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Valuation:PartI

DiscountedCashFlowValuation
B40.3331
AswathDamodaran

Aswath Damodaran

DiscountedCashflowValuation:BasisforApproach

CF1
CF2
CF3
CF4
CFn
Value of asset =

.....
1
2
3
4
(1 + r) (1 + r)
(1 + r)
(1 + r)
(1 + r) n

whereCFtistheexpectedcashflowinperiodt,risthediscountrateappropriate
giventheriskinessofthecashflowandnisthelifeoftheasset.
Proposition1:Foranassettohavevalue,theexpectedcashflowshavetobe
positivesometimeoverthelifeoftheasset.
Proposition2:Assetsthatgeneratecashflowsearlyintheirlifewillbeworth
morethanassetsthatgeneratecashflowslater;thelattermayhowever
havegreatergrowthandhighercashflowstocompensate.

Aswath Damodaran

DCFChoices:EquityValuationversusFirmValuation
FirmValuation:Valuetheentirebusiness
A ssets
E x is tin g In v e s tm e n ts
G e n e ra te c a s h flo w s to d a y
In c lu d e s lo n g liv e d (fix e d ) a n d
s h o rt-liv e d (w o rk in g
c a p ita l) a s s e ts
E x p e c te d V a lu e th a t w ill b e
c re a te d b y fu tu re in v e s tm e n ts

L ia b i li ti es
A s s e ts in P la c e

D ebt

G ro w th A s s e ts

E q u ity

F ix e d C la im o n c a s h flo w s
L ittle o r N o ro le in m a n a g e m e n t
F i x e d M a tu r i ty
T a x D e d u c ti b l e

R e s id u a l C la im o n c a s h flo w s
S ig n ific a n t R o le in m a n a g e m e n t
P e r p e tu a l L i v e s

Equityvaluation:Valuejustthe
equityclaiminthebusiness

Aswath Damodaran

EquityValuation

F i g u r e 5 .5 : E q u i ty V a l u a ti o n
A ssets
C a s h flo w s c o n s id e re d a re
c a s h flo w s fro m a s s e ts ,
a fte r d e b t p a y m e n ts a n d
a fte r m a k in g re in v e s tm e n ts
n e e d e d fo r fu tu re g ro w th

L ia b i l i ti es
A s s e ts in P la c e

G ro w th A s s e ts

D ebt

E q u ity

D is c o u n t ra te re fle c ts o n ly th e
c o s t o f ra is in g e q u ity fin a n c in g

P r e s e n t v a lu e is v a lu e o f ju s t th e e q u ity c la im s o n th e f ir m

Aswath Damodaran

FirmValuation

F i g u r e 5 .6 : F i r m V a l u a ti o n
A ssets
C a s h flo w s c o n s id e re d a re
c a s h flo w s fro m a s s e ts ,
p rio r to a n y d e b t p a y m e n ts
b u t a fte r firm h a s
re in v e s te d to c re a te g ro w th
a s s e ts

L ia b i l i ti es
A s s e ts in P la c e

G ro w th A s s e ts

D ebt

E q u ity

D is c o u n t ra te re fle c ts th e c o s t
o f ra is in g b o th d e b t a n d e q u ity
fin a n c in g , in p ro p o rtio n to th e ir
use

P re s e n t v a lu e is v a lu e o f th e e n tire firm , a n d re fle c ts th e v a lu e o f


a ll c la im s o n th e firm .

Aswath Damodaran

FirmValueandEquityValue

A.
B.
C.
D.

A.
B.
C.

Togetfromfirmvaluetoequityvalue,whichofthefollowingwouldyou
needtodo?
Subtractoutthevalueoflongtermdebt
Subtractoutthevalueofalldebt
Subtractthevalueofanydebtthatwasincludedinthecostofcapital
calculation
Subtractoutthevalueofallliabilitiesinthefirm
Doingso,willgiveyouavaluefortheequitywhichis
greaterthanthevalueyouwouldhavegotinanequityvaluation
lesserthanthevalueyouwouldhavegotinanequityvaluation
equaltothevalueyouwouldhavegotinanequityvaluation

Aswath Damodaran

CashFlowsandDiscountRates

Assumethatyouareanalyzingacompanywiththefollowingcashflowsfor
thenextfiveyears.
Year
CFtoEquity
InterestExp(1taxrate)
CFtoFirm
1
$50
$40
$90
2
$60
$40
$100
3
$68
$40
$108
4
$76.2
$40
$116.2
5
$83.49
$40
$123.49
TerminalValue
$1603.0
$2363.008
Assumealsothatthecostofequityis13.625%andthefirmcanborrowlong
termat10%.(Thetaxrateforthefirmis50%.)
Thecurrentmarketvalueofequityis$1,073andthevalueofdebtoutstanding
is$800.

Aswath Damodaran

EquityversusFirmValuation

Method1:DiscountCFtoEquityatCostofEquitytogetvalueofequity

CostofEquity=13.625%
ValueofEquity=50/1.13625+60/1.136252+68/1.136253+76.2/1.136254+
(83.49+1603)/1.136255=$1073

Method2:DiscountCFtoFirmatCostofCapitaltogetvalueoffirm
CostofDebt=Pretaxrate(1taxrate)=10%(1.5)=5%
WACC
=13.625%(1073/1873)+5%(800/1873)=9.94%
PVofFirm=90/1.0994+100/1.09942+108/1.09943+116.2/1.09944+
(123.49+2363)/1.09945=$1873
ValueofEquity=ValueofFirmMarketValueofDebt
=$1873$800=$1073

Aswath Damodaran

FirstPrincipleofValuation

Nevermixandmatchcashflowsanddiscountrates.
Thekeyerrortoavoidismismatchingcashflowsanddiscountrates,since
discountingcashflowstoequityattheweightedaveragecostofcapitalwill
leadtoanupwardlybiasedestimateofthevalueofequity,whilediscounting
cashflowstothefirmatthecostofequitywillyieldadownwardbiased
estimateofthevalueofthefirm.

Aswath Damodaran

TheEffectsofMismatchingCashFlowsandDiscountRates

Error1:DiscountCFtoEquityatCostofCapitaltogetequityvalue
PVofEquity=50/1.0994+60/1.09942+68/1.09943+76.2/1.09944+
(83.49+1603)/1.09945=$1248
Valueofequityisoverstatedby$175.

Error2:DiscountCFtoFirmatCostofEquitytogetfirmvalue
PVofFirm=90/1.13625+100/1.136252+108/1.136253+116.2/1.136254+
(123.49+2363)/1.136255=$1613
PVofEquity=$1612.86$800=$813
ValueofEquityisunderstatedby$260.

Error3:DiscountCFtoFirmatCostofEquity,forgettosubtractoutdebt,and
gettoohighavalueforequity
ValueofEquity=$1613
ValueofEquityisoverstatedby$540

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DiscountedCashFlowValuation:TheSteps

Estimatethediscountrateorratestouseinthevaluation

Discountratecanbeeitheracostofequity(ifdoingequityvaluation)oracostof
capital(ifvaluingthefirm)
Discountratecanbeinnominaltermsorrealterms,dependinguponwhetherthe
cashflowsarenominalorreal
Discountratecanvaryacrosstime.

Estimatethecurrentearningsandcashflowsontheasset,toeitherequity
investors(CFtoEquity)ortoallclaimholders(CFtoFirm)
Estimatethefutureearningsandcashflowsonthefirmbeingvalued,
generallybyestimatinganexpectedgrowthrateinearnings.
Estimatewhenthefirmwillreachstablegrowthandwhatcharacteristics
(risk&cashflow)itwillhavewhenitdoes.
ChoosetherightDCFmodelforthisassetandvalueit.

Aswath Damodaran

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GenericDCFValuationModel

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Aswath Damodaran

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VALUING A FIRM
Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF

Value of Operating Assets


+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity

Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)

Beta
- Measures market risk

Type of
Business

Aswath Damodaran

Firm is in stable growth:


Grows at constant rate
forever

Terminal Value= FCFF n+1 /(r-g n )


FCFF1
FCFF2
FCFF3
FCFF4
FCFF5
FCFFn
.........
Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows

Expected Growth
Reinvestment Rate
* Return on Capital

Operating
Leverage

Weights
Based on Market Value

Risk Premium
- Premium for average
risk investment

Financial
Leverage

Base Equity
Premium

Country Risk
Premium

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DiscountedCashFlowValuation:TheInputs
AswathDamodaran

Aswath Damodaran

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I.EstimatingDiscountRates

DCFValuation

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EstimatingInputs:DiscountRates

Criticalingredientindiscountedcashflowvaluation.Errorsinestimatingthe
discountrateormismatchingcashflowsanddiscountratescanleadtoserious
errorsinvaluation.
Atanintuitivelevel,thediscountrateusedshouldbeconsistentwithboththe
riskinessandthetypeofcashflowbeingdiscounted.

Aswath Damodaran

EquityversusFirm:Ifthecashflowsbeingdiscountedarecashflowstoequity,the
appropriatediscountrateisacostofequity.Ifthecashflowsarecashflowstothe
firm,theappropriatediscountrateisthecostofcapital.
Currency:Thecurrencyinwhichthecashflowsareestimatedshouldalsobethe
currencyinwhichthediscountrateisestimated.
NominalversusReal:Ifthecashflowsbeingdiscountedarenominalcashflows
(i.e.,reflectexpectedinflation),thediscountrateshouldbenominal

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CostofEquity

Thecostofequityshouldbehigherforriskierinvestmentsandlowerforsafer
investments
Whileriskisusuallydefinedintermsofthevarianceofactualreturnsaround
anexpectedreturn,riskandreturnmodelsinfinanceassumethattheriskthat
shouldberewarded(andthusbuiltintothediscountrate)invaluationshould
betheriskperceivedbythemarginalinvestorintheinvestment
Mostriskandreturnmodelsinfinancealsoassumethatthemarginalinvestor
iswelldiversified,andthattheonlyriskthatheorsheperceivesinan
investmentisriskthatcannotbediversifiedaway(I.e,marketornon
diversifiablerisk)

Aswath Damodaran

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TheCostofEquity:CompetingModels

Model
CAPM

APM

Multi

ExpectedReturn
E(R)=Rf+(RmRf)

InputsNeeded
RiskfreeRate

E(R)=Rf+j=1j(RjRf)

Betarelativetomarketportfolio
MarketRiskPremium
RiskfreeRate;#ofFactors;

E(R)=Rf+j=1,,Nj(RjRf)

Betasrelativetoeachfactor
Factorriskpremiums
RiskfreeRate;Macrofactors

E(R)=a+j=1..NbjYj

Betasrelativetomacrofactors
Macroeconomicriskpremiums
Proxies

factor
Proxy

Regressioncoefficients

Aswath Damodaran

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TheCAPM:CostofEquity

Considerthestandardapproachtoestimatingcostofequity:
CostofEquity=RiskfreeRate+EquityBeta*(EquityRiskPremium)
Inpractice,

Aswath Damodaran

Goverrnmentsecurityratesareusedasriskfreerates
Historicalriskpremiumsareusedfortheriskpremium
Betasareestimatedbyregressingstockreturnsagainstmarketreturns

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ARiskfreeRate

Onariskfreeasset,theactualreturnisequaltotheexpectedreturn.Therefore,
thereisnovariancearoundtheexpectedreturn.
Foraninvestmenttoberiskfree,then,ithastohave

1.
2.

Nodefaultrisk
Noreinvestmentrisk

Timehorizonmatters:Thus,theriskfreeratesinvaluationwilldependupon
whenthecashflowisexpectedtooccurandwillvaryacrosstime.
Notallgovernmentsecuritiesareriskfree:Somegovernmentsfacedefaultrisk
andtheratesonbondsissuedbythemwillnotberiskfree.

Aswath Damodaran

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Test1:AriskfreerateinUSdollars!

a)
b)
c)
d)

Invaluation,weestimatecashflowsforever(oratleastforverylongtime
periods).TherightriskfreeratetouseinvaluingacompanyinUSdollars
wouldbe
AthreemonthTreasurybillrate
AtenyearTreasurybondrate
AthirtyyearTreasurybondrate
ATIPs(inflationindexedtreasury)rate

Aswath Damodaran

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Test2:ARiskfreeRateinEuros

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Test3:ARiskfreeRateinIndianRupees

a)
b)
c)
d)

TheIndiangovernmenthad10yearRupeebondsoutstanding,witha
yieldtomaturityofabout8%onJanuary1,2011.
InJanuary2011,theIndiangovernmenthadalocalcurrency
sovereignratingofBa1.Thetypicaldefaultspread(overadefaultfree
rate)forBa1ratedcountrybondsinearly2010was2.4%.
TheriskfreerateinIndianRupeesis
Theyieldtomaturityonthe10yearbond(8%)
Theyieldtomaturityonthe10yearbond+Defaultspread(10.4%)
Theyieldtomaturityonthe10yearbondDefaultspread(5.6%)
Noneoftheabove

Aswath Damodaran

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SovereignDefaultSpread:Twopathstothesame
destination

Sovereigndollaroreurodenominatedbonds:Findsovereignbonds
denominatedinUSdollars,issuedbyemergingmarkets.Thedifference
betweentheinterestrateonthebondandtheUStreasurybondrateshouldbe
thedefaultspread.Forinstance,inJanuary2011,theUSdollardenominated
10yearbondissuedbytheBraziliangovernment(withaBaa3rating)hadan
interestrateof5.1%,resultinginadefaultspreadof1.8%overtheUS
treasuryrateof3.3%atthesamepointintime.
CDSspreads:ObtainthedefaultspreadsforsovereignsintheCDSmarket.In
January2011,theCDSspreadforBrazilinthatmarketwas1.51%.

Aswath Damodaran

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SovereignDefaultSpreads:January2011
Rating Default spread in basis points

Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3

Aswath Damodaran

0
25
50
70
85
100
115
150
175
200
240
275
325
400
500
600
700
850
1000

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Test4:ARealRiskfreeRate
Insomecases,youmaywantariskfreerateinrealterms(inreal
terms)ratherthannominalterms.
Togetarealriskfreerate,youwouldlikeasecuritywithnodefault
riskandaguaranteedrealreturn.Treasuryindexedsecuritiesofferthis
combination.
InJanuary2011,theyieldona10yearindexedtreasurybondwas
1.5%.Whichofthefollowingstatementswouldyousubscribeto?
a) This(1.5%)istherealriskfreeratetouse,ifyouarevaluingUS
companiesinrealterms.
b) This(1.5%)istherealriskfreeratetouse,anywhereintheworld
Explain.

Aswath Damodaran

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Nodefaultfreeentity:Choiceswithriskfreerates.

Estimatearangefortheriskfreerateinlocalterms:

Approach1:Subtractdefaultspreadfromlocalgovernmentbondrate:
GovernmentbondrateinlocalcurrencytermsDefaultspreadforGovernmentinlocal
currency
Approach2:Useforwardratesandtherisklessrateinanindexcurrency(sayEuros
ordollars)toestimatetherisklessrateinthelocalcurrency.

Dotheanalysisinrealterms(ratherthannominalterms)usingarealriskfree
rate,whichcanbeobtainedinoneoftwoways

fromaninflationindexedgovernmentbond,ifoneexists
setequal,approximately,tothelongtermrealgrowthrateoftheeconomyinwhich
thevaluationisbeingdone.

Dotheanalysisinacurrencywhereyoucangetariskfreerate,sayUSdollars
orEuros.

Aswath Damodaran

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Test5:Matchingupriskfreerates

YouarevaluingEmbraer,aBraziliancompany,inU.S.dollarsandare
attemptingtoestimateariskfreeratetouseintheanalysis(inAugust2004).
Theriskfreeratethatyoushoulduseis
A. TheinterestrateonaBrazilianReaisdenominatedlongtermbondissuedbythe
BrazilianGovernment(11%)
B. TheinterestrateonaUS$denominatedlongtermbondissuedbytheBrazilian
Government(6%)
C. TheinterestrateonadollardenominatedbondissuedbyEmbraer(9.25%)
D. TheinterestrateonaUStreasurybond(3.75%)
E. Noneoftheabove

Aswath Damodaran

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Whydoriskfreeratesvaryacrosscurrencies?
January2011Riskfreerates

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Onemoretestonriskfreerates

a)

b)

c)

InJanuary2009,the10yeartreasurybondrateintheUnitedStates
was2.2%,ahistoriclow.Assumethatyouwerevaluingacompanyin
USdollarsthen,butwerewaryabouttheriskfreeratebeingtoolow.
Whichofthefollowingshouldyoudo?
Replacethecurrent10yearbondratewithamorereasonable
normalizedriskfreerate(theaverage10yearbondrateoverthelast5
yearshasbeenabout4%)
Usethecurrent10yearbondrateasyourriskfreeratebutmakesure
thatyourotherassumptions(aboutgrowthandinflation)are
consistentwiththeriskfreerate
Somethingelse

Aswath Damodaran

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Everyoneuseshistoricalpremiums,but..

