Valuation

Aswath Damodaran

Aswath Damodaran

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First Principles

Q

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

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

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

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

Objective: Maximize the Value of the Firm
Aswath Damodaran

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

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

Aswath Damodaran

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Equity Valuation

Q

The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm.
t=n CF to Equity t Value of Equity = ∑ (1+ k e )t t=1

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

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

Aswath Damodaran

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Firm Valuation

Q

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

Value of Firm =

CF to

Firm t
t=1 (1+ WACC) t

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

Aswath Damodaran

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.. Forever Discount Rate Firm:Cost of Capital Equity: Cost of Equity Aswath Damodaran 191 ....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 ....

At an intutive level. Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. Discount Rates Q Q Q Critical ingredient in discounted cashflow valuation. Aswath Damodaran 192 . The cost of equity is the rate at which we discount cash flows to equity (dividends or free cash flows to equity).Estimating Inputs: I. the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. The cost of capital is the rate at which we discount free cash flows to the firm.

49 (1+ (1-.Estimating Aracruz’s Cost of Equity Q Average Unlevered Beta for Paper and Pulp firms is 0.61 Q Aracruz has a cash balance which was 20% of the market value in 1997. Premium + Brazil Risk (from rating)) Aswath Damodaran 193 .5%) = 10.5% (U.71 (7.8) ( 0.71 Q Cost of Equity for Aracruz = Real Riskfree Rate + Beta(Premium) = 5% + 0.61) + 0. which is much higher than the typical cash balance at other paper and pulp firms.488 Q Using Aracruz’s gross debt equity ratio of 66. Unlevered Beta for Aracruz = (0. The beta of cash is zero.33% Real Riskfree Rate = 5% (Long term Growth rate in Brazilian economy) Risk Premium = 7.67% and a tax rate of 33%: Levered Beta for Aracruz = 0.2 (0) = 0.33) (.6667)) = 0.S.

commercial banking and investment banking.5%) = 12.90) + 0.94 (5.30)= 0. Q To estimate its commercial banking beta.94 Q Cost of Equity for Deutsche Bank (in DM) = 7. Q To estimate the investment banking beta. we will use the average bet of investment banks in the U.S and U.S.90 90% U. Comparable Firms Average Beta Weight Commercial Banks in Germany 0. investment banks 1.5% + 0.9 (.1 (1. we will use the average beta of commercial banks in Germany.67% Aswath Damodaran 194 . and U.K.Estimating Cost of Equity: Deutsche Bank Q Deutsche Bank is in two different segments of business .30 10% Q Beta for Deutsche Bank = 0.K.

90 1.50% 5.97% D/E Ratio Levered Beta 1.00% 7.61% 13.92% 20.92% 59.42 1.00% 7.50 0.50% Cost of Equity 14.02 1.50% 5.92% 20.31% 13.50% 5.50% Aswath Damodaran 195 .92% 20.25 1.91% 12.10 0.00% 7.Reviewing Disney’s Costs of Equity & Debt Business Creative Content Retailing Broadcasting Theme Parks Real Estate Disney Q Unlevered Beta 1.00% Risk Premium 5.70 1.50% 5.00% 7.35% 12.26 0.25 Riskfree Rate 7.80% 16.00% 7.27% 21.70 1.50% 5.09 20.92 1.85% Disney’s Cost of Debt (based upon rating) = 7.

18) = 12.50% (1-.22% Aswath Damodaran 196 .85%(.Estimating Cost of Capital: Disney Q Equity • Cost of Equity = • Market Value of Equity = • Equity/(Debt+Equity ) = 13.80%(.88 Billion 82% 7.80% $ 11.85% $50.82)+4.18 Billion 18% Q Cost of Capital = 13.36) = Q Debt • After-tax Cost of debt = • Market Value of Debt = • Debt/(Debt +Equity) = 4.

Depreciation) . Estimating Cash Flows Cash Flows To Equity To Firm The Strict View Dividends + Stock Buybacks The Broader View Net Income .( Cap Ex .Net Cap Ex (1-Debt Ratio) .II.Change in Working Capital = Free Cashflow to Firm Aswath Damodaran 197 .Debt Ratio) = Free Cashflow to Equity EBIT (1-t) .Chg WC (1 .

