Moves to 0.

97% 149.56% 14.91% 44.85 CY151.93% 30.94% 23.71% 14.41% 14.98% 109.97% 149.81 149.Tsingtao: Projected Cash Flows Equity Year Expected Growth Net Income Reinvestment Rate Current 1 2 3 4 5 6 7 8 9 10 44.98 CY1.99% 50.00% (CY52.71% 14.04 CY172.61 CY834.71% 14.16 ($186.61 CY363.14) (CY83.97% 149.26% 14.92) (CY110.97% 129.29 CY665.83 CY107.16 CY319.97% 149.08) (CY116.65) FCFE Cost of Equity Present Value Sum of the present values of FCFE during high growth = Aswath Damodaran 231 .92 CY1.36 CY104.29 CY637.11% 13.91% 37.00% CY72.331.32) (CY84.96% 16.96% (CY45.210.91 14.35) CY103.91% 44.71% 14.71% 14.02) (CY159.99% 69.98% 10.68) (CY57.97% 149.93 CY220.74 CY1.98% 89.89) (CY92.70) (CY72.02) CY34.034.43) (CY231.91% 44.40) (CY75.01) (CY32.91% 44.02) (CY191.03 CY462.

96% Expected FCFE in year 11 = Net Income11*(1.81 (1.5) = CY 732.Tsingtao: Terminal Value Expected stable growth rate =10% Equity reinvestment rate in stable growth = 50% Cost of equity in stable growth = 13.1396-.10)(1-.50 million Terminal Value of equity in Tsingtao Breweries = FCFE11/(Stable period cost of equity – Stable growth rate) = 732.497 million Aswath Damodaran 232 .Stable period equity reinvestment rate) = CY 1331.5/(.10) = CY 18.

596 million Value of Equity per share = Value of Equity/ Number of Shares = CY 4.65+CY18.04 per share The stock was trading at 10. based upon this valuation.14715*1.1456*1.15 = CY 7. which would make it overvalued. Aswath Damodaran 233 .1396) = CY 4.596/653.1441*1.10 Yuan per share.Tsingtao: Valuation Value of Equity = PV of FCFE during the high growth period + PV of terminal value =-CY186.1426*1.497/(1.1411*1.

Aswath Damodaran 234 . We will therefore assume that the ﬁrm is in stable growth. the debt ratio will probably change over time. Hence. Since this is a relatively new organization.DaimlerChrysler: Rationale for Model June 2000 DaimlerChrysler is a mature ﬁrm in a mature industry. we will use the FCFF model. with two different cultures on the use of debt (Daimler has traditionally been more conservative and bankoriented in its use of debt than Chrysler).

Based upon this operating income and the book values of debt and equity as of 1998.61. The market value of equity is 62. Aswath Damodaran 235 . We will assume that the ﬁrm will maintain a long term growth rate of 3%. while the estimated market value of debt is 64. The long term German bond rate is 4.87% (in DM) and the mature market premium of 4% is used.15%. DaimlerChrysler had an after-tax return on capital of 7.324 million DM and had an effective tax rate of 46. Daimler Chrysler had earnings before interest and taxes of 9.3 billion DM.5 billion The bottom-up unlevered beta for automobile ﬁrms is 0. and Daimler is AAA rated.94%.Daimler Chrysler: Inputs to the Model In 1999.

5))+ 2.98% Cost of Capital • • • • Bottom-up Levered Beta = 0.65%(62.5)) = 5.69% (64.20%) (1-.945 (4%) = 8.3+64.945 Cost of Equity = 4.65% After-tax Cost of Debt = (4.5/(62.61 (1+(1-.4694)= 2.5/62.Daimler/Chrysler: Analyzing the Inputs Expected Reinvestment Rate = g/ ROC = 3%/7.3/(62.15% = 41.3)) = 0.4694)(64.62% Aswath Damodaran 236 .87% + 0.87% + 0.3+64.69% Cost of Capital = 8.

03) (1-.139 mil DM 2.488 mil DM 66.2 DM per share on June 1.4694) = Expected Reinvestment needs = 5.427 mil DM Valuation of Firm Value of operating assets = 2957 / (.096(.068 mil DM 130. 2000 Aswath Damodaran 237 .42) = Expected FCFF next year = 5.915 mil DM 64.03) = + Cash + Marketable Securities = Value of Firm = .Debt Outstanding = Value of Equity = Value per Share = 72.7 DM per share Stock was trading at 62.056-.847 mil DM 18.Daimler Chrysler Valuation Estimating FCFF Expected EBIT (1-t) = 9324 (1.096 mil DM 2.957 mil DM 112.

