Aswath Damodaran

SESSION  1:  AN  INTRODUCTION  

TO  VALUATION  
Aswath  Damodaran  
 Some  Ini=al  Thoughts  
2

¨ "  One  hundred  thousand  lemmings  cannot  be  wrong"  

 Graffi=  

We thought we were in the top of the eighth inning, when we were in the bottom of the
ninth..
Stanley

Druckenmiller
2

 Misconcep=ons  about  Valua=on  
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¨ Myth  1:  A  valua=on  is  an  objec=ve  search  for  “true”  value  
¤ Truth  1.1:  All  valua=ons  are  biased.  The  only  ques=ons  are  how  much  and  
in  which  direc=on.  
¤ Truth  1.2:  The  direc=on  and  magnitude  of  the  bias  in  your  valua=on    is  
directly  propor=onal  to  who  pays  you  and  how  much  you  are  paid.  
¨ Myth  2.:  A  good  valua=on  provides  a  precise  es=mate  of  value  
¤ Truth  2.1:  There  are  no  precise  valua=ons.    
¤ Truth  2.2:  The  payoff  to  valua=on  is  greatest  when  valua=on  is  least  
precise.  
¨ Myth  3:  .  The  more  quan=ta=ve  a  model,  the  beRer  the  valua=on  
¤ Truth  3.1:  One’s  understanding  of  a  valua=on  model    is  inversely  
propor=onal  to  the  number  of  inputs  required  for  the  model.  
¤ Truth  3.2:  Simpler  valua=on  models  do  much  beRer  than  complex  ones.  

Aswath Damodaran

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 Approaches  to  Valua=on  
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¨ Intrinsic  valua=on,  relates  the  value  of  an  asset  to  its  intrinsic  
characteris=cs:  its  capacity  to  generate  cash  flows  and  the  
risk  in  the  cash  flows.  In  it’s  most  common  form,  intrinsic  
value  is  computed  with  a  discounted  cash  flow  valua=on,  
with  the  value  of  an  asset  being  the  present  value  of  
expected  future  cashflows  on  that  asset.    
¨ Rela=ve  valua=on,  es=mates  the  value  of  an  asset  by  looking  
at  the  pricing  of  'comparable'  assets  rela=ve  to  a  common  
variable  like  earnings,  cashflows,  book  value  or  sales.    
¨ Con=ngent  claim  valua=on,  uses  op=on  pricing  models  to  
measure  the  value  of  assets  that  share  op=on  characteris=cs.    

Aswath Damodaran

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 Basis  for  all  valua=on  approaches  
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¨ The  use  of  valua=on  models  in  investment  decisions  

(i.e.,  in  decisions  on  which  assets  are  under  valued  
and  which  are  over  valued)  are  based  upon    
¤  a  percep=on  that  markets  are  inefficient  and  make  
mistakes  in  assessing  value  
¤ an  assump=on  about  how  and  when  these  inefficiencies  
will  get  corrected  
¨ In  an  efficient  market,  the  market  price  is  the  best  
es=mate  of  value.  The  purpose  of  any  valua=on  
model  is  then  the  jus=fica=on  of  this  value.  
Aswath Damodaran

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 Discounted  Cash  Flow  Valua=on  
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¨ What  is  it:  In  discounted  cash  flow  valua=on,  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  
es=mated,  based  upon  its  characteris=cs  in  terms  of  cash  flows,  
growth  and  risk.  
¨ Informa=on  Needed:  To  use  discounted  cash  flow  valua=on,  you  
need  
¤ to  es=mate  the  life  of  the  asset  
¤ to  es=mate  the  cash  flows  during  the  life  of  the  asset  
¤ to  es=mate  the  discount  rate  to  apply  to  these  cash  flows  to  get  present  
value  
¨ Market  Inefficiency:  Markets  are  assumed  to  make  mistakes  in  
pricing  assets  across  =me,  and  are  assumed  to  correct  themselves  
over  =me,  as  new  informa=on  comes  out  about  assets.  

Aswath Damodaran

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 Rela=ve  Valua=on  
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¨ What  is  it?:  The  value  of  any  asset  can  be  es=mated  by  looking  at  
how  the  market  prices  “similar”  or  ‘comparable”  assets.  
¨ Philosophical  Basis:  The  intrinsic  value  of  an  asset  is  impossible  (or  
close  to  impossible)  to  es=mate.  The  value  of  an  asset  is  whatever  
the  market  is  willing  to  pay  for  it  (based  upon  its  characteris=cs)  
¨ Informa=on  Needed:  To  do  a  rela=ve  valua=on,  you  need    
¤ an  iden=cal  asset,  or  a  group  of  comparable  or  similar  assets  
¤ a  standardized  measure  of  value  (in  equity,  this  is  obtained  by  dividing  the  
price  by  a  common  variable,  such  as  earnings  or  book  value)  
¤ and  if  the  assets  are  not  perfectly  comparable,  variables  to  control  for  the  
differences  
¨ Market  Inefficiency:  Pricing  errors  made  across  similar  or  
comparable  assets  are  easier  to  spot,  easier  to  exploit  and  are  
much  more  quickly  corrected.  

Aswath Damodaran

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 Con=ngent  Claim  (Op=on)  Valua=on  
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¨ What  is  it:  In  con=ngent  claim  valua=on,  you  value  an  asset  
with  cash  flows  con=ngent  on  an  event  happening  as  op=ons.    
¨ Philosophical  Basis:  When  you  buy  an  op=on-­‐like  asset,  you  
change  your  risk  tradeoff  –  you  have  limited  downside  risk  
and  almost  unlimited  upside  risk.  Thus,  risk  becomes  your  
ally.  
¨ Informa=on  Needed:  To  use  con=ngent  claim  valua=on,  you  
need  
¤ define  the  underlying  asset  on  which  you  have  the  op=on  
¤ a  conven=onal  value  for  your  asset,  using  discounted  cash  flow  
valua=on  
¤ the  con=ngency  that  will  trigger  the  cash  flow  on  the  op=on  
¨ Market  Inefficiency:  Investors  who  ignore  the  op=onality  in  
op=on-­‐like  assets  will  misprice  them.  
Aswath Damodaran

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 Indirect  Examples  of  Op=ons  
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¨ Equity  in  a  deeply  troubled  firm  -­‐  a  firm  with  nega=ve  

earnings  and  high  leverage  -­‐  can  be  viewed  as  an  op=on  to  
liquidate  that  is  held  by  the  stockholders  of  the  firm.    Viewed  
as  such,  it  is  a  call  op=on  on  the  assets  of  the  firm.  
¨ The  reserves  owned  by  natural  resource  firms  can  be  viewed  
as  call  op=ons  on  the  underlying  resource,  since  the  firm  can  
decide  whether  and  how  much  of  the  resource  to  extract  
from  the  reserve,  
¨ The  patent  owned  by  a  firm  or  an  exclusive  license  issued  to  a  
firm  can  be  viewed  as  an  op=on  on  the  underlying  product  
(project).  The  firm  owns  this  op=on  for  the  dura=on  of  the  
patent.  
¨ The  rights  possessed  by  a  firm  to  expand  an  exis=ng  
investment  into    new  markets  or  new  products.  
Aswath Damodaran

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 In  summary…  
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¨ While  there  are  hundreds  of  valua=on  models  and  

metrics  around,  there  are  only  three  valua=on  
approaches:  
¤ Intrinsic  valua=on  (usually,  but  not  always  a  DCF  valua=on)  
¤ Rela=ve  valua=on    
¤ Con=ngent  claim  valua=on  
¨ The  three  approaches  can  yield  different  es=mates  of  
value  for  the  same  asset  at  the  same  point  in  =me.  
¨ To  truly  grasp  valua=on,  you  have  to  be  able  to  
understand  and  use  all  three  approaches.  There  is  a  =me  
and  a  place  for  each  approach,  and  knowing  when  to  use  
each  one  is  a  key  part  of  mastering  valua=on.  

Aswath Damodaran

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 Aswath Damodaran! 1!

SESSION  2:  INTRINSIC  

VALUATION  
LAYING  THE  FOUNDATION  
‹#›! Aswath  Damodaran  
 The  essence  of  intrinsic  value  
2!

¨ In  intrinsic  valuaFon,  you  value  an  asset  based  upon  its  

intrinsic  characterisFcs.    
¨ For  cash  flow  generaFng  assets,  the  intrinsic  value  will  
be  a  funcFon  of  the  magnitude  of  the  expected  cash  
flows  on  the  asset  over  its  lifeFme  and  the  uncertainty  
about  receiving  those  cash  flows.  
¨ Discounted  cash  flow  valuaFon  is  a  tool  for  esFmaFng  
intrinsic  value,  where  the  expected  value  of  an  asset  is  
wriOen  as  the  present  value  of  the  expected  cash  flows  
on  the  asset,  with  either  the  cash  flows  or  the  discount  
rate  adjusted  to  reflect  the  risk.  

Aswath Damodaran!
2!
 The  two  faces  of  discounted  cash  flow  valuaFon  
3!

¨ The  value  of  a  risky  asset  can  be  esFmated  by  discounFng  the  
expected  cash  flows  on  the  asset  over  its  life  at  a  risk-­‐adjusted  
discount  rate:    
 
   
where  the  asset  has  a  n-­‐year  life,  E(CFt)  is  the  expected  cash  flow  in  period  t  
and  r  is  a  discount  rate  that  reflects  the  risk  of  the  cash  flows.  
¨ AlternaFvely,  we  can  replace  the  expected  cash  flows  with  the  
guaranteed  cash  flows  we  would  have  accepted  as  an  alternaFve  
(certainty  equivalents)  and  discount  these  at  the  riskfree  rate:  

   
 where  CE(CFt)  is  the  certainty  equivalent  of  E(CFt)  and  rf    is  
the  riskfree  rate.  

Aswath Damodaran!
3!
 Risk  Adjusted  Value:  Two  Basic  ProposiFons  
4!

¨ ProposiFon  1:  For  an  asset  to  have  value,  the  expected  cash  
flows  have  to  be  posiFve  some  Fme  over  the  life  of  the  asset.  
¨ ProposiFon  2:  Assets  that  generate  cash  flows  early  in  their  
life  will  be  worth  more  than  assets  that  generate  cash  flows  
later;  the  laOer  may  however  have  greater  growth  and  higher  
cash  flows  to  compensate.  
Aswath Damodaran!
4!
 DCF  Choices:  Equity  ValuaFon  versus  Firm  
ValuaFon  
5!

Firm Valuation: Value the entire business!

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Equity valuation: Value just the

equity claim in the business

Aswath Damodaran!
5!
 Equity  ValuaFon  
6!

Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

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

Aswath Damodaran!
6!
 Firm  ValuaFon  
7!

Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

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

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

Aswath Damodaran!
7!
 Generic  DCF  ValuaFon  Model  
8!

DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Equity: After debt Net Income/EPS Firm is in stable growth:
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

Aswath Damodaran!
8!
 First  Principle  of  ValuaFon  
9!

¨ Consistency  principle:  Your  discount  rate  should  match  

up  to  your  cash  flows.      
¨ The  key  error  to  avoid  is  mismatching  cashflows  and  
discount  rates:  
¤ DiscounFng  cashflows  to  equity  at  the  weighted  average  cost  of  
capital  will  lead  to  an  upwardly  biased  esFmate  of  the  value  of  
equity  
¤ DiscounFng  cashflows  to  the  firm  at  the  cost  of  equity  will  yield  
a  downward  biased  esFmate  of  the  value  of  the  firm.  

Aswath Damodaran!
9!
 Aswath Damodaran! 1!

SESSION  3:  DISCOUNT  RATE  

BASICS  
THE  RISK  FREE  RATE  
Aswath  Damodaran  
 Es=ma=ng  Inputs:  Discount  Rates  
2!

¨ Cri=cal  ingredient  in  discounted  cashflow  valua=on.  Errors  in  

es=ma=ng  the  discount  rate  or  mismatching  cashflows  and  
discount  rates  can  lead  to  serious  errors  in  valua=on.    
¨ At  an  intui=ve  level,  the  discount  rate  used  should  be  
consistent  with  both  the  riskiness  and  the  type  of  cashflow  
being  discounted.  
¤ Equity  versus  Firm:  If  the  cash  flows  being  discounted  are  cash  flows  to  
equity,  the  appropriate  discount  rate  is  a  cost  of  equity.  If  the  cash  
flows  are  cash  flows  to  the  firm,  the  appropriate  discount  rate  is  the  
cost  of  capital.  
¤ Currency:  The  currency  in  which  the  cash  flows  are  es=mated  should  
also  be  the  currency  in  which  the  discount  rate  is  es=mated.  
¤ Nominal  versus  Real:  If  the  cash  flows  being  discounted  are  nominal  
cash  flows  (i.e.,  reflect  expected  infla=on),  the  discount  rate  should  be  
nominal  

Aswath Damodaran!
2!
 Cost  of  Equity  
3!

¨ The  cost  of  equity  should  be  higher  for  riskier  

investments  and  lower  for  safer  investments  
¨ While  risk  is  usually  defined  in  terms  of  the  variance  of  
actual  returns  around  an  expected  return,  risk  and  
return  models  in  finance  assume  that  the  risk  that  
should  be  rewarded  (and  thus  built  into  the  discount  
rate)  in  valua=on  should  be  the  risk  perceived  by  the  
marginal  investor  in  the  investment  
¨ Most  risk  and  return  models  in  finance  also  assume  that  
the  marginal  investor  is  well  diversified,  and  that  the  
only  risk  that  he  or  she  perceives  in  an  investment  is  risk  
that  cannot  be  diversified  away  (I.e,  market  or  non-­‐
diversifiable  risk)  
Aswath Damodaran!
3!
 The  Cost  of  Equity:  Compe=ng  Models  
4!

Model  Expected  Return      Inputs  Needed  

CAPM  E(R)  =  Rf  +  β  (Rm-­‐  Rf)      Riskfree  Rate  
         Beta  rela=ve  to  market  porXolio  
         Market  Risk  Premium  
APM  E(R)  =  Rf  +  Σ βj  (Rj-­‐  Rf)      Riskfree  Rate;  #  of  
Factors;  
         Betas  rela=ve  to  each  factor  
         Factor  risk  premiums  
Mul=    E(R)  =  Rf  +  Σ βj  (Rj-­‐  Rf)      Riskfree  Rate;  Macro  
factors  
factor          Betas  rela=ve  to  macro  factors  
         Macro  economic  risk  premiums  
Proxy  E(R)  =  a  +  Σ    bj  Yj        Proxies      
         Regression  coefficients  

Aswath Damodaran!
4!
 The  CAPM:  Cost  of  Equity  
5!

¨ While  the  CAPM  (and  the  CAPM  beta)  has  come  in  for  well-­‐
jus=fied  cri=cism  over  the  last  four  decades  (for  making  
unrealis=c  assump=ons,  for  having  parameters  that  are  tough  
to  es=mate  and  for  not  working  well),  it  remains  the  most-­‐
widely  used  model  in  prac=ce.  
¨ In  the  CAPM,  the  cost  of  equity  is  a  func=on  of  three  inputs  

 Cost  of  Equity  =  Riskfree  Rate  +  Equity  Beta  *  (Equity  

Risk  Premium)  
¨ In  prac=ce,  
¤ Government  security  rates  are  used  as  risk  free  rates  
¤ Historical  risk  premiums  are  used  for  the  risk  premium  
¤ Betas  are  es=mated  by  regressing  stock  returns  against  market  returns  

Aswath Damodaran!
5!
 A  Riskfree  Rate  
6!

¨ On  a  riskfree  asset,  the  actual  return  is  equal  to  the  expected  
return.  Therefore,  there  is  no  variance  around  the  expected  return.  
¨ For  an  investment  to  be  riskfree,  then,  it  has  to  have  
¤ No  default  risk  
¤ No  reinvestment  risk  
1. Time  horizon  mabers:  Thus,  the  riskfree  rates  in  valua=on  will  
depend  upon  when  the  cash  flow  is  expected  to  occur  and  will  
vary  across  =me.  If  your  cash  flows  stretch  out  over  the  long  
term,  your  risk  free  rate  has  to  be  a  long  term  risk  free  rate.    
2. Not  all  government  securi=es  are  riskfree:  Some  governments  
face  default  risk  and  the  rates  on  bonds  issued  by  them  will  not  
be  riskfree.  

Aswath Damodaran!
6!
 Let’s  start  easy  
A  riskfree  rate  in  US  dollars!  
7!

¨ If  you  are  valuing  a  company  in  US  dollars,  you  need  a  US  dollar  
risk  free  rate.  
¨ In  prac=ce,  we  have  tended  to  use  US  treasury  rates  as  risk  free  
rates,  but  that  is  built  on  the  presump=on  that  the  US  treasury  is  
default  free.  
¤ If  you  accept  the  premise  that  the  US  treasury  is  default  free,  you  s=ll  have  
several  choices,  since  the  US  treasury  issues  securi=es  with  differing  
maturi=es  (ranging  from  3  months  to  30  years)  as  well  in  real  or  nominal  
terms  (Infla=on  protected  treasuries  (TIPs)  or  nominal  treasuries)  
¤ In  valua=on,  we  es=mate  cash  flows  forever  (or  at  least  for  very  long  =me  
periods)  and  in  nominal  terms.  The  correct  risk  free  rate  to  use  should  
therefore  be  a  long  term,  nominal  rate.  The  thirty-­‐year  treasury  bond  rate  
is  the  longest  term  rate  that  you  can  find  and  there  is  a  good  case  to  be  
made  that  it  should  be  the  risk  free  rate.  However,  given  how  difficult  it  is  
to  get  the  other  inputs  for  the  discount  rate  (default  spreads  &  equity  risk  
premium)  over  thirty  year  periods,  you  should  consider  using  the  ten-­‐year  
US  treasury  bond  rate  as  your  risk  free  rate  for  US  dollar  valua=ons.  

Aswath Damodaran!
7!
 A  Riskfree  Rate  in  Euros  
8!

Aswath Damodaran!
8!
 A  Riskfree  Rate  in  nominal  Reais  
9!

¨ The  Brazilian  government  had  10-­‐year  BR$  denominated  

bonds  outstanding  in  January  2013,  with  an  interest  rate  of  
9%.    
¨ In  January  2013,  the  Brazilian  government  had  a  local  
currency  sovereign  ra=ng  of  Baa2.  The  typical  default  spread  
(over  a  default  free  rate)  for  Baa2  rated  country  bonds  in  
January  2013  was  1.75%.  The  risk  free  rate  in  nominal  reais  is  
therefore:  
Riskfree  rate  in  Reais    =  Nominal  10-­‐year  BR$  rate  –  Default  spread  
     =  9%  -­‐  1.75%  =  7.25%  

Aswath Damodaran!
9!
 Sovereign  Default  Spreads:  Two  paths  to  the  
same  des=na=on…  
10!

Aswath Damodaran!
10!
 And  a  third  –  Average  Default  Spreads:  January  
2013  
11!

Rating! Default spread in basis points!

Aaa   0  
Aa1   25  
Aa2   50  
Aa3   70  
A1   85  
A2   100  
A3   115  
Baa1   150  
Baa2   175  
Baa3   200  
Ba1   240  
Ba2   275  
Ba3   325  
B1   400  
B2   500  
B3   600  
Caa1   700  
Caa2   850  
Caa3   1000  

Aswath Damodaran!
11!
 Risk  free  rates  in  different  currencies:  January  
2013  
12!

Aswath Damodaran!
12!
 Aswath Damodaran! 1!

SESSION  4:  EQUITY  RISK  

PREMIUMS  
DCF  Valua8on  
 Equity  Risk  Premiums:  Intui8on  
2!

¨ The  equity  risk  premium  is  the  premium  that  investors    

charge  for  inves8ng  in  the  average  equity.  For  lack  of    a  
beLer  descrip8on,  think  of  it  as  the  price  of  bearing  a  
unit  of  equity  risk.  
¨ It  is  a  func8on  of    
¤ How  risk  averse  investors  are  collec8vely  
¤ How  much  risk  they  see  in  the  average  equity  
¨ The  level  of  the  equity  risk  premium  should  vary  over  
8me  as  a  func8on  of:  
¤ Changing  macro  economic  risk  (infla8on  &  GDP  growth)  
¤ The  fear  of  catastrophic  risk    
¤ The  transparency  or  lack  thereof  of  the  companies  issuing  
equity  
Aswath Damodaran!
2!
 Equity  Risk  Premiums  
The  ubiquitous  historical  risk  premium  
3!

¨ The  historical  premium  is  the  premium  that  stocks  have  historically  earned  over  
riskless  securi8es.  
¨ While  the  users  of  historical  risk  premiums  act  as  if  it  is  a  fact  (rather  than  an  
es8mate),  it  is  sensi8ve  to    
¤ How  far  back  you  go  in  history…  
¤ Whether  you  use  T.bill  rates  or  T.Bond  rates  
¤ Whether  you  use  geometric  or  arithme8c  averages.  

Aswath Damodaran!
3!
 The  perils  of  trus8ng  the  past…….  
4!

¨ Noisy  es8mates:  Even  with  long  8me  periods  of  history,  

the  risk  premium  that  you  derive  will  have  substan8al  
standard  error.  For  instance,  if  you  go  back  to  1928  
(about  80  years  of  history)  and  you  assume  a  standard  
devia8on  of  20%  in  annual  stock  returns,  you  arrive  at  a  
standard  error  of  greater  than  2%:      
Standard  Error  in  Premium  =  20%/√80  =  2.26%  
¨ Survivorship  Bias:  Using  historical  data  from  the  U.S.  
equity  markets  over  the  twen8eth  century  does  create  a  
sampling  bias.  Ader  all,  the  US  economy  and  equity  
markets  were  among  the  most  successful  of  the  global  
economies  that  you  could  have  invested  in  early  in  the  
century.  
Aswath Damodaran!
4!
 An  Updated  Equity  Risk  Premium:    

¨ On  January  1,  2013,  the  S&P  500  was  at  1426.19,  essen8ally  unchanged  
for  the  year.  And  it  was  a  year  of  macro  shocks  –  poli8cal  upheaval  in  the  
Middle  East  and  sovereign  debt  problems  in  Europe.  The  treasury  bond  
rate  dropped  below  2%  and  buybacks/dividends  surged.  

In 2012, the actual cash

returned to stockholders was After year 5, we will assume that
Analysts expect earnings to grow 7.67% in 2013, 7.28% in 2014,
72.25. Using the average total earnings on the index will grow at
scaling down to 1.76% in 2017, resulting in a compounded annual
yield for the last decade yields 1.76%, the same rate as the entire
growth rate of 5.27% over the next 5 years. We will assume that
69.46 economy (= riskfree rate).
dividends & buybacks will tgrow 5.27% a year for the next 5 years.

73.12 76.97 81.03 85.30 89.80 Data Sources:

Dividends and Buybacks
last year: S&P
73.12 76.97 81.03 85.30 89.80 89.80(1.0176) Expected growth rate:
January 1, 2013 1426.19 = + + + + +
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (r −.0176)(1+ r)5
2 3 4 5
S&P, Media reports,
S&P 500 is at 1426.19 Factset, Thomson-
Adjusted Dividends & Buybacks Expected Return on Stocks (1/1/13) = 7.54% Reuters
for base year = 69.46 T.Bond rate on 1/1/13 = 1.76%
Equity Risk Premium = 7.54% - 1.76% = 5.78%

Aswath Damodaran

5!
 6!

2012

2011

2010

2009

Implied  Premiums  in  the  US:  1960-­‐2012  

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

Implied Premium for US Equity Market

1989

1988

1987

Year

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1970

1969

1968

1967

1966

Aswath Damodaran!
1965

1964

1963

1962

1961

1960

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Implied Premium

6!
 Why  implied  premiums  maLer?  
7!

¨ In  many  investment  banks,  it  is  common  prac8ce  (especially  

in  corporate  finance  departments)  to  use  historical  risk  
premiums  (and  arithme8c  averages  at  that)  as  risk  premiums  
to  compute  cost  of  equity.  If  all  analysts  in  the  department  
used  the  geometric  average  premium  for  1928-­‐2012  of  4.2%  
to  value  stocks  in  January  2013,  given  the  implied  premium  of  
5.78%,  what  were  they  likely  to  find?  
¨ The  values  they  obtain  will  be  too  low  (most  stocks  will  look  
overvalued)  
¨ The  values  they  obtain  will  be  too  high  (most  stocks  will  look  
under  valued)    
¨ There  should  be  no  systema8c  bias  as  long  as  they  use  the  
same  premium  (4.2%)  to  value  all  stocks.  

Aswath Damodaran!
7!
 Es8ma8ng  a  risk  premium  for  an  emerging  market  
Approach  1:  Build  off  a  mature  market  premium  
8!

¨ Assume  that  the  equity  risk  premium  for  the  US  and  other  mature  
equity  markets  was  5.8%  in  January  2013.  You  could  then  add  on  
an  addi8onal  premium  for  inves8ng  in  an  emerging  markets.  
¨ Two  ways  of  es8ma8ng  the  country  risk  premium:  
¤ Default  spread  on  Country  Bond:  In  this  approach,  the  country  equity  risk  
premium  is  set  equal  to  the  default  spread  of  the  bond  issued  by  the  
country.  Brazil’s  default  spread,  based  on  its  ra8ng,  in  September  2011  
was  1.75%.  
n Equity  Risk  Premium  for  Brazil  =  5.8%  +  1.75%  =  7.55%  
¤ Adjusted  for  equity  risk:  The  country  equity  risk  premium  is  based  upon  
the  vola8lity  of  the  equity  market  rela8ve  to  the  government  bond    rate.  
n Standard  Devia8on  in  Bovespa  =  21%  
n Standard  Devia8on  in  Brazilian  government  bond=  14%  
n Default  spread  on  Brazilian  Bond=  1.75%  
n Total  equity  risk  premium  for  Brazil  =  5.8%  +  1.75%  (21/14)  =  8.43%  

Aswath Damodaran!
8!
 Approach  2:  Es8mate  an  implied  equity  risk  
premium  for  Brazil  
9!

