Picking the Right Investments: Investment Analysis

Aswath Damodaran

Aswath Damodaran


First Principles
Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
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Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon the stockholders‟ characteristics.

Aswath Damodaran

What is a investment or a project?
Any decision that requires the use of resources (financial or otherwise) is a project. Broad strategic decisions
• Entering new areas of business • Entering new markets • Acquiring other companies
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Tactical decisions Management decisions
• The product mix to carry • The level of inventory and credit terms

Decisions on delivering a needed service
• Lease or buy a distribution system • Creating and delivering a management information system

Aswath Damodaran


The notion of a benchmark
Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable. This hurdle will be higher for riskier projects than for safer projects. A simple representation of the hurdle rate is as follows: Hurdle rate = Riskless Rate + Risk Premium The two basic questions that every risk and return model in finance tries to answer are:
• How do you measure risk? • How do you translate this risk measure into a risk premium?

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Aswath Damodaran


Aswath Damodaran 5 . for instance. reproduced below. give a much better description of risk   The first symbol is the symbol for “danger”. is viewed as a „negative‟. defines risk as “exposing to danger or hazard”.What is Risk? Risk. Webster‟s dictionary. making risk a mix of danger and opportunity. in traditional terms. while the second is the symbol for “opportunity”. The Chinese symbols for risk.

Measures the non-diversifiable risk with beta. Translates beta into expected return Expected Return = Riskfree rate + Beta * Risk Premium Works as well as the next best alternative in most cases. which is standardized around one.The Capital Asset Pricing Model Uses variance as a measure of risk Specifies that a portion of variance can be diversified away. and that is only the non-diversifiable portion that is rewarded.      Aswath Damodaran 6 .

The Mean-Variance Framework The variance on any investment measures the disparity between actual and expected returns. Low Variance Investment  High Variance Investment Expected Return Aswath Damodaran 7 .

Some of the risk is specific to the firm. The risk faced by a firm can be fall into the following categories – • (1) Project-specific. which reflects the effect on earnings and cash flows of macro economic factors that essentially affect all companies Aswath Damodaran 8   . whereas the rest of the risk is market wide and affects all investments. an individual project may have higher or lower cash flows than expected. • (2) Competitive Risk. • (4) International Risk. and is called firm-specific.The Importance of Diversification: Risk Types The risk (variance) on any individual investment can be broken down into two sources. arising from having some cash flows in currencies other than the one in which the earnings are measured and stock is priced • (5) Market risk. which is that the earnings and cash flows on a project can be affected by the actions of competitors. which covers factors that primarily impact the earnings and cash flows of a specific industry. • (3) Industry-specific Risk.

these effects will average out to zero. Market-wide risk cannot. by being diversified). (For every firm. it is argued. where something bad happens. where something good happens. there will be some other firm. muting the effect (positive or negative) on the overall portfolio.)   Aswath Damodaran 9 . • (b) Firm-specific actions can be either positive or negative.The Effects of Diversification Firm-specific risk can be reduced. This can be justified on either economic or statistical grounds. if not eliminated.e.. In a large portfolio. On economic grounds. by increasing the number of investments in your portfolio (i. diversifying and holding a larger portfolio eliminates firm-specific risk for two reasons• (a) Each investment is a much smaller percentage of the portfolio.

Aswath Damodaran 10 . the largest investor may not be the marginal investor. Since trading is required. we assume that the marginal investor is well diversified.The Role of the Marginal Investor    The marginal investor in a firm is the investor who is most likely to be the buyer or seller on the next trade. especially if he or she is a founder/manager of the firm (Michael Dell at Dell Computers or Bill Gates at Microsoft) In all risk and return models in finance.

and that all assets can be traded. A little more risk 25% in T-Bills.  Aswath Damodaran 11 . the limit of diversification is to hold a portfolio of every single asset in the economy (in proportion to market value). 75% in Market Portfolio Even more risk 100% in Market Portfolio A risk hog. by adjusting their allocations to this market portfolio and a riskless asset (such as a T-Bill) Preferred risk level Allocation decision No risk 100% in T-Bills Some risk 50% in T-Bills.  Every investor holds some combination of the risk free asset and the market portfolio. Borrow money.  Individual investors will adjust for risk. Invest in market portfolio. This portfolio is called the market portfolio.. 50% in Market Portfolio.The Market Portfolio Assuming diversification costs nothing (in terms of transactions costs).