Circular Reasoning in FCFF Valuation In discounting FCFF. Is there circular reasoning here? Yes No If there is. We then use the present value of the FCFF as our value for the ﬁrm and derive an estimated value for equity. can you think of a way around this problem? Aswath Damodaran 238 . we use the cost of capital. which is calculated using the market values of equity and debt.

Tube Investment: Rationale for Using 2-Stage FCFF Model June 2000 Tube Investments is a diversiﬁed manufacturing ﬁrm in India. Aswath Damodaran 239 . While its growth rate has been anemic. The ﬁrm’s ﬁnancing policy is also in a state of ﬂux as the family running the ﬁrm reassesses its policy of funding the ﬁrm. there is potential for high growth over the next 5 years.

292 $2.80% Cost of Debt (12%+1.Chg WC 4.425 60% .316 Term Yr 6.079 3.775 Discount at Cost of Capital (WACC) = 22.0552 5.1478-.092-= .578 13.35% Terminal Value 5= 2775/(.558) + 9.52 % Return on Capital 9.20% Stable Growth g = 5%.23% Aswath Damodaran 240 .8% D = 44.670 $2.2% Country Premium= 3% ROC= 9.653 18.05) = 28.50%)(1-.8% (.442) = 16.45% (0.90% Cost of Equity 22.30) = 9.200 $3.Nt CpX 843 .Debt: =Equity -Options Value/Share 19.120 $2.971 $5.Tube Investments: Status Quo (in Rs) Current Cashflow to Firm Reinvestment Rate EBIT(1-t) : 4.150 = FCFF .158 0 61.802 $1. Beta = 1.568 Reinvestment Rate =112. Debt ratio = 44.00.790 $3.195 $5.304 2.868 $4.487 $3.957 $1.17 X Risk Premium 9.928 $2.23% Unlevered Beta for Sectors: 0.474 $2.2% Riskfree Rate : Real riskfree rate = 12% + Beta 1.080 $5.75 Firm’s D/E Ratio: 79% Mature risk premium 4% Country Risk Premium 5.82% Expected Growth in EBIT (1-t) .Reinvestment FCFF $4.60*.22% Reinvestment Rate=54.378 Firm Value: + Cash: .073 15.45% Weights E = 55.57 EBIT(1-t) .

Stable Growth Rate and Value In estimating terminal value for Tube Investments. If I used a 7% stable growth rate instead. I used a stable growth rate of 5%.) Aswath Damodaran 241 . what would my terminal value be? (Assume that the cost of capital and return on capital remain unchanged.

which management believes will increase the return on capital to 12.20% on just new investments (and not on existing investments) over the next 5 years. The value of the ﬁrm will be higher. Aswath Damodaran 242 . because of higher expected growth.The Effects of Return Improvements on Value The ﬁrm is considering changes in the way in which it invests.

90% Cost of Equity 22.470 $3.780 $2.82% Expected Growth in EBIT (1-t) .282 $2.765 0 84.32 % Return on Capital 12.60*.749 $2.188 $5.98% Terminal Value 5= 3904/(.0732 7.45% Weights E = 55.150 = FCFF .23% Unlevered Beta for Sectors: 0.073 20.122-= .711 3.8% D = 44.097 $3.23% Aswath Damodaran 243 .75 Firm’s D/E Ratio: 79% Mature risk premium 4% Country Risk Premium 5.300 $3.850 $1.2% Country Premium= 3% ROC=12.520 Discount at Cost of Capital (WACC) = 22.558) + 9.20% Stable Growth g = 5%.442) = 16.Tube Investments: Higher Marginal Return(in Rs) Current Cashflow to Firm Reinvestment Rate EBIT(1-t) : 4.653 18. Debt ratio = 44.Debt: =Equity -Options Value/Share 25.425 60% .348 $6.Chg WC 4.871 $3.522 $2.Nt CpX 843 .2% Riskfree Rate : Real riskfree rate = 12% + Beta 1. Beta = 1.34 Term Yr 6.1478-.80% Cost of Debt (12%+1.058 $2.45% (0.185 13.17 X Risk Premium 9.22% Reinvestment Rate= 40.568 Reinvestment Rate =112.900 $5.Reinvestment FCFF $4.039 $5.05) = 39.904 EBIT(1-t) .921 Firm Value: + Cash: .615 2.00.8% (.50%)(1-.30) = 9.