Aswath Damodaran!
9!
 Belgium
1.05%
6.85%
Albania
6.00%
11.80%

Germany
0.00%
5.80%
Armenia
4.13%
9.93%
Bangladesh
4.88%
10.68%

Portugal
4.88%
10.68%
Azerbaijan
3.00%
8.80%
Cambodia
7.50%
13.30%

China
1.05%
6.85%

Italy
2.63%
8.43%
Belarus
9.00%
14.80%

Country Risk Premiums!
Luxembourg
0.00%
5.80%
Bosnia &
Fiji Islands
6.00%
11.80%

Hong Kong
0.38%
6.18%

January 2013! Austria
0.00%
5.80%
Herzegovina
9.00%
14.80%
India
3.00%
8.80%

Denmark
0.00%
5.80%
Bulgaria
2.63%
8.43%
Indonesia
3.00%
8.80%

France
0.38%
6.18%
Croatia
3.00%
8.80%
Japan
1.05%
6.85%

Finland
0.00%
5.80%
Czech Republic
1.28%
7.08%
Korea
1.05%
6.85%

Estonia
1.28%
7.08%
Macao
1.05%
6.85%

Canada
0.00%
5.80%
Greece
10.50%
16.30%

3.00%
8.80%
Georgia
4.88%
10.68%
Malaysia
1.73%
7.53%

USA
0.00%
5.80%
Iceland

9.40%
Hungary
3.60%
9.40%
Mongolia
6.00%
11.80%

N. America
0.00%
5.80%
Ireland
3.60%

Netherlands
0.00%
5.80%
Kazakhstan
2.63%
8.43%
Pakistan
10.50%
16.30%

Papua New Guinea
6.00%
11.80%

Norway
0.00%
5.80%
Latvia
3.00%
8.80%

Slovenia
2.63%
8.43%
Lithuania
2.25%
8.05%
Philippines
3.60%
9.40%

Singapore
0.00%
5.80%

Argentina
9.00%
14.80%

Spain
3.00%
8.80%
Moldova
9.00%
14.80%

Sri Lanka
6.00%
11.80%

Belize
15.00%
20.80%

Sweden
0.00%
5.80%
Montenegro
4.88%
10.68%
Taiwan
1.05%
6.85%

Bolivia
4.88%
10.68%
Poland
1.50%
7.30%
Thailand
2.25%
8.05%

Switzerland
0.00%
5.80%

Brazil
2.63%
8.43%
Romania
3.00%
8.80%
Vietnam
7.50%
13.30%

Turkey
3.60%
9.40%

Chile
1.05%
6.85%

UK
0.00%
5.80%
Russia
2.25%
8.05%
Asia
1.55%
7.35%

Colombia
3.00%
8.80%
Slovakia
1.50%
7.30%

W.Europe
1.05%
6.85%

Costa Rica
3.00%
8.80%
Ukraine
9.00%
14.80%

Ecuador
10.50%
16.30%
Angola
4.88%
10.68%
E. Europe &
El Salvador
4.88%
10.68%
Botswana
1.50%
7.30%
Russia
2.68%
8.48%

Guatemala
3.60%
9.40%
Egypt
7.50%
13.30%

Honduras
7.50%
13.30%
Kenya
6.00%
11.80%
Bahrain
2.25%
8.05%
Australia
0.00%
5.80%

Mexico
2.25%
8.05%
Mauritius
2.25%
8.05%
Israel
1.28%
7.08%
New Zealand
0.00%
5.80%

Nicaragua
9.00%
14.80%
Morocco
3.60%
9.40%
Jordan
4.13%
9.93%
Australia &
Panama
2.63%
8.43%
Namibia
3.00%
8.80%
Kuwait
0.75%
6.55%
NZ
0.00%
5.80%

Paraguay
6.00%
11.80%
Nigeria
4.88%
10.68%
Lebanon
6.00%
11.80%

Peru
2.63%
8.43%
Senegal
6.00%
11.80%
Oman
1.28%
7.08%
Black #: Total ERP

Uruguay
3.00%
8.80%
South Africa
2.25%
8.05%
Qatar
0.75%
6.55%
Red #: Country risk premium

Venezuela
6.00%
11.80%
AVG: GDP weighted average

10
Aswath Damodaran
Tunisia
3.00%
8.80%
Saudi Arabia
1.05%
6.85%

Latin America
3.38%
9.18%
Zambia
6.00%
11.80%
United Arab Emirates
0.75%
6.55%

Africa
4.29%
10.09%
Middle East
1.16%
6.96%

 From  Country  Equity  Risk  Premiums  to  
Corporate  Equity  Risk  premiums  
¨ Approach  1:  Assume  that  every  company  in  the  country  is  equally  exposed  to  country  risk.  In  this  
case,    
¤ E(Return)  =  Riskfree  Rate  +  CRP  +  Beta  (Mature  ERP)  
¤ Implicitly,  this  is  what  you  are  assuming  when  you  use  the  local  Government’s  dollar  borrowing  rate  as  your  
riskfree  rate.  
¨ Approach  2:  Assume  that  a  company’s  exposure  to  country  risk  is  similar  to  its  exposure  to  other  
market  risk.  
¤ E(Return)  =  Riskfree  Rate  +  Beta  (Mature  ERP+  CRP)  
¨ Approach  3:  Treat  country  risk  as  a  separate  risk  factor  and  allow  firms  to  have  different  exposures  
to  country  risk  (perhaps  based  upon  the  propor8on  of  their  revenues  come  from  non-­‐domes8c  
sales)  
¤ E(Return)=Riskfree  Rate+  β  (Mature  ERP)  +  λ  (CRP)  
¨ Mature  ERP  =  Mature  market  Equity  Risk  Premium  
¨ CRP  =  Addi8onal  country  risk  premium  

Aswath Damodaran

11!
Approaches  1  &  2:  Es8ma8ng  country  risk  
premium  exposure  
¨ Loca8on  based  CRP:  The  standard  approach  in  valua8on  is  to  aLach  a  
country  risk  premium  to  a  company  based  upon  its  country  of  
incorpora8on.  Thus,  if  you  are  an  Indian  company,  you  are  assumed  to  be  
exposed  to  the  Indian  country  risk  premium.  A  developed  market  
company  is  assumed  to  be  unexposed  to  emerging  market  risk.  
¨ Opera8on-­‐based  CRP:  There  is  a  more  reasonable  modified  version.  The  
country  risk  premium  for  a  company  can  be  computed  as  a  weighted  
average  of  the  country  risk  premiums  of  the  countries  that  it  does  
business  in,  with  the  weights  based  upon  revenues  or  opera8ng  income.  
If  a  company  is  exposed  to  risk  in  dozens  of  countries,  you  can  take  a  
weighted  average  of  the  risk  premiums  by  region.  

Aswath Damodaran

12!
Opera8on  based  CRP:  Single  versus  Mul8ple  
Emerging  Markets  
¨ Single  emerging  market:  Embraer,  in  2004,  reported  that  it  derived  3%  of  
its  revenues  in  Brazil  and  the  balance  from  mature  markets.  The  mature  
market  ERP  in  2004  was  5%  and  Brazil’s  CRP  was  7.89%.  

¨ Mul8ple  emerging  markets:  Ambev,  the  Brazilian-­‐based  beverage  

company,  reported  revenues  from  the  following  countries  during  2011.    

Aswath Damodaran

13!
Extending  to  a  mul8na8onal:  Regional  breakdown  
Coca  Cola’s  revenue  breakdown  and  ERP  in  2012  

Things to watch out for!

1. Aggregation across regions. For instance, the Pacific region often includes Australia & NZ with Asia
2. 14!
Obscure aggregations including Eurasia and Oceania!
14!
Approach  3:  Es8mate  a  lambda  for  country  risk  

¨ Source  of  revenues:  Other  things  remaining  equal,  a  company  should  be  
more  exposed  to  risk  in  a  country  if  it  generates  more  of  its  revenues  
from  that  country.      
¨ Manufacturing  facili8es:  Other  things  remaining  equal,  a  firm  that  has  all  
of  its  produc8on  facili8es  in  a  “risky  country”  should  be  more  exposed  to  
country  risk  than  one  which  has  produc8on  facili8es  spread  over  mul8ple  
countries.  The  problem  will  be  accented  for  companies  that  cannot  move  
their  produc8on  facili8es  (mining  and  petroleum  companies,  for  
instance).  
¨ Use  of  risk  management  products:  Companies  can  use  both  op8ons/
futures  markets  and  insurance  to  hedge  some  or  a  significant  por8on  of  
country  risk.  

Aswath Damodaran

15!
Es8ma8ng  Lambdas:  The  Revenue  Approach  

¨ The  easiest  and  most  accessible  data  is  on  revenues.  Most  companies  break  their  revenues  down  
by  region.    
 λ  =  %  of  revenues  domes8callyfirm/  %  of  revenues  domes8cally  average  firm  
¨ Consider,  for  instance,  Embraer  and  Embratel,  both  of  which  are  incorporated  and  traded  in  Brazil.  
Embraer  gets  3%  of  its  revenues  from  Brazil  whereas  Embratel  gets  almost  all  of  its  revenues  in  
Brazil.  The  average  Brazilian  company  gets  about  77%  of  its  revenues  in  Brazil:  
¤ LambdaEmbraer  =  3%/  77%  =  .04  
¤ LambdaEmbratel  =  100%/77%  =  1.30  
¨ Note  that  if  the  propor8on  of  revenues  of  the  average  company  gets  in  the  market  is  assumed  to  
be  100%,  this  approach  collapses  into  the  first  one.,  
¨ There  are  two  implica8ons  
¤ A  company’s  risk  exposure  is  determined  by  where  it  does  business  and  not  by  where  it  is  located  
¤ Firms  might  be  able  to  ac8vely  manage  their  country  risk  exposure  

Aswath Damodaran

16!
 Aswath Damodaran! 1!

SESSION  5:  BETAS  

‹#›! Aswath  Damodaran  
 MPT Quadrant The CAPM Beta
APM/ Multi-factor Models Accounting Risk
Regression beta of
Estimate 'betas' against stock returns at Quadrant
multiple macro risk factors, firm versus stock
using past price data returns on market Accounting Earnings Volatility
index How volatile is your company's
Sector-average Beta
earnings, relative to the average
Average regression beta
company's earnings?
across all companies in the
business(es) that the firm
operates in. Accounting Earnings Beta
Regression beta of changes
in earnings at firm versus
Price Variance Model changes in earnings for
Standard deviation, relative to the Relative Risk Measure market index
average across all stocks How risky is this asset,
relative to the average
risk investment?
Balance Sheet Ratios
Debt cost based Risk based upon balance
Estimate cost of equity based sheet ratios (debt ratio,
upon cost of debt and relative working capital, cash, fixed
volatility assets) that measure risk

Implied Beta/ Cost of equity Composite Risk Measures

Price based, Model
Agnostic Quadrant
Estimate a cost of equity for
Proxy measures Use a mix of quantitative (price,
firm or sector based upon
Use a proxy for risk ratios) & qualitative analysis
price today and expected (management quality) to
(market cap, sector).
cash flows in future estimate relative risk

Intrinsic Risk Quadrant

2! Aswath Damodaran! ‹#›!
 The  Default:  The  CAPM  Beta  
3!

¨ The  standard  procedure  for  es@ma@ng  betas  is  to  

regress  stock  returns  (Rj)  against  market  returns  (Rm)  -­‐  
¨ Rj  =  a  +  b  Rm  
¤ where    a  is  the  intercept  and  b  is  the  slope  of  the  regression.    
¨ The  slope  of  the  regression  corresponds  to  the  beta  of  
the  stock,  and  measures  the  riskiness  of  the  stock.    
¨ This  beta  has  three  problems:  
¤ It  has  high  standard  error  
¤ It  reflects  the  firm’s  business  mix  over  the  period  of  the  
regression,  not  the  current  mix  
¤ It  reflects  the  firm’s  average  financial  leverage  over  the  period  
rather  than  the  current  leverage.  

Aswath Damodaran!
3!
 Beta  Es@ma@on:  Is  this  Embraer’s  beta?  
4!

Aswath Damodaran!
4!
 Or  is  this  it?  
5!

Aswath Damodaran!
5!
 And  watch  out  if  your  regression  looks  too  
good…  
6!

Aswath Damodaran!
6!
 Determinants  of  Betas  
7!

Beta of Equity (Levered Beta)

Beta of Firm (Unlevered Beta) Financial Leverage:

Nature of product or
service offered by
company:
Other things remaining equal,
the more discretionary the
product or service, the higher
the beta.
Operating Leverage (Fixed
Costs as percent of total
costs):
Other things remaining equal
the greater the proportion of
the costs that are fixed, the
higher the beta of the
company.
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))

Implications
1. Cyclical companies should
have higher betas than non-
cyclical 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!
7!
 BoVom-­‐up  Betas  
8!

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 If you can, adjust this beta for differences
traded firms. Unlever this average beta using the average debt to between your firm and the comparable
equity ratio across the publicly traded firms in the sample. firms on operating leverage and product
Unlevered beta for business = Average beta across publicly traded characteristics.
firms/ (1 + (1- t) (Average D/E ratio across firms))

While revenues or operating income

Step 3: Estimate how much value your firm derives from each of are often used as weights, it is better
the different businesses it is in. to try to estimate the value of each
business.

Step 4: Compute a weighted average of the unlevered betas of the If you expect the business mix of your
different businesses (from step 2) using the weights from step 3. firm to change over time, you can
Bottom-up Unlevered beta for your firm = Weighted average of the change the weights on a year-to-year
unlevered betas of the individual business basis.

If you expect your debt to equity ratio to

Step 5: Compute a levered beta (equity beta) for your firm, using change over time, the levered beta will
the market debt to equity ratio for your firm. change over time.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

Aswath Damodaran!
8!
 Why  boVom-­‐up  betas?  
9!

¨ The  standard  error  in  a  boVom-­‐up  beta  will  be  significantly  

lower  than  the  standard  error  in  a  single  regression  beta.  
Roughly  speaking,  the  standard  error  of  a  boVom-­‐up  beta  
es@mate  can  be  wriVen  as  Average
follows:  
Std Error across Betas
Standard  error  of  boVom-­‐up  beta  =Number
    of firms in sample

¨ The  boVom-­‐up  beta  can  be  adjusted  to  reflect  changes  in  the  
firm’s  business  mix  
€ and  financial  leverage.  Regression  betas  
reflect  the  past.  
¨ You  can  es@mate  boVom-­‐up  betas  even  when  you  do  not  
have  historical  stock  prices.  This  is  the  case  with  ini@al  public  
offerings,  private  businesses  or  divisions  of  companies.  

Aswath Damodaran!
9!
 Es@ma@ng  a  boVom  up  beta  for  Embraer  in  
2004  
10!

¨ Embraer  is  in  a  single  business,  aerospace,  where  there  are  no  other  listed  firms  in  
La@n  America  and  very  few  in  emerging  markets.  To  es@mate  the  boVom  up  beta,  
we  therefore  used  all  publicly  listed  companies  in  the  aerospace  business  
(globally),  averaged  their  betas  and  es@mated  an  average  unlevered  beta  for  the  
business  of  0.95  
¨ We  then  applied  Embraer’s  gross  debt  to  equity  ra@o  of  18.95%  and  the  Brazilian  
marginal  tax  rate  of  34%  to  es@mate  a  levered  beta  for  the  company.  
 Business    Unlevered  Beta  D/E  Ra@o  Levered  beta  
 Aerospace    0.95    18.95%  1.07    
 Levered  Beta  =  Unlevered  Beta  (  1  +  (1-­‐  tax  rate)  (D/E  Ra@o)  
     =  0.95  (  1  +  (1-­‐.34)  (.1895))  =  1.07  
¨ The  fact  that  most  of  the  other  companies  in  this  business  are  listed  on  developed  
markets  is  not  a  deal  breaker,  since  betas  average  to  one  in  every  market.  The  fact  
that  Brazil  may  be  a  riskier  market  is  captured  in  the  equity  risk  premium,  not  in  
the  beta.  

Aswath Damodaran!
10!
 BoVom-­‐up  Beta:  Firm  in  Mul@ple  Businesses  
SAP  in  2004  
¨ When  a  company  is  in  mul@ple  businesses,  its  beta  will  be  a  weighted  
average  of  the  unlevered  betas  of  these  businesses.  The  weights  should  
be  “value”  weights,  though  you  may  have  to  es@mate  the  values,  based  
on  revenues  on  opera@ng  income.  The  levered  beta  for  the  firm  can  then  
be  es@mated,  using  its  tax  rate  and  debt  to  equity  ra@o.  
¨ SAP  is  in  three  business:  sokware,  consul@ng  and  training.  We  will  
aggregate  the  consul@ng  and  training  businesses.  
Business  Revenues  EV/Sales  Value  Weights  Unlevered  Beta  
Sokware  $  5.3    3.25  17.23  80%  1.30  
Consul@ng  $  2.2    2.00      4.40  20%  1.05  
SAP    $  7.5      21.63    1.25    
Levered  Beta  =  1.25  (1  +  (1-­‐  .32)(.0141))  =  1.26  (Tax  rate  =32%;  D/E  =1.41%)  

Aswath Damodaran

11!
 You  don’t  like  betas…  
12!

¨ There  are  many  investors  who  are  inherently  suspicious  about  beta  as  a  measure  
of  risk,  though  the  reasons  for  the  suspicion  vary.  If  you  don’t  like  betas,  use  
another  measure  of  rela@ve  risk.  
¨ Here  is  a  simple  guideline  
¤ If  you  don’t  like  betas  because  they  are  different  in  different  services:  Use  sector  average  or  
boVom  up  betas  
¤ If  you  don’t  like  betas  because  you  think  you  should  be  measuring  total  risk  &  not  market  risk:  
Use  rela@ve  standard  devia@on.  
¤ If  you  don’t  like  betas  because  they  are  based  upon  stock  prices  (and  you  care  about  intrinsic  
value):  Use  accoun@ng  measures  (earnings  or  balance  sheet)    to  get  a  measure  of  rela@ve  risk.  
¤ If  you  don’t  like  betas  because  they  don’t  bring  in  qualita@ve  variables  (such  as  the  quality  of  
management):  Those  variables  are  generally  beVer  reflected  in  your  cash  flows,  but  if  you  
insist,  use  them  to  come  up  with  qualita@ve  measures  of  risk.  

Aswath Damodaran!
12!
 Aswath Damodaran! 1!

SESSION  6:  ESTIMATING  COST  OF  

DEBT,  DEBT  RATIOS  AND  COST  OF  
CAPITAL  
‹#›!
 What  is  debt?  
2!

¨ For  an  item  to  be  classified  as  debt,  it  has  to  meet  three  criteria:  
¤ It  has  to  give  rise  to  a  contractual  commitment,  that  has  to  be  met  in  good  
Imes  or  bad.  
¤ That  commitment  usually  is  tax  deducIble  
¤ Failure  to  make  that  commitment  can  cost  you  control  over  the  business.  
¨ Using  these  criteria,  all  interest-­‐bearing  commitments,  short  term  
as  well  as  long  term,  are  clearly  debt.  So,  are  all  lease  
commitments.  
¨ The  items  below  can  be  debt,  if  they  meet  other  condiIons  
¤ Accounts  payable  &  supplier  credit,  but  only  if  you  are  willing  to  make  the  
implicit  interest  expenses  (the  discounts  lost  by  using  the  credit)  explicit.  
¤ Under  funded  pension  and  health  care  obligaIons,  but  only  if  there  is  a  
legal  requirement  that  you  cover  the  underfunding  with  fixed  payments  in  
future  years.  

Aswath Damodaran!
2!
 EsImaIng  the  Cost  of  Debt  
3!

¨ The  cost  of  debt  is  the  rate  at  which  you  can  borrow  at  
currently,  It  will  reflect  not  only  your  default  risk  but  also  the  
level  of  interest  rates  in  the  market.  
¨ The  two  most  widely  used  approaches  to  esImaIng  cost  of  
debt  are:  
¤ Looking  up  the  yield  to  maturity  on  a  straight  bond  outstanding  from  
the  firm.  The  limitaIon  of  this  approach  is  that  very  few  firms  have  
long  term  straight  bonds  that  are  liquid  and  widely  traded  
¤ Looking  up  the  raIng  for  the  firm  and  esImaIng  a  default  spread  
based  upon  the  raIng.  While  this  approach  is  more  robust,  different  
bonds  from  the  same  firm  can  have  different  raIngs.  You  have  to  use  a  
median  raIng  for  the  firm  
¨ When  in  trouble  (either  because  you  have  no  raIngs  or  
mulIple  raIngs  for  a  firm),  esImate  a  syntheIc  raIng  for  
your  firm  and  the  cost  of  debt  based  upon  that  raIng.  
Aswath Damodaran!
3!
 EsImaIng  SyntheIc  RaIngs  
4!

¨ The  raIng  for  a  firm  can  be  esImated  using  the  financial  
characterisIcs  of  the  firm.  In  its  simplest  form,  the  raIng  
can  be  esImated  from  the  interest  coverage  raIo  
Interest  Coverage  RaIo  =  EBIT  /  Interest  Expenses  
¨ For  Embraer’s  interest  coverage  raIo,  we  used  the  
interest  expenses  from  2003  and  the  average  EBIT  from  
2001  to  2003.  (The  aircra`  business  was  badly  affected  
by  9/11  and  its  a`ermath.  In  2002  and  2003,  Embraer  
reported  significant  drops  in  operaIng  income)  
Interest  Coverage  RaIo  =  462.1  /129.70  =  3.56  

Aswath Damodaran!
4!
 Interest  Coverage  RaIos,  RaIngs  and  Default  
Spreads:  2003  &  2004  
5!

If  Interest  Coverage  RaIo  is  EsImated  Bond  RaIng  Default  Spread(2003)  Default  
Spread(2004)  
>  8.50    (>12.50)  AAA    0.75%    0.35%  
6.50  -­‐  8.50  (9.5-­‐12.5)  AA    1.00%    0.50%    
5.50  -­‐  6.50  (7.5-­‐9.5)  A+    1.50%    0.70%  
4.25  -­‐  5.50  (6-­‐7.5)  A    1.80%    0.85%  
3.00  -­‐  4.25  (4.5-­‐6)  A–    2.00%    1.00%  
2.50  -­‐  3.00  (4-­‐4.5)  BBB    2.25%    1.50%  
2.25-­‐  2.50  (3.5-­‐4)  BB+    2.75%    2.00%    
2.00  -­‐  2.25  ((3-­‐3.5)  BB    3.50%    2.50%  
1.75  -­‐  2.00  (2.5-­‐3)  B+    4.75%    3.25%  
1.50  -­‐  1.75  (2-­‐2.5)  B    6.50%    4.00%  
1.25  -­‐  1.50  (1.5-­‐2)  B  –    8.00%    6.00%  
0.80  -­‐  1.25  (1.25-­‐1.5)  CCC    10.00%    8.00%  
0.65  -­‐  0.80  (0.8-­‐1.25)  CC    11.50%    10.00%  
0.20  -­‐  0.65  (0.5-­‐0.8)  C    12.70%    12.00%  
<  0.20  (<0.5)  D      15.00%    20.00%.  

Aswath Damodaran
5!
 Cost  of  Debt  computaIons  
6!

¨ The  cost  of  debt  for  a  company  is  then  the  sum  of  the  riskfree  rate  and  the  default  
spread:  
¤ Pre-­‐tax  cost  of  debt  =  Risk  free  rate  +  Default  spread  
¤ The  default  spread  can  be  esImated  from  the  raIng  or  from  a  traded  bond  issued  by  the  
company  or  even  a  company  CDS.  
¨ Companies  in  countries  with  low  bond  raIngs  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  significant  porIon  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  syntheIc  raIng  for  Embraer  is  A-­‐.  Using  the  2004  default  spread  of  1.00%,  we  
esImate  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!
6!
 Weights  for  the  Cost  of  Capital  ComputaIon  
7!

¨ In  compuIng  the  cost  of  capital  for  a  publicly  traded  

firm,  the  general  rule  for  compuIng  weights  for  debt  
and  equity  is  that  you  use  market  value  weights.  
¨ That  is  not  because  the  market  is  right  but  because  
that  is  what  it  would  cost  you  to  buy  the  company  in  
the  market  today,  even  if  you  think  that  the  price  is  
wrong.  

Aswath Damodaran!
7!
 EsImaIng  Cost  of  Capital:  Embraer  in  2004  
8!

¨ Equity  
¤ Cost  of  Equity  =  4.29%  +  1.07  (4%)  +  0.27  (7.89%)  =  10.70%    
¤ Market  Value  of  Equity  =11,042  million  BR  ($  3,781  million)  
¨ Debt  
¤ Cost  of  debt  =  4.29%  +  4.00%  +1.00%=  9.29%    
¤ Market  Value  of  Debt  =  2,083  million  BR  ($713  million)  
¨ Cost  of  Capital  
Cost  of  Capital  =  10.70  %  (.84)  +  9.29%  (1-­‐  .34)  (0.16))  =  9.97%  
¨ The  book  value  of  equity  at  Embraer  is  3,350  million  BR.  
¨ The  book  value  of  debt  at  Embraer  is  1,953  million  BR;  Interest  
expense  is  222  mil  BR;  Average  maturity  of  debt  =  4  years  
¨ EsImated  market  value  of  debt  =  222    million  (PV  of  annuity,  4  
years,  9.29%)  +  $1,953  million/1.09294  =  2,083  million  BR  

Aswath Damodaran!
8!
 If  you  had  to  do  it….ConverIng  a  Dollar  Cost  of  
Capital  to  a  Nominal  Real  Cost  of  Capital  
9!

¨ Approach  1:  Use  a  BR  riskfree  rate  in  all  of  the  calculaIons  above.  
For  instance,  if  the  BR  riskfree  rate  was  12%,  the  cost  of  capital  
would  be  computed  as  follows:  
¤ Cost  of  Equity  =  12%  +  1.07(4%)  +  0.27  (7.89%)  =  18.41%    
¤ Cost  of  Debt  =  12%  +  1%  =  13%    
¤ (This  assumes  the  riskfree  rate  has  no  country  risk  premium  
embedded  in  it.)  
¨ Approach  2:  Use  the  differenIal  inflaIon  rate  to  esImate  the  cost  
of  capital.  For  instance,  if  the  inflaIon  rate  in  BR  is  8%  and  the  
inflaIon  rate  in  the  U.S.  is  2%   " 1+ Inflation %
BR
(1+ Cost of Capital$ )$ '
# 1+ Inflation$ &

 Cost  of  capital=  

    €  =  1.0997  (1.08/1.02)-­‐1      =  0.1644  or  16.44%  

Aswath Damodaran!
9!
 Dealing  with  Hybrids  and  Preferred  Stock  
10!

¨ When  dealing  with  hybrids  (converIble  bonds,  for  instance),  break  

the  security  down  into  debt  and  equity  and  allocate  the  amounts  
accordingly.  Thus,  if  a  firm  has  $  125  million  in  converIble  debt  
outstanding,  break  the  $125  million  into  straight  debt  and  
conversion  opIon  components.  The  conversion  opIon  is  equity.  
¨ When  dealing  with  preferred  stock,  it  is  beqer  to  keep  it  as  a  
separate  component.  The  cost  of  preferred  stock  is  the  preferred  
dividend  yield.  (As  a  rule  of  thumb,  if  the  preferred  stock  is  less  
than  5%  of  the  outstanding  market  value  of  the  firm,  lumping  it  in  
with  debt  will  make  no  significant  impact  on  your  valuaIon).  