which is defined to be the asset's beta. Rf = Riskfree rate E(Rm) = Expected Return on the Market Index      Aswath Damodaran 12 . this risk can be measured by how much an asset moves with the market (called the covariance) Beta is a standardized measure of this covariance Beta is a measure of the non-diversifiable risk for any asset can be measured by the covariance of its returns with returns on a market index. Cost of Equity = Rf + Equity Beta * (E(Rm) .Rf) where. The cost of equity will be the required return.The Risk of an Individual Asset The risk of any asset is the risk that it adds to the market portfolio Statistically.

Aswath Damodaran 13 .The reality is that – the relationship between betas and returns is weak – Other variables (size.Limitations of the CAPM 1. The parameters of the model cannot be estimated precisely • .If the model is right. price/book value) seem to explain differences in returns better. there should be – a linear relationship between returns and betas – the only variable that should explain returns is betas • . The model does not work well • .Definition of a market index • .Firm may have changed during the 'estimation' period'    3. The model makes unrealistic assumptions 2.

differences in returns across long periods must be due to market risk differences.Alternatives to the CAPM Step 1: Defining Risk The risk in an investment can be measured by the variance in actual returns around an expected return Riskless Investment Low Risk Investment High Risk Investment E(R) E(R) E(R) Step 2: Differentiating between Rewarded and Unrewarded Risk Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk) Can be diversified away in a diversified portfolio Cannot be diversified away since most assets 1. 2. Step 3: Measuring Market Risk The CAPM If there is 1. Thus. Market Risk = Risk exposures of any asset to macro economic factors. Market Risk = Risk exposures of any asset to market factors Multi-Factor Models Since market risk affects most or all investments. it must come from macro economic factors. no private information 2. Market Risk = Captured by the Proxy Variable(s) Equation relating returns to proxy variables (from a regression) Beta of asset relative to Market portfolio (from a regression) Betas of asset relative to unspecified market factors (from a factor analysis) Betas of assets relative to specified macro economic factors (from a regression) Aswath Damodaran 14 . only market risk will be rewarded and priced. no transactions cost the optimal diversified portfolio includes every traded asset. each investment is a small proportion of portfolio are affected by it. risk averages out across investments in portfolio The marginal investor is assumed to hold a “diversified” portfolio. Proxy Models In an efficient market. Everyone will hold this market portfolio Market Risk = Risk added by any investment to the market portfolio: The APM If there are no arbitrage opportunities then the market risk of any asset must be captured by betas relative to factors that affect all investments. Looking for variables correlated with returns should then give us proxies for this risk.

6Application Test: Who is the marginal investor in your firm?  Looking at the top 15 stockholders in your firm again. consider whether the marginal investor is An institutional investor  An individual investor  The manager(s) of the firm  Aswath Damodaran 15 .

Aswath Damodaran 16 .Inputs required to use the CAPM (a) the current risk-free rate (b) the expected market risk premium (the premium expected for investing in risky assets over the riskless asset) (c) the beta of the asset being analyzed.

there is no variance around the expected return. i. however. Note. • There can be no uncertainty about reinvestment rates. Therefore.e. which generally implies that the security has to be issued by the government. which implies that it is a zero coupon security with the same maturity as the cash flow being analyzed. two conditions have to be met – • There has to be no default risk. to have an actual return be equal to the expected return. For an investment to be riskfree.    Aswath Damodaran 17 .The Riskfree Rate and Time Horizon On a riskfree asset.. the actual return is equal to the expected return. that not all governments can be viewed as default free.

the present value effect of using time varying riskfree rates is small enough that it may not be worth it.the 1 year zero coupon rate for the cash flow in year 2.. if there is substantial uncertainty about expected cash flows. Theoretically. this translates into using different riskfree rates for each cash flow .Riskfree Rate in Practice The riskfree rate is the rate on a zero coupon government bond matching the time horizon of the cash flow being analyzed.    Aswath Damodaran 18 .. Practically speaking. the 2-year zero coupon rate for the cash flow in year 2 .