its value will increase even more.122-. The expected growth rate over the next 5 years will then have a second component arising from improving returns on existing assets: Expected Growth Rate = .20% from 9.20%.60 +{ (1+(.092)1/5-1} =.1313 or 13.Return Improvements on Existing Assets If Tube Investments is also able to increase the return on capital on existing assets to 12.092)/.13% Aswath Damodaran 244 .122*.

50%)(1-.98% Terminal Value 5= 5081/(.003 $5.22% Reinvestment Rate= 40.956 Firm Value: + Cash: .407 $3.920 $3.265 $6.280 Discount at Cost of Capital (WACC) = 22.Chg WC 4.13 % Return on Capital 12.006 $3.45% (0.558) + 9.1478-.122 + .23% Unlevered Beta for Sectors: 0.75 Firm’s D/E Ratio: 79% Mature risk premium 4% Country Risk Premium 5.610 3.568 Reinvestment Rate =112.8% D = 44.82% Expected Growth 60*. Debt ratio = 44.Tube Investments: Higher Average Return(in Rs) Current Cashflow to Firm Reinvestment Rate EBIT(1-t) : 4. Beta = 1.081 EBIT(1-t) .425 60% .829 13.073 27.004 $2.092) 1/5-1} Stable Growth g = 5%.Nt CpX 843 .8% (.Reinvestment FCFF $5.90% Cost of Equity 22.2% Country Premium= 3% ROC=12.1313 13.00.2% Riskfree Rate : Real riskfree rate = 12% + Beta 1.349 $2.80% Cost of Debt (12%+1.409 0 111.092)/.529 5.899 $8.30) = 9.248 $4.17 X Risk Premium 9.200 $4.20% Improvement on existing assets { (1+(.3 Term Yr 8.150 = FCFF .0581 = .398 $2.05) = 51.664 $3.45% Weights E = 55.23% Aswath Damodaran 245 .563 $7.653 18.Debt: =Equity -Options Value/Share 31.844 $2.122-.442) = 16.

Aswath Damodaran 246 . Latin American and many European companies have little or no power over the managers of the ﬁrm. Would you discount the value that you estimated to allow for this absence of stockholder power? Yes No. In many cases. insiders own voting shares and control the ﬁrm and the potential for conﬂict of interests is huge.Tube Investments and Tsingtao: Should there be a corporate governance discount? Stockholders in Asian.

17%/8.Embraer: An Emerging Market Company? A Valuation in October 2003 We will use a 2-stage FCFF model to value Embraer to allow for maximum ﬂexibility.04% 1.07 0.17% 4.93% 8.93% 21.00% 15.81% 5.27 5.67% 15.85% 9. High Growth Stable Growth Beta Lambda Counry risk premium Debt Ratio Return on Capital Cost of Capital Expected Growth Rate Reinvestment Rate 1.76% = 47.48% 25.76% 4.76% 8.62% Aswath Damodaran 247 .00 0.27 7.

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%

**Embraer: Status Quo ($)
**

Reinvestment Rate 25.08% Expected Growth in EBIT (1-t) .2185*.2508=.0548 5.48%

Return on Capital 21.85% 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% 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 2 449 113 336 3 474 119 355

