Picking the Right Investments:

Investment Analysis
Aswath Damodaran

Aswath Damodaran 1
 First Principles

n 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.
n Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
n 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.

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 What is a investment or a project?

n Any decision that requires the use of resources (financial or otherwise)

is a project.
n Broad strategic decisions
• Entering new areas of business
• Entering new markets
• Acquiring other companies
n Tactical decisions
n Management decisions
• The product mix to carry
• The level of inventory and credit terms
n Decisions on delivering a needed service
• Lease or buy a distribution system
• Creating and delivering a management information system

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 The notion of a benchmark

n Since financial resources are finite, there is a hurdle that projects have
to cross before being deemed acceptable.
n This hurdle will be higher for riskier projects than for safer projects.
n A simple representation of the hurdle rate is as follows:
Hurdle rate = Riskless Rate + Risk Premium
n 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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 What is Risk?

n Risk, in traditional terms, is viewed as a ‘negative’. Webster’s

dictionary, for instance, defines risk as “exposing to danger or hazard”.
The Chinese symbols for risk, reproduced below, give a much better
description of risk

n The first symbol is the symbol for “danger”, while the second is the
symbol for “opportunity”, making risk a mix of danger and
opportunity.

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 The Capital Asset Pricing Model

n Uses variance as a measure of risk

n Specifies that a portion of variance can be diversified away, and that is
only the non-diversifiable portion that is rewarded.
n Measures the non-diversifiable risk with beta, which is standardized
around one.
n Translates beta into expected return -
Expected Return = Riskfree rate + Beta * Risk Premium
n Works as well as the next best alternative in most cases.

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 The Mean-Variance Framework

n The variance on any investment measures the disparity between actual

and expected returns. Low Variance Investment

High Variance Investment

Expected Return

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 The Importance of Diversification: Risk Types

n The risk (variance) on any individual investment can be broken down

into two sources. Some of the risk is specific to the firm, and is called
firm-specific, whereas the rest of the risk is market wide and affects all
investments.
n The risk faced by a firm can be fall into the following categories –
• (1) Project-specific; an individual project may have higher or lower cash
flows than expected.
• (2) Competitive Risk, which is that the earnings and cash flows on a
project can be affected by the actions of competitors.
• (3) Industry-specific Risk, which covers factors that primarily impact the
earnings and cash flows of a specific industry.
• (4) International Risk, 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 reflects the effect on earnings and cash flows of
macro economic factors that essentially affect all companies
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 The Effects of Diversification

n Firm-specific risk can be reduced, if not eliminated, by increasing the

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

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 The Role of the Marginal Investor

n The marginal investor in a firm is the investor who is most likely to be

the buyer or seller on the next trade.
n Since trading is required, the largest investor may not be the marginal
investor, especially if he or she is a founder/manager of the firm
(Michael Dell at Dell Computers or Bill Gates at Microsoft)
n In all risk and return models in finance, we assume that the marginal
investor is well diversified.

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 The Market Portfolio

n Assuming diversification costs nothing (in terms of transactions costs),

and that all assets can be traded, the limit of diversification is to hold a
portfolio of every single asset in the economy (in proportion to market
value). This portfolio is called the market portfolio.
n Individual investors will adjust for risk, 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; 50% in Market Portfolio;
A little more risk 25% in T-Bills; 75% in Market Portfolio
Even more risk 100% in Market Portfolio
A risk hog.. Borrow money; Invest in market portfolio;
n Every investor holds some combination of the risk free asset and the
market portfolio.
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 The Risk of an Individual Asset

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

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 Limitations of the CAPM

n 1. The model makes unrealistic assumptions

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

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 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. each investment is a small proportion of portfolio are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will
be rewarded and priced.
Step 3: Measuring Market Risk
The CAPM The APM Multi-Factor Models Proxy Models
If there is If there are no Since market risk affects In an efficient market,
1. no private information arbitrage opportunities most or all investments, differences in returns
2. no transactions cost then the market risk of it must come from across long periods must
the optimal diversified any asset must be macro economic factors. be due to market risk
portfolio includes every captured by betas Market Risk = Risk differences. Looking for
traded asset. Everyone relative to factors that exposures of any variables correlated with
will hold this market portfolio affect all investments. asset to macro returns should then give
Market Risk = Risk Market Risk = Risk economic factors. us proxies for this risk.
added by any investment exposures of any Market Risk =
to the market portfolio: asset to market Captured by the
factors Proxy Variable(s)
Beta of asset relative to Betas of asset relative Betas of assets relative Equation relating
Market portfolio (from to unspecified market to specified macro returns to proxy
a regression) factors (from a factor economic factors (from variables (from a
analysis) a regression) regression)

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 6Application Test: Who is the marginal investor
in your firm?

n Looking at the top 15 stockholders in your firm again, consider

whether the marginal investor is
o An institutional investor
o An individual investor
o The manager(s) of the firm

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 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.

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 The Riskfree Rate and Time Horizon

n On a riskfree asset, the actual return is equal to the expected return.