I used the average earnings per share from 1992 to 1996.18 BR/share Q Change in Working Capital = 0. Working Capital*(1-DR) BR 0.03 BR/share Debt Ratio = 39% Q Aswath Damodaran 198 .24 BR/share Q Depreciation per share next year = 0.042 -Chg.018 Free Cashflow to Equity BR 0.170 Q Earnings: Since Aracruz’s 1996 earnings are “abnormally” low.222 .Estimating FCFE next year: Aracruz All inputs are per share numbers: Earnings BR 0.(CapEx-Depreciation)*(1-DR) BR 0. Q Capital Expenditures per share next year = 0.

Change in WC $ 617 = FCFF $ 2.559 Million Capital spending = $ 1.134 Million Increase in Non-cash Working capital = $ 617 Million Estimating FCFF EBIT (1-t) $ 3.558 + Depreciation $ 1.746 Million Depreciation = $ 1.329 Million Aswath Damodaran 199 .134 .Capital Expenditures $ 1.746 .Estimating FCFF: Disney Q Q Q Q Q EBIT = $5.

If using statement of cash flows EBIT (1-t) EBIT (1-t) + Depreciation + Depreciation . Application Test: Estimating your firm’s FCFF Q Estimate the FCFF for your firm in its most recent financial year: In general.Change in Non-cash WC + Change in Non-cash WC = FCFF = FCFF Estimate the dollar reinvestment at your firm: Reinvestment = EBIT (1-t) .Capital Expenditures + Capital Expenditures .FCFF Aswath Damodaran 200 .

For Disney. If a firm’s debt ratio is not expected to change over time. For financial service firms. we will discount free cash flows to equity. we will discount the free cash flow to the firm. the free cash flows to equity can be discounted to yield the value of equity. it is difficult to estimate free cash flows. we will be discounting dividends. free cash flows to equity become cumbersome to estimate. For Aracruz. the only cash flow that you can discount is dividends. we would discount free cash flows to the firm. Aswath Damodaran 201 .Choosing a Cash Flow to Discount Q Q Q When you cannot estimate the free cash fllows to equity or the firm. For Deutsche Bank. Here. If a firm’s debt ratio might change over time.

III.Dividends/Net Income X Return on Equity Net Income/Book Value of Equity Reinvestment Rate = (Net Cap Ex + Chg in WC/EBIT(1-t) X Return on Capital = EBIT(1-t)/Book Value of Capital Aswath Damodaran 202 . Expected Growth Expected Growth Net Income Operating Income Retention Ratio= 1 .

Aswath Damodaran 203 .Expected Growth in EPS • gEPS = Retained Earningst-1/ NIt-1 * ROE = Retention Ratio * ROE = b * ROE Proposition 1: The expected growth rate in earnings for a company cannot exceed its return on equity in the long term.

91% Deutsche Bank 7.81% 2.00% Exp Growth 19. the forecast ROE is set equal to the average ROE for German banks Aswath Damodaran 204 .25% 39.04% 6.42% 9.00% 45. forecasted ROE is expected to be close to current ROE • For Aracruz.30% • For Disney.Estimating Expected Growth in EPS: Disney.38% 25% Aracruz 2.00% 1.89% 14. since 1996 was a abnormally bad year • For Deutsche Bank.68% 19.22% 65.44% 13.68% 65.00% ROE: Return on Equity for most recent year Forecasted ROE = Expected ROE for the next 5 years Retention Ratio 77. the average ROE between 1994 and 1996 is used.95% 77. Forecast Ratio Growth ROE Disney 24. Aracruz and Deutsche Bank Company ROE Retention Exp.

i (1-t)) where.ROE and Leverage Q ROE = ROC + D/E (ROC .t) / Book Value of Capital D/E = BV of Debt/ BV of Equity i = Interest Expense on Debt / Book Value of Debt t = Tax rate on ordinary income Note that BV of Capital = BV of Debt + BV of Equity. Q Aswath Damodaran 205 .tax rate)) / Book Value of Capital = EBIT (1. ROC = (EBIT (1 .

69% Q Debt Equity Ratio = Book Value of Debt/ Book Value of Equity= 45% Q Interest Rate on Debt = 7.69 % + .45 (18.Decomposing ROE: Disney in 1996 Q Return on Capital = (EBIT(1-tax rate) / (BV: Debt + BV: Equity) = 5559 (1-.69% .95% Aswath Damodaran 206 .7.36)/ (7663+11668) = 18.50% Q Expected Return on Equity = ROC + D/E (ROC .50(1-.i(1-t)) = 18.36)) = 24.