Thehistoricalpremiumisthepremiumthatstockshavehistoricallyearned
overrisklesssecurities.
Practitionersneverseemtoagreeonthepremium;itissensitiveto

Howfarbackyougoinhistory
WhetheryouuseT.billratesorT.Bondrates
Whetheryouusegeometricorarithmeticaverages.

Forinstance,lookingattheUS:

Aswath Damodaran

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Theperilsoftrustingthepast.
Noisyestimates:Evenwithlongtimeperiodsofhistory,theriskpremiumthat
youderivewillhavesubstantialstandarderror.Forinstance,ifyougobackto
1928(about80yearsofhistory)andyouassumeastandarddeviationof20%
inannualstockreturns,youarriveatastandarderrorofgreaterthan2%:
StandardErrorinPremium=20%/80=2.26%
(Anaside:Theimpliedstandarddeviationinequitiesrosetoalmost50%during
thelastquarterof2008.Thinkabouttheconsequencesforusinghistoricalrisk
premiums,ifthisvolatilitypersisted)
SurvivorshipBias:UsinghistoricaldatafromtheU.S.equitymarketsoverthe
twentiethcenturydoescreateasamplingbias.Afterall,theUSeconomyand
equitymarketswereamongthemostsuccessfuloftheglobaleconomiesthat
youcouldhaveinvestedinearlyinthecentury.

Aswath Damodaran

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RiskPremiumforaMatureMarket?Broadeningthesample

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TwoWaysofEstimatingCountryEquityRiskPremiumsfor
othermarkets..BrazilinAugust2004

DefaultspreadonCountryBond:Inthisapproach,thecountryequityrisk
premiumissetequaltothedefaultspreadofthebondissuedbythecountry
(butonlyifitisdenominatedinacurrencywhereadefaultfreeentityexists.
BrazilwasratedB2byMoodysandthedefaultspreadontheBrazilian
dollardenominatedC.BondattheendofAugust2004was6.01%.
(10.30%4.29%)
RelativeEquityMarketapproach:Thecountryequityriskpremiumisbased
uponthevolatilityofthemarketinquestionrelativetoU.Smarket.
Totalequityriskpremium=RiskPremiumUS*CountryEquity/USEquity
Usinga4.82%premiumfortheUS,thisapproachwouldyield:
TotalriskpremiumforBrazil=4.82%(34.56%/19.01%)=8.76%
CountryequityriskpremiumforBrazil=8.76%4.82%=3.94%
(Thestandarddeviationinweeklyreturnsfrom2002to2004fortheBovespa
was34.56%whereasthestandarddeviationintheS&P500was19.01%)

Aswath Damodaran

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Andathirdapproach

Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsandequity
riskpremiumsarehighlycorrelated,onewouldexpectequityspreadstobe
higherthandebtspreads.
Anotheristomultiplythebonddefaultspreadbytherelativevolatilityof
stockandbondpricesinthatmarket.UsingthisapproachforBrazilinAugust
2004,youwouldget:

CountryEquityriskpremium=Defaultspreadoncountrybond*CountryEquity/
CountryBond
StandardDeviationinBovespa(Equity)=34.56%
StandardDeviationinBrazilCBond=26.34%
DefaultspreadonCBond=6.01%

Aswath Damodaran

CountryEquityRiskPremium=6.01%(34.56%/26.34%)=7.89%

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Cancountryriskpremiumschange?UpdatingBrazil
January2007andJanuary2009

InJanuary2007,BrazilsratinghadimprovedtoB1andtheinterestrateon
theBrazilian$denominatedbonddroppedto6.2%.TheUStreasurybondrate
thatdaywas4.7%,yieldingadefaultspreadof1.5%forBrazil.

StandardDeviationinBovespa(Equity)=24%
StandardDeviationinBrazil$Bond=12%
DefaultspreadonBrazil$Bond=1.50%
CountryRiskPremiumforBrazil=1.50%(24/12)=3.00%

OnJanuary1,2009,BrazilsratingwasBa1buttheinterestrateontheBrazilian
$denominatedbondwas6.3%,4.1%higherthantheUStreasurybondrateof
2.2%onthatday.

Aswath Damodaran

StandardDeviationinBovespa(Equity)=33%
StandardDeviationinBrazil$Bond=20%
DefaultspreadonBrazil$Bond=4.1%
CountryRiskPremiumforBrazil=4.10%(33/20)=6.77%

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Country Risk Premiums


January 2011

Canada
UnitedStates

Argentina
Belize
Bolivia
Brazil
Chile
Colombia
CostaRica
Ecuador
ElSalvador
Guatemala
Honduras
Mexico
Nicaragua
Panama
Paraguay
Peru

Aswath Damodaran

5.00%
5.00%

14.00%
14.00%
11.00%
8.00%
6.05%
8.00%
8.00%
20.00%
20.00%
8.60%
12.50%
7.25%
14.00%
8.00%
11.00%
8.00%

Austria[1]
Belgium[1]
Cyprus[1]
Denmark
Finland[1]
France[1]
Georgia
Germany[1]
Greece[1]
Iceland
Ireland[1]
Italy[1]
Malta[1]
Netherlands[1]
Norway
Portugal[1]
Spain[1]
Sweden
Switzerland
United
Kingdom
Angola

5.00%
5.38%
6.05%
5.00%
5.00%
5.00%
9.88%
5.00%
8.60%
8.00%
7.25%
5.75%
6.28%
5.00%
5.00%
6.28%
5.38%
5.00%
5.00%
5.00%
11.00%

Botswana

6.50%

Egypt

8.60%

Mauritius

7.63%

Morocco

8.60%

SouthAfrica

6.73%

Tunisia

7.63%

Albania
Armenia
Azerbaijan
Belarus
Bosniaand
Herzegovina
Bulgaria
Croatia
Czech
Republic
Estonia
Hungary
Kazakhstan
Latvia
Lithuania
Moldova
Montenegro
Poland
Romania
Russia
Slovakia
Slovenia[1]
Ukraine
Bahrain
Israel
Jordan
Kuwait
Lebanon
Oman
Qatar
SaudiArabia
UnitedArabEmirates

11.00%
9.13%
8.60%
11.00%
12.50%
8.00%
8.00%
6.28%
6.28%
8.00%
7.63%
8.00%
7.25%
14.00%
9.88%
6.50%
8.00%
7.25%
6.28%
5.75%
12.50%
6.73%
6.28%
8.00%
5.75%
11.00%
6.28%
5.75%
6.05%
5.75%

Bangladesh
Cambodia
China
FijiIslands
HongKong
India
Indonesia
Japan
Korea
Macao
Mongolia
Pakistan
PapuaNew
Guinea
Philippines
Singapore
SriLanka
Taiwan
Thailand
Turkey

9.88%
12.50%
6.05%
11.00%
5.38%
8.60%
9.13%
5.75%
6.28%
6.05%
11.00%
14.00%
11.00%
9.88%
5.00%
11.00%
6.05%
7.25%
9.13%

Australia
NewZealand

5.00%
5.00%

39

FromCountryEquityRiskPremiumstoCorporateEquity
Riskpremiums

Approach1:Assumethateverycompanyinthecountryisequallyexposedto
countryrisk.Inthiscase,
E(Return)=RiskfreeRate+CountryERP+Beta(USpremium)
Implicitly,thisiswhatyouareassumingwhenyouusethelocalGovernmentsdollar
borrowingrateasyourriskfreerate.

Approach2:Assumethatacompanysexposuretocountryriskissimilarto
itsexposuretoothermarketrisk.
E(Return)=RiskfreeRate+Beta(USpremium+CountryERP)
Approach3:Treatcountryriskasaseparateriskfactorandallowfirmsto
havedifferentexposurestocountryrisk(perhapsbasedupontheproportionof
theirrevenuescomefromnondomesticsales)
E(Return)=RiskfreeRate+(USpremium)+CountryERP)
ERP:EquityRiskPremium

Aswath Damodaran

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EstimatingCompanyExposuretoCountryRisk:
Determinants

Sourceofrevenues:Otherthingsremainingequal,acompanyshouldbemore
exposedtoriskinacountryifitgeneratesmoreofitsrevenuesfromthat
country.ABrazilianfirmthatgeneratesthebulkofitsrevenuesinBrazil
shouldbemoreexposedtocountryriskthanonethatgeneratesasmaller
percentofitsbusinesswithinBrazil.
Manufacturingfacilities:Otherthingsremainingequal,afirmthathasallof
itsproductionfacilitiesinBrazilshouldbemoreexposedtocountryriskthan
onewhichhasproductionfacilitiesspreadovermultiplecountries.The
problemwillbeaccentedforcompaniesthatcannotmovetheirproduction
facilities(miningandpetroleumcompanies,forinstance).
Useofriskmanagementproducts:Companiescanusebothoptions/futures
marketsandinsurancetohedgesomeorasignificantportionofcountryrisk.

Aswath Damodaran

41

EstimatingLambdas:TheRevenueApproach
Theeasiestandmostaccessibledataisonrevenues.Mostcompaniesbreaktheir
revenuesdownbyregion.
%ofrevenuesdomestically firm/%ofrevenuesdomestically avgfirm

Consider,forinstance,EmbraerandEmbratel,bothofwhichareincorporatedandtraded
inBrazil.Embraergets3%ofitsrevenuesfromBrazilwhereasEmbratelgetsalmostall
ofitsrevenuesinBrazil.TheaverageBraziliancompanygetsabout77%ofitsrevenues
inBrazil:

Therearetwoimplications

LambdaEmbraer=3%/77%=.04
LambdaEmbratel=100%/77%=1.30
Acompanysriskexposureisdeterminedbywhereitdoesbusinessandnotbywhereitis
located
Firmsmightbeabletoactivelymanagetheircountryriskexposures

Consider,forinstance,thefactthatSAPgotabout7.5%ofitssalesinEmergingAsia,
wecanestimatealambdaforSAPforAsia(usingtheassumptionthatthetypicalAsian
firmgetsabout75%ofitsrevenuesinAsia)
LambdaSAP,Asia=7.5%/75%=0.10

Aswath Damodaran

42

EstimatingLambdas:EarningsApproach

1.5

40.00%

30.00%

0.5

20.00%

10.00%
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 2002 2002 2002 2003 2003 2003

-0.5

0.00%

-1

-10.00%

-1.5

-20.00%

-2

% change in C Bond Price

Quarterly EPS

Figure 2: EPS changes versus Country Risk: Embraer and Embratel

-30.00%
Quarter
Embraer

Aswath Damodaran

Embratel

C Bond

43

EstimatingLambdas:StockReturnsversusCBondReturns
ReturnEmbraer=0.0195+0.2681ReturnCBond
ReturnEmbratel=0.0308+2.0030ReturnCBond
E m b ra e r v e rs u s C B o n d: 2 0 0 0 -2 0 0 3

E m b r a te l v e rs u s C B o n d : 2 0 0 0 - 2 0 0 3

40

100
80
60

R e t u rn o n E m b ra t e l

R e tu r n o n E m b ra e r

20

-2 0

40
20
0
-2 0
-4 0

-4 0

-6 0
-6 0

-8 0
-30

-2 0

-1 0

R e tu r n o n C - B o n d

Aswath Damodaran

10

20

-3 0

-2 0

-1 0

10

20

R e tu r n o n C - B o n d

44

EstimatingaUSDollarCostofEquityforEmbraer
September2004
AssumethatthebetaforEmbraeris1.07,andthattheriskfreerateusedis4.29%.Also
assumethattheriskpremiumfortheUSis4.82%andthecountryriskpremiumfor
Brazilis7.89%.
Approach1:Assumethateverycompanyinthecountryisequallyexposedtocountry
risk.Inthiscase,
E(Return)=4.29%+1.07(4.82%)+7.89%=17.34%
Approach2:Assumethatacompanysexposuretocountryriskissimilartoitsexposure
toothermarketrisk.
E(Return)=4.29%+1.07(4.82%+7.89%)=17.89%
Approach3:Treatcountryriskasaseparateriskfactorandallowfirmstohavedifferent
exposurestocountryrisk(perhapsbasedupontheproportionoftheirrevenuescome
fromnondomesticsales)
E(Return)=4.29%+(4.82%)+%)=11.58%

Aswath Damodaran

45

ValuingEmergingMarketCompanieswithsignificant
exposureindevelopedmarkets
Theconventionalpracticeininvestmentbankingistoaddthecountryequity
riskpremiumontothecostofequityforeveryemergingmarketcompany,
notwithstandingitsexposuretoemergingmarketrisk.Thus,Embraerwould
havebeenvaluedwithacostofequityof17.34%eventhoughitgetsonly3%
ofitsrevenuesinBrazil.Asaninvestor,whichofthefollowingconsequences
doyouseefromthisapproach?
A. Emergingmarketcompanieswithsubstantialexposureindevelopedmarkets
willbesignificantlyovervaluedbyequityresearchanalysts.
B. Emergingmarketcompanieswithsubstantialexposureindevelopedmarkets
willbesignificantlyundervaluedbyequityresearchanalysts.
Canyouconstructaninvestmentstrategytotakeadvantageofthemisvaluation?

Aswath Damodaran

46

ImpliedEquityPremiums

Ifweassumethatstocksarecorrectlypricedintheaggregateandwecan
estimatetheexpectedcashflowsfrombuyingstocks,wecanestimatethe
expectedrateofreturnonstocksbycomputinganinternalrateofreturn.
Subtractingouttheriskfreerateshouldyieldanimpliedequityriskpremium.
Thisimpliedequitypremiumisaforwardlookingnumberandcanbeupdated
asoftenasyouwant(everyminuteofeveryday,ifyouaresoinclined).

Aswath Damodaran

47

ImpliedEquityPremiums:January2008

Wecanusetheinformationinstockpricestobackouthowriskaversethemarketisandhowmuch
ofariskpremiumitisdemanding.

Between 2001 and 2007


dividends and stock
buybacks averaged 4.02%
of the index each year.

Analysts expect earnings to grow 5% a year for the next 5 years. We


will assume that dividends & buybacks will keep pace..
Last years cashflow (59.03) growing at 5% a year
61.98

65.08

68.33

71.75

After year 5, we will assume that


earnings on the index will grow at
4.02%, the same rate as the entire
economy (= riskfree rate).

75.34

January 1, 2008
S&P 500 is at 1468.36
4.02% of 1468.36 = 59.03

Ifyoupaythecurrentleveloftheindex,youcanexpecttomakeareturnof8.39%onstocks(which
isobtainedbysolvingforrinthefollowingequation)

1468.36

61.98 65.08
68.33
71.75
75.34
75.35(1.0402)

(1 r) (1 r) 2 (1 r) 3 (1 r) 4 (1 r) 5 (r .0402)(1 r) 5

ImpliedEquityriskpremium=ExpectedreturnonstocksTreasurybondrate=8.39%4.02%=
4.37%


Aswath Damodaran

48

ImpliedRiskPremiumDynamics

Assumethattheindexjumps10%onJanuary2andthatnothingelsechanges.
Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease
Assumethattheearningsjump10%onJanuary2andthatnothingelse
changes.Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease
Assumethattheriskfreerateincreasesto5%onJanuary2andthatnothing
elsechanges.Whatwillhappentotheimpliedequityriskpremium?
Impliedequityriskpremiumwillincrease
Impliedequityriskpremiumwilldecrease

Aswath Damodaran

49

Ayearthatmadeadifference..Theimpliedpremiumin
January2009
Year
2001
2002
2003
2004
2005
2006
2007
2008
Normalized

Market value of
index

Aswath Damodaran

1148.09
879.82
1111.91
1211.92
1248.29
1418.30
1468.36

903.25
903.25

Dividends
15.74
15.96
17.88
19.01
22.34
25.04
28.14
28.47
28.47

Buybacks
14.34
13.87
13.70
21.59
38.82
48.12
67.22
40.25
24.11

Cash to
equity
30.08
29.83
31.58
40.60
61.17
73.16
95.36
68.72
52.584

Dividend
yield
1.37%
1.81%
1.61%
1.57%
1.79%
1.77%
1.92%
3.15%
3.15%

Buyback
yield
1.25%
1.58%
1.23%
1.78%
3.11%
3.39%
4.58%
4.61%
2.67%

Total yield
2.62%
3.39%
2.84%
3.35%
4.90%
5.16%
6.49%
7.77%
5.82%

50

TheAnatomyofaCrisis:ImpliedERPfromSeptember12,
2008toJanuary1,2009

Aswath Damodaran

51

EquityRiskPremium:AJanuary2011update

ByJanuary1,2011,theworstofthecrisisseemedtobebehindus.Fearsofa
depressionhadrecededandbankslookedliketheywerestrugglingbacktoa
morestablesetting.Defaultspreadsstartedtodropandriskwasnolonger
frontandcenterinpricing.