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

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 Riskfree Rate in Practice

n The riskfree rate is the rate on a zero coupon government bond

matching the time horizon of the cash flow being analyzed.
n Theoretically, this translates into using different riskfree rates for each
cash flow - the 1 year zero coupon rate for the cash flow in year 2, the
2-year zero coupon rate for the cash flow in year 2 ...
n Practically speaking, if there is substantial uncertainty about expected
cash flows, the present value effect of using time varying riskfree rates
is small enough that it may not be worth it.

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 The Bottom Line on Riskfree Rates

n 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.
n For short term analysis, it is entirely appropriate to use a short term
government security rate as the riskfree rate.
n If the analysis is being done in real terms (rather than nominal terms)
use a real riskfree rate, which can be obtained in one of two ways –
• from an inflation-indexed government bond, if one exists
• set equal, approximately, to the long term real growth rate of the economy
in which the valuation is being done.

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 Measurement of the risk premium

n The risk premium is the premium that investors demand for investing
in an average risk investment, relative to the riskfree rate.
n As a general proposition, 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

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 What is your risk premium?

n Assume that stocks are the only risky assets and that you are offered
two investment options:
• a riskless investment (say a Government Security), on which you can
make 6.7%
• a mutual fund of all stocks, 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?
o Less than 6.7%
o Between 6.7 - 7.8%
o Between 8.7 - 10.7%
o Between 10.7 - 12.7%
o Between 12.7 - 14.7%
o More than 14.7%

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 Risk Aversion and Risk Premiums

n If this were the capital market line, the risk premium would be a
weighted average of the risk premiums demanded by each and every
investor.
n The weights will be determined by the magnitude of wealth that each
investor has. Thus, Warren Bufffet’s risk aversion counts more
towards determining the “equilibrium” premium than yours’ and mine.
n As investors become more risk averse, you would expect the
“equilibrium” premium to increase.

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 Risk Premiums do change..

Go back to the previous example. Assume now that you are making the
same choice but that you are making it in the aftermath of a stock
market crash (it has dropped 25% in the last month). Would you
change your answer?
o I would demand a larger premium
o I would demand a smaller premium
o I would demand the same premium

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 Estimating Risk Premiums in Practice

n Survey investors on their desired risk premiums and use the average
premium from these surveys.
n Assume that the actual premium delivered over long time periods is
equal to the expected premium - i.e., use historical data
n Estimate the implied premium in today’s asset prices.

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 The Survey Approach

n Surveying all investors in a market place is impractical.

n However, you can survey a few investors (especially the larger
investors) and use these results. In practice, this translates into surveys
of money managers’ expectations of expected returns on stocks over
the next year.
n 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; even the longest surveys do not go beyond one
year

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 The Historical Premium Approach

n This is the default approach used by most to arrive at the premium to

use in the model
n In most cases, this approach does the following
• it defines a time period for the estimation (1926-Present, 1962-Present....)
• 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
n The limitations of this approach are:
• it assumes that the risk aversion of investors has not changed in a
systematic way across time. (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.

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 Historical Average Premiums for the United
States

Historical period Stocks - T.Bills Stocks - T.Bonds

Arith Geom Arith Geom
1926-1999 9.41% 8.14% 7.64% 6.60%
1962-1999 7.07% 6.46% 5.96% 5.74%
1981-1999 13.24% 11.62% 16.08% 14.17%

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 What is the right historical premium?

n Go back as far as you can. Otherwise, the standard error in the

estimate will be large. The standard error in the risk premium estimate
is roughly equal to
• Standard Error in Risk premium = Annual Standard deviation in Stock
prices / Square root of the number of years of historical data
• With an annual standard deviation in stock prices of 24% and 25 years of
data, for instance, the standard error would be
Standard Error of Estimate = 24%/ √25 = 4.8%
n Be consistent in your use of a riskfree rate. If you use the
T.Bill(T.Bond) rate, use the spread over the T.Bill (T.Bond) rate.
n Use arithmetic premiums for one-year estimates of costs of equity and
geometric premiums for estimates of long term costs of equity.

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 What about historical premiums for other
markets?

n Historical data for markets outside the United States tends to be sketch
and unreliable.
n Ibbotson, for instance, estimates the following premiums for major
markets from 1970-1996
Country Annual Return on Annual Return on Equity Risk Premium
Australia 8.47% 6.99% 1.48%
France 11.51% 9.17% 2.34%
Germany 11.30% 12.10% -0.80%
Italy 5.49% 7.84% -2.35%
Japan 15.73% 12.69% 3.04%
Mexico 11.88% 10.71% 1.17%
Singapore 15.48% 6.45% 9.03%
Spain 8.22% 7.91% 0.31%
Switzerland 13.49% 10.11% 3.38%
UK 12.42% 7.81% 4.61%
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 Assessing Country Risk Using Currency
Ratings: Latin America - June 1999