Aswath Damodaran 207 .Expected Growth in EBIT And Fundamentals Q Q Q Reinvestment Rate and Return on Capital gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC Proposition 2: No firm can expect its operating income to grow over time without reinvesting some of the operating income in net capital expenditures and/or working capital. for a given growth rate. Proposition 3: The net capital expenditure needs of a firm. should be inversely proportional to the quality of its investments.

adding in the Capital Cities acquisition to all capital expenditures would have yielded a reinvestment rate of roughly 50%.69%) Expected Growth in EBIT =.5% Forecasted Reinvestment Rate = 50% Return on Capital =20% (Higher than this year’s 18.Estimating Growth in EBIT: Disney Actual reinvestment rate in 1996 = (Net Cap Ex+ Chg in WC)/ EBIT (1-t) • • • • Q Q Q Q Net Cap Ex in 1996 = (1745-1134) Change in Working Capital = 617 EBIT (1.tax rate) = 5559(1-. Between 1992 and 1996.36) Reinvestment Rate = (1745-1134+617)/(5559*.5(20%) = 10% The forecasted reinvestment rate is much higher than the actual reinvestment rate in 1996. Aswath Damodaran 208 . because it includes projected acquisition.64)= 34.

based upon these inputs Aswath Damodaran 209 . Application Test: Estimating Expected Growth Q Estimate the following: • The reinvestment rate for your firm • The after-tax return on capital • The expected growth in operating income.

we estimate cash flows for a “growth period” and then estimate a terminal value.IV. t = ∞ CF t Value = ∑ t t = 1 (1+ r) Q Since we cannot estimate cash flows forever. The value is therefore the present value of cash flows forever. to capture the value at the end of the period: t = N CF Terminal Value t Value = ∑ + t (1 + r) N t = 1 (1 + r) Aswath Damodaran 210 . Getting Closure in Valuation Q A publicly traded firm potentially has an infinite life.

r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate Q Q Q 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 valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.g) where.Stable Growth and Terminal Value Q When a firm’s cash flows grow at a “constant” rate forever. Aswath Damodaran 211 . When they do approach stable growth. they will all approach “stable growth” at some point in time. 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 .

In general. in which case the firm is already in stable growth • there will be high growth for a period. and the pattern of growth during that period.Growth Patterns Q A key assumption in all discounted cash flow models is the period of high growth. at the end of which the growth rate will decline gradually to a stable growth rate(3-stage) Q The assumption of how long high growth will continue will depend upon several factors including: • the size of the firm (larger firm -> shorter high growth periods) • current growth rate (if high -> longer high growth period) • barriers to entry and differential advantages (if high -> longer growth period) Aswath Damodaran 212 . 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. we can make one of three assumptions: • there is no high growth.

Length of High Growth Period Q R R R Assume that you are analyzing two firms. which of the two firms would you expect to have a longer high growth period? Earthlink Network Biogen Both are well managed and should have the same high growth period Aswath Damodaran 213 . which operates in an environment with few barriers to entry and extraordinary competition. an internet service provider. a biotechnology firm which is enjoying growth from two drugs to which it owns patents for the next decade. both of which are enjoying high growth. The first firm is Earthlink Network. Assuming that both firms are well managed. The second firm is Biogen.

5 years (2-stage) economy Aracruz Real BR Equity: FCFE Deutsche Bank Nominal DM 0 years Equity: Dividends 5%: based upon expected long term real growth rate for Brazilian economy 5%: set equal to nominal growth rate in the world economy Aswath Damodaran 214 .Choosing a Growth Pattern: Examples Company Disney Valuation in Nominal U.S.S. $ Firm Growth Period Stable Growth 10 years 5%(long term (3-stage) nominal growth rate in the U.

Firm Characteristics as Growth Changes Variable Risk Dividend Payout Net Cap Ex Return on Capital Leverage High Growth Firms tend to be above-average risk pay little or no dividends have high net cap ex earn high ROC (excess return) have little or no debt Stable Growth Firms tend to be average risk pay high dividends have low net cap ex earn ROC closer to WACC higher leverage Aswath Damodaran 215 .

in stable growth. • Leverage is a tougher call. use current leverage. in which case we assume that the firm will stop earning excess returns on its projects as a result of competition.Estimating Stable Growth Inputs Q Start with the fundamentals: • Profitability measures such as return on equity and capital. While industry averages can be used here as well. it depends upon how entrenched current management is and whether they are stubborn about their policy on leverage (If they are. in which case we assume that this firm in stable growth will look like the average firm in the industry – cost of equity and capital. Aswath Damodaran 216 . can be estimated by looking at – industry averages for these measure. use industry averages) Q Use the relationship between growth and fundamentals to estimate payout and net capital expenditures. if they are not.

