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Aswath Damodaran
where
the
asset
has
a
n-year
life,
E(CFt)
is
the
expected
cash
ow
in
period
t
and
r
is
a
discount
rate
that
reects
the
risk
of
the
cash
ows.
Aswath Damodaran
If
the
value
of
an
asset
is
the
risk-adjusted
present
value
of
the
cash
ows:
1.
2.
3.
The
IT
proposiJon:
If
IT
does
not
aect
the
expected
cash
ows
or
the
riskiness
of
the
cash
ows,
IT
cannot
aect
value.
The
DUH
proposiJon:
For
an
asset
to
have
value,
the
expected
cash
ows
have
to
be
posiJve
some
Jme
over
the
life
of
the
asset.
The
DONT
FREAK
OUT
proposiJon:
Assets
that
generate
cash
ows
early
in
their
life
will
be
worth
more
than
assets
that
generate
cash
ows
later;
the
laRer
may
however
have
greater
growth
and
higher
cash
ows
to
compensate.
Aswath Damodaran
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
Aswath Damodaran
Equity
ValuaJon
6
Assets in Place
Growth Assets
Liabilities
Debt
Equity
Aswath Damodaran
Firm
ValuaJon
7
Assets in Place
Growth Assets
Liabilities
Debt
Equity
Present value is value of the entire firm, and reflects the value of
all claims on the firm.
Aswath Damodaran
a.
b.
c.
d.
a.
b.
c.
Aswath Damodaran
CF
to
Firm
$
90
$
100
$
108
$
116.2
$
123.49
$
2363.008
Assume
also
that
the
cost
of
equity
is
13.625%
and
the
rm
can
borrow
long
term
at
10%.
(The
tax
rate
for
the
rm
is
50%.)
The
current
market
value
of
equity
is
$1,073
and
the
value
of
debt
outstanding
is
$800.
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11
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12
1.
1.
2.
3.
2.
3.
4.
5.
Discount
rate
can
be
either
a
cost
of
equity
(if
doing
equity
valuaJon)
or
a
cost
of
capital
(if
valuing
the
rm)
Discount
rate
can
be
in
nominal
terms
or
real
terms,
depending
upon
whether
the
cash
ows
are
nominal
or
real
Discount
rate
can
vary
across
Jme.
EsJmate
the
current
earnings
and
cash
ows
on
the
asset,
to
either
equity
investors
(CF
to
Equity)
or
to
all
claimholders
(CF
to
Firm)
EsJmate
the
future
earnings
and
cash
ows
on
the
rm
being
valued,
generally
by
esJmaJng
an
expected
growth
rate
in
earnings.
EsJmate
when
the
rm
will
reach
stable
growth
and
what
characterisJcs
(risk
&
cash
ow)
it
will
have
when
it
does.
Choose
the
right
DCF
model
for
this
asset
and
value
it.
Aswath Damodaran
13
Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS
Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows
Terminal Value
Value
Firm: Value of Firm
CF1
CF2
CF3
CF4
CF5
CFn
.........
Forever
Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity
Aswath Damodaran
14
Input
Dividend
Discount
Model
FCFE
(Poten;al
FCFF
(rm)
dividend)
discount
valua;on
model
model
Cash ow
Dividend
PotenJal
dividends
=
FCFE
=
Cash
ows
aper
taxes,
reinvestment
needs
and
debt
cash
ows
Expected growth
In
equity
income
and
dividends
In
equity
income
and
FCFE
In
operaJng
income
and
FCFF
Discount rate
Cost of equity
Cost of equity
Cost of capital
Steady state
When
dividends
grow
at
constant
rate
forever
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15
Expected
growth in net
income
Net Income
* Payout ratio
= Dividends
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Retention ratio
needed to
sustain growth
Stable Growth
When net income and
dividends grow at constant
rate forever.
16
Expected growth in
net income
Free Cashflow to Equity
Non-cash Net Income
- (Cap Ex - Depreciation)
- Change in non-cash WC
- (Debt repaid - Debt issued)
= Free Cashflow to equity
Equity reinvestment
needed to sustain
growth
Stable Growth
When net income and FCFE
grow at constant rate forever.
Cost of equity
Rate of return
demanded by equity
investors
Aswath Damodaran
17
Expected growth in
operating ncome
Free Cashflow to Firm
After-tax Operating Income
- (Cap Ex - Depreciation)
- Change in non-cash WC
= Free Cashflow to firm
Reinvestment
needed to sustain
growth
Stable Growth
When operating income and
FCFF grow at constant rate
forever.
Cost of capital
Weighted average of
costs of equity and
debt
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Equity
versus
Firm:
If
the
cash
ows
being
discounted
are
cash
ows
to
equity,
the
appropriate
discount
rate
is
a
cost
of
equity.
If
the
cash
ows
are
cash
ows
to
the
rm,
the
appropriate
discount
rate
is
the
cost
of
capital.
Currency:
The
currency
in
which
the
cash
ows
are
esJmated
should
also
be
the
currency
in
which
the
discount
rate
is
esJmated.
Nominal
versus
Real:
If
the
cash
ows
being
discounted
are
nominal
cash
ows
(i.e.,
reect
expected
inaJon),
the
discount
rate
should
be
nominal
Aswath Damodaran
21
Risk Adjusted
Cost of equity
Aswath Damodaran
Relative risk of
company/equity in
questiion
22
EsJmaJon
uncertainty
reects
the
possibility
that
you
could
have
the
wrong
model
or
esJmated
inputs
incorrectly
within
this
model.
Economic
uncertainty
comes
the
fact
that
markets
and
economies
can
change
over
Jme
and
that
even
the
best
models
will
fail
to
capture
these
unexpected
changes.
Micro
uncertainty
refers
to
uncertainty
about
the
potenJal
market
for
a
rms
products,
the
compeJJon
it
will
face
and
the
quality
of
its
management
team.
Macro
uncertainty
reects
the
reality
that
your
rms
fortunes
can
be
aected
by
changes
in
the
macro
economic
environment.
Discrete
risk:
Risks
that
lie
dormant
for
periods
but
show
up
at
points
in
Jme.
(Examples:
A
drug
working
its
way
through
the
FDA
pipeline
may
fail
at
some
stage
of
the
approval
process
or
a
company
in
Venezuela
may
be
naJonalized)
ConJnuous
risk:
Risks
changes
in
interest
rates
or
economic
growth
occur
conJnuously
and
aect
value
as
they
happen.
Aswath Damodaran
23
Not
all
risk
counts:
While
the
noJon
that
the
cost
of
equity
should
be
higher
for
riskier
investments
and
lower
for
safer
investments
is
intuiJve,
what
risk
should
be
built
into
the
cost
of
equity
is
the
quesJon.
Risk
through
whose
eyes?
While
risk
is
usually
dened
in
terms
of
the
variance
of
actual
returns
around
an
expected
return,
risk
and
return
models
in
nance
assume
that
the
risk
that
should
be
rewarded
(and
thus
built
into
the
discount
rate)
in
valuaJon
should
be
the
risk
perceived
by
the
marginal
investor
in
the
investment
The
diversicaJon
eect:
Most
risk
and
return
models
in
nance
also
assume
that
the
marginal
investor
is
well
diversied,
and
that
the
only
risk
that
he
or
she
perceives
in
an
investment
is
risk
that
cannot
be
diversied
away
(i.e,
market
or
non-diversiable
risk).
In
eect,
it
is
primarily
economic,
macro,
conJnuous
risk
that
should
be
incorporated
into
the
cost
of
equity.
Aswath Damodaran
24
Inputs
Needed
Riskfree
Rate
Beta
relaJve
to
market
porvolio
Market
Risk
Premium
Riskfree
Rate;
#
of
Factors;
Betas
relaJve
to
each
factor
Factor
risk
premiums
Riskfree
Rate;
Macro
factors
Betas
relaJve
to
macro
factors
Macro
economic
risk
premiums
Proxies
Regression
coecients
25
In
pracJce,
Government
security
rates
are
used
as
risk
free
rates
Historical
risk
premiums
are
used
for
the
risk
premium
Betas
are
esJmated
by
regressing
stock
returns
against
market returns
Aswath Damodaran
26
I.
A
Riskfree
Rate
27
1.
2.
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27
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29
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30
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31
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32
33
Moody's
CDS
Spread
CDS
Spread
Country
ra;ng
adj
for
US
Aa2
Caa1
Aaa
Aaa
Baa2
Aa3
Baa2
Baa2
Aa3
Aa3
Baa2
Ba1
Ba1
B3
A1
Caa1
A1
Aaa
Aa1
Aaa
Caa1
Aa1
1.43%
83.48%
0.97%
0.81%
3.18%
1.20%
3.17%
2.99%
1.77%
1.78%
2.57%
3.58%
3.65%
6.35%
1.25%
3.56%
1.20%
0.81%
1.22%
0.74%
10.76%
1.12%
Aswath Damodaran
1.12%
83.17%
0.66%
0.50%
2.87%
0.89%
2.86%
2.68%
1.46%
1.47%
2.26%
3.27%
3.34%
6.04%
0.94%
3.25%
0.89%
0.50%
0.91%
0.43%
10.45%
0.81%
Hungary
Iceland
India
Indonesia
Ireland
Israel
Italy
Japan
Kazakhstan
Korea
Latvia
Lebanon
Lithuania
Malaysia
Mexico
Netherlands
New
Zealand
Norway
Pakistan
Panama
Peru
Philippines
Moody's
CDS
Spread
CDS
Spread
Country
ra;ng
adj
for
US
Ba1
Baa3
Baa3
Baa3
Baa1
A1
Baa2
A1
Baa2
Aa3
Baa1
B2
Baa1
A3
A3
Aaa
Aaa
Aaa
Caa1
Baa2
A3
Baa2
2.64%
2.27%
2.64%
2.82%
1.26%
0.42%
2.34%
1.55%
4.16%
1.17%
1.92%
4.69%
1.88%
2.15%
2.05%
0.78%
1.01%
0.61%
10.41%
2.09%
2.23%
1.98%
2.33%
1.96%
2.33%
2.51%
0.95%
0.11%
2.03%
1.24%
3.85%
0.86%
1.61%
4.38%
1.57%
1.84%
1.74%
0.47%
0.70%
0.30%
10.10%
1.78%
1.92%
1.67%
Poland
Portugal
Qatar
Romania
Russia
Saudi
Arabia
Slovakia
Slovenia
South
Africa
Spain
Sweden
Switzerland
Thailand
Tunisia
Turkey
Ukraine
United
Arab
Emirates
United
Kingdom
United
States
of
America
Venezuela
Vietnam
Moody's
CDS
Spread
CDS
Spread
ra;ng
adj
for
US
A2
Ba1
Aa2
Baa3
Baa2
Aa3
A2
Ba1
Baa2
Baa2
Aaa
Aaa
Baa1
Ba3
Baa3
Caa3
Aa2
Aa1
Aaa
Caa1
B1
1.46%
3.09%
1.57%
2.23%
5.63%
1.39%
1.32%
2.14%
2.96%
1.79%
0.65%
0.72%
1.91%
3.38%
2.77%
15.74%
1.54%
0.77%
0.31%
18.06%
3.15%
1.15%
2.78%
1.26%
1.92%
5.32%
1.08%
1.01%
1.83%
2.65%
1.48%
0.34%
0.41%
1.60%
3.07%
2.46%
15.43%
1.23%
0.46%
0.00%
17.75%
2.84%
34
Aswath Damodaran
Sovereign
Rating
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
Default Spread
over riskfree
0.00%
0.40%
0.50%
0.60%
0.70%
0.85%
1.20%
1.60%
1.90%
2.20%
2.50%
3.00%
3.60%
4.50%
5.50%
6.50%
7.50%
9.00%
10.00%
35
Aswath Damodaran
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Aswath Damodaran
37
Do
the
analysis
in
a
currency
where
you
can
get
a
riskfree
rate,
say
US
dollars
or
Euros.
Aswath Damodaran
38
2.
0.00%
-2.00%
Japanese
Yen
Czech
Koruna
Swiss
Franc
Euro
Danish
Krone
Swedish
Krona
Taiwanese
$
Hungarian
Forint
Bulgarian
Lev
Kuna
Thai
Baht
BriJsh
Pound
Romanian
Leu
Norwegian
Krone
HK
$
Israeli
Shekel
Polish
Zloty
Canadian
$
Korean
Won
US
$
Singapore
$
Phillipine
Peso
Pakistani
Rupee
Venezuelan
Bolivar
Vietnamese
Dong
Australian
$
Malyasian
Ringgit
Chinese
Yuan
NZ
$
Chilean
Peso
Iceland
Krona
Peruvian
Sol
Mexican
Peso
Colombian
Peso
Indonesian
Rupiah
Indian
Rupee
Turkish
Lira
South
African
Rand
Kenyan
Shilling
Reai
Naira
Russian
Ruble
40
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
Aswath Damodaran
40
b.
c.
