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Valuing a Business

It is not rocket science


Aswath Damodaran
http://www.damodaran.com

Aswath Damodaran

Misconceptions about Valuation

Myth 1: A valuation is an objective search for true value

Myth 2.: A good valuation provides a precise estimate of value

Truth 1.1: All valuations are biased. The only questions are how much and in
which direction.
Truth 1.2: The direction and magnitude of the bias in your valuation is directly
proportional to who pays you and how much you are paid.
Truth 2.1: There are no precise valuations
Truth 2.2: The payoff to valuation is greatest when valuation is least precise.

Myth 3: . The more quantitative a model, the better the valuation

Aswath Damodaran

Truth 3.1: Ones understanding of a valuation model is inversely proportional to


the number of inputs required for the model.
Truth 3.2: Simpler valuation models do much better than complex ones.

The Traditional Accounting Balance Sheet

The Balance Sheet


Assets

Liabilities
Fixed Assets

Current
Liabilties

Current Assets

Debt

Debt obligations of firm

Investments in securities &


assets of other firms

Financial Investments

Other
Liabilities

Other long-term obligations

Assets which are not physical,


like patents & trademarks

Intangible Assets

Equity

Equity investment in firm

Long Lived Real Assets


Short-lived Assets

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Short-term liabilities of the firm

The Financial View of the Firm

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

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Liabilities
Assets in Place

Debt

Growth Assets

Equity

Fixed Claim on cash flows


Little or No role in management
Fixed Maturity
Tax Deductible

Residual Claim on cash flows


Significant Role in management
Perpetual Lives

Four Ways of Valuing a Business

Requires least information, most imprecise but also quickest to do

Value based upon signals, cues and perceptions

Trust the accountants: Go with book value

Estimate a value based upon how similar assets were priced in the market

Estimate intrinsic value based upon firms fundamentals


Requires most information, most precise but also takes most resources

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I. Perceptions of Prosperity
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When we have little or no real information to work with, we are reduced to


assessing value based upon perceptions.
For better or worse, these perceptions are based upon what we see on the
surface - the location and look of the offices used by the business, the owners
possessions (suit, car).
In finance, we call these signals and signals are useful only when they
cannot be replicated at low cost by imposters.

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II. Trust the accountants


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The accounting measure of what a business is worth and what the equity
possessed by the owner is worth is in the balance sheet. The book value of
assets reflects the former and the book value of equity reflects the latter.
The advantage of using book value is that it is relatively easy to obtain for
almost any business - public or private.
The disadvantage of using book value is that is often not a reliable indicator of
the true value of either a business or its equity.

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When book value is likely to understate the true value..


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When a firms assets are kept off the books, for illegal or legal reasons.

If a firm consistently underreports income to the tax authorities, the book value is
likely to be a poor reflection of true value. (The illegal)
Accountants are also not entirely consistent in the way they treat spending. For
instance, they require firms to expense R&D expenditures rather than capitalize
them and show them as assets. This results in book values being understand for
technology firms.

When a big portion of a firms value comes from expected future growth:
Accounting statements reflect investments that a firm has already made rather
than investments it expects to make. Thus, the book value will be substantially
lower than market value for high growth firms.

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Tale of two companies


Con Eds Financial Balance Sheet
Assets
$ 15 billion

$ 3 billion

Liabilities

Investments already
made

Debt

Investments yet to
be made

Equity

$ 7 billion

$ 11 billion

EBays Financial Balance Sheet


Assets
$ 6 billion

$ 71.12 billion

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Liabilities

Investments already
made

Debt

Investments yet to
be made

Equity

$ 0.12 billion

$ 77 billion

III. Assess relative value


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One simple way to extend valuation is to bring in information from markets on


how similar assets are being priced in real transactions.
For real assets and collectibles, this is fairly simple to do. Real estate, for
instance, is often valued on this basis.
For financial assets and businesses, it is more complicated. There are no two
similar businesses and we often have to stretch the definition of comparable
firms.