Country Rating Default Spread over US T.Bond

Argentina Ba3 525
Bolivia B1 600
Brazil B2 750
Chile Baa1 150
Colombia Baa3 200
Ecuador B3 850
Paraguay B2 750
Peru Ba3 525
Uruguay Baa3 200
Venezuela B2 750

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 Using Country Ratings to Estimate Equity
Spreads

n 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). Thus, the risk premium for Argentina would be:
Risk Premium = U.S. premium + 5.25%
n Country ratings measure default risk. While default risk premiums and
equity risk premiums are highly correlated, one would expect equity
spreads to be higher than debt spreads.
• One way to estimate it is to multiply the bond spread by the relative
volatility of stock and bond prices in that market. For example,
– Standard Deviation in Merval (Equity) = 42.87%
– Standard Deviation in Argentine Long Bond = 21.37%
– Adjusted Equity Spread = 5.25% (42.87/21.37) = 10.53%

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 Implied Equity Premiums

n If we use a basic discounted cash flow model, we can estimate the

implied risk premium from the current level of stock prices.
n For instance, 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, the dividends on the index and
expected growth rate will yield a “implied” expected return on stocks.
Subtracting out the riskfree rate will yield the implied premium.
n The problems with this approach are:
• the discounted cash flow model used to value the stock index has to be the
right one.
• the inputs on dividends and expected growth have to be correct
• it implicitly assumes that the market is currently correctly valued

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 Implied Premiums in the US

Implied Premium for US Equity Market

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Year

Aswath Damodaran 33
 6 Application Test: A Market Risk Premium

n Based upon our discussion of historical risk premiums so far, the risk
premium looking forward should be:
o About 10%, which is what the arithmetic average premium has been
since 1981, for stocks over T.Bills
o About 6%, which is the geometric average premum since 1926, for
stocks over T.Bonds
o About 2%, which is the implied premium in the stock market today

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 In Summary...

n The historical risk premium is 6.6%, if we use a geometric risk

premium, and much higher, if we use arithmetic averages.
n The implied risk premium is much lower. Even if we use liberal
estimates of cashflows (dividends +stock buybacks) and high expected
growth rates, the implied premium is about 4% and probably lower.
n We will use a risk premium of 5.5%, because
• The historical risk premium is much too high to use in a market, where
equities are priced with with premiums of 4% or lower.
• The implied premium might be too low, especially if we believe that
markets can become overvalued.

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 Estimating Beta

n 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.
n The slope of the regression corresponds to the beta of the stock, and
measures the riskiness of the stock.

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 Estimating Performance

n The intercept of the regression provides a simple measure of

performance during the period of the regression, relative to the capital
asset pricing model.
Rj = Rf + b (Rm - Rf)
= Rf (1-b) + b Rm ........... Capital Asset Pricing Model
Rj = a + b Rm ........... Regression Equation
n If
a > Rf (1-b) .... Stock did better than expected during regression period
a = Rf (1-b) .... Stock did as well as expected during regression period
a < Rf (1-b) .... Stock did worse than expected during regression period
n This is Jensen's alpha.

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 Firm Specific and Market Risk

n The R squared (R2) of the regression provides an estimate of the

proportion of the risk (variance) of a firm that can be attributed to
market risk;
n The balance (1 - R2) can be attributed to firm specific risk.

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 Setting up for the Estimation

n Decide on an estimation period

• Services use periods ranging from 2 to 5 years for the regression
• Longer estimation period provides more data, but firms change.
• Shorter periods can be affected more easily by significant firm-specific
event that occurred during the period (Example: ITT for 1995-1997)
n Decide on a return interval - daily, weekly, monthly
• Shorter intervals yield more observations, but suffer from more noise.
• Noise is created by stocks not trading and biases all betas towards one.
n Estimate returns (including dividends) on stock
• Return = (PriceEnd - PriceBeginning + DividendsPeriod)/ PriceBeginning
• Included dividends only in ex-dividend month
n Choose a market index, and estimate returns (inclusive of dividends)
on the index for each interval for the period.

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 Choosing the Parameters: Boeing

n Period used: 5 years

n Return Interval = Monthly
n Market Index: S&P 500 Index.
n For instance, to calculate returns on Boeing in May 1995,
• Price for Boeing at end of April= $ 27.50
• Price for Boeing at end of May = $ 29.44
• Dividends during month = $0.125 (It was an ex-dividend month)
• Return =($29.44 - $ 27.50 + $ 0.125)/$ 27.50= 7.50%
n To estimate returns on the index in the same month
• Index level (including dividends) at end of April = 514.7
• Index level (including dividends) at end of May = 533.4
• Dividends on the Index in May = 1.84
• Return =(533.4-514.7+1.84)/ 514.7 = 3.99%

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 Boeing’s Historical Beta

Boeing versus S&P 500: 10/93-9/98

10.00%

Regression
5.00% line

0.00%
-25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00%
Returns on S&P 500

-5.00%
Beta is slope of this line

-10.00%

-15.00%

Each point represents a month

of data.