Aswath Damodaran
41
15.00%
10.00%
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
1958
1956
0.00%
1954
5.00%
-5.00%
Aswath Damodaran
42
Arithmetic Average
Geometric Average
2.17%
2.32%
1965-2014
6.19%
4.12%
4.84%
3.14%
2.42%
2.74%
2005-2014
7.94%
4.06%
6.18%
2.73%
6.05%
8.65%
Aswath Damodaran
43
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44
5.70%
5.30%
5.30%
5.40%
5.10%
5.00%
4.50%
3.90%
4.00%
3.00%
3.50%
2.90%
2.40%
3.20%
3.40%
2.60%
2.10%
3.40%
3.90%
3.10%
2.40%
2.20%
2.10%
3.30%
3.30%
2.90%
Stocks
-
ST
Government
Stocks
-
LT
Government
2.00%
1.00%
0.00%
Aswath Damodaran
45
Aswath Damodaran
46
Aswath Damodaran
47
Aswath Damodaran
48
Andorra
8.15%
2.40%
Italy
Austria
5.75%
0.00%
Jersey
Belgium
6.65%
0.90%
Liechtenstein
Cyprus
15.50%
9.75%
Luxembourg
Denmark
5.75%
0.00%
Malta
Finland
5.75%
0.00%
Netherlands
France
6.35%
0.60%
Norway
Germany
5.75%
0.00%
Portugal
Greece
17.00%
11.25%
Spain
Guernsey
6.35%
0.60%
Sweden
Iceland
9.05%
3.30%
Switzerland
Ireland
8.15%
2.40%
Turkey
Isle
of
Man
6.35%
0.60%
UK
W.
Europe
Canada
5.75%
US
5.75%
North
America
5.75%
ArgenJna
Belize
Bolivia
Brazil
Chile
Colombia
Costa
Rica
Ecuador
El
Salvador
Guatemala
Honduras
Mexico
Nicaragua
Panama
Paraguay
Peru
Suriname
Uruguay
Venezuela
La;n
America
0.00%
0.00%
0.00%
17.00%
19.25%
11.15%
8.60%
6.65%
8.60%
9.50%
15.50%
11.15%
9.50%
15.50%
7.55%
15.50%
8.60%
10.25%
7.55%
11.15%
8.60%
17.00%
9.95%
11.25%
13.50%
5.40%
2.85%
0.90%
2.85%
3.75%
9.75%
5.40%
3.75%
9.75%
1.80%
9.75%
2.85%
4.50%
1.80%
5.40%
2.85%
11.25%
4.20%
Angola
Botswana
Burkina
Faso
Cameroon
Cape
Verde
Congo
(DR)
Congo
(Republic)
Cte
d'Ivoire
Egypt
Ethiopia
Gabon
Ghana
Kenya
Morocco
Mozambique
Namibia
Nigeria
Rwanda
Senegal
South
Africa
Tunisia
Uganda
Zambia
Africa
8.60%
6.35%
5.75%
5.75%
7.55%
5.75%
5.75%
9.50%
8.60%
5.75%
5.75%
9.05%
6.35%
6.88%
2.85%
0.60%
0.00%
0.00%
1.80%
0.00%
0.00%
3.75%
2.85%
0.00%
0.00%
3.30%
0.60%
1.13%
10.25%
4.50%
7.03%
1.28%
15.50%
9.75%
14.00%
8.25%
14.00%
8.25%
15.50%
9.75%
11.15%
5.40%
12.50%
6.75%
17.00%
11.25%
12.50%
6.75%
11.15%
5.40%
14.00%
8.25%
12.50%
6.75%
9.50%
3.75%
12.50%
6.75%
9.05%
3.30%
11.15%
5.40%
14.00%
8.25%
12.50%
6.75%
8.60%
2.85%
11.15%
5.40%
12.50%
6.75%
12.50%
6.75%
11.73%
5.98%
Albania
Armenia
Azerbaijan
Belarus
Bosnia
12.50%
10.25%
9.05%
15.50%
15.50%
6.75%
4.50%
3.30%
9.75%
.75%
Montenegro
Poland
Romania
Russia
Serbia
11.15%
7.03%
9.05%
8.60%
12.50%
5.40%
1.28%
3.30%
2.85%
6.75%
Bulgaria
CroaJa
8.60%
9.50%
2.85%
Slovakia
3.75%
Slovenia
7.03%
9.50%
1.28%
3.75%
Czech
Repub
Estonia
Georgia
Hungary
Kazakhstan
Latvia
Lithuania
Macedonia
Moldova
6.80%
6.80%
11.15%
9.50%
8.60%
8.15%
8.15%
11.15%
15.50%
1.05%
Ukraine
20.75%
1.05%
E.
Europe
9.08%
5.40%
Bangladesh
3.75%
Cambodia
2.85%
China
2.40%
Fiji
2.40%
Hong
Kong
5.40%
India
9.75%
Indonesia
Japan
Korea
Macao
Abu
Dhabi
6.50%
0.75%
Malaysia
Bahrain
8.60%
2.85%
MauriJus
Israel
6.80%
1.05%
Mongolia
Jordan
12.50%
6.75%
Pakistan
Kuwait
6.50%
0.75%
Papua
New
Guinea
Lebanon
14.00%
8.25%
Philippines
Oman
6.80%
1.05%
Singapore
Qatar
6.50%
0.75%
Sri
Lanka
Ras
Al
Khaimah
7.03%
1.28%
Taiwan
Saudi
Arabia
6.65%
0.90%
Thailand
Sharjah
7.55%
1.80%
Vietnam
UAE
6.50%
0.75%
Asia
Middle
East
6.85%
1.10%
15.00%
3.33%
11.15%
14.00%
6.65%
12.50%
6.35%
9.05%
9.05%
6.80%
6.65%
6.50%
7.55%
8.15%
14.00%
17.00%
12.50%
8.60%
5.75%
12.50%
6.65%
8.15%
12.50%
7.26%
5.40%
8.25%
0.90%
6.75%
0.60%
3.30%
3.30%
1.05%
0.90%
0.75%
1.80%
2.40%
8.25%
11.25%
6.75%
2.85%
0.00%
6.75%
0.90%
2.40%
6.75%
1.51%
Australia
5.75%
0.00%
Cook
Islands
New
Zealand
12.50%
5.75%
6.75%
0.00%
Australia & NZ
5.75%
0.00%
Approach
3:
Treat
country
risk
as
a
separate
risk
factor
and
allow
rms
to
have
dierent
exposures
to
country
risk
(perhaps
based
upon
the
proporJon
of
their
revenues
come
from
non-domesJc
sales)
Aswath Damodaran
50
Aswath Damodaran
51
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52
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54
Aswath Damodaran
55
rm
56
40
100
80
60
Return on Embrat el
Return on Embraer
20
-20
40
20
0
-20
-40
-40
-60
-60
-30
-80
-20
-10
Return on C-Bond
Aswath Damodaran
10
20
-30
-20
-10
10
20
Return on C-Bond
57
Assume
that
the
beta
for
Embraer
is
1.07,
and
that
the
US
$
riskfree
rate
used
is
4%.
Also
assume
that
the
risk
premium
for
the
US
is
5%
and
the
country
risk
premium
for
Brazil
is
7.89%.
Finally,
assume
that
Embraer
gets
3%
of
its
revenues
in
Brazil
&
the
rest
in
the
US.
There
are
ve
esJmates
of
$
cost
of
equity
for
Embraer:
Aswath Damodaran
58
Aswath Damodaran
59
Aswath Damodaran
60
We
can
use
the
informaJon
in
stock
prices
to
back
out
how
risk
averse
the
market
is
and
how
much
of
a
risk
premium
it
is
demanding.
Between 2001 and 2007
dividends and stock
buybacks averaged 4.02%
of the index each year.
65.08
68.33
71.75
January 1, 2008
S&P 500 is at 1468.36
4.02% of 1468.36 = 59.03
If
you
pay
the
current
level
of
the
index,
you
can
expect
to
make
a
return
of
8.39%
on
stocks
(which
is
obtained
by
solving
for
r
in
the
following
equaJon)
1468.36 =
61.98 65.08
68.33
71.75
75.34
75.35(1.0402)
+
+
+
+
+
(1+ r) (1+ r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r .0402)(1+ r) 5
Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 8.39% - 4.02% = 4.37%
Aswath Damodaran
61
a.
b.
a.
b.
a.
b.
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
earnings
jump
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
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62
1148.09
879.82
1111.91
1211.92
1248.29
1418.30
1468.36
903.25
903.25
Dividends
15.74
15.96
17.88
19.01
22.34
25.04
28.14
28.47
28.47
Buybacks
14.34
13.87
13.70
21.59
38.82
48.12
67.22
40.25
24.11
January 1, 2009
S&P 500 is at 903.25
Adjusted Dividends &
Buybacks for 2008 = 52.58
Aswath Damodaran
903.25 =
Total yield
2.62%
3.39%
2.84%
3.35%
4.90%
5.16%
6.49%
7.77%
5.82%
63
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64
100.5 growing @
5.58% a year
112.01
106.10
118.26
124.85
131.81
Beyond year 5
Expected growth rate =
Riskfree rate = 2.17%
Expected CF in year 6 =
131.81(1.0217)
Aswath Damodaran
65
4.00%
3.00%
Implied Premium
6.00%
5.00%
2.00%
1.00%
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967
1966
1965
1964
1963
1962
1961
1960
0.00%
Year
66
Aswath Damodaran
20.00%
15.00%
10.00%
5.00%
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
0.00%
T. Bond Rate
Aswath Damodaran
67
9.00
8.00
6.00%
7.00
6.00
4.00%
5.00
3.00%
4.00
3.00
Premium (Spread)
5.00%
2.00%
2.00
1.00%
1.00
0.00%
0.00
ERP/Baa Spread
Aswath Damodaran
ERP
68
Figure
17:
Equity
Risk
Premiums,
Cap
Rates
and
Bond
Spreads
8.00%
6.00%
4.00%
2.00%
0.00%
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
ERP
Baa
Spread
Cap
Rate
premium
-2.00%
-4.00%
-6.00%
-8.00%
Aswath Damodaran
69
a.
b.
c.
Aswath Damodaran
70
Premium to use
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71
Aswath Damodaran
72
8.00%
7.00%
Risk Premium
6.00%
4.00%4.31%
3.70%
3.23%
3.15%
5.00%
4.06%
4.00%
0.65%
1.34%1.87%
2.28%
2.43%
0.86%0.70%
0.82%
3.00%
5.10%
4.55%4.86%
4.05%4.12%3.95%3.88%3.95%4.04%
2.00%
3.51%
2.50%
1.00%
US premium
6.35%
5.59%5.28%
0.00%
Aswath Damodaran
73
Aswath Damodaran
74
Sector-average Beta
Average regression beta
across all companies in the
business(es) that the firm
operates in.
Accounting Risk
Quadrant
Accounting Earnings Volatility
How volatile is your company's
earnings, relative to the average
company's earnings?
Accounting Earnings Beta
Regression beta of changes
in earnings at firm versus
changes in earnings for
market index
Proxy measures
Use a proxy for risk
(market cap, sector).
75
Aswath Damodaran
Aswath Damodaran
76
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77
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78
Aswath Damodaran
79
AccounJng
risk
measures:
To
the
extent
that
you
dont
trust
market-
priced
based
measures
of
risk,
you
could
compute
relaJve
risk
measures
based
on
Aswath Damodaran
80
Implications
1. Cyclical companies should
have higher betas than noncyclical companies.
2. Luxury goods firms should
have higher betas than basic
goods.
3. High priced goods/service
firms should have higher betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.
Implications
1. Firms with high infrastructure
needs and rigid cost structures
should have higher betas than
firms with flexible cost structures.
2. Smaller firms should have higher
betas than larger firms.
3. Young firms should have higher
betas than more mature firms.
Aswath Damodaran
Financial Leverage:
Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
equity beta will be
Implciations
Highly levered firms should have highe betas
than firms with less debt.
Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))
81
Adjust the business beta for the operating leverage of the firm to arrive at the
unlevered beta for the firm.
Use the financial leverage of the firm to estimate the equity beta for the firm
Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (Debt/Equity))
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82
Aswath Damodaran
83
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84
BoRom-up
Betas
85
Step 1: Find the business or businesses that your firm operates in.
Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
obtain their regression betas. Compute the simple average across
these regression betas to arrive at an average beta for these publicly
traded firms. Unlever this average beta using the average debt to
equity ratio across the publicly traded firms in the sample.
Unlevered beta for business = Average beta across publicly traded
firms/ (1 + (1- t) (Average D/E ratio across firms))
Step 3: Estimate how much value your firm derives from each of
the different businesses it is in.
Step 5: Compute a levered beta (equity beta) for your firm, using
the market debt to equity ratio for your firm.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))
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85
Aswath Damodaran
86
Sample'
size'
Metals'&'
Mining'
Global'firms'in'metals'&'
mining,'Market'cap>$1'
billion'
48'
0.86'
$9,013'
1.97'
$17,739'
16.65%'
Iron'Ore'
Global'firms'in'iron'ore'
78'
0.83'
$32,717'
2.48'
$81,188'
76.20%'
Fertilizers'
Global'specialty'
chemical'firms'
693'
0.99'
$3,777'
1.52'
$5,741'
5.39%'
Global'transportation'
firms'
223'
0.75'
$1,644'
1.14'
$1,874'
1.76%'
''
0.8440'
$47,151'
''
$106,543'
100.00%'
Business'
Logistics'
Vale'
Operations'
''
Aswath Damodaran
Unlevered'beta'
of'business'
Revenues'
Peer'Group'
EV/Sales'
Value'of'
Business'
Proportion'of'
Vale'
87
Business
Aerospace
a.
b.
Levered
beta
1.07
Aswath Damodaran
88
Analysts
in
Europe
and
LaJn
America
open
take
the
dierence
between
debt
and
cash
(net
debt)
when
compuJng
debt
raJos
and
arrive
at
very
dierent
values.
For
Embraer,
using
the
gross
debt
raJo
The
cost
of
Equity
using
net
debt
levered
beta
for
Embraer
will
be
much
lower
than
with
the
gross
debt
approach.
The
cost
of
capital
for
Embraer
will
even
out
since
the
debt
raJo
used
in
the
cost
of
capital
equaJon
will
now
be
a
net
debt
raJo
rather
than
a
gross
debt
raJo.
Aswath Damodaran
89
Riskfree Rate
Aswath Damodaran
Beta *
(Risk Premium)
Historical Premium
1. Mature Equity Market Premium:
Average premium earned by
stocks over T.Bonds in U.S.
2. 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
90
Aswath Damodaran
91
Aswath Damodaran
92
Default Spread(2004)
>
8.50
6.50
-
8.50
5.50
-
6.50
4.25
-
5.50
3.00
-
4.25
2.50
-
3.00
2.25-
2.50
2.00
-
2.25
1.75
-
2.00
1.50
-
1.75
1.25
-
1.50
0.80
-
1.25
0.65
-
0.80
0.20
-
0.65
<
0.20
(<0.5)
AAA
AA
A+
A
A
BBB
BB+
BB
B+
B
B
CCC
CC
C
0.35%
0.50%
0.70%
0.85%
1.00%
1.50%
2.00%
2.50%
3.25%
4.00%
6.00%
8.00%
10.00%
12.00%
20.00%
(>12.50)
(9.5-12.5)
(7.5-9.5)
(6-7.5)
(4.5-6)
(4-4.5)
(3.5-4)
((3-3.5)
(2.5-3)
(2-2.5)
(1.5-2)
(1.25-1.5)
(0.8-1.25)
(0.5-0.8)
D
0.75%
1.00%
1.50%
1.80%
2.00%
2.25%
2.75%
3.50%
4.75%
6.50%
8.00%
10.00%
11.50%
12.70%
15.00%
The
rst
number
under
interest
coverage
raJos
is
for
larger
market
cap
companies
and
the
second
in
brackets
is
for
smaller
market
cap
companies.
For
Embraer
,
I
used
the
interest
coverage
raJo
table
for
smaller/riskier
rms
(the
numbers
in
brackets)
which
yields
a
lower
raJng
for
the
same
interest
coverage
raJo.
Aswath Damodaran
93
Companies
in
countries
with
low
bond
raJngs
and
high
default
risk
might
bear
the
burden
of
country
default
risk,
especially
if
they
are
smaller
or
have
all
of
their
revenues
within
the
country.
Larger
companies
that
derive
a
signicant
porJon
of
their
revenues
in
global
markets
may
be
less
exposed
to
country
default
risk.
In
other
words,
they
may
be
able
to
borrow
at
a
rate
lower
than
the
government.
The
syntheJc
raJng
for
Embraer
is
A-.
Using
the
2004
default
spread
of
1.00%,
we
esJmate
a
cost
of
debt
of
9.29%
(using
a
riskfree
rate
of
4.29%
and
adding
in
two
thirds
of
the
country
default
spread
of
6.01%):
Cost
of
debt
=
Riskfree
rate
+
2/3(Brazil
country
default
spread)
+
Company
default
spread
=4.29%
+
4.00%+
1.00%
=
9.29%
Aswath Damodaran
94
Aswath Damodaran
95
1-Jan-08
0.99%
1.15%
1.25%
1.30%
1.35%
1.42%
1.48%
12-Sep-08
1.40%
1.45%
1.50%
1.65%
1.85%
1.95%
2.15%
12-Nov-08
2.15%
2.30%
2.55%
2.80%
3.25%
3.50%
3.75%
1-Jan-09
2.00%
2.25%
2.50%
2.75%
3.25%
3.50%
3.75%
1-Jan-10
0.50%
0.55%
0.65%
0.70%
0.85%
0.90%
1.05%
1-Jan-11
0.55%
0.60%
0.65%
0.75%
0.85%
0.90%
1.00%
Baa1/BBB+
Baa2/BBB
1.73%
2.02%
2.65%
2.90%
4.50%
5.00%
5.25%
5.75%
1.65%
1.80%
1.40%
1.60%
Baa3/BBBBa1/BB+
Ba2/BB
Ba3/BBB1/B+
B2/B
B3/B-
2.60%
3.20%
3.65%
4.00%
4.55%
5.65%
6.45%
3.20%
4.45%
5.15%
5.30%
5.85%
6.10%
9.40%
5.75%
7.00%
8.00%
9.00%
9.50%
10.50%
13.50%
7.25%
9.50%
10.50%
11.00%
11.50%
12.50%
15.50%
2.25%
3.50%
3.85%
4.00%
4.25%
5.25%
5.50%
2.05%
2.90%
3.25%
3.50%
3.75%
5.00%
6.00%
Caa/CCC+
ERP
7.15%
4.37%
9.80%
4.52%
14.00%
6.30%
16.50%
6.43%
7.75%
4.36%
7.75%
5.20%96
RaJng
Aaa/AAA
Aa1/AA+
Aa2/AA
Aa3/AA-
A1/A+
A2/A
A3/A-
Baa1/BBB+
Baa2/BBB
Baa3/BBB-
Ba1/BB+
Ba2/BB
Ba3/BB-
B1/B+
B2/B
B3/B-
Caa/CCC+
Aswath Damodaran
1
yr
0.05%
0.09%
0.13%
0.18%
0.23%
0.29%
0.40%
0.54%
0.65%
1.04%
1.93%
2.23%
2.52%
2.87%
3.17%
3.47%
3.81%
2
yr
0.08%
0.20%
0.32%
0.39%
0.45%
0.49%
0.61%
0.79%
0.96%
1.39%
2.06%
2.37%
2.68%
3.04%
3.35%
3.66%
4.02%
3
yr
0.12%
0.28%
0.44%
0.51%
0.58%
0.61%
0.74%
0.93%
1.14%
1.60%
2.21%
2.53%
2.85%
3.22%
3.54%
3.87%
4.23%
5
yr
0.18%
0.38%
0.58%
0.66%
0.74%
0.76%
0.89%
1.12%
1.36%
1.87%
2.36%
2.70%
3.03%
3.41%
3.75%
4.08%
4.46%
7
yr
0.28%
0.48%
0.68%
0.76%
0.85%
0.86%
0.99%
1.23%
1.51%
2.04%
2.48%
2.83%
3.17%
3.57%
3.92%
4.26%
4.65%
10
yr
0.42%
0.60%
0.78%
0.87%
0.96%
0.97%
1.10%
1.36%
1.67%
2.22%
2.61%
2.97%
3.33%
3.74%
4.10%
4.45%
4.86%
30
yr
0.65%
0.87%
1.09%
1.19%
1.28%
1.31%
1.44%
1.75%
2.15%
2.72%
2.83%
3.16%
3.50%
3.92%
4.29%
4.66%
5.08%
97
a.
b.
c.
Aswath Damodaran
98
Aswath Damodaran
99
Equity
Debt
Cost
of
Capital
Cost
of
Capital
=
10.70
%
(.84)
+
9.29%
(1-
.34)
(0.16))
=
9.97%
Aswath Damodaran
100
Aswath Damodaran
101
Aswath Damodaran
102
Aswath Damodaran
103
Cost of equity
based upon bottom-up
beta
Aswath Damodaran
Cost of Borrowing
(1-t)
(Debt/(Debt + Equity))
104
Aswath Damodaran
105
Aswath Damodaran
106
Aswath Damodaran
Net Income
- (Capital Expenditures - Depreciation)
- Change in non-cash Working Capital
- (Principal Repaid - New Debt Issues)
- Preferred Dividend
Dividends
+ Stock Buybacks
107
Aswath Damodaran
108
Firms
history
Comparable
Firms
Operating leases
- Convert into debt
- Adjust operating income
Normalize
Earnings
R&D Expenses
- Convert into asset
- Adjust operating income
Measuring Earnings
Update
- Trailing Earnings
- Unofficial numbers
Aswath Damodaran
109
I.
Update
Earnings
110
UpdaJng
makes
the
most
dierence
for
smaller
and
more
volaJle
rms,
as
well
as
for
rms
that
have
undergone
signicant
restructuring.
Time
saver:
To
get
a
trailing
12-month
number,
all
you
need
is
one
10K
and
one
10Q
(example
third
quarter).
Use
the
Year
to
date
numbers
from
the
10Q:
Trailing
12-month
Revenue
=
Revenues
(in
last
10K)
-
Revenues
from
rst
3
quarters
of
last
year
+
Revenues
from
rst
3
quarters
of
this
year.
Aswath Damodaran
110
Financial
expense:
Any
commitment
that
is
tax
deducJble
that
you
have
to
meet
no
maRer
what
your
operaJng
results:
Failure
to
meet
it
leads
to
loss
of
control
of
the
business.
Example:
OperaJng
Leases:
While
accounJng
convenJon
treats
operaJng
leases
as
operaJng
expenses,
they
are
really
nancial
expenses
and
need
to
be
reclassied
as
such.
This
has
no
eect
on
equity
earnings
but
does
change
the
operaJng
earnings
Make
sure
that
there
are
no
capital
expenses
mixed
in
with
the
operaJng
expenses
Aswath Damodaran
111
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Market
Aswath Damodaran
Apparel Stores
Furniture Stores
Restaurants
112
Aswath Damodaran
113
The
Gap
has
convenJonal
debt
of
about
$
1.97
billion
on
its
balance
sheet
and
its
pre-tax
cost
of
debt
is
about
6%.
Its
operaJng
lease
payments
in
the
2003
were
$978
million
and
its
commitments
for
the
future
are
below:
Year
Commitment
(millions)
Present
Value
(at
6%)
1
$899.00
$848.11
2
$846.00
$752.94
3
$738.00
$619.64
4
$598.00
$473.67
5
$477.00
$356.44
6&7
$982.50
each
year
$1,346.04
Debt
Value
of
leases
=
$4,396.85
(Also
value
of
leased
asset)
Debt
outstanding
at
The
Gap
=
$1,970
m
+
$4,397
m
=
$6,367
m
Adjusted
OperaJng
Income
=
Stated
OI
+
OL
exp
this
year
-
Deprecn
Aswath Damodaran
114
!
Conventional!Accounting!
Income!Statement!
EBIT&&Leases&=&1,990&
0&Op&Leases&&&&&&=&&&&978&
EBIT&&&&&&&&&&&&&&&&=&&1,012&
Balance!Sheet!
Off&balance&sheet&(Not&shown&as&debt&or&as&an&
asset).&Only&the&conventional&debt&of&$1,970&
million&shows&up&on&balance&sheet&
&
Cost&of&capital&=&8.20%(7350/9320)&+&4%&
(1970/9320)&=&7.31%&
Cost&of&equity&for&The&Gap&=&8.20%&
After0tax&cost&of&debt&=&4%&
Market&value&of&equity&=&7350&
Return&on&capital&=&1012&(10.35)/(3130+1970)&
&&&&&&&&&=&12.90%&
Operating!Leases!Treated!as!Debt!
