Aswath Damodaran!

VALUATION:  ART,  CRAFT  OR  

MAGIC?  
Aswath  Damodaran  
www.damodaran.com  
Some  IniBal  Thoughts  

"  One  hundred  thousand  lemmings  cannot  be  wrong"      

             
 GraffiB  

Aswath Damodaran!
2!
MisconcepBons  about  ValuaBon  

¨  Myth  1:  A  valuaBon  is  an  objecBve  search  for  “true”  value  
¤  Truth  1.1:  All  valuaBons  are  biased.  The  only  quesBons  are  how  much  and  
in  which  direcBon.  
¤  Truth  1.2:  The  direcBon  and  magnitude  of  the  bias  in  your  valuaBon    is  
directly  proporBonal  to  who  pays  you  and  how  much  you  are  paid.  
¨  Myth  2.:  A  good  valuaBon  provides  a  precise  esBmate  of  value  
¤  Truth  2.1:  There  are  no  precise  valuaBons  
¤  Truth  2.2:  The  payoff  to  valuaBon  is  greatest  when  valuaBon  is  least  
precise.  
¨  Myth  3:  .  The  more  quanBtaBve  a  model,  the  beSer  the  valuaBon  
¤  Truth  3.1:  One’s  understanding  of  a  valuaBon  model    is  inversely  
proporBonal  to  the  number  of  inputs  required  for  the  model.  
¤  Truth  3.2:  Simpler  valuaBon  models  do  much  beSer  than  complex  ones.  

Aswath Damodaran!
3!
Approaches  to  ValuaBon  

¨  Intrinsic  valua-on,  relates  the  value  of  an  asset  to  
the  present  value  of  expected  future  cashflows  on  
that  asset.  In  its  most  common  form,  this  takes  the  
form  of  a  discounted  cash  flow  valuaBon.  
¨  Rela-ve  valua-on,  esBmates  the  value  of  an  asset  
by  looking  at  the  pricing  of  'comparable'  assets  
relaBve  to  a  common  variable  like  earnings,  cash  
flows,  book  value  or  sales.    
¨  Con-ngent  claim  valua-on,  uses  opBon  pricing  
models  to  measure  the  value  of  assets  that  share  
opBon  characterisBcs.    
Aswath Damodaran!
4!
Discounted  Cash  Flow  ValuaBon  

¨  What  is  it:  In  discounted  cash  flow  valuaBon,  the  value  of  an  asset  
is  the  present  value  of  the  expected  cash  flows  on  the  asset.  
¨  Philosophical  Basis:  Every  asset  has  an  intrinsic  value  that  can  be  
esBmated,  based  upon  its  characterisBcs  in  terms  of  cash  flows,  
growth  and  risk.  
¨  Informa3on  Needed:  To  use  discounted  cash  flow  valuaBon,  you  
need  
¤  to  esBmate  the  life  of  the  asset  
¤  to  esBmate  the  cash  flows  during  the  life  of  the  asset  
¤  to  esBmate  the  discount  rate  to  apply  to  these  cash  flows  to  get  present  
value  
¨  Market  Inefficiency:  Markets  are  assumed  to  make  mistakes  in  
pricing  assets  across  Bme,  and  are  assumed  to  correct  themselves  
over  Bme,  as  new  informaBon  comes  out  about  assets.  

Aswath Damodaran!
5!
Risk  Adjusted  Value:  Three  Basic  ProposiBons  

¨  The  value  of  an  asset  is  the  present  value  of  the  expected  
cash  flows  on  that  asset,  over  its  expected  life:  

¨  ProposiBon  1:  If  “it”  does  not  affect  the  cash  flows  or  alter  
risk  (thus  changing  discount  rates),  “it”  cannot  affect  value.    
¨  ProposiBon  2:  For  an  asset  to  have  value,  the  expected  cash  
flows  have  to  be  posiBve  some  Bme  over  the  life  of  the  asset.  
¨  ProposiBon  3:  Assets  that  generate  cash  flows  early  in  their  
life  will  be  worth  more  than  assets  that  generate  cash  flows  
later;  the  laSer  may  however  have  greater  growth  and  higher  
cash  flows  to  compensate.  