-20.00%
Returns on Boeing

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 The Regression Output

n ReturnsBoeing = -0.09% + 0.96 ReturnsS & P 500 (R squared=29.57%)

(0.20)
n Intercept = -0.09%
n Slope = 0.96

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 Analyzing Boeing’s Performance

n Intercept = -0.09%
n This is an intercept based on monthly returns. Thus, it has to be
compared to a monthly riskfree rate.
n Between 1993 and 1998,
• Monthly Riskfree Rate = 0.4% (Annual T.Bill rate divided by 12)
• Riskfree Rate (1-Beta) = 0.4% (1-0.96) = .01%
n The Comparison is then between
Intercept versus Riskfree Rate (1 - Beta)
-0.09% versus 0.4%(1-0.96)= 0.01%
n Jensen’s Alpha = -0.09% -(0.01%) = -0.10%
n Boeing did 0.1% worse than expected, per month, between 1993 and
1998.
n Annualized, Boeing’s annual excess return = (1-.0001)^12-1= -1.22%
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 More on Jensen’s Alpha

If you did this analysis on every stock listed on an exchange, what would
the average Jensen’s alpha be across all stocks?
o Depend upon whether the market went up or down during the period
o Should be zero
o Should be greater than zero, because stocks tend to go up more often
than down

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 Estimating Boeing’s Beta

n Slope of the Regression of 0.96 is the beta

n Regression parameters are always estimated with noise. The noise is
captured in the standard error of the beta estimate, which in the case of
Boeing is 0.20.
n Assume that I asked you what Boeing’s true beta is, after this
regression.
• What is your best point estimate?

• What range would you give me, with 67% confidence?

• What range would you give me, with 95% confidence?

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 The Dirty Secret of “Standard Error”

Distribution of Standard Errors: Beta Estimates for U.S. stocks

1600

1400

1200
Number of Firms

1000

800

600

400

200

0
<.10 .10 - .20 .20 - .30 .30 - .40 .40 -.50 .50 - .75 > .75

Standard Error in Beta Estimate

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 Breaking down Boeing’s Risk

n R Squared = 29.57%
n This implies that
• 29.57% of the risk at Boeing comes from market sources
• 70.43%, therefore, comes from firm-specific sources
n The firm-specific risk is diversifiable and will not be rewarded

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 The Relevance of R Squared

You are a diversified investor trying to decide whether you should invest
in Boeing or Amgen. They both have betas of 0.96, but Boeing has an
R Squared of 30% while Amgen’s R squared of only 15%. Which one
would you invest in?
o Amgen, because it has the lower R squared
o Boeing, because it has the higher R squared
o You would be indifferent
Would your answer be different if you were an undiversified investor?

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 Beta Estimation in Practice: Bloomberg

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 Estimating Expected Returns: December 31,
1998

n Boeing’s Beta = 0.96

n Riskfree Rate = 5.00% (Long term Government Bond rate)
n Risk Premium = 5.50% (Approximate historical premium)
n Expected Return = 5.00% + 0.96 (5.50%) = 10.31%

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 Use to a Potential Investor in Boeing

As a potential investor in Boeing, what does this expected return of

10.31% tell you?
o This is the return that I can expect to make in the long term on Boeing,
if the stock is correctly priced and the CAPM is the right model for
risk,
o This is the return that I need to make on Boeing in the long term to
break even on my investment in the stock
o Both
Assume now that you are an active investor and that your research
suggests that an investment in Boeing will yield 25% a year for the
next 5 years. Based upon the expected return of 10.31%, you would
o Buy the stock
o Sell the stock

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 How managers use this expected return

n Managers at Boeing
• need to make at least 10.31% as a return for their equity investors to break
even.
• this is the hurdle rate for projects, when the investment is analyzed from
an equity standpoint
n In other words, Boeing’s cost of equity is 10.31%.
n What is the cost of not delivering this cost of equity?

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 6 Application Test: Analyzing the Risk
Regression

n Using your Bloomberg risk and return print out, answer the following
questions:
• How well or badly did your stock do, relative to the market, during the
period of the regression? (You can assume an annualized riskfree rate of
4.8% during the regression period)
• What proportion of the risk in your stock is attributable to the market?
What proportion is firm-specific?
• What is the historical estimate of beta for your stock? What is the range
on this estimate with 67% probability? With 95% probability?
• Based upon this beta, what is your estimate of the required return on this
stock?

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 A Quick Test

You are advising a very risky software firm on the right cost of equity to
use in project analysis. You estimate a beta of 2.0 for the firm and
come up with a cost of equity of 18%. The CFO of the firm is
concerned about the high cost of equity and wants to know whether
there is anything he can do to lower his beta.
How do you bring your beta down?

Should you focus your attention on bringing your beta down?

o Yes
o No

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 Beta Estimation and Index Choice

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 A Few Questions

n The R squared for Deutsche Bank is very high (57%), at least relative
to U.S. firms. Why is that?
n The beta for Deutsche Bank is 0.84.
• Is this an appropriate measure of risk?
• If not, why not?
n If you were an investor in primarily U.S. stocks, would this be an
appropriate measure of risk?