!Income!Statement!
EBIT&&Leases&=&1,990&
0&Deprecn:&OL=&&&&&&628&
EBIT&&&&&&&&&&&&&&&&=&&1,362&
Interest&expense&will&rise&to&reflect&the&
conversion&of&operating&leases&as&debt.&Net&
income&should¬&change.&
Balance!Sheet!
Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&
OL&Asset&&&&&&&4397&&&&&&&&&&&OL&Debt&&&&&4397&
Total&debt&=&4397&+&1970&=&$6,367&million&
Cost&of&capital&=&8.20%(7350/13717)&+&4%&
(6367/13717)&=&6.25%&
&
Return&on&capital&=&1362&(10.35)/(3130+6367)&
&&&&&&&&&=&9.30%&
&
Aswath Damodaran
115
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Market
Aswath Damodaran
Petroleum
Computers
116
Aswath Damodaran
117
Year
Current
-1
-2
-3
-4
-5
R&D
Expense
1020.02
993.99
909.39
898.25
969.38
744.67
Aswath Damodaran
2,914
million
903
million
117
million
118
!
Conventional!Accounting!
Income!Statement!
EBIT&&R&D&&&=&&3045&
.&R&D&&&&&&&&&&&&&&=&&1020&
EBIT&&&&&&&&&&&&&&&&=&&2025&
EBIT&(1.t)&&&&&&&&=&&1285&m&
R&D!treated!as!capital!expenditure!
!Income!Statement!
EBIT&&R&D&=&&&3045&
.&Amort:&R&D&=&&&903&
EBIT&&&&&&&&&&&&&&&&=&2142&(Increase&of&117&m)&
EBIT&(1.t)&&&&&&&&=&1359&m&
Ignored&tax&benefit&=&(1020.903)(.3654)&=&43&
Adjusted&EBIT&(1.t)&=&1359+43&=&1402&m&
(Increase&of&117&million)&
Net&Income&will&also&increase&by&117&million&&
Balance!Sheet!
Balance!Sheet!
Off&balance&sheet&asset.&Book&value&of&equity&at&
Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&
3,768&million&Euros&is&understated&because&
R&D&Asset&&&&2914&&&&&Book&Equity&&&+2914&
biggest&asset&is&off&the&books.&
Total&Book&Equity&=&3768+2914=&6782&mil&&
Capital!Expenditures!
Capital!Expenditures!
Conventional&net&cap&ex&of&2&million&
Net&Cap&ex&=&2+&1020&&903&=&119&mil&
Euros&
Cash!Flows!
Cash!Flows!
EBIT&(1.t)&&&&&&&&&&=&&1285&&
EBIT&(1.t)&&&&&&&&&&=&&&&&1402&&&
.&Net&Cap&Ex&&&&&&=&&&&&&&&2&
.&Net&Cap&Ex&&&&&&=&&&&&&&119&
FCFF&&&&&&&&&&&&&&&&&&=&&1283&&&&&&
FCFF&&&&&&&&&&&&&&&&&&=&&&&&1283&m&
Return&on&capital&=&1285/(3768+530)&
Return&on&capital&=&1402/(6782+530)&
Aswath Damodaran
119
Yes
No
Aswath Damodaran
120
Aswath Damodaran
121
Temporary
Problems
Cyclicality:
Eg. Auto firm
in recession
Leverage
Problems: Eg.
An otherwise
healthy firm with
too much debt.
Long-term
Operating
Problems: Eg. A firm
with significant
production or cost
problems.
Normalize Earnings
Average Dollar
Earnings (Net Income
if Equity and EBIT if
Firm made by
the firm over time
Aswath Damodaran
122
The
tax
rate
that
you
should
use
in
compuJng
the
aper-
tax
operaJng
income
should
be
a.
b.
c.
d.
e.
f.
Aswath Damodaran
123
Aswath Damodaran
124
Aswath Damodaran
125
Aswath Damodaran
126
Two
caveats:
1.
Most
rms
do
not
do
acquisiJons
every
year.
Hence,
a
normalized
measure
of
acquisiJons
(looking
at
an
average
over
Jme)
should
be
used
2.
The
best
place
to
nd
acquisiJons
is
in
the
statement
of
cash
ows,
usually
categorized
under
other
investment
acJviJes
Aswath Damodaran
127
Acquired
Method
of
AcquisiJon
GeoTel
Pooling
Fibex
Pooling
SenJent
Pooling
American
Internet
Purchase
Summa
Four
Purchase
Clarity
Wireless
Purchase
Selsius
Systems
Purchase
PipeLinks
Purchase
Amteva
Tech
Purchase
Aswath Damodaran
Price
Paid
$1,344
$318
$103
$58
$129
$153
$134
$118
$159
$2,516
128
Aswath Damodaran
129
Aswath Damodaran
130
Aswath Damodaran
131
Revenues
Non-cash
WC
%
of
Revenues
Change
from
last
year
Average:
last
3
years
Average:
industry
Amazon
$
1,640
-$419
-25.53%
$
(309)
-15.16%
8.71%
Cisco
$12,154
-$404
-3.32%
($700)
-3.16%
-2.71%
Motorola
$30,931
$2547
8.23%
($829)
8.91%
7.04%
WC as % of Revenue
3.00%
0.00%
8.23%
Aswath Damodaran
132
Aswath Damodaran
133
Earnings
are
not
cash
ows,
since
there
are
both
non-cash
revenues
and
expenses
in
the
earnings
calculaJon
Even
if
earnings
were
cash
ows,
a
rm
that
paid
its
earnings
out
as
dividends
would
not
be
invesJng
in
new
assets
and
thus
could
not
grow
ValuaJon
models,
where
earnings
are
discounted
back
to
the
present,
will
over
esJmate
the
value
of
the
equity
in
the
rm
The
potenJal
dividends
of
a
rm
are
the
cash
ows
lep
over
aper
the
rm
has
made
any
investments
it
needs
to
make
to
create
future
growth
and
net
debt
repayments
(debt
repayments
-
new
debt
issues)
Aswath Damodaran
134
Aswath Damodaran
135
Net
Income
-
(1-
)
(Capital
Expenditures
-
DepreciaJon)
-
(1-
)
Working
Capital
Needs
=
Free
Cash
ow
to
Equity
=
Debt/Capital
RaJo
For
this
rm,
Aswath Damodaran
136
$1,533
Mil
$465.90
[(1746-1134)(1-.2383)]
$363.33
[477(1-.2383)]
$
704
Million
Dividends Paid
$ 345 Million
Aswath Damodaran
137
1400
1200
FCFE
1000
800
600
400
200
0
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Debt Ratio
Aswath Damodaran
138
7.00
6.00
Beta
5.00
4.00
3.00
2.00
1.00
0.00
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Debt Ratio
Aswath Damodaran
139
Aswath Damodaran
140
Aswath Damodaran
141
Look
at
fundamentals
UlJmately,
all
growth
in
earnings
can
be
traced
to
two
Aswath Damodaran
142
Aswath Damodaran
143
Aswath Damodaran
144
A
Test
145
a.
b.
c.
d.
Aswath Damodaran
145
Aswath Damodaran
146
147
148
Aswath Damodaran
149
tends
to
decrease
with
the
forecast
period
(next
quarter
versus
5
years)
tends
to
be
greater
for
larger
rms
than
for
smaller
rms
tends
to
be
greater
at
the
industry
level
than
at
the
company
level
Aswath Damodaran
150
There
is
no
evidence
that
analysts
who
are
chosen
for
the
All-America
Analyst
team
were
chosen
because
they
were
beRer
forecasters
of
earnings.
(Their
median
forecast
error
in
the
quarter
prior
to
being
chosen
was
30%;
the
median
forecast
error
of
other
analysts
was
28%)
However,
in
the
calendar
year
following
being
chosen
as
All-America
analysts,
these
analysts
become
slightly
beRer
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
recommendaJons
made
by
the
All
America
analysts
have
a
greater
impact
on
stock
prices
(3%
on
buys;
4.7%
on
sells).
For
these
recommendaJons
the
price
changes
are
sustained,
and
they
conJnue
to
rise
in
the
following
period
(2.4%
for
buys;
13.8%
for
the
sells).
Aswath Damodaran
151
Aswath Damodaran
152
Aswath Damodaran
153
Investment
in Existing
Projects
$ 1000
Investment
in Existing
Projects
$1000
Investment
in Existing
Projects
$1000
Current Return on
Investment on
Projects
12%
Next Periods
Return on
Investment
12%
Change in
ROI from
current to next
period: 0%
Aswath Damodaran
Current
Earnings
$120
Investment
in New
Projects
$100
Investment
in New
Projects
$100
Return on
Investment on
New Projects
12%
Return on
Investment on
New Projects
12%
Next
Periods
Earnings
132
Change in Earnings
= $ 12
154
In the special case where ROI on existing projects remains unchanged and is equal to the ROI on new projects
Investment in New Projects
Current Earnings
100
120
Reinvestment Rate
83.33%
X
X
X
X
Return on Investment
Change in Earnings
Current Earnings
12%
$12
$120
Return on Investment
12%
=
=
in the more general case where ROI can change from period to period, this can be expanded as follows:
Investment in Existing Projects*(Change in ROI) + New Projects (ROI)
Investment in Existing Projects* Current ROI
Change in Earnings
Current Earnings
For instance, if the ROI increases from 12% to 13%, the expected growth rate can be written as follows:
$1,000 * (.13 - .12) + 100 (13%)
$ 1000 * .12
Aswath Damodaran
$23
$120
19.17%
155
Earnings Measure
Reinvestment Measure
Return Measure
OperaJng Income
Aswath Damodaran
156
Aswath Damodaran
157
Aswath Damodaran
158
Aswath Damodaran
159
160
Aswath Damodaran
161
Aswath Damodaran
162
Net
Income
from
non-cash
assets
=
Net
income
Interest
income
from
cash
(1-
t)
Equity
Reinvestment
Rate
=
(Net
Capital
Expenditures
+
Change
in
Working
Capital)
(1
-
Debt
RaJo)/
Net
Income
from
non-cash
assets
Non-cash
ROE
=
Net
Income
from
non-cash
assets/
(BV
of
Equity
Cash)
Expected
GrowthNet
Income
=
Equity
Reinvestment
Rate
*
Non-cash
ROE
Aswath Damodaran
163
Aswath Damodaran
164
Aswath Damodaran
165
Ciscos
Fundamentals
Reinvestment
Rate
=
106.81%
Return
on
Capital
=34.07%
Expected
Growth
in
EBIT
=(1.0681)(.3407)
=
36.39%
Motorolas
Fundamentals
Reinvestment
Rate
=
52.99%
Return
on
Capital
=
12.18%
Expected
Growth
in
EBIT
=
(.5299)(.1218)
=
6.45%
Aswath Damodaran
166
Aswath Damodaran
167
Note
that
I
am
assuming
that
the
new
investments
start
making
17.22%
immediately,
while
allowing
for
exisJng
assets
to
improve
returns
gradually
Aswath Damodaran
168
Aswath Damodaran
169
Aswath Damodaran
170
Year
OperaJng
Growth $
Margin
Income
Current
$187
-419.92%
-$787
200.00% $562
-199.96%
-$1,125
100.00% $1,125
-89.98%
-$1,012
80.00%
$2,025
-34.99%
-$708
60.00%
$3,239
-7.50%
-$243
40.00%
$4,535
6.25%
$284
25.00%
$5,669
13.13%
$744
20.00%
$6,803
16.56%
$1,127
15.00%
$7,823
18.28%
$1,430
10.00%
$8,605
19.14%
$1,647
10
5.00%
$9,035
19.57%
$1,768
Aswath Damodaran
171
Capital Invested
Operating Income (Loss)
Imputed ROC
$
1,657
-$787
$
1,907
-$1,125
-67.87%
$
2,282
-$1,012
-53.08%
$
2,882
-$708
-31.05%
$
3,691
-$243
-8.43%
$
4,555
$284
7.68%
$
5,311
$744
16.33%
$
6,067
$1,127
21.21%
$
6,747
$1,430
23.57%
$
7,269
$1,647
17.56%
$
7,556
$1,768
15.81%
Aswath Damodaran
172
Equity Earnings
Analysts
Fundamentals
Operating Income
Historical
Fundamentals
Stable ROC
Changing ROC
ROC *
Reinvestment Rate
ROCt+1*Reinvestment Rate
+ (ROCt+1-ROCt)/ROCt
Stable ROE
173
Changing ROE
ROEt+1*Retention Ratio
+ (ROEt+1-ROEt)/ROEt
Aswath Damodaran
ROE * Equity
Reinvestment Ratio
Negative Earnings
1. Revenue Growth
2. Operating Margins
3. Reinvestment Needs
Net Income
Stable ROE
Historical
Changing ROE
Aswath Damodaran
174
Since
we
cannot
esJmate
cash
ows
forever,
we
esJmate
cash
ows
for
a
growth
period
and
then
esJmate
a
terminal
value,
to
capture
the
value
at
the
end
of
the
period:
t=N CF
t + Terminal Value
Value =
N
t
(1+r)
t=1 (1+r)
Aswath Damodaran
175
Terminal Value
Liquidation
Value
Most useful
when assets
are separable
and
marketable
Aswath Damodaran
Multiple Approach
Stable Growth
Model
Technically soundest,
but requires that you
make judgments about
when the firm will grow
at a stable rate which it
can sustain forever,
and the excess returns
(if any) that it will earn
during the period.