Aswath Damodaran

52

ImpliedPremiumsintheUS:19602010

Aswath Damodaran

53

ImpliedPremiumversusRiskFreeRate

Aswath Damodaran

54

EquityRiskPremiumsandBondDefaultSpreads

Aswath Damodaran

55

EquityRiskPremiumsandCapRates(RealEstate)

Aswath Damodaran

56

Whyimpliedpremiumsmatter?

Inmanyinvestmentbanks,itiscommonpractice(especiallyincorporate
financedepartments)tousehistoricalriskpremiums(andarithmeticaverages
atthat)asriskpremiumstocomputecostofequity.Ifallanalystsinthe
departmentusedthegeometricaveragepremiumfor19282008of3.9%to
valuestocksinJanuary2009,giventheimpliedpremiumof6.43%,whatwere
theylikelytofind?
Thevaluestheyobtainwillbetoolow(moststockswilllookovervalued)
Thevaluestheyobtainwillbetoohigh(moststockswilllookundervalued)
Thereshouldbenosystematicbiasaslongastheyusethesamepremium
(3.9%)tovalueallstocks.

Aswath Damodaran

57

WhichequityriskpremiumshouldyouusefortheUS?

HistoricalRiskPremium:Whenyouusethehistoricalriskpremium,youare
assumingthatpremiumswillrevertbacktoahistoricalnormandthatthetime
periodthatyouareusingistherightnorm.
CurrentImpliedEquityRiskpremium:Youareassumingthatthemarketis
correctintheaggregatebutmakesmistakesonindividualstocks.Ifyouare
requiredtobemarketneutral,thisisthepremiumyoushoulduse.(What
typesofvaluationsrequiremarketneutrality?)
AverageImpliedEquityRiskpremium:Theaverageimpliedequityrisk
premiumbetween19602010intheUnitedStatesisabout4.25%.Youare
assumingthatthemarketiscorrectonaveragebutnotnecessarilyatapointin
time.

Aswath Damodaran

58

ImpliedpremiumfortheSensex(September2007)

Inputsforthecomputation

Sensexon9/5/07=15446
Dividendyieldonindex=3.05%
Expectedgrowthratenext5years=14%
Growthratebeyondyear5=6.76%(setequaltoriskfreerate)

Solvingfortheexpectedreturn:

15446

537.06 612.25 697.86 795.67 907.07


907.07(1.0676)

(1 r) (1 r) 2 (1 r) 3 (1 r) 4 (1 r) 5 (r .0676)(1 r) 5

Expectedreturnonstocks=11.18%
ImpliedequityriskpremiumforIndia=11.18%6.76%=4.42%

Aswath Damodaran

59

ImpliedEquityRiskPremiumcomparison:
January2008versusJanuary2009

Country
United States
UK
Germany
Japan
India
China
Brazil

Aswath Damodaran

ERP (1/1/08)
4.37%
4.20%
4.22%
3.91%

ERP (1/1/09)
6.43%
6.51%
6.49%
6.25%

4.88%
3.98%
5.45%

9.21%
7.86%
9.06%

60

EstimatingBeta

Thestandardprocedureforestimatingbetasistoregressstockreturns(Rj)
againstmarketreturns(Rm)
Rj=a+bRm

whereaistheinterceptandbistheslopeoftheregression.

Theslopeoftheregressioncorrespondstothebetaofthestock,andmeasures
theriskinessofthestock.
Thisbetahasthreeproblems:

Aswath Damodaran

Ithashighstandarderror
Itreflectsthefirmsbusinessmixovertheperiodoftheregression,notthecurrent
mix
Itreflectsthefirmsaveragefinancialleverageovertheperiodratherthanthe
currentleverage.

61

BetaEstimation:TheNoiseProblem

Aswath Damodaran

62

BetaEstimation:TheIndexEffect

Aswath Damodaran

63

SolutionstotheRegressionBetaProblem

Modifytheregressionbetaby

Estimatethebetaforthefirmusing

thestandarddeviationinstockpricesinsteadofaregressionagainstanindex
accountingearningsorrevenues,whicharelessnoisythanmarketprices.

Estimatethebetaforthefirmfromthebottomupwithoutemployingthe
regressiontechnique.Thiswillrequire

changingtheindexusedtoestimatethebeta
adjustingtheregressionbetaestimate,bybringingininformationaboutthe
fundamentalsofthecompany

understandingthebusinessmixofthefirm
estimatingthefinancialleverageofthefirm

Useanalternativemeasureofmarketrisknotbaseduponaregression.

Aswath Damodaran

64

TheIndexGame

Aswath Damodaran

65

DeterminantsofBetas

Aswath Damodaran

66

Inaperfectworldwewouldestimatethebetaofafirmby
doingthefollowing

Aswath Damodaran

67

Adjustingforoperatingleverage

Withinanybusiness,firmswithlowerfixedcosts(asapercentageoftotal
costs)shouldhavelowerunleveredbetas.Ifyoucancomputefixedand
variablecostsforeachfirminasector,youcanbreakdowntheunleveredbeta
intobusinessandoperatingleveragecomponents.

Unleveredbeta=Purebusinessbeta*(1+(Fixedcosts/Variablecosts))

Thebiggestproblemwithdoingthisisinformational.Itisdifficulttoget
informationonfixedandvariablecostsforindividualfirms.
Inpractice,wetendtoassumethattheoperatingleverageoffirmswithina
businessaresimilarandusethesameunleveredbetaforeveryfirm.

Aswath Damodaran

68

Adjustingforfinancialleverage

Conventionalapproach:Ifweassumethatdebtcarriesnomarketrisk(hasa
betaofzero),thebetaofequityalonecanbewrittenasafunctionofthe
unleveredbetaandthedebtequityratio
L=u(1+((1t)D/E))
Insomeversions,thetaxeffectisignoredandthereisno(1t)intheequation.

DebtAdjustedApproach:Ifbetacarriesmarketriskandyoucanestimatethe
betaofdebt,youcanestimatetheleveredbetaasfollows:
L=u(1+((1t)D/E))debt(1t)(D/E)

Whilethelatterismorerealistic,estimatingbetasfordebtcanbedifficultto
do.

Aswath Damodaran

69

BottomupBetas

Aswath Damodaran

70

Whybottomupbetas?
Thestandarderrorinabottomupbetawillbesignificantlylowerthanthe
standarderrorinasingleregressionbeta.Roughlyspeaking,thestandarderror
ofabottomupbetaestimatecanbewrittenasfollows:
Stderrorofbottomupbeta= Average Std Error across Betas

Number of firms in sample

Thebottomupbetacanbeadjustedtoreflectchangesinthefirmsbusiness
mixandfinancialleverage.Regressionbetasreflectthepast.
Youcanestimatebottomupbetasevenwhenyoudonothavehistoricalstock

prices.Thisisthecasewithinitialpublicofferings,privatebusinessesor
divisionsofcompanies.

Aswath Damodaran

71

BottomupBeta:FirminMultipleBusinesses
SAPin2004

Approach1:Basedonbusinessmix

SAPisinthreebusiness:software,consultingandtraining.Wewillaggregatethe
consultingandtrainingbusinesses
Business
Revenues EV/Sales
Value
Weights
Beta
Software
$5.3
3.25
17.23
80%
1.30
Consulting $2.2
2.00
4.40
20%
1.05
SAP
$7.5
21.63
1.25

Approach2:CustomerBase

Aswath Damodaran

72

EmbraersBottomupBeta
Business
UnleveredBeta
Aerospace
0.95

D/ERatio
18.95%

Leveredbeta
1.07

LeveredBeta
=UnleveredBeta(1+(1taxrate)(D/ERatio)
=0.95(1+(1.34)(.1895))=1.07

Aswath Damodaran

73

ComparableFirms?
CananunleveredbetaestimatedusingU.S.andEuropeanaerospacecompanies
beusedtoestimatethebetaforaBrazilianaerospacecompany?
Yes
No
Whatconcernswouldyouhaveinmakingthisassumption?

Aswath Damodaran

74

GrossDebtversusNetDebtApproaches

GrossDebtRatioforEmbraer=1953/11,042=18.95%
LeveredBetausingGrossDebtratio=1.07
NetDebtRatioforEmbraer=(DebtCash)/MarketvalueofEquity
=(19532320)/11,042=3.32%
LeveredBetausingNetDebtRatio=0.95(1+(1.34)(.0332))=0.93
ThecostofEquityusingnetdebtleveredbetaforEmbraerwillbemuchlower
thanwiththegrossdebtapproach.ThecostofcapitalforEmbraer,though,
willevenoutsincethedebtratiousedinthecostofcapitalequationwillnow
beanetdebtratioratherthanagrossdebtratio.

Aswath Damodaran

75

TheCostofEquity:ARecap

Aswath Damodaran

76

EstimatingtheCostofDebt

Thecostofdebtistherateatwhichyoucanborrowatcurrently,Itwillreflect
notonlyyourdefaultriskbutalsothelevelofinterestratesinthemarket.
Thetwomostwidelyusedapproachestoestimatingcostofdebtare:

Lookinguptheyieldtomaturityonastraightbondoutstandingfromthefirm.The
limitationofthisapproachisthatveryfewfirmshavelongtermstraightbondsthat
areliquidandwidelytraded
Lookinguptheratingforthefirmandestimatingadefaultspreadbaseduponthe
rating.Whilethisapproachismorerobust,differentbondsfromthesamefirmcan
havedifferentratings.Youhavetouseamedianratingforthefirm

Whenintrouble(eitherbecauseyouhavenoratingsormultipleratingsfora
firm),estimateasyntheticratingforyourfirmandthecostofdebtbasedupon
thatrating.

Aswath Damodaran

77

EstimatingSyntheticRatings

Theratingforafirmcanbeestimatedusingthefinancialcharacteristicsofthe
firm.Initssimplestform,theratingcanbeestimatedfromtheinterest
coverageratio
InterestCoverageRatio=EBIT/InterestExpenses
ForEmbraersinterestcoverageratio,weusedtheinterestexpensesfrom
2003andtheaverageEBITfrom2001to2003.(Theaircraftbusinesswas
badlyaffectedby9/11anditsaftermath.In2002and2003,Embraerreported
significantdropsinoperatingincome)

Aswath Damodaran

InterestCoverageRatio=462.1/129.70=3.56

78

InterestCoverageRatios,RatingsandDefaultSpreads:2003
&2004
IfInterestCoverageRatiois
EstimatedBondRating
DefaultSpread(2003)
DefaultSpread(2004)
>8.50
(>12.50)
AAA
0.75%
0.35%
6.508.50
(9.512.5)
AA
1.00%
0.50%
5.506.50
(7.59.5)
A+
1.50%
0.70%
4.255.50
(67.5)
A
1.80%
0.85%
3.004.25
(4.56)
A
2.00%
1.00%
2.503.00
(44.5)
BBB
2.25%
1.50%
2.252.50
(3.54)
BB+
2.75%
2.00%
2.002.25
((33.5)
BB
3.50%
2.50%
1.752.00
(2.53)
B+
4.75%
3.25%
1.501.75
(22.5)
B
6.50%
4.00%
1.251.50
(1.52)
B
8.00%
6.00%
0.801.25
(1.251.5)
CCC
10.00%
8.00%
0.650.80
(0.81.25)
CC
11.50%
10.00%
0.200.65
(0.50.8)
C
12.70%
12.00%
<0.20
(<0.5)
D
15.00%
20.00%
Thefirstnumberunderinterestcoverageratiosisforlargermarketcapcompaniesandthesecondinbracketsisfor
smallermarketcapcompanies.ForEmbraer,Iusedtheinterestcoverageratiotableforsmaller/riskierfirms(the
numbersinbrackets)whichyieldsalowerratingforthesameinterestcoverageratio.

Aswath Damodaran

79

CostofDebtcomputations

Companiesincountrieswithlowbondratingsandhighdefaultriskmightbear
theburdenofcountrydefaultrisk,especiallyiftheyaresmallerorhaveallof
theirrevenueswithinthecountry.
Largercompaniesthatderiveasignificantportionoftheirrevenuesinglobal
marketsmaybelessexposedtocountrydefaultrisk.Inotherwords,theymay
beabletoborrowataratelowerthanthegovernment.
ThesyntheticratingforEmbraerisA.Usingthe2004defaultspreadof
1.00%,weestimateacostofdebtof9.29%(usingariskfreerateof4.29%and
addingintwothirdsofthecountrydefaultspreadof6.01%):

Costofdebt
=Riskfreerate+2/3(Brazilcountrydefaultspread)+Companydefaultspread=4.29%+
4.00%+1.00%=9.29%

Aswath Damodaran

80

SyntheticRatings:SomeCaveats

Therelationshipbetweeninterestcoverageratiosandratings,developedusing
UScompanies,tendstotravelwell,aslongasweareanalyzinglarge
manufacturingfirmsinmarketswithinterestratesclosetotheUSinterestrate
Theyaremoreproblematicwhenlookingatsmallercompaniesinmarkets
withhigherinterestratesthantheUS.Onewaytoadjustforthisdifferenceis
modifytheinterestcoverageratiotabletoreflectinterestratedifferences(For
instances,ifinterestratesinanemergingmarketaretwiceashighasratesin
theUS,halvetheinterestcoverageratio.

Aswath Damodaran

81

DefaultSpreads:Theeffectofthecrisisof2008..Andthe
aftermath

Rating
Aaa/AAA
Aa1/AA+
Aa2/AA
Aa3/AAA1/A+
A2/A
A3/ABaa1/BBB+
Baa2/BBB
Baa3/BBBBa1/BB+
Ba2/BB
Ba3/BBB1/B+
B2/B
B3/BCaa/CCC+
ERP

Aswath Damodaran

Default spread over treasury


1-Jan-08
12-Sep-08
12-Nov-08
0.99%
1.40%
2.15%
1.15%
1.45%
2.30%
1.25%
1.50%
2.55%
1.30%
1.65%
2.80%
1.35%
1.85%
3.25%
1.42%
1.95%
3.50%
1.48%
2.15%
3.75%
1.73%
2.65%
4.50%
2.02%
2.90%
5.00%
2.60%
3.20%
5.75%
3.20%
4.45%
7.00%
3.65%
5.15%
8.00%
4.00%
5.30%
9.00%
4.55%
5.85%
9.50%
5.65%
6.10%
10.50%
6.45%
9.40%
13.50%
7.15%
9.80%
14.00%
4.37%
4.52%
6.30%

1-Jan-09
2.00%
2.25%
2.50%
2.75%
3.25%
3.50%
3.75%
5.25%
5.75%
7.25%
9.50%
10.50%
11.00%
11.50%
12.50%
15.50%
16.50%
6.43%

1-Jan-10
0.50%
0.55%
0.65%
0.70%
0.85%
0.90%
1.05%
1.65%
1.80%
2.25%
3.50%
3.85%
4.00%
4.25%
5.25%
5.50%
7.75%
4.36%

1-Jan-11
0.55%
0.60%
0.65%
0.75%
0.85%
0.90%
1.00%
1.40%
1.60%
2.05%
2.90%
3.25%
3.50%
3.75%
5.00%
6.00%
7.75%
5.20%

82

SubsidizedDebt:Whatshouldwedo?

AssumethattheBraziliangovernmentlendsmoneytoEmbraerata
subsidizedinterestrate(say6%indollarterms).Incomputingthecostof
capitaltovalueEmbraer,shouldbeweusethecostofdebtbasedupondefault
riskorthesubisidizedcostofdebt?
Thesubsidizedcostofdebt(6%).Thatiswhatthecompanyispaying.
Thefaircostofdebt(9.25%).Thatiswhatthecompanyshouldrequireits
projectstocover.
Anumberinthemiddle.

Aswath Damodaran

83

WeightsfortheCostofCapitalComputation
Incomputingthecostofcapitalforapubliclytradedfirm,thegeneralrulefor
computingweightsfordebtandequityisthatyouusemarketvalueweights
(andnotbookvalueweights).Why?
Becausethemarketisusuallyright
Becausemarketvaluesareeasytoobtain
Becausebookvaluesofdebtandequityaremeaningless
Noneoftheabove

Aswath Damodaran

84

EstimatingCostofCapital:Embraerin2003

Equity

CostofEquity=4.29%+1.07(4%)+0.27(7.89%)=10.70%
MarketValueofEquity=11,042millionBR($3,781million)

Debt

Costofdebt=4.29%+4.00%+1.00%=9.29%
MarketValueofDebt=2,083millionBR($713million)

CostofCapital
CostofCapital=10.70%(.84)+9.29%(1.34)(0.16))=9.97%
ThebookvalueofequityatEmbraeris3,350millionBR.
ThebookvalueofdebtatEmbraeris1,953millionBR;Interestexpenseis222milBR;
Averagematurityofdebt=4years
Estimatedmarketvalueofdebt=222million(PVofannuity,4years,9.29%)+$1,953
million/1.09294=2,083millionBR

Aswath Damodaran

85

Ifyouhadtodoit.ConvertingaDollarCostofCapitaltoa
NominalRealCostofCapital

Approach1:UseaBRriskfreerateinallofthecalculationsabove.Forinstance,ifthe
BRriskfreeratewas12%,thecostofcapitalwouldbecomputedasfollows:

CostofEquity=12%+(4%)+%)=18.41%
CostofDebt=12%+1%=13%
(Thisassumestheriskfreeratehasnocountryriskpremiumembeddedinit.)