Aswath Damodaran!
10!
 Recapping  the  Cost  of  Capital  
11!

Cost of borrowing should be based upon

(1) synthetic or actual bond rating Marginal tax rate, reflecting
(2) default spread tax benefits of debt
Cost of Borrowing = Riskfree rate + Default spread

Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + Cost of Borrowing (1-t) (Debt/(Debt + Equity))

Cost of equity
based upon bottom-up Weights should be market value weights
beta

Aswath Damodaran!
11!
 Aswath Damodaran! 1!

SESSION  7:  ESTIMATING  CASH  

FLOWS  
Aswath  Damodaran  
 Defining  Cashflow  
2!

Cash flows can be measured to

Just Equity Investors

All claimholders in the firm

EBIT (1- tax rate) Net Income Dividends

- ( Capital Expenditures - Depreciation) - (Capital Expenditures - Depreciation) + Stock Buybacks
- Change in non-cash working capital - Change in non-cash Working Capital
= Free Cash Flow to Firm (FCFF) - (Principal Repaid - New Debt Issues)
- Preferred Dividend

Aswath Damodaran!
2!
 The  basic  ingredients  for  free  cash  flows..  
3!

¨ EsFmate  the  current  earnings  of  the  firm  

¤ If  looking  at  cash  flows  to  equity,  look  at  earnings  aMer  interest  
expenses  -­‐  i.e.  net  income  
¤ If  looking  at  cash  flows  to  the  firm,  look  at  operaFng  earnings  aMer  
taxes  
¨ Consider  how  much  the  firm  invested  to  create  future  growth  
¤ If  the  investment  is  not  expensed,  it  will  be  categorized  as  capital  
expenditures.  To  the  extent  that  depreciaFon  provides  a  cash  flow,  it  
will  cover  some  of  these  expenditures.  
¤ Increasing  working  capital  needs  are  also  investments  for  future  
growth  
¨ If  looking  at  cash  flows  to  equity,  consider  the  cash  flows  
from  net  debt  issues  (debt  issued  -­‐  debt  repaid)  

Aswath Damodaran!
3!
 Step  1:  Get  your  earnings  “right”  
4!
Operating leases R&D Expenses
Firm!s Comparable - Convert into debt - Convert into asset
history Firms - Adjust operating income - Adjust operating income

Normalize Cleanse operating items of

Earnings - Financial Expenses
- Capital Expenses
- Non-recurring expenses

Measuring Earnings

Update
- Trailing Earnings
- Unofficial numbers

Aswath Damodaran!
4!
 Dealing  with  OperaFng  Lease  Expenses  
5!

¨ OperaFng  Lease  Expenses  are  treated  as  operaFng  expenses  in  

compuFng  operaFng  income.  In  reality,  operaFng  lease  expenses  
should  be  treated  as  financing  expenses,  with  the  following  
adjustments  to  earnings  and  capital:  
Debt  Value  of  OperaFng  Leases  =  Present  value  of  OperaFng  Lease  
Commitments  at  the  pre-­‐tax  cost  of  debt  
¨ When  you  convert  operaFng  leases  into  debt,  you  also  create  an  
asset  to  counter  it  of  exactly  the  same  value.  That  asset  then  has  to  
be  depreciated.  
¨ Adjusted  OperaFng  Earnings  
¤ Adjusted  OperaFng  Earnings  =  OperaFng  Earnings  +  OperaFng  Lease  
Expenses  -­‐  DepreciaFon  on  Leased  Asset  
¤ As  an  approximaFon,  this  works:  
¤ Adjusted  OperaFng  Earnings  =  OperaFng  Earnings  +  Pre-­‐tax  cost  of  Debt  *  
PV  of  OperaFng  Leases.  

Aswath Damodaran!
5!
OperaFng  Leases  at  The  Gap  in  2003  

¨ The  Gap  has  convenFonal  debt  of  about  $  1.97  billion  on  its  balance  sheet  and  its  
pre-­‐tax  cost  of  debt  is  about  6%.  Its  operaFng  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  OperaFng  Income  =  Stated  OI  +  OL  exp  this  year  -­‐  Deprec’n  
=  $1,012  m  +  978  m  -­‐  4397  m  /7  =  $1,362  million  (7  year  life  for  assets)  
¨ Approximate  OI  =  $1,012  m  +  $  4397  m  (.06)  =  $1,276  m  

6!
Aswath Damodaran

6!
 The  Collateral  Effects  of  TreaFng  OperaFng  
Leases  as  Debt  

! 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&not&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
7!
 R&D  Expenses:  OperaFng  or  Capital  Expenses  
8!

¨ AccounFng  standards  require  us  to  consider  R&D  as  an  

operaFng  expense  even  though  it  is  designed  to  
generate  future  growth.  It  is  more  logical  to  treat  it  as  
capital  expenditures.  
¨ To  capitalize  R&D,  
¤ Specify  an  amorFzable  life  for  R&D  (2  -­‐  10  years)  
¤ Collect  past  R&D  expenses  for  as  long  as  the  amorFzable  life  
¤ Sum  up  the  unamorFzed  R&D  over  the  period.  (Thus,  if  the  
amorFzable  life  is  5  years,  the  research  asset  can  be  obtained  by  
adding  up  1/5th  of  the  R&D  expense  from  five  years  ago,  2/5th  
of  the  R&D  expense  from  four  years  ago...:  

Aswath Damodaran!
8!
Capitalizing  R&D  Expenses:  SAP  

¨ R  &  D  was  assumed  to  have  a  5-­‐year  life.    

Year    R&D  Expense  UnamorFzed    AmorFzaFon  this  year  
Current    1020.02    1.00  1020.02    
-­‐1    993.99    0.80  795.19    €  198.80    
-­‐2    909.39    0.60  545.63    €  181.88    
-­‐3    898.25    0.40  359.30    €  179.65    
-­‐4    969.38    0.20  193.88    €  193.88    
-­‐5    744.67    0.00  0.00    €  148.93    
Value  of  research  asset  =        €  2,914  million  
AmorFzaFon  of  research  asset  in  2004    =    €  903  million  
Increase  in  OperaFng  Income  =  1020  -­‐  903  =    €  117  million  

9!
Aswath Damodaran

9!
The  Effect  of  Capitalizing  R&D  at  SAP  

! Conventional!Accounting!
Income!Statement!
EBIT&&R&D&&&=&&3045&
.&R&D&&&&&&&&&&&&&&=&&1020&
EBIT&&&&&&&&&&&&&&&&=&&2025&
EBIT&(1.t)&&&&&&&&=&&1285&m&
Balance!Sheet!
Off&balance&sheet&asset.&Book&value&of&equity&at&
3,768&million&Euros&is&understated&because&
biggest&asset&is&off&the&books.&
Capital!Expenditures!
Conventional&net&cap&ex&of&2&million&Euros&
Cash!Flows!
EBIT&(1.t)&&&&&&&&&&=&&1285&&
.&Net&Cap&Ex&&&&&&=&&&&&&&&2&
FCFF&&&&&&&&&&&&&&&&&&=&&1283&&&&&&
Return&on&capital&=&1285/(3768+530)&
10!
Aswath Damodaran
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!
Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&
R&D&Asset&&&&2914&&&&&Book&Equity&&&+2914&
Total&Book&Equity&=&3768+2914=&6782&mil&&
Capital!Expenditures!
Net&Cap&ex&=&2+&1020&–&903&=&119&mil&
Cash!Flows!
EBIT&(1.t)&&&&&&&&&&=&&&&&1402&&&
.&Net&Cap&Ex&&&&&&=&&&&&&&119&
FCFF&&&&&&&&&&&&&&&&&&=&&&&&1283&m&
Return&on&capital&=&1402/(6782+530)&
10!
 And
 the
 consequences…
 
11!

EBIT(1- t) + R & D Expense - Amortization of Research Asset

ROC R& D Adjusted =
(BV of Capital + Research Asset)
Aswath Damodaran!
11!
€
 Step  2:  Consider  the  effect  of  taxes…  
12!

¨ Your  earnings  and  cash  flows  should  be  aMer  corporate  taxes.  With  cash  
flow  to  equity,  you  start  with  net  income,  which  is  already  aMer  taxes.  So,  
you  are  set.  
¨ When  you  do  free  cash  flow  to  the  firm,  you  are  compuFng  your  cash  
flows  “as  if  you  had  no  debt”.  That  is  why  it  is  called  an  unlevered  cash  
flow.  
¨ Consequently,  you  have  to  compute  the  tax  you  would  have  paid  on  your  
operaFng  income,  as  if  it  were  taxable  income.    
¨ For  the  short  term,  you  can  use  the  effecFve  tax  rate,  since  it  is  the  tax  
rate  you  paid  on  average  on  your  taxable  income.  Over  Fme,  though,  you  
would  expect  this  tax  rate  to  climb  towards  your  marginal  tax  rate.  

Aswath Damodaran!
12!
 Step  3:  Define  reinvestment  broadly  
For  long  term  assets…  
13!

¨ Research  and  development  expenses,  once  they  have  been  re-­‐categorized  

as  capital  expenses.  The  adjusted  net  cap  ex  will  be  
¤ Adjusted  Net  Capital  Expenditures  =  Net  Capital  Expenditures  +  Current  year’s  R&D  
expenses  -­‐  AmorFzaFon  of  Research  Asset  
¨ AcquisiFons  of  other  firms,  since  these  are  like  capital  expenditures.  The  
adjusted  net  cap  ex  will  be  
¤ Adjusted  Net  Cap  Ex  =  Net  Capital  Expenditures  +  AcquisiFons  of  other  firms  -­‐  
AmorFzaFon  of  such  acquisiFons  
¤ Two  caveats:  
1.  Most  firms  do  not  do  acquisiFons  every  year.  Hence,  a  normalized  measure  
of  acquisiFons  (looking  at  an  average  over  Fme)  should  be  used  
2. The  best  place  to  find  acquisiFons  is  in  the  statement  of  cash  flows,  usually  
categorized  under  other  investment  acFviFes  

Aswath Damodaran!
13!
 And  short  term  assets  
14!

¨ In  accounFng  terms,  the  working  capital  is  the  difference  between  current  assets  
(inventory,  cash  and  accounts  receivable)  and  current  liabiliFes  (accounts  
payables,  short  term  debt  and  debt  due  within  the  next  year)  
¨ A  cleaner  definiFon  of  working  capital  from  a  cash  flow  perspecFve  is  the  
difference  between  non-­‐cash  current  assets  (inventory  and  accounts  receivable)  
and  non-­‐debt  current  liabiliFes  (accounts  payable)  
¨ Any  investment  in  this  measure  of  working  capital  Fes  up  cash.  Therefore,  any  
increases  (decreases)  in  working  capital  will  reduce  (increase)  cash  flows  in  that  
period.  
¨ When  forecasFng  future  growth,  it  is  important  to  forecast  the  effects  of  such  
growth  on  working  capital  needs,  and  building  these  effects  into  the  cash  flows.  

Aswath Damodaran!
14!
 Step  4:  To  get  from  FCFF  to  FCFE,  consider  debt  
cash  flows….  
15!

¨ In  the  strictest  sense,  the  only  cash  flow  that  an  investor  will  receive  from  an  equity  investment  in  
a  publicly  traded  firm  is  the  dividend  that  will  be  paid  on  the  stock.  
¨ Actual  dividends,  however,  are  set  by  the  managers  of  the  firm  and  may  be  much  lower  than  the  
potenFal  dividends  (that  could  have  been  paid  out)  
¤ managers  are  conservaFve  and  try  to  smooth  out  dividends  
¤ managers  like  to  hold  on  to  cash  to  meet  unforeseen  future  conFngencies  and  investment  opportuniFes  
¨ The  potenFal  dividends  of  a  firm  are  the  cash  flows  leM  over  aMer  the  firm  has  made  any  
“investments”  it  needs  to  make  to  create  future  growth  and  net  debt  repayments  (debt  
repayments  -­‐  new  debt  issues):  
 Net  Income  
 -­‐  (Capital  Expenditures  -­‐  DepreciaFon)  
 -­‐  Changes  in  non-­‐cash  Working  Capital  
 -­‐  (Principal  Repayments  -­‐  New  Debt  Issues)      
 =  Free  Cash  flow  to  Equity  

Aswath Damodaran!
15!
 Aswath Damodaran! 1!

SESSION  8:  ESTIMATING  

GROWTH  
 Growth  in  Earnings  
2!

¨ Look  at  the  past  

¤ The  historical  growth  in  earnings  per  share  is  usually  a  
good  starCng  point  for  growth  esCmaCon  
¨ Look  at  what  others  are  esCmaCng  
¤ Analysts  esCmate  growth  in  earnings  per  share  for  many  
firms.  It  is  useful  to  know  what  their  esCmates  are.  
¨ Look  at  fundamentals  
¤ UlCmately,  all  growth  in  earnings  can  be  traced  to  two  
fundamentals  -­‐  how  much  the  firm  is  invesCng  in  new  
projects,  and  what  returns  these  projects  are  making  for  
the  firm.  

Aswath Damodaran!
2!
 I.  Historical  Growth  in  EPS  
3!

¨ The  historical  growth  rate  in  earnings  for  a  company  may  

seem  like  a  fact  but  it  is  an  esCmate.  In  fact,  it  is  sensiCve  to    
¤ How  it  is  computed:  The  growth  rates  in  earnings  will  be  different,  
depending  upon  how  you  compute  the  average.  An  simple  (arithmeCc)  
average  growth  rate  will  tend  to  be  higher  than  a  compounded  
(geometric)  average  growth  rate.    
¤ EsCmaCon  period:  The  starCng  point  for  the  computaCon  can  make  a  
big  difference.  Using  a  bad  year  as  the  base  year  will  generate  much  
higher  growth  rates.  
¨ In  using  historical  growth  rates,  recognize  the  following:  
¤ Growth  rates  become  meaningless  when  earnings  go  from  negaCve  
values  to  posiCve  values  
¤ Growth  rates  will  go  down  as  companies  get  larger  
¨ Worst  of  all,  there  is  evidence  that  historical  growth  rates  in  
earnings  are  not  very  good  predictors  of  future  earnings…  
Aswath Damodaran!
3!
 II.  Management/Analyst  Forecasts  
4!

¨ When  valuing  companies,  we  oVen  fall  back  on  

management  forecasts  for  the  future  (aVer  all,  they  
know  the  company  beWer  than  we  do)  or  forecasts  of  
other  analysts.  
¨ Management  forecasts  may  reflect  their  “superior”  
knowledge,  but  they  have  a  fatal  flaw.  They  are  biased.  
¨ Analyst  forecasts  may  seem  like  a  simple  way  to  avoid  
the  problem,  but  not  only  are  they  also  biased  but  using  
them  represents  an  abandonment  of  a  basic  
requirement  in  valuaCon:  that  you  make  your  own  best  
judgment  of  growth.  

Aswath Damodaran!
4!
 III.  Fundamental  Growth  
5!

¨ Growth  has  to  be  earned  by  a  company.  You  and  I  

do  not  have  the  power  to  endow  a  company  with  
growth.  
¨ In  terms  of  basic  fundamentals,  for  a  company  to  
grow  its  earnings,  it  has  to  
¤ Add  to  its  asset  or  capital  base  and  generate  returns  on  
that  added  capital  (new  investment  growth)  
¤ Manage  its  exisCng  assets  more  efficiently,  generaCng  
higher  margins  and  higher  returns  on  exisCng  assets  
(efficiency  growth)  

Aswath Damodaran!
5!
 a.  New  Investment  Growth  
6!

¨ The  growth  in  earnings  for  a  firm  from  new  investments  is  a  funcCon  of  two  decisions:  
¤ How  much  to  reinvest  back  into  the  business  for  long  term  growth  
n Equity  earnings:  PorCon  of  net  income  put  back  into  the  business  (retenCon)  

n OperaCng  earnings:  PorCon  of  aVer-­‐tax  operaCng  income  invested  in  the  business.  
¤ How  well  it  reinvests  its  money,  defined  again  
n With  equity  earnings,  the  return  on  equity  
n With  operaCng  earnings,  the  return  on  invested  capital  

Expected Growth

Net Income Operating Income

Retention Ratio= Return on Equity Reinvestment Return on Capital =

1 - Dividends/Net X Net Income/Book Value of Rate = (Net Cap X EBIT(1-t)/Book Value of
Income Equity Ex + Chg in Capital
WC/EBIT(1-t)

Aswath Damodaran!
6!
 The  Key  Number:  Return  on  Capital  (Equity)  
7!

Adjust EBIT for Use a marginal tax rate

a. Extraordinary or one-time expenses or income to be safe. A high ROC
b. Operating leases and R&D created by paying low
c. Cyclicality in earnings (Normalize) effective taxes is not
d. Acquisition Debris (Goodwill amortization etc.) sustainable

EBIT ( 1- tax rate)

ROC =
Book Value of Equity + Book value of debt - Cash

Adjust book equity for Adjust book value of debt for

1. Capitalized R&D a. Capitalized operating leases
2. Acquisition Debris (Goodwill)

Use end of prior year numbers or average over the year

but be consistent in your application

Aswath Damodaran!
7!
 b.  Efficiency  Growth  
8!

¨ When  the  return  on  equity  or  capital  is  changing,  there  will  be  a  second  component  to  
growth,  posiCve  if  the  return  is  increasing  and  negaCve  if  the  return  is  decreasing.  If  ROC  t  is  
the  return  on  capital  in  period  t  and  ROC  t+1  is  the  return  on  capital  in  period  t+1,  the  growth  
rate  in  operaCng  income  will  be:  
Expected  Growth  Rate    =  ROCt+1  *  Reinvestment  rate    +(ROC  t+1  –  ROCt)  /  ROCt    
¨ For  example,  assume  that  you  have  a  firm  that  is  generaCng  a  return  on  capital  of  8%  on  its  
exisCng  assets  and  expects  to  increase  this  return  to  10%  next  year.  The  efficiency  growth  
for  this  firm  is  
Efficiency  growth  =  (10%  -­‐8%)/  8%  =  25%  
¨ Thus,  if  this  firm  has  a  reinvestment  rate  of  50%  and  makes  a  10%  return  on  capital  on  its  
new  investments  as  well,  its  total  growth  next  year  will  be  30%  
Growth  rate  =  .50  *  10%  +  25%  =  30%  
¨ The  key  difference  is  that  growth  from  new  investments  is  sustainable  whereas  returns  from  
efficiency  are  short  term  (or  transitory).  

Aswath Damodaran!
8!
 Revenue  Growth  and  OperaCng  Margins  
9!

¨ All  of  the  fundamental  growth  equaCons  assume  that  the  firm  has  a  return  on  equity  or  
return  on  capital  it  can  sustain  in  the  long  term.  
¨ When  operaCng  income  is  negaCve  or  margins  are  expected  to  change  over  Cme:  
¤ EsCmate  growth  rates  in  revenues  over  Cme  
n Use  historical  revenue  growth  to  get  esCmates  of  revenue  growth  in  the  near  future  
n Decrease  the  growth  rate  as  the  firm  becomes  larger  
n Keep  track  of  absolute  revenues  to  make  sure  that  the  growth  is  feasible  
¤ EsCmate  expected  operaCng  margins  each  year  
n Set  a  target  margin  that  the  firm  will  move  towards  
n Adjust  the  current  margin  towards  the  target  margin  
¤ EsCmate  the  capital  that  needs  to  be  invested  to  generate  revenue  growth  and  expected  margins  
n EsCmate  a  sales  to  capital  raCo  that  you  will  use  to  generate  reinvestment  needs  each  year.  

Aswath Damodaran!
9!
 Sirius  Radio:  Revenues  and  Revenue  Growth-­‐    
June  2006  
Year    Revenue  Revenue    OperaCng      OperaCng  
   Growth    $  Margin    Income  
Current      $187  -­‐419.92%    -­‐$787  
1    200.00%  $562  -­‐199.96%    -­‐$1,125  
2    100.00%  $1,125  -­‐89.98%    -­‐$1,012  
3    80.00%  $2,025  -­‐34.99%    -­‐$708  
4    60.00%  $3,239  -­‐7.50%    -­‐$243  
5    40.00%  $4,535  6.25%    $284  
6    25.00%  $5,669  13.13%    $744  
7    20.00%  $6,803  16.56%    $1,127  
8    15.00%  $7,823  18.28%    $1,430  
9    10.00%  $8,605  19.14%    $1,647  
10    5.00%  $9,035  19.57%    $1,768  

Target margin based upon

Clear Channel

Aswath Damodaran

10!
 Sirius:  Reinvestment  Needs  
Year Revenues Change in revenue Sales/Capital Ratio Reinvestment Capital Invested Operating Income (Loss) Imputed ROC
Current $187 $ 1,657 -$787
1 $562 $375 1.50 $250 $ 1,907 -$1,125 -67.87%
2 $1,125 $562 1.50 $375 $ 2,282 -$1,012 -53.08%
3 $2,025 $900 1.50 $600 $ 2,882 -$708 -31.05%
4 $3,239 $1,215 1.50 $810 $ 3,691 -$243 -8.43%
5 $4,535 $1,296 1.50 $864 $ 4,555 $284 7.68%
6 $5,669 $1,134 1.50 $756 $ 5,311 $744 16.33%
7 $6,803 $1,134 1.50 $756 $ 6,067 $1,127 21.21%
8 $7,823 $1,020 1.50 $680 $ 6,747 $1,430 23.57%
9 $8,605 $782 1.50 $522 $ 7,269 $1,647 17.56%
10 $9,035 $430 1.50 $287 $ 7,556 $1,768 15.81%

Capital invested in year t+!=

Capital invested in year t +
Reinvestment in year t+1

Industry average Sales/Cap Ratio

Aswath Damodaran
11!
 Aswath Damodaran! 1!

SESSION  9:  TERMINAL  VALUE  

 Getting Closure in Valuation!
2!

¨ A publicly traded firm potentially has an infinite life. The

value is therefore the present value of cash flows forever.


t=∞ CF
Value = ∑ t

t=1 (1+r)
t

¨ Since we cannot estimate cash flows forever, we estimate

cash flows for a “growth period” and then estimate a
terminal value, to capture the value at the end of the
period:

t=N CF
Value = ∑ t + Terminal Value
(1+r) t (1+r) N
t=1
Aswath Damodaran!
2!
 Ways of Estimating Terminal Value!
3!

Terminal Value

Liquidation Multiple Approach Stable Growth

Value Model

Most useful Easiest approach but Technically soundest,

when assets makes the valuation but requires that you
are separable a relative valuation make judgments about
and when the firm will grow
marketable at a stable rate which it
can sustain forever,
and the excess returns
(if any) that it will earn
during the period.

Aswath Damodaran!
3!
 Stable Growth and Terminal Value!
4!

¨ When a firm’s cash flows grow at a “constant” rate

forever, the present value of those cash flows can be
written as:

Value = Expected Cash Flow Next Period / (r - g)

where,


r = Discount rate (Cost of Equity or Cost of Capital)


g = Expected growth rate

¨ This “constant” growth rate is called a stable growth rate
and cannot be higher than the growth rate of the economy
in which the firm operates.

¨ While companies can maintain high growth rates for
extended periods, they will all approach “stable growth”
at some point in time.

Aswath Damodaran!
4!
 1. How high can the stable growth rate be?!
5!

¨ 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 firms, the growth rate of the latter will probably be lower than
the growth rate of the economy.

¤ The stable growth rate can be negative. The terminal value will be
lower and you are assuming that your firm will disappear over time.

¤ If you use nominal cashflows and discount rates, the growth rate should
be nominal in the currency in which the valuation is denominated.

¨ One simple proxy for the nominal growth rate of the economy
is the riskfree rate.

¤ Riskfree rate = Expected inflation + Expected Real Interest Rate

¤ Nominal growth rate in economy = Expected Inflation + Expected Real
Growth

Aswath Damodaran!
5!
 2. When will the firm reach stable growth?!
6!

¨ Size of the firm

¤ Success usually makes a firm larger. As firms become larger, it becomes
much more difficult for them to maintain high growth rates

¨ Current growth rate

¤ While past growth is not always a reliable indicator of future growth,
there is a correlation between current growth and future growth. Thus, a
firm growing at 30% currently probably has higher growth and a longer
expected growth period than one growing 10% a year now.

¨ Barriers to entry and differential advantages

¤ Ultimately, high growth comes from high project returns, which, in
turn, comes from barriers to entry and differential advantages.

¤ The question of how long growth will last and how high it will be can
therefore be framed as a question about what the barriers to entry are,
how long they will stay up and how strong they will remain.

Aswath Damodaran!
6!
 3. What else should change in stable
growth?!
7!

¨ In stable growth, firms should have the characteristics of other

stable growth firms. In particular,

¤ The risk of the firm, as measured by beta and ratings, should reflect that of
a stable growth firm.

n Beta should move towards one

n The cost of debt should reflect the safety of stable firms (BBB or higher)

¤ The debt ratio of the firm might increase to reflect the larger and more
stable earnings of these firms.

n The debt ratio of the firm might moved to the optimal or an industry
average

n If the managers of the firm are deeply averse to debt, this may never
happen

¤ The return on capital generated on investments should move to sustainable
levels, relative to both the sector and the company’s own cost of capital.

Aswath Damodaran!
7!
 4. What excess returns will you generate in
stable growth and why does it matter?!
8!

¨ Strange though this may seem, the terminal value is not as much a
function of stable growth as it is a function of what you assume
about excess returns in stable growth.

¨ The key connecting link is the reinvestment rate that you have in
stable growth, which is a function of your return on capital:

Reinvestment Rate = Stable growth rate/ Stable ROC


The terminal value can be written in terms of ROC as follows:

Terminal Value = EBITn+1 (1-t) (1 – g/ ROC)/ (Cost of capital – g)

¨ In the scenario where you assume that a firm earns a return on
capital equal to its cost of capital in stable growth, the terminal
value will not change as the growth rate changes.

¨ If you assume that your firm will earn positive (negative) excess
returns in perpetuity, the terminal value will increase (decrease) as
the stable growth rate increases.

Aswath Damodaran!
8!
 These  are  things  (cri;ques)  you  should  not  
worry  about…  
9!