4 500 126 374

5 527 132 395

Term Yr 549 - 261 = 288

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

Cost of Equity 10.52%

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

On October 6, 2003 Embraer Price = R$15.51 Weights E = 84% D = 16%

Riskfree Rate: $ Riskfree Rate= 4.17%

+

Beta 1.07

X

Mature market premium 4% Firm’s D/E Ratio: 19%

+

Lambda 0.27

X

Country Equity Risk Premium 7.67% Rel Equity Mkt Vol 1.28

Unlevered Beta for Sectors: 0.95

Country Default Spread 6.01%

X

Aswath Damodaran

248

**Embraer’s Cash and Cross Holdings
**

Embraer has a 60% interest in an equipment company and the ﬁnancial statements of that company are consolidated with those of Embraer. The minority interests (representing the equity in the subsidiary that does not belong to Embraer) are shown on the balance sheet at 23 million BR. Estimated market value of minority interests = Book value of minority interest * P/BV of sector that subsidiary belongs to = 23.12 *1.5 = 34.68 million BR or $11.88 million dollars. Present Value of FCFF in high growth phase = $1,342.97 Present Value of Terminal Value of Firm = $3,928.67 Value of operating assets of the ﬁrm = $5,271.64 + Value of Cash, Marketable Securities = $794.52 Value of Firm = $6,066.16 Market Value of outstanding debt = $716.74 - Minority Interest in consolidated holdings =34.68/2.92 = $11.88 Market Value of Equity = $5,349.42 - Value of Equity in Options = $27.98 Value of Equity in Common Stock = $5,321.44 Market Value of Equity/share = $7.47 Market Value of Equity/share in BR =7.47 *2.92 BR/$ = R$ 21.75

Aswath Damodaran

249

**Dealing with Distress
**

A DCF valuation values a ﬁrm as a going concern. If there is a signiﬁcant likelihood of the ﬁrm failing before it reaches stable growth and if the assets will then be sold for a value less than the present value of the expected cashﬂows (a distress sale value), DCF valuations will understate the value of the ﬁrm. Value of Equity= DCF value of equity (1 - Probability of distress) + Distress sale value of equity (Probability of distress) There are three ways in which we can estimate the probability of distress:

• • • Use the bond rating to estimate the cumulative probability of distress over 10 years Estimate the probability of distress with a probit Estimate the probability of distress by looking at market value of bonds..

The distress sale value of equity is usually best estimated as a percent of book value (and this value will be lower if the economy is doing badly and there are other ﬁrms in the same business also in distress).

Aswath Damodaran

250

Current Revenue $ 3,804

Current Margin: -49.82% EBIT -1895m

Stable Growth

Cap ex growth slows and net cap ex decreases Revenue Growth: 13.33% EBITDA/Sales -> 30% Stable Stable Revenue EBITDA/ Growth: 5% Sales 30% Stable ROC=7.36% Reinvest 67.93%

NOL: 2,076m

Revenues EBITDA EBIT EBIT (1-t) + Depreciation - Cap Ex - Chg WC FCFF Beta Cost of Equity Cost of Debt Debt Ratio Cost of Capital

**Terminal Value= 677(.0736-.05) =$ 28,683
**

$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 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% 3.00 16.80% 12.80% 74.91% 13.80% $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 2.60 15.20% 11.84% 67.93% 12.92% 2.20 13.60% 10.88% 60.95% 11.94% 1.80 12.00% 9.92% 53.96% 10.88% 1.40 10.40% 8.96% 46.98% 9.72% 1.00 8.80% 6.76% 40.00% 7.98% Term. Year $13,902 $ 4,187 $ 3,248 $ 2,111 $ 939 $ 2,353 $ 20 $ 677

Value of Op Assets $ + Cash & Non-op $ = Value of Firm $ - Value of Debt $ = Value of Equity $ - Equity Options $ Value per share $

5,530 2,260 7,790 4,923 2867 14 3.22

Forever

Cost of Equity 16.80%

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

Weights Debt= 74.91% -> 40%

Riskfree Rate: T. Bond rate = 4.8%

+

Beta 3.00> 1.10

X

Risk Premium 4%

Global Crossing November 2001 Stock price = $1.86

Internet/ Retail

Operating Leverage

Current D/E: 441%

Base Equity Premium

Country Risk Premium

Aswath Damodaran

251

**Valuing Global Crossing with Distress
**

Probability of distress

• Price of 8 year, 12% bond issued by Global Crossing = $ 653 t= 8 t 8

653 = $

• •

120(1" # Distress ) 1000(1" # Distress ) + t (1.05) (1.05) 8 t=1

Probability of distress = 13.53% a year Cumulative probability of survival over 10 years = (1- .1353)10 = 23.37% Book value of capital = $14,531 million Distress sale value = 15% of book value = .15*14531 = $2,180 million Book value of debt = $7,647 million Distress sale value of equity = $ 0 Value of Global Crossing = $3.22 (.2337) + $0.00 (.7663) = $0.75

**! Distress sale value of equity
**

• • • •

**Distress adjusted value of equity
**

•

Aswath Damodaran

252

The Dark Side of Valuation Aswath Damodaran http://www.nyu.stern.edu/~adamodar Aswath Damodaran 253 .