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 Deutsche Bank: To a U.S. Investor?

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 Deutsche Bank: To a Global Investor

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 Beta Estimation With an Index Problem

n The Local Solution: Estimate the beta relative to a local index, that is
equally weighted or more diverse than the one in use.
n The U.S. Solution: If the stock has an ADR listed on the U.S.
exchanges, estimate the beta relative to the S&P 500.
n The Global Solution: Use a global index to estimate the beta
n An Alternative Solution: Do not use a regression to estimate the firm’s
beta.

Aswath Damodaran 59
 Fundamental Determinants of Betas

n 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.
n 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)
n Financial Leverage: Firms that borrow more (higher debt, relative to
equity) will have higher equity betas than firms that borrow less.

Aswath Damodaran 60
 Determinant 1: Product Type

n 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.
• 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 61
 A Simple Test

Consider an investment in Tiffany’s. What kind of beta do you think this

investment will have?
o Much higher than one
o Close to one
o Much lower than one

Aswath Damodaran 62
 Determinant 2: Operating Leverage Effects

n Operating leverage refers to the proportion of the total costs of the firm
that are fixed.
n Other things remaining equal, higher operating leverage results in
greater earnings variability which in turn results in higher betas.

Aswath Damodaran 63
 Measures of Operating Leverage

Fixed Costs Measure = Fixed Costs / Variable Costs

n This measures the relationship between fixed and variable costs. The
higher the proportion, the higher the operating leverage.
EBIT Variability Measure = % Change in EBIT / % Change in Revenues
n This measures how quickly the earnings before interest and taxes
changes as revenue changes. The higher this number, the greater the
operating leverage.

Aswath Damodaran 64
 A Look at The Home Depot’s Operating
Leverage

Year Net Sales % Change in Sales EBIT % Change in

EBIT
1988 $ 1,454 $ 98
1989 $ 2,000 37.55% $ 127 29.59%
1990 $ 2,759 37.95% $ 185 45.67%
1991 $ 3,815 38.27% $ 265 43.24%
1992 $ 5,137 34.65% $ 382 44.15%
1993 $ 7,148 39.15% $ 549 43.72%
1994 $ 9,239 29.25% $ 744 35.52%
1995 $ 12,477 35.05% $ 1,039 39.65%
1996 $ 15,470 23.99% $ 1,232 18.58%
1997 $ 19,536 26.28% $ 1,534 24.51%
1998 $ 24,156 23.65% $ 1,914 24.77%
Average (87-96) 32.58% 34.94%

Aswath Damodaran 65
 Reading The Home Depot’s Operating
Leverage

n Operating Leverage = % Change in EBIT/ % Change in Sales

= 34.94%/ 32.58% = 1.07
n This is similar to the operating leverage for other retail firms, which
we computed to be 1.05. This would suggest that The Home Depot has
a similar cost structure to its competitors.

Aswath Damodaran 66
 A Test

Assume that you are comparing a European automobile manufacturing

firm with a U.S. automobile firm. European firms are generally much
more constrained in terms of laying off employees, if they get into
financial trouble. What implications does this have for betas, if they
are estimated relative to a common index?
p European firms will have much higher betas than U.S. firms
p European firms will have similar betas to U.S. firms
p European firms will have much lower betas than U.S. firms

Aswath Damodaran 67
 Determinant 3: Financial Leverage

n As firms borrow, they create fixed costs (interest payments) that make
their earnings to equity investors more volatile.
n This increased earnings volatility which increases the equity beta

Aswath Damodaran 68
 Equity Betas and Leverage

n The beta of equity alone can be written as a function of the unlevered

beta and the debt-equity ratio
βL = βu (1+ ((1-t)D/E)
where
βL = Levered or Equity Beta
βu = Unlevered Beta
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
n The unlevered beta measures the riskiness of the business that a firm is
in and is often called an asset beta.

Aswath Damodaran 69
 Effects of leverage on betas: Boeing

n The regression beta for Boeing is 0.96. This beta is a levered beta
(because it is based on stock prices, which reflect leverage) and the
leverage implicit in the beta estimate is the average market debt equity
ratio during the period of the regression (1993 to 1998)
n The average debt equity ratio during this period was 17.88%.
n The unlevered beta for Boeing can then be estimated:(using a marginal
tax rate of 35%)
= Current Beta / (1 + (1 - tax rate) (Average Debt/Equity))
= 0.96 / ( 1 + (1 - 0.35) (0.1788)) = 0.86

Aswath Damodaran 70
 Boeing : Beta and Leverage

Debt to Capital Debt/Equity Ratio Beta Effect of Leverage

0.00% 0.00% 0.86 0.00
10.00% 11.11% 0.92 0.06
20.00% 25.00% 1.00 0.14
30.00% 42.86% 1.10 0.24
40.00% 66.67% 1.23 0.37
50.00% 100.00% 1.42 0.56
60.00% 150.00% 1.70 0.84
70.00% 233.33% 2.16 1.30
80.00% 400.00% 3.10 2.24
90.00% 900.00% 5.89 5.03