Approach2:Usethedifferentialinflationratetoestimatethecostofcapital.For
instance,iftheinflationrateinBRis8%andtheinflationrateintheU.S.is2%
1 Inflation
Costofcapital=

BR
(1 Cost of Capital$ )

1 Inflation$

=1.0997(1.08/1.02)1=0.1644or16.44%

Aswath Damodaran

86

DealingwithHybridsandPreferredStock

Whendealingwithhybrids(convertiblebonds,forinstance),breakthe
securitydownintodebtandequityandallocatetheamountsaccordingly.
Thus,ifafirmhas$125millioninconvertibledebtoutstanding,breakthe
$125millionintostraightdebtandconversionoptioncomponents.The
conversionoptionisequity.
Whendealingwithpreferredstock,itisbettertokeepitasaseparate
component.Thecostofpreferredstockisthepreferreddividendyield.(Asa
ruleofthumb,ifthepreferredstockislessthan5%oftheoutstandingmarket
valueofthefirm,lumpingitinwithdebtwillmakenosignificantimpacton
yourvaluation).

Aswath Damodaran

87

Decomposingaconvertiblebond

Assumethatthefirmthatyouareanalyzinghas$125millioninfacevalueof
convertibledebtwithastatedinterestrateof4%,a10yearmaturityanda
marketvalueof$140million.IfthefirmhasabondratingofAandthe
interestrateonAratedstraightbondis8%,youcanbreakdownthevalueof
theconvertiblebondintostraightdebtandequityportions.

Aswath Damodaran

Straightdebt=(4%of$125million)(PVofannuity,10years,8%)+125
million/1.0810=$91.45million
Equityportion=$140million$91.45million=$48.55million

88

RecappingtheCostofCapital

Aswath Damodaran

89

II.EstimatingCashFlows

DCFValuation

Aswath Damodaran

90

StepsinCashFlowEstimation

Estimatethecurrentearningsofthefirm

Considerhowmuchthefirminvestedtocreatefuturegrowth

Iflookingatcashflowstoequity,lookatearningsafterinterestexpensesi.e.net
income
Iflookingatcashflowstothefirm,lookatoperatingearningsaftertaxes
Iftheinvestmentisnotexpensed,itwillbecategorizedascapitalexpenditures.To
theextentthatdepreciationprovidesacashflow,itwillcoversomeofthese
expenditures.
Increasingworkingcapitalneedsarealsoinvestmentsforfuturegrowth

Iflookingatcashflowstoequity,considerthecashflowsfromnetdebtissues
(debtissueddebtrepaid)

Aswath Damodaran

91

MeasuringCashFlows
Cash fows can bemeasured to
All claimholders in thefrm
EBIT (1- tax rate)
- ( Capital Expenditures - Depreciation)
- Change in non-cash working capital
= Free Cash Flow to Firm (FCFF)

Aswath Damodaran

J ust Equity Investors

Net Income
- (Capital Expenditures - Depreciation)
- Change in non-cash Working Capital
- (Principal Repaid - New Debt Issues)
- Preferred Dividend

Dividends
+ Stock Buybacks

92

MeasuringCashFlowtotheFirm

EBIT(1taxrate)
(CapitalExpendituresDepreciation)
ChangeinWorkingCapital
=Cashflowtothefirm
Wherearethetaxsavingsfrominterestpaymentsinthiscashflow?

Aswath Damodaran

93

FromReportedtoActualEarnings

Aswath Damodaran

94

I.UpdateEarnings

Whenvaluingcompanies,weoftendependuponfinancialstatementsfor
inputsonearningsandassets.Annualreportsareoftenoutdatedandcanbe
updatedbyusing

Trailing12monthdata,constructedfromquarterlyearningsreports.
Informalandunofficialnewsreports,ifquarterlyreportsareunavailable.

Updatingmakesthemostdifferenceforsmallerandmorevolatilefirms,as
wellasforfirmsthathaveundergonesignificantrestructuring.
Timesaver:Togetatrailing12monthnumber,allyouneedisone10Kand
one10Q(examplethirdquarter).UsetheYeartodatenumbersfromthe10Q:
Trailing12monthRevenue=Revenues(inlast10K)Revenuesfromfirst3quarters
oflastyear+Revenuesfromfirst3quartersofthisyear.

Aswath Damodaran

95

II.CorrectingAccountingEarnings

Makesurethattherearenofinancialexpensesmixedinwithoperating
expenses

Financialexpense:Anycommitmentthatistaxdeductiblethatyouhavetomeetno
matterwhatyouroperatingresults:Failuretomeetitleadstolossofcontrolofthe
business.
Example:OperatingLeases:Whileaccountingconventiontreatsoperatingleases
asoperatingexpenses,theyarereallyfinancialexpensesandneedtobereclassified
assuch.Thishasnoeffectonequityearningsbutdoeschangetheoperating
earnings

Makesurethattherearenocapitalexpensesmixedinwiththeoperating
expenses

Aswath Damodaran

Capitalexpense:Anyexpensethatisexpectedtogeneratebenefitsovermultiple
periods.
R&DAdjustment:SinceR&Disacapitalexpenditure(ratherthananoperating
expense),theoperatingincomehastobeadjustedtoreflectitstreatment.

96

TheMagnitudeofOperatingLeases

Aswath Damodaran

97

DealingwithOperatingLeaseExpenses

OperatingLeaseExpensesaretreatedasoperatingexpensesincomputing
operatingincome.Inreality,operatingleaseexpensesshouldbetreatedas
financingexpenses,withthefollowingadjustmentstoearningsandcapital:
DebtValueofOperatingLeases=PresentvalueofOperatingLease
Commitmentsatthepretaxcostofdebt
Whenyouconvertoperatingleasesintodebt,youalsocreateanassetto
counteritofexactlythesamevalue.
AdjustedOperatingEarnings
AdjustedOperatingEarnings=OperatingEarnings+OperatingLeaseExpenses
DepreciationonLeasedAsset
Asanapproximation,thisworks:
AdjustedOperatingEarnings=OperatingEarnings+PretaxcostofDebt*PVof
OperatingLeases.

Aswath Damodaran

98

OperatingLeasesatTheGapin2003

TheGaphasconventionaldebtofabout$1.97billiononitsbalancesheetand
itspretaxcostofdebtisabout6%.Itsoperatingleasepaymentsinthe2003
were$978millionanditscommitmentsforthefuturearebelow:

Year
Commitment(millions)
PresentValue(at6%)
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 $982.50eachyear
$1,346.04
DebtValueofleases=
$4,396.85(Alsovalueofleasedasset)
DebtoutstandingatTheGap=$1,970m+$4,397m=$6,367m

AdjustedOperatingIncome=StatedOI+OLexpthisyearDeprecn
=$1,012m+978m4397m/7=$1,362million(7yearlifeforassets)
ApproximateOI=$1,012m+$4397m(.06)=$1,276m

Aswath Damodaran

99

TheCollateralEffectsofTreatingOperatingLeasesasDebt
C o nventional Accounting
Income Statement
EBIT& Leases = 1,990
- 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%
After-tax cost of debt = 4%
Market value of equity = 7350
Return on capital = 1012 (1-.35)/(3130+1970)
= 12.90%

Aswath Damodaran

Operating Leases Treated as Debt


Income Statement
EBIT& Leases = 1,990
- 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 (1-.35)/(3130+6367)


= 9.30%

100

TheMagnitudeofR&DExpenses

Aswath Damodaran

101

R&DExpenses:OperatingorCapitalExpenses

AccountingstandardsrequireustoconsiderR&Dasanoperatingexpense
eventhoughitisdesignedtogeneratefuturegrowth.Itismorelogicaltotreat
itascapitalexpenditures.
TocapitalizeR&D,

Aswath Damodaran

SpecifyanamortizablelifeforR&D(210years)
CollectpastR&Dexpensesforaslongastheamortizablelife
SumuptheunamortizedR&Dovertheperiod.(Thus,iftheamortizablelifeis5
years,theresearchassetcanbeobtainedbyaddingup1/5thoftheR&Dexpense
fromfiveyearsago,2/5thoftheR&Dexpensefromfouryearsago...:

102

CapitalizingR&DExpenses:SAP

R&Dwasassumedtohavea5yearlife.

Year

R&DExpense

Unamortizedportion

Amortizationthisyear

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
Valueofresearchasset=
2,914million
Amortizationofresearchassetin2004
=
903million
IncreaseinOperatingIncome=1020903=117million

Aswath Damodaran

103

TheEffectofCapitalizingR&DatSAP
C o nventional 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)
= 29.90%

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)
= 19.93%

104

III.OneTimeandNonrecurringCharges
Assumethatyouarevaluingafirmthatisreportingalossof$500million,
duetoaonetimechargeof$1billion.Whatistheearningsyouwouldusein
yourvaluation?
Alossof$500million
Aprofitof$500million
Wouldyouranswerbeanydifferentifthefirmhadreportedonetimelosseslike
theseonceeveryfiveyears?
Yes
No

Aswath Damodaran

105

IV.AccountingMalfeasance.

Thoughallfirmsmaybegovernedbythesameaccountingstandards,the
fidelitythattheyshowtothesestandardscanvary.Moreaggressivefirmswill
showhigherearningsthanmoreconservativefirms.
Whileyouwillnotbeabletocatchoutrightfraud,youshouldlookfor
warningsignalsinfinancialstatementsandcorrectforthem:

Aswath Damodaran

Incomefromunspecifiedsourcesholdingsinotherbusinessesthatarenot
revealedorfromspecialpurposeentities.
Incomefromassetsalesorfinancialtransactions(foranonfinancialfirm)
SuddenchangesinstandardexpenseitemsabigdropinS,G&AorR&D
expensesasapercentofrevenues,forinstance.
Frequentaccountingrestatements
Accrualearningsthatrunaheadofcashearningsconsistently
Bigdifferencesbetweentaxincomeandreportedincome

106

V.DealingwithNegativeorAbnormallyLowEarnings

Aswath Damodaran

107

Whattaxrate?

Thetaxratethatyoushoulduseincomputingtheaftertaxoperatingincome
shouldbe
Theeffectivetaxrateinthefinancialstatements(taxespaid/Taxableincome)
ThetaxratebasedupontaxespaidandEBIT(taxespaid/EBIT)
Themarginaltaxrateforthecountryinwhichthecompanyoperates
Theweightedaveragemarginaltaxrateacrossthecountriesinwhichthe
companyoperates
Noneoftheabove
Anyoftheabove,aslongasyoucomputeyouraftertaxcostofdebtusingthe
sametaxrate

Aswath Damodaran

108

TheRightTaxRatetoUse

Thechoicereallyisbetweentheeffectiveandthemarginaltaxrate.Indoing
projections,itisfarsafertousethemarginaltaxratesincetheeffectivetax
rateisreallyareflectionofthedifferencebetweentheaccountingandthetax
books.
Byusingthemarginaltaxrate,wetendtounderstatetheaftertaxoperating
incomeintheearlieryears,buttheaftertaxtaxoperatingincomeismore
accurateinlateryears
Ifyouchoosetousetheeffectivetaxrate,adjustthetaxratetowardsthe
marginaltaxrateovertime.

Aswath Damodaran

Whileanargumentcanbemadeforusingaweightedaveragemarginaltaxrate,it
issafesttousethemarginaltaxrateofthecountry

109

ATaxRateforaMoneyLosingFirm
Assumethatyouaretryingtoestimatetheaftertaxoperatingincomefora
firmwith$1billioninnetoperatinglossescarriedforward.Thisfirmis
expectedtohaveoperatingincomeof$500millioneachyearforthenext3
years,andthemarginaltaxrateonincomeforallfirmsthatmakemoneyis
40%.Estimatetheaftertaxoperatingincomeeachyearforthenext3years.
Year1
Year2
Year3
EBIT
500
500
500
Taxes
EBIT(1t)
Taxrate

Aswath Damodaran

110

NetCapitalExpenditures

Netcapitalexpendituresrepresentthedifferencebetweencapitalexpenditures
anddepreciation.Depreciationisacashinflowthatpaysforsomeoralot(or
sometimesallof)thecapitalexpenditures.
Ingeneral,thenetcapitalexpenditureswillbeafunctionofhowfastafirmis
growingorexpectingtogrow.Highgrowthfirmswillhavemuchhighernet
capitalexpendituresthanlowgrowthfirms.
Assumptionsaboutnetcapitalexpenditurescanthereforeneverbemade
independentlyofassumptionsaboutgrowthinthefuture.

Aswath Damodaran

111

Capitalexpendituresshouldinclude

Researchanddevelopmentexpenses,oncetheyhavebeenrecategorizedas
capitalexpenses.Theadjustednetcapexwillbe
AdjustedNetCapitalExpenditures=NetCapitalExpenditures+CurrentyearsR&D
expensesAmortizationofResearchAsset

Acquisitionsofotherfirms,sincethesearelikecapitalexpenditures.The
adjustednetcapexwillbe
AdjustedNetCapEx=NetCapitalExpenditures+Acquisitionsofotherfirms
Amortizationofsuchacquisitions
Twocaveats:
1.Mostfirmsdonotdoacquisitionseveryyear.Hence,anormalizedmeasureof
acquisitions(lookingatanaverageovertime)shouldbeused
2.Thebestplacetofindacquisitionsisinthestatementofcashflows,usually
categorizedunderotherinvestmentactivities

Aswath Damodaran

112

CiscosAcquisitions:1999
Acquired
GeoTel
Fibex
Sentient
American Internent
Summa Four
Clarity Wireless
Selsius Systems
PipeLinks
Amteva Tech

Aswath Damodaran

Method of Acquisition
Pooling
Pooling
Pooling
Purchase
Purchase
Purchase
Purchase
Purchase
Purchase

Price Paid
$1,344
$318
$103
$58
$129
$153
$134
$118
$159
$2,516

113

CiscosNetCapitalExpendituresin1999
CapExpenditures(fromstatementofCF)
Depreciation(fromstatementofCF)
NetCapEx(fromstatementofCF)
+R&Dexpense
AmortizationofR&D
+Acquisitions
AdjustedNetCapitalExpenditures

=$584mil
=$486mil
=$98mil
=$1,594mil
=$485mil
=$2,516mil
=$3,723mil

(Amortizationwasincludedinthedepreciationnumber)

Aswath Damodaran

114

WorkingCapitalInvestments

Inaccountingterms,theworkingcapitalisthedifferencebetweencurrent
assets(inventory,cashandaccountsreceivable)andcurrentliabilities
(accountspayables,shorttermdebtanddebtduewithinthenextyear)
Acleanerdefinitionofworkingcapitalfromacashflowperspectiveisthe
differencebetweennoncashcurrentassets(inventoryandaccounts
receivable)andnondebtcurrentliabilities(accountspayable)
Anyinvestmentinthismeasureofworkingcapitaltiesupcash.Therefore,
anyincreases(decreases)inworkingcapitalwillreduce(increase)cashflows
inthatperiod.
Whenforecastingfuturegrowth,itisimportanttoforecasttheeffectsofsuch
growthonworkingcapitalneeds,andbuildingtheseeffectsintothecash
flows.

Aswath Damodaran

115

WorkingCapital:GeneralPropositions

Changesinnoncashworkingcapitalfromyeartoyeartendtobevolatile.A
farbetterestimateofnoncashworkingcapitalneeds,lookingforward,canbe
estimatedbylookingatnoncashworkingcapitalasaproportionofrevenues
Somefirmshavenegativenoncashworkingcapital.Assumingthatthiswill
continueintothefuturewillgeneratepositivecashflowsforthefirm.While
thisisindeedfeasibleforaperiodoftime,itisnotforever.Thus,itisbetter
thatnoncashworkingcapitalneedsbesettozero,whenitisnegative.

Aswath Damodaran

116

VolatileWorkingCapital?

Revenues
NoncashWC
%ofRevenues
Changefromlastyear
Average:last3years
Average:industry

Amazon
$1,640
419 404
25.53%
$(309)
15.16%
8.71%

AssumptioninValuation
WCas%ofRevenue 3.00%

Aswath Damodaran

Cisco
Motorola
$12,154
$30,931
2547
3.32%
8.23%
($700)
($829)
3.16%
8.91%
2.71%
7.04%

0.00%

8.23%

117

DividendsandCashFlowstoEquity

Inthestrictestsense,theonlycashflowthataninvestorwillreceivefroman
equityinvestmentinapubliclytradedfirmisthedividendthatwillbepaidon
thestock.
Actualdividends,however,aresetbythemanagersofthefirmandmaybe
muchlowerthanthepotentialdividends(thatcouldhavebeenpaidout)

managersareconservativeandtrytosmoothoutdividends
managersliketoholdontocashtomeetunforeseenfuturecontingenciesand
investmentopportunities

Whenactualdividendsarelessthanpotentialdividends,usingamodelthat
focusesonlyondividendswillunderstatethetruevalueoftheequityina
firm.

