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The intrinsic value of a cash flow generating asset is a function of how long you

expect it to generate cfs as well as how large and predictable those cash flows are.
Dark Side of Valuation- first principle are abandoned, new paradigms are created,
and common sense is the casualty.
TO value the company we have to value both the investments already made and
growth assets, while factoring in the mix of debt and equity used to fund the
Determinants of Value:
4 questions
1. What are the cash flows that will be generated by the existing
investments of the company
2. How much value, if any, will be added by future growth
- Valuing growth assets will generally pose more challenges that valuing
existing assets, and there will be far more volatility in growth assets.
5. How risky are the expected cashflows from both existing and growth
investments and what is the cost of funding them.
a. Risk of the firm may change over time as its asset mix changes and
6. When will the firm become a stable growth firm, allowing us to estimate a
terminal value.
a. Look at the sector in which the firm operates
Interest Rates: Fundamental question: What can you expect to earn as a rate of
return on a riskless investment.
Equity risk premium: additional return that we assume that investors will demand
for investing in risk assets as a class, relative to the riskfree rate.
ERP economic shocks can change equity risk premiums and default spreads, ERP
we estimate for near term is different than estimate for the long term.
Issues for growth companies:

How well the revenue growth decline as the firm gets bigger
How profit margins will evolve over time as revenues grow
Assumptions about reinvestment to sustain revenue growth
Revenue growth and profit margins change over time as well as risk of
firm changes.

Intangibles: no reason why tools for physical assets cant be applied to intangibles.
Standard pattern he sees in valuation:

1. Base year fixation, may not reflect long term earnings capability,
2. Outsource key assumptions to outside source, results in inconsistent numbers
3. Trust management forecasts too biased.
Common Errors in valuation:

Ignoring scaling effect- hard to maintain high growth rates

Inconsistent numbers high growth will little reinvestment
Using anecdotal evidence, exceptions
Paradigm shifts rules have changed, be skeptical of this
Building bigger and more complex models. More detail = garbage in garbage
6. Using rules of thumb to ignore complexity
Post valuation havoc:
1. Adding arbitrary premiums and discounts to estimated value, adjs reflect
whatever preconceptions the analyst might have had about the company.
2. Market feedback: drift towards market price bc analyst is not confident.
Chapter 2 Intrinsic Valuation
Important that we look past uncertainty and market perceptions and gauge the
intrinsic value of an asset.
Can value the firm: the entire business with both existing assets and growth assets.
The cfs before debt payments and after reinvestment needs are termed free cash
flow to the firm and the discount rate is the cost of capital.
Can value just the equity: Cash flows after debt payment and after reinvestment are
Can always get from firm value to equity value by netting out the value of all nonequity claims from firm value.
Potential dividends: instead of just dividends, or dividends including buybacks, FCFE
are potential dividends
Cash tied up in non cash working capital, inventory and a/r, are wasting assets bc
they do not generate a return.
Risk: Two ways to think
1. Risk in a firms operating assets
2. Risk in the equity investment in this business
Growth comes from new investments and efficiency growth
Analysts often use the efficiency argument to justify much higher growth rates. Cant
happen forever.

Key assumption in the terminal value is not what growth rate you use but what
excess returns accompany that growth rate.
Cash: if cfs are based on operating income we have not valued cash yet and should
be added to present value. Net income already included cash income.
Cross holdings: FCFF: holdings are not included yet
Potential liabilities: pensions, health care, lawsuits have to subtract out these claims
to get to equity value
Chapter 4 Relative Valuation
First step is to ensure multiple is consistently defined .
Second step is to be aware of the cross sectional distribution.
Third step is to analyze the multiple and understand what fundamentals determine
the multiple but how changes in fund translate in changes in the multiple.
Have to have both equity measures or both firm measures.
Price to ebitda is not consistent. Firms with a lot of debt will look cheaper than no
debt firms.
Be aware of bias in p/e ratios. Firms with negative earnings will drop out. Hard to
compare to historical p/e.
Can go back to simple DCF models for equity and firm value to derive the multiple.
Multiple, Companion Variable, Valuation Mismatch
Pe ratio, expected growth, low pe with highe eps growth
Pb ratio, roe, low pb with high roe
Ps ratio, net margin, low ps with high net pm
Ev/ebitda, reinvestment rate, low ev/ebitda with low reinvestment rate
Ev/capital, roc, low ev/capital with high roc
Ev/sales, after tax om, low ev/sales with high after tax om
Peg ratio assume pe ratios and growth are linearly related, there are very few linear
relationships in valuation.