Aswath Damodaran 71
 Betas are weighted Averages

n The beta of a portfolio is always the market-value weighted average of

the betas of the individual investments in that portfolio.
n 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 72
 The Boeing/McDonnell Douglas Merger

Company Beta Debt Equity Firm Value

Boeing 0.95 $ 3,980 $ 32,438 $ 36,418
McDonnell Douglas 0.90 $ 2,143 $ 12,555 $ 14,698

Aswath Damodaran 73
 Beta Estimation: Step 1

n Calculate the unlevered betas for both firms

Boeing = 0.95/(1+0.65*(3980/32438)) = 0.88
McDonnell Douglas = 0.90/(1+0.65*(2143/12555)) = 0.81
n Calculate the unlevered beta for the combined firm
Unlevered Beta for combined firm
= 0.88 (36,418/51,116) + 0.81 (14,698/51,116)
= 0.86

Aswath Damodaran 74
 Beta Estimation: Step 2

n Boeing’s acquisition of McDonnell Douglas was accomplished by

issuing new stock in Boeing to cover the value of McDonnell
Douglas’s equity of $12,555 million.
Debt = McDonnell Douglas Old Debt + Boeing’s Old Debt
= $3,980 + $2,143 = $6,123 million
Equity = Boeing’s Old Equity + New Equity used for Acquisition
= $ 32,438 + $ 12,555 = $44,993 million
D/E Ratio = $ 6,123/44,993 = 13.61%
New Beta = 0.86 (1 + 0.65 (.1361)) = 0.94

Aswath Damodaran 75
 Firm Betas versus divisional Betas

n Firm Betas as weighted averages: The beta of a firm is the weighted

average of the betas of its individual projects.
n At a broader level of aggregation, the beta of a firm is the weighted
average of the betas of its individual division.

Aswath Damodaran 76
 Bottom-up versus Top-down Beta

n The top-down beta for a firm comes from a regression

n The bottom up beta can be estimated by doing the following:
• Find out the businesses that a firm operates in
• Find the unlevered betas of other firms in these businesses
• Take a weighted (by sales or operating income) average of these
unlevered betas
• Lever up using the firm’s debt/equity ratio
n The bottom up beta will give you a better estimate of the true beta
when
• the standard error of the beta from the regression is high (and) the beta for
a firm is very different from the average for the business
• the firm has reorganized or restructured itself substantially during the
period of the regression
• when a firm is not traded
Aswath Damodaran 77
 The Home Depot’s Comparable Firms

Company Name Beta Market Cap $ (Mil) Debt Due 1-Yr Out Long-Term Debt
Building Materials 1.05 $136 $1 $113
Catalina Lighting 1 $16 $7 $19
Cont'l Materials Corp 0.55 $32 $2 $7
Eagle Hardware 0.95 $612 $6 $146
Emco Limited 0.65 $187 $39 $119
Fastenal Co. 1.25 $1,157 $16 $ -
HomeBase Inc. 1.1 $227 $116
Hughes Supply 1 $610 $1 $335
Lowe's Cos. 1.2 $12,554 $111 $1,046
Waxman Industries 1.25 $18 $6 $121
Westburne Inc. 0.65 $607 $9 $34
Wolohan Lumber 0.55 $76 $2 $20
Sum $16,232 $200 $2,076
Average 0.93

Aswath Damodaran 78
 Estimating The Home Depot’s Bottom-up Beta

n Average Beta of comparable firms = 0.93

n D/E ratio of comparable firms = (200+2076)/16,232 = 14.01%
n Unlevered Beta for comparable firms = 0.93/(1+(1-.35)(.1401))
= 0.86

Aswath Damodaran 79
 Decomposing Boeing’s Beta

Segment Revenues Estimated Value unlevered Weight Weighted

Commercial Aircraft $ 26,929 $ 30,160 0.91 70.39% 0.6405
ISDS $ 18,125 $ 12,688 0.80 29.61% 0.2369
Firm $ 42,848 100.00% 0.88

n The values were estimated based upon the revenues in each business and the
typical multiple of revenues that other firms in that business trade for.
n The unlevered betas for each business were estimated by looking at other
publicly traded firms in each business, averaging across the betas estimated for
these firms, and then unlevering the beta using the average debt to equity ratio
for firms in that business.
Unlevered Beta = Average Beta / (1 + (1-tax rate) (Average D/E))
n Using Boeing’s current market debt to equity ratio of 25%
Boeing’s Beta = = 0.88 (1+(1-.35)(.25)) = 1.014

Aswath Damodaran 80
 Discussion Issue

n If you were the chief financial officer of Boeing, what cost of equity
would you use in capital budgeting in the different divisions?
o The cost of equity for Boeing as a company
o The cost of equity for each of Boeing’s divisions?