25% of after-tax operating income. assume that Disney in stable growth will grow 5% and that its return on capital in stable growth will be 16%. The reinvestment rate will then be: Reinvestment Rate for Disney in Stable Growth = 5/16 = 31.Estimating Stable Period Net Cap Ex gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC Q Moving terms around.25% In other words. Q • the net capital expenditures and working capital investment each year during the stable growth period will be 31. Aswath Damodaran 217 . Reinvestment Rate = gEBIT / Return on Capital Q For instance.

30% { I used the normalized numbers for this] Cost of equity = 7.. Growth is close to stable growth already) • Dividend Discount Model (FCFE is tough to estimate) Q Valuation • Expected Dividends per Share next year = 2.063) = 42.67%.Valuation: Deutsche Bank Q Q Q Q Sustainable growth at Deutsche Bank = ROE * Retention Ratio = 14% (.73 DM • Value per Share = 2.45) = 6.73 DM / (.5%) = 12.1267 .89 DM Q Deutsche Bank was trading for 119 DM on the day of this analysis.94 (5. Aswath Damodaran 218 .61 DM (1.063) = 2. Current Dividends per share = 2.61 DM Model Used: • Stable Growth (Large firm.5% + 0.

What does the valuation tell us? Q Q Q Stock is tremendously overvalued: This valuation would suggest that Deutsche Bank is significantly overvalued. Aswath Damodaran 219 . TheFCFE could have been significantly higher than the dividends paid. Dividends may not reflect the cash flows generated by Deutsche Bank. thus reducing our estimate of value. given our estimates of expected growth and risk. Estimates of growth and risk are wrong: It is also possible that we have underestimated growth or overestimated risk in the model.

Valuation: Aracruz Cellulose Q Q Q The current earnings per share for Aracruz Cellulose is 0. we use the average earnings per share between 1994 and 1996 of 0. To normalize earnings.204 BR per share as a measure of the normalized earnings per share. These earnings are abnormally low. Model Used: • Real valuation (since inflation is still in double digits) • 2-Stage Growth (Firm is still growing in a high growth economy) • FCFE Discount Model (Dividends are lower than FCFE: See Dividend section) Aswath Damodaran 220 .044 BR.

5%) = 10.24 BR and deprec’n will be 0. Rf=5%) (Assumes beta moves to 1) Net Capital Expenditures Net capital ex grows at same Capital expenditures are assumed rate as earnings. Debt Ratio 39. Working Capital 32. to be 120% of depreciation capital ex will be 0.71 (7.15% of Revenues. Aswath Damodaran 221 .5% (Beta =0. Next year.33% 5% + 1(7.Aracruz Cellulose: Inputs for Valuation High Growth Phase Stable Growth Phase Length 5 years Forever.5%) = 12.71.01% of net capital ex and working capital investments come from debt.18 BR.65 * 13. 32.15% of Revenues.18% Cost of Equity 5% + 0.91%= 8. after year 5 Expected Growth Retention Ratio * ROE 5% (Real Growth Rate in Brazil) = 0. Revenues grow at same rate as earnings in both periods.

147 The present value is computed by discounting the FCFE at the current cost of equity of 10.33%.149 BR 0.060 BR 0. Working Capital*(1-DR) Free Cashflow to Equity Present Value BR 0.202 BR 0.170 BR 0. Aswath Damodaran 222 .046 BR 0.243 BR 0.269 BR 0.055 BR 0.052 BR 0.(CapEx-Depreciation)*(1-DR) -Chg.014 BR 0.Aracruz: Estimating FCFE for next 5 years 1 Earnings .010 BR 0.013 BR 0.241 BR 0.221 BR 0.150 4 5 Terminal BR 0.222 BR 0.264 BR 0.330 BR 0.042 BR 0.012 BR 0.008 BR 0.152 3 BR 0.186 BR 0.011 BR 0.288 BR 0.154 2 BR 0.050 BR 0.314 BR 0.

