Aswath Damodaran 1

Valuation: Lecture Note Packet 1

Intrinsic Valuation
Aswath Damodaran
Updated: September 2015
 The essence of intrinsic value
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 In intrinsic valuation, you value an asset based upon its

intrinsic characteristics.
 For cash flow generating assets, the intrinsic value will
be a function of the magnitude of the expected cash
flows on the asset over its lifetime and the uncertainty
about receiving those cash flows.
 Discounted cash flow valuation is a tool for estimating
intrinsic value, where the expected value of an asset is
written as the present value of the expected cash flows
on the asset, with either the cash flows or the discount
rate adjusted to reflect the risk.

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 The two faces of discounted cash flow valuation
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 The value of a risky asset can be estimated by discounting the

expected cash flows on the asset over its life at a risk-adjusted
discount rate:

where the asset has a n-year life, E(CFt) is the expected cash flow in period t
and r is a discount rate that reflects the risk of the cash flows.
 Alternatively, we can replace the expected cash flows with the
guaranteed cash flows we would have accepted as an alternative
(certainty equivalents) and discount these at the riskfree rate:

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

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 Risk Adjusted Value: Two Basic Propositions
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 If the value of an asset is the risk-adjusted present value of the cash flows:

1. The “IT” proposition: If IT does not affect the expected cash flows or the riskiness
of the cash flows, IT cannot affect value.
2. The “DUH” proposition: For an asset to have value, the expected cash flows have
to be positive some time over the life of the asset.
3. The “DON’T FREAK OUT” proposition: Assets that generate cash flows early in
their life will be worth more than assets that generate cash flows later; the latter
may however have greater growth and higher cash flows to compensate.

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 DCF Choices: Equity Valuation versus Firm
Valuation
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Firm Valuation: Value the entire business

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

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

Equity valuation: Value just the

equity claim in the business

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 Equity Valuation
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Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

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

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

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 Firm Valuation
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Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

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

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

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 Cash Flows and Discount Rates
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 Assume that you are analyzing a company with the following

cashflows for the next five years.
Year CF to Equity Interest Exp (1-tax rate) CF to Firm
1 $ 50 $ 40 $ 90
2 $ 60 $ 40 $ 100
3 $ 68 $ 40 $ 108
4 $ 76.2 $ 40 $ 116.2
5 $ 83.49 $ 40 $ 123.49
Terminal Value $ 1603.0 $ 2363.008
 Assume also that the cost of equity is 13.625% and the firm can
borrow long term at 10%. (The tax rate for the firm is 50%.)
 The current market value of equity is $1,073 and the value of debt
outstanding is $800.

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 Equity versus Firm Valuation
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 Method 1: Discount CF to Equity at Cost of Equity to get value

of equity
 Cost of Equity = 13.625%
 Value of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 +
76.2/1.136254 + (83.49+1603)/1.136255 = $1073
 Method 2: Discount CF to Firm at Cost of Capital to get value
of firm
 Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
Cost of Capital = 13.625% (1073/1873) + 5% (800/1873) = 9.94%
 PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 +
(123.49+2363)/1.09945 = $1873
 Value of Equity = Value of Firm - Market Value of Debt
= $ 1873 - $ 800 = $1073

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 First Principle of Valuation
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 Discounting Consistency Principle: Never mix and

match cash flows and discount rates.
 Mismatching cash flows to discount rates is deadly.
 Discounting cashflows after debt cash flows (equity cash
flows) at the weighted average cost of capital will lead to
an upwardly biased estimate of the value of equity
 Discounting pre-debt cashflows (cash flows to the firm) at
the cost of equity will yield a downward biased estimate of
the value of the firm.

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 The Effects of Mismatching Cash Flows and
Discount Rates
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 Error 1: Discount CF to Equity at Cost of Capital to get equity

value
 PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944 +
(83.49+1603)/1.09945 = $1248
 Value of equity is overstated by $175.
 Error 2: Discount CF to Firm at Cost of Equity to get firm value
 PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 +
116.2/1.136254 + (123.49+2363)/1.136255 = $1613
 PV of Equity = $1612.86 - $800 = $813
 Value of Equity is understated by $ 260.
 Error 3: Discount CF to Firm at Cost of Equity, forget to
subtract out debt, and get too high a value for equity
 Value of Equity = $ 1613
 Value of Equity is overstated by $ 540