¨ The  terminal  value  is  a  high  percentage  of  the  es;mated  

value  of  the  firm  today.  Cri;cs  of  DCF  oOen  argue  that  since  
the  terminal  value  is  a  high  percentage  of  the  value  today  
(80%  or  higher)  that  
¤ Your  assump;ons  about  the  high  growth  period  don’t  maUer;  this  is  
not  true  since  the  base  on  which  you  compute  your  terminal  value  
(earnings,  cash  flows)  are  affected  by  your  high  growth  inputs  
¤ DCF  is  flawed;  Why?  It  reflects  the  reality  that  the  bulk  of  your  returns  
from  buying  stocks  comes  from  price  apprecia;on.  
¨ The  terminal  value  can  be  made  as  high  as  you  want  it  to  be,  
if  you  play  with  the  growth  rate.    
¤ That  is  true,  if  you  play  with  the  growth  rate.  It  is  not  true,  if  you  follow  
the  four  rules  we  laid  out.  
¤ BoUom  line:  Tie  growth  to  reinvestment  and  excess  returns  and  cap  
your  growth  rate  at  the  riskfree  rate.  

Aswath Damodaran!
9!
 Aswath Damodaran! 1!

SESSION  10:  VALUE  

ENHANCEMENT  
 Price  Enhancement  versus  Value  Enhancement  
2!

Aswath Damodaran!
2!
 The  Paths  to  Value  CreaAon..  Back  to  the  
determinants  of  value..  
3!

Aswath Damodaran!
3!
 Value  CreaAon  1:  Increase  Cash  Flows  from  
Assets  in  Place  
4!

More efficient
operations and Revenues
cost cuttting:
Higher Margins * Operating Margin

= EBIT
Divest assets that
have negative EBIT - Tax Rate * EBIT

= EBIT (1-t) Live off past over-

Reduce tax rate investment
- moving income to lower tax locales + Depreciation
- transfer pricing - Capital Expenditures
- risk management - Chg in Working Capital Better inventory
= FCFF management and
tighter credit policies

Aswath Damodaran!
4!
 Value  CreaAon  2:  Increase  Expected  Growth  
5!

Price Leader versus Volume Leader Strategies!

Return on Capital = Operating Margin * Capital Turnover Ratio!

Reinvest more in Do acquisitions

projects Reinvestment Rate

Increase operating * Return on Capital Increase capital turnover ratio

margins
= Expected Growth Rate

Aswath Damodaran!
5!
 Value  CreaAng  Growth…  EvaluaAng  the  
AlternaAves..  
6!

Aswath Damodaran!
6!
 III.  Building  CompeAAve  Advantages:  Increase  
length  of  the  growth  period  
7!

Increase length of growth period

Build on existing Find new

competitive competitive
advantages advantages

Brand Legal Switching Cost

name Protection Costs advantages

Aswath Damodaran!
7!
 IV.  Reduce  Cost  of  Capital    
8!

Outsourcing Flexible wage contracts &

cost structure

Reduce operating Change financing mix

leverage

Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital

Make product or service Match debt to

less discretionary to assets, reducing
customers default risk

Changing More Swaps Derivatives Hybrids

product effective
characteristics advertising

Aswath Damodaran!
8!
 Avg Reinvestment SAP: Status Quo
rate = 36.94%
Return on Capital
Reinvestment Rate 19.93%
Current Cashflow to Firm 57.42%
EBIT(1-t) : 1414 Expected Growth
in EBIT (1-t) Stable Growth
- Nt CpX 831
- Chg WC - 19 .5742*.1993=.1144 g = 3.41%; Beta = 1.00;
= FCFF 602 11.44% Debt Ratio= 20%
Cost of capital = 6.62%
Reinvestment Rate = 812/1414 ROC= 6.62%; Tax rate=35%
=57.42% Reinvestment Rate=51.54%
Growth decreases Terminal Value10 = 1717/(.0662-.0341) = 53546
First 5 years gradually to 3.41%
Op. Assets 31,615 Year 1 2 3 4 5 6 7 8 9 10 Term Yr
+ Cash: 3,018 EBIT 2,483 2,767 3,083 3,436 3,829 4,206 4,552 4,854 5,097 5,271 5451
- Debt 558 EBIT(1-t) 1,576 1,756 1,957 2,181 2,430 2,669 2,889 3,080 3,235 3,345 3543
- Pension Lian 305 - Reinvestm 905 1,008 1,124 1,252 1,395 1,501 1,591 1,660 1,705 1,724 1826
- Minor. Int. 55 = FCFF 671 748 833 929 1,035 1,168 1,298 1,420 1,530 1,621 1717
=Equity 34,656
-Options 180
Value/Share106.12 Cost of Capital (WACC) = 8.77% (0.986) + 2.39% (0.014) = 8.68%
Debt ratio increases to 20%
Beta decreases to 1.00

On May 5, 2005,
Cost of Equity Cost of Debt SAP was trading at
8.77% (3.41%+..35%)(1-.3654) Weights 122 Euros/share
= 2.39% E = 98.6% D = 1.4%

Riskfree Rate: Risk Premium

Euro riskfree rate = 3.41% Beta 4.25%
+ 1.26 X

Unlevered Beta for Mature risk Country

Sectors: 1.25 premium Equity Prem
4% 0.25%
SAP : Optimal Capital Structure!

Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)
0% 1.25 8.72% AAA 3.76% 36.54% 2.39% 8.72% $39,088
10% 1.34 9.09% AAA 3.76% 36.54% 2.39% 8.42% $41,480
20% 1.45 9.56% A 4.26% 36.54% 2.70% 8.19% $43,567
30% 1.59 10.16% A- 4.41% 36.54% 2.80% 7.95% $45,900
40% 1.78 10.96% CCC 11.41% 36.54% 7.24% 9.47% $34,043
50% 2.22 12.85% C 15.41% 22.08% 12.01% 12.43% $22,444
60% 2.78 15.21% C 15.41% 18.40% 12.58% 13.63% $19,650
70% 3.70 19.15% C 15.41% 15.77% 12.98% 14.83% $17,444
80% 5.55 27.01% C 15.41% 13.80% 13.28% 16.03% $15,658
90% 11.11 50.62% C 15.41% 12.26% 13.52% 17.23% $14,181

10!
 Avg Reinvestment SAP: Restructured
rate = 36.94% Reinvest more in
Return on Capital
Reinvestment Rate emerging markets 19.93%
Current Cashflow to Firm 70%
EBIT(1-t) : 1414 Expected Growth
in EBIT (1-t) Stable Growth
- Nt CpX 831
- Chg WC - 19 .70*.1993=.1144 g = 3.41%; Beta = 1.00;
= FCFF 602 13.99% Debt Ratio= 30%
Cost of capital = 6.27%
Reinvestment Rate = 812/1414 ROC= 6.27%; Tax rate=35%
=57.42% Reinvestment Rate=54.38%
Growth decreases Terminal Value10 = 1898/(.0627-.0341) = 66367
First 5 years gradually to 3.41%
Op. Assets 38045 Year 1 2 3 4 5 6 7 8 9 10 Term Yr
+ Cash: 3,018 EBIT 2,543 2,898 3,304 3,766 4,293 4,802 5,271 5,673 5,987 6,191 6402
- Debt 558 EBIT(1-t) 1,614 1,839 2,097 2,390 2,724 3,047 3,345 3,600 3,799 3,929 4161
- Pension Lian 305 - Reinvest 1,130 1,288 1,468 1,673 1,907 2,011 2,074 2,089 2,052 1,965 2263
- Minor. Int. 55 = FCFF 484 552 629 717 817 1,036 1,271 1,512 1,747 1,963 1898
=Equity 40157
-Options 180
Value/Share 126.51 Cost of Capital (WACC) = 10.57% (0.70) + 2.80% (0.30) = 8.24%

On May 5, 2005,
Cost of Equity Cost of Debt SAP was trading at
10.57% (3.41%+1.00%)(1-.3654) Weights 122 Euros/share
= 2.80% E = 70% D = 30%
Use more debt financing.

Riskfree Rate: Risk Premium

Euro riskfree rate = 3.41% Beta 4.50%
+ 1.59 X

Unlevered Beta for Mature risk Country

Sectors: 1.25 premium Equity Prem
4% 0.5%
SESSION  11:  LOOSE  ENDS  IN  
VALUATION  –    I  
FROM  OPERATING  ASSETS  TO  EQUITY  
VALUE  
Aswath  Damodaran  
The  loose  ends  maCer…  

¨ Once  you  have  discounted  cash  flows  back  at  the  cost  of  capital,  you  have  
esPmated  the  value  of  operaPng  assets  in  the  firm.  To  get  to  the  value  of  
equity,  you  need  to  deal  with  the  following.  
a. Cash  and  marketable  securiPes:  If  the  income  from  these  investments  is  
not  in  your  cash  flows,  you  need  to  incorporate  their  value  into  the  
company.  But  what  should  that  value  be?  The  number  that  is  on  the  
balance  sheet?  A  discount  on  that  value?  A  premium?  
b. Cross  holdings  in  other  companies:  Depending  on  how  the  income  for  
these  holdings  is  accounted  for,  you  may  or  may  not  have  valued  them  
already.  
c. Other  assets:  If  there  are  any  other  assets  that  have  not  been  counted  
in  your  DCF  valuaPon,  here  is  your  last  chance  to  mop  up.  
d. Debt:  Finally,  if  you  have  valued  the  firm,  you  need  to  net  out  debt  (but  
what  should  be  in  this  number?)  

2!
1.  The  Value  of  Cash  
An  Exercise  in  Cash  ValuaPon  
     Firm  A    Firm  B    Firm  C  
Enterprise  Value    $  1  billion  $  1  billion  $  1  
billion  
Cash        $  100  mil  $  100  mil  $  100  mil  
Return  on  Capital    10%    5%    22%  
Cost  of  Capital    10%    10%    12%  
Trades  in      US    US    ArgenPna  
¨ In  which  of  these  companies  is  cash  most  likely  to  trade  
at    
¤ Face  value?  
¤ At  a  discount?  
¤ At  a  premium?  

3!
Cash:  Discount  or  Premium?  

4!
2.  Dealing  with  Holdings  in  Other  firms  

¨ Holdings  in  other  firms  can  be  categorized  into  

¤ Minority  passive  holdings,  in  which  case  only  the  dividend  from  the  
holdings  is  shown  in  the  balance  sheet  
¤ Minority  acPve  holdings,  in  which  case  the  share  of  equity  income  is  
shown  in  the  income  statements  
¤ Majority  acPve  holdings,  in  which  case  the  financial  statements  are  
consolidated.  
¨ We  tend  to  be  sloppy  in  pracPce  in  dealing  with  cross  
holdings.  Ader  valuing  the  operaPng  assets  of  a  firm,  using  
consolidated  statements,  it  is  common  to  add  on  the  balance  
sheet  value  of  minority  holdings  (which  are  in  book  value  
terms)  and  subtract  out  the  minority  interests  (again  in  book  
value  terms),  represenPng  the  porPon  of  the  consolidated  
company  that  does  not  belong  to  the  parent  company.    

5!
How  to  value  holdings  in  other  firms..  In  a  
perfect  world..  
¨ In  a  perfect  world,  we  would  strip  the  parent  company  from  
its  subsidiaries  and  value  each  one  separately.    
¤ Value  of  the  combined  firm=  Value  of  parent  company  +  ProporPon  of  
value  of  each  subsidiary  
¨ To  do  this  right,  you  will  need  to  be  provided  detailed  
informaPon  on  each  subsidiary  to  esPmated  cash  flows  and  
discount  rates.  
¨ In  pracPce,  you  generally  will  not  have  or  be  provided  
enough  informaPon  to  value  the  subsidiaries  fully  or  even  
parPally,  especially  if  the  subsidiaries  are  privately  owned.  
¨ In  many  cases,  that  opacity  on  the  part  of  firms  with  cross  
holdings  is  intenPonal  and  is  a  way  of  preserving  control  over  
these  firms.  

6!
Two  compromise  soluPons…  

¨ The  market  value  soluPon:  When  the  subsidiaries  are  

publicly  traded,  you  could  use  their  traded  market  
capitalizaPons  to  esPmate  the  values  of  the  cross  
holdings.  You  do  risk  carrying  into  your  valuaPon  any  
mistakes  that  the  market  may  be  making  in  valuaPon.  
¨ The  relaPve  value  soluPon:  When  there  are  too  many  
cross  holdings  to  value  separately  or  when  there  is  
insufficient  informaPon  provided  on  cross  holdings,  you  
can  convert  the  book  values  of  holdings  that  you  have  
on  the  balance  sheet  (for  both  minority  holdings  and  
minority  interests  in  majority  holdings)  by  using  the  
average  price  to  book  value  raPo  of  the  sector  in  which  
the  subsidiaries  operate.  

7!
3.  Other  Assets  that  have  not  been  counted  
yet..  
¨ Assets  that  you  should  not  be  counPng  (or  adding  on  to  DCF  values)  
¤ If  an  asset  is  contribuPng  to  your  cashflows,  you  cannot  count  the  market  value  of  
the  asset  in  your  value.  Thus,  you  should  not  be  counPng  the  real  estate  on  which  
your  offices  stand,  the  PP&E  represenPng  your  factories  and  other  producPve  
assets,  any  values  aCached  to  brand  names  or  customer  lists  and  definitely  no  non-­‐
assets  (such  as  goodwill).  
¨ Assets  that  you  can  count  (or  add  on  to  your  DCF  valuaPon)  
¤ Overfunded  pension  plans:  If  you  have  a  defined  benefit  plan  and  your  assets  
exceed  your  expected  liabiliPes,  you  could  consider  the  over  funding  with  two  
caveats:  
n CollecPve  bargaining  agreements  may  prevent  you  from  laying  claim  to  these  
excess  assets.  
n There  are  tax  consequences.  Oden,  withdrawals  from  pension  plans  get  taxed  at  
much  higher  rates.  
¤ UnuPlized  assets:  If  you  have  assets  or  property  that  are  not  being  uPlized  to  
generate  cash  flows  (vacant  land,  for  example),  you  have  not  valued  it  yet.  You  can  

8!
4.  Be  circumspect  about  defining  debt  for  cost  
of  capital  purposes…  
¨ General  Rule:  Debt  generally  has  the  following  characterisPcs:  
¤ Commitment  to  make  fixed  payments  in  the  future  
¤ The  fixed  payments  are  tax  deducPble  
¤ Failure  to  make  the  payments  can  lead  to  either  default  or  loss  of  control  
of  the  firm  to  the  party  to  whom  payments  are  due.  
¨ Defined  as  such,  debt  should  include    
¤ All  interest  bearing  liabiliPes,  short  term  as  well  as  long  term  
¤ All  leases,  operaPng  as  well  as  capital  
¨ Debt  should  not  include  
¤ Accounts  payable  or  supplier  credit  

9!
But  should  consider  other  potenPal  liabiliPes  
when  gelng  to  equity  value…  
¨ If  you  have  under  funded  pension  fund  or  health  care  plans,  you  should  
consider  the  under  funding  at  this  stage  in  gelng  to  the  value  of  equity.  
¤ If  you  do  so,  you  should  not  double  count  by  also  including  a  cash  flow  line  item  
reflecPng  cash  you  would  need  to  set  aside  to  meet  the  unfunded  obligaPon.  
¤ You  should  not  be  counPng  these  items  as  debt  in  your  cost  of  capital  
calculaPons….  
¨ If  you  have  conPngent  liabiliPes  -­‐  for  example,  a  potenPal  liability  from  a  
lawsuit  that  has  not  been  decided  -­‐  you  should  consider  the  expected  
value  of  these  conPngent  liabiliPes  
¤ Value  of  conPngent  liability  =  Probability  that  the  liability  will  occur  *  Expected  
value  of  liability  

10!
 Aswath Damodaran! 1!

SESSION  12:  LOOSE  ENDS  IN  

VALUATION  –  II  
ACQUISITION  ORNAMENTS  –  
SYNERGY,  CONTROL  AND  
COMPLEXITY  
Aswath  Damodaran  
 1.  The  Value  of  Synergy  
2!

Synergy is created when two firms are combined and can be

either financial or operating

Operating Synergy accrues to the combined firm as Financial Synergy

Added Debt
Strategic Advantages Economies of Scale Tax Benefits Capacity Diversification?

Higher returns on More new More sustainable Cost Savings in Lower taxes on Higher debt May reduce
new investments Investments excess returns current operations earnings due to raito and lower cost of equity
- higher cost of capital for private or
depreciaiton closely held
- operating loss firm
Higher ROC Higher Reinvestment carryforwards
Longer Growth Higher Margin
Higher Growth Higher Growth Rate Period
Rate Higher Base-
year EBIT

Aswath Damodaran!
2!
 Valuing  Synergy  
3!

1. The  firms  involved  in  the  merger  are  valued  

independently,  by  discounQng  expected  cash  flows  to  
each  firm  at  the  weighted  average  cost  of  capital  for  
that  firm.    
2. The  value  of  the  combined  firm,  with  no  synergy,  is  
obtained  by  adding  the  values  obtained  for  each  firm  in  
the  first  step.    
3. The  effects  of  synergy  are  built  into  expected  growth  
rates  and  cashflows,  and  the  combined  firm  is  re-­‐
valued  with  synergy.    
Value  of  Synergy  =  Value  of  the  combined  firm,  with  
synergy  -­‐    Value  of  the  combined  firm,  without  synergy  

Aswath Damodaran!
3!
 Valuing  Synergy:  P&G  +  GilleZe  
4!

P&G Gillette Combined:/No/Synergy Combined:/Synergy

Free/Cashflow/to/Equity $5,864.74 $1,547.50 $7,412.24 $7,569.73 Annual/operating/expenses/reduced/by/$250/million
Growth/rate/for/first/5/years 12% 10% 11.58% 12.50% Slighly/higher/growth/rate
Growth/rate/after/five/years 4% 4% 4.00% 4.00%
Beta 0.90 0.80 0.88 0.88
Cost/of/Equity 7.90% 7.50% 7.81% 7.81% Value/of/synergy
Value/of/Equity $221,292 $59,878 $281,170 $298,355 $17,185

Aswath Damodaran!
4!
 2.  The  Value  of  Control  
5!

¨ The  value  of  the  control  premium  that  will  be  paid  to  
acquire  a  block  of  equity  will  depend  upon  two  factors  -­‐  
¤ Probability  that  control  of  firm  will  change:  This  refers  to  the  
probability  that  incumbent  management  will  be  replaced.  this  
can  be  either  through  acquisiQon  or  through  exisQng  
stockholders  exercising  their  muscle.  
¤ Value  of  Gaining  Control  of  the  Company:  The  value  of  gaining  
control  of  a  company  arises  from  two  sources  -­‐  the  increase  in  
value  that  can  be  wrought  by  changes  in  the  way  the  company  is  
managed  and  run,  and  the  side  benefits  and  perquisites  of  being  
in  control  
¤ Value  of  Gaining  Control  =  Present  Value  (Value  of  Company  
with  change  in  control  -­‐  Value  of  company  without  change  in  
control)  +  Side  Benefits  of  Control  

Aswath Damodaran!
5!
 Adris Grupa (Status Quo): 4/2010
Average from 2004-09 Average from 2004-09 Stable Growth
Current Cashflow to Firm 70.83% 9.69% g = 4%; Beta = 0.80
EBIT(1-t) : 436 HRK Country Premium= 2%
- Nt CpX 3 HRK Expected Growth
Reinvestment Rate from new inv. Return on Capital Cost of capital = 9.92%
- Chg WC -118 HRK 70.83% .7083*.0969 =0.0686 9.69% Tax rate = 20.00%
= FCFF 551 HRK ROC=9.92%;
or 6.86%
Reinv Rate = (3-118)/436= -26.35%; Reinvestment Rate=g/ROC
Tax rate = 17.35% =4/9.92= 40.32%
Return on capital = 8.72%

Terminal Value5= 365/(.0992-.04) =6170 HRK

HKR Cashflows
Op. Assets 4312 Year 1 2 3 4 5
+ Cash: 1787 EBIT (1-t) HRK 466 HRK 498 HRK 532 HRK 569 HRK 608
- Debt 141 - Reinvestment HRK 330 HRK 353 HRK 377 HRK 403 HRK 431 612
246
- Minority int 465 FCFF HRK 136 HRK 145 HRK 155 HRK 166 HRK 177
=Equity 5,484 365
/ (Common + Preferred
shares)
Value non-voting share Discount at $ Cost of Capital (WACC) = 10.7% (.974) + 5.40% (0.026) = 10.55%
335 HRK/share

On May 1, 2010
AG Pfd price = 279 HRK
Cost of Equity Cost of Debt
Weights AG Common = 345 HRK
10.70% (4.25%+ 0.5%+2%)(1-.20)
= 5.40 % E = 97.4% D = 2.6%

Lambda CRP for Croatia

0.68 X (3%)
Riskfree Rate:
HRK Riskfree Rate= Beta Mature market
+ 0.70 X premium +
4.25% Lambda X CRP for Central Europe
4.5%
0.42 (3%)

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.68 Ratio: 2.70% Country Default Mkt Vol
Spread X
1.50
2%

6! Aswath Damodaran!
Adris Grupa: 4/2010 (Restructured) Increased ROIC to cost
Average from 2004-09
of capital
e Stable Growth
Current Cashflow to Firm 70.83% g = 4%; Beta = 0.80
EBIT(1-t) : 436 HRK Country Premium= 2%
- Nt CpX 3 HRK Expected Growth
Reinvestment Rate from new inv. Return on Capital Cost of capital = 9.65%
- Chg WC -118 HRK 70.83% .7083*.01054=0. 10.54% Tax rate = 20.00%
= FCFF 551 HRK or 6.86% ROC=9.94%;
Reinv Rate = (3-118)/436= -26.35%; Reinvestment Rate=g/ROC
Tax rate = 17.35% =4/9.65= 41/47%
Return on capital = 8.72%
Terminal Value5= 367/(.0965-.04) =6508 HRK
HKR Cashflows
Op. Assets 4545 Year 1 2 3 4 5
+ Cash: 1787 EBIT (1-t) HRK 469 HRK 503 HRK 541 HRK 581 HRK 623 628
- Debt 141 - Reinvestment HRK 332 HRK 356 HRK 383 HRK 411 HRK 442 246
- Minority int 465 FCFF HRK 137 HRK 147 HRK 158 HRK 169 HRK 182 367
=Equity 5,735

Value/non-voting 334
Value/voting 362 Discount at $ Cost of Capital (WACC) = 11.12% (.90) + 8.20% (0.10) = 10.55%
Changed mix of debt
and equity tooptimal
On May 1, 2010
AG Pfd price = 279 HRK
Cost of Equity Cost of Debt AG Common = 345 HRK
11.12% (4.25%+ 4%+2%)(1-.20) Weights
= 8.20% E = 90 % D = 10 %

Lambda CRP for Croatia

0.68 X (3%)
Riskfree Rate:
HRK Riskfree Rate= Beta Mature market
4.25% + 0.75 X premium +
4.5% Lambda X CRP for Central Europe
0.42 (3%)

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.68 Ratio: 11.1% Country Default Mkt Vol
Spread X
1.50
2%

7! Aswath Damodaran!
 Value  of  Control  and  the  Value  of  VoQng  Rights  
8!

¨ The  value  of  control  at  Adris  Grupa  can  be  computed  as  the  difference  between  the  status  
quo  value  (5469)  and  the  opQmal  value  (5735).  
¨ In  this  case,  we  have  two  values  for  Adris  Grupa’s    Equity.  
 Status  Quo  Value  of  Equity  =  5,469  million  HKR  
¨ All  shareholders,  common  and  preferred,  get  an  equal  share  of  the  status  quo  value.  
 Value  for  a  non-­‐voQng  share  =  5469/(9.616+6.748)  =  334  HKR/share  
¨ The  value  of  the  voQng  shares  derives  from  the  capacity  to  change  the  way  the  firm  is  run  
 OpQmal  value  of  Equity  =  5,735  million  HKR  
 Value  of  control  at  Adris  Grupa  =  5,735  –  5469  =  266  million  HKR  
 Only  voQng  shares  get  a  share  of  this  value  of  control  
 Value  per  voQng  share  =334  HKR  +    266/9.616  =  362  HKR  

Aswath Damodaran!
8!
 3.  A  Discount  for  Complexity:  
An  Experiment  
9!

     Company  A  Company  B  
OperaQng  Income  $  1  billion  $  1  billion  
Tax  rate        40%    40%  
ROIC      10%    10%  
Expected  Growth    5%    5%  
Cost  of  capital    8%    8%  
Business  Mix    Single  Business  MulQple  Businesses  
Holdings      Simple    Complex  
AccounQng    Transparent  Opaque  
¨ Which  firm  would  you  value  more  highly?  

Aswath Damodaran!
9!
 Measuring  Complexity:  Volume  of  Data  in  
Financial  Statements  
10!

Company Number of pages in last 10Q Number of pages in last 10K

General Electric 65 410
Microsoft 63 218
Wal-mart 38 244
Exxon Mobil 86 332
Pfizer 171 460
Citigroup 252 1026
Intel 69 215
AIG 164 720
Johnson & Johnson 63 218
IBM 85 353

Aswath Damodaran!
10!
 Measuring  Complexity:  A  Complexity  Score  
11!

11!
 Dealing  with  Complexity  
12!

¨ In  Discounted  Cashflow  ValuaQon  

¤ The  Aggressive  Analyst:  Trust  the  firm  to  tell  the  truth  and  value  the  firm  based  upon  the  firm’s  statements  
about  their  value.  
¤ The  ConservaQve  Analyst:  Don’t  value  what  you  cannot  see.  
¤ The  Compromise:  Adjust  the  value  for  complexity  
n Adjust  cash  flows  for  complexity  
n Adjust  the  discount  rate  for  complexity  
n Adjust  the  expected  growth  rate/  length  of  growth  period  
n Value  the  firm  and  then  discount  value  for  complexity  

¨ In  relaQve  valuaQon  
¤ You  may  be  able  to  assess  the  price  that  the  market  is  charging  for  complexity:  
¤ With  the  hundred  largest  market  cap  firms,  for  instance:  
PBV  =  0.65  +  15.31  ROE  –  0.55  Beta  +  3.04  Expected  growth  rate  –  0.003  #  Pages  in  10K  

Aswath Damodaran!
12!
 Aswath Damodaran! 1!

SESSION  13:  LOOSE  ENDS  IN  

VALUATION  –III  
DISTRESS,  DILUTION  AND  ILLIQUIDITY  
Aswath  Damodaran  
 1.    Distress  and  the  Going  Concern  AssumpHon  
2!