176
When
a
rms
cash
ows
grow
at
a
constant
rate
forever,
the
present
value
of
those
cash
ows
can
be
wriRen
as:
Value
=
Expected
Cash
Flow
Next
Period
/
(r
-
g)
where,
r
=
Discount
rate
(Cost
of
Equity
or
Cost
of
Capital)
g
=
Expected
growth
rate
The
stable
growth
rate
cannot
exceed
the
growth
rate
of
the
economy
but
it
can
be
set
lower.
If
you
assume
that
the
economy
is
composed
of
high
growth
and
stable
growth
rms,
the
growth
rate
of
the
laRer
will
probably
be
lower
than
the
growth
rate
of
the
economy.
The
stable
growth
rate
can
be
negaJve.
The
terminal
value
will
be
lower
and
you
are
assuming
that
your
rm
will
disappear
over
Jme.
If
you
use
nominal
cashows
and
discount
rates,
the
growth
rate
should
be
nominal
in
the
currency
in
which
the
valuaJon
is
denominated.
One simple proxy for the nominal growth rate of the economy is the riskfree rate.
Aswath Damodaran
177
<
5
years
5
years
10
years
>10
years
Aswath Damodaran
178
Aswath Damodaran
179
Aswath Damodaran
180
While
growth
rates
seem
to
fade
quickly
as
rms
become
larger,
well
managed
rms
seem
to
do
much
beRer
at
sustaining
excess
returns
for
longer
periods.
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181
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182
Risk
and
costs
of
equity
and
capital:
Stable
growth
rms
tend
to
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183
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184
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185
(a)
for
rms
which
have
stable
leverage,
whether
high
or
not,
and
(b)
if
equity
(stock)
is
being
valued
(a)
for
rms
which
have
leverage
which
is
too
high
or
too
low,
and
expect
to
change
the
leverage
over
Jme,
because
debt
payments
and
issues
do
not
have
to
be
factored
in
the
cash
ows
and
the
discount
rate
(cost
of
capital)
does
not
change
dramaJcally
over
Jme.
(b)
for
rms
for
which
you
have
parJal
informaJon
on
leverage
(eg:
interest
expenses
are
missing..)
(c)
in
all
other
cases,
where
you
are
more
interested
in
valuing
the
rm
than
the
equity.
(Value
ConsulJng?)
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186
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187
Match
the
currency
in
which
you
esJmate
the
risk
free
rate
to
the
currency
of
your
cash
ows
Aswath Damodaran
188
If your rm is
large
and
growing
at
a
rate
close
to
or
less
than
growth
rate
of
the
economy,
or
constrained
by
regulaJon
from
growing
at
rate
faster
than
the
economy
has
the
characterisJcs
of
a
stable
rm
(average
risk
&
reinvestment
rates)
If your rm
If your rm
is
small
and
growing
at
a
very
high
rate
(>
Overall
growth
rate
+
10%)
or
has
signicant
barriers
to
entry
into
the
business
has
rm
characterisJcs
that
are
very
dierent
from
the
norm
189
Choose a
Cash Flow
Dividends
Expected Dividends to
Stockholders
Cashflows to Equity
Cashflows to Firm
Net Income
Cost of Equity
Basis: The riskier the investment, the greater is the cost of equity.
Models:
Cost of Capital
WACC = ke ( E/ (D+E))
+ kd ( D/(D+E))
Stable Growth
Two-Stage Growth
g
Three-Stage Growth
g
|
t
Aswath Damodaran
High Growth
|
Stable
High Growth
Transition
Stable
190
Aswath Damodaran
191
Value of Firm
- Value of Debt
= Value of Equity
/ Number of shares
= Value per share
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192
The
simplest
and
most
direct
way
of
dealing
with
cash
and
marketable
securiJes
is
to
keep
it
out
of
the
valuaJon
-
the
cash
ows
should
be
before
interest
income
from
cash
and
securiJes,
and
the
discount
rate
should
not
be
contaminated
by
the
inclusion
of
cash.
(Use
betas
of
the
operaJng
assets
alone
to
esJmate
the
cost
of
equity).
Once
the
operaJng
assets
have
been
valued,
you
should
add
back
the
value
of
cash
and
marketable
securiJes.
In
many
equity
valuaJons,
the
interest
income
from
cash
is
included
in
the
cashows.
The
discount
rate
has
to
be
adjusted
then
for
the
presence
of
cash.
(The
beta
used
will
be
weighted
down
by
the
cash
holdings).
Unless
cash
remains
a
xed
percentage
of
overall
value
over
Jme,
these
valuaJons
will
tend
to
break
down.
Aswath Damodaran
193
Enterprise
Value
Cash
Return
on
Capital
Cost
of
Capital
Trades
in
Aswath Damodaran
$
1
billion
$
100
mil
5%
10%
US
$
1
billion
$
100
mil
22%
12%
ArgenJna
194
There
are
some
analysts
who
argue
that
companies
with
a
lot
of
cash
on
their
balance
sheets
should
be
penalized
by
having
the
excess
cash
discounted
to
reect
the
fact
that
it
earns
a
low
return.
Excess
cash
is
usually
dened
as
holding
cash
that
is
greater
than
what
the
rm
needs
for
operaJons.
A
low
return
is
dened
as
a
return
lower
than
what
the
rm
earns
on
its
non-cash
investments.
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195
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196
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197
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198
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199
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200
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201
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202
Debt of Company j)
j=1
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203
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204
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205
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206
Assets that you should not be counJng (or adding on to DCF values)
If
an
asset
is
contribuJng
to
your
cashows,
you
cannot
count
the
market
value
of
the
asset
in
your
value.
Thus,
you
should
not
be
counJng
the
real
estate
on
which
your
oces
stand,
the
PP&E
represenJng
your
factories
and
other
producJve
assets,
any
values
aRached
to
brand
names
or
customer
lists
and
denitely
no
non-
assets
(such
as
goodwill).
Assets that you can count (or add on to your DCF valuaJon)
Overfunded
pension
plans:
If
you
have
a
dened
benet
plan
and
your
assets
exceed
your
expected
liabiliJes,
you
could
consider
the
over
funding
with
two
caveats:
n CollecJve
bargaining
agreements
may
prevent
you
from
laying
claim
to
these
excess
assets.
n There
are
tax
consequences.
Open,
withdrawals
from
pension
plans
get
taxed
at
much
higher
rates.
UnuJlized
assets:
If
you
have
assets
or
property
that
are
not
being
uJlized
to
generate
cash
ows
(vacant
land,
for
example),
you
have
not
valued
it
yet.
You
can
assess
a
market
value
for
these
assets
and
add
them
on
to
the
value
of
the
rm.
Aswath Damodaran
207
Company
A
Company
B
OperaJng
Income
$
1
billion
$
1
billion
Tax
rate
40%
40%
ROIC
10%
10%
Expected
Growth
5%
5%
Cost
of
capital
8%
8%
Business
Mix
Single
MulJple
Holdings
Simple
Complex
AccounJng
Transparent
Opaque
Which
rm
would
you
value
more
highly?
Aswath Damodaran
208
Company
General Electric
Microsoft
Wal-mart
Exxon Mobil
Pfizer
Citigroup
Intel
AIG
Johnson & Johnson
IBM
Aswath Damodaran
209
Aswath Damodaran
210
The
Aggressive
Analyst:
Trust
the
rm
to
tell
the
truth
and
value
the
rm
based
upon
the
rms
statements
about
their
value.
The
ConservaJve
Analyst:
Dont
value
what
you
cannot
see.
The
Compromise:
Adjust
the
value
for
complexity
n Adjust
cash
ows
for
complexity
n Adjust
the
discount
rate
for
complexity
n Adjust
the
expected
growth
rate/
length
of
growth
period
n Value
the
rm
and
then
discount
value
for
complexity
In
relaJve
valuaJon
In
a
relaJve
valuaJon,
you
may
be
able
to
assess
the
price
that
the
market
is
charging
for
complexity:
With
the
hundred
largest
market
cap
rms,
for
instance:
PBV
=
0.65
+
15.31
ROE
0.55
Beta
+
3.04
Expected
growth
rate
0.003
#
Pages
in
10K
Aswath Damodaran
211
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212
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213
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214
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215
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216
A
simple
example
217
Aswath Damodaran
=
2000
=
1000
=
1000
=
1000/100
=
$10
217
c.
Aswath Damodaran
218
=
2000
=
1000
=
1000
=
110
=
1000/110
=
$9.09
219
Aswath Damodaran
220
=
2000
=
1000
=
1000
=
110
=
10
*
10
=
100
=
(1000+
100)/110
=
$
10
221
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222
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223
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224
Stock
Price
=
$
10
Strike
Price
=
$
10
Maturity
=
10
years
Standard
deviaJon
in
stock
price
=
40%
Riskless
Rate
=
4%
Aswath Damodaran
225
(0.3624) = $5.42
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226
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=
2000
=
1000
=
1000
=
$
54.2
=
$945.8
/
100
=
$
9.46
227
Aswath Damodaran
228
EsJmate
the
value
of
opJons
granted
each
year
over
the
last
few
years
as
a
percent
of
revenues.
Forecast
out
the
value
of
opJon
grants
as
a
percent
of
revenues
into
future
years,
allowing
for
the
fact
that
as
revenues
get
larger,
opJon
grants
as
a
percent
of
revenues
will
become
smaller.
Consider
this
line
item
as
part
of
operaJng
expenses
each
year.
This
will
reduce
the
operaJng
margin
and
cashow
each
year.
Aswath Damodaran
229
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230
Favored Tools
- Accounting statements
- Excel spreadsheets
- Statistical Measures
- Pricing Data
Favored Tools
- Anecdotes
- Experience (own or others)
- Behavioral evidence
A Good Valuation
The Numbers People
Illusions/Delusions
1. Precision: Data is precise
2. Objectivity: Data has no bias
3. Control: Data can control reality
Illusions/Delusions
1. Creativity cannot be quantified
2. If the story is good, the
investment will be.
3. Experience is the best teacher
232
233
Aswath Damodaran
234
X
Market Share
=
Revenues (Sales)
Operating Expenses
=
Operating Income
Taxes
=
After-tax Operating Income
-
Reinvestment
=
After-tax Cash Flow
Adjust for time value & risk
Adjusted for operating risk
with a discount rate and
for failure with a
probability of failure.
VALUE OF
OPERATING
ASSETS
235
Aswath Damodaran
236
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237
Narra;ve Break/End
Narra;ve Shia
Narra;ve
Change
(Expansion
or
Contrac;on)
Improvement
or
deterioraJon
in
iniJal
business
model,
changing
market
size,
market
share
and/or
protability.
Unexpected
entry/success
in
a
new
market
or
unexpected
exit/failure
in
an
exisJng
market.
238
Aswath Damodaran
239
The
equity
risk
premiums
that
I
have
used
in
the
valuaJons
that
follow
reect
my
thinking
(and
how
it
has
evolved)
on
the
issue.
Pre-1998
valuaJons:
In
the
valuaJons
prior
to
1998,
I
use
a
risk
premium
of
5.5%
for
mature
markets
(close
to
both
the
historical
and
the
implied
premiums
then)
Between
1998
and
Sept
2008:
In
the
valuaJons
between
1998
and
September
2008,
I
used
a
risk
premium
of
4%
for
mature
markets,
reecJng
my
belief
that
risk
premiums
in
mature
markets
do
not
change
much
and
revert
back
to
historical
norms
(at
least
for
implied
premiums).
ValuaJons
done
in
2009:
Aper
the
2008
crisis
and
the
jump
in
equity
risk
premiums
to
6.43%
in
January
2008,
I
have
used
a
higher
equity
risk
premium
(5-6%)
for
the
next
5
years
and
will
assume
a
reversion
back
to
historical
norms
(4%)
only
aper
year
5.