Aswath Damodaran

118

MeasuringPotentialDividends

Someanalystsassumethattheearningsofafirmrepresentitspotential
dividends.Thiscannotbetrueforseveralreasons:

Earningsarenotcashflows,sincetherearebothnoncashrevenuesandexpensesin
theearningscalculation
Evenifearningswerecashflows,afirmthatpaiditsearningsoutasdividends
wouldnotbeinvestinginnewassetsandthuscouldnotgrow
Valuationmodels,whereearningsarediscountedbacktothepresent,willover
estimatethevalueoftheequityinthefirm

Thepotentialdividendsofafirmarethecashflowsleftoverafterthefirmhas
madeanyinvestmentsitneedstomaketocreatefuturegrowthandnetdebt
repayments(debtrepaymentsnewdebtissues)

Aswath Damodaran

Thecommoncategorizationofcapitalexpendituresintodiscretionaryandnon
discretionarylosesitsbasiswhenthereisfuturegrowthbuiltintothevaluation.

119

EstimatingCashFlows:FCFE

CashflowstoEquityforaLeveredFirm
NetIncome
(CapitalExpendituresDepreciation)
ChangesinnoncashWorkingCapital
(PrincipalRepaymentsNewDebtIssues)
=FreeCashflowtoEquity

Aswath Damodaran

Ihaveignoredpreferreddividends.Ifpreferredstockexist,preferreddividendswill
alsoneedtobenettedout

120

EstimatingFCFEwhenLeverageisStable

NetIncome
(1)(CapitalExpendituresDepreciation)
(1)WorkingCapitalNeeds
=FreeCashflowtoEquity
=Debt/CapitalRatio
Forthisfirm,

Proceedsfromnewdebtissues=PrincipalRepayments+(CapitalExpenditures
Depreciation+WorkingCapitalNeeds)

IncomputingFCFE,thebookvaluedebttocapitalratioshouldbeusedwhen
lookingbackintimebutcanbereplacedwiththemarketvaluedebttocapital
ratio,lookingforward.

Aswath Damodaran

121

EstimatingFCFE:Disney

NetIncome=$1533Million
Capitalspending=$1,746Million
DepreciationperShare=$1,134Million
Increaseinnoncashworkingcapital=$477Million
DebttoCapitalRatio=23.83%
EstimatingFCFE(1997):
NetIncome
(Cap.ExpDepr)*(1DR)
Chg.WorkingCapital*(1DR)
=FreeCFtoEquity

$1,533Mil
$465.90
[(17461134)(1.2383)]
$363.33
[477(1.2383)]
$704Million

DividendsPaid

$345Million

Aswath Damodaran

122

FCFEandLeverage:Isthisafreelunch?

Debt Ratio and FCFE: Disney


1600

1400

1200

FCFE

1000

800

600

400

200

0
0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Debt Ratio

Aswath Damodaran

123

FCFEandLeverage:TheOtherShoeDrops

Debt Ratio and Beta


8.00

7.00

6.00

Beta

5.00

4.00

3.00

2.00

1.00

0.00
0%

1 0%

20 %

3 0%

40 %

5 0%

60 %

7 0%

80%

90 %

Debt Ratio

Aswath Damodaran

124

Leverage,FCFEandValue

Inadiscountedcashflowmodel,increasingthedebt/equityratiowill
generallyincreasetheexpectedfreecashflowstoequityinvestorsoverfuture
timeperiodsandalsothecostofequityappliedindiscountingthesecash
flows.Whichofthefollowingstatementsrelatingleveragetovaluewouldyou
subscribeto?
Increasingleveragewillincreasevaluebecausethecashfloweffectswill
dominatethediscountrateeffects
Increasingleveragewilldecreasevaluebecausetheriskeffectwillbegreater
thanthecashfloweffects
Increasingleveragewillnotaffectvaluebecausetheriskeffectwillexactly
offsetthecashfloweffect
Anyoftheabove,dependinguponwhatcompanyyouarelookingatand
whereitisintermsofcurrentleverage

Aswath Damodaran

125

III.EstimatingGrowth

DCFValuation

Aswath Damodaran

126

WaysofEstimatingGrowthinEarnings

Lookatthepast

Lookatwhatothersareestimating

Thehistoricalgrowthinearningspershareisusuallyagoodstartingpointfor
growthestimation
Analystsestimategrowthinearningspershareformanyfirms.Itisusefultoknow
whattheirestimatesare.

Lookatfundamentals

Aswath Damodaran

Ultimately,allgrowthinearningscanbetracedtotwofundamentalshowmuch
thefirmisinvestinginnewprojects,andwhatreturnstheseprojectsaremakingfor
thefirm.

127

I.HistoricalGrowthinEPS

Historicalgrowthratescanbeestimatedinanumberofdifferentways

Historicalgrowthratescanbesensitiveto

ArithmeticversusGeometricAverages
SimpleversusRegressionModels
theperiodusedintheestimation

Inusinghistoricalgrowthrates,thefollowingfactorshavetobeconsidered

Aswath Damodaran

howtodealwithnegativeearnings
theeffectofchangingsize

128

Motorola:ArithmeticversusGeometricGrowthRates

Aswath Damodaran

129

ATest

YouaretryingtoestimatethegrowthrateinearningspershareatTime
Warnerfrom1996to1997.In1996,theearningspersharewasadeficitof
$0.05.In1997,theexpectedearningspershareis$0.25.Whatisthegrowth
rate?
600%
+600%
+120%
Cannotbeestimated

Aswath Damodaran

130

DealingwithNegativeEarnings

Whentheearningsinthestartingperiodarenegative,thegrowthratecannot
beestimated.(0.30/0.05=600%)
Therearethreesolutions:

Usethehigherofthetwonumbersasthedenominator(0.30/0.25=120%)
Usetheabsolutevalueofearningsinthestartingperiodasthedenominator
(0.30/0.05=600%)
Usealinearregressionmodelanddividethecoefficientbytheaverageearnings.

Whenearningsarenegative,thegrowthrateismeaningless.Thus,whilethe
growthratecanbeestimated,itdoesnottellyoumuchaboutthefuture.

Aswath Damodaran

131

TheEffectofSizeonGrowth:CallawayGolf

Year
NetProfit
GrowthRate
1990
1.80
1991
6.40
255.56%
1992
19.30
201.56%
1993
41.20
113.47%
1994
78.00
89.32%
1995
97.70
25.26%
1996
122.30
25.18%
GeometricAverageGrowthRate=102%

Aswath Damodaran

132

ExtrapolationanditsDangers

Year
NetProfit
1996
$122.30
1997
$247.05
1998
$499.03
1999
$1,008.05
2000
$2,036.25
2001
$4,113.23
Ifnetprofitcontinuestogrowatthesamerateasithasinthepast6years,the
expectednetincomein5yearswillbe$4.113billion.

Aswath Damodaran

133

II.AnalystForecastsofGrowth

Whilethejobofananalystistofindunderandovervaluedstocksinthe
sectorsthattheyfollow,asignificantproportionofananalyststime(outside
ofselling)isspentforecastingearningspershare.

Mostofthistime,inturn,isspentforecastingearningspershareinthenext
earningsreport
Whilemanyanalystsforecastexpectedgrowthinearningspershareoverthenext5
years,theanalysisandinformation(generally)thatgoesintothisestimateisfar
morelimited.

Analystforecastsofearningspershareandexpectedgrowtharewidely
disseminatedbyservicessuchasZacksandIBES,atleastforU.Scompanies.

Aswath Damodaran

134

Howgoodareanalystsatforecastinggrowth?

AnalystsforecastsofEPStendtobeclosertotheactualEPSthansimpletime
seriesmodels,butthedifferencestendtobesmall

Study
Collins&Hopwood
Brown&Rozeff
Fried&Givoly

AnalystForecastError
31.7%
28.4%
16.4%

TimeSeriesModel
34.1%
32.2%
19.8%

Theadvantagethatanalystshaveovertimeseriesmodels

TimePeriod
ValueLineForecasts
ValueLineForecasts
EarningsForecaster

tendstodecreasewiththeforecastperiod(nextquarterversus5years)
tendstobegreaterforlargerfirmsthanforsmallerfirms
tendstobegreaterattheindustrylevelthanatthecompanylevel

Forecastsofgrowth(andrevisionsthereof)tendtobehighlycorrelatedacross
analysts.

Aswath Damodaran

135

Aresomeanalystsmoreequalthanothers?

AstudyofAllAmericaAnalysts(chosenbyInstitutionalInvestor)foundthat

Aswath Damodaran

ThereisnoevidencethatanalystswhoarechosenfortheAllAmericaAnalyst
teamwerechosenbecausetheywerebetterforecastersofearnings.(Theirmedian
forecasterrorinthequarterpriortobeingchosenwas30%;themedianforecast
errorofotheranalystswas28%)
However,inthecalendaryearfollowingbeingchosenasAllAmericaanalysts,
theseanalystsbecomeslightlybetterforecastersthantheirlessfortunatebrethren.
(ThemedianforecasterrorforAllAmericaanalystsis2%lowerthanthemedian
forecasterrorforotheranalysts)
EarningsrevisionsmadebyAllAmericaanalyststendtohaveamuchgreater
impactonthestockpricethanrevisionsfromotheranalysts
TherecommendationsmadebytheAllAmericaanalystshaveagreaterimpacton
stockprices(3%onbuys;4.7%onsells).Fortheserecommendationstheprice
changesaresustained,andtheycontinuetoriseinthefollowingperiod(2.4%for
buys;13.8%forthesells).

136

TheFiveDeadlySinsofanAnalyst

TunnelVision:Becomingsofocusedonthesectorandvaluationswithinthe
sectorthatyoulosesightofthebiggerpicture.
Lemmingitis:Strongurgefelttochangerecommendations&reviseearnings
estimateswhenotheranalystsdothesame.
StockholmSyndrome:Referstoanalystswhostartidentifyingwiththe
managersofthefirmsthattheyaresupposedtofollow.
Factophobia(generallyiscoupledwithdelusionsofbeingafamousstory
teller):Tendencytobasearecommendationonastorycoupledwitha
refusaltofacethefacts.
Dr.Jekyll/Mr.Hyde:Analystwhothinkshisprimaryjobistobringin
investmentbankingbusinesstothefirm.

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137

PropositionsaboutAnalystGrowthRates

Proposition1:Thereiffarlessprivateinformationandfarmorepublic
informationinmostanalystforecaststhanisgenerallyclaimed.
Proposition2:Thebiggestsourceofprivateinformationforanalystsremains
thecompanyitselfwhichmightexplain

whytherearemorebuyrecommendationsthansellrecommendations(information
biasandtheneedtopreservesources)
whythereissuchahighcorrelationacrossanalystsforecastsandrevisions
whyAllAmericaanalystsbecomebetterforecastersthanotheranalystsafterthey
arechosentobepartoftheteam.

Proposition3:Thereisvaluetoknowingwhatanalystsareforecastingas
earningsgrowthforafirm.Thereis,however,dangerwhentheyagreetoo
much(lemmingitis)andwhentheyagreetolittle(inwhichcasethe
informationthattheyhaveissonoisyastobeuseless).

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138

III.FundamentalGrowthRates

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139

GrowthRateDerivations

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140

I.ExpectedLongTermGrowthinEPS

Whenlookingatgrowthinearningspershare,theseinputscanbecastasfollows:
ReinvestmentRate=RetainedEarnings/CurrentEarnings=RetentionRatio
ReturnonInvestment=ROE=NetIncome/BookValueofEquity
InthespecialcasewherethecurrentROEisexpectedtoremainunchanged

gEPS

=RetainedEarningst1/NIt1*ROE
=RetentionRatio*ROE
=b*ROE
Proposition 1: The expected growth rate in earnings for a company cannot
exceeditsreturnonequityinthelongterm.

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141

EstimatingExpectedGrowthinEPS:WellsFargoin2008

Returnonequity(basedon2008earnings)=17.56%
RetentionRatio(basedon2008earningsanddividends)=45.37%
ExpectedgrowthrateinearningspershareforWellsFargo,ifitcanmaintain
thesenumbers.
ExpectedGrowthRate=0.4537(17.56%)=7.97%

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142

RegulatoryEffectsonExpectedEPSgrowth

Assumenowthatthebankingcrisisof2008willhaveanimpactonthecapital
ratiosandprofitabilityofbanks.Inparticular,youcanexpectthatthebook
capital(equity)neededbybankstodobusinesswillincrease30%,starting
now.AssumingthatWellscontinueswithitsexistingbusinesses,estimatethe
expectedgrowthrateinearningspershareforthefuture.
NewReturnonEquity=
Expectedgrowthrate=

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143

OnewaytopumpupROE:Usemoredebt

ROE=ROC+D/E(ROCi(1t))
where,
ROC=EBITt(1taxrate)/BookvalueofCapitalt1

D/E=BVofDebt/BVofEquity
i=InterestExpenseonDebt/BVofDebt
t=Taxrateonordinaryincome
NotethatBookvalueofcapital=BookValueofDebt+Bookvalueof
Equity.

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144

DecomposingROE:Brahmain1998

Brahma(nowAmbev)hadanextremelyhighreturnonequity,partlybecause
itborrowedmoneyataratewellbelowitsreturnoncapital

ReturnonCapital=19.91%
Debt/EquityRatio=77%
AftertaxCostofDebt=5.61%
ReturnonEquity=ROC+D/E(ROCi(1t))
19.91%+0.77(19.91%5.61%)=30.92%

Thisseemslikeaneasywaytodeliverhighergrowthinearningsper
share.What(ifany)isthedownside?

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145

DecomposingROE:TitanWatches(India)

ReturnonCapital=9.54%
Debt/EquityRatio=191%(bookvalueterms)
AftertaxCostofDebt=10.125%
ReturnonEquity=ROC+D/E(ROCi(1t))
9.54%+1.91(9.54%10.125%)=8.42%

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146

II.ExpectedGrowthinNetIncome

ThelimitationoftheEPSfundamentalgrowthequationisthatitfocuseson
pershareearningsandassumesthatreinvestedearningsareinvestedin
projectsearningthereturnonequity.
Amoregeneralversionofexpectedgrowthinearningscanbeobtainedby
substitutingintheequityreinvestmentintorealinvestments(netcapital
expendituresandworkingcapital):
EquityReinvestmentRate=(NetCapitalExpenditures+ChangeinWorkingCapital)
(1DebtRatio)/NetIncome
ExpectedGrowthNetIncome=EquityReinvestmentRate*ROE

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147

III.ExpectedGrowthinEBITAndFundamentals:Stable
ROCandReinvestmentRate

Whenlookingatgrowthinoperatingincome,thedefinitionsare
ReinvestmentRate=(NetCapitalExpenditures+ChangeinWC)/EBIT(1t)
ReturnonInvestment=ROC=EBIT(1t)/(BVofDebt+BVofEquity)

ReinvestmentRateandReturnonCapital
gEBIT =(NetCapitalExpenditures+ChangeinWC)/EBIT(1t)*ROC
ReinvestmentRate*ROC
Proposition:Thenetcapitalexpenditureneedsofafirm,foragiven
growthrate,shouldbeinverselyproportionaltothequalityofits
investments.

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148

EstimatingGrowthinEBIT:CiscoversusMotorola1999

CiscosFundamentals
ReinvestmentRate=106.81%
ReturnonCapital=34.07%
ExpectedGrowthinEBIT=(1.0681)(.3407)=36.39%
MotorolasFundamentals
ReinvestmentRate=52.99%
ReturnonCapital=12.18%
ExpectedGrowthinEBIT=(.5299)(.1218)=6.45%

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149

IV.OperatingIncomeGrowthwhenReturnonCapitalis
Changing
Whenthereturnoncapitalischanging,therewillbeasecondcomponentto
growth,positiveifthereturnoncapitalisincreasingandnegativeifthereturn
oncapitalisdecreasing.
IfROCtisthereturnoncapitalinperiodtandROCt+1isthereturnoncapital
inperiodt+1,theexpectedgrowthrateinoperatingincomewillbe:
ExpectedGrowthRate=ROCt+1*Reinvestmentrate

+(ROCt+1ROCt)/ROCt

Ifthechangeisovermultipleperiods,thesecondcomponentshouldbespread
outovereachperiod.