269/(.150 + 0.147 + 3.59/1. Aswath Damodaran 223 .94 BR Q Q The stock was trading at 2.152 + 0.149 + 0.59 BR • Value per Share = 0. • Terminal Value = 0.Aracruz: Estimating Terminal Price and Value per share Q The terminal value at the end of year 5 is estimated using the FCFE in the terminal year.33%.10335 = 2.05) = 3.154 + 0.125-. discount this value per share back to the present at the cost of equity of 10. The value per share is based upon normalized earnings.40 BR in September 1997. To the extent that it will take some time to get to normal earnings. • The FCFE in year 6 reflects the drop in net capital expenditures after year 5.

Disney Valuation Q Model Used: • Cash Flow: FCFF (since I think leverage will change over time) • Growth Pattern: 3-stage Model (even though growth in operating income is only 10%. there are substantial barriers to entry) Aswath Damodaran 224 .

25% of after-tax operating $ 1. and is assumed Reinvestment Rate = g/ROC to grow at same rate as earnings 20% * .00.25% as ROC and 31. Depreciation in 1996 is growth rates drop: income.00.67% of revenues. ke = 13. based upon overall nominal economic growth Stable debt ratio of 30% Beta decreases linearly to 1. Cost of debt stays at 7.Disney: Inputs to Valuation High Growth Phase Length of Period Revenues 5 years Transition Phase 5 years Stable Growth Phase Forever after 10 years Current Revenues: $ 18.25. Stable beta is 1. Continues to grow at same rate Grows at stable growth rate Expected to grow at same rate a as operating earnings operating earnings Pre-tax Operating Margin 29. 36% Declines linearly to 16% 5% of Revenues 36% Tax Rate Return on Capital Working Capital Reinvestment Rate Investments/EBIT) Expected Growth Rate in EBIT Debt/Capital Ratio Risk Parameters 36% 20% (approximately 1996 level) 5% of Revenues Stable ROC of 16% 5% of Revenues 50% of after-tax operating Declines to 31.739.5% (Long Term Bond Rate = 7%) Rate Increases linearly to 30% Cost of debt stays at 7. revenues.5% (Net Cap Ex + Working Capital income. due to economies of 32%.559 million. scale. this is estimated from the growth rate of 5% Reinvestment rate = g/ROC ROC * Reinvestment Rate = Linear decline to Stable Growth 5%. based upon Increases gradually to 32% of Stable margin is assumed to be 1996 EBIT of $ 5.88% Cost of Debt = 7.5 = 10% 18% Beta = 1.5% Aswath Damodaran 225 .134 million.

941 5.370 $ 19.71% 31.139 $ 5.372 $ 3.53% 32.912 $ 10.726 $ 7.431 $ 2.379 $ 20% 50% 29.613 $ 22.67% 10% 10% 10% 10% 1 2 3 4 5 10% 6 9% 7 8% 8 7% 9 10 6% 5% $ 18.464 $ 5.209 $ 1.77% 5.932 $ 18.115 $ 6.134 $ 1.674 $ 24.558 $ 8.966 $ 20% 50% $ 1.67% 29.552 $ 17.809 $ 12.132 $ 8.879 $ 20% 30.67% 29.101 $ $ 1.210 $ 5.07% 31.67% 8.4% 43.103 $ 132 $ 3.399 $ 4.13% 30.67% 8.559 $ 6.706 $ 13.6% 39.730 $ 1.548 124 $ 114 $ 101 4. Margin EBIT EBIT (1-t) + Depreciation .344 $ 2.665 2.8% 16% 35.009 $ 4.539 6.163 20% 50% $ 3.310 29.754 $ 3. Rate 20% $ 1.Change in WC $ = FCFF ROC Reinv.48% 7.228 $ 5.Capital Exp.957 16.871 $ 11.875% 6.953 $ 5.914 $ 4.00% 9.313 $ 5.Disney: FCFF Estimates Base Expected Growth Revenues Oper.558 $ 3.25% Aswath Damodaran 226 .942 $ 27.826 $ 4.436 $ 30.674 $ 2.014 $ 40.957 $ 2.540 $ 137 $ 2.411 $ 103 $ 2.779 $ 94 $ 94 $ 1.67% 29.509 $ 3.660 $ 4.527 $ 38.247 $ 1.60% 31.2% 50% 46.128 $ 125 $ 2.752 $ 113 $ $ 2.735 $ 1.305 $ $ 5.617 $ 20% 50% 29.895 $ 35.295 $ 42.739 $ 20.847 $ 136 $ 3. .179 $ 32.