it is entirely appropriate to use a short term government security rate as the riskfree rate. For short term analysis. if one exists • set equal.The Bottom Line on Riskfree Rates Using a long term government rate (even on a coupon bond) as the riskfree rate on all of the cash flows in a long term analysis will yield a close approximation of the true value. approximately. If the analysis is being done in real terms (rather than nominal terms) use a real riskfree rate.    Aswath Damodaran 19 . to the long term real growth rate of the economy in which the valuation is being done. which can be obtained in one of two ways – • from an inflation-indexed government bond.

relative to the riskfree rate. As a general proposition.Measurement of the risk premium The risk premium is the premium that investors demand for investing in an average risk investment. this premium should be • greater than zero • increase with the risk aversion of the investors in that market • increase with the riskiness of the “average” risk investment   Aswath Damodaran 20 .

7 .7%  More than .7% Aswath Damodaran 21 . on which you can make 6. on which the returns are uncertain  How much of an expected return would you demand to shift your money from the riskless asset to the mutual fund?  Less than 6.7%  Between 6.7 .7%  Between 12.What is your risk premium? Assume that stocks are the only risky assets and that you are offered two investment options: • a riskless investment (say a Government Security).8%  Between 8.7 .7% • a mutual fund of all stocks.10.14.7%  Between 10.

i.Estimating Risk Premiums in Practice Survey investors on their desired risk premiums and use the average premium from these surveys.. Assume that the actual premium delivered over long time periods is equal to the expected premium .e. use historical data Estimate the implied premium in today‟s asset prices.    Aswath Damodaran 22 .

The Survey Approach Surveying all investors in a market place is impractical. you can survey a few investors (especially the larger investors) and use these results. However. even the longest surveys do not go beyond one year    Aswath Damodaran 23 . this translates into surveys of money managers‟ expectations of expected returns on stocks over the next year. In practice. The limitations of this approach are: • there are no constraints on reasonability (the survey could produce negative risk premiums or risk premiums of 50%) • they are extremely volatile • they tend to be short term.

(The risk aversion may change from year to year. but it reverts back to historical averages) • it assumes that the riskiness of the “risky” portfolio (stock index) has not changed in a systematic way across time.The Historical Premium Approach This is the default approach used by most to arrive at the premium to use in the model In most cases. Aswath Damodaran 24 ..) • it calculates average returns on a stock index during the period • it calculates average returns on a riskless security over the period • it calculates the difference between the two • and uses it as a premium looking forward    The limitations of this approach are: • it assumes that the risk aversion of investors has not changed in a systematic way across time. 1962-Present.. this approach does the following • it defines a time period for the estimation (1926-Present..

07% 6.Historical Average Premiums for the United States Historical period Stocks .Bonds Arith Geom 7.T.08% 14.96% 5.T.14% 1962-1999 7.Bills Arith Geom 1926-1999 9.60% 5.64% 6.46% 1981-1999 13.74% 16.62% Stocks .17% Aswath Damodaran 25 .41% 8.24% 11.

Bond 525 600 750 150 200 850 750 525 200 750 Aswath Damodaran 26 .Assessing Country Risk Using Currency Ratings: Latin America .June 1999 Country Argentina Bolivia Brazil Chile Colombia Ecuador Paraguay Peru Uruguay Venezuela Rating Ba3 B1 B2 Baa1 Baa3 B3 B2 Ba3 Baa3 B2 Default Spread over US T.

the risk premium for Argentina would be: Risk Premium = U. Thus.Using Country Ratings to Estimate Equity Spreads   The simplest way of estimating a country risk premium for another country is to add the default spread for that country to the US risk premium (treating the US premium as the premium for a mature equity market).25% Country ratings measure default risk. premium + 5. one would expect equity spreads to be higher than debt spreads. Aswath Damodaran 27 . While default risk premiums and equity risk premiums are highly correlated.S.

if stock prices are determined by the simple Gordon Growth Model: • Value = Expected Dividends next year/ (Required Returns on Stocks Expected Growth Rate) • Plugging in the current level of the index. we can estimate the implied risk premium from the current level of stock prices. Subtracting out the riskfree rate will yield the implied premium.    The problems with this approach are: • the discounted cash flow model used to value the stock index has to be the right one. For instance. the dividends on the index and expected growth rate will yield a “implied” expected return on stocks.Implied Equity Premiums If we use a basic discounted cash flow model. • the inputs on dividends and expected growth have to be correct • it implicitly assumes that the market is currently correctly valued Aswath Damodaran 28 .