Chapter 6 RiskFree Rate

Chapter 7 Assessing the Price of Risk
While the actual equity risk premium can be negative, the expected risk premium
cannot: an investor who can receive 4% in a riskfree investment will not invest in
equities unless he believes that he can earn a higher return.
Over/under estimating risk premiums will not affect all valuations proportionately.
Growth company will move greater because the cfs are further in the future than
mature companies.
Chapter 8 Macro Matters: The real economy
The only reason that the currency you do a valuation in matters is because inflation
rates vary across currencies.
Biggest danger we face is building in estimates for the future that are unsustainable
for the long term. The expected inflation rate, in addition to affecting expected
earnings growth in a company, also will affect the riskfree rate.
Chapter 9 Start-up companies
By focusing on revenues and earnings and ignoring intermediate items, existing
owners will try to avoid having to flesh out the consequences in terms of future
capital investment.
Chapter 10 Growth Companies
The value of growth assets is a function of not only how much gorwht is anticipated
but also the excess returns that accompany that growth.
Operating numbers reflect the existing investments of the firm and these
investments may represent a very small portion of the overall value of the firm.
To value existing assets, we start with cfs generated by these assets and discount
back at an appropriate risk adj rate. Note: SGA expense may not just involve
existing assets but growth assets in a growth company.
Delineating the risk in each category can make a big difference in how we value
Terminal Value: make assessment of not only how quickly it will grow but also how it
will respond to more aggressive competition.
Value of equity per share: to get from the value of operating assets to the value of
equity per share, we generally add the cash and cross holdings, subtract out debt
and non-equity claims and divide by the number of shares.

The hazy line between operating and capital expenses at young firms can skew both
earnings and reinvestment numbers.
The focus on growth and earnings takes attention away from a critical variable: the
reinvestment that the firm will have to make to deliver this growth. There is a lack
of care is estimating excess returns. Given that the potential for efficiency growth is
small at growth firms, it is extremely unlikely that a firm can deliver double-digit
growth for extended periods of time without having to make substantial
investments in the business.
Rather than dealing with differences in growth rate quantitatively, analysts rely on
stories to justify higher multiples for higher growth companies. They are fuzzy on
how much more growth there is and what premium it justifies.
PEG: ignores the effects of risk and assumes pe increases with growth
When valuing growth companies, value the operating assets including both existing
assets and growth assets.
Estimate for reinvestment for growth firms early in life cycle: Reinvestment =
Change in revenues/(sales/capital)
Estiate for reinvestment for mature phase: Growth rate stable/Return on Capitalstable
Some use the fact that terminal value is 80-100% or the value against DCF. However
the base year for the terminal value calculation is a function of the assumptions
during the high growth phase; changing these assumptions will have a big effect on
From a valuation perspective, no difference between leases or sponsorships and
Growth company estimates will be less precise than for a mature company. This
comes not from the quality of the information or precision of the valuation model,
but from the real world. Future is full of suprises and for growth firms so much of the
value lies in the future.
Focus on the one or two key drivers of value for the company and look on the
effects of varying the assumptions and the breakeven points in terms of the current
Relative valuations techniques have to be adapted to meet the limitations of growth
companies the paucity and unreliability of current operating numbers and the
shifting risk/growth characteristics over time.
Analysts adopt short cuts that yield misleading results. They fail to adjust growth
rates as the company gets bigger, and make assumptions about risk and
reinvestment that are inconsistent with their own growth estimates.