in valuing a software ﬁrm. in valuing Ford. we draw our information from.. • • The industry and comparable ﬁrm data • We often substitute one type of information for another. we have 70 years+ of historical data.To make our estimates. we might not have too much historical data but we have lots of comparable ﬁrms.. The ﬁrm’s current ﬁnancial statement • • How much did the ﬁrm sell? How much did it earn? How fast have the ﬁrm’s revenues and earnings grown over time? What can we learn about cost structure and proﬁtability from these trends? Susceptibility to macro-economic factors (recessions and cyclical ﬁrms) What happens to ﬁrms as they mature? (Margins. for instance. but not too many comparable ﬁrms. Aswath Damodaran 254 . Revenue growth… Reinvestment needs… Risk) The ﬁrm’s ﬁnancial history. usually summarized in its ﬁnancial statements.

they are all at the same stage of the life cycle as the ﬁrm being valued) Aswath Damodaran 255 .. Valuation is most difﬁcult when a company • • • Has negative earnings and low revenues in its current ﬁnancial statements No history No comparables ( or even if they exist.The Dark Side..

.NOLs Current Operating Margin Reinvestment Stable Growth Sales Turnover Ratio Revenue Growth Competitive Advantages Expected Operating Margin Stable Revenue Growth Stable Stable Operating Reinvestment Margin FCFF = Revenue* Op Margin (1-t) .No default risk ..Discounted Cash Flow Valuation: High Growth with Negative Earnings Current Revenue EBIT Tax Rate .Equity Options = Value of Equity in Stock FCFF1 FCFF2 FCFF3 FCFF4 Terminal Value= FCFF n+1 /(r-g n) FCFF5 FCFFn .....Measures market risk X Risk Premium .Value of Debt = Value of Equity .Reinvestment Value of Operating Assets + Cash & Non-op Assets = Value of Firm ..Premium for average risk investment Type of Business Operating Leverage Financial Leverage Base Equity Premium Country Risk Premium Aswath Damodaran 256 ..No reinvestment risk . Forever Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) Cost of Equity Cost of Debt (Riskfree Rate + Default Spread) (1-t) Weights Based on Market Value Riskfree Rate : .In same currency and in same terms (real or nominal as cash flows + Beta .

Hence we will use the beta of internet companies to begin the valuation but move the beta. after the ﬁrst ﬁve years.Amazon’s Bottom-up Beta Unlevered beta for ﬁrms in internet retailing = Unlevered beta for ﬁrms in specialty retailing = 1.60 1. towards the beta of the retailing business.00 Amazon is a specialty retailer. Aswath Damodaran 257 . but its risk currently seems to be determined by the fact that it is an online retailer.

We computed an average interest coverage ratio of 2. This yields an average rating of BBB for Amazon. In its simplest form.com for the ﬁrst 5 years. the rating can be estimated from the interest coverage ratio Interest Coverage Ratio = EBIT / Interest Expenses Amazon.82 over the next 5 years. the rating will be lower in the earlier years and higher in the later years than BBB) Aswath Damodaran 258 . (In effect.com has negative operating income.Estimating Synthetic Ratings and cost of debt The rating for a ﬁrm can be estimated using the ﬁnancial characteristics of the ﬁrm. this yields a negative interest coverage ratio. which should suggest a low rating.

00% 0% 0% 0% 16.75% 7.00% 8.00% 8. As the ﬁrm’s tax rate changes and its cost of debt changes.80% 7.00% 8.50% = 8.20% Aswath Damodaran 259 .50% + 1.50% Pre-tax cost of debt = Riskfree Rate + Default spread = 6. the after tax cost of debt will change as well.00% 8.1% 35% 35% 35% 35% 35% 35% 5.00% After-tax cost of debt right now = 8.50% 7. 1 2 3 4 5 6 7 8 9 10 8.71% 5.00% (1.00%: The ﬁrm is paying no taxes currently.07% 5.com is BBB.98% 4.67% 7.00% 6.55% Pre-tax Tax rate After-tax 8.00% 8.00% 7. The default spread for BBB rated bonds is 1.04% 4.Estimating the cost of debt The synthetic rating for Amazon.88% 4.0) = 8.00% 8.