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 Discounted Cash Flow Valuation: The Steps
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1. Estimate the discount rate or rates to use in the valuation

1. Discount rate can be either a cost of equity (if doing equity valuation) or a cost of
capital (if valuing the firm)
2. Discount rate can be in nominal terms or real terms, depending upon whether
the cash flows are nominal or real
3. Discount rate can vary across time.
2. Estimate the current earnings and cash flows on the asset, to either
equity investors (CF to Equity) or to all claimholders (CF to Firm)
3. Estimate the future earnings and cash flows on the firm being valued,
generally by estimating an expected growth rate in earnings.
4. Estimate when the firm will reach “stable growth” and what
characteristics (risk & cash flow) it will have when it does.
5. Choose the right DCF model for this asset and value it.

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 Generic DCF Valuation Model
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 Same ingredients, different approaches…
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Input Dividend Discount FCFE (Potential FCFF (firm)

Model dividend) discount valuation model
model
Cash flow Dividend Potential dividends FCFF = Cash flows
= FCFE = Cash flows before debt
after taxes, payments but after
reinvestment needs reinvestment needs
and debt cash and taxes.
flows
Expected growth In equity income In equity income In operating
and dividends and FCFE income and FCFF
Discount rate Cost of equity Cost of equity Cost of capital
Steady state When dividends When FCFE grow at When FCFF grow at
grow at constant constant rate constant rate
rate forever forever forever
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 Start easy: The Dividend Discount Model
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 Moving on up: The “potential dividends” or FCFE
model
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 To valuing the entire business: The FCFF model
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 Estimating Inputs: Discount Rates
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 While discount rates obviously matter in DCF valuation, they

don’t matter as much as most analysts think they do.
 At an intuitive level, the discount rate used should be
consistent with both the riskiness and the type of cashflow
being discounted.
 Equity versus Firm: If the cash flows being discounted are cash flows to
equity, the appropriate discount rate is a cost of equity. If the cash
flows are cash flows to the firm, the appropriate discount rate is the
cost of capital.
 Currency: The currency in which the cash flows are estimated should
also be the currency in which the discount rate is estimated.
 Nominal versus Real: If the cash flows being discounted are nominal
cash flows (i.e., reflect expected inflation), the discount rate should be
nominal

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 Risk in the DCF Model
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 Risk and Cost of Equity: The role of the marginal
investor
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 Not all risk counts: While the notion that the cost of equity should
be higher for riskier investments and lower for safer investments is
intuitive, what risk should be built into the cost of equity is the
question.
 Risk through whose eyes? While risk is usually defined in terms of
the variance of actual returns around an expected return, risk and
return models in finance assume that the risk that should be
rewarded (and thus built into the discount rate) in valuation should
be the risk perceived by the marginal investor in the investment
 The diversification effect: Most risk and return models in finance
also assume that the marginal investor is well diversified, and that
the only risk that he or she perceives in an investment is risk that
cannot be diversified away (i.e, market or non-diversifiable risk). In
effect, it is primarily economic, macro, continuous risk that should
be incorporated into the cost of equity.

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 The Cost of Equity: Competing “ Market Risk” Models
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Model Expected Return Inputs Needed

CAPM E(R) = Rf + (Rm- Rf) Riskfree Rate
Beta relative to market portfolio
Market Risk Premium
APM E(R) = Rf + j (Rj- Rf) Riskfree Rate; # of Factors;
Betas relative to each factor
Factor risk premiums
Multi E(R) = Rf + j (Rj- Rf) Riskfree Rate; Macro factors
factor Betas relative to macro factors
Macro economic risk premiums
Proxy E(R) = a + bj Yj Proxies
Regression coefficients

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 The CAPM: Cost of Equity
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 Consider the standard approach to estimating cost

of equity:
Cost of Equity = Riskfree Rate + Equity Beta * (Equity Risk
Premium)
 In practice,
 Government security rates are used as risk free rates
 Historical risk premiums are used for the risk premium

 Betas are estimated by regressing stock returns against

market returns

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 I. A Riskfree Rate
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 On a riskfree asset, the actual return is equal to the

expected return. Therefore, there is no variance around
the expected return.
 For an investment to be riskfree, then, it has to have
 No default risk
 No reinvestment risk
1. Time horizon matters: Thus, the riskfree rates in
valuation will depend upon when the cash flow is
expected to occur and will vary across time.
2. Not all government securities are riskfree: Some
governments face default risk and the rates on bonds
issued by them will not be riskfree.