¨ TradiHonal  valuaHon  techniques  are  built  on  the  assumpHon  

of  a  going  concern,  i.e.,  a  firm  that  has  conHnuing  operaHons  
and  there  is  no  significant  threat  to  these  operaHons.  
¤ In  discounted  cashflow  valuaHon,  this  going  concern  assumpHon  finds  
its  place  most  prominently  in  the  terminal  value  calculaHon,  which  
usually  is  based  upon  an  infinite  life  and  ever-­‐growing  cashflows.  
¤ In  relaHve  valuaHon,  this  going  concern  assumpHon  oRen  shows  up  
implicitly  because  a  firm  is  valued  based  upon  how  other  firms  -­‐  most  
of  which  are  healthy  -­‐  are  priced  by  the  market  today.  
¨ When  there  is  a  significant  likelihood  that  a  firm  will  not  
survive  the  immediate  future  (next  few  years),  tradiHonal  
valuaHon  models  may  yield  an  over-­‐opHmisHc  esHmate  of  
value.  

Aswath Damodaran!
2!
 Reinvestment:
Capital expenditures include cost of Stable Growth
Current Current new casinos and working capital Stable Stable
Revenue Margin: Stable Operating ROC=10%
$ 4,390 4.76% Revenue Margin: Reinvest 30%
Extended Industry Growth: 3% 17% of EBIT(1-t)
reinvestment average
EBIT break, due ot
$ 209m investment in Expected
past Margin: Terminal Value= 758(.0743-.03)
-> 17% =$ 17,129

Term. Year
Revenues $4,434 $4,523 $5,427 $6,513 $7,815 $8,206 $8,616 $9,047 $9,499 $9,974 $10,273
Oper margin 5.81% 6.86% 7.90% 8.95% 10% 11.40% 12.80% 14.20% 15.60% 17% 17%
EBIT $258 $310 $429 $583 $782 $935 $1,103 $1,285 $1,482 $1,696 $ 1,746
Tax rate 26.0% 26.0% 26.0% 26.0% 26.0% 28.4% 30.8% 33.2% 35.6% 38.00% 38%
EBIT * (1 - t) $191 $229 $317 $431 $578 $670 $763 $858 $954 $1,051 $1,083
- Reinvestment -$19 -$11 $0 $22 $58 $67 $153 $215 $286 $350 $ 325
Value of Op Assets $ 9,793 FCFF $210 $241 $317 $410 $520 $603 $611 $644 $668 $701 $758
+ Cash & Non-op $ 3,040 1 2 3 4 5 6 7 8 9 10
= Value of Firm $12,833 Forever
- Value of Debt $ 7,565 Beta 3.14 3.14 3.14 3.14 3.14 2.75 2.36 1.97 1.59 1.20
= Value of Equity $ 5,268 Cost of equity 21.82% 21.82% 21.82% 21.82% 21.82% 19.50% 17.17% 14.85% 12.52% 10.20%
Cost of debt 9% 9% 9% 9% 9% 8.70% 8.40% 8.10% 7.80% 7.50%
Value per share $ 8.12 Debtl ratio 73.50% 73.50% 73.50% 73.50% 73.50% 68.80% 64.10% 59.40% 54.70% 50.00%
Cost of capital 9.88% 9.88% 9.88% 9.88% 9.88% 9.79% 9.50% 9.01% 8.32% 7.43%

Cost of Equity Cost of Debt Weights

21.82% 3%+6%= 9% Debt= 73.5% ->50%
9% (1-.38)=5.58%

Riskfree Rate:
T. Bond rate = 3% Las Vegas Sands
Risk Premium
Beta 6% Feburary 2009
+ 3.14-> 1.20 X Trading @ $4.25

3! Aswath Damodaran! Casino Current Base Equity Country Risk

1.15 D/E: 277% Premium Premium
 The  Distress  Factor  
4!

¨ In  February  2009,  LVS  was  rated  B+  by  S&P.  Historically,  28.25%  of  B+  
rated  bonds  default  within  10  years.  LVS  has  a  6.375%  bond,  maturing  in  
February  2015  (7  years),  trading  at  $529.  If  we  discount  the  expected  cash  
flows  on  the  bond  at  the  riskfree  rate,  we  can  back  out  the  probability  of  
distress  from  the  bond  price:  

¨ Solving  for  the  probability  of  bankruptcy,  we  get:  

¨ πDistress    =  Annual  probability  of  default  =  13.54%  
¤ CumulaHve  probability  of  surviving  10  years  =  (1  -­‐  .1354)10  =  23.34%  
¤ CumulaHve  probability  of  distress  over  10  years  =  1  -­‐  .2334  =  .7666  or  76.66%  
¨ If  LVS  is  becomes  distressed:  
¤ Expected  distress  sale  proceeds  =  $2,769  million  <  Face  value  of  debt  
¤ Expected  equity  value/share  =  $0.00  
¨ Expected  value  per  share  =  $8.12  (1  -­‐  .7666)  +  $0.00  (.7666)  =  $1.92  

Aswath Damodaran!
4!
 2.  Analyzing  the  Effect  of  Illiquidity  on  Value  
5!

¨ The  simplest  way  to  think  about  illiquidity  is  to  

consider  it  the  cost  of  buyer’s  remorse:  it  is  the  cost  
of  reversing  an  asset  trade  almost  instantaneously  
aRer  you  make  the  trade.  
¨ Defined  thus,  all  assets  are  illiquid.  The  difference  is  

really  a  conHnuum,  with  some  assets  being  more  Least liquid

Most liquid
liquid  than  others.  
¨ The  noHon   that  publicly   traded   firms  are  withliquid   and  
Treasury Hiihgly rated Liquid, widely Stock in traded Stock in lightly Real Private Private business
bonds corporate held stock in company with traded, OTC or assets business without control
and bills bonds developed small float emerging control

private  businesses  
market
are  not  market
is  tstock
oo  simplisHc.    
Which is more illiquid?

Aswath Damodaran!
5!
 The  Theory  on  Illiquidity  Discounts  
6!

¨ Illiquidity  discount  on  value:  You  should  reduce  the  value  of  an  
asset  by  the  expected  cost  of  trading  that  asset  over  its  lifeHme.  
¤ The  illiquidity  discount  should  be  greater  for  assets  with  higher  trading  
costs  
¤ The  illiquidity  discount  should  be  decrease  as  the  Hme  horizon  of  the  
investor  holding  the  asset  increases  
¨ Illiquid  assets  should  be  valued  using  higher  discount  rates  
¤ Risk-­‐Return  model:  Some  illiquidity  risk  is  systemaHc.  In  other  words,  the  
illiquidity  increases  when  the  market  is  down.  This  risk  should  be  built  into  
the  discount  rate.  
¤ Empirical:  Assets  that  are  less  liquid  have  historically  earned  higher  
returns.  RelaHng  returns  to  measures  of  illiquidity  (turnover  rates,  spreads  
etc.)  should  allow  us  to  esHmate  the  discount  rate  for  less  liquid  assets.  
¨ Illiqudiity  can  be  valued  as  an  opHon:  When  you  are  not  allowed  to  
trade  an  asset,  you  lose  the  opHon  to  sell  it  if  the  price  goes  up  
(and  you  want  to  get  out).  
Aswath Damodaran!
6!
 a.  Illiquidity  Discount  in  Value  
7!

¨ Amihud  and  Mendelson  make  the  interesHng  argument  that  

when  you  pay  for  an  asset  today  will  incorporate  the  present  
value  of  all  expected  future  transacHons  costs  on  that  asset.  
For  instance,  assume  that  the  transacHons  costs  are  2%  of  
the  price  and  that  the  average  holding  period  is  1  year.  The  
illiquidity  discount  can  be  computed  as  follows:  
¤ Illiquidity  discount  =  2%
  +
2%
+
2%
... =
2%
= 20%
2 3
(1.10) (1.10) (1.10) .10
¤ With  a  holding  period  of  3  years,  the  illiqudity  discount  will  be  much  
smaller  (about  6.67%)    
¨ It  follows  then  that  the  illiquidity  discount  will  be  
¤ An  increasing  funcHon  of  transacHons  costs  
¤ A  decreasing  funcHon  of  the  average  holding  period  

Aswath Damodaran!
7!
 b.  AdjusHng  discount  rates  for  illiquidity  
8!

¨ Liquidity  as  a  systemaHc  risk  factor  

¤ If  liquidity  is  correlated  with  overall  market  condiHons,  less  liquid  stocks  
should  have  more  market  risk  than  more  liquid  stocks  
¤ To  esHmate  the  cost  of  equity  for  stocks,  we  would  then  need  to  esHmate  
a  “liquidity  beta”  for  every  stock  and  mulHply  this  liquidity  beta  by  a  
liquidity  risk  premium.  
¤ The  liquidity  beta  is  not  a  measure  of  liquidity,  per  se,  but  a  measure  of  
liquidity  that  is  correlated  with  market  condiHons.  
¨ Liquidity  premiums  
¤ You  can  always  add  liquidity  premiums  to  convenHonal  risk  and  return  
models  to  reflect  the  higher  risk  of  less  liquid  stocks.  
¤ These  premiums  are  usually  based  upon  historical  data  and  reflect  what  
you  would  have  earned  on  less  liquid  investments  historically  (usually  
smaller  stocks  with  lower  trading  volume)  relaHve  to  more  liquid  
investments.  Amihud  and  Mendelson  esHmate  that  the  expected  return  
increases  about  0.25%  for  every  1%  increase  in  the  bid-­‐ask  spread.  

Aswath Damodaran!
8!
 3.  Equity  to  Employees:  Effect  on  Value  
9!

¨ In  recent  years,  firms  have  turned  to  giving  employees  (and  

especially  top  managers)  equity  opHon  packages  as  part  of  
compensaHon.  These  opHons  are  usually  
¤ Long  term  
¤ At-­‐the-­‐money  when  issued  
¤ On  volaHle  stocks  
¨ Are  they  worth  money?  And  if  yes,  who  is  paying  for  them?  
¨ Two  key  issues  with  employee  opHons:  
¤ How  do  opHons  granted  in  the  past  affect  equity  value  per  share  today?  
¤ How  do  expected  future  opHon  grants  affect  equity  value  today?  

Aswath Damodaran!
9!
 Short  cuts  used  to  deal  with  opHons  
10!

¨ Fully  diluted  value  per  share  

¤ Once  you  have  esHmated  the  overall  value  of  equity,  you  can  divide  by  
the  total  number  of  shares  outstanding,  including  those  underlying  the  
opHons.  
¤ Doing  so  will  understate  the  value  of  your  equity,  since  the  opHons,  
even  if  exercised,  will  bring  in  cash  to  the  firm.  
¨ Treasury  stock  approach  
¤ Value  per  share  =  (EsHmated  Equity  value  +  Proceeds  from  exercise  of  
opHons)/  (Number  of  shares  +  Number  of  opHons)  
¤ This  approach  will  overstate  the  value  of  equity  since  it  values  opHons  
at  exercise  value  and  ignores  the  Hme  premium  on  opHons.  

Aswath Damodaran!
10!
 Dealing  with  Employee  OpHons:  The  Right  way  
11!

¨ OpHons  outstanding  
¤ Step  1:  List  all  opHons  outstanding,  with  maturity,  exercise  price  and  vesHng  status.  
¤ Step  2:  Value  the  opHons,  taking  into  account  diluHon,  vesHng  and  early  exercise  
consideraHons  
¤ Step  3:  Subtract  from  the    value  of  equity  and  divide  by  the  actual  number  of  
shares  outstanding  (not  diluted  or  parHally  diluted).  
¨ Expected  future  opHon  and  restricted  stock  issues  
¤ Step  1:  Forecast  value  of  opHons  that  will  be  granted  each  year  as  percent  of  
revenues  that  year.  (As  firm  gets  larger,  this  should  decrease)  
¤ Step  2:  Treat  as  operaHng  expense  and  reduce  operaHng  income  and  cash  flows  
¤ Step  3:  Take  present  value  of  cashflows  to  value  operaHons  or  equity.  

Aswath Damodaran!
11!
 Aswath Damodaran! 1!

SESSION  14:  RELATIVE  

VALUATION  
INTRODUCTION  AND  BASICS  
Aswath  Damodaran  
 The  Essence  of    relaAve  valuaAon?  
2!

¨ In  relaAve  valuaAon,  the  value  of  an  asset  is  compared  

to  the  values  assessed  by  the  market  for  similar  or  
comparable  assets.  
¨ To  do  relaAve  valuaAon  then,  
¤ we  need  to  idenAfy  comparable  assets  and  obtain  market  values  
for  these  assets  
¤ convert  these  market  values  into  standardized  values,  since  the  
absolute  prices  cannot  be  compared  This  process  of  
standardizing  creates  price  mulAples.  
¤ compare  the  standardized  value  or  mulAple  for  the  asset  being  
analyzed  to  the  standardized  values  for  comparable  asset,  
controlling  for  any  differences  between  the  firms  that  might  
affect  the  mulAple,  to  judge  whether  the  asset  is  under  or  over  
valued  

Aswath Damodaran!
2!
 RelaAve  valuaAon  is  pervasive…  
3!

¨ Most  valuaAons  on  Wall  Street  are  relaAve  valuaAons.    

¤ Almost  85%  of  equity  research  reports  are  based  upon  a  mulAple  and  
comparables.  
¤ More  than  50%  of  all  acquisiAon  valuaAons  are  based  upon  mulAples  
¤ Rules  of  thumb  based  on  mulAples  are  not  only  common  but  are  oYen  
the  basis  for  final  valuaAon  judgments.  
¨ While  there  are  more  discounted  cashflow  valuaAons  in  
consulAng  and  corporate  finance,  they  are  oYen  relaAve  
valuaAons  masquerading  as  discounted  cash  flow  valuaAons.  
¤ The  objecAve  in  many  discounted  cashflow  valuaAons  is  to  back  into  a  
number  that  has  been  obtained  by  using  a  mulAple.  
¤ The  terminal  value  in  a  significant  number  of  discounted  cashflow  
valuaAons  is  esAmated  using  a  mulAple.  

Aswath Damodaran!
3!
 Why  relaAve  valuaAon?  
4!

“If  you  think  I’m  crazy,  you  should  see  the  guy  who  lives  across  
the  hall“  
 Jerry  Seinfeld  talking  about  Kramer  in  a  Seinfeld  episode  

“  A  li]le  inaccuracy  someAmes  saves  tons  of  explanaAon”  

H.H.  Munro  
“  If  you  are  going  to  screw  up,  make  sure  that  you  have  lots  of  
company”  
   Ex-­‐poraolio  manager  

Aswath Damodaran!
4!
 So,  you  believe  only  in  intrinsic  value?  Here’s  
why  you  should  sAll  care  about  relaAve  value  
5!

¨ Even  if  you  are  a  true  believer  in  discounted  

cashflow  valuaAon,  presenAng  your  findings  on  a  
relaAve  valuaAon  basis  will  make  it  more  likely  that  
your  findings/recommendaAons  will  reach  a  
recepAve  audience.  
¨ In  some  cases,  relaAve  valuaAon  can  help  find  weak  
spots  in  discounted  cash  flow  valuaAons  and  fix  
them.  
¨ The  problem  with  mulAples  is  not  in  their  use  but  in  
their  abuse.  If  we  can  find  ways  to  frame  mulAples  
right,  we  should  be  able  to  use  them  be]er.  
Aswath Damodaran!
5!
 MulAples  are  just  standardized  esAmates  of  
price…  
6!

Market value of equity Market value for the firm Market value of operating assets of firm
Firm value = Market value of equity Enterprise value (EV) = Market value of equity
+ Market value of debt + Market value of debt
- Cash

Numerator = What you are paying for the asset

Multiple =
Denominator = What you are getting in return

Revenues Earnings Cash flow Book Value

a. Accounting a. To Equity investors a. To Equity a. Equity
revenues - Net Income - Net Income + Depreciation = BV of equity
b. Drivers - Earnings per share - Free CF to Equity b. Firm
- # Customers b. To Firm b. To Firm = BV of debt + BV of equity
- # Subscribers - Operating income (EBIT) - EBIT + DA (EBITDA) c. Invested Capital
= # units - Free CF to Firm = BV of equity + BV of debt - Cash

Aswath Damodaran!
6!
 The  Four  Steps  to  Understanding  MulAples  
7!

¨ Define  the  mulAple  

¤ In  use,  the  same  mulAple  can  be  defined  in  different  ways  by  different  
users.  When  comparing  and  using  mulAples,  esAmated  by  someone  else,  it  
is  criAcal  that  we  understand  how  the  mulAples  have  been  esAmated  
¨ Describe  the  mulAple  
¤ Too  many  people  who  use  a  mulAple  have  no  idea  what  its  cross  secAonal  
distribuAon  is.  If  you  do  not  know  what  the  cross  secAonal  distribuAon  of  
a  mulAple  is,  it  is  difficult  to  look  at  a  number  and  pass  judgment  on  
whether  it  is  too  high  or  low.  
¨ Analyze  the  mulAple  
¤ It  is  criAcal  that  we  understand  the  fundamentals  that  drive  each  mulAple,  
and  the  nature  of  the  relaAonship  between  the  mulAple  and  each  variable.  
¨ Apply  the  mulAple  
¤ Defining  the  comparable  universe  and  controlling  for  differences  is  far  
more  difficult  in  pracAce  than  it  is  in  theory.  

Aswath Damodaran!
7!
 DefiniAonal  Tests  
8!

¨ Is  the  mulAple  consistently  defined?  

¤ ProposiAon  1:  Both  the  value  (the  numerator)  and  the  
standardizing  variable  (  the  denominator)  should  be  to  the  same  
claimholders  in  the  firm.  In  other  words,  the  value  of  equity  
should  be  divided  by  equity  earnings  or  equity  book  value,  and  
firm  value  should  be  divided  by  firm  earnings  or  book  value.  
¨ Is  the  mulAple  uniformly  esAmated?  
¤ The  variables  used  in  defining  the  mulAple  should  be  esAmated  
uniformly  across  assets  in  the  “comparable  firm”  list.  
¤ If  earnings-­‐based  mulAples  are  used,  the  accounAng  rules  to  
measure  earnings  should  be  applied  consistently  across  assets.  
The  same  rule  applies  with  book-­‐value  based  mulAples.  

Aswath Damodaran!
8!
 DescripAve  Tests  
9!

¨ What  is  the  average  and  standard  deviaAon  for  this  mulAple,  
across  the  universe  (market)?  
¨ How  asymmetric  is  the  distribuAon  and  what  is  the  effect  of  this  
asymmetry  on  the  moments  of    the  distribuAon?    
¨ How  large  are  the  outliers  to  the  distribuAon,  and  how  do  we  deal  
with  the  outliers?  
¤ Throwing  out  the  outliers  may  seem  like  an  obvious  soluAon,  but  if  the  
outliers  all  lie  on  one  side  of  the  distribuAon,  this  can  lead  to  a  biased  
esAmate.  
¤ Capping  the  outliers  is  another  soluAon,  though  the  point  at  which  you  
cap  is  arbitrary  and  can  skew  results  
¨ Are  there  cases  where  the  mulAple  cannot  be  esAmated?  Will  
ignoring  these  cases  lead  to  a  biased  esAmate  of  the  mulAple?  
¨ How  has  this  mulAple  changed  over  Ame?  

Aswath Damodaran!
9!
 AnalyAcal  Tests  
10!

¨ What  are  the  fundamentals  that  determine  and  drive  these  

mulAples?  
¤ ProposiAon  2:  Embedded  in  every  mulAple  are  all  of  the  variables  that  
drive  every  discounted  cash  flow  valuaAon  -­‐  growth,  risk  and  cash  flow  
pa]erns.  
¨ How  do  changes  in  these  fundamentals  change  the  mulAple?  
¤ The  relaAonship  between  a  fundamental  (like  growth)  and  a  mulAple  
(such  as  PE)  is  almost  never  linear.    
¤ ProposiAon  3:  It  is  impossible  to  properly  compare  firms  on  a  mulAple,  
if  we  do  not  know  how  fundamentals  and  the  mulAple  move.  

Aswath Damodaran!
10!
 DeconstrucAng  MulAples  
11!

Equity Multiple or Firm Multiple

Equity Multiple Firm Multiple

1. Start with an equity DCF model (a dividend or FCFE 1. Start with a firm DCF model (a FCFF model)
model)

2. Isolate the denominator of the multiple in the model 2. Isolate the denominator of the multiple in the model
3. Do the algebra to arrive at the equation for the multiple 3. Do the algebra to arrive at the equation for the multiple

Aswath Damodaran!
11!
 ApplicaAon  Tests  
12!

¨ Given  the  firm  that  we  are  valuing,  what  is  a  “comparable”  firm?  
¤ While  tradiAonal  analysis  is  built  on  the  premise  that  firms  in  the  same  
sector  are  comparable  firms,  valuaAon  theory  would  suggest  that  a  
comparable  firm  is  one  which  is  similar  to  the  one  being  analyzed  in  terms  
of  fundamentals.  
¤ ProposiAon  4:  There  is  no  reason  why  a  firm  cannot  be  compared  with  
another  firm  in  a  very  different  business,  if  the  two  firms  have  the  same  
risk,  growth  and  cash  flow  characterisAcs.  
¨ Given  the  comparable  firms,  how  do  we  adjust  for  differences  
across  firms  on    the  fundamentals?  
¤ ProposiAon  5:  It  is  impossible  to  find  an  exactly  idenAcal  firm  to  the  one  
you  are  valuing.  

Aswath Damodaran!
12!
 Aswath Damodaran! 1!

SESSION  15:  PE  RATIOS  

Aswath  Damodaran  
 Price  Earnings  Ra=o:  Defini=on  
2!

PE  =  Market  Price  per  Share  /  Earnings  per  Share  

¨ There  are  a  number  of  variants  on  the  basic  PE  ra=o  in  use.  They  
are  based  upon  how  the  price  and  the  earnings  are  defined.  
¨ Price:    
¤ is  usually  the  current  price  (though  some  like  to  use  average  price  over  last  
6  months  or  year)  
¨ EPS:      
¤ Time  variants:  EPS  in  most  recent  financial  year  (current),  EPS  in  most  
recent  four  quarters  (trailing),  EPS  expected  in  next  fiscal  year  or  next  four  
quartes  (both  called  forward)  or  EPS  in  some  future  year  
¤ Primary,  diluted  or  par=ally  diluted  
¤ Before  or  aRer  extraordinary  items  
¤ Measured  using  different  accoun=ng  rules  (op=ons  expensed  or  not,  
pension  fund  income  counted  or  not…)  

Aswath Damodaran!
2!
 Characteris=c  1:  Skewed  Distribu=ons  
PE  ra=os  for  US  companies  in  January  2013  
3!

Aswath Damodaran!
3!
 Characteris=c  2:  Biased  Samples  
PE  ra=os  in  January  2013  
4!

Aswath Damodaran!
4!
Characteris=c  3:  Across  Markets  
PE  Ra=os:  US,  Europe,  Japan  and  Emerging  Markets  –  January  2013  
5!

Aswath Damodaran!
5!
 PE  Ra=o:  Understanding  the  Fundamentals  
6!

¨ To  understand  the  fundamentals,  start  with  a  basic  equity  discounted  cash  flow  
model.  With  a  stable  growth  dividend  discount  model:  
 
DPS1
¨
P =
Dividing  both  sides  by  the  current  0 earnings  per  share  or  forward  EPS:  
r − gn
             

P0 Payout Ratio*(1+ g n ) P0 Payout Ratio

¨
= PE=
If  this  had  been  a  FCFE  Model,     = PE=
EPS0 r-g EPS1 r-gn
n

FCFE1
P0 =
r − gn

P0 (FCFE/Earnings)*(1+ g n )
= PE=
EPS0 r-gn
Aswath Damodaran!
6!
 PE  Ra=o  and  Fundamentals  
7!

¨ Proposi=on  1:  Other  things  held  equal,  higher  growth  

firms  will  have  higher  PE  ra=os  than  lower  growth  firms.  
¨ Proposi=on  2:  Other  things  held  equal,  higher  risk  firms  
will  have  lower  PE  ra=os  than  lower  risk  firms  
¨ Proposi=on  3:  Other  things  held  equal,  firms  with  lower  

reinvestment  needs  will  have  higher  PE  ra=os  than  firms  

with  higher  reinvestment  rates.  
Of  course,  other  things  are  difficult  to  hold  equal  since  high  
growth  firms,  tend  to  have  risk  and  high  reinvestment  rats.  

Aswath Damodaran!
7!
 The  perfect  under  valued  company…  
8!

¨ If  you  were  looking  for  the  perfect  undervalued  asset,  it  would  be  one  
¤ With  a  low  PE  ra=o  (it  is  cheap)  
¤ With  high  expected  growth  in  earnings  
¤ With  low  risk  (and  cost  of  equity)  
¤ And  with  high  ROE  
¤ In  other  words,  it  would  be  cheap  with  no  good  reason  for  being  cheap  
¨ In  the  real  world,  most  assets  that  look  cheap  on  a  mul=ple  of  earnings  
basis  deserve  to  be  cheap.  In  other  words,  one  or  more  of  these  variables  
works  against  the  company  (It  has  low  growth,  high  risk  or  a  low  ROE).    
¨ When  presented  with  a  cheap  stock  (low  PE),  here  are  the  key  ques=ons:  
¤ What  is  the  expected  growth  in  earnings?  
¤ What  is  the  risk  in  the  stock?  
¤ How  efficiently  does  this  company  generate  its  growth?  

Aswath Damodaran!
8!
 Example  1:  Let’s  try  some  story  telling  
Comparing  PE  ra=os  across  firms  in  a  sector  
9!

Aswath Damodaran!
9!
 Example  2:  The  limits  of  story  telling  
Telecom  ADRs  in  1999  
10!

Company Name PE Growth

PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zealand ADR 11.2 0.11
Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunication Organization SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Satellite Telecom Holdings ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexico ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gilat Communications 22.7 0.31
Deutsche Telekom AG ADR 24.6 0.11
British Telecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomunikasi Indonesia ADR 28.4 0.32
Cable & Wireless PLC ADR 29.8 0.14
APT Satellite Holdings ADR 31 0.33
Telefonica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Italia SPA ADR 42.2 0.14
Nippon Telegraph & Telephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Telecom ADR 71.3 0.44

Aswath Damodaran!
10!
 PE,  Growth  and  Risk  
11!

¨ Dependent  variable  is:  PE      

¨ R  squared  =  66.2%          R  squared  (adjusted)  =  63.1%  

Variable    Coefficient  SE  t-­‐ra2o  Probability  

Constant  13.1151    3.471  3.78  0.0010  
Growth  rate  1.21223    19.27  6.29    ≤  0.0001  
Emerging  Market  -­‐13.8531  3.606  -­‐3.84  0.0009  
Emerging  Market  is  a  dummy:  1  if  emerging  market  
         0  if  not  
¨ Predicted  PE  for  Telebras=  13.12  +  1.2122  (7.5)  -­‐  13.85  (1)  =  8.35  
¨ At  an  actual  price  to  earnings  ra=o  of  8.9,  Telebras  is  slightly  overvalued.  