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Steps in relative valuation


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Step 1: Find other companies similar to your business that have been sold/
bought.
Step 2: Obtain the transaction prices.
Step 3: Scale the transaction prices to some common variable:

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With real estate: Market price/square foot


With medical practices: Market price/ patient
With subscription based services: Market price/subscriber
In general: Market value/Revenues, Market value/ Earnings

Step 4: Estimate the value of your business based upon the scaled price
Step 5: Adjust the value for the specific characteristics of your business

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An Exercise in Relative Valuation


Q

Kristin Kandy

Revenues in 2004 = $ 500,000


Operating income after taxes = $ 160,000
Net Income = $ 150,000

Relative Valuation
Variable Used
Average for comparables
Value of Kristin Kandy
Revenue
3.00
3* 500,000 = $1.5 million
Operating Income 10.00
10*160,000 = $1.6 million
Net Income
12.00
12* 150,000 = $1.8 million
Q

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Limitations of relative valuation


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Finding comparable businesses if often difficult, if not impossible, to do.


Adjusting for differences across firms is often a subjective exercise, fraught
with bias and error.
Even if you can find comparable firms and can adjust for differences, you risk
building market mistakes into your valuation.

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IV. Estimate the intrinsic value of the business

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What is it: In discounted cash flow valuation, the value of an asset is the
present value of the expected cash flows on the asset.
Philosophical Basis: Every asset has an intrinsic value that can be estimated,
based upon its characteristics in terms of cash flows, growth and risk.
Information Needed: To use discounted cash flow valuation, you need

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to estimate the life of the asset


to estimate the cash flows during the life of the asset
to estimate the discount rate to apply to these cash flows to get present value.

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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.

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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

Liabilities

Assets in Place

Debt

Growth Assets

Equity

Fixed Claim on cash flows


Little or No role in management
Fixed Maturity
Tax Deductible

Residual Claim on cash flows


Significant Role in management
Perpetual Lives

Equity valuation: Value just the


equity claim in the business

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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

Growth Assets

Liabilities
Debt

Equity

Discount rate reflects only the


cost of raising equity financing

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

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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

Growth Assets

Liabilities
Debt

Equity

Discount rate reflects the cost


of raising both debt and equity
financing, in proportion to their
use

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

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Kristins Kandy: Status Quo


Current Cashflow to Firm
EBIT(1-t) :
300,000
- Nt CpX
100,000
- Chg WC
40,000
= FCFF
160,000
Reinvestment Rate = 46.67%

Return on Capital
13.64%

Reinvestment Rate
46.67%

Expected Growth
in EBIT (1-t)
.4667*.1364= .0636
6.36 %

Stable Growth
g = 4%; Beta =3.00;
ROC= 12.54%
Reinvestment Rate=31.90%

Terminal Value10 = 289/(.1254-.04) = 3,403


Year
EBIT (1-t)
- Reinvestment
=FCFF

Firm Value:
2,571
+ Cash
125
- Debt:
900
=Equity
1,796
Liq. Discount 12.5%
Equity value 1572

1
$319
$149
$170

2
$339
$158
$181

3
$361
$168
$193

4
$384
$179
$205

5
$408
$191
$218

Term Yr
425
136
289

Discount atCost of Capital (WACC) = 16.26% (.70) + 3.30% (.30) = 12.37%

Cost of Debt
(4.5%+1.00)(1-.40)
= 3.30%

Cost of Equity
16.26%

Weights
E =70% D = 30%

Synthetic rating = ABeta Correlation


0.98 0.33

Riskfree Rate :
Riskfree rate = 4.50%
(10-year T.Bond rate)

Total Beta
2.94

Unlevered Beta for


Sectors: 0.82

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Risk Premium
4.00%

Firms D/E
Ratio: 1.69%

Mature risk
premium
4%

Country Risk
Premium
0%

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Basic Propositions about valuation


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Proposition 1: The value of a business ultimately rests on its capacity to


generate large positive cashflows and to grow these cashflows.
Proposition 2: A business can be valuable (in terms of its assets owned), but
its equity can be worth nothing or very little.
Proposition 3: A growth business is always more difficult to value than a
mature business.
Proposition 4: The value of a business is volatile and will change from day to
day.

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