50% + 1.00%) = 12.Estimating Cost of Capital: Amazon.988) + 8.com has a book value of equity of $ 138 million and a book value of debt of $ 349 million.60 (4.2%) Debt • • Cost of Capital Cost of Capital = 12.50% + 1. Aswath Damodaran 260 .012)) = 12.00% (1.0) (.00% Market Value of Debt = $ 349 mil (1. Shows you how irrelevant book value is in this process.50% (default spread) = 8.79 mil shs = $ 28.90% Market Value of Equity = $ 84/share* 340.9 % (.626 mil (98.com Equity • • Cost of Equity = 6.8%) Cost of debt = 6.84% Amazon.

One of the problems with using ﬁnancial statements is that they are dated.$125 million . As a general rule. Last 10-K Trailing 12-month Revenues $ 610 million $1. This rule becomes even more critical when valuing companies that are evolving and growing rapidly.$ 410 million Aswath Damodaran 261 . it is better to use 12-month trailing estimates for earnings and revenues than numbers for the most recent ﬁnancial year.Calendar Years.117 million EBIT . Financial Years and Updated Information The operating income and revenue that we use in valuation should be updated numbers.

If we adopt this rationale. It will also mean that they are reinvesting far more than we think they are. we should be computing earnings before these expenses. make not their cash ﬂows less negative. Should Amazon. however.Are S. which will make many of these ﬁrms proﬁtable.com’s selling expenses be treated as cap ex? Aswath Damodaran 262 . It will. G & A expenses capital expenditures? Many internet companies are arguing that selling and G&A expenses are the equivalent of R&D expenses for a high-technology ﬁrms and should be treated as capital expenditures.

058 35% $0 After year 5.038 $167 $871 16. Aswath Damodaran 263 . the tax rate becomes 35%.628 $570 $1.com’s Tax Rate Year 1 2 3 4 5 EBIT Taxes EBIT(1-t) Tax rate NOL -$373 $0 -$373 0% $500 -$94 $0 -$94 0% $873 $407 $0 $407 0% $967 $1.13% $560 $1.Amazon.

$410 million .(Capital Spending .Estimating FCFF: Amazon.tax rate) = .80 million Estimating FCFF (1999) Current EBIT * (1 .Change in Working Capital = -$ 80 million Current FCFF = .Depreciation) = $212 million .410 (1-0) = .com EBIT (Trailing 1999) = -$ 410 million Tax rate used = 0% (Assumed Effective = Marginal) Capital spending (Trailing 1999) = $ 243 million (includes acquisitions) Depreciation (Trailing 1999) = $ 31 million Non-cash Working capital Change (1999) = .$542 million Aswath Damodaran 264 .

19% Growth 150.59% 25.80% Revenue Investment $1.00% 50.62% -8.00 3.60% 10.868 $1.623 $4.40% 15.494 $3.16% 22.00 20.803 $1.00 3. Aswath Damodaran 265 .00 3.00 3.82% 21.629 $4.96% 20.601 $4.00% 30.887 $1.00 ROC -76.482 $1.Growth in Revenues.00 was based on what Amazon accomplished last year and the averages for the industry.00% 75.189 $1.20% 20.398 $1. Earnings and Reinvestment: Amazon Year 1 2 3 4 5 6 7 8 9 Revenue Chg in New Sales/Capital 3.39% The sales/capital ratio of 3.196 10 6.23% 22.676 $559 $2.00% 100.00% 25.00% $2.00 3.208 $736 3.466 $4.00 3.793 $931 $4.587 $1.00 3.396 $4.30% 21.00 3.87% 21.

com: Stable Growth Inputs High Growth • • • • • Beta Debt Ratio Return on Capital Expected Growth Rate Reinvestment Rate 1.Amazon.60 1.20% Negative NMF >100% Stable Growth 1.00 15% 20% 6% 6%/20% = 30% Aswath Damodaran 266 .

79 million Value of options outstanding (using dilution-adjusted Black-Scholes model) • Aswath Damodaran 267 .892 million $ 13.00% 0.4 years 50.50% 38 million 340.375 8.Estimating the Value of Equity Options Details of options outstanding • • • • • • • Average strike price of options outstanding = Average maturity of options outstanding = Standard deviation in ln(stock price) = Annualized dividend yield on stock = Treasury bond rate = Number of options outstanding = Number of shares outstanding = Value of equity options = $ 2.00% 6.