Aswath Damodaran!
6!
DCF  Choices:  Equity  ValuaBon  versus  Firm  
ValuaBon  
Firm Valuation: Value the entire business

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

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

Equity valuation: Value just the

equity claim in the business

Aswath Damodaran!
7!
The  Drivers  of  Value…  

Growth from new investments Efficiency Growth

Growth created by making new Growth generated by
investments; function of amount and using existing assets
quality of investments better
Terminal Value of firm (equity)
Current Cashflows
These are the cash flows from Expected Growth during high growth period
existing investment,s, net of any Stable growth firm,
reinvestment needed to sustain with no or very
future growth. They can be limited excess returns
computed before debt cashflows (to
the firm) or after debt cashflows (to Length of the high growth period
equity investors). Since value creating growth requires excess returns,
this is a function of
- Magnitude of competitive advantages
- Sustainability of competitive advantages

Cost of financing (debt or capital) to apply to

discounting cashflows
Determined by
- Operating risk of the company
- Default risk of the company
- Mix of debt and equity used in financing

Aswath Damodaran!
8!
 DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm Expected Growth

EBIT (1-t) Reinvestment Rate
- (Cap Ex - Depr) * Return on Capital
Firm is in stable growth:
- Change in WC
Grows at constant rate
= FCFF
forever

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

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn
Value of Operating Assets .........
+ Cash & Non-op Assets Forever
= Value of Firm
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
- Value of Debt
= Value of Equity

Cost of Equity Cost of Debt Weights

(Riskfree Rate Based on Market Value
+ Default Spread) (1-t)

Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
- In same currency and + - Measures market risk X
risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium Premium
Aswath Damodaran!
 Cap Ex = Acc net Cap Ex(255) +
Acquisitions (3975) + R&D (2216) Amgen: Status Quo
Return on Capital
Current Cashflow to Firm Reinvestment Rate 16%
EBIT(1-t)= :7336(1-.28)= 6058 60%
- Nt CpX= 6443 Expected Growth
in EBIT (1-t) Stable Growth
- Chg WC 37 .60*.16=.096 g = 4%; Beta = 1.10;
= FCFF - 423 9.6% Debt Ratio= 20%; Tax rate=35%
Reinvestment Rate = 6480/6058 Cost of capital = 8.08%
=106.98% ROC= 10.00%;
Return on capital = 16.71% Reinvestment Rate=4/10=40%
Growth decreases Terminal Value10 = 7300/(.0808-.04) = 179,099
First 5 years gradually to 4%
Op. Assets 94214 Year 1 2 3 4 5 6 7 8 9 10 Term Yr
+ Cash: 1283 EBIT $9,221 $10,106 $11,076 $12,140 $13,305 $14,433 $15,496 $16,463 $17,306 $17,998 18718
- Debt 8272 EBIT (1-t) $6,639 $7,276 $7,975 $8,741 $9,580 $10,392 $11,157 $11,853 $12,460 $12,958 12167
=Equity 87226 - Reinvestment $3,983 $4,366 $4,785 $5,244 $5,748 $5,820 $5,802 $5,690 $5,482 $5,183 4867
-Options 479 = FCFF $2,656 $2,911 $3,190 $3,496 $3,832 $4,573 $5,355 $6,164 $6,978 $7,775 7300
Value/Share $ 74.33
Cost of Capital (WACC) = 11.7% (0.90) + 3.66% (0.10) = 10.90%
Debt ratio increases to 20%
Beta decreases to 1.10

On May 1,2007,
Amgen was trading
Cost of Equity Cost of Debt at $ 55/share
11.70% (4.78%+..85%)(1-.35) Weights
= 3.66% E = 90% D = 10%