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 II. Equity Risk Premiums
The ubiquitous historical risk premium
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 The historical premium is the premium that stocks have historically

earned over riskless securities.
 While the users of historical risk premiums act as if it is a fact (rather than
an estimate), it is sensitive to
 How far back you go in history…

 Whether you use T.bill rates or T.Bond rates

 Whether you use geometric or arithmetic averages.

 For instance, looking at the US:

Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2014 8.00% 6.25% 6.11% 4.60%
2.17% 2.32%
1965-2014 6.19% 4.12% 4.84% 3.14%
2.42% 2.74%
2005-2014 7.94% 4.06% 6.18% 2.73%
6.05% 8.65%

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 The CAPM Beta
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 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.
 The slope of the regression corresponds to the beta of
the stock, and measures the riskiness of the stock.
 This beta has three problems:
It has high standard error
It reflects the firm’s business mix over the period of the
regression, not the current mix
It reflects the firm’s average financial leverage over the period
rather than the current leverage.

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 The Cost of Equity: A Recap
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 Recapping the Cost of Capital
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II. ESTIMATING CASH FLOWS

Cash is king…
 Measuring Cash Flows
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Cash flows can be measured to

Just Equity Investors

All claimholders in the firm

EBIT (1- tax rate) Net Income Dividends

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

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 Measuring Cash Flow to the Firm
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EBIT ( 1 - tax rate)

- (Capital Expenditures - Depreciation)
- Change in Working Capital
= Cash flow to the firm
 Where are the tax savings from interest payments in
this cash flow?

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 From Reported to Actual Earnings
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 Estimating Cash Flows: FCFE
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 Cash flows to Equity for a Levered Firm

Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)
= Free Cash flow to Equity
 I have ignored preferred dividends. If preferred stock
exist, preferred dividends will also need to be netted
out

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 Ways of Estimating Terminal Value
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 Which cash flow should I discount?
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 Use Equity Valuation

(a) for firms which have stable leverage, whether high or not, and
(b) if equity (stock) is being valued
 Use Firm Valuation
(a) for firms which have leverage which is too high or too low, and
expect to change the leverage over time, because debt payments
and issues do not have to be factored in the cash flows and the
discount rate (cost of capital) does not change dramatically over
time.
(b) for firms for which you have partial information on leverage
(eg: interest expenses are missing..)
(c) in all other cases, where you are more interested in valuing the
firm than the equity. (Value Consulting?)

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 Given cash flows to equity, should I discount
dividends or FCFE?
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 Use the Dividend Discount Model

(a) For firms which pay dividends (and repurchase stock) which are
close to the Free Cash Flow to Equity (over a extended period)
(b)For firms where FCFE are difficult to estimate (Example: Banks
and Financial Service companies)
 Use the FCFE Model
(a) For firms which pay dividends which are significantly higher or
lower than the Free Cash Flow to Equity. (What is significant? ... As
a rule of thumb, if dividends are less than 80% of FCFE or dividends
are greater than 110% of FCFE over a 5-year period, use the FCFE
model)
(b) For firms where dividends are not available (Example: Private
Companies, IPOs)

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 What discount rate should I use?
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 Cost of Equity versus Cost of Capital

 If discounting cash flows to equity -> Cost of Equity
 If discounting cash flows to the firm -> Cost of Capital
 What currency should the discount rate (risk free rate)
be in?
 Match the currency in which you estimate the risk free rate to
the currency of your cash flows
 Should I use real or nominal cash flows?
 If discounting real cash flows -> real cost of capital
 If nominal cash flows -> nominal cost of capital
 If inflation is low (<10%), stick with nominal cash flows since
taxes are based upon nominal income
 If inflation is high (>10%) switch to real cash flows
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 Which Growth Pattern Should I use?
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 If your firm is
 large and growing at a rate close to or less than growth rate of the economy, or
 constrained by regulation from growing at rate faster than the economy
 has the characteristics of a stable firm (average risk & reinvestment rates)
Use a Stable Growth Model
 If your firm
 is large & growing at a moderate rate (≤ Overall growth rate + 10%) or
 has a single product & barriers to entry with a finite life (e.g. patents)
Use a 2-Stage Growth Model
 If your firm
 is small and growing at a very high rate (> Overall growth rate + 10%) or
 has significant barriers to entry into the business
 has firm characteristics that are very different from the norm
Use a 3-Stage or n-stage Model

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 The Building Blocks of Valuation
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VALUATION: RELATIVE
VALUATION, PRIVATE COMPANY
VALUATION
Aswath Damodaran
Updated: September 2015
 The Essence of relative valuation?
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 In relative valuation, the value of an asset is compared to

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

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 Multiples are just standardized estimates of price…
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 The Four Steps to Deconstructing Multiples
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 Define the multiple

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

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 Definitional Tests
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 Is the multiple consistently defined?