80% 4.00% 18.40% 22.88% 13.00% 18.00% 18.88% 13.05% 12.97% 10.80% 4.33% 13.80% 4.00% 18.80% 4.38% 10.80% 4.78% 12.80% 4.24% 12.80% 4.80% 4.80% 11.80% 18.24% 12.50% Cost of Debt Debt Ratio 4.24% 11.88% 13.88% 13.80% 25.24% 12.19% Aswath Damodaran 227 .24% 12.60% 30.20% 27.00% 20.60% 13.Disney: Costs of Capital Year 1 2 3 4 5 6 7 8 9 10 Cost of Equity 13.00% Cost of Capital 12.88% 13.57% 10.80% 4.

19% Terminal Value = $ 6.Disney: Terminal Value Q Q Q Q Q The terminal value at the end of year 10 is estimated based upon the free cash flows to the firm in year 11 and the cost of capital in year 11.539 (1.255/(.539 (1.05) = $ 120..05) (1-.05) (1-.255 million Note that the reinvestment rate is estimated from the cost of capital of 16% and the expected growth rate of 5%.521 million Aswath Damodaran 228 .$ 13.36) (. Cost of Capital in terminal year = 10.EBIT (1-t) Reinvestment Rate = $ 13.36) .3125) = $ 6.1019 . FCFF11 = EBIT (1-t) .

228 $ 5.920 42.932 $ 4.24% 12.552 $ 5.80% 11.682 $1.849 $ 1.616 $ 1.Disney: Present Value Year FCFF Term Value Present Value Cost of Capital 1 2 3 4 5 6 7 8 9 10 $ 1.24% 12.163 $ 2.617 $ 2.773 $ 1.167 12.24% 11.379 $ 2.370 $ 3.879 $ 3.692 $1.38% 10.717 $ 1.966 $ 2.57% 10.752 $ 1.24% 12.24% 12.19% Aswath Damodaran 229 .97% 10.521 $ 1.649 $1.957 120.

Confirm the present value of the FCFF in year 7.Present Value Check Q The FCFF and costs of capital are provided for all 10 years. Aswath Damodaran 230 .

817 million $ 0 (almost no non-operating cash) $ 11.08 Aswath Damodaran 231 .13 $ 69.637 million 675.Value of Debt = = Value of Equity = / Number of Shares Value Per Share = $ 57.180 million $ 46.Disney: Value Per Share Value of the Firm = + Value of Cash = .

5% Country Risk Premium 0% Aswath Damodaran 232 .36) = 4.20 = .00 Debt ratio rises to 30% Weights E = 82% D = 18% Cost of Equity 13.932 4.163 2.00% Cashflow to Firm EBIT(1-t) : 3.879 3. D/(D+E) = 30%.80% Riskfree Rate : Government Bond Rate = 7% + Beta 1.18) = 12.Disney: A Valuation Reinvestment Rate 50.95% Historical US Premium 5.00 % Return on Capital 20% Stable Growth g = 5%.379 2.329 Expected Growth in EBIT (1-t) .5% Unlevered Beta for Sectors: 1.Nt CpX 612 .637 Per Share: 69.25% 2. ROC=16% Reinvestment Rate=31.817 .00.82) + 4.11.966 2.50%)(1-.957 Forever Discount at Cost of Capital (WACC) = 13.552 5.08 1.85% Cost of Debt (7%+ 0.Chg WC 617 = FCFF 2.180= 46.09 Firm’s D/E Ratio: 21.617 Terminal Value 10 = 6255/(.1019-.25% 57.10 10.22% Transition Beta drops to 1. rate drops to 31. Beta = 1.521 ROC drops to 16% Reinv.8% (0.50*.558 .85% (0.05) = 120.228 5.25 X Risk Premium 5.370 3.