Riskfree Rate: Risk Premium

Riskfree rate = 4.78% Beta 4%
+ 1.73 X

Unlevered Beta for

Sectors: 1.59 D/E=11.06%
Aswath Damodaran!
 Average reinvestment rate
Tata Motors: April 2010 from 2005-09: 179.59%; Return on Capital
without acquisitions: 70% Stable Growth
17.16%
Current Cashflow to Firm g = 5%; Beta = 1.00
EBIT(1-t) : Rs 20,116 Reinvestment Rate
Expected Growth Country Premium= 3%
- Nt CpX Rs 31,590 70%
from new inv. Cost of capital = 10.39%
- Chg WC Rs 2,732 Tax rate = 33.99%
.70*.1716=0.1201
= FCFF - Rs 14,205 ROC= 10.39%;
Reinv Rate = (31590+2732)/20116 = Reinvestment Rate=g/ROC
170.61%; Tax rate = 21.00% =5/ 10.39= 48.11%
Return on capital = 17.16%

Terminal Value5= 23493/(.1039-.05) = Rs 435,686

Rs Cashflows
Op. Assets Rs210,813 Year 1 2 3 4 5 6 7 8 9 10
+ Cash: 11418 EBIT (1-t) 22533 25240 28272 31668 35472 39236 42848 46192 49150 51607 45278
+ Other NO 140576 - Reinvestment 15773 17668 19790 22168 24830 25242 25138 24482 23264 21503 21785
- Debt 109198 FCFF 6760 7572 8482 9500 10642 13994 17711 21710 25886 30104 23493
=Equity 253,628

Value/Share Rs 614
Discount at Cost of Capital (WACC) = 14.00% (.747) + 8.09% (0.253) = 12.50%
Growth declines to 5%
and cost of capital
moves to stable period
level.
Cost of Equity Cost of Debt
14.00% (5%+ 4.25%+3)(1-.3399) Weights
E = 74.7% D = 25.3% On April 1, 2010
= 8.09% Tata Motors price = Rs 781

Riskfree Rate:
Rs Riskfree Rate= 5% Beta Mature market Country Equity Risk
+ 1.20 X premium + Lambda X Premium
4.5% 0.80 4.50%

Unlevered Beta for Firmʼs D/E Rel Equity

Country Default
Aswath Damodaran! Sectors: 1.04 Ratio: 33%
Spread X Mkt Vol
1.50
3%
 Current Cashflow to Firm Indofoods - April 2014
Average annual values from 2009-2013
EBIT(1-t)= 6,222(1-.263)= 4,587 Stable Growth
- (Cap Ex - Deprecn) 4,997 Reinvestment Rate Return on Capital g = 6%; Beta = 1.00;
- Chg Working capital 63 78.03% 22.20% Debt %= 30.3%; k(debt)= 7.5%
= FCFF -473 Cost of capital =12.2%
Reinvestment Rate = 7,967/4587 Expected Growth Tax rate=25%; ROC= 15%;
=175.04% .222*.7803=.1725 or 17.25% Reinvestment Rate=6/15=40%
Return on capital = 21.15%

First 5 years
Growth declines Terminal Value10= 10,810/(.122-.06) = 174,434
gradually to 2.75%
Op. Assets 71,223 Term Yr
Year 1 2 3 4 5 6 7 8 9 10
+ Cash: 18,367 EBIT3(15t) 5388 6328 7432 8729 10252 11809 13338 14763 16008 16997 18,017
- Debt 27,492 353Reinvestment 4204 4938 5799 6811 7999 8317 8378 8151 7621 6799 7,207
- Minority Int 14,725 FCFF 1184 1390 1633 1918 2252 3493 4959 6612 8387 10198 10,810
=Equity 47,373
-Options 0 Cost of capital declines
Value/Share 5,395 IDR Cost of Capital (WACC) = 14.20% (0.697) + 9.56% (0.303) = 12.79% gradually to 12.2%