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

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 Example 1: Price Earnings Ratio: Definition
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PE = Market Price per Share / Earnings per Share

 There are a number of variants on the basic PE ratio
in use. They are based upon how the price and the
earnings are defined.
Price: is usually the current price
is sometimes the average price for the year
EPS: EPS in most recent financial year
EPS in trailing 12 months
Forecasted earnings per share next year
Forecasted earnings per share in future year

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 Example 3: Enterprise Value /EBITDA Multiple
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 The enterprise value to EBITDA multiple is obtained by

netting cash out against debt to arrive at enterprise
value and dividing by EBITDA.
Enterprise Value Market Value of Equity + Market Value of Debt - Cash
=
EBITDA Earnings before Interest, Taxes and Depreciation

1. Why do we net out cash from firm value?

2. What happens if a firm has cross holdings which are
categorized as:
 Minority interests?
 Majority active interests?

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 II. PEG Ratio
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 PEG Ratio = PE ratio/ Expected Growth Rate in EPS

 For consistency, you should make sure that your earnings growth
reflects the EPS that you use in your PE ratio computation.
 The growth rates should preferably be over the same time period.

 To understand the fundamentals that determine PEG ratios, let us return

again to a 2-stage equity discounted cash flow model:
æ (1+g)n ö
EPS0 *Payout Ratio*(1+g)*ç1- n ÷
è (1+r) ø EPS0 *Payout Ratio n *(1+g) *(1+g n )
n
P0 = +
r-g (r-g n )(1+r)n
 Dividing both sides of the equation by the earnings gives us the equation
for the PE ratio. Dividing it again by the expected growth ‘g:
æ (1+g)n ö
Payout Ratio*(1+g)*ç1- n ÷
è (1+r) ø Payout Ratio n *(1+g) *(1+g n )
n
PEG= +
g(r-g) g(r-g n )(1+r)n

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 PEG Ratios and Fundamentals
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 Risk and payout, which affect PE ratios, continue to

affect PEG ratios as well.
 Implication: When comparing PEG ratios across companies,
we are making implicit or explicit assumptions about these
variables.
 Dividing PE by expected growth does not neutralize
the effects of expected growth, since the
relationship between growth and value is not linear
and fairly complex (even in a 2-stage model)

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 III. Price to Book Ratio
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 Going back to a simple dividend discount model,

DPS1
P0 =
r - gn
 Defining the return on equity (ROE) = EPS0 / Book Value of Equity, the
value of equity can be written as:
BV0 *ROE*Payout Ratio*(1+ g n )
P0 =
r-gn
P0 ROE*Payout Ratio*(1+ g n )
= PBV=
BV0 r-gn
 If the return on equity is based upon expected earnings in the next time
period, this can be simplified to,
P0 ROE*Payout Ratio
= PBV=
BV0 r-gn
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 Price Book Value Ratio: Stable Growth Firm
Another Presentation
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 This formulation can be simplified even further by relating

growth to the return on equity:
g = (1 - Payout ratio) * ROE
 Substituting back into the P/BV equation,
P0 ROE - g n
= PBV=
BV0 r-gn
 The price-book value ratio of a stable firm is determined by
the differential between the return on equity and the
required rate of return on its projects.
 Building on this equation, a company that is expected to
generate a ROE higher (lower than, equal to) its cost of equity
should trade at a price to book ratio higher (less than, equal
to) one.
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 Now changing to an Enterprise value multiple
EV/ Book Capital
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 To see the determinants of the value/book ratio,

consider the simple free cash flow to the firm model:
FCFF1
V0 =
WACC - g
 Dividing both sides by the book value, we get:
V0 FCFF1 /BV
=
BV WACC-g
 If we replace, FCFF = EBIT(1-t) - (g/ROC) EBIT(1-t),we
get:
V0 ROC - g
=
BV WACC-g
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 IV. EV to EBITDA - Determinants
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 The value of the operating assets of a firm can be written as:

FCFF1
EV0 =
WACC - g
 Now the value of the firm can be rewritten as

 Dividing both sides of the equation by EBITDA,

 The determinants of EV/EBITDA are:

 The cost of capital
 Expected growth rate
 Tax rate
 Reinvestment rate (or ROC)

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 V. EV/Sales Ratio
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 If pre-tax operating margins are used, the appropriate value

estimate is that of the firm. In particular, if one makes the
replaces the FCFF with the expanded version:
 Free Cash Flow to the Firm = EBIT (1 - tax rate) (1 - Reinvestment Rate)
 Then the Value of é the Firm canæbe written ö a function of the
(1+g)n as ù
ê (1-RIR growth )(1+g)*ç1- n÷ ú
è (1-t)/Sales ø (1-RIR stable )(1+g) *(1+g n ) ú
n
Margin*ê
after-tax (1+WACC)
Oper.operating margin= (EBIT
Value
=After-tax +
Sales0 ê WACC-g (WACC-g n )(1+WACC) ú n

ê ú
ë û
g = Growth rate in after-tax operating income for the first n years
gn = Growth rate in after-tax operating income after n years forever (Stable
growth rate)
RIR Growth, Stable = Reinvestment rate in high growth and stable periods
WACC = Weighted average cost of capital

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 Choosing Between the Multiples
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 As presented in this section, there are dozens of multiples

that can be potentially used to value an individual firm.
 In addition, relative valuation can be relative to a sector (or
comparable firms) or to the entire market (using the
regressions, for instance)
 Since there can be only one final estimate of value, there are
three choices at this stage:
 Use a simple average of the valuations obtained using a number of
different multiples
 Use a weighted average of the valuations obtained using a nmber of
different multiples
 Choose one of the multiples and base your valuation on that multiple

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 Picking one Multiple
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 This is usually the best way to approach this issue. While a

range of values can be obtained from a number of multiples,
the “best estimate” value is obtained using one multiple.
 The multiple that is used can be chosen in one of two ways:
 Use the multiple that best fits your objective. Thus, if you want the
company to be undervalued, you pick the multiple that yields the
highest value.
 Use the multiple that has the highest R-squared in the sector when
regressed against fundamentals. Thus, if you have tried PE, PBV, PS,
etc. and run regressions of these multiples against fundamentals, use
the multiple that works best at explaining differences across firms in
that sector.
 Use the multiple that seems to make the most sense for that sector,
given how value is measured and created.

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 A More Intuitive Approach
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 Managers in every sector tend to focus on specific

variables when analyzing strategy and performance. The
multiple used will generally reflect this focus. Consider
three examples.
 In retailing: The focus is usually on same store sales (turnover)
and profit margins. Not surprisingly, the revenue multiple is
most common in this sector.
 In financial services: The emphasis is usually on return on equity.
Book Equity is often viewed as a scarce resource, since capital
ratios are based upon it. Price to book ratios dominate.
 In technology: Growth is usually the dominant theme. PEG ratios
were invented in this sector.

Aswath Damodaran
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 Conventional usage…
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Sector Multiple Used Rationale

Cyclical Manufacturing PE, Relative PE Often with normalized
earnings
Growth firms PEG ratio Big differences in growth
rates
Young growth firms w/ Revenue Multiples What choice do you have?
losses
Infrastructure EV/EBITDA Early losses, big DA
REIT P/CFE (where CFE = Net Big depreciation charges
income + Depreciation) on real estate

Financial Services Price/ Book equity Marked to market?

Retailing Revenue multiples Margins equalize sooner
or later

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 Ecommerce Valuation
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 Methods of Valuation
 Why Relative Valuation?
 Concept of GMV
 GMV Multiples
 Current Valuations
 Down Round of Flipkart

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 Macro Economics Discussion - India
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 Types of Policies
 Fiscal Policy
 Monetary Policy

 RBI and Monetary Policy Regime

 Monetary Policy Tools
 OMOs, Reserve Requirements, Policy Rates
 Monetary Policy Committee

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 Macro Economics Discussion - Global
59

 US: Fed Funds Rate Hike

 Rate Hike and its impact on Fixed Income and Equities
 US: US elections and its impact on global markets
 Unconventional Monetary Policies

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