Aswath Damodaran!
11!
 Aswath Damodaran! 1!

SESSION  16:  MORE  EARNINGS  

MULTIPLES  
Aswath  Damodaran  
 Value/Earnings  and  Value/Cashflow  RaFos  
2!

¨ While  Price  earnings  raFos  look  at  the  market  value  of  equity  
relaFve  to  earnings  to  equity  investors,  Value  earnings  raFos  
look  at  the  market  value  of  the  operaFng  assets  of  the  firm  
(Enterprise  value  or  EV)  relaFve  to  operaFng  earnings  or  cash  
flows.  
 EV  =  Market  value  of  equity  +  Debt  –  Cash  
¨ The  form  of  value  to  cash  flow  raFos  that  has  the  closest  
parallels  in  DCF  valuaFon  is  the  raFo  of  Enterprise  value  to  
Free  Cash  Flow  to  the  Firm.  
FCFF  =  EBIT  (1-­‐t)  -­‐  Net  Cap  Ex  -­‐  Change  in  WC  
¨ In  pracFce,  what  we  observe  more  commonly  are  firm  values  
as  mulFples  of  operaFng  income  (EBIT),  a\er-­‐tax  operaFng  
income  (EBIT  (1-­‐t))  or  EBITDA.  

Aswath Damodaran!
2!
 Enterprise  Value/EBITDA  MulFple  
3!

¨ The  Classic  DefiniFon  

Value Market Value of Equity + Market Value of Debt
=
  EBITDA Earnings before Interest, Taxes and Depreciation
¨ The  No-­‐Cash  Version  

Enterprise Value Market Value of Equity + Market Value of Debt - Cash

=
EBITDA Earnings before Interest, Taxes and Depreciation

Aswath Damodaran!
3!
 Enterprise  Value/EBITDA  :  Global  Data  
6  Fmes  EBITDA  seems  like  a  good  rule  of  thumb..  
4!

Aswath Damodaran!
4!
 But  not  in  early  2009…  
5!

Aswath Damodaran!
5!
 The  Determinants  of  Value/EBITDA  MulFples:  
Linkage  to  DCF  ValuaFon  
6!

¨ The  value  of  the  operaFng  assets  of  a  firm  can  be  
wriaen  as:  

FCFF1
EV0 =
WACC-g
¨ The  numerator  can  be  wriaen  as  follows:  
 FCFF    =  EBIT  (1-­‐t)  -­‐  (Cex  -­‐  Depr)  -­‐  Δ  Working  Capital  
   =  (EBITDA  -­‐  Depr)  (1-­‐t)  -­‐  (Cex  -­‐  Depr)  -­‐  Δ  Working  
Capital    
   =  EBITDA  (1-­‐t)  +  Depr  (t)  -­‐  Cex  -­‐  Δ  Working  Capital  

Aswath Damodaran!
6!
 From  Firm  Value  to  EBITDA  MulFples  
7!

¨ Now  the  value  of  the  firm  can  be  rewriaen  as,  
EBITDA (1- t) + Depr (t) - Cex - Δ Working Capital
EV =
WACC - g

¨ Dividing  both  sides  of  the  equaFon  by  EBITDA,  

€ EV =
(1- t)
+
Depr (t)/EBITDA
-
CEx/EBITDA
-
Δ Working Capital/EBITDA
EBITDA WACC - g WACC - g WACC - g WACC - g

¨ Since  Reinvestment  =  (CEx  –  DepreciaFon  +  D  Working  

€ Capital),  the  determinants  of  EV/EBITDA  are:  
¤ The  cost  of  capital  
¤ Expected  growth  rate  
¤ Tax  rate  
¤ Reinvestment  rate  (or  ROC)  

Aswath Damodaran!
7!
 A  Simple  Example  
8!

¨ Consider  a  firm  with  the  following  characterisFcs:  

¤ Tax  Rate  =  36%  
¤ Capital  Expenditures/EBITDA  =  30%  

¤ DepreciaFon/EBITDA  =  20%  

¤ Cost  of  Capital  =  10%  

¤ The  firm  has  no  working  capital  requirements  

¤ The  firm  is  in  stable  growth  and  is  expected  to  grow  5%  a  
year  forever.    

Aswath Damodaran!
8!
 CalculaFng  Value/EBITDA  MulFple  
9!

¨ In  this  case,  the  Value/EBITDA  mulFple  for  this  firm  

can  be  esFmated  as  follows:  

Value (1- .36) (0.2)(.36) 0.3 0

= + - - = 8.24
EBITDA .10 -.05 .10 -.05 .10 - .05 .10 - .05

Aswath Damodaran!
9!
 The  Determinants  of  EV/EBITDA  
10!

¨    
Tax

Rates
Reinvestment

Needs

Excess

Returns

Aswath Damodaran!
10!
 Value/EBITDA  MulFple:  Trucking  Companies:  
Is  Ryder  cheap?  
11!
Company Name Value EBITDA Value/EBITDA
KLLM Trans. Svcs. $ 114.32 $ 48.81 2.34
Ryder System $ 5,158.04 $ 1,838.26 2.81
Rollins Truck Leasing $ 1,368.35 $ 447.67 3.06

With  infrastructure   Cannon Express Inc.

Hunt (J.B.)
Yellow Corp.
$ 83.57
$ 982.67
$ 931.47
$ 27.05
$ 310.22
$ 292.82
3.09
3.17
3.18

companies,  be  wary   Roadway Express

Marten Transport Ltd.
Kenan Transport Co.
$ 554.96
$ 116.93
$ 67.66
$ 169.38
$
$
35.62
19.44
3.28
3.28
3.48

about  low  EV/EBITDA  

M.S. Carriers $ 344.93 $ 97.85 3.53
Old Dominion Freight $ 170.42 $ 45.13 3.78
Trimac Ltd $ 661.18 $ 174.28 3.79

mulFples,  since  they  

Matlack Systems $ 112.42 $ 28.94 3.88
XTRA Corp. $ 1,708.57 $ 427.30 4.00
Covenant Transport Inc $ 259.16 $ 64.35 4.03

can  be  affected  by  

Builders Transport $ 221.09 $ 51.44 4.30
Werner Enterprises $ 844.39 $ 196.15 4.30
Landstar Sys. $ 422.79 $ 95.20 4.44
AMERCO $ 1,632.30 $ 345.78 4.72

investment  Fming  and   USA Truck

Frozen Food Express
Arnold Inds.
$ 141.77
$ 164.17
$ 472.27
$
$
$
29.93
34.10
96.88
4.74
4.81
4.87

irregular  reinvestment   Greyhound Lines Inc.

USFreightways
Golden Eagle Group Inc.
$ 437.71
$ 983.86
$ 12.50
$ 89.61
$ 198.91
$ 2.33
4.88
4.95
5.37

needs. ! Arkansas Best

Airlease Ltd.
Celadon Group
$ 578.78
$ 73.64
$ 182.30
$ 107.15
$
$
13.48
32.72
5.40
5.46
5.57
Amer. Freightways $ 716.15 $ 120.94 5.92
Transfinancial Holdings $ 56.92 $ 8.79 6.47
Vitran Corp. 'A' $ 140.68 $ 21.51 6.54
Interpool Inc. $ 1,002.20 $ 151.18 6.63
Intrenet Inc. $ 70.23 $ 10.38 6.77
Swift Transportation $ 835.58 $ 121.34 6.89
Landair Services $ 212.95 $ 30.38 7.01
CNF Transportation $ 2,700.69 $ 366.99 7.36
Budget Group Inc $ 1,247.30 $ 166.71 7.48
Caliber System $ 2,514.99 $ 333.13 7.55
Knight Transportation Inc $ 269.01 $ 28.20 9.54
Heartland Express $ 727.50 $ 64.62 11.26
Greyhound CDA Transn Corp $ 83.25 $ 6.99 11.91
Mark VII $ 160.45 $ 12.96 12.38
Coach USA Inc $ 678.38 $ 51.76 13.11
US 1 Inds Inc. $ 5.60 $ (0.17) NA
Average 5.61

Aswath Damodaran!
11!
 Aswath Damodaran! 1!

SESSION  17:  BOOK  VALUE  

MULTIPLES  
Aswath  Damodaran  
 Price-­‐Book  Value  RaFo:  DefiniFon  
2!

¨ The  price/book  value  raFo  is  the  raFo  of  the  market  
value  of  equity  to  the  book  value  of  equity,  i.e.,  the  
measure  of  shareholders’  equity  in  the  balance  sheet.  
Price/Book  Value  =    Market  Value  of  Equity/  Book  Value  of  Equity  
¨ Extending  this  mulFple  to  cover  broader  measures  of  
value,  we  get  
Value/  Book  =  (Market  Value  of  Equity+  Debt)/  (Book  Value  
of  Equity  +  Debt)  
EV/  Invested  Capital=  (Market  Value  of  Equity+  Debt  –  
Cash)/  (Book  Value  of  Equity  +  Debt  –  Cash))  

Aswath Damodaran!
2!
 Price  to  Book:  U.S.,  Europe,  Japan  and  Emerging  
Markets  –  January  2013  
3!

Aswath Damodaran!
3!
 Price  Book  Value  RaFo:  Stable  Growth  Firm  
4!

¨ Going  back  to  a  simple  dividend  discount  model,  

DPS1
P0 =
r − gn

¨ Defining  the  return  on  equity  (ROE)  =  EPS0  /  Book  Value  of  
Equity,  the  value  oP f  =eBV
0
quity  
* ROEc
0 an  bRatio
* Payout e  w
* (1ri_en  
+g )
n as:  
r-gn
P0 ROE * Payout Ratio * (1 + g n )
= PBV =
BV 0 r-g n

¨ If  the  return  on  equity  is  based  upon  expected  earnings  in  the  
next  Fme  period,  this  
P0 can  bROE
= PBV =
e  *sPayout
implified  
Ratio to,  
     
BV 0 r-g
¨ n

Aswath Damodaran!
4!
 Price  Book  Value  RaFo:  Stable  Growth  Firm  
Another  PresentaFon  
5!

¨  This  formulaFon  can  be  simplified  even  further  by  

relaFng  growth  to  the  return  on  equity:  
 g  =  (1  -­‐  Payout  raFo)  *  ROE  
¨ SubsFtuFng  back  into  the  P/BV  equaFon,    

P0 ROE - g n
= PBV=
BV0 r-gn
¨  The  price-­‐book  value  raFo  of  a  stable  firm  is  determined  
by  the  differenFal  between  the  return  on  equity  and  the  
required  rate  of  return  on  its  projects.  

Aswath Damodaran!
5!
 Looking  for  undervalued  securiFes  -­‐  PBV  RaFos  
and  ROE  
6!

¨ Given  the  relaFonship  between  price-­‐book  value  

raFos  and  returns  on  equity,  it  is  not  surprising  to  
see  firms  which  have  high  returns  on  equity  selling  
for  well  above  book  value  and  firms  which  have  low  
returns  on  equity  selling  at  or  below  book  value.    
¨ The  firms  which  should  draw  a_enFon  from  
investors  are  those  which  provide  mismatches  of  
price-­‐book  value  raFos  and  returns  on  equity  -­‐  low  
P/BV  raFos  and  high  ROE  or  high  P/BV  raFos  and  low  
ROE.  
Aswath Damodaran!
6!
 An  Eyeballing  Exercise:  
European  Banks  in  2010  
7!

Name   PBV  Ra*o   Return  on  Equity   Standard  Devia*on  

BAYERISCHE  HYPO-­‐UND  
VEREINSB   0.80   -­‐1.66%   49.06%  
COMMERZBANK  AG   1.09   -­‐6.72%   36.21%  
DEUTSCHE  BANK  AG  -­‐REG   1.23   1.32%   35.79%  
BANCA  INTESA  SPA   1.66   1.56%   34.14%  
BNP  PARIBAS   1.72   12.46%   31.03%  
BANCO  SANTANDER  CENTRAL  
HISP   1.86   11.06%   28.36%  
SANPAOLO  IMI  SPA   1.96   8.55%   26.64%  
BANCO  BILBAO  VIZCAYA  
ARGENTA   1.98   11.17%   18.62%  
SOCIETE  GENERALE   2.04   9.71%   22.55%  
ROYAL  BANK  OF  SCOTLAND  
GROUP   2.09   20.22%   18.35%  
HBOS  PLC   2.15   22.45%   21.95%  
BARCLAYS  PLC   2.23   21.16%   20.73%  
UNICREDITO  ITALIANO  SPA   2.30   14.86%   13.79%  
KREDIETBANK  SA  
LUXEMBOURGEOI   2.46   17.74%   12.38%  
ERSTE  BANK  DER  OESTER  
7!
SPARK   2.53   10.28%   21.91%  
STANDARD  CHARTERED  PLC   2.59   20.18%   19.93%  
HSBC  HOLDINGS  PLC   2.94   18.50%   19.66%  
 The  median  test…  
8!

¨ We  are  looking  for  stocks  that  trade  at  low  price  to  book  
raFos,  while  generaFng  high  returns  on  equity,  with  low  risk.  
But  what  is  a  low  price  to  book  raFo?  Or  a  high  return  on  
equity?  Or  a  low  risk  
¨ One  simple  measure  of  what  is  par  for  the  sector  are  the  
median  values  for  each  of  the  variables.  A  simplisFc  decision  
rule  on  under  and  over  valued  stocks  would  therefore  be:  
¤ Undervalued  stocks:  Trade  at  price  to  book  raFos  below  the  median  
for  the  sector,(2.05),  generate  returns  on  equity  higher  than  the  sector  
median  (11.82%)  and  have  standard  deviaFons  lower  than  the  median  
(21.93%).  

¤ Overvalued  stocks:  Trade  at  price  to  book  raFos  above  the  median  for  
the  sector  and  generate  returns  on  equity  lower  than  the  sector  
median.  

Aswath Damodaran!
8!
 How  about  this  mechanism?  
9!

¨ We  are  looking  for  stocks  that  trade  at  low  price  to  
book  raFos,  while  generaFng  high  returns  on  equity.  
But  what  is  a  low  price  to  book  raFo?  Or  a  high  
return  on  equity?  
¨ Taking  the  sample  of  18  banks,  we  ran  a  regression  
of  PBV  against  ROE  and  standard  deviaFon  in  stock  
prices  (as  a  proxy  for  risk).  
 PBV  =    2.27  +  3.63  ROE  -­‐    2.68  Std  dev  
   (5.56)    (3.32)      (2.33)  
R  squared  of  regression  =  79%  
Aswath Damodaran!
9!
 And  these  predicFons?  
10!

Aswath Damodaran!
10!
 The  ValuaFon  Matrix  
11!

MV/BV

Overvalued
Low ROE High ROE
High MV/BV High MV/BV

ROE-r

Undervalued
Low ROE High ROE
Low MV/BV Low MV/BV

Aswath Damodaran!
11!
 Price  to  Book  vs  ROE:  Largest  Market  Cap  Firms  
in  the  United  States:  January  2010  
12!

Aswath Damodaran!
12!
 Bringing  it  all  together…  Largest  US  stocks  
13!

Aswath Damodaran!
13!
 Aswath Damodaran! 1!

SESSION  18:  REVENUE  

MULTIPLES  
 Price  Sales  Ra8o:  Defini8on  
2!

¨ The  price/sales  ra8o  is  the  ra8o  of  the  market  value  of  
equity  to  the  sales.  
Price/  Sales  =   Market
    value of equity
Revenues
¨ Consistency  Tests  
¤ The  price/sales  ra8o  is  internally  inconsistent,  since  the  market  
value  of  equity  is  divided  by  the  total  revenues  of  the  firm.    
¤ Analysts  have  historically  been  able  to  get  away  with  this  
inconsistency  because  they  have  used  it  in  sectors  with  no  debt  
(technology)  or  sectors  where  financial  leverage  is  similar  
(retail).  

Aswath Damodaran!
2!
 Revenue  Mul8ples:    US  stocks  
3!

Aswath Damodaran!
3!
 Price/Sales  Ra8o:  Determinants  
4!

¨ The  price/sales  ra8o  of  a  stable  growth  firm  can  be  es8mated  
beginning  with  a  2-­‐stage  equity  valua8on  model:  

DPS1
P0 =
¨ Dividing  both  sides  by  the  
r −sgales  
n per  share:  
 

P0 Net Profit Margin* Payout Ratio *(1+ g n )

= PS =
Sales 0 r-g n

Aswath Damodaran!
4!
 Price  Sales  Ra8os  and  Profit  Margins  
5!

¨ The  key  determinant  of  price-­‐sales  ra8os  is  the  profit  

margin.    
¨ A  decline  in  profit  margins  has  a  two-­‐fold  effect.  
¤ First,  the  reduc8on  in  profit  margins  reduces  the  price-­‐
sales  ra8o  directly.    
¤ Second,  the  lower  profit  margin  can  lead  to  lower  growth  
and  hence  lower  price-­‐sales  ra8os.    
Expected  growth  rate      
=  Reten8on  ra8o  *  Return  on  Equity  
=  Reten8on  Ra8o  *(Net  Profit  /  Sales)  *  (  Sales  /  BV  of  Equity)  
=  Reten8on  Ra8o  *  Profit  Margin  *  Sales/BV  of  Equity  

Aswath Damodaran!
5!
 EV/Sales  Ra8os:  Analysis  of  Determinants  
6!

¨ If  pre-­‐tax  opera8ng  margins  are  used,  the  appropriate  value  es8mate  is  
that  of  the  firm.  In  par8cular,  if  one  makes  the  assump8on  that  
Free  Cash  Flow  to  the  Firm  =  EBIT  (1  -­‐  tax  rate)  (1  -­‐  Reinvestment  Rate)  
¨ Then  the  Value  of  the  Firm  can  be  wriZen  as  a  func8on  of  the  a[er-­‐tax  
opera8ng  margin=  (EBIT  (1-­‐t)/Sales  

( " (1+g)n % +
* (1-RIR growth )(1+g)* $1− n' n -
Value # (1+WACC) & (1-RIR )(1+g) *(1+g )
=After-tax Oper. Margin** + stable n -
Sales0 * WACC-g (WACC-g n )(1+WACC)n -
  * -
g  =   )
 Growth  rate  in  a[er-­‐tax  opera8ng  income  for  the  first  n  years   ,
gn  =    Growth  rate  in  a[er-­‐tax  opera8ng  income  a[er  n  years  forever  
(Stable  growth  rate)  
RIR  Growth,  Stable  =  Reinvestment  rate  in  high  growth  and  stable  periods  
WACC  =  Weighted  average  cost  of  capital  

Aswath Damodaran!
6!
 EV/Sales  Ra8o:  An  Example  with  Coca  Cola  
7!

¨ Consider,  for  example,  the  Value/Sales  ra8o  of  Coca  Cola.  The  
company  had  the  following  characteris8cs:  
¤ A[er-­‐tax  Opera8ng  Margin  =18.56%  Sales/BV  of  Capital  =    
1.67    
¤ Return  on  Capital  =  1.67*  18.56%  =  31.02%      
¤ Reinvestment  Rate=  65.00%  in  high  growth;  20%  in  stable  
growth;  
¤ Expected  Growth  =  31.02%  *  0.65  =20.16%    (Stable  
Growth  Rate=6%)  
¤ Length  of  High  Growth  Period  =  10  years  
¤ Cost  of  Equity    =12.33%      E/(D+E)  =  
97.65%  
¤ A[er-­‐tax    Cost  of  Debt  ( =  4.16% "   10  D/(D+E)  2.35%   +
(1.2016) %
¤ Cost  of  Capital=  
Value of Firm12.33%   ( .9765)
* (1- .65)(1.2016)* $1−
+4.16%  
# (1.1213) (&.0235)   = *  1 2.13%  
10' 10 -
0 * (1- .20)(1.2016) (1.06) - = 6.10
= .1856* +
Sales 0 * .1213- .2016 (.1213- .06)(1.1213)1 0 -
* -
) ,
Aswath Damodaran!
7!
 EV/Sales  Ra8os  and  Opera8ng  Margins  
8!

Aswath Damodaran!
8!
 Brand  Name  Premiums  in  Valua8on  
9!

¨ You  have  been  hired  to  value  Coca  Cola  for  an  analyst    
reports  and  you  have  valued  the  firm  at  6.10  8mes  
revenues,  using  the  model  described  in  the  last  few  
pages.  Another  analyst  is  arguing  that  there  should  be  a  
premium  added  on  to  reflect  the  value  of  the  brand  
name.  Do  you  agree?  
a. Yes  
b. No  
¨  Explain.  

Aswath Damodaran!
9!
 Valuing  Brand  Name  
10!

     Coca  Cola  With  CoZ  Margins  

Current  Revenues  =    $21,962.00    $21,962.00    
Length  of  high-­‐growth  period      10  10  
Reinvestment  Rate    =    50%  50%  
Opera8ng  Margin  (a[er-­‐tax)    15.57%  5.28%  
Sales/Capital  (Turnover  ra8o)    1.34  1.34  
Return  on  capital  (a[er-­‐tax)    20.84%  7.06%  
Growth  rate  during  period  (g)  =    10.42%  3.53%  
Cost  of  Capital  during  period    =    7.65%  7.65%  
Stable  Growth  Period  
Growth  rate  in  steady  state  =    4.00%  4.00%  
Return  on  capital  =    7.65%  7.65%  
Reinvestment  Rate  =    52.28%  52.28%  
Cost  of  Capital  =      7.65%  7.65%  
Value  of  Firm  =      $79,611.25    $15,371.24    
Value  of  brand  name  =  $79,611  -­‐$15,371  =  $64,240  million  

Aswath Damodaran!
10!
 1

SESSION  19:  A  DETOUR  INTO  

ASSET  BASED  VALUATION  
Aswath  Damodaran  
 What  is  asset  based  valuaCon?  

¨ In  intrinsic  valuaCon,  you  value  a  business  based  

upon  the  cash  flows  you  expect  that  business  to  
generate  over  Cme.  
¨ In  relaCve  valuaCon,  you  value  a  business  based  
upon  how  similar  businesses  are  priced.  
¨ In  asset  based  valuaCon,  you  value  a  business  by  
valuing  its  individual  assets.  These  individual  assets  
can  be  tangible  or  intangible.  

2!
Aswath Damodaran

2!
 Why  would  you  do  asset  based  valuaCon?  

¨ LiquidaCon:  If  you  are  liquidaCng  a  business  by  selling  its  assets  
piece  meal,  rather  than  as  a  composite  business,  you  would  like  to  
esCmate  what  you  will  get  from  each  asset  or  asset  class  
individually.  
¨ AccounCng  mission:  As  both  US  and  internaConal  accounCng  
standards  have  turned  to  “fair  value”  accounCng,  accountants  have  
been  called  upon  to  redo  balance  sheet  to  reflect  the  assets  at  
their  fair  rather  than  book  value.  
¨ Sum  of  the  parts:  If  a  business  is  made  up  of  individual  divisions  or  
assets,  you  may  want  to  value  these  parts  individually  for  one  of  
two  groups:  
¤ PotenCal  acquirers  may  want  to  do  this,  as  a  precursor  to  restructuring  the  
business.  
¤ Investors  may  be  interested  because  a  business  that  is  selling  for  less  than  
the  sum  of  its  parts  may  be  “cheap”.  

3!
Aswath Damodaran

3!
 How  do  you  do  asset  based  valuaCon?  

¨ Intrinsic  value:  EsCmate  the  expected  cash  flows  on  

each  asset  or  asset  class,  discount  back  at  a  risk  
adjusted  discount  rate  and  arrive  at  an  intrinsic  
value  for  each  asset.  
¨ RelaCve  value:  Look  for  similar  assets  that  have  sold  
in  the  recent  past  and  esCmate  a  value  for  each  
asset  in  the  business.  
¨ AccounCng  value:  You  could  use  the  book  value  of  
the  asset  as  a  proxy  for  the  esCmated  value  of  the  
asset.  

4!
Aswath Damodaran

4!
 When  is  asset-­‐based  valuaCon  easiest  to  do?  

¨ Separable  assets:  If  a  company  is  a  collecCon  of  separable  assets  (a  set  of  
real  estate  holdings,  a  holding  company  of  different  independent  
businesses),  asset-­‐based  valuaCon  is  easier  to  do.  If  the  assets  are  
interrelated  or  difficult  to  separate,  asset-­‐based  valuaCon  becomes  
problemaCc.  Thus,  while  real  estate  or  a  long  term  licensing/franchising  
contract  may  be  easily  valued,  brand  name  (which  cuts  across  assets)  is  
more  difficult  to  value  separately.  
¨ Stand  alone  earnings/  cash  flows:  An  asset  is  much  simpler  to  value  if  you  
can  trace  its  earnings/cash  flows  to  it.  It  is  much  more  difficult  to  value  
when  the  business  generates  earnings,  but  the  role  of  individual  assets  in  
generaCng  these  earnings  cannot  be  isolated.  
¨ AcCve  market  for  similar  assets:  If  you  plan  to  do  a  relaCve  valuaCon,  it  is  
easier  if  you  can  find  an  acCve  market  for  “similar”  assets  which  you  can  
draw  on  for  transacCons  prices.  

5!
Aswath Damodaran

5!
 I.  LiquidaCon  ValuaCon  

¨ In  liquidaCon  valuaCon,  you  are  trying  to  assess  how  

much  you  would  get  from  selling  the  assets  of  the  
business  today,  rather  than  the  business  as  a  going  
concern.  
¨ Consequently,  it  makes  more  sense  to  price  those  assets  
(i.e.,  do  relaCve  valuaCon)  than  it  is  to  value  them  (do  
intrinsic  valuaCon).  For  assets  that  are  separable  and  
traded  (example:  real  estate),  pricing  is  easy  to  do.  For  
assets  that  are  not,  you  o_en  see  book  value  used  either  
as  a  proxy  for  liquidaCon  value  or  as  a  basis  for  
esCmaCng  liquidaCon  value.  
¨ To  the  extent  that  the  liquidaCon  is  urgent,  you  may  
a`ach  a  discount  to  the  esCmated  value.  
6!
Aswath Damodaran

6!
 II.  AccounCng  ValuaCon:  Glimmers  from  FAS  
157  
¨ The  ubiquitous  “market  parCcipant”:  Through  FAS  157,  
accountants  are  asked  to  a`ach  values  to  assets/liabiliCes  that  
market  parCcipants  would  have  been  willing  to  pay/  receive.  
¨ Tilt  towards  relaCve  value:  “The  definiCon  focuses  on  the  price  
that  would  be  received  to  sell  the  asset  or  paid  to  transfer  the  
liability  (an  exit  price),  not  the  price  that  would  be  paid  to  acquire  
the  asset  or  received  to  assume  the  liability  (an  entry  price).”  The  
hierarchy  puts  “market  prices”,  if  available  for  an  asset,  at  the  top  
with  intrinsic  value  being  accepted  only  if  market  prices  are  not  
accessible.  
¨ Split  mission:  While  accounCng  fair  value  is  Ctled  towards  relaCve  
valuaCon,  accountants  are  also  required  to  back  their  relaCve  
valuaCons  with  intrinsic  valuaCons.  O_en,  this  leads  to  reverse  
engineering,  where  accountants  arrive  at  values  first  and  develop  
valuaCons  later.  