In April 2014,
Cost of Debt Indofoods was trading
Cost of Equity (6.24%+4.3%+2.2%)(1-.25) Weights at 7200 IDR/share
14.20 = 9.56% E = 69.7% D = 30.3%
Based on actual A rating

Riskfree Rate: ERP for operations

Beta X
Riskfree rate = 6.24% + 0.97
8.21%

Indonesia 92.70% 8.30%

Other countries 7.30% Varied
Unlevered Beta for D/E=
Indofood 100.00% 8.21%
Sectors: 0.7323 43.49%

Aswath Damodaran!
 Aswath Damodaran!

DCF  INPUTS  
“Garbage  in,  garbage  out”  
I.  Measure  earnings  right..    

Operating leases R&D Expenses

Firmʼs Comparable - Convert into debt - Convert into asset
history Firms - Adjust operating income - Adjust operating income

Normalize Cleanse operating items of

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

Measuring Earnings

Update
- Trailing Earnings
- Unofficial numbers

Aswath Damodaran!
14!
OperaBng  Leases  at  Amgen  in  2007  
¨  Amgen  has  lease  commitments  and  its  cost  of  debt  (based  on  it’s  A  raBng)  is  5.63%.  
Year  Commitment  Present  Value  
1    $96.00      $90.88    
2    $95.00      $85.14    
3    $102.00      $86.54    
4    $98.00      $78.72    
5    $87.00      $66.16    
6-­‐12    $107.43      $462.10  ($752  million  prorated)  
¨  Debt  Value  of  leases  =      $869.55    
¨  Debt  outstanding  at  Amgen  =  $7,402  +  $  870  =  $8,272  million  
¨  Adjusted  OperaBng  Income  =  Stated  OI  +  Lease  expense  this  year  –  DepreciaBon  
 =  5,071  m  +  69  m  -­‐  870/12  =  $5,068  million  (12  year  life  for  assets)  
¨  Approximate  OperaBng  income=  stated  OI  +  PV  of  Lease  commitment  *  Pre-­‐tax  cost  of  debt  
=  $5,071  m  +  870  m  (.0563)  =  $  5,120  million  

Aswath Damodaran!
15!
Capitalizing  R&D  Expenses:  Amgen  
¨  R  &  D  was  assumed  to  have  a  10-­‐year  life.    
Year    R&D  Expense  UnamorBzed  porBon    AmorBzaBon  this  year  
Current    3366.00    1.00  3366.00    
-­‐1    2314.00    0.90  2082.60    $231.40    
-­‐2    2028.00    0.80  1622.40    $202.80    
-­‐3    1655.00    0.70  1158.50    $165.50    
-­‐4    1117.00    0.60  670.20    $111.70    
-­‐5    865.00    0.50  432.50    $86.50    
-­‐6    845.00    0.40  338.00    $84.50    
-­‐7    823.00    0.30  246.90    $82.30    
-­‐8    663.00    0.20  132.60    $66.30    
-­‐9    631.00    0.10  63.10    $63.10    
-­‐10    558.00      0.00    $55.80    
Value  of  Research  Asset  =      $10,112.80    $1,149.90    
¨  Adjusted  OperaBng  Income  =  $5,120  +  3,366  -­‐  1,150  =  $7,336  million  

Aswath Damodaran!
16!
II.  Get  the  big  picture  (not  the  accounBng  one)  
when  it  comes  to  cap  ex  and  working  capital  

¨  Capital  expenditures  should  include  

¤  Research  and  development  expenses,  once  they  have  been  re-­‐
categorized  as  capital  expenses.    
¤  AcquisiBons  of  other  firms,  whether  paid  for  with  cash  or  stock.  