Estimating Beta The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) Rj = a + b Rm • where a is the intercept and b is the slope of the regression. and measures the riskiness of the stock. Aswath Damodaran 29 .   The slope of the regression corresponds to the beta of the stock.

Operating Leverage: Firms with greater fixed costs (as a proportion of total costs) will have higher betas than firms will lower fixed costs (as a proportion of total costs) Financial Leverage: Firms that borrow more (higher debt.Fundamental Determinants of Betas    Type of Business: Firms in more cyclical businesses or that sell products that are more discretionary to their customers will have higher betas than firms that are in non-cyclical businesses or sell products that are necessities or staples. Aswath Damodaran 30 . relative to equity) will have higher equity betas than firms that borrow less.

• Cyclical companies have higher betas than non-cyclical firms • Firms which sell more discretionary products will have higher betas than firms that sell less discretionary products  Aswath Damodaran 31 .Determinant 1: Product Type Industry Effects: The beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market.

What kind of beta do you think this investment will have?  Much higher than one  Close to one  Much lower than one Aswath Damodaran 32 .A Simple Test Consider an investment in Tiffany‟s.

Determinant 2: Operating Leverage Effects Operating leverage refers to the proportion of the total costs of the firm that are fixed. Other things remaining equal. higher operating leverage results in greater earnings variability which in turn results in higher betas.   Aswath Damodaran 33 .

The higher this number. The higher the proportion. the greater the operating leverage.Measures of Operating Leverage Fixed Costs Measure = Fixed Costs / Variable Costs  This measures the relationship between fixed and variable costs. Aswath Damodaran 34 . the higher the operating leverage. EBIT Variability Measure = % Change in EBIT / % Change in Revenues  This measures how quickly the earnings before interest and taxes changes as revenue changes.

Determinant 3: Financial Leverage As firms borrow. they create fixed costs (interest payments) that make their earnings to equity investors more volatile. This increased earnings volatility which increases the equity beta   Aswath Damodaran 35 .

Equity Betas and Leverage The beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio L = u (1+ ((1-t)D/E) where  L = Levered or Equity Beta u = Unlevered Beta t = Corporate marginal tax rate D = Market Value of Debt E = Market Value of Equity  The unlevered beta measures the riskiness of the business that a firm is in and is often called an asset beta. Aswath Damodaran 36 .

00% 11.37 0.03 Aswath Damodaran 37 .33% 400.06 0.30 2.10 1.00% 42.00% 50.00% Beta 0.00% 233.16 3.84 1.00 0.00% 10.23 1.56 0.00% 900.92 1.00% 60.86% 66.00% 150.86 0.70 2.67% 100.10 5.24 0.00 1.00% 80.42 1.00% 20.00% 30.24 5.11% 25.00% 70.00% Debt/Equity Ratio 0.00% 40.89 Effect of Leverage 0.14 0.00% 90.Boeing : Beta and Leverage Debt to Capital 0.

Betas are weighted Averages The beta of a portfolio is always the market-value weighted average of the betas of the individual investments in that portfolio. Thus. • the beta of a mutual fund is the weighted average of the betas of the stocks and other investment in that portfolio • the beta of a firm after a merger is the market-value weighted average of the betas of the companies involved in the merger.   Aswath Damodaran 38 .

There are two ways in which betas can be estimated for non-traded assets • using comparable firms • using accounting earnings   Aswath Damodaran 39 .Estimating Betas for Non-Traded Assets The conventional approaches of estimating betas from regressions do not work for assets that are not traded.