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150

MotorolasGrowthRate
Motorolascurrentreturnoncapitalis12.18%anditsreinvestmentrateis
52.99%.
WeexpectMotorolasreturnoncapitaltoriseto17.22%overthenext5years
(whichishalfwaytowardstheindustryaverage)
ExpectedGrowthRate
=ROCNewInvestments*ReinvestmentRatecurrent+{[1+(ROCIn5yearsROCCurrent)/ROCCurrent]1/51}
=.1722*.5299+{[1+(.1722.1218)/.1218]1/51}
=.1629or16.29%
OnewaytothinkaboutthisistodecomposeMotorolasexpectedgrowthinto
Growthfromnewinvestments:.1722*5299=9.12%
Growthfrommoreefficientlyusingexistinginvestments:16.29%9.12%=7.17%
{Note that I am assuming that the new investments start making 17.22%
immediately,whileallowingforexistingassetstoimprovereturnsgradually}

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151

TheValueofGrowth

Expectedgrowth=Growthfromnewinvestments+Efficiencygrowth
=ReinvRate*ROC
+(ROCtROCt1)/ROCt1
Assumethatyourcostofcapitalis10%.Asaninvestor,rankthese
firmsintheorderofmostvaluegrowthtoleastvaluegrowth.

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152

V.EstimatingGrowthwhenOperatingIncomeisNegative
orMarginsarechanging

Whenoperatingincomeisnegativeormarginsareexpectedtochangeover
time,weuseathreestepprocesstoestimategrowth:

Estimategrowthratesinrevenuesovertime
Usehistoricalrevenuegrowthtogetestimatesofrevenuegrowthinthenearfuture
Decreasethegrowthrateasthefirmbecomeslarger
Keeptrackofabsoluterevenuestomakesurethatthegrowthisfeasible

Estimateexpectedoperatingmarginseachyear
Setatargetmarginthatthefirmwillmovetowards
Adjustthecurrentmargintowardsthetargetmargin

Estimatethecapitalthatneedstobeinvestedtogeneraterevenuegrowthand
expectedmargins
Estimateasalestocapitalratiothatyouwillusetogeneratereinvestmentneedseach
year.

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153

SiriusRadio:RevenuesandRevenueGrowth
June2006
Year
Current
1
2
3
4
5
6
7
8
9
10

Aswath Damodaran

Revenue
Growthrate
200.00%
100.00%
80.00%
60.00%
40.00%
25.00%
20.00%
15.00%
10.00%
5.00%

Revenues
$187
$562
$1,125
$2,025
$3,239
$4,535
$5,669
$6,803
$7,823
$8,605
$9,035

Operating
Margin
419.92%
199.96%
89.98%
34.99%
7.50%
6.25%
13.13%
16.56%
18.28%
19.14%
19.57%

Targetmarginbasedupon
ClearChannel

OperatingIncome
$787
$1,125
$1,012
$708
$243
$284
$744
$1,127
$1,430
$1,647
$1,768

154

Sirius:ReinvestmentNeeds
Year
Revenues Change in revenue
Sales/Capital Ratio
Reinvestment
Current
$187
1
$562
$375
1.50
$250
2
$1,125
$562
1.50
$375
3
$2,025
$900
1.50
$600
4
$3,239
$1,215
1.50
$810
5
$4,535
$1,296
1.50
$864
6
$5,669
$1,134
1.50
$756
7
$6,803
$1,134
1.50
$756
8
$7,823
$1,020
1.50
$680
9
$8,605
$782
1.50
$522
10
$9,035
$430
1.50
$287

Capital Invested
Operating Income (Loss)
Imputed ROC
$
1,657
-$787
$
1,907
-$1,125
-67.87%
$
2,282
-$1,012
-53.08%
$
2,882
-$708
-31.05%
$
3,691
-$243
-8.43%
$
4,555
$284
7.68%
$
5,311
$744
16.33%
$
6,067
$1,127
21.21%
$
6,747
$1,430
23.57%
$
7,269
$1,647
17.56%
$
7,556
$1,768
15.81%

Capitalinvestedinyeart+!=
Capitalinvestedinyeart+
Reinvestmentinyeart+1
IndustryaverageSales/CapRatio

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155

Expected Growth Rate

Equity Earnings

Analysts

Fundamentals

Operating Income

Historical

Fundamentals

Stable ROC

Changing ROC

ROC *
Reinvestment Rate

ROCt+1*Reinvestment Rate
+ (ROCt+1-ROCt)/ROCt

Earnings per share

Stable ROE

Changing ROE

ROE * Retention Ratio

Aswath Damodaran

ROEt+1*Retention Ratio
+ (ROEt+1-ROEt)/ROEt

ROE * Equity
Reinvestment Ratio

Negative Earnings

1. Revenue Growth
2. Operating Margins
3. Reinvestment Needs

Net Income

Stable ROE

Historical

Changing ROE

ROEt+1*Eq. Reinv Ratio


+ (ROEt+1-ROEt)/ROEt

156

IV.ClosureinValuation

DiscountedCashflowValuation

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157

GettingClosureinValuation

Apubliclytradedfirmpotentiallyhasaninfinitelife.Thevalueistherefore
thepresentvalueofcashflowsforever.
t = CFt
Value =
t
t = 1 (1+ r)

Sincewecannotestimatecashflowsforever,weestimatecashflowsfora
growthperiodandthenestimateaterminalvalue,tocapturethevalueatthe
endoftheperiod:
t = N CF
t Terminal Value
Value =
N
t
(1 + r)
t = 1 (1 + r)

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158

WaysofEstimatingTerminalValue

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159

GettingTerminalValueRight
1.Obeythegrowthcap

Whenafirmscashflowsgrowataconstantrateforever,thepresentvalueofthose
cashflowscanbewrittenas:
Value=ExpectedCashFlowNextPeriod/(rg)
where,
r=Discountrate(CostofEquityorCostofCapital)
g=Expectedgrowthrate

Thestablegrowthratecannotexceedthegrowthrateoftheeconomybutitcanbeset
lower.

Ifyouassumethattheeconomyiscomposedofhighgrowthandstablegrowthfirms,the
growthrateofthelatterwillprobablybelowerthanthegrowthrateoftheeconomy.
Thestablegrowthratecanbenegative.Theterminalvaluewillbelowerandyouareassuming
thatyourfirmwilldisappearovertime.
Ifyouusenominalcashflowsanddiscountrates,thegrowthrateshouldbenominalinthe
currencyinwhichthevaluationisdenominated.

Onesimpleproxyforthenominalgrowthrateoftheeconomyistheriskfreerate.

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160

GettingTerminalValueRight
2.Dontwaittoolong
Assumethatyouarevaluingayoung,highgrowthfirmwithgreatpotential,just
afteritsinitialpublicoffering.Howlongwouldyousetyourhighgrowth
period?
<5years
5years
10years
>10years
Whathighgrowthperiodwouldyouuseforalargerfirmwithaproventrack
recordofdeliveringgrowthinthepast?
5years
10years
15years
Longer

Aswath Damodaran

161

Someevidenceongrowthatsmallfirms

Whileanalystsroutinelyassumeverylonghighgrowthperiods(with
substantialexcessreturnsduringtheperiods),theevidencesuggeststhatthey
aremuchtoooptimistic.AstudyofrevenuegrowthatfirmsthatmakeIPOsin
theyearsaftertheIPOshowsthefollowing:

Aswath Damodaran

162

Dontforgetthatgrowthhastobeearned..
3.Thinkaboutwhatyourfirmwillearnasreturnsforever..

Inthesectiononexpectedgrowth,welaidoutthefundamentalequationfor
growth:
Growthrate=ReinvestmentRate*Returnoninvestedcapital
+Growthratefromimprovedefficiency

Instablegrowth,youcannotcountonefficiencydeliveringgrowth(why?)
andyouhavetoreinvesttodeliverthegrowthratethatyouhaveforecast.
Consequently,yourreinvestmentrateinstablegrowthwillbeafunctionof
yourstablegrowthrateandwhatyoubelievethefirmwillearnasareturn
oncapitalinperpetuity:

ReinvestmentRate=Stablegrowthrate/StableperiodReturnoncapital

Akeyissueinvaluationiswhetheritokaytoassumethatfirmscanearn
morethantheircostofcapitalinperpetuity.Therearesome(McKinsey,for
instance)whoarguethatthereturnoncapital=costofcapitalinstable
growth

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163

Therearesomefirmsthatearnexcessreturns..

Whilegrowthratesseemtofadequicklyasfirmsbecomelarger,well
managedfirmsseemtodomuchbetteratsustainingexcessreturnsforlonger
periods.

Aswath Damodaran

164

Anddontfallforsleightofhand

AtypicalassumptioninmanyDCFvaluations,whenitcomesto
stablegrowth,isthatcapitalexpendituresoffsetdepreciationandthere
arenoworkingcapitalneeds.Stablegrowthfirms,wearetold,just
havetomakemaintenancecapex(replacingexistingassets)to
delivergrowth.Ifyoumakethisassumption,whatexpectedgrowth
ratecanyouuseinyourterminalvaluecomputation?

Whatifthestablegrowthrate=inflationrate?Isitokaytomakethis
assumptionthen?

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165

GettingTerminalValueRight
4.Beinternallyconsistent..

Riskandcostsofequityandcapital:Stablegrowthfirmstendto

Havebetasclosertoone
Havedebtratiosclosertoindustryaverages(ormaturecompanyaverages)
Countryriskpremiums(especiallyinemergingmarketsshouldevolveovertime)

Theexcessreturnsatstablegrowthfirmsshouldapproach(orbecome)zero.
ROC>CostofcapitalandROE>Costofequity
Thereinvestmentneedsanddividendpayoutratiosshouldreflectthelower
growthandexcessreturns:

Aswath Damodaran

Stableperiodpayoutratio=1g/ROE
Stableperiodreinvestmentrate=g/ROC

166

V.BeyondInputs:ChoosingandUsingthe
RightModel
DiscountedCashflowValuation

Aswath Damodaran

167

SummarizingtheInputs

Insummary,atthisstageintheprocess,weshouldhaveanestimateofthe

thecurrentcashflowsontheinvestment,eithertoequityinvestors(dividendsor
freecashflowstoequity)ortothefirm(cashflowtothefirm)
thecurrentcostofequityand/orcapitalontheinvestment
theexpectedgrowthrateinearnings,baseduponhistoricalgrowth,analysts
forecastsand/orfundamentals

Thenextstepintheprocessisdeciding

Aswath Damodaran

whichcashflowtodiscount,whichshouldindicate
whichdiscountrateneedstobeestimatedand
whatpatternwewillassumegrowthtofollow

168

WhichcashflowshouldIdiscount?

UseEquityValuation
(a)forfirmswhichhavestableleverage,whetherhighornot,and
(b)ifequity(stock)isbeingvalued

UseFirmValuation
(a)forfirmswhichhaveleveragewhichistoohighortoolow,andexpecttochange
theleverageovertime,becausedebtpaymentsandissuesdonothavetobefactored
inthecashflowsandthediscountrate(costofcapital)doesnotchange
dramaticallyovertime.
(b)forfirmsforwhichyouhavepartialinformationonleverage(eg:interestexpenses
aremissing..)
(c)inallothercases,whereyouaremoreinterestedinvaluingthefirmthantheequity.
(ValueConsulting?)

Aswath Damodaran

169

Givencashflowstoequity,shouldIdiscountdividendsor
FCFE?

UsetheDividendDiscountModel

(a)Forfirmswhichpaydividends(andrepurchasestock)whichareclosetothe
FreeCashFlowtoEquity(overaextendedperiod)
(b)ForfirmswhereFCFEaredifficulttoestimate(Example:BanksandFinancial
Servicecompanies)

UsetheFCFEModel

Aswath Damodaran

(a)Forfirmswhichpaydividendswhicharesignificantlyhigherorlowerthanthe
FreeCashFlowtoEquity.(Whatissignificant?...Asaruleofthumb,ifdividends
arelessthan80%ofFCFEordividendsaregreaterthan110%ofFCFEovera5
yearperiod,usetheFCFEmodel)
(b)Forfirmswheredividendsarenotavailable(Example:PrivateCompanies,
IPOs)

170

WhatdiscountrateshouldIuse?

CostofEquityversusCostofCapital

Whatcurrencyshouldthediscountrate(riskfreerate)bein?

Ifdiscountingcashflowstoequity >CostofEquity
Ifdiscountingcashflowstothefirm
>CostofCapital
Matchthecurrencyinwhichyouestimatetheriskfreeratetothecurrencyofyour
cashflows

ShouldIuserealornominalcashflows?

Aswath Damodaran

Ifdiscountingrealcashflows
>realcostofcapital
Ifnominalcashflows
>nominalcostofcapital
Ifinflationislow(<10%),stickwithnominalcashflowssincetaxesarebasedupon
nominalincome
Ifinflationishigh(>10%)switchtorealcashflows

171

WhichGrowthPatternShouldIuse?

Ifyourfirmis

largeandgrowingatarateclosetoorlessthangrowthrateoftheeconomy,or
constrainedbyregulationfromgrowingatratefasterthantheeconomy
hasthecharacteristicsofastablefirm(averagerisk&reinvestmentrates)
UseaStableGrowthModel

Ifyourfirm

islarge&growingatamoderaterate(Overallgrowthrate+10%)or
hasasingleproduct&barrierstoentrywithafinitelife(e.g.patents)

Usea2StageGrowthModel

Ifyourfirm

issmallandgrowingataveryhighrate(>Overallgrowthrate+10%)or
hassignificantbarrierstoentryintothebusiness
hasfirmcharacteristicsthatareverydifferentfromthenorm

Usea3StageornstageModel

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172

TheBuildingBlocksofValuation

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173

6.TyingupLooseEnds

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174

Butwhatcomesnext?

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175

1.TheValueofCash

Thesimplestandmostdirectwayofdealingwithcashandmarketable
securitiesistokeepitoutofthevaluationthecashflowsshouldbebefore
interestincomefromcashandsecurities,andthediscountrateshouldnotbe
contaminatedbytheinclusionofcash.(Usebetasoftheoperatingassetsalone
toestimatethecostofequity).
Oncetheoperatingassetshavebeenvalued,youshouldaddbackthevalueof
cashandmarketablesecurities.
Inmanyequityvaluations,theinterestincomefromcashisincludedinthe
cashflows.Thediscountratehastobeadjustedthenforthepresenceofcash.
(Thebetausedwillbeweighteddownbythecashholdings).Unlesscash
remainsafixedpercentageofoverallvalueovertime,thesevaluationswill
tendtobreakdown.

Aswath Damodaran

176

AnExerciseinCashValuation

CompanyC
EnterpriseValue
Cash
ReturnonCapital
CostofCapital
Tradesin

Aswath Damodaran

$1billion
$100mil
10%
10%
US

CompanyA

CompanyB

$1billion
$100mil
5%
10%
US

$1billion
$100mil
22%
12%
Argentina

177

Shouldyoueverdiscountcashforitslowreturns?

Therearesomeanalystswhoarguethatcompanieswithalotofcashontheir
balancesheetsshouldbepenalizedbyhavingtheexcesscashdiscountedto
reflectthefactthatitearnsalowreturn.

Excesscashisusuallydefinedasholdingcashthatisgreaterthanwhatthefirm
needsforoperations.
Alowreturnisdefinedasareturnlowerthanwhatthefirmearnsonitsnoncash
investments.

Thisisthewrongreasonfordiscountingcash.Ifthecashisinvestedin
risklesssecurities,itshouldearnalowrateofreturn.Aslongasthereturnis
highenough,giventherisklessnatureoftheinvestment,cashdoesnotdestroy
value.
Thereisarightreason,though,thatmayapplytosomecompanies
Managerscandostupidthingswithcash(overpricedacquisitions,pieinthe
skyprojects.)andyouhavetodiscountforthispossibility.

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178

Cash:DiscountorPremium?

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179

TheCaseofClosedEndFunds:PriceandNAV

D i s c o u n ts /P r e m i u m s o n C l o s e d E n d F u n d s - J u n e 2 0 0 2
70

60

50

40

30

20

10

0
D is c o u n t
> 15%

Aswath Damodaran

D is c o u n t: D is c o u n t: D is c o u n t: D is c o u n t: D is c o u n t: P re m iu m : P re m iu m : P r e m iu m : P re m iu m : P re m iu m : P re m iu m
1 0 -1 5 %
7 .5 -1 0 %
5 - 7 .5 %
2 .5 -5 %
0 - 2 .5 %
0 - 2 .5 %
2 .5 -5 %
5 - 7 .5 %
7 .5 -1 0 %
1 0 -1 5 %
> 15%
D is c o u n t o r P re m iu m o n N A V

180

ASimpleExplanationfortheClosedEndDiscount

Assumethatyouhaveaclosedendfundthatinvestsinaverageriskstocks.
Assumealsothatyouexpectthemarket(averageriskinvestments)tomake
11.5%annuallyoverthelongterm.Iftheclosedendfundunderperformsthe
marketby0.50%,estimatethediscountonthefund.

Aswath Damodaran

181

APremiumforMarketableSecurities:BerkshireHathaway

Aswath Damodaran

182

2.DealingwithHoldingsinOtherfirms

Holdingsinotherfirmscanbecategorizedinto

Aswath Damodaran

Minoritypassiveholdings,inwhichcaseonlythedividendfromtheholdingsis
showninthebalancesheet
Minorityactiveholdings,inwhichcasetheshareofequityincomeisshowninthe
incomestatements
Majorityactiveholdings,inwhichcasethefinancialstatementsareconsolidated.