Need to reflect market potential and competition; the cost of debt and equity are
likely to decrease as the firm goes from high growth to stable growth
Ch. 11 Mature Companies
Rather than focus on sales growth and operating measures, we can look at the
proportion of a frims value that comes from existing investments as opposed to
growth investments.
Mature companies get the bulk of their value from existing investments.
Mature firms reveal the most variation is in the competitive advantage that they
hold on to manifested by the excess returns that they generate on their
Key inputs into valuing existing assets is estimating the CFs they generate.
The notion that existing assets can be easily valued at mature companies b/c of
long operating history is defensible only at: 1. Well managed companies or 2. When
management is entrenched and wont change.
Reinvestment and ROC should reflect both organic and inorganic growth . Expected
growth rate = reinvestment rate x roc
If simply using the reinvestment numbers from the most recent FS, we will overstate
the value if there was a large acq during the period and understate the value if
period was in between acqs
Terminal Value: Since mature companies have growth rates close to that of the
economy, there are still 2 factors to deal with
1. Stable growth rate, but unstable risk and investment profile firm needs to
have risk profile of stable firm
2. Firm may not be managed optimally look for changes needed to CFs
When valuing acquisitive companies, analysts often use historical growth rate in
revenue and earnings as a bsis for future projections and use capex numbers
reported in the CF statement.
This is a mismatch. Growth in operating numbers reflects the acqs that a firm has
made but the capex numbers do not reflect the acqs.
Gives the companies the benefit of future acquisitions in the form of higher growth
without factoring gin the cost of making these acqs
The most damaging way to deal with management change is to arbitrarily add a
premium. Looking at the other companies and the premium paid for them ignores

the value of synergy and any overpayment. Market prices may also already reflect
the likelihood of mgmt change.
Growth and acqs
Assess if acqs are unusual of part of LT strategy
If part of LT strategy, collect data on cost of the acqs over 3-10 years
Estimate the reinvestment rate: Capex + acqs Depr/ after tax operating income
If we assume goodwill is the premium for growth assets. ROC = after tax operating
income/BV of debt+bv of equity cash +goodwill
Since income is generating by existing assets and not by growth assets, we remove
goodwill to preserve consistency. However, this is too generous for firms that
overpay. Leave in any goodwill due to synergy, control, overpayment.
Divestiture: real test is whether the divestiture value exceeds the value of
continuing in the business, if it is , divestiture makes sense. If its earnings poor
returns, buyer will not pay premium price for it.
Higher growth from new investment has to come from a higher reinvestment rate or
a higher ROC or both.
Managers of equity funded companies can become lazy b/c they can hide under
large CFs losses.
Myth: optimal debt ratios increase as interest rate declines
It does lower the cost of debt, but also lowers the cost of equity as well and its
relative costs that determine financing choices.
The difference between voting and nonvoting shares should go to zero if there is no
change of changing management or control.
Chapter 12 Winding Down: Declining Companies
Valuing companies in decline is a psychological one.
Declining companies get none or close to none of their value from gorwht assets.
They may actually lose money from growth investments. Telling sign of company in
decline is the inability to increase revenues over extended periods. Look of industry
overall is having weak revenues, if not than it is company specific.
Negative or shrinking margins because firms are losing pricing power and partly bc
they are dropping prices to keep revenues from falling further.
In many declining firms, existing assets are earnings less than their cost of capital.

Declining firms can be in denial about their status and continue to invest in new
If operating earnings drop below interest expense, the tax benefits of debt will also
dissipate, leading to further pressure upwards on the after tax cost of debt.
Cash balance today may bear little resemblance to the cahs balance reported in the
BS. Cash can deplete quickly. The market value of debt in distressed firms will trade
at a discount to the book value. Re-estimate the value of equity in this firm if acq by
healthy suitor who also assumes the debt. The value of debt will be revalued
towards book value , which holding the firm value constant will very quickly reduce
or even eliminate the value of equity.
Unlikely that declining firms will return to historic margins and excess returns and
infeasible for some.
Terminal value = after tax operating income (1+g)(1-reinvestment rate)/(cost of
capital g)
Valuing an airline at debt to cap of 90% and leaving it there while assuming airline
returns to profitability is internally inconsistent.
Divestiture follies
Need to be consistent and realistic on incorporating these cfs
Managers may overestimate what they will be able to get. Weak bargaining
position. Need to reflect the loss of earnings when including the cash proceeds in
their forecasts.
Cost of capital is not always responsive to distress. Risk of distress is a truncation
risk. Analysts use a postvaluation storytelling exercise to arbitrarily discount the
4 possible combinations :
Reversible decline, low distress
Irreversible decline, low distress
Reversible decline, high distress
Irreversible decline, high distress
It is worth noting the most troubled firms never turn it around and that righting the
ship is not easy.
An adjustment to the value that results from using a higher discount rate is only a
partial one. A significant portion of the firms current value still comes from the