In
2010,
2011
&
2012:
In
2010,
I
reverted
back
to
a
mature
market
premium
of
4.5%,
reecJng
the
drop
in
equity
risk
premiums
during
2009.
In
2011,
I
used
5%,
reecJng
again
the
change
in
implied
premium
over
the
year.
In
2012
and
2013,
stayed
with
6%,
reverted
to
5%
in
2014
and
will
be
using
5.75%
in
2015.
Aswath Damodaran
240
Value per share today= Expected Dividends per share next year / (Cost of equity - Growth rate)
= 2.32 (1.021)/ (.077 - ,021) = $42.30
Cost of Equity = 4.1% + 0.8 (4.5%) = 7.70%
Riskfree rate
4.10%
10-year T.Bond rate
Beta
0.80
Beta for regulated
power utilities
Equity Risk
Premium
4.5%
Implied Equity Risk
Premium - US
market in 8/2008
Test 3: Is the firms risk and cost of equity consistent with a stable growith firm?
Beta of 0.80 is at lower end of the range of stable company betas: 0.8 -1.2
241
$50.00
$40.00
$30.00
$20.00
$10.00
$0.00
4.10%
Aswath Damodaran
3.10%
2.10%
1.10%
0.10%
-0.90%
Expected Growth rate
-1.90%
-2.90%
-3.90%
242
Aswath Damodaran
243
Expected Growth in
EBIT (1-t)
.30*.25=.075
7.5%
Value/Share $ 83.55
Year
EBIT (1-t)
- Reinvestment
= FCFF
1
$3,734
$1,120
$2,614
3
$4,279
$1,312
$2,967
Cost of Debt
(3.72%+.75%)(1-.35)
= 2.91%
Beta
1.15
244
2
$4,014
$1,204
$2,810
4
$4,485
$1,435
$3,049
5
$4,619
$1,540 ,
$3,079
Term Yr
$4,758
$2,113
$2,645
Cost of Equity
8.32%
Riskfree Rate:
Riskfree rate = 3.72%
Stable Growth
g = 3%; Beta = 1.10;
Debt Ratio= 20%; Tax rate=35%
Cost of capital = 6.76%
ROC= 6.76%;
Reinvestment Rate=3/6.76=44%
First 5 years
Op. Assets 60607
+ Cash:
3253
- Debt
4920
=Equity
58400
Return on Capital
25%
Aswath Damodaran
Weights
E = 92% D = 8%
Risk Premium
4%
D/E=8.8%
On September 12,
2008, 3M was
trading at $70/share
Value/Share $ 60.53
Cost of Equity
10.86%
Riskfree Rate:
Riskfree rate = 3.96%
Year
EBIT (1-t)
- Reinvestment
= FCFF
1
$3,339
$835
$2,504
2
$3,506
$877
$2,630
3
$3,667
$1,025
$2,642
4
$3,807
$1,288
$2,519
5
$3,921
$1,558
$2,363
Term Yr
$4,038
$1,604
$2,434
Beta
1.15
245
Return on Capital
20%
First 5 years
Op. Assets 43,975
+ Cash:
3253
- Debt
4920
=Equity
42308
Aswath Damodaran
Weights
E = 92% D = 8%
D/E=8.8%
From a Company to the Market: Valuing the S&P 500: Dividend Discount Model in January 2015
Rationale for model
Why dividends? Because it is the only tangible cash flow, right?
Why 2-stage? Because the expected growth rate in near term is higher than stable growth rate.
Expected Growth
Analyst estimate for
growth over next 5
years = 5.58%
Dividends
$ Dividends in trailing 12
months = 38.57
Dividends
40.72
42.99
45.39
47.92
50.59
.........
Forever
Riskfree Rate:
Treasury bond rate
2.17%
246
Beta
1.00
Risk Premium
5.11%
Set at the average ERP over
the last decade
From a Company to the Market: Valuing the S&P 500: Augmented Dividend Discount Model in January 2015
Rationale for model
Why augmented dividends? Because companies are increasing returning cash in the form of stock buybacks
Why 2-stage? Because the expected growth rate in near term is higher than stable growth rate.
Expected Growth
Analyst estimate for
growth over next 5
years = 5.58%
Dividends
$ Dividends + $ Buybacks in
trailing 12 months = 100.50
Dividends
106.10
112.01
118.26
128.45
131.81
.........
Forever
Riskfree Rate:
Treasury bond rate
2.17%
Beta
1.00
247
Risk Premium
5.11%
Set at the average ERP over
the last decade
Valuing the S&P 500: Augmented Dividends and Fundamental Growth January 2015
Rationale for model
Why augmented dividends? Because companies are increasing returning cash in the form of stock buybacks
Why 2-stage? Why not?
ROE = 16.03%
Dividends
$ Dividends + $ Buybacks in
trailing 12 months = 100.50
Expected Growth
ROE * Retention Ratio
= .1603*.1242 = 1.99%
Dividends
102.50
104.54
106.62
108.74
110.90
.........
Forever
Riskfree Rate:
Treasury bond rate
2.17%
Beta
1.00
248
Aswath Damodaran
Risk Premium
5.11%
Set at the average ERP over
the last decade
Aswath Damodaran
249
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250
Aswath Damodaran
251
Across markets
Young,
growth
rms:
Limited
history,
small
revenues
in
conjuncJon
with
big
operaJng
losses
and
a
propensity
for
failure
make
these
companies
tough
to
value.
Mature
companies
in
transiJon:
When
mature
companies
change
or
are
forced
to
change,
history
may
have
to
be
abandoned
and
parameters
have
to
be
reesJmated.
Declining
and
Distressed
rms:
A
long
but
irrelevant
history,
declining
markets,
high
debt
loads
and
the
likelihood
of
distress
make
them
troublesome.
Emerging
market
companies
are
open
dicult
to
value
because
of
the
way
they
are
structured,
their
exposure
to
country
risk
and
poor
corporate
governance.
Across sectors
Financial
service
rms:
Opacity
of
nancial
statements
and
diculJes
in
esJmaJng
basic
inputs
leave
us
trusJng
managers
to
tell
us
whats
going
on.
Commodity
and
cyclical
rms:
Dependence
of
the
underlying
commodity
prices
or
overall
economic
growth
make
these
valuaJons
suscepJble
to
macro
factors.
Firms
with
intangible
assets:
AccounJng
principles
are
lep
to
the
wayside
on
these
rms.
Aswath Damodaran
252
Aswath Damodaran
253
It
is
when
valuing
these
companies
that
you
nd
yourself
tempted
by
the
dark
side,
where
Aswath Damodaran
254
From previous
years
NOL:
500 m
Current
Margin:
-36.71%
Sales Turnover
Ratio: 3.00
EBIT
-410m
- Value of Debt
= Value of Equity
- Equity Options
Value per share
$ 349
$14,587
$ 2,892
$ 34.32 Cost of Equity
Riskfree Rate:
T. Bond rate = 6.5%
9,774
$407
$407
$1,396
-$989
14,661
$1,038
$871
$1,629
-$758
19,059
$1,628
$1,058
$1,466
-$408
12.90%
8.00%
8.00%
12.84%
12.90%
8.00%
8.00%
12.84%
12.90%
8.00%
6.71%
12.83%
12.90%
8.00%
5.20%
12.81%
12.42%
7.80%
5.07%
12.13%
12.30%
7.75%
5.04%
11.96%
12.10%
7.67%
4.98%
11.69%
11.70%
7.50%
4.88%
11.15%
23,862
$2,212
$1,438
$1,601
-$163
28,729
$2,768
$1,799
$1,623
$177
Cost of Debt
6.5%+1.5%=8.0%
Tax rate = 0% -> 35%
Operating
Leverage
Stable
ROC=20%
Reinvest 30%
of EBIT(1-t)
5,585
-$94
-$94
$931
-$1,024
Used average
interest coverage
ratio over next 5
years to get BBB
rating.
Internet/
Retail
Aswath Damodaran
Expected
Margin:
-> 10.00%
$2,793
-$373
-$373
$559
-$931
12.90%
Cost of Debt
8.00%
AT cost of debt 8.00%
Cost of Capital 12.84%
Cost of Equity
12.90%
255
Competitive
Advantages
Revenue
Growth:
42%
Revenues
Value of Op Assets $ 14,910 EBIT
(1-t)
+ Cash
$
26 EBIT
- Reinvestment
= Value of Firm
$14,936 FCFF
Stable Growth
Stable
Stable
Operating
Revenue
Margin:
Growth: 6%
10.00%
33,211
$3,261
$2,119
$1,494
$625
36,798
$3,646
$2,370
$1,196
$1,174
39,006
$3,883
$2,524
$736
$1,788
Term. Year
$41,346
10.00%
35.00%
$2,688
$ 807
$1,881
10
10.50%
7.00%
4.55%
9.61%
Weights
Debt= 1.2% -> 15%
Forever
Amazon was
trading at $84 in
January 2000.
Current
D/E: 1.21%
Base Equity
Premium
Country Risk
Premium
Aswath Damodaran
256
Year
Tr12m
1
2
3
4
5
6
7
8
9
10
TY(11)
Revenues
$1,117
$2,793
$5,585
$9,774
$14,661
$19,059
$23,862
$28,729
$33,211
$36,798
$39,006
$41,346
Aswath Damodaran
OperaJng
Margin
-36.71%
-13.35%
-1.68%
4.16%
7.08%
8.54%
9.27%
9.64%
9.82%
9.91%
9.95%
10.00%
EBIT
-$410
-$373
-$94
$407
$1,038
$1,628
$2,212
$2,768
$3,261
$3,646
$3,883
$4,135
257
Aswath Damodaran
258
Year
1
2
3
4
5
6
7
8
9
10
Rev
growth
150.00%
100.00%
75.00%
50.00%
30.00%
25.20%
20.40%
15.60%
10.80%
6.00%
Aswath Damodaran
Chg
in
Rev
$1,676
$2,793
$4,189
$4,887
$4,398
$4,803
$4,868
$4,482
$3,587
$2,208
To
grow,
the
company
will
have
to
issue
new
shares
either
to
raise
cash
to
take
projects
or
to
oer
to
target
company
stockholders
in
acquisiJons
Many
young,
growth
companies
also
oer
opJons
to
managers
as
compensaJon
and
these
opJons
will
get
exercised,
if
the
company
is
successful.
The
need
for
new
equity
issues
is
captured
in
negaJve
cash
ows
in
the
earlier
years.
The
present
value
of
these
negaJve
cash
ows
will
drag
down
the
current
value
of
equity
and
this
is
the
eect
of
future
diluJon.
The
opJons
are
valued
and
neRed
out
against
the
current
value.
Using
an
opJon
pricing
model
allows
you
to
incorporate
the
expected
likelihood
that
they
will
be
exercised
and
the
price
at
which
they
will
be
exercised.