00% 35.892 Value per share $ 34.Value of Debt $ 349 = Value of Equity $14.50% 4.494 $625 8 12.396 -$989 3 12.438 $1.211 $3.370 $1.00% 8.00% 4.84% Forever Cost of Equity 12.00% 8.00% Stable Growth Stable Stable Operating Revenue Margin: Growth: 6% 10.5% + Beta 1.862 $2.06) =52.261 $2.212 $1.646 $2.96% 33.788 10 10.81% 23.15% 39.67% 4.585 -$94 -$94 $931 -$1.601 -$163 6 12.42% 7.793 -$373 -$373 $559 -$931 1 5.50% 7.90% 8.729 $2.881 Value of Op Assets $ 14.70% 7.00% Stable ROC=20% Reinvest 30% of EBIT(1-t) Terminal Value= 1881/(.524 $736 $1.90% 8.04% 11.629 -$758 4 12.00% 12.90% 8.024 2 12.83% 19.60 -> 1.Reinvestment: Current Revenue $ 1.88% 11.13% 28.2% -> 15% Riskfree Rate : T.84% 14.006 $3.80% 5.936 .910 + Cash $ 26 = Value of Firm $14.774 $407 $407 $1.84% 9.71% Cap ex includes acquisitions Working capital is 3% of revenues Sales Turnover Ratio: 3.00% 5.883 $2.Equity Options $ 2.0961-.55% 9.768 $1.00% 12.32 $2. Bond rate = 6.90% 8.119 $1.20% 12.90% Cost of Debt 6.148 Term.98% 11.0% Tax rate = 0% -> 35% Weights Debt= 1.5%+1.059 $1.5%=8.00 Revenue Growth: 42% Competitive Advantages Expected Margin: -> 10.117 EBIT -410m NOL: 500 m Revenues EBIT EBIT (1-t) .90% 8.661 $1.628 $1.196 $1.Reinvestment FCFF Current Margin: -36.038 $871 $1.com January 2000 Stock Price = $ 84 Internet/ Retail Operating Leverage Current D/E: 1.058 $1.00% 8.799 $1.466 -$408 5 12.00% $2.688 $ 807 $1.174 9 11.587 .10% 7.75% 5.346 10.623 $177 7 12. Year $41.21% Base Equity Premium Country Risk Premium Aswath Damodaran 268 .798 $3.07% 12.61% Cost of Equity Cost of Debt AT cost of debt Cost of Capital 12.30% 7.69% 36.00% 6.71% 12.00% 12.00 X Risk Premium 4% Amazon.

66 $ $ $ $ $ $ $ 12% 12.93 26.84 15.34 67.47 33.What do you need to break-even at $ 84? 30% 35% 40% 45% 50% 55% 60% $ $ $ $ $ $ $ 6% (1.50 59.33 25.22 $ $ $ $ $ $ $ 14% 17.21 45.84 156.05 59.10 12.53 $ $ $ $ $ $ $ 8% 2.37 15.41 6.77 78.74 40.52 85.59 21.54 53.57 29.53 111.48 97.71 22.47 49.72 120.60 85.54 137.95 8.77 Aswath Damodaran 269 .34 40.94) 1.95 191.27 35.10 $ $ $ $ $ $ $ 10% 7.