7!
Aswath Damodaran

7!
 III.  Sum  of  the  parts  valuaCon  

¨ You  can  value  a  company  in  pieces,  using  either  relaCve  

or  intrinsic  valuaCon.  Which  one  you  use  will  depend  on  
who  you  are  and  your  moCves  for  doing  the  sum  of  the  
parts  valuaCon.  
¨ If  you  are  long  term,  passive  investor  in  the  company,  
your  intent  may  be  to  find  market  mistakes  that  you  
hope  will  get  corrected  over  Cme.  If  that  is  the  case,  you  
should  do  an  intrinsic  valuaCon  of  the  individual  assets.    
¨ If  you  are  an  acCvist  investor  that  plans  to  acquire  the  
company  or  push  for  change,  you  should  be  more  
focused  on  relaCve  valuaCon,  since  your  intent  is  to  get  
the  company  to  split  up  and  gain  the  increase  in  value.  

8!
Aswath Damodaran

8!
 Let’s  try  this  
United  Technologies:  Raw  Data  -­‐  2009  
Pre-tax
EBITDA Operating Capital Total
Division Business Revenues Income Expenditures Depreciation Assets
Refrigeration
Carrier systems $14,944 $1,510 $1,316 $191 $194 $10,810
Pratt &
Whitney Defense $12,965 $2,490 $2,122 $412 $368 $9,650
Otis Construction $12,949 $2,680 $2,477 $150 $203 $7,731
UTC Fire &
Security Security $6,462 $780 $542 $95 $238 $10,022
Hamilton
Sundstrand Manufacturing $6,207 $1,277 $1,099 $141 $178 $8,648
Sikorsky Aircraft $5,368 $540 $478 $165 $62 $3,985
The company also had corporate expenses, unallocated to the divisions
of $408 million in the most recent year.

Aswath Damodaran
9!
 United  Technologies:  RelaCve  ValuaCon  
A  Simple  CalculaCon  
Division   Business   EBITDA   EV/EBITDA  for  sector   Value  of  Business  
Carrier   RefrigeraCon  systems   $1,510     5.25   $7,928    
Pra`  &  Whitney   Defense   $2,490     8.00   $19,920    
OCs   ConstrucCon   $2,680     6.00   $16,080    
UTC  Fire  &  Security   Security   $780     7.50   $5,850    
Hamilton  Sundstrand   Industrial  Products   $1,277     5.50   $7,024    
Sikorsky   Aircra_   $540     9.00   $4,860    
Sum  of  the  parts  value  
   
for  business  =     $61,661    

10!
Aswath Damodaran

10!
 United  Technologies:  RelaCve  ValuaCon  
A  “be`er”  valuaCon?  
Current
value for
Scaling scaling Operating Tax Estimated
Division Variable variable ROC Margin Rate Predicted Multiple Value
5.35 – 3.55 (.38) + 14.17
Carrier EBITDA $1,510 13.57% 8.81% 38% (.1357) =5.92 $8,944.47
Pratt &
Whitney Revenues $12,965 24.51% 16.37% 38% 0.85 + 7.32 (.1637) =2.05 $26,553.29
3.17 – 2.87 (.38)+14.66
Otis EBITDA $2,680 35.71% 19.13% 38% (.3571) =7.31 $19,601.70
UTC Fire &
Security Capital $5,575 6.03% 8.39% 38% 0.55 + 8.22 (.0603) =1.05 $5,828.76
Hamilton
Sundstrand Revenues $6,207 14.16% 17.71% 38% 0.51 + 6.13 (.1771) =1.59 $9,902.44
Sikorsky Capital $2,217 13.37% 8.90% 38% 0.65 + 6.98 (.1337) =1.58 $3,509.61
Sum of the parts value for operating assets = $74,230.37

11!
Aswath Damodaran

11!
 United  Technologies,  DCF  valuaCon  
Growth  Choices  

Cost of Return on Reinvestment Expected Length of growth Stable Stable

Division capital capital Rate growth period growth rate ROC
Carrier 7.84% 13.57% 43.28% 5.87% 5 3% 7.84%
Pratt &
Whitney 7.72% 24.51% 57.90% 14.19% 5 3% 12.00%
Otis 9.94% 35.71% 18.06% 6.45% 5 3% 14.00%
UTC Fire
& Security 6.78% 6.03% 52.27% 3.15% 0 3% 6.78%
Hamilton
Sundstrand 9.06% 14.16% 38.26% 5.42% 5 3% 9.06%
Sikorsky 9.82% 13.37% 102.95% 13.76% 5 3% 9.82%

12!
Aswath Damodaran

12!
 United  Technologies,  DCF  valuaCon    
Values  of  the  parts  

Cost of PV of PV of Terminal Value of Operating

Business capital FCFF Value Assets
Carrier 7.84% $2,190 $9,498 $11,688
Pratt & Whitney 7.72% $3,310 $27,989 $31,299
Otis 9.94% $5,717 $14,798 $20,515
UTC Fire &
Security 6.78% $0 $4,953 $4,953
Hamilton
Sundstrand 9.06% $1,902 $6,343 $8,245
Sikorsky 9.82% -$49 $3,598 $3,550
Sum $80,250

13!
Aswath Damodaran

13!
 United  Technologies,  DCF  valuaCon  
Sum  of  the  Parts  

¨ Value  of  the  parts            =  

$80,250  
¨ Value   of  corporate  
Corporate ExpensesCurrent expenses  
(1− t)(1+ g)   408(1−.38)(1.03)
   
= =
¨   (Cost   of   Company    
capital − g)   (.0868   −.03)  =  $    4,587  

¨ Value  of  operaCng  assets  (sum  of  parts  DCF)  =  $75,663  

¨ Value  of  operaCng  assets  (sum  of  parts  RV)  =  $74,230  
¨ Value  of  operaCng  assets  (company  DCF)  =  $71,410  
¨ Enterprise  value  (based  on  market  prices)  =  $52,261  

14!
Aswath Damodaran

14!
 Aswath Damodaran
1

SESSION  19A:  PRIVATE  COMPANY  

VALUATION  
Aswath  Damodaran  
 Key  issues  in  valuing  private  businesses  
2

¨ No  market  value:  In  discounted  cash  flow  valuaLon,  

we  are  oNen  dependent  upon  market  value  for  
inputs  (weights  in  the  cost  of  capital),  for  risk  
measures  (beta)  and  for  output  (to  compare  
esLmated  value  to  a  the  end).  
¨ AccounLng  issues:  Small,  private  business  
accounLng  standards  can  oNen  vary,  with    
¤ An  intermingling  of  personal  and  business  expenses  
¤ A  failure  to  separate  salary  from  dividends  

Aswath Damodaran

2

 Private  company  valuaLons:  MoLve  MaTers  
3

¨ Private  to  private  transacLons:  You  can  value  a  

private  business  for  sale  by  one  individual  to  
another.  
¨ Private  to  VC  to  Public:  You  can  value  a  private  firm  
that  is  expected  to  raise  venture  capital  along  the  
way  on  its  path  to  going  public.  
¨ Private  to  public  transacLons:  You  can  value  a  
private  firm  for  sale  to  a  publicly  traded  firm.    
¨ Private  to  IPO:  You  can  value  a  private  firm  for  an  
iniLal  public  offering.      

Aswath Damodaran

3

 I.  Private  to  Private  transacLon  
4

¨ In  private  to  private  transacLons,  a  private  business  is  

sold  by  one  individual  to  another.    There  are  three  key  
issues  that  we  need  to  confront  in  such  transacLons:  
¨ Neither  the  buyer  nor  the  seller  is  diversified.  Consequently,  risk  
and  return  models  that  focus  on  just  the  risk  that  cannot  be  
diversified  away  will  seriously  under  esLmate  the  discount  
rates.  
¨ The  investment  is  illiquid.  Consequently,  the  buyer  of  the  
business  will  have  to  factor  in  an  “illiquidity  discount”  to  
esLmate  the  value  of  the  business.  
¨ Key  person  value:  There  may  be  a  significant  personal  
component  to  the  value.  In  other  words,  the  revenues  and  
operaLng  profit  of  the  business  reflect  not  just  the  potenLal  of  
the  business  but  the  presence  of  the  current  owner.  

Aswath Damodaran

4

 A.  EsLmaLng  discount  rates  
5

Private Owner versus Publicly Traded Company Perceptions of Risk in an Investment

Total Beta measures all risk

= Market Beta/ (Portion of the
total risk that is market risk)

80 units
Is exposed of firm
to all the risk specific
in the firm risk
Private owner of business
with 100% of your weatlth
invested in the business
Market Beta measures just
Demands a market risk
cost of equity
that reflects this
risk
Eliminates firm-
specific risk in
portfolio

20 units Publicly traded company

of market with investors who are diversified
risk
Demands a
cost of equity
that reflects only
market risk

Aswath Damodaran

5

 EsLmaLng  a  total  beta  
6

¨ To  get  from  the  market  beta  to  the  total  beta,  we  need  a  
measure  of  how  much  of  the  risk  in  the  firm  comes  from  the  
market  and  how  much  is  firm-­‐specific.  
¨ For  instance,  to  compute  the  total  beta  for  a  privately  owned  
retail  business  (high  end),  you  would  look  at  publicly  traded  
high  end  retailers  and  look  up  two  numbers:  
¨ The  average  “unlevered”  beta  for  high  end  retailers  is  1.18  
¨ The  average  correlaLon  of  high  end  retailers  with  the  market  is  0.50.  
(This  should  be  available  in  the  same  regression  that  yields  the  beta)  
Total  Unlevered  Beta  
   =  Market  Beta/  CorrelaLon    with  the  market  
   =  1.18  /  0.5  =  2.36  

Aswath Damodaran

6

 EsLmate  a  Debt  to  equity  raLo,  cost  of  equity  &  
cost  of  capital  
7

¨ We  will  assume  that  this  privately  owned  retailer  will  

have  a  debt  to  equity  raLo  (14.33%)  similar  to  the  
average  publicly  traded  retailers:  
¨ Levered  beta  =  2.36  (1  +  (1-­‐.4)  (.1433))  =  2.56    
¨ Cost  of  equity  =4.25%  +  2.56  (4%)  =  14.50%  
(T  Bond  rate  was  4.25%  at  the  Lme;  4%  is  the  equity  risk  premium)    
¨ To  compute  the  cost  of  capital,  we  will  use  the  same  
industry  average  debt  raLo  that  we  used  to  lever  the  
betas.  
¤ Cost  of  capital  =  14.50%  (100/114.33)  +  4.50%  (14.33/114.33)  =  
13.25%  
¤ (The  debt  to  equity  raLo  is  14.33%;  the  cost  of  capital  is  based  
on  the  debt  to  capital  raLo)        

Aswath Damodaran

7

 B.  Assess  the  impact  of  the  “key”  person  
8

¨ When  a  private  business  is  dependent  upon  a  “key  

person”,  usually  the  owner/operator,  a  potenLal  
buyer  will  have  to  incorporate  the  effect  of  that  key  
person  leaving  on  value.    
¨ The  easiest  way  to  incorporate  the  effect  of  a  key  
person  is  to  compute  the  operaLng  income  that  the  
business  would  have  without  the  key  person  
involved  and  value  it  with  that  income.  
¨ The  current  owner  will  therefore  get  a  higher  value  
for  his  or  her  business,  if  he  or  she  agrees  to  stay  on  
for  a  period,  to  ease  the  transiLon.  
Aswath Damodaran

8

 C.  Consider  the  effect  of  illiquidity  
9

¨ In  private  company  valuaLon,  illiquidity  is  a  constant  

theme.  All  the  talk,  though,  seems  to  lead  to  a  rule  of  
thumb.  The  illiquidity  discount  for  a  private  firm  is  
between  20-­‐30%  and  does  not  vary  across  private  firms.  
¨ But  illiquidity  should  vary  across:  
¤ Companies:  Healthier  and  larger  companies,  with  more  liquid  
assets,  should  have  smaller  discounts  than  money-­‐losing  smaller  
businesses  with  more  illiquid  assets.  
¤ Time:  Liquidity  is  worth  more  when  the  economy  is  doing  badly  
and  credit  is  tough  to  come  by  than  when  markets  are  booming.    
¤ Buyers:  Liquidity  is  worth  more  to  buyers  who  have  shorter  Lme  
horizons  and  greater  cash  needs  than  for  longer  term  investors  
who  don’t  need  the  cash  and  are  willing  to  hold  the  investment.  

Aswath Damodaran

9

 Ways  of  incorporaLng  illiquidity  into  
private  company  value  
10

¨ Reduce  your  esLmated  value  by  an  illiquidity  

discount,  with  that  discount  either  being  a  
¤ Fixed  percentage  of  value  for  all  businesses  
¤ A  variable  percentage  of  value,  as  a  funcLon  of  the  size,  
health  and  specific  characterisLcs  of  the  business  being  
valued.  
¨ Increase  your  discount  rate  to  reflect  illiquidity,  with  
the  increase  either  being  
¤ An  arbitrary  number  that  you  apply  for  all  illiquid  company  
¤ A  number  that  you  can  Le  to  a  measure  of  how  illiquid  
your  company  is.  

Aswath Damodaran

10

 II.  Private  company  sold  to  publicly  traded  
company  
11

¨ The  key  difference  between  this  scenario  and  the  

previous  scenario  is  that  the  seller  of  the  business  is  not  
diversified  but  the  buyer  is  (or  at  least  the  investors  in  
the  buyer  are).  Consequently,  they  can  look  at  the  same  
firm  and  see  very  different  amounts  of  risk  in  the  
business  with  the  seller  seeing  more  risk  than  the  buyer.  
¨ The  cash  flows  may  also  be  affected  by  the  fact  that  the  
tax  rates  for  publicly  traded  companies  can  diverge  from  
those  of  private  owners.  
¨ Finally,  there  should  be  no  illiquidity  discount  to  a  public  
buyer,  since  investors  in  the  buyer  can  sell  their  holdings  
in  a  market.  

Aswath Damodaran

11

 III.  Private  company  for  iniLal  public  
offering  
12

¨ In  an  iniLal  public  offering,  the  private  business  is  

opened  up  to  investors  who  clearly  are  diversified  
(or  at  least  have  the  opLon  to  be  diversified).  
¨ There  are  control  implicaLons  as  well.  When  a  
private  firm  goes  public,  it  opens  itself  up  to  
monitoring  by  investors,  analysts  and  market.  
¨ The  reporLng  and  informaLon  disclosure  
requirements  shiN  to  reflect  a  publicly  traded  firm.  

Aswath Damodaran

12

 The  twists  in  an  iniLal  public  offering  
13

¨ ValuaLon  issues:  
¤ Use  of  the  proceeds  from  the  offering:  The  proceeds  from  the  offering  
can  be  held  as  cash  by  the  firm  to  cover  future  investment  needs,  paid  
to  exisLng  equity  investors  who  want  to  cash  out  or  used  to  pay  down  
debt.  
¤ Warrants/  Special  deals  with  prior  equity  investors:  If  venture  
capitalists  and  other  equity  investors  from  earlier  iteraLons  of  fund  
raising  have  rights  to  buy  or  sell  their  equity  at  pre-­‐specified  prices,  it  
can  affect  the  value  per  share  offered  to  the  public.    
¨ Pricing  issues:  
¤ InsLtuLonal  set-­‐up:  Most  IPOs  are  backed  by  investment  banking  
guarantees  on  the  price,  which  can  affect  how  they  are  priced.  
¤ Follow-­‐up  offerings:  The  proporLon  of  equity  being  offered  at  iniLal  
offering  and  subsequent  offering  plans  can  affect  pricing.  

Aswath Damodaran

13

 IV.  An  Intermediate  Problem  
Private  to  VC  to  Public  offering…  
14

¨ When  a  venture  capitalist  is  asked  to  invest  in  a  private  business,  you  fall  
somewhere  between  the  two  extremes  in  terms  of  the  buyer  being  diversified.  A  
venture  capitalist  is  usually  sector  focused  and  not  as  diversified  as  the  typical  
insLtuLonal  investor  in  the  market  but  is  more  diversified  that  the  typical  private  
business  owner.  
¨ Consequently,  the  beta  for  a  VC  will  fall  between  the  total  beta  (private  business)  
and  the  market  beta  (diversified  investor),  yielding  a  cost  of  equity  that  lies  
between  the  two  numbers.  
¨ Following  through,  if  you  are  valuing  a  small  private  business  that  you  expect  to  
transiLon  through  being  held  by  a  VC  and  then  to  being  a  public  company,  your  
cost  of  equity  will  change  over  the  forecasted  Lme  period,  going  from  a  total  beta  
cost  of  equity  in  the  early  years  (when  the  owner  is  the  sole  investor)  to  a  lower  
VC  cost  of  equity  in  the  intermediate  years  (when  the  VC  is  the  marginal  investor)  
to  a  market  beta  cost  of  equity  (when  the  company  goes  public).  

Aswath Damodaran

14

 Aswath Damodaran! 1!

SESSION  20:  THE  ESSENCE  OF  

REAL  OPTIONS  
Aswath  Damodaran  
 Underlying  Theme:  Searching  for  an  Elusive  
Premium  
2!

¨ TradiGonal  discounted  cashflow  models  under  esGmate  

the  value  of  investments,  where  there  are  opGons  
embedded  in  the  investments  to  
¤ Delay  or  defer  making  the  investment  (delay)  
¤ Adjust  or  alter  producGon  schedules  as  price  changes  (flexibility)  
¤ Expand  into  new  markets  or  products  at  later  stages  in  the  
process,  based  upon  observing  favorable  outcomes  at  the  early  
stages  (expansion)  
¤ Stop  producGon  or  abandon  investments  if  the  outcomes  are  
unfavorable  at  early  stages  (abandonment)  
¨ Put  another  way,  real  opGon  advocates  believe  that  you  
should  be  paying  a  premium  on  discounted  cashflow  
value  esGmates.  

Aswath Damodaran!
2!
 A  bad  investment…  
3!

+100

Success
1/2

Today

1/2

Failure

-120

Aswath Damodaran!
3!
 Becomes  a  good  one…  
4!

+80
2/3

+20
1/3
1/3

Now -100

2/3
-20 STOP
Aswath Damodaran!
4!
 Three  Basic  QuesGons  
5!

¨ When  is  there  a  real  opGon  embedded  in  a  decision  

or  an  asset?  
¨ When  does  that  real  opGon  have  significant  
economic  value?  
¨ Can  that  value  be  esGmated  using  an  opGon  pricing  
model?  

Aswath Damodaran!
5!
 When  is  there  an  opGon  embedded  in  an  
acGon?  
6!

¨ An  opGon  provides  the  holder  with  the  right  to  buy  

or  sell  a  specified  quanGty  of  an  underlying  asset  at  
a  fixed  price  (called  a  strike  price  or  an  exercise  
price)  at  or  before  the  expiraGon  date  of  the  opGon.    
¤ There  has  to  be  a  clearly  defined  underlying  asset  whose  
value  changes  over  Gme  in  unpredictable  ways.  
¤ The  payoffs  on  this  asset  (real  opGon)  have  to  be  
conGngent  on  an  specified  event  occurring  within  a  finite  
period.  

Aswath Damodaran!
6!
 Payoff  Diagram  on  a  Call  
7!

Net Payoff

Strike Price



Price of underlying asset

Aswath Damodaran!
7!
 Payoff  Diagram  on  Put  OpGon  
8!

Net Payoff

On Put

Strike

Price



Price of underlying asset

Aswath Damodaran!
8!
 When  does  the  opGon  have  significant  
economic  value?  
9!

¨ For  an  opGon  to  have  significant  economic  value,  

there  has  to  be  a  restricGon  on  compeGGon  in  the  
event  of  the  conGngency.    
¤ In  a  perfectly  compeGGve  product  market,  no  conGngency,  
no  maZer  how  posiGve,  will  generate  posiGve  net  present  
value.  
¨ At  the  limit,  real  opGons  are  most  valuable  when  
you  have  exclusivity  -­‐  you  and  only  you  can  take  
advantage  of  the  conGngency.  They  become  less  
valuable  as  the  barriers  to  compeGGon  become  less  
steep.  

Aswath Damodaran!
9!
 Determinants  of  opGon  value  
10!

¨ Variables  RelaGng  to  Underlying  Asset  

¤ Value  of  Underlying  Asset;  as  this  value  increases,  the  right  to  buy  at  a  fixed  price  (calls)  will  
become  more  valuable  and  the  right  to  sell  at  a  fixed  price  (puts)  will  become  less  valuable.  
¤ Variance  in  that  value;  as  the  variance  increases,  both  calls  and  puts  will  become  more  
valuable  because  all  opGons  have  limited  downside  and  depend  upon  price  volaGlity  for  
upside.  
¤ Expected  dividends  on  the  asset,  which  are  likely  to  reduce  the  price  appreciaGon  component  
of  the  asset,  reducing  the  value  of  calls  and  increasing  the  value  of  puts.  
¨ Variables  RelaGng  to  OpGon  
¤ Strike  Price  of  OpGons;  the  right  to  buy  (sell)  at  a  fixed  price  becomes  more  (less)  valuable  at  a  
lower  price.  
¤ Life  of  the  OpGon;  both  calls  and  puts  benefit  from  a  longer  life.  
¨ Level  of  Interest  Rates;  as  rates  increase,  the  right  to  buy  (sell)  at  a  fixed  price  in  
the  future  becomes  more  (less)  valuable.  

Aswath Damodaran!
10!
 When  can  you  use  opGon  pricing  models  to  
value  real  opGons?  
11!

¨ The  noGon  of  a  replicaGng  por^olio  that  drives  opGon  pricing  models  
makes  them  most  suited  for  valuing  real  opGons  where  
¤ The  underlying  asset  is  traded  -­‐  this  yield  not  only  observable  prices  and  volaGlity  
as  inputs  to  opGon  pricing  models  but  allows  for  the  possibility  of  creaGng  
replicaGng  por^olios  
¤ An  acGve  marketplace  exists  for  the  opGon  itself.  
¤ The  cost  of  exercising  the  opGon  is  known  with  some  degree  of  certainty.  
¨ When  opGon  pricing  models  are  used  to  value  real  assets,  we  have  to  
accept  the  fact  that  
¤ The  value  esGmates  that  emerge  will  be  far  more  imprecise.  
¤ The  value  can  deviate  much  more  dramaGcally  from  market  price  because  of  the  
difficulty  of  arbitrage.  

Aswath Damodaran!
11!
 Choices  of  Models  
12!

¨ Black-­‐Scholes  Model:  Makes  restricGve  assumpGons  about  volaGlity  (fixed  over  

opGon  life)  and  early  exercise  (none)  and  price  process  for  underlying  asset  (no  
jumps),  but  arrives  at  a  parsimonious  model  where  the  opGon  value  is  a  funcGon  
of  only  6  observable  inputs:  
¤ The  current  price  of  the  underlying  asset  
¤ The  strike  price  on  the  opGon  
¤ The  life  of  the  opGon  
¤ The  variance  in  the  price  of  the  underlying  assets  
¤ The  riskless  rate  for  the  opGon  life  
¤ Dividends  over  the  life  of  the  opGon  (not  in  original  Black  Scholes)  
¨ Binomial  Model:  This  is  a  more  general  and  less  restricGve  model  but  it  requires  a  
great  deal  more  data  on  how  the  price  of  the  underlying  asset  will  evolve  over  
Gme.    

Aswath Damodaran!
12!
 Choice  of  OpGon  Pricing  Models  
13!

¨ Most  pracGGoners  who  use  opGon  pricing  models  to  value  

real  opGons  argue  for  the  binomial  model  over  the  Black-­‐
Scholes  and  jusGfy  this  choice  by  noGng  that  
¤ Early  exercise  is  the  rule  rather  than  the  excepGon  with  real  opGons  
¤ Underlying  asset  values  are  generally  disconGnous.  
¨ If  you  can  develop  a  binomial  tree  with  outcomes  at  each  
node,  it  looks  a  great  deal  like  a  decision  tree  from  capital  
budgeGng.  The  quesGon  then  becomes  when  and  why  the  
two  approaches  yield  different  esGmates  of  value.  

Aswath Damodaran!
13!
 Key  Tests  for  Real  OpGons  
14!

¨ Is  there  an  opGon  embedded  in  this  asset/  decision?  

¤ Can  you  idenGfy  the  underlying  asset?  
¤ Can  you  specify  the  conGgency  under  which  you  will  get  payoff?  
¨ Is  there  exclusivity?  
¤ If  yes,  there  is  opGon  value.  
¤ If  no,  there  is  none.  
¤ If  in  between,  you  have  to  scale  value.  
¨ Can  you  use  an  opGon  pricing  model  to  value  the  real  opGon?  
¤ Is  the  underlying  asset  traded?  
¤ Can  the  opGon  be  bought  and  sold?  
¤ Is  the  cost  of  exercising  the  opGon  known  and  clear?  

Aswath Damodaran!
14!
 Aswath Damodaran! 1!

SESSION  21:  THE  OPTION  TO  DELAY  

VALUING  PATENTS  AND  NATURAL  
RESOURCE  RESERVES  
Aswath  Damodaran  
 The Option to Delay!
2!

¨ When a firm has exclusive rights to a project or

product for a specific period, it can delay taking this
project or product until a later date.

¨ A traditional investment analysis just answers the
question of whether the project is a “good” one if
taken today.

¨ Thus, the fact that a project does not pass muster
today (because its NPV is negative, or its IRR is less
than its hurdle rate) does not mean that the rights to
this project are not valuable.

Aswath Damodaran!
2!
 Valuing the Option to Delay a Project!
3!

PV of Cash Flows

from Project

Initial Investment in

Project

Present Value of Expected

Cash Flows on Product

Project's NPV turns

Project has negative

positive in this section

NPV

in this section

Aswath Damodaran!
3!
 Example 1: Valuing product patents as
options!
4!