¨  Working  capital  should  be  defined  not  as  the  difference  
between  current  assets  and  current  liabiliBes  but  as  the  
difference  between  non-­‐cash  current  assets  and  non-­‐
debt  current  liabiliBes.  
¨  On  both  items,  start  with  what  the  company  did  in  the  
most  recent  year  but  do  look  at  the  company’s  history  
and  at  industry  averages.    

Aswath Damodaran!
17!
Amgen’s  Net  Capital  Expenditures  

¨  The  accounBng  net  cap  ex  at  Amgen  is  small:  
¤  AccounBng  Capital  Expenditures  =    $1,218  million  
¤  -­‐  AccounBng  DepreciaBon  =      $    963  million  
¤  AccounBng  Net  Cap  Ex  =      $    255  million  
¨  We  define  capital  expenditures  broadly  to  include  R&D  and  
acquisiBons:  
¤  AccounBng  Net  Cap  Ex  =      $    255  million  
¤  Net  R&D  Cap  Ex  =  (3366-­‐1150)  =    $2,216  million  
¤  AcquisiBons  in  2006  =      $3,975  million  
¤  Total  Net  Capital  Expenditures  =    $  6,443  million  
¨  AcquisiBons  have  been  a  volaBle  item.  Amgen  was  quiet  on  
the  acquisiBon  front  in  2004  and  2005  and  had  a  significant  
acquisiBon  in  2003.  

Aswath Damodaran!
18!
III.  The  government  bond  rate  is  not  
always  the  risk  free  rate  
¨  When  valuing  Amgen  in  US  dollars,  the  US$  ten-­‐year  bond  rate  of  4.78%  
was  used  as  the  risk  free  rate.  We  assumed  that  the  US  treasury  was  
default  free.  
¨  When  valuing  Tata  Motors  in  Indian  rupees  in  2010,  the  Indian  
government  bond  rate  of  8%  was  not  default  free.  Using  the  Indian  
government’s  local  currency  raBng  of  Ba2  yielded  a  default  spread  of  3%  
for  India  and  a  riskfree  rate  of  5%  in  Indian  rupees.  
 Risk  free  rate  in  Indian  Rupees  =  8%  -­‐  3%  =  5%  
¨  To  esBmate  a  risk  free  rate  in  Indonesian  Rupiah  for  Indofoods,  we  
started  with  the  Indonesian  government  bond  rate  in  rupiah  of  8.44%  and  
subtracted  out  a  default  risk  spread  for  Indonesia    (esBmated  at  2.20%  
based  on  its  raBngs  of  Baa3  and  at  2.44%  in  the  CDS  market):  
¤  Risk  free  rate  in  Indonesian  Rupiah  (based  on  raBng)  =  8.44%-­‐2.20%  =  6.24%  
¤  Risk  free  rate  in  Indonesian  Rupiah  (based  on  CDS)  =  8.44%  -­‐  2.44%  =  6.00%  

Aswath Damodaran!
19!
Risk  free  rates  will  vary  across  currencies!  

Risk  free  rate  by  Currency:  January  2014  

12.00%  

10.00%  

8.00%  

6.00%  

4.00%  

2.00%  

0.00%  

Aswath Damodaran!
20!
But  valuaBons  should  not!  

Aswath Damodaran!
21!
IV.  Betas  do  not  come  from  regressions…  and  
are  noisy…  

Aswath Damodaran!
22!
Look  beSer  for  some  companies,  but  not  if  run  
against  narrow  indices  

Aswath Damodaran!
23!
Determinants  of  Betas  
Beta of Equity

Beta of Firm Financial Leverage:

Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
Nature of product or Operating Leverage (Fixed equity beta will be
service offered by Costs as percent of total
company: costs):
Other things remaining equal, Other things remaining equal
the more discretionary the the greater the proportion of Implciations
product or service, the higher the costs that are fixed, the Highly levered firms should have highe betas
the beta. higher the beta of the than firms with less debt.
company.