Reinvestment: Current Revenue $ 2. Bond rate = 5.com January 2001 Stock price = $14 Internet/ Retail Operating Leverage Current D/E: 37.509 $ 445 $1.10 X Risk Premium 4% Amazon.62% 8 23.09% 6.75 12.77% 3 27.310 Term.74 $24.566 $1.60% Cap ex includes acquisitions Working capital is 3% of revenues Sales Turnover Ratio: 3.81% 1.032 $24.912 $2.32% Stable ROC=16.25% 7 24.94% Reinvest 29.95% 6.18% 1.98% 9 21.18 13.406 $374 $1.81% 10.322 $1.1% + Beta 2.85% Tax rate = 0% -> 35% Weights Debt= 27.27% 2.018 $766 $252 $20.00% 1.53% 9.187 $687 $501 $22.10 9.133 $796 $337 $18.5% of EBIT(1-t) Terminal Value= 1064/(.5% Base Equity Premium Country Risk Premium Aswath Damodaran 270 .20% 1.18-> 1.00% 12.059 $54 $54 $857 -$803 $11.18 13.50% 4.81% 10.27% 2.27% 2.81% 9.85% 9.77% 4 27.00% 12.41% Competitive Advantages Expected Margin: -> 9.55% 8.064 1 Debt Ratio Beta Cost of Equity AT cost of debt Cost of Capital 27.465 EBIT -853m NOL: 1.81% 10.05) =$ 28.02 Revenue Growth: 25.22% 5.078 $9.028 $1.18 13.890 = Value of Equity $ 7. Year $4.289 m Revenues EBIT EBIT(1-t) .0876-.849 $1.11% 11.38% -> 15% Riskfree Rate : T.967 + Cash & Non-op $ 1.81% Cost of Debt 5.76% Forever Cost of Equity 13.Reinvestment FCFF Current Margin: -34.314 -$703 -$703 $612 -$1.77% 5 27.77% 2 27.06% 12.1%+4.32% Stable Growth Stable Stable Operating Revenue Margin: Growth: 5% 9.340 .318 $554 $764 $23.32 10.00% 12.96 12.912 $2.18 13.18 13.922 $1.315 $6.230 .726 $2.75%= 9.471 -$364 -$364 $714 -$1.27% 2.132 $898 $898 $780 $118 $16.52% 6 24.322 $1.064 Value of Op Assets $ 7.Equity Options $ 748 Value per share $ 18.509 $445 $1.01% 10.36% 5.34% 10 15.596 $2.13% 1.53 11.255 $1.81% 10.827 $1.263 = Value of Firm $ 9.00% 12.534 $1.Value of Debt $ 1.27% 2.777 $499 $499 $900 -$401 $14.164 $1.

417 $582 $836 9 1.30% 9.45% 12.772 $1.15 -> 1.780 $1.456 .84% 5.170 Term.35% 8.78% 8.70% + Beta 2.220 = Value of Equity $ 9.42% Beta Cost of Equity Cost of Debt AT cost of debt Cost of Capital 2.Equity Options $ 827 Value per share $ 23.96% 5.15 13.60% $17.669 + Cash $ 1007 = Value of Firm $11.683 $5 $5 $517 -$512 1 $6.23% 5.78% $19.224 $935 $818 $116 5 2.Reinvestment FCFF $4.122 EBIT -202m NOL: 2183 m Current Margin: -6.94 12.7%+4.56% $23.830 $1.790 $268 $268 $698 -$430 2 2.45% 9.08% Competitive Advantages Expected Margin: -> 9.15 13.95% $24. Year $26.15 13.497 $393 $1.31 9.303 $1.02 Revenue Growth: 23.713 $2.15 13.069 $2.22% 11.30% 9.351 $1.82% 10.22% $14.0842-.956 $2.32% Stable Revenue Growth: 4.74% 10.152 $804 $347 7 1.084 Value of Op Assets $ 10.506 $588 $588 $899 -$312 3 2.45% 12.45% 9.32% Stable ROC=15% Reinvest 31.17% $21.01 Revenues EBIT EBIT(1-t) .00 X Risk Premium 4% Amazon July 2002 Stock price =15.30% Cost of Debt 4.358 $926 $926 $944 -$19 4 2.181 $1.300 $720 $579 8 1.62% 8.30% 9.33% of EBIT(1-t) Terminal Value= 1084/(.7% Stable Growth Stable Operating Margin: 9.10 9.5% Base Equity Premium Country Risk Premium 271 .579 $495 $1.94% 8.45% 7.30% 9.676 .55% 8.22% $9.45% Tax rate = 0% -> 35% Weights Debt= 28% -> 15% Riskfree Rate: T.898 $2.73 11.430 $1.63% 5.45% 12.61% 9.52 10.30% 9.15 13.509 $981 $835 $146 6 1.045) = 29.000 $1. Bond rate = 4.46% 8.45% 9.104 10 1.45% 12.45% 9.50 Aswath Damodaran Internet/ Retail Operating Leverage Current D/E: 33.10% 7.75%=9.Value of Debt $ 2.22% $12.22% Forever Cost of Equity 13.48% Cap ex includes acquisitions Working capital is 3% of revenues Sales Turnover Ratio: 3.00% 4.Reinvestment: Current Revenue $ 3.

Amazon over time… Amazon: Value and Price $90.00 $0.00 $30.00 $80.00 Value per share Price per share $40.00 $50.00 $60.00 $20.00 $70.00 $10.00 2000 2001 Time of analysis 2002 2003 Aswath Damodaran 272 .

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