terminal value. The biggest risk of distress is the loss of all future cfs is not
adequately captured in value.
Expected cfs would b emuch lower for a firm with a significantly probability of
distress. Contrary to conventional wisdom, this is not a risk adjustment. We are
doing what we should have been doing in the first place and estimating the
expected cfs correctly.
Equity is not worthless even if assets < liabilities bc there is the option value.
Chapter 13 Cyclical and Commodity Companies
Trying to forecast the next cycle is dangerous, far better to normalize earnings and
cash flows across the cycle.
Errors in valuation arise either because analysts choose to completely ignore the
economic or commodity price cycle or because they fixate too much on it.
Analysts with strong views on the economy and the direction of commodity prices
often find it difficult to leave their views behind when valuing these companies.
To normalize right, we have to carry it to an extreme. In addition to earnings, we
also have to normalize return on capital, reinvestment, and cost of financing. Most
analysts normalize earnings but leave the rest of the inputs at current year figures.
Safest way to remove our views of commodity prices from valuations of commodity
companies is to use market based prices for the commodity in our forecasts.
Chapter 14: Financial Service Companies
Difficult to define both debt and reinvestment. Debt for a fin service firm is more like
a raw material than a source of capital; the notion of cost of capital and enterprise
value may be meaningless as a consequence.
Because of mark to market, book equity measures not what was originally invested
in assets but an updated value.
Fin Service firms invest in intangibles like brand name and human capital. These are
charged as expenses so banks show little or no capital expen and low depr.
Reinvestment should include investment in regulatory capital, acqs, in order to
NWC can yield strange numbers in any given year and is not reliable.
If assets are truly marked to market, the roe on every assets should be equal to the
cost of equity; there is nothing to distinguish firms from making good investments
from those making bad investments.

BV of equity is much more likely to track the market value of equity invested in
existing assets.
Chapter 15 Intangible Assets
Reinvestment made by the firm is often buried in the operating expesnses rather
than showing up separately as capex. ROE and ROC measures are then unreliable.
Biggest problem with treating capex as operating expenses is that we lose the most
potent tool that we have for not only estimating growth but also for checking for
internal consistency; the growth rates we use for a firm hav eto be consistent with
our estimates of reinvestment and return on capital for that firm. Anaylsts make
their own judgments on future growth, based either on history or conversations with
the managers of the company. There is a tendency to over estimate growth during
good times and under estimate growth in bad times.
We have to make an assumption about how long it takes for R&D to be converted,
on average, into commercial products. This is the amortizable life of these assets.
Adjusted operating income = operating income + R&D expenses amortization of
research asset.
Chapter 16: Emerging Markets
Problems: family owned, different voting rights, cross holdings, legal restrictions
and absence of access to capital. Analysts double or triple count risks: higher
riskfree rate, higher risk premiums, and haircutting expected cashflows.
People pay too much attention to where a company is incorporated and too little to
where it does business.
Often times people ignore weak corporate governance rules when things are going
well and then overrely on them when things go bad.
Expected inflation rate built into our discount rate matches the inflation rate implicit
in our cash flows.
Chapter 17: Multi-business, global companies
Ignoring centralized costs, while valuing divisions based upon pre-allocation
divisional earnings or revenues will lead to significant overvaluation.
Minority interest need to be valued at market value, not book value.
Dealing with cash: To the extent that stockholders anticipate such sub-standard
investments, the current market value of the firm will reflect the cash at a
discounted level.
Chapter 18: Vanquishing the Dark Side

An analyst who argues that firms can grow forever without reinvesting is violating a
first principle, as is one who says risk does not matter in determining value.
Continuous risk is best caputured in discount rate, whereas discrete risk is more
earily measured by assessing both the probablility and the consequences of the
event occurring.
Ultimately, the expected growth in earnings and cash flows in a company have to
come either from new investments or improved efficiency. The latter is finite growth
there is a limit to how efficient you can become as a firm. That is the reason why
growth in the terminal value computation is estimated purely from new investments
in every valuation done in this book.
Do not be wedded to the past:
Trust in mean reversion, but watch out for structural breaks and changes.