Aswath Damodaran 40 .   As a consequence. debt should include • Any interest-bearing liability. whether short term or long term.What is debt? General Rule: Debt generally has the following characteristics: • Commitment to make fixed payments in the future • The fixed payments are tax deductible • Failure to make the payments can lead to either default or loss of control of the firm to the party to whom payments are due. whether operating or capital. • Any lease obligation.

• and it has recently borrowed long term from a bank. straight (no special features) bond can be used as the interest rate. and the bonds are traded.Estimating the Cost of Debt If the firm has bonds outstanding. Aswath Damodaran 41 . If the firm is rated. and use the synthetic rating to arrive at a default spread and a cost of debt     The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation. use the interest rate on the borrowing or • estimate a synthetic rating for the company. the yield to maturity on a long-term. use the rating and a typical default spread on bonds with that rating to estimate the cost of debt. If the firm is not rated.

Estimating Synthetic Ratings The rating for a firm can be estimated using the financial characteristics of the firm. the rating can be estimated from the interest coverage ratio Interest Coverage Ratio = EBIT / Interest Expenses Consider InfoSoft.   Aswath Damodaran 42 . a firm with EBIT of $2000 million and interest expenses of $ 315 million Interest Coverage Ratio = 2. we would estimate a rating of A for the firm. In its simplest form.000/315= 6.15 • Based upon the relationship between interest coverage ratios and ratings.

50% 0.25% 1.5 9.Interest Coverage Ratios.00 1.50 1.00% 6.20% 0.50 – 2.00% 7.65 Aswath Damodaran Rating AAA AA A+ A ABBB BB B+ B BCCC CC C D Default Spread 0.50 2.12.50 6.00% 2.25 0.50% 10.00% 1.80% 1.80 < 0.00 – 7.00 2.00 – 3.50 – 0.00% 43 .50 – 3.25% 4.50 7. Ratings and Default Spreads Interest Coverage Ratio > 12.50% 2.50 – 4.50 – 9.50% 3.00 3.50 .50 3.25 – 1.50 4.2.50 – 6.25% 5.50 0.00 .80 – 1.

Costs of Debt for Boeing.00% 6. Aswath Damodaran 44 .58% Home Depot A+ Actual 0. the Home Depot and InfoSoft Boeing AA Actual 0.48% Bond Rating Rating is Default Spread over treasury Market Interest Rate Marginal tax rate Cost of Debt The treasury bond rate is 5%.50% 35% 3.77% InfoSoft A Synthetic 1.50% 5.00% 42% 3.80% 35% 3.80% 5.

Estimating Market Value Weights Market Value of Equity should include the following • Market Value of Shares outstanding • Market Value of Warrants outstanding • Market Value of Conversion Option in Convertible Bonds   Market Value of Debt is more difficult to estimate because few firms have only publicly traded debt. There are two solutions: • Assume book value of debt is equal to market value • Estimate the market value of debt from the book value Aswath Damodaran 45 .

There was wide variation in the market risk premium used. 70% of firms used 10-year treasuries or longer as the riskless rate. 15% used book value weights and 19% were uncertain about what weights they used. 4% used a modified capital asset pricing model and 15% were uncertain about how they estimated the cost of equtiy. 59% used market value weights for debt and equity in the cost of capital. while 30% estimated it themselves. 7% used 3 to 5-year treasuries and 4% used the treasury bill rate.Current Practices: Costs of Capital Cost of capital item Cost of Equity  Current Practices 81% of firms used the capital asset pricing model to estimate the cost of equity. with 37% using a premium between 5 and 6%. while 37% used the current average borrowing rate and the effective tax rate. 52% of firms used a marginal borrowing rate and a marginal tax rate. 52% used a published source for a beta estimate.    Cost of Debt Weights for Debt and Equity   Aswath Damodaran 46 .

• The form of returns .    Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. they should also consider both positive and negative side effects of these projects. • The hurdle rate should be higher for riskier projects and reflect the financing mix used . return the cash to stockholders. 47 Aswath Damodaran .will depend upon the stockholders‟ characteristics.owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows.Back to First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. If there are not enough investments that earn the hurdle rate.dividends and stock buybacks .

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