Aswath Damodaran
260
30%
35%
40%
45%
50%
55%
60%
$
$
$
$
$
$
$
Aswath Damodaran
6%
(1.94)
1.41
6.10
12.59
21.47
33.47
49.53
$
$
$
$
$
$
$
8%
2.95
8.37
15.93
26.34
40.50
59.60
85.10
$
$
$
$
$
$
$
10%
7.84
15.33
25.74
40.05
59.52
85.72
120.66
$
$
$
$
$
$
$
12%
12.71
22.27
35.54
53.77
78.53
111.84
156.22
$
$
$
$
$
$
$
14%
17.57
29.21
45.34
67.48
97.54
137.95
191.77
261
Aswath Damodaran
262
Reinvestment:
Current
Margin:
-34.60%
Sales Turnover
Ratio: 3.02
EBIT
-853m
Revenue
Growth:
25.41%
NOL:
1,289 m
Competitiv
e
Advantages
Expected
Margin:
-> 9.32%
2
$6,471
-$107
-$107
$714
-$822
2
3
$9,059
$347
$347
$857
-$510
3
4
$11,777
$774
$774
$900
-$126
4
5
$14,132
$1,123
$1,017
$780
$237
5
6
$16,534
$1,428
$928
$796
$132
6
7
$18,849
$1,692
$1,100
$766
$333
7
8
$20,922
$1,914
$1,244
$687
$558
8
9
$22,596
$2,087
$1,356
$554
$802
9
10
$23,726
$2,201
$1,431
$374
$1,057
10
Debt Ratio
Beta
Cost of Equity
AT cost of debt
Cost of Capital
27.27%
2.18
13.81%
10.00%
12.77%
27.27%
2.18
13.81%
10.00%
12.77%
27.27%
2.18
13.81%
10.00%
12.77%
27.27%
2.18
13.81%
9.06%
12.52%
24.81%
1.96
12.95%
6.11%
11.25%
24.20%
1.75
12.09%
6.01%
10.62%
23.18%
1.53
11.22%
5.85%
9.98%
21.13%
1.32
10.36%
5.53%
9.34%
15.00%
1.10
9.50%
4.55%
8.76%
27.27%
2.18
13.81%
10.00%
12.77%
Cost of Debt
6.5%+3.5%=10.0%
Tax rate = 0% -> 35%
Riskfree Rate:
T. Bond rate = 5.1%
+
Aswath Damodaran
Beta
2.18-> 1.10
Internet/
Retail
Operating
Leverage
Term. Year
$24,912
$2,302
$1,509
$ 445
$1,064
Forever
Weights
Debt= 27.3% -> 15%
Amazon.com
January 2001
Stock price = $14
Risk Premium
4%
Current
D/E: 37.5%
Stable
ROC=16.94%
Reinvest 29.5%
of EBIT(1-t)
1
Revenues
$4,314
EBIT
-$545
EBIT(1-t)
-$545
- Reinvestment $612
FCFF
-$1,157
1
Cost of Equity
13.81%
263
Stable Growth
Stable
Stable
Operating
Revenue
Margin:
Growth: 5%
9.32%
Base Equity
Premium
Country Risk
Premium
$90.00
$80.00
$70.00
$60.00
$50.00
Value per share
Price per share
$40.00
$30.00
$20.00
$10.00
$0.00
2000
2001
2002
2003
Time of analysis
Aswath Damodaran
264
Aswath Damodaran
265
Aswath Damodaran
266
267
Aswath Damodaran
Aswath Damodaran
268
Excess
Return
(ROC
minus
Cost
of
Capital)
for
rms
with
market
capitalizaDon>
$50
million:
Global
in
2014
45.00%
40.00%
35.00%
30.00%
<-5%
25.00%
-5%
-
0%
0
-5%
20.00%
5
-10%
15.00%
>10%
10.00%
5.00%
0.00%
Australia,
NZ
and
Developed
Europe
Emerging
Markets
Canada
Aswath Damodaran
Japan
United States
Global
269
Current Cost
of Capital
Aswath Damodaran
Optimal: Cost of
capital lowest
between 20 and
30%.
270
Aswath Damodaran
271
Aswath Damodaran
272
Reinvestment Rate
-30.00%
Return on Capital
5%
Expected Growth
in EBIT (1-t)
-.30*..05=-0.015
-1.5%
Stable Growth
g = 2%; Beta = 1.00;
Country Premium= 0%
Cost of capital = 7.13%
ROC= 7.13%; Tax rate=38%
Reinvestment Rate=28.05%
Terminal Value4= 868/(.0713-.02) = 16,921
EBIT (1-t)
- Reinvestment
FCFF
1
$1,165
($349)
$1,514
2
$1,147
($344)
$1,492
3
$1,130
($339)
$1,469
4
$1,113
($334)
$1,447
Term Yr
$1,206
$ 339
$ 868
Cost of Equity
9.58%
Riskfree Rate
Riskfree rate = 4.09%
273
Aswath Damodaran
Cost of Debt
(4.09%+3,65%)(1-.38)
= 4.80%
Beta
1.22
Weights
E = 56.6% D = 43.4%
Risk Premium
4.00%
Firms D/E
Ratio: 93.1%
Mature risk
premium
4%
Country
Equity Prem
0%
Use
the
bond
raJng
to
esJmate
the
cumulaJve
probability
of
distress
over
10
years
EsJmate
the
probability
of
distress
with
a
probit
EsJmate
the
probability
of
distress
by
looking
at
market
value
of
bonds..
Aswath Damodaran
274
Reinvestment:
Current
Revenue
$ 4,390
Extended
reinvestment
break, due ot
investment in
past
EBIT
$ 209m
Value of Op Assets
+ Cash & Non-op
= Value of Firm
- Value of Debt
= Value of Equity
$ 9,793
$ 3,040
$12,833
$ 7,565
$ 5,268
$ 8.12
Industry
average
Expected
Margin:
-> 17%
$4,434
5.81%
$258
26.0%
$191
-$19
$210
1
$4,523
6.86%
$310
26.0%
$229
-$11
$241
2
$5,427
7.90%
$429
26.0%
$317
$0
$317
3
$6,513
8.95%
$583
26.0%
$431
$22
$410
4
$7,815
10%
$782
26.0%
$578
$58
$520
5
$8,206
11.40%
$935
28.4%
$670
$67
$603
6
$8,616
12.80%
$1,103
30.8%
$763
$153
$611
7
$9,047
14.20%
$1,285
33.2%
$858
$215
$644
8
$9,499 $9,974
15.60% 17%
$1,482 $1,696
35.6% 38.00%
$954
$1,051
$286
$350
$668
$701
9
10
Beta
Cost of equity
Cost of debt
Debtl ratio
Cost of capital
3.14
21.82%
9%
73.50%
9.88%
3.14
21.82%
9%
73.50%
9.88%
3.14
21.82%
9%
73.50%
9.88%
3.14
21.82%
9%
73.50%
9.88%
3.14
21.82%
9%
73.50%
9.88%
2.75
19.50%
8.70%
68.80%
9.79%
2.36
17.17%
8.40%
64.10%
9.50%
1.97
14.85%
8.10%
59.40%
9.01%
1.59
12.52%
7.80%
54.70%
8.32%
Cost of Debt
3%+6%= 9%
9% (1-.38)=5.58%
Riskfree Rate:
T. Bond rate = 3%
+
Aswath Damodaran
Beta
3.14-> 1.20
Casino
1.15
1.20
10.20%
7.50%
50.00%
7.43%
Term. Year
$10,273
17%
$ 1,746
38%
$1,083
$ 325
$758
Forever
Weights
Debt= 73.5% ->50%
Risk Premium
6%
Current
D/E: 277%
Stable
ROC=10%
Reinvest 30%
of EBIT(1-t)
Revenues
Oper margin
EBIT
Tax rate
EBIT * (1 - t)
- Reinvestment
FCFF
Cost of Equity
21.82%
275
Stable Growth
Stable
Stable
Operating
Revenue
Margin:
Growth: 3%
17%
Current
Margin:
4.76%
Base Equity
Premium
Country Risk
Premium
CumulaJve
probability
of
distress
over
10
years
=
1
-
.2334
=
.7666
or
76.66%
Expected
distress
sale
proceeds
=
$2,769
million
<
Face
value
of
debt
Expected
equity
value/share
=
$0.00
Aswath Damodaran
276
Aswath Damodaran
277
Aswath Damodaran
278
Avg Reinvestment
rate =40%
A $ Valuation of Embraer
Reinvestment Rate
40%
Return on Capital
18.1%
Expected Growth in
EBIT (1-t)
.40*.181=.072
7.2%
$ Cashflows
Op. Assets $ 6,239
+ Cash:
3,068
- Debt
2,070
- Minor. Int.
177
=Equity
7,059
-Options
4
Value/Share $9.53
R$ 15.72
Year
EBIT (1-t)
- Reinvestment
FCFF
3
$535
$214
$321
4
$574
$229
$344
Term Yr
524
270
= 254
5
$615
$246
$369
Cost of Debt
(3.8%+1.7%+1.1%)(1-.34)
= 4.36%
Beta
0.88
279
2
$499
$200
$299
Cost of Equity
8.31%
Riskfree Rate:
US$ Riskfree Rate=
3.8%
1
$465
$186
$279
Stable Growth
g = 3.8%; Beta = 1.00;
Country Premium= 1.5%
Cost of capital = 7.38%
ROC= 7.38%; Tax rate=34%
Reinvestment Rate=g/ROC
=3.8/7.38 = 51.47%
Aswath Damodaran
Weights
E = 78.8% D = 21.2%
Mature market
premium
4%
Firms D/E
Ratio: 26.84%
Lambda
0.27
Country Default
Spread
2.2%
Rel Equity
Mkt Vol
1.64
Aswath Damodaran
280
a.
b.
Aswath Damodaran
281
Return on Capital
9.20%
Stable Growth
g = 5%; Beta = 1.00;
Debt ratio = 44.2%
Country Premium= 3%
ROC= 9.22%
Reinvestment Rate=54.35%
Expected Growth
in EBIT (1-t)
.60*.092-= .0552
5.52%
19,578
13,653
18,073
15,158
0
EBIT(1-t)
- Reinvestment
FCFF
$4,928
$2,957
$1,971
$5,200
$3,120
$2,080
$5,487
$3,292
$2,195
$5,790
$3,474
$2,316
Term Yr
6,079
3,304
2,775
Cost of Equity
22.80%
Riskfree Rate:
Rs riskfree rate = 12%
282
$4,670
$2,802
$1,868
Aswath Damodaran
Cost of Debt
(12%+1.50%)(1-.30)
= 9.45%
Beta
1.17
Weights
E = 55.8% D = 44.2%
Risk Premium
9.23%
Firms D/E
Ratio: 79%
Mature risk
premium
4%
Country Risk
Premium
5.23%
Company earns
higher returns on new
projects
Expected Growth
in EBIT (1-t)
.60*.122-= .0732
7.32%
Return on Capital
12.20%
Stable Growth
g = 5%; Beta = 1.00;
Debt ratio = 44.2%
Country Premium= 3%
ROC=12.2%
Reinvestment Rate= 40.98%
Terminal Value5= 3904/(.1478-.05) = 39.921
EBIT(1-t)
- Reinvestment
FCFF
$4,749
$2,850
$1,900
$5,097
$3,058
$2,039
$5,470
$3,282
$2,188
$5,871
$3,522
$2,348
$6,300
$3,780
$2,520
Cost of Equity
22.80%
Riskfree Rate:
Rs riskfree rate = 12%
Cost of Debt
(12%+1.50%)(1-.30)
= 9.45%
Beta
1.17
283
Aswath Damodaran
Weights
E = 55.8% D = 44.2%
Risk Premium
9.23%
Firms D/E
Ratio: 79%
Mature risk
premium
4%
Country Risk
Premium
5.23%
Term Yr
6,615
2,711
3,904
Return on Capital
12.20%
Expected Growth
60*.122 +
.0581 = .1313
13.13%
5.81%
EBIT(1-t)
- Reinvestment
FCFF
$5,006
$3,004
$2,003
$5,664
$3,398
$2,265
$6,407
$3,844
$2,563
$7,248
$4,349
$2,899
$8,200
$4,920
$3,280
Cost of Equity
22.80%
Riskfree Rate:
Rsl riskfree rate = 12%
284
Aswath Damodaran
Cost of Debt
(12%+1.50%)(1-.30)
= 9.45%
Beta
1.17
Weights
E = 55.8% D = 44.2%
Risk Premium
9.23%
Firms D/E
Ratio: 79%
Mature risk
premium
4%
Country Risk
Premium
5.23%
Term Yr
8,610
3,529
5,081
Aswath Damodaran
285
Year
EBIT (1-t)
- Reinvestment
FCFF
Rs Cashflows
1
2
INR 6,174 INR 6,535
INR 3,488 INR 3,692
INR 2,685 INR 2,842
Return on Capital
10.35%
Stable Growth
g = 5%; Beta = 1.00
Country Premium= 3%
Tax rate = 33.99%
Cost of capital = 9.78%
ROC= 9.78%;
Reinvestment Rate=g/ROC
=5/ 9.78= 51.14%
4
INR 7,321
INR 4,137
INR 3,184
5
INR 7,749
INR 4,379
INR 3,370
7841
4010
3831
Return on Capital
17.16%
Rs Cashflows
Op. Assets Rs231,914
+ Cash:
11418
+ Other NO 140576
- Debt
109198
=Equity
274,710
Year
EBIT (1-t)
- Reinvestment
FCFF
1
22533
15773
6760
2
25240
17668
7572
3
28272
19790
8482
Stable Growth
g = 5%; Beta = 1.00
Country Premium= 3%
Cost of capital = 10.39%
Tax rate = 33.99%
ROC= 12%;
Reinvestment Rate=g/ROC
=5/ 12= 41.67%
Expected Growth
from new inv.