Aswath Damodaran 81
 Estimating Betas for Non-Traded Assets

n The conventional approaches of estimating betas from regressions do

not work for assets that are not traded.
n There are two ways in which betas can be estimated for non-traded
assets
• using comparable firms
• using accounting earnings

Aswath Damodaran 82
 Beta for InfoSoft, a Private Software Firm

The following table summarizes the unlevered betas for publicly traded
software firms.
Grouping Number of Beta D/E Ratio Unlevered
Firms Beta
All Software 264 1.45 3.70% 1.42
Small-cap Software 125 1.54 10.12% 1.45
Entertainment Software 31 1.50 7.09% 1.43
n We will use the beta of entertainment software firms as the unlevered
beta for InfoSoft.
n We will also assume that InfoSoft’s D/E ratio will be similar to that of
these publicly traded firms (D/E = 7.09%)
n Beta for InfoSoft = 1.43 (1 + (1-.42) (.0709)) = 1.49
(We used a tax rate of 42% for the private firm)
Aswath Damodaran 83
 Using Accounting Earnings to Estimate Beta for
InfoSoft

Period InfoSoft S&P 500 Period InfoSoft S&P 500

1992: Q1 7.50% -1.30% 1995: Q2 24.10% 8.50%
1992: Q2 8.30% 2.20% 1995: Q3 17.50% 6.00%
1992: Q3 8.80% 2.50% 1995: Q4 16.00% 5.00%
1992: Q4 7.90% 3.00% 1996: Q1 27.00% 8.10%
1993: Q1 14.30% 3.60% 1996: Q2 21.30% 7.00%
1993: Q2 16.50% 5.10% 1996: Q3 22.50% 7.20%
1993: Q3 17.10% 5.50% 1996: Q4 20.00% 6.00%
1993: Q4 13.50% 6.20% 1997: Q1 17.10% 5.80%
1994: Q1 11.50% 4.30% 1997: Q2 22.20% 8.00%
1994: Q2 12.30% 4.70% 1997: Q3 17.80% 6.10%
1994: Q3 13.00% 4.50% 1997: Q4 14.50% 4.50%
1994: Q4 11.10% 4.20% 1998: Q1 8.50% 1.30%
1995: Q1 18.60% 7.10% 1998: Q2 3.50% -0.50%

Aswath Damodaran 84
 The Accounting Beta for InfoSoft

n Regressing the changes in profits at InfoSoft against changes in profits

for the S&P 500 yields the following:
InfoSoft Earnings Change = 0.05 + 2.15 (S & P 500 Earnings Change)
n Based upon this regression, the beta for InfoSoft’s equity is 2.15.
n Using operating earnings for both the firm and the S&P 500 should
yield the equivalent of an unlevered beta.

Aswath Damodaran 85
 Is Beta an Adequate Measure of Risk for a
Private Firm?

n The owners of most private firms are not diversified. Beta measures
the risk added on to a diversified portfolio. Therefore, using beta to
arrive at a cost of equity for a private firm will
o Under estimate the cost of equity for the private firm
o Over estimate the cost of equity for the private firm
o Could under or over estimate the cost of equity for the private firm

Aswath Damodaran 86
 Total Risk versus Market Risk

n Adjust the beta to reflect total risk rather than market risk. This
adjustment is a relatively simple one, since the R squared of the
regression measures the proportion of the risk that is market risk.
Total Beta = Market Beta / √R squared
n In the InfoSoft example, where the market beta is 1.10 and the
average R-squared of the comparable publicly traded firms is 16%,
• Total Beta = 1.49/√0.16 = 3.725
• Total Cost of Equity = 5% + 3.725 (5.5%)= 25.49%
n This cost of equity is much higher than the cost of equity based upon
the market beta because the owners of the firm are not diversified.

Aswath Damodaran 87
 6 Application Test: Estimating a Bottom-up
Beta

n Based upon the business or businesses that your firm is in right now,
and its current financial leverage, estimate the bottom-up unlevered
beta for your firm.

Aswath Damodaran 88
 From Cost of Equity to Cost of Capital

n The cost of capital is a composite cost to the firm of raising financing

to fund its projects.
n In addition to equity, firms can raise capital from debt

Aswath Damodaran 89
 What is debt?

n 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.
n As a consequence, debt should include
• Any interest-bearing liability, whether short term or long term.
• Any lease obligation, whether operating or capital.

Aswath Damodaran 90
 Estimating the Cost of Debt

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

Aswath Damodaran 91
 Estimating Synthetic Ratings

n The rating for a firm can be estimated using the financial

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

Aswath Damodaran 92
 Interest Coverage Ratios, Ratings and Default
Spreads

Interest Coverage Ratio Rating Default Spread

> 12.5 AAA 0.20%
9.50 - 12.50 AA 0.50%
7.50 – 9.50 A+ 0.80%
6.00 – 7.50 A 1.00%
4.50 – 6.00 A- 1.25%
3.50 – 4.50 BBB 1.50%
3.00 – 3.50 BB 2.00%
2.50 – 3.00 B+ 2.50%
2.00 - 2.50 B 3.25%
1.50 – 2.00 B- 4.25%
1.25 – 1.50 CCC 5.00%
0.80 – 1.25 CC 6.00%
0.50 – 0.80 C 7.50%
< 0.65 D 10.00%

Aswath Damodaran 93
 Costs of Debt for Boeing, the Home Depot and
InfoSoft

Boeing Home Depot InfoSoft

Bond Rating AA A+ A
Rating is Actual Actual Synthetic
Default Spread over treasury 0.50% 0.80% 1.00%
Market Interest Rate 5.50% 5.80% 6.00%
Marginal tax rate 35% 35% 42%
Cost of Debt 3.58% 3.77% 3.48%
The treasury bond rate is 5%.