183

AnExerciseinValuingCrossHoldings

AssumethatyouhavevaluedCompanyAusingconsolidatedfinancialsfor$1billion
(usingFCFFandcostofcapital)andthatthefirmhas$200millionindebt.Howmuch
istheequityinCompanyAworth?

NowassumethatyouaretoldthatCompanyAowns10%ofCompanyBandthatthe
holdingsareaccountedforaspassiveholdings.IfthemarketcapofcompanyBis$500
million,howmuchistheequityinCompanyAworth?

NowaddontheassumptionthatCompanyAowns60%ofCompanyCandthatthe
holdingsarefullyconsolidated.TheminorityinterestincompanyCisrecordedat$40
millioninCompanyAsbalancesheet.HowmuchistheequityinCompanyAworth?

Aswath Damodaran

184

MoreonCrossHoldingValuation

Buildingonthepreviousexample,assumethat

YouhavevaluedequityincompanyBat$250million(whichishalfthemarkets
estimateofvaluecurrently)
CompanyAisasteelcompanyandthatcompanyCisachemicalcompany.
Furthermore,assumethatyouhavevaluedtheequityincompanyCat$250
million.
EstimatethevalueofequityincompanyA.

Aswath Damodaran

185

Ifyoureallywanttovaluecrossholdingsright.

Step1:Valuetheparentcompanywithoutanycrossholdings.Thiswill
requireusingunconsolidatedfinancialstatementsratherthanconsolidated
ones.
Step2:Valueeachofthecrossholdingsindividually.(Ifyouusethemarket
valuesofthecrossholdings,youwillbuildinerrorsthemarketmakesin
valuingthemintoyourvaluation.
Step3:ThefinalvalueoftheequityintheparentcompanywithNcross
holdingswillbe:
Valueofunconsolidatedparentcompany
Debtofunconsolidatedparentcompany
+
j N

% owned of Company j * (Value of Company j - Debt of Company j)


j1

Aswath Damodaran

186

Ifyouhavetosettleforanapproximation,trythis

Formajorityholdings,withfullconsolidation,converttheminorityinterest
frombookvaluetomarketvaluebyapplyingapricetobookratio(basedupon
thesectoraverageforthesubsidiary)totheminorityinterest.

Estimatedmarketvalueofminorityinterest=Minorityinterestonbalancesheet*
PricetoBookratioforsector(ofsubsidiary)
Subtractthisfromtheestimatedvalueoftheconsolidatedfirmtogettovalueofthe
equityintheparentcompany.

Forminorityholdingsinothercompanies,convertthebookvalueofthese
holdings(whicharereportedonthebalancesheet)intomarketvalueby
multiplyingbythepricetobookratioofthesector(s).Addthisvalueontothe
valueoftheoperatingassetstoarriveattotalfirmvalue.

Aswath Damodaran

187

3.OtherAssetsthathavenotbeencountedyet..

Unutilizedassets:Ifyouhaveassetsorpropertythatarenotbeingutilizedtogenerate
cashflows(vacantland,forexample),youhavenotvaluedityet.Youcanassessa
marketvaluefortheseassetsandaddthemontothevalueofthefirm.
Overfundedpensionplans:Ifyouhaveadefinedbenefitplanandyourassetsexceed
yourexpectedliabilities,youcouldconsidertheoverfundingwithtwocaveats:

Collectivebargainingagreementsmaypreventyoufromlayingclaimtotheseexcessassets.
Therearetaxconsequences.Often,withdrawalsfrompensionplansgettaxedatmuchhigher
rates.

Donotdoublecountanasset.Ifanassetiscontributingtoyour
cashflows,youcannotcountthemarketvalueoftheassetinyour
value.

Aswath Damodaran

188

4.ADiscountforComplexity:
AnExperiment

OperatingIncome $1billion
Taxrate
40%
ROIC
10%
ExpectedGrowth 5%
Costofcapital
8%
BusinessMix
SingleBusiness
Holdings
Simple
Accounting
Transparent
Whichfirmwouldyouvaluemorehighly?

Aswath Damodaran

CompanyA CompanyB
$1billion
40%
10%
5%
8%
MultipleBusinesses
Complex
Opaque

189

MeasuringComplexity:VolumeofDatainFinancial
Statements

Company
General Electric
Microsoft
Wal-mart
Exxon Mobil
Pfizer
Citigroup
Intel
AIG
Johnson & Johnson
IBM

Aswath Damodaran

Number of pages in last 10Q


65
63
38
86
171
252
69
164
63
85

Number of pages in last 10K


410
218
244
332
460
1026
215
720
218
353

190

MeasuringComplexity:AComplexityScore

Aswath Damodaran

191

DealingwithComplexity
InDiscountedCashflowValuation
TheAggressiveAnalyst:Trustthefirmtotellthetruthandvaluethefirmbasedupon
thefirmsstatementsabouttheirvalue.
TheConservativeAnalyst:Dontvaluewhatyoucannotsee.
TheCompromise:Adjustthevalueforcomplexity

Adjustcashflowsforcomplexity
Adjustthediscountrateforcomplexity
Adjusttheexpectedgrowthrate/lengthofgrowthperiod
Valuethefirmandthendiscountvalueforcomplexity

Inrelativevaluation
Inarelativevaluation,youmaybeabletoassessthepricethatthemarketischargingforcomplexity:
Withthehundredlargestmarketcapfirms,forinstance:
PBV=0.65+15.31ROE0.55Beta+3.04Expectedgrowthrate0.003#Pagesin10K

Aswath Damodaran

192

5.Becircumspectaboutdefiningdebtforcostofcapital
purposes

GeneralRule:Debtgenerallyhasthefollowingcharacteristics:

Definedassuch,debtshouldinclude

Commitmenttomakefixedpaymentsinthefuture
Thefixedpaymentsaretaxdeductible
Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrolofthefirm
tothepartytowhompaymentsaredue.
Allinterestbearingliabilities,shorttermaswellaslongterm
Allleases,operatingaswellascapital

Debtshouldnotinclude

Aswath Damodaran

Accountspayableorsuppliercredit

193

BookValueorMarketValue
Youarevaluingadistressedtelecomcompanyandhavearrivedatanestimate
of$1billionfortheenterprisevalue(usingadiscountedcashflowvaluation).
Thecompanyhas$1billioninfacevalueofdebtoutstandingbutthedebtis
tradingat50%offacevalue(becauseofthedistress).Whatisthevalueofthe
equity?
Theequityisworthnothing(EVminusFaceValueofDebt)
Theequityisworth$500million(EVminusMarketValueofDebt)
Wouldyouranswerbedifferentifyouweretoldthattheliquidationvalueofthe
assetsofthefirmtodayis$1.2billionandthatyouwereplanningtoliquidate
thefirmtoday?

Aswath Damodaran

194

Butyoushouldconsiderotherpotentialliabilitieswhen
gettingtoequityvalue

Ifyouhaveunderfundedpensionfundorhealthcareplans,youshould
considertheunderfundingatthisstageingettingtothevalueofequity.

Ifyoudoso,youshouldnotdoublecountbyalsoincludingacashflowlineitem
reflectingcashyouwouldneedtosetasidetomeettheunfundedobligation.
Youshouldnotbecountingtheseitemsasdebtinyourcostofcapital
calculations.

Ifyouhavecontingentliabilitiesforexample,apotentialliabilityfroma
lawsuitthathasnotbeendecidedyoushouldconsidertheexpectedvalueof
thesecontingentliabilities

Aswath Damodaran

Valueofcontingentliability=Probabilitythattheliabilitywilloccur*Expected
valueofliability

195

6.EquityOptionsissuedbythefirm..

Anyoptionsissuedbyafirm,whethertomanagementoremployeesorto
investors(convertiblesandwarrants)createclaimsontheequityofthefirm.
Bycreatingclaimsontheequity,theycanaffectthevalueofequitypershare.
Failingtofullytakeintoaccountthisclaimontheequityinvaluationwill
resultinanoverstatementofthevalueofequitypershare.

Aswath Damodaran

196

Whydooptionsaffectequityvaluepershare?

Itistruethatoptionscanincreasethenumberofsharesoutstandingbut
dilutionperseisnottheproblem.
Optionsaffectequityvalueatexercisebecause

Sharesareissuedatbelowtheprevailingmarketprice.Optionsgetexercisedonly
whentheyareinthemoney.
Alternatively,thecompanycanusecashflowsthatwouldhavebeenavailableto
equityinvestorstobuybackshareswhicharethenusedtomeetoptionexercise.
Thelowercashflowsreduceequityvalue.

Optionsaffectequityvaluebeforeexercisebecausewehavetobuildinthe
expectationthatthereisaprobabilityandacosttoexercise.

Aswath Damodaran

197

Asimpleexample

XYZcompanyhas$100millioninfreecashflowstothefirm,growing3%a
yearinperpetuityandacostofcapitalof8%.Ithas100millionshares
outstandingand$1billionindebt.Itsvaluecanbewrittenasfollows:
Valueoffirm=100/(.08.03)
=2000
Debt
=1000
=Equity
=1000
Valuepershare
=1000/100=$10

Aswath Damodaran

198

Nowcometheoptions

XYZdecidestogive10millionoptionsatthemoney(withastrikepriceof
$10)toitsCEO.Whateffectwillthishaveonthevalueofequitypershare?
a) None.Theoptionsarenotinthemoney.
b) Decreaseby10%,sincethenumberofsharescouldincreaseby10million
c) Decreasebylessthan10%.Theoptionswillbringincashintothefirmbutthey
havetimevalue.

Aswath Damodaran

199

DealingwithEmployeeOptions:TheBludgeonApproach

Thesimplestwayofdealingwithoptionsistotrytoadjustthedenominator
forsharesthatwillbecomeoutstandingiftheoptionsgetexercised.
Intheexamplecited,thiswouldimplythefollowing:
Valueoffirm=100/(.08.03)
=2000
Debt
=1000
=Equity
=1000
Numberofdilutedshares =110
Valuepershare
=1000/110=$9.09

Aswath Damodaran

200

Problemwiththedilutedapproach

Thedilutedapproachfailstoconsiderthatexercisingoptionswillbringin
cashintothefirm.Consequently,theywilloverestimatetheimpactofoptions
andunderstatethevalueofequitypershare.
Thedegreetowhichtheapproachwillunderstatevaluewilldependuponhow
hightheexercisepriceisrelativetothemarketprice.
Incaseswheretheexercisepriceisafractionoftheprevailingmarketprice,
thedilutedapproachwillgiveyouareasonableestimateofvaluepershare.

Aswath Damodaran

201

TheTreasuryStockApproach

Thetreasurystockapproachaddstheproceedsfromtheexerciseofoptionsto
thevalueoftheequitybeforedividingbythedilutednumberofshares
outstanding.
Intheexamplecited,thiswouldimplythefollowing:
Valueoffirm=100/(.08.03)
=2000
Debt
=1000
=Equity
=1000
Numberofdilutedshares
=110
Proceedsfromoptionexercise
=10*10=100(Exerciseprice=10)
Valuepershare
=(1000+100)/110=$10

Aswath Damodaran

202

Problemswiththetreasurystockapproach

Thetreasurystockapproachfailstoconsiderthetimepremiumontheoptions.
Intheexampleused,weareassumingthatanatthemoneyoptionis
essentiallyworthnothing.
Thetreasurystockapproachalsohasproblemswithoutofthemoneyoptions.
Ifconsidered,theycanincreasethevalueofequitypershare.Ifignored,they
aretreatedasnonexistent.

Aswath Damodaran

203

Dealingwithoptionstherightway

Step1:Valuethefirm,usingdiscountedcashfloworothervaluationmodels.
Step2:Subtractoutthevalueoftheoutstandingdebttoarriveatthevalueof
equity.Alternatively,skipstep1andestimatetheofequitydirectly.
Step3:Subtractoutthemarketvalue(orestimatedmarketvalue)ofother
equityclaims:

ValueofWarrants=MarketPriceperWarrant*NumberofWarrants
:
Alternativelyestimatethevalueusingoptionpricingmodel
ValueofConversionOption=MarketValueofConvertibleBondsValueof
StraightDebtPortionofConvertibleBonds
ValueofemployeeOptions:Valueusingtheaverageexercisepriceandmaturity.

Step4:Dividetheremainingvalueofequitybythenumberofshares
outstandingtogetvaluepershare.

Aswath Damodaran

204

ValuingEquityOptionsissuedbyfirmsTheDilution
Problem

Optionpricingmodelscanbeusedtovalueemployeeoptionswithfour
caveats

Employeeoptionsarelongterm,makingtheassumptionsaboutconstantvariance
andconstantdividendyieldsmuchshakier,
Employeeoptionsresultinstockdilution,and
Employeeoptionsareoftenexercisedbeforeexpiration,makingitdangeroustouse
Europeanoptionpricingmodels.
Employeeoptionscannotbeexerciseduntiltheemployeeisvested.

Theseproblemscanbepartiallyalleviatedbyusinganoptionpricingmodel,
allowingforshiftsinvarianceandearlyexercise,andfactoringinthedilution
effect.Theresultingvaluecanbeadjustedfortheprobabilitythatthe
employeewillnotbevested.

Aswath Damodaran

205

BacktothenumbersInputsforOptionvaluation

StockPrice=$10
StrikePrice=$10
Maturity=10years
Standarddeviationinstockprice=40%
RisklessRate=4%

Aswath Damodaran

206

ValuingtheOptions

UsingadilutionadjustedBlackScholesmodel,wearriveatthefollowing
inputs:

N(d1)=0.8199
N(d2)=0.3624
Valuepercall=$9.58(0.8199)$10exp(0.04)(10)(0.3624)=$5.42

DilutionadjustedStockprice

Aswath Damodaran

207

ValueofEquitytoValueofEquitypershare

Usingthevaluepercallof$5.42,wecannowestimatethevalueofequityper
shareaftertheoptiongrant:
Valueoffirm=100/(.08.03)
Debt
=Equity
Valueofoptionsgranted
=ValueofEquityinstock =$945.8
/Numberofsharesoutstanding
=Valuepershare

Aswath Damodaran

=2000
=1000
=1000
=$54.2
/100
=$9.46

208

Totaxadjustornottotaxadjust

Intheexampleabove,wehaveassumedthattheoptionsdonotprovideany
taxadvantages.Totheextentthattheexerciseoftheoptionscreatestax
advantages,theactualcostoftheoptionswillbelowerbythetaxsavings.
Onesimpleadjustmentistomultiplythevalueoftheoptionsby(1taxrate)
togetanaftertaxoptioncost.

Aswath Damodaran

209

Optiongrantsinthefuture

Assumenowthatthisfirmintendstocontinuegrantingoptionseachyeartoits
topmanagementaspartofcompensation.Theseexpectedoptiongrantswill
alsoaffectvalue.
Thesimplestmechanismforbringinginfutureoptiongrantsintotheanalysis
istodothefollowing:

Aswath Damodaran

Estimatethevalueofoptionsgrantedeachyearoverthelastfewyearsasapercent
ofrevenues.
Forecastoutthevalueofoptiongrantsasapercentofrevenuesintofutureyears,
allowingforthefactthatasrevenuesgetlarger,optiongrantsasapercentof
revenueswillbecomesmaller.
Considerthislineitemaspartofoperatingexpenseseachyear.Thiswillreducethe
operatingmarginandcashfloweachyear.

210

Whenoptionsaffectequityvaluepersharethemost

Optiongrantsaffectvaluemore

Thelowerthestrikepriceissetrelativetothestockprice
Thelongerthetermtomaturityoftheoption
Themorevolatilethestockprice

Theeffectonvaluewillbemagnifiedifcompaniesareallowedtorevisit
optiongrantsandresettheexercisepriceifthestockpricemovesdown.

Aswath Damodaran

211

Valuations
AswathDamodaran

Aswath Damodaran

212

CompaniesValued
Company

ModelUsed

Keyemphasis

1.ConEd
2a.ABNAmro
2b.Goldman
2c.WellsFargo
2d.DeutscheBank
3.S&P500
4.Tsingtao
5.Toyota
6.TubeInvest.
7.KRKA
8.TataGroup
9.Amazon.com
10.Amgen
11.Sears
12.LVS

StableDDM
2StageDDM
3StageDDM
2stageDDM
2stageFCFE
2StageDDM
3StageFCFE
StableFCFF
2stageFCFF
2stageFCFF
2stageFCFF
nstageFCFF
3stageFCFF
2stageFCFF
2stageFCFF

Stablegrowthinputs;Impliedgrowth
Breakingdownvalue;Macrorisk?
Regulatoryoverlay?
Effectsofamarketmeltdown?
Estimatingcashflowsforabank
DividendsvsFCFE;Riskpremiums
HighGrowth&Changingfundamentals
NormalizedEarnings
Thecostofcorporategovernance
Multiplecountryrisk..
CrossHoldingmess
TheDarkSideofValuation
CapitalizingR&D
NegativeGrowth?
DealingwithDistress

Aswath Damodaran

213

RiskpremiumsinValuation

TheequityriskpremiumsthatIhaveusedinthevaluationsthatfollowreflect
mythinking(andhowithasevolved)ontheissue.