¨ A product patent provides the firm with the right to develop

the product and market it.

¨ It will do so only if the present value of the expected cash
flows from the product sales exceed the cost of development.

¨ If this does not occur, the firm can shelve the patent and not
incur any further costs.

¨ If I is the present value of the costs of developing the product,
and V is the present value of the expected cashflows from
development, the payoffs from owning a product patent can be
written as:

Payoff from owning a product patent
= V - I

if V>
I







= 0

if V ≤ I

Aswath Damodaran!
4!
 Payoff on Product Option!
5!

Net Payoff to

introduction

Cost of product

introduction

Present Value of

cashflows on product

Aswath Damodaran!
5!
Obtaining Inputs for Patent Valuation!
Input
1. Value of the Underlying Asset
2. Variance in value of underlying asset
3. Exercise Price on Option
4. Expiration of the Option
5. Dividend Yield
Estimation Process
• Present Value of Cash Inflows from taking project
now
• This will be noisy, but that adds value.
• Variance in cash flows of similar assets or firms
• Variance in present value from capital budgeting
simulation.
• Option is exercised when investment is made.
• Cost of making investment on the project ; assumed
to be constant in present value dollars.
• Life of the patent
• Cost of delay
• Each year of delay translates into one less year of
value-creating cashflows
1
Annual cost of delay =
n
 Valuing a Product Patent: Avonex!
7!

¨ Biogen, a bio-technology firm, has a patent on Avonex, a drug to

treat multiple sclerosis, for the next 17 years, and it plans to produce
and sell the drug by itself. The key inputs on the drug are as
follows:

PV of Cash Flows from Introducing the Drug Now = S = $ 3.422 billion

PV of Cost of Developing Drug for Commercial Use = K = $ 2.875 billion

Patent Life = t = 17 years Riskless Rate = r = 6.7% (17-year T.Bond rate)

Variance in Expected Present Values =σ2 = 0.224 (Industry average firm
variance for bio-tech firms)

Expected Cost of Delay = y = 1/17 = 5.89%

d1 = 1.1362
N(d1) = 0.8720

d2 = -0.8512
N(d2) = 0.2076

Call Value= 3,422 exp(-0.0589)(17) (0.8720) - 2,875 (exp(-0.067)(17)
(0.2076)= $ 907 million

Aswath Damodaran!
7!
 Example 2: Valuing Natural Resource
Options!
8!

¨ In a natural resource investment, the underlying asset is

the resource and the value of the asset is based upon two
variables - the quantity of the resource that is available in
the investment and the price of the resource.

¨ In most such investments, there is a cost associated with
developing the resource, and the difference between the
value of the asset extracted and the cost of the
development is the profit to the owner of the resource.

¨ Defining the cost of development as X, and the estimated
value of the resource as V, the potential payoffs on a
natural resource option can be written as follows:


Payoff on natural resource investment
= V - X
if V > X







= 0
if V≤ X

Aswath Damodaran!
8!
 Payoff Diagram on Natural Resource Firms!
9!

Net Payoff on

Extraction

Cost of Developing

Reserve

Value of estimated reserve

of natural resource

Aswath Damodaran!
9!
 Estimating Inputs for Natural Resource
Options!
Input
1. Value of Available Reserves of the Resource
2. Cost of Developing Reserve (Strike Price)
3. Time to Expiration
4. Variance in value of underlying asset
5. Net Production Revenue (Dividend Yield)
6. Development Lag
Estimation Process
• Expert estimates (Geologists for oil..); The
present value of the after-tax cash flows from
the resource are then estimated.
• Past costs and the specifics of the investment
• Relinqushment Period: if asset has to be
relinquished at a point in time.
• Time to exhaust inventory - based upon
inventory and capacity output.
• based upon variability of the price of the
resources and variability of available reserves.
• Net production revenue every year as percent
of market value.
• Calculate present value of reserve based upon
the lag.
 Valuing an Oil Reserve!
11!

¨ Consider an offshore oil property with an estimated oil

reserve of 50 million barrels of oil, where the present
value of the development cost is $12 per barrel and the
development lag is two years.

¨ The firm has the rights to exploit this reserve for the next
twenty years and the marginal value per barrel of oil is
$12 per barrel currently (Price per barrel - marginal cost
per barrel).

¨ Once developed, the net production revenue each year
will be 5% of the value of the reserves.

¨ The riskless rate is 8% and the variance in ln(oil prices)
is 0.03.

Aswath Damodaran!
11!
 Inputs to Option Pricing Model!
12!

¨ Current Value of the asset = S = Value of the developed reserve discounted back
the length of the development lag at the dividend yield = $12 * 50 /(1.05)2 = $
544.22

(If development is started today, the oil will not be available for sale until two years from now. The
estimated opportunity cost of this delay is the lost production revenue over the delay period.
Hence, the discounting of the reserve back at the dividend yield)

¨ Exercise Price = Present Value of development cost = $12 * 50 = $600 million

¨ Time to expiration on the option = 20 years

¨ Variance in the value of the underlying asset = 0.03

¨ Riskless rate =8%

¨ Dividend Yield = Net production revenue / Value of reserve = 5%

Aswath Damodaran!
12!
 Valuing the Option!
13!

¨ Based upon these inputs, the Black-Scholes model

provides the following value for the call:

d1 = 1.0359
N(d1) = 0.8498

d2 = 0.2613
N(d2) = 0.6030

Call Value= 544 .22 exp(-0.05)(20) (0.8498) -600 (exp(-0.08)(20)
(0.6030)= $ 97.08 million

¨ This oil reserve, though not viable at current prices, still
is a valuable property because of its potential to create
value if oil prices go up.

Aswath Damodaran!
13!
 Aswath Damodaran! 1!

SESSION  22:  THE  OPTIONS  TO  

EXPAND  AND  ABANDON  
Aswath  Damodaran  
 The  Op<on  to  Expand/Take  Other  Projects  
2!

¨ Taking  a  project  today  may  allow  a  firm  to  consider  

and  take  other  valuable  projects  in  the  future.  
¨ Thus,  even  though  a  project  may  have  a  nega<ve  
NPV,  it  may  be  a  project  worth  taking  if  the  op<on  it  
provides  the  firm  (to  take  other  projects  in  the  
future)  provides  a  more-­‐than-­‐compensa<ng  value.  
¨ These  are  the  op<ons  that  firms  oQen  call  “strategic  
op<ons”  and  use  as  a  ra<onale  for  taking  on  
“nega<ve  NPV”  or  even  “nega<ve  return”  projects.  

Aswath Damodaran!
2!
 The  Op<on  to  Expand  
3!

PV of Cash Flows

from Expansion

Additional Investment

to Expand

Present Value of Expected

Cash Flows on Expansion

Expansion becomes

Firm will not expand in
attractive in this section


this section

Aswath Damodaran!
3!
 An  Example  of  an  Expansion  Op<on  
4!

¨ Ambev  is  considering  introducing  a  soQ  drink  to  the  U.S.  market.  
The  drink  will  ini<ally  be  introduced  only  in  the  metropolitan  areas  
of  the  U.S.  and  the  cost  of  this  “limited  introduc<on”    is  $  500  
million.    
¨ A  financial  analysis  of  the  cash  flows  from  this  investment  suggests  
that  the  present  value  of  the  cash  flows  from  this  investment  to  
Ambev  will  be  only  $  400  million.  Thus,  by  itself,  the  new  
investment  has  a  nega<ve  NPV  of  $  100  million.  
¨ If  the  ini<al  introduc<on  works  out  well,  Ambev  could  go  ahead  
with  a  full-­‐scale  introduc<on  to  the  en<re  market  with  an  
addi<onal  investment  of  $  1  billion  any  <me  over  the  next  5  years.  
While  the  current  expecta<on  is  that  the  cash  flows  from  having  
this  investment  is  only  $  750  million,  there  is  considerable  
uncertainty  about  both  the  poten<al  for  the  drink,  leading  to  
significant  variance  in  this  es<mate.  

Aswath Damodaran!
4!
 Valuing  the  Expansion  Op<on  
5!

¨ Value  of  the  Underlying  Asset  (S)  =  PV  of  Cash  Flows  from  
Expansion  to  en<re  U.S.  market,  if  done  now  =$  750  Million  
¨ Strike  Price  (K)  =  Cost  of  Expansion  into  en<re  U.S  market  =    $  
1000  Million  
¨ We  es<mate  the  standard  devia<on  in  the  es<mate  of  the  
project  value  by  using  the  annualized  standard  devia<on  in  
firm  value  of  publicly  traded  firms  in  the  beverage  markets,  
which  is  approximately  34.25%.    
¤ Standard  Devia<on  in  Underlying  Asset’s  Value  =  34.25%  
¨ Time  to  expira<on  =  Period  for  which  expansion  op<on  
applies  =  5  years  
¨ Call  Value=  $  234  Million  
Aswath Damodaran!
5!
 Considering  the  Project  with  Expansion  Op<on  
6!

¨ NPV  of  Limited  Introduc<on    

=  $  400  Million  -­‐  $  500  Million    
=  -­‐  $  100  Million  
¨ Value  of  Op<on  to  Expand  to  full  market=  $  234  

Million  
¨ NPV  of  Project  with  op<on  to  expand      
=  -­‐  $  100  million  +  $  234  million  =  $  134  million  
¨ Invest  in  the  project  

Aswath Damodaran!
6!
 Opportuni<es  are  not  Op<ons…  
7!

Is the first investment necessary for the second investment?

Not necessary Pre-Requisit

A Zero competitive An Exclusive Right to

advantage on Second Investment Second Investment

No option value 100% of option value

Option has no value Option has high value

Second investment
Second Investment has has large sustainable
zero excess returns excess return

First- Technological Brand Telecom Pharmaceutical

Mover Edge Name Licenses patents

Increasing competitive advantage/ barriers to entry

Aswath Damodaran!
7!
 The  Op<on  to  Abandon  
8!

¨ A  firm  may  some<mes  have  the  op<on  to  abandon  a  project,  if  the  cash  
flows  do  not  measure  up  to  expecta<ons.    
¨ If  abandoning  the  project  allows  the  firm  to  save  itself  from  further  
losses,  this  op<on  can  make    a  project  more  valuable.  

PV of Cash Flows

from Project

Cost of Abandonment

Present Value of Expected

Cash Flows on Project

Aswath Damodaran!
8!
 Valuing  the  Op<on  to  Abandon  
9!

¨ Airbus  is  considering  a  joint  venture  with  Lear  AircraQ  to  produce  a  small  
commercial  airplane  (capable  of  carrying  40-­‐50  passengers  on  short  haul  
flights)  
¤ Airbus  will  have  to  invest  $  500  million  for  a  50%  share  of  the  venture  
¤ Its  share  of  the  present  value  of  expected  cash  flows  is  480  million.    
¨ Lear  AircraQ,  which  is  eager  to  enter  into  the  deal,  offers  to  buy  Airbus’s  
50%  share  of  the  investment  any<me  over  the  next  five  years  for    $  400  
million,  if  Airbus  decides  to  get  out  of  the  venture.  
¨  A  simula<on  of  the  cash  flows  on  this  <me  share  investment  yields  a  
variance  in  the  present  value  of  the  cash  flows  from  being  in  the  
partnership  is  0.16.  
¨ The  project  has  a  life  of  30  years.  

Aswath Damodaran!
9!
 Project  with  Op<on  to  Abandon  
10!

¨ Value  of  the  Underlying  Asset  (S)  =  PV  of  Cash  Flows  from  Project
           =  $  480  million  
¨ Strike  Price  (K)  =  Salvage  Value  from  Abandonment  =  $  400  million  
¨ Variance  in  Underlying  Asset’s  Value  =  0.16  
¨ Time  to  expira<on  =  Life  of  the  Project  =5  years  
¨ Dividend  Yield  =  1/Life  of  the  Project  =  1/30  =  0.033  (We  are  
assuming  that  the  project’s  present  value  will  drop  by  roughly  1/n  
each  year  into  the  project)  
¨ Assume  that  the  five-­‐year  riskless  rate  is  6%.  The  value  of  the  put  
op<on  can  be  es<mated  as  follows:  

Aswath Damodaran!
10!
 Should  Airbus  enter  into  the  joint  venture?  
11!

¨ Value  of  Put  =Ke-­‐rt  (1-­‐N(d2))-­‐  Se-­‐yt  (1-­‐N(d1))    

=400  (exp(-­‐0.06)(5)  (1-­‐0.4624)  -­‐  480  exp(-­‐0.033)(5)  (1-­‐0.7882)    
=  $  73.23  million  
¨ The  value  of  this  abandonment  op<on  has  to  be  
added  on  to  the  net  present  value  of  the  project  of  -­‐
$  20  million,  yielding  a  total  net  present  value  with  
the  abandonment  op<on  of  $  53.23  million.  

Aswath Damodaran!
11!
 Implica<ons  for  Investment  Analysis/  Valua<on  
12!

¨ Having  a  op<on  to  abandon  a  project  can  make  otherwise  

unacceptable  projects  acceptable.  
¨ Other  things  remaining  equal,  you  would  alach  more  value  to  
companies  with  
¤ More  cost  flexibility,  that  is,  making  more  of  the  costs  of  the  projects  into  
variable  costs  as  opposed  to  fixed  costs.  
¤ Fewer  long-­‐term  contracts/obliga<ons  with  employees  and  customers,  
since  these  add  to  the  cost  of  abandoning  a  project.  
¨ These  ac<ons  will  undoubtedly  cost  the  firm  some  value,  but  this  
has  to  be  weighed  off  against  the  increase  in  the  value  of  the  
abandonment  op<on.  

Aswath Damodaran!
12!
 Aswath Damodaran! 1!

SESSION  23:  VALUING  EQUITY  IN  

DISTRESSED  FIRMS  AS  AN  
OPTION  
 Valuing  Equity  as  an  opCon  
2!

¨ The  equity  in  a  firm  is  a  residual  claim,  i.e.,  equity  

holders  lay  claim  to  all  cashflows  leO  over  aOer  other  
financial  claim-­‐holders  (debt,  preferred  stock  etc.)  have  
been  saCsfied.    
¨ If  a  firm  is  liquidated,  the  same  principle  applies,  with  
equity  investors  receiving  whatever  is  leO  over  in  the  
firm  aOer  all  outstanding  debts  and  other  financial  
claims  are  paid  off.    
¨ The  principle  of  limited  liability,  however,  protects  
equity  investors  in  publicly  traded  firms  if  the  value  of  
the  firm  is  less  than  the  value  of  the  outstanding  debt,  
and  they  cannot  lose  more  than  their  investment  in  the  
firm.    
Aswath Damodaran!
2!
 Equity  as  a  call  opCon  
3!

¨ The  payoff  to  equity  investors,  on  liquidaCon,  can  

therefore  be  wriXen  as:  
 Payoff  to  equity  on  liquidaCon    =  V  -­‐  D    if  V  >  D  
         =  0    if  V  ≤  D  
where,  
 V  =  Value  of  the  firm  
 D  =  Face  Value  of  the  outstanding  debt  and  other  external  
claims  
¨ A  call  opCon,  with  a  strike  price  of  K,  on  an  asset  with  a  
current  value  of  S,  has  the  following  payoffs:  
 Payoff  on  exercise      =  S  -­‐  K    if  S  >  K  
         =  0    if  S  ≤  K  

Aswath Damodaran!
3!
 Payoff  Diagram  for  LiquidaCon  OpCon  
4!

Net Payoff
on Equity

Face Value
of Debt

Value of firm

Aswath Damodaran!
4!
 ApplicaCon  to  valuaCon:  A  simple  example  
5!

¨ Assume  that  you  have  a  firm  whose  assets  are  

currently  valued  at  $100  million  and  that  the  
standard  deviaCon  in  this  asset  value  is  40%.  
¨ Further,  assume  that  the  face  value  of  debt  is  $80  
million  (It  is  zero  coupon  debt  with  10  years  leO  to  
maturity).    
¨ If  the  ten-­‐year  treasury  bond  rate  is  10%,    
¤ how  much  is  the  equity  worth?    
¤ What  should  the  interest  rate  on  debt  be?  

Aswath Damodaran!
5!
 Model  Parameters  
6!

¨ Value  of  the  underlying  asset  =  S  =  Value  of  the  firm  

=  $  100  million  
¨ Exercise  price  =  K  =  Face  Value  of  outstanding  debt  =  
$  80  million  
¨ Life  of  the  opCon  =  t  =  Life  of  zero-­‐coupon  debt  =  10  
years  
¨ Variance  in  the  value  of  the  underlying  asset  =  σ2  =  
Variance  in  firm  value  =  0.16  
¨ Riskless  rate  =  r  =  Treasury  bond  rate  corresponding  
to  opCon  life  =  10%  

Aswath Damodaran!
6!
 Valuing  Equity  as  a  Call  OpCon  
7!

¨ Inputs  to  opCon  pricing  model  

¤ Value  of  the  underlying  asset  =  S  =  Value  of  the  firm  =  $  100  million  
¤ Exercise  price  =  K  =  Face  Value  of  outstanding  debt  =  $  80  million  
¤ Life  of  the  opCon  =  t  =  Life  of  zero-­‐coupon  debt  =  10  years  
¤ Variance  in  the  value  of  the  underlying  asset  =  σ2  =  Variance  in  firm  value  =  0.16  
¤ Riskless  rate  =  r  =  Treasury  bond  rate  corresponding  to  opCon  life  =  10%  
¨ Based  upon  these  inputs,  the  Black-­‐Scholes  model  provides  the  following  
value  for  the  call:  
¤ d1  =  1.5994    N(d1)  =  0.9451  
¤ d2  =  0.3345    N(d2)  =  0.6310  
¨ Value  of  the  call  =  100  (0.9451)  -­‐  80  exp(-­‐0.10)(10)  (0.6310)  =  $75.94  
million  
¨ Value  of  the  outstanding  debt  =  $100  -­‐  $75.94  =  $24.06  million  
¨ Interest  rate  on  debt  =  ($  80  /  $24.06)1/10  -­‐1  =  12.77%  

Aswath Damodaran!
7!
 The  Effect  of  Catastrophic  Drops  in  Value  
8!

¨ Assume  now  that  a  catastrophe  wipes  out  half  the  value  

of  this  firm  (the  value  drops  to  $  50  million),  while  the  
face  value  of  the  debt  remains  at  $  80  million.  What  will  
happen  to  the  equity  value  of  this  firm?  
a. It  will  drop  in  value  to  $  25.94  million  [  $  50  million  -­‐  
market  value  of  debt  from  previous  page]  
b. It  will  be  worth  nothing  since  debt  outstanding  >  Firm  
Value  
c. It  will  be  worth  more  than  $  25.94  million  

Aswath Damodaran!
8!
 Valuing  Equity  in  the  Troubled  Firm  
9!

¨ Value  of  the  underlying  asset  =  S  =  Value  of  the  firm  =  $  50  
million  
¨ Exercise  price  =  K  =  Face  Value  of  outstanding  debt  =  $  80  
million  
¨ Life  of  the  opCon  =  t  =  Life  of  zero-­‐coupon  debt  =  10  years  
¨ Variance  in  the  value  of  the  underlying  asset  =  σ2  =  Variance  
in  firm  value  =  0.16  
¨ Riskless  rate  =  r  =  Treasury  bond  rate  corresponding  to  opCon  
life  =  10%  

Aswath Damodaran!
9!
 The  Value  of  Equity  as  an  OpCon  
10!

¨ Based  upon  these  inputs,  the  Black-­‐Scholes  model  provides  the  following  
value  for  the  call:  
¤ d1  =  1.0515    N(d1)  =  0.8534  
¤ d2  =  -­‐0.2135    N(d2)  =  0.4155  
¨ Value  of  the  call  =  50  (0.8534)  -­‐  80  exp(-­‐0.10)(10)  (0.4155)  =  $30.44  
million  
¨ Value  of  the  bond=  $50  -­‐  $30.44  =  $19.56  million  
¨ The  equity  in  this  firm  drops  by  $45.50  million,  but  not  by  $50  million,  
because  of  the  opCon  characterisCcs  of  equity.    
¨ This  might  explain  why  stock  in  firms,  which  are  in  Chapter  11  and  
essenCally  bankrupt,  sCll  has  value.  

Aswath Damodaran!
10!
 Equity  value  persists  ..  
11!

Value of Equity as Firm Value Changes

80

70

60

50
Equity

40
of
Value

30

20

10

0
100 90 80 70 60 50 40 30 20 10
Value of Firm ($ 80 Face Value of Debt)

Aswath Damodaran!
11!
Obtaining  opCon  pricing  inputs  in  the  real  
worlds  
Input Estimation Process
Value of the Firm • Cumulate market values of equity and debt (or)
• Value the assets in place using FCFF and WACC (or)
• Use cumulated market value of assets, if traded.
Variance in Firm Value • If stocks and bonds are traded,
σ2firm = we2 σe2 + wd2 σd2 + 2 we wd ρed σe σd
where σe2 = variance in the stock price
we = MV weight of Equity

σd2 = the variance in the bond price w d = MV weight of debt

• If not traded, use variances of similarly rated bonds.
• Use average firm value variance from the industry in which
company operates.
Value of the Debt • If the debt is short term, you can use only the face or book value
of the debt.
• If the debt is long term and coupon bearing, add the cumulated
nominal value of these coupons to the face value of the debt.
Maturity of the Debt • Face value weighted duration of bonds outstanding (or)
• If not available, use weighted maturity
 Aswath Damodaran
1

SESSION  24:  CLOSING  THOUGHTS  

Aswath  Damodaran  
 Back  to  the  very  beginning:  
Approaches  to  ValuaIon  
2

¨ Discounted  cashflow  valuaIon,  where  we  try  

(someImes  desperately)  to  esImate  the  intrinsic  
value  of  an  asset  by  using  a  mix  of  theory,  guesswork  
and  prayer.  
¨ RelaIve  valuaIon,  where  we  pick  a  group  of  assets,  
aRach  the  name  “comparable”  to  them  and  tell  a  
story.  
¨ ConIngent  claim  valuaIon,  where  we  take  the  
valuaIon  that  we  did  in  the  DCF  valuaIon  and  divvy  
it  up  between  the  potenIal  thieves  of  value  (equity)  
and  the  potenIal  vicIms  of  this  crime  (lenders)  
Aswath Damodaran

2

 DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Net Income/EPS Firm is in stable growth:
Equity: After debt
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

3
Aswath Damodaran

 RelaIve  ValuaIon:  The  Four  Steps  to  
Understanding  MulIples  
4

¨ We  all  know  what  a  PE  raIo  is,  right?  Do  we?  

¤ In  use,  the  same  mulIple  can  be  defined  in  different  ways  by  different  
users.  When  comparing  and  using  mulIples,  esImated  by  someone  else,  it  
is  criIcal  that  we  understand  how  the  mulIples  have  been  esImated  
¨ 8  Imes  EBITDA  is  not  always  cheap…  
¤ Too  many  people  who  use  a  mulIple  have  no  idea  what  its  cross  secIonal  
distribuIon  is.  If  you  do  not  know  what  the  cross  secIonal  distribuIon  of  
a  mulIple  is,  it  is  difficult  to  look  at  a  number  and  pass  judgment  on  
whether  it  is  too  high  or  low.  
¨ You  cannot  get  away  without  making  assumpIons  
¤ It  is  criIcal  that  we  understand  the  fundamentals  that  drive  each  mulIple,  
and  the  nature  of  the  relaIonship  between  the  mulIple  and  each  variable.  
¨ There  are  no  perfect  comparables  
¤ Defining  the  comparable  universe  and  controlling  for  differences  is  far  
more  difficult  in  pracIce  than  it  is  in  theory.  

Aswath Damodaran

4

 Value of Stock = DPS 1/(k e - g)

PE=Payout Ratio PEG=Payout ratio PBV=ROE (Payout ratio) PS= Net Margin (Payout ratio)
(1+g)/(r-g) (1+g)/g(r-g) (1+g)/(r-g) (1+g)/(r-g)

PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)

Equity Multiples

Firm Multiples

V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)

Value/FCFF=(1+g)/ Value/EBIT(1-t) = (1+g) Value/EBIT=(1+g)(1- VS= Oper Margin (1-

(WACC-g) (1- RIR)/(WACC-g) RiR)/(1-t)(WACC-g) RIR) (1+g)/(WACC-g)

Value of Firm = FCFF 1/(WACC -g)

5
Aswath Damodaran

 ConIngent  Claim  (OpIon)  ValuaIon  
6

¨ OpIons  have  several  features  

¤ They  derive  their  value  from  an  underlying  asset,  which  
has  value  
¤ The  payoff  on  a  call  (put)  opIon  occurs  only  if  the  value  of  
the  underlying  asset  is  greater  (lesser)  than  an  exercise  
price  that  is  specified  at  the  Ime  the  opIon  is  created.  If  
this  conIngency  does  not  occur,  the  opIon  is  worthless.  
¤ They  have  a  fixed  life  

¨ Any  security  that  shares  these  features  can  be  

valued  as  an  opIon.  

Aswath Damodaran

6

 Choices…Choices…Choices…  
Valuation Models

Asset Based Discounted Cashflow Relative Valuation Contingent Claim

Valuation Models Models

Liquidation Equity Sector Option to Option to Option to

Value delay expand liquidate
Stable Current Firm
Market
Young Equity in
Replacement Two-stage firms troubled
Cost Normalized
firm
Three-stage
or n-stage
Earnings Book Revenues Sector Undeveloped
Value specific land

Equity Valuation Firm Valuation

Models Models
Patent Undeveloped
Reserves
Dividends

Aswath Damodaran
Cost of capital APV Excess Return
Free Cashflow approach approach Models 7

to Equity
 Picking  your  approach  
8

¨ Asset  characterisIcs  
¤ Marketability  
¤ Cash  flow  generaIng  capacity  
¤ Uniqueness  

¨ Your  characterisIcs  
¤ Time  horizon  
¤ Reasons  for  doing  the  valuaIon  
¤ Beliefs  about  markets  

Aswath Damodaran

8

 Some  Not  Very  Profound  Advice  
9

¨ Its  all  in  the  fundamentals.  The  more  things  change,  

the  more  they  stay  the  same.  
¨ Focus  on  the  big  picture;  don’t  let  the  details  trip  
you  up.  
¨ Experience  does  not  equal  knowledge.  
¨ Keep  your  perspecIve.  It  is  only  a  valuaIon.  
¨ Luck  dominates…  

Aswath Damodaran

9

 Or  maybe  you  can  fly….  
10

Aswath Damodaran

10