.70*.1716=0.1201
4
31668
22168
9500
5
35472
24830
10642
6
39236
25242
13994
7
42848
25138
17711
8
46192
24482
21710
9
49150
23264
25886
10
51607
21503
30104
45278
18866
26412
Value/Share Rs 665
Cost of Equity
13.82%
Riskfree Rate:
Rs Riskfree Rate= 5%
Cost of Debt
(5%+ 2%+3)(1-.3399)
= 6.6%
Beta
1.21
Weights
E = 69.5% D = 30.5%
Mature market
premium
4.5%
Firms D/E
Ratio: 42%
Lambda
0.75
On April 1, 2010
Tata Chemicals price = Rs 314
Country Default
Spread
3%
Riskfree Rate:
Rs Riskfree Rate= 5%
Beta
1.20
Rel Equity
Mkt Vol
1.50
Mature market
premium
4.5%
Firms D/E
Ratio: 33%
Reinvestment Rate
56.73%
Return on Capital
40.63%
Expected Growth
from new inv.
5673*.4063=0.2305
Year
EBIT (1-t)
- Reinvestment
FCFF
1
53429
30308
23120
2
65744
37294
28450
3
80897
45890
35007
4
99544
56468
43076
5
122488
69483
53005
Rel Equity
Mkt Vol
1.50
Stable Growth
g = 5%; Beta = 1.00
Country Premium= 3%
Cost of capital = 9.52%
Tax rate = 33.99%
ROC= 15%;
Reinvestment Rate=g/ROC
=5/ 15= 33.33%
Rs Cashflows
Op. Assets 1,355,361
+ Cash:
3,188
+ Other NO
66,140
- Debt
505
=Equity
1,424,185
Country Default
Spread
3%
Lambda
0.80
6
146299
76145
70154
7
169458
80271
89187
8
190165
81183
108983
9
206538
78509
128029
10
216865
72288
144577
177982
59327
118655
Cost of Equity
10.63%
Riskfree Rate:
Rs Riskfree Rate= 5%
Cost of Debt
(5%+ 0.5%+3)(1-.3399)
= 5.61%
Beta
1.05
286
Aswath Damodaran
Growth declines to 5%
and cost of capital
moves to stable period
level.
Weights
E = 99.9% D = 0.1%
Mature market
premium
4.5%
Firms D/E
Ratio: 0.1%
Lambda
0.20
On April 1, 2010
TCS price = Rs 841
Country Default
Spread
3%
Rel Equity
Mkt Vol
1.50
100.00%
5.32%
1.62%
2.97%
0.22%
4.64%
36.62%
80.00%
47.45%
47.06%
60.00%
40.00%
60.41%
47.62%
50.94%
20.00%
0.00%
Tata Chemicals
Aswath Damodaran
Tata Steel
Tata Motors
TCS
287
Aswath Damodaran
288
Aswath Damodaran
289
Preferred stock is a
significant source of
capital.
What is the value of
equity in the firm?
Aswath Damodaran
290
Dividends
EPS =
1.85 Eur
* Payout Ratio 48.65%
DPS = 0.90 Eur
ROE = 16%
Expected Growth
51.35% *
16% = 8.22%
2.17 Eur
1.05 Eur
2.34Eur
1.14 Eur
2.54 Eur
1.23 Eur
2.75 Eur
1.34 Eur
.........
Forever
Riskfree Rate:
Long term bond rate in
Euros
4.35%
291
Aswath Damodaran
Beta
0.95
Risk Premium
4%
Mature Market
4%
Country Risk
0%
Dividends
EPS =
$16.77 *
Payout Ratio 8.35%
DPS =$1.40
(Updated numbers for 2008
financial year ending 11/08)
ROE = 13.19%
Expected Growth in
first 5 years =
91.65%*13.19% =
12.09%
EPS
Payout ratio
DPS
1
$18.80
8.35%
$1.57
2
$21.07
8.35%
$1.76
3
$23.62
8.35%
$1.97
4
$26.47
8.35%
$2.21
5
$29.67
8.35%
$2.48
6
$32.78
18.68%
$6.12
7
$35.68
29.01%
$10.35
8
$38.26
39.34%
$15.05
9
$40.41
49.67%
$20.07
10
$42.03
60.00%
$25.22
Forever
Cost of Equity
4.10% + 1.40 (4.5%) = 10.4%
Riskfree Rate:
Treasury bond rate
4.10%
Beta
1.40
292
Aswath Damodaran
Risk Premium
4.5%
Impled Equity Risk
premium in 8/08
Mature Market
4.5%
Country Risk
0%
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293
Return on
equity: 17.56%
Retention
Ratio =
45.37%
Dividends (Trailing 12
months)
EPS =
$2.16 *
Payout Ratio 54.63%
DPS =
$1.18
Expected Growth
45.37% *
13.5% = 6.13%
$2.43
$1.33
$2.58
$1.41
$2.74
$1.50
$2.91
$1.59
.........
Forever
Riskfree Rate:
Long term treasury bond
rate
3.60%
294
Aswath Damodaran
Beta
1.20
Risk Premium
5%
Updated in October 2008
Mature Market
5%
Country Risk
0%
The
book
value
of
assets
and
equity
is
mostly
irrelevant
when
valuing
non-nancial
service
companies.
Aper
all,
the
book
value
of
equity
is
a
historical
gure
and
can
be
nonsensical.
(The
book
value
of
equity
can
be
negaJve
and
is
so
for
more
than
a
1000
publicly
traded
US
companies)
With
nancial
service
rms,
book
value
of
equity
is
relevant
for
two
reasons:
Since
nancial
service
rms
mark
to
market,
the
book
value
is
more
likely
to
reect
what
the
rms
own
right
now
(rather
than
a
historical
value)
The
regulatory
capital
raJos
are
based
on
book
equity.
Thus,
a
bank
with
negaJve
or
even
low
book
equity
will
be
shut
down
by
the
regulators.
Aswath Damodaran
295
Aswath Damodaran
296
297
Aswath Damodaran
Aswath Damodaran
298
With
pharmaceuJcal
and
technology
rms,
R&D
is
the
ulJmate
cap
ex
but
is
treated
as
an
operaJng
expense.
With
consulJng
rms
and
other
rms
dependent
on
human
capital,
recruiJng
and
training
expenses
are
your
long
term
investments
that
are
treated
as
operaJng
expenses.
With
brand
name
consumer
product
companies,
a
porJon
of
the
adverJsing
expense
is
to
build
up
brand
name
and
is
the
real
capital
expenditure.
It
is
treated
as
an
operaJng
expense.
Aswath Damodaran
299
4
Current years R&D expense = Cap ex = $3,030 million
R&D amortization = Depreciation = $ 1,694 million
Unamortized R&D = Capital invested (R&D) = $13,284 million
300
Aswath Damodaran
First 5 years
Op. Assets 94214
+ Cash:
1283
- Debt
8272
=Equity
87226
-Options
479
Value/Share $ 74.33
Year
EBIT
EBIT (1-t)
- Reinvestment
= FCFF
1
$9,221
$6,639
$3,983
$2,656
2
$10,106
$7,276
$4,366
$2,911
3
$11,076
$7,975
$4,785
$3,190
Return on Capital
16%
Expected Growth
in EBIT (1-t)
.60*.16=.096
9.6%
Growth decreases
Terminal Value10 = 7300/(.0808-.04) = 179,099
gradually to 4%
4
5
6
7
8
9
10
Term Yr
$12,140 $13,305 $14,433 $15,496 $16,463 $17,306 $17,998
18718
$8,741 $9,580 $10,392 $11,157 $11,853 $12,460 $12,958
12167
$5,244 $5,748 $5,820 $5,802 $5,690 $5,482 $5,183
4867
$3,496 $3,832 $4,573 $5,355 $6,164 $6,978 $7,775
7300
Cost of Equity
11.70%
Riskfree Rate:
Riskfree rate = 4.78%
301
Aswath Damodaran
Cost of Debt
(4.78%+..85%)(1-.35)
= 3.66%
Beta
1.73
Stable Growth
g = 4%; Beta = 1.10;
Debt Ratio= 20%; Tax rate=35%
Cost of capital = 8.08%
ROC= 10.00%;
Reinvestment Rate=4/10=40%
Weights
E = 90% D = 10%
Risk Premium
4%
D/E=11.06%
On May 1,2007,
Amgen was trading
at $ 55/share
Aswath Damodaran
302
Aswath Damodaran
303
Normalized Earnings 1
As a cyclical company, Toyotas earnings have been volatile and 2009 earnings reflect the
troubled global economy. We will assume that when economic growth returns, the
operating margin for Toyota will revert back to the historical average.
Normalized Operating Income = Revenues in 2009 * Average Operating Margin (98--09)
= 22661 * .0733 =1660.7 billion yen
304
Stable Growth 4
Once earnings are normalized, we
assume that Toyota, as the largest
market-share company, will be able
to maintain only stable growth
(1.5% in Yen terms)
19,640
2,288
6,845
11,862
583
/3,448
4735
Regressing Exxons operating income against the oil price per barrel
from 1985-2008:
Operating Income = -6,395 + 911.32 (Average Oil Price) R2 = 90.2%
(2.95) (14.59)
Exxon Mobil's operating income increases about $9.11 billion for every
$ 10 increase in the price per barrel of oil and 90% of the variation in
Exxon's earnings over time comes from movements in oil prices.
Aswath Damodaran
306
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307
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308
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309
Value of cashflows,
adjusted for time
and risk
INTRINSIC
VALUE
Aswath Damodaran
Value
THE GAP
Is there one?
Will it close?
Price
PRICE
Drivers of price
- Market moods & momentum
- Surface stories about fundamentals
310
Investment Strategies
The
Ecient
Marketer
Index funds
The
value
extremist
The
pricing
extremist
Aswath Damodaran
311
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312
Aswath Damodaran
313
MOS
comes
into
play
at
the
end
of
the
investment
process,
not
at
the
beginning.
MOS
does
not
subsJtute
for
risk
assessment
and
intrinsic
valuaJon,
but
augments
them.
The
MOS
cannot
and
should
not
be
a
xed
number,
but
should
be
reecJve
of
the
uncertainty
in
the
assessment
of
intrinsic
value.
Being
too
conservaJve
can
be
damaging
to
your
long
term
investment
prospects.
Too
high
a
MOS
can
hurt
you
as
an
investor.
Aswath Damodaran
314
There
is
a
widely
held
view
among
value
investors
that
they
are
not
as
exposed
to
risk
as
the
rest
of
the
market,
because
they
do
their
homework,
poring
over
nancial
statements
or
using
raJos
to
screen
for
risky
stocks.
Put
simply,
they
are
assuming
that
the
more
they
know
about
an
investment,
the
less
risky
it
becomes.
That
may
be
true
from
some
peripheral
risks
and
a
few
rm
specic
risks,
but
it
denitely
is
not
for
the
macro
risks.
You
cannot
make
a
cyclical
company
less
cyclical
by
studying
it
more
or
take
the
naJonalizaJon
risk
out
of
Venezuelan
company
by
doing
more
research.
ImplicaDon
1:
The
need
for
diversicaJon
does
not
decrease
just
because
you
are
a
value
investor
who
picks
stocks
with
much
research
and
care.
ImplicaDon
2:
There
is
a
law
of
diminishing
returns
to
informaJon.
At
a
point,
addiJonal
informaJon
will
only
serve
to
distract
you.
Aswath Damodaran
315
Best-case,
Worst-case
analyses,
where
you
set
all
the
inputs
at
their
most
opJmisJc
and
most
pessimisJc
levels
Plausible
scenarios:
Here,
you
dene
what
you
feel
are
the
most
plausible
scenarios
(allowing
for
the
interacJon
across
variables)
and
value
the
company
under
these
scenarios
SensiJvity
to
specic
inputs:
Change
specic
and
key
inputs
to
see
the
eect
on
value,
or
look
at
the
impact
of
a
large
event
(FDA
approval
for
a
drug
company,
loss
in
a
lawsuit
for
a
tobacco
company)
on
value.
Aswath Damodaran
316
Correlation =0.4
Aswath Damodaran
317
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318
The
karmic
approach:
In
this
one,
you
buy
(sell
short)
under
(over)
valued
companies
and
sit
back
and
wait
for
the
gap
to
close.
You
are
implicitly
assuming
that
given
Jme,
the
market
will
see
the
error
of
its
ways
and
x
that
error.
The
catalyst
approach:
For
the
gap
to
close,
the
price
has
to
converge
on
value.
For
that
convergence
to
occur,
there
usually
has
to
be
a
catalyst.
If
you
are
an
acJvist
investor,
you
may
be
the
catalyst
yourself.
In
fact,
your
act
of
buying
the
stock
may
be
a
sucient
signal
for
the
market
to
reassess
the
price.
If
you
are
not,
you
have
to
look
for
other
catalysts.
Here
are
some
to
watch
for:
a
new
CEO
or
management
team,
a
blockbuster
new
product
or
an
acquisiJon
bid
where
the
rm
is
targeted.
Aswath Damodaran
319
A
closing
thought
320
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320