Aswath Damodaran

Pre1998valuations:Inthevaluationspriorto1998,Iuseariskpremiumof5.5%
formaturemarkets(closetoboththehistoricalandtheimpliedpremiumsthen)
Between1998andSept2008:Inthevaluationsbetween1998andSeptember2008,
Iusedariskpremiumof4%formaturemarkets,reflectingmybeliefthatrisk
premiumsinmaturemarketsdonotchangemuchandrevertbacktohistorical
norms(atleastforimpliedpremiums).
Valuationsdonein2009:Afterthe2008crisisandthejumpinequityrisk
premiumsto6.43%inJanuary2008,Ihaveusedahigherequityriskpremium(5
6%)forthenext5yearsandwillassumeareversionbacktohistoricalnorms(4%)
onlyafteryear5.
In2010&2011:In2010,Irevertedbacktoamaturemarketpremiumof4.5%,
reflectingthedropinequityriskpremiumsduring2009.In2011,Iplantouse5%,
reflectingagainthechangeinimpliedpremiumovertheyear.

214

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215

ConEd:BreakEvenGrowthRates

Aswath Damodaran

216

FollowinguponDCFvaluation

AssumethatyoubelievethatyourvaluationofConEd($42.30)isafair
estimateofthevalue,7.70%isareasonableestimateofConEdscostof
equityandthatyourexpecteddividendsfornextyear(2.32*1.021)isafair
estimate,whatistheexpectedstockpriceayearfromnow(assumingthatthe
marketcorrectsitsmistake?)

Ifyouboughtthestocktodayat$40.76,whatreturncanyouexpecttomake
overthenextyear(assumingagainthatthemarketcorrectsitsmistake)?

Aswath Damodaran

217

Aswath Damodaran

218

Aswath Damodaran

219

Aswath Damodaran

220

Aswath Damodaran

221

PresentValueMechanicswhendiscountratesare
changing
ConsiderthecostsofequityforGoldmanSachsoverthenext10
years.
Year
15
6
7
8
9
10on
Costofequity
10.4% 10.22% 10.04% 9.86% 9.68% 9.50%
Inestimatingtheterminalvalue,weusedthe9.50%costofequityin
stablegrowth,toarriveataterminalvalueof$476.86.Whatisthe
presentvalueofthisterminalvalue?

Intuitively,explainwhy.

Aswath Damodaran

222

TheValueofGrowth

P0 =

Inanyvaluationmodel,itispossibletoextracttheportionofthevaluethat
canbeattributedtogrowth,andtobreakthisdownfurtherintothatportion
attributabletohighgrowthandtheportionattributabletostablegrowth.
Inthecaseofthe2stageDDM,thiscanbeaccomplishedasfollows:
t=n

DPS t + Pn
(1+r)
t
(1+r)n
t=1

- DPS0 *(1+gn )
(r-gn )

DPS 0 *(1+gn ) - DPS0


r
(r-gn )

DPS0
r

ValueofHighGrowth
ValueofStableGrowth
Assetsin
Place
DPSt=Expecteddividendspershareinyeart
r=CostofEquity
Pn=Priceattheendofyearn
gn=Growthrateforeverafteryearn

Aswath Damodaran

223

ABNAmroandGoldmanSachs:DecomposingValue

Assets in
place
Stable
Growth
Growth
Assets
Total

Aswath Damodaran

ABN Amro (2003)

Proportio
n

Goldman (2008)

Proportions

0.90/.0835 =
$10.78

39.02%

1.40/.095 =
$14.74

6.62%

0.90*1.04/
(.0835-.04) =
$10.74

38.88%

1.40*1.04/(.095-.04) =
$11.74

5.27%

222.49-14.74-11.74 =
$196.02

88.10%

27.62-10.78-10.74 =
22.10%
$6.10
$27.62

$222.49

224

Aswath Damodaran

225

Aswath Damodaran

226

In2001,stockwas
tradingat10.10Yuan
pershare

WhyFCFE?CompanyhasnegativeFCFE
Why3stage?Highgrowth
Aswath Damodaran

227

DecomposingvalueatTsingtaoBreweries
BreakingdownthevaluetodayofTsingtaoBreweries,youarriveat
thefollowing:
PVofCashflowstoEquityoverfirst10years= 187million
PVofTerminalValueofEquity=
4783million
Valueofequitytoday=
4596million
Morethan100%ofthevalueofequitytodaycomesfromtheterminal
value.
a. Isthisareasonforconcern?

b.

Howwouldyouintuitivelyexplainwhatthismeansforanequity
investorinthefirm?

Aswath Damodaran

228

Aswath Damodaran

229

CircularReasoninginFCFFValuation

IndiscountingFCFF,weusethecostofcapital,whichiscalculatedusingthe
marketvaluesofequityanddebt.WethenusethepresentvalueoftheFCFF
asourvalueforthefirmandderiveanestimatedvalueforequity.(For
instance,intheToyptavaluation,weusedthecurrentmarketvalueofequity
of3200yen/sharetoarriveatthedebtratioof52.9%whichweusedinthe
costofcapital.However,weconcludedthatthevalueofToyotasequitywas
4735yen/share.Istherecircularreasoninghere?
Yes
No
Ifthereis,canyouthinkofawayaroundthisproblem?

Aswath Damodaran

230

Aswath Damodaran

231

StableGrowthRateandValue

InestimatingterminalvalueforTubeInvestments,Iusedastablegrowthrate
of5%.IfIuseda7%stablegrowthrateinstead,whatwouldmyterminal
valuebe?(Assumethatthecostofcapitalandreturnoncapitalremain
unchanged.)

Whatarethelessonsthatyoucandrawfromthisanalysisforthekey
determinantsofterminalvalue?

Aswath Damodaran

232

Aswath Damodaran

233

Aswath Damodaran

234

TubeInvestments:Shouldtherebeacorporategovernance
discount?

StockholdersinAsian,LatinAmericanandmanyEuropeancompanieshave
littleornopoweroverthemanagersofthefirm.Inmanycases,insidersown
votingsharesandcontrolthefirmandthepotentialforconflictofinterestsis
huge.Wouldyoudiscountthevaluethatyouestimatedtoallowforthis
absenceofstockholderpower?
Yes
No.

Aswath Damodaran

235

Aswath Damodaran

236

8.TheTataGroupApril2010

Aswath Damodaran

237

ComparingtheTataCompanies:CostofCapital

Tata Chemicals Tata Steel


% of production in India
90%
90%
% of revenues in India
75%
88.83%
Lambda
0.75
1.10

Beta
Lambda
Cost of equity
Synthetic rating
Cost of debt

Aswath Damodaran

Tata Chemicals Tata Steel


1.21
1.57
0.75
1.1
13.82%
17.02%

Tata Motors TCS


90% 92.00%
91.37% 7.62%
0.80
0.20

Tata Motors
1.2
0.8
14.00%

TCS
1.05
0.2
10.63%

BBB
6.60%

A
6.11%

B+
8.09%

AAA
5.61%

Debt Ratio

30.48%

29.59%

25.30%

0.03%

Cost of Capital

11.62%

13.79%

12.50%

10.62%

238

GrowthandValue
Tata Chemicals
Return on capital
Reinvestment Rate
Expected Growth

10.35%
56.50%
5.85%

Cost of capital

11.62%

Aswath Damodaran

Tata Steel Tata Motors


TCS
13.42%
11.81%
38.09%
70.00%
5.11%
8.27%
13.79%

12.50%

40.63%
56.73%
23.05%
10.62%

239

TataCompanies:ValueBreakdown

Aswath Damodaran

240

A LifeCycleViewof Valuation
Idea
Companies

Young
Growth

Mature Growth

Mature

Decline

Revenues
$ Revenues/
Earnings
Earnings

Time
Valuation
players/setting
Revenue/Earnings

Survival Issues

Owners
Angel financiers

Venture Capitalists
IPO

1. What is the
potential market?
2. Will this product
sell and at what
price?
3. What are the
expected margins?

Will the firm


make it?

Key valuatioin inputs Potential market


Margins
Capital Investment
Key person value?
Data Issues

Aswath Damodaran

No history
No financials

Growth investors
Equity analysts

Value investors
Private equity funds

1. Can the
company scale
up? (How will
revenue growth
change as firm
gets larger?)
2. How will
competition
affect margins?
Will the firm
being acquired?

1. As growth
declines, how will
the firms
reinvestment
policy change?
2. Will financing
policy change as
firm matures?

1. Is there the
possibility of the
firm being
restructured?

Revenue Growth
Target Margins

Return on capital
Reinvestment Rate
Length of growth

Low Revenues
Past data reflects
Negative earnings smaller company
Changing margins

Vulture investors
Break-up valuations
Low, as projects dry
up.

Will the firm be


taken private?

Will the firm be


liquidated/ go
bankrupt?

Current Earnings
Efficiency growth
Changing cost of
capital
Numbers can change
if management
changes

Asset divestrture
Liquidation
values
Declining revenues
Negative earnings?

241

Aswath Damodaran

242

Thedarksideofvaluation...

Whenvaluingcompanies,wedrawonthreesourcesofinformation:

Thefirmscurrentfinancialstatement

Thefirmscurrentfinancialstatement
Howmuchdidthefirmsell?
Howmuchdiditearn?
Thefirmsfinancialhistory,usuallysummarizedinitsfinancialstatements.
Howfasthavethefirmsrevenuesandearningsgrownovertime?Whatcanwelearn
aboutcoststructureandprofitabilityfromthesetrends?
Susceptibilitytomacroeconomicfactors(recessionsandcyclicalfirms)
Theindustryandcomparablefirmdata
Whathappenstofirmsastheymature?(Margins..RevenuegrowthReinvestment
needsRisk)

Valuationismostdifficultwhenacompany

Aswath Damodaran

Hasnegativeearningsandlowrevenuesinitscurrentfinancialstatements
Nohistory
Nocomparables(oreveniftheyexist,theyareallatthesamestageofthelifecycleasthefirm
beingvalued)

243

Aswath Damodaran

244

Whatdoyouneedtobreakevenat$84?

Aswath Damodaran

245

Aswath Damodaran

246

Amazonovertime
A m a z o n : V a lu e a n d P r ic e

$ 9 0 .0 0

$ 8 0 .0 0

$ 7 0 .0 0

$ 6 0 .0 0

$ 5 0 .0 0
V a lu e p e r s h a r e
P r ic e p e r s h a r e

$ 4 0 .0 0

$ 3 0 .0 0

$ 2 0 .0 0

$ 1 0 .0 0

$ 0 .0 0
2000

2001

2002

2003

T im e o f a n a ly s is

Aswath Damodaran

247

Aswath Damodaran

248

Amgen:TheR&DEffect?

Aswath Damodaran

249

Uncertaintyisendemictovaluation.
Assumethatyouhavevaluedyourfirm,usingadiscountedcashflowmodelandwiththeall
theinformationthatyouhaveavailabletoyouatthetime.Whichofthefollowing
statementsaboutthevaluationwouldyouagreewith?
IfIknowwhatIamdoing,theDCFvaluationwillbeprecise
NomatterhowcarefulIam,theDCFvaluationgivesmeanestimate
Ifyousubscribetothelatterstatement,howwouldyoudealwiththeuncertainty?
Collectmoreinformation,sincethatwillmakemyvaluationmoreprecise
Makemymodelmoredetailed
Dowhatifanalysisonthevaluation
Useasimulationtoarriveatadistributionofvalue
Willnotbuythecompany

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Option1:Collectmoreinformation

Therearetwotypesoferrorsinvaluation.Thefirstisestimationerrorandthe
secondisuncertaintyerror.Theformerisamenabletoinformationcollection
butthelatterisnot.
Waysofincreasinginformationinvaluation

Collectmorehistoricaldata(withthecaveatthatfirmschangeovertime)
Lookatcrosssectionaldata(hopingtheindustryaveragesconveyinformationthat
theindividualfirmsfinancialdonot)
Trytoconvertqualitativeinformationintoquantitativeinputs

Proposition1:Moreinformationdoesnotalwaysleadtomorepreciseinputs,
sincethenewinformationcancontradictoldinformation.
Proposition2:Thehumanmindisincapableofhandlingtoomuchdivergent
information.Informationoverloadcanleadtovaluationtrauma.

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Option2:Buildbiggermodels

Whenvaluationsareimprecise,thetemptationoftenistobuildmoredetailintomodels,
hopingthatthedetailtranslatesintomoreprecisevaluations.Thedetailcanvaryand
includes:
Morelineitemsforrevenues,expensesandreinvestment
Breakingtimeseriesdataintosmallerormorepreciseintervals(Monthlycash
flows,midyearconventionsetc.)
Morecomplexmodelscanprovidetheillusionofmoreprecision.
Proposition1:Thereisnopointtobreakingdownitemsintodetail,ifyoudonothave
theinformationtosupplythedetail.
Proposition2:Yourcapacitytosupplythedetailwilldecreasewithforecastperiod
(almostimpossibleafteracoupleofyears)andincreasewiththematurityofthefirm(it
isverydifficulttoforecastdetailwhenyouarevaluingayoungfirm)
Proposition3:Lessisoftenmore

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Option3:BuildWhatifanalyses

Avaluationisafunctionoftheinputsyoufeedintothevaluation.Tothe
degreethatyouarepessimisticoroptimisticonanyoftheinputs,your
valuationwillreflectit.
Therearethreewaysinwhichyoucandowhatifanalyses

Bestcase,Worstcaseanalyses,whereyousetalltheinputsattheirmostoptimistic
andmostpessimisticlevels
Plausiblescenarios:Here,youdefinewhatyoufeelarethemostplausiblescenarios
(allowingfortheinteractionacrossvariables)andvaluethecompanyunderthese
scenarios
Sensitivitytospecificinputs:Changespecificandkeyinputstoseetheeffecton
value,orlookattheimpactofalargeevent(FDAapprovalforadrugcompany,
lossinalawsuitforatobaccocompany)onvalue.
Proposition1:Asageneralrule,whatifanalyseswillyieldlargerangesforvalue,

withtheactualpricesomewherewithintherange.

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Option 4: Simulation
The Inputs for Amgen
Correlation=0.4

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TheSimulatedValuesofAmgen:
WhatdoIdowiththisoutput?

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DealingwithDistress

ADCFvaluationvaluesafirmasagoingconcern.Ifthereisasignificantlikelihoodofthefirm
failingbeforeitreachesstablegrowthandiftheassetswillthenbesoldforavaluelessthanthe
presentvalueoftheexpectedcashflows(adistresssalevalue),DCFvaluationswillunderstatethe
valueofthefirm.
ValueofEquity=DCFvalueofequity(1Probabilityofdistress)+Distresssalevalueofequity
(Probabilityofdistress)
Therearethreewaysinwhichwecanestimatetheprobabilityofdistress:

Usethebondratingtoestimatethecumulativeprobabilityofdistressover10years
Estimatetheprobabilityofdistresswithaprobit
Estimatetheprobabilityofdistressbylookingatmarketvalueofbonds..

Thedistresssalevalueofequityisusuallybestestimatedasapercentofbookvalue(andthisvalue
willbeloweriftheeconomyisdoingbadlyandthereareotherfirmsinthesamebusinessalsoin
distress).

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AdjustingthevalueofLVSfordistress..

InFebruary2009,LVSwasratedB+byS&P.Historically,28.25%ofB+rated
bondsdefaultwithin10years.LVShasa6.375%bond,maturinginFebruary2015
(7years),tradingat$529.Ifwediscounttheexpectedcashflowsonthebondatthe
riskfreerate,wecanbackouttheprobabilityofdistressfromthebondprice:
t 7

63.75(1 Distress ) t 1000(1 Distress )7


529

Solvingfortheprobabilityofbankruptcy,weget:
t
7
(1.03)
(1.03)
t 1
Distress=Annualprobabilityofdefault=13.54%

IfLVSisbecomesdistressed:

Cumulativeprobabilityofsurviving10years=(1.1354) 10=23.34%
Cumulativeprobabilityofdistressover10years=1.2334=.7666or76.66%
Expecteddistresssaleproceeds=$2,769million<Facevalueofdebt
Expectedequityvalue/share=$0.00

Expectedvaluepershare=$8.12(1.7666)+$0.00(.7666)=$1.92

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Anothertypeoftruncationrisk?

AssumethatyouarevaluingGazprom,theRussianoilcompanyand
haveestimatedavalueofUS$180billionfortheoperatingassets.The
firmhas$30billionindebtoutstanding.Whatisthevalueofequityin
thefirm?

Nowassumethatthefirmhas15billionsharesoutstanding.Estimate
thevalueofequitypershare.

TheRussiangovernmentowns42%oftheoutstandingshares.Would
thatchangeyourestimateofvalueofequitypershare?

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