Aswath Damodaran 94
 6 Application Test: Estimating a Cost of Debt

n Based upon your firm’s current earnings before interest and taxes, its
interest expenses, estimate
• An interest coverage ratio for your firm
• A synthetic rating for your firm (use the table from previous page)
• A pre-tax cost of debt for your firm
• An after-tax cost of debt for your firm

Aswath Damodaran 95
 Estimating Market Value Weights

n 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
n 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
• For Boeing, the book value of debt is $6,972 million, the interest expense
on the debt is $ 453 million, the average maturity of the debt is 13.76
years and the pre-tax cost of debt is 5.50%.
 1 
 (1 − 13.76 
(1.055) 6,972
Estimated MV of Boeing Debt = 453 + 13.76 = $7,631
 .055  (1.055)
 

Aswath Damodaran 96
 Converting Operating Leases to Debt

n The “debt value” of operating leases is the present value of the lease
payments, at a rate that reflects their risk.
n In general, this rate will be close to or equal to the rate at which the
company can borrow.

Aswath Damodaran 97
 Operating Leases at Boeing

n The pre-tax cost of debt at Boeing is 5.80%

Year Commitment Present Value at 5.5%
1 $ 205.00 $ 194.31
2 $ 167.00 $ 150.04
3 $ 120.00 $ 102.19
4 $ 86.00 $ 69.42
5 $ 61.00 $ 46.67
PV of Operating Leases = $ 562.64
n Debt outstanding at Boeing = $ 7,631 + $ 563 = $ 8,194 mil

Aswath Damodaran 98
 6 Application Test: Estimating Market Value

n Estimate the
• Market value of equity at your firm and Book Value of equity
• Market value of debt and book value of debt (If you cannot find the
average maturity of your debt, use 3 years): Remember to capitalize the
value of operating leases and add them on to both the book value and the
market value of debt.
n Estimate the
• Weights for equity and debt based upon market value
• Weights for equity and debt based upon book value

Aswath Damodaran 99
 Estimating Cost of Capital: Boeing

n Equity
• Cost of Equity = 5% + 1.01 (5.5%) = 10.58%
• Market Value of Equity = $32.60 Billion
• Equity/(Debt+Equity ) = 82%
n Debt
• After-tax Cost of debt = 5.50% (1-.35) = 3.58%
• Market Value of Debt = $ 8.2 Billion
• Debt/(Debt +Equity) = 18%
n Cost of Capital = 10.58%(.80)+3.58%(.20) = 9.17%

Aswath Damodaran 100

 Boeing’s Divisional Costs of Capital

Boeing Aerospace Defense

Cost of Equity 10.58% 10.77% 10.07%
Equity/(Debt + Equity) 79.91% 79.91% 79.91%
Cost of Debt 3.58% 3.58% 3.58%
Debt/(Debt + Equity) 20.09% 20.09% 20.09%
Cost of Capital 9.17% 9.32% 8.76%

Aswath Damodaran 101

 Cost of Capital: InfoSoft and The Home Depot

The Home Depot InfoSoft

Cost of Equity 9.78% 13.19%
Equity/(Debt + Equity) 95.45% 93.38%
Cost of Debt 3.77% 3.48%
Debt/(Debt + Equity) 4.55% 6.62%
Cost of Capital 9.51% 12.55%

Aswath Damodaran 102

 6 Application Test: Estimating Cost of Capital

n Using the bottom-up unlevered beta that you computed for your firm,
and the values of debt and equity you have estimated for your firm,
estimate a bottom-up levered beta and cost of equity for your firm.

n Based upon the costs of equity and debt that you have estimated, and
the weights for each, estimate the cost of capital for your firm.

n How different would your cost of capital have been, if you used book
value weights?

Aswath Damodaran 103

 Current Practices: Costs of Capital

Cost of capital item Current Practices

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

Aswath Damodaran 104

 Choosing a Hurdle Rate

n Either the cost of equity or the cost of capital can be used as a hurdle
rate, depending upon whether the returns measured are to equity
investors or to all claimholders on the firm (capital)
n If returns are measured to equity investors, the appropriate hurdle rate
is the cost of equity.
n If returns are measured to capital (or the firm), the appropriate hurdle
rate is the cost of capital.

Aswath Damodaran 105

 Back to First Principles

n 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.
n Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
n 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 106