708 Aswath Damodaran FCFF Terminal Value $ 1.682 $ 1.379 $ 2.957 $ 7.914 $ 4.817 $11.773 $ 1.752 $ 1.851 $ 2.762 $ 3.00% Cost of Capital = 10. and matches the assets being financed.558 $ 8.67% Return on Capital = 16% Beta = 1.966 $ 2.637 $ 69.649 $ 1. return the cash to the owners Reinvestment Rate 50% The Financing Decision Choose a financing mix that maximizes the value of the projects taken.947 $ 2.Value of Debt = = Value of Equity Value of Disney/share = PV $ 1.196 $ 4.717 $ 1.228 $ 5.879 $ 3.22% Transition to stable growth inputs Year 1 2 3 4 5 6 7 8 9 10 EBIT(1-t) $ 3. Return on Capital 20.849 $ 1.920 $ 42.552 $ 5.344 $ 6.558 million Expected Growth = ROC * RR = .142 $ 2.132 $ 8.866 $ 2.50 * 20%= 10% Cost of Capital 12.19% 233 .00% Equity: Beta=1.180 $ 46.356 $ 2.957 $ 120.974 $ 2.305 $ 4.616 $ 1.08 In stable growth: Reinvestment Rate=31.163 $ 2.209 $ 5.Determine the business risk of the firm (Beta.904 $ 2.167 $ 57. Default Risk) The Investment Decision Invest in projects that yield a return greater than the minimum acceptable hurdle rate The Dividend Decision If there are not enough investments that earn the hurdle rate.521 Value of Disney = .692 $ 1.730 $ 6.343 $ 2.370 $ 4.735 $ 5.25 Debt:: Default Risk Current EBIT(1-t) = $3.006 $ 2.00 Debt Ratio = 30.665 Reinvestment $ 1.

Cash Flow multiples) • Price/Sales ratios Aswath Damodaran 234 . book value or revenues. the value of an asset is derived from the pricing of 'comparable' assets. Examples include -• Price/Earnings (P/E) ratios • Price/Book (P/BV) ratios – and variants (Tobin's Q) – and variants (EBIT multiples. standardized using a common variable such as earnings.Relative Valuation Q In relative valuation. cashflows. EBITDA multiples.

Multiples and Fundamenals P0 = DPS1 Q Q r − gn Gordon Growth Model: Dividing both sides by the earnings. Payout Ratio * (1 + g n ) P0 = PE = EPS0 r-g n Q Dividing both sides by the book value of equity. Profit Margin * Payout Ratio * (1 + g n ) P0 = PS = Sales0 r-g n Aswath Damodaran 235 .g n P0 = PBV = BV 0 r-g n Q Dividing by the Sales per share. ROE * Payout Ratio * (1 + g n ) P0 = PBV = BV 0 r-g n Q If the return on equity is written in terms of the retention ratio and the expected growth rate ROE .

9 12.8 20.79 1.49 0.92 1.Disney: Relative Valuation Company King World Productions Aztar Viacom All American Communications GC Companies Circus Circus Enterprises Polygram NV ADR Regal Cinemas Walt Disney AMC Entertainment Premier Parks Family Golf Centers CINAR Films Average Aswath Damodaran PE 10.00% 18.48 1.00% 20.8 27.2 20.00% 13.5 32.00% 12.6 25.4 11.20 236 .00% 25.18 0.55 1.8 22.74 1.1 48.12 1.35 1.94 1.1 15.00% 15.9 29.22 1.9 33.19 Expected Growth 7.00% 28.00% 20.00% 23.4 22.99 0.67 0.00% 36.00% 18.56% PEG 1.00% 17.00% 18.

over or correctly valued? Under Valued Over Valued Correctly Valued Based upon the PEG ratio. is Disney under.Is Disney fairly valued? Q R R R Q R R R Q R R Based upon the PE ratio. is Disney under valued? Under Valued Over Valued Correctly Valued Will this valuation give you a higher or lower valuation than the discounted CF valutaion? Higher Lower Aswath Damodaran 237 .

fairly priced The earnings of the firms in the group are being measured consistently The firms in the group are all of equivalent risk The firms in the group are all at the same stage in the growth cycle The firms in the group are of equivalent risk and have similar cash flow patterns All of the above Aswath Damodaran 238 . Implicitly. what is the underlying assumption or assumptions being made by this analyst? The sector itself is.Relative Valuation Assumptions Q R R R R R R Assume that you are reading an equity research report where a buy recommendation for a company is being based upon the fact that its PE ratio is lower than the average for the industry. on average.

they should also consider both positive and negative side effects of these projects. If there are not enough investments that earn the hurdle rate.dividends and stock buybacks . • The form of returns .will depend upon the stockholders’ characteristics. return the cash to stockholders. Q Q Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows. Objective: Maximize the Value of the Firm Aswath Damodaran 239 . • The hurdle rate should be higher for riskier projects and reflect the financing mix used .First Principles Q Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

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