Implications Implications
1. Cyclical companies should 1. Firms with high infrastructure
have higher betas than non- needs and rigid cost structures
cyclical companies. shoudl have higher betas than
2. Luxury goods firms should firms with flexible cost structures.
have higher betas than basic 2. Smaller firms should have higher
goods. betas than larger firms.
3. High priced goods/service 3. Young firms should have
firms should have higher betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Aswath Damodaran!
24!
BoSom-­‐up  Betas  
Step 1: Find the business or businesses that your firm operates in.

Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
obtain their regression betas. Compute the simple average across
these regression betas to arrive at an average beta for these publicly If you can, adjust this beta for differences
traded firms. Unlever this average beta using the average debt to between your firm and the comparable
equity ratio across the publicly traded firms in the sample. firms on operating leverage and product
Unlevered beta for business = Average beta across publicly traded characteristics.
firms/ (1 + (1- t) (Average D/E ratio across firms))

While revenues or operating income

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

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

If you expect your debt to equity ratio to

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

Aswath Damodaran!
25!
Three  examples…  

¨  Amgen    
¤  The  unlevered  beta  for  pharmaceuBcal  firms  is  1.59.  Using  Amgen’s  debt  to  
equity  raBo  of  11%,  the  boSom  up  beta  for  Amgen    is  
¤  BoSom-­‐up  Beta  =  1.59  (1+  (1-­‐.35)(.11))  =  1.73  
¨  Tata  Motors  
¤  The  unlevered  beta  for  automobile  firms  is  0.98.  Using  Tata  Motor’s  debt  to  
equity  raBo  of  33.87%,  the  boSom  up  beta  for  Tata  Motors    is  
¤  BoSom-­‐up  Beta  =  0.98  (1+  (1-­‐.3399)(.3387))  =  1.20  

Aswath Damodaran!
26!
A  mulB-­‐business  company  

¨  Indofoods  is  in  three  businesses  –  agribusiness,  food  

processing  and  food  distribuBon:  
Business
Revenues
EV/Sales
Estimated Value
% of company
Unlevered Beta

Food Processing
$68.00
1.3988
$95.12
83.02%
0.7606

Agribusiness
$24.00
0.6300
$15.12
13.20%
0.5700

Retail/Wholesale Food
$8.00
0.5414
$4.33
3.78%
0.6770

Indofoods
 $100.00      $114.57     0.7323  

¨  To  get  the  levered  beta  for  the  operaBng  assets  of  the  
company,  we  use  Indofood’s  market  D/E  raBo  of  43.49%:  
  Business  
Food  Processing  
Unlevered  Beta  
0.7606  
D/E  ra3o  
43.49%  
Levered  Beta  
1.01  
Agribusiness   0.5700   43.49%   0.76  
Retail/Wholesale  Food   0.6770   43.49%   0.90  
Indofoods   0.7323   43.49%   0.97  

Aswath Damodaran!
27!
V.  And  the  past  is  not  always  a  good  indicator  of  
the  future  

   "
 "
Arithmetic Average" Geometric Average"
Stocks - T. Bills" Stocks - T. Bonds" Stocks - T. Bills" Stocks - T. Bonds"
1928-2013" 7.93%" 6.29%" 6.02%" 4.62%"
 Std Error" 2.19%! 2.34%!  "  "
1964-2013" 6.18%" 4.32%" 4.83%" 3.33%"
 Std Error" 2.42%! 2.75%!  "  "
2004-2013" 7.55%" 4.41%" 5.80%" 3.07%"
 Std Error" 6.02%! 8.66%!  "  "

Base year cash flow

Dividends (TTM): 34.32 Expected growth in next 5 years
+ Buybacks (TTM): 49.85 Top down analyst estimate of
= Cash to investors (TTM): 84.16 earnings growth for S&P 500 with
Earnings in TTM: stable payout: 4.28%
Beyond year 5
E(Cash to investors) 87.77 91.53 95.45 99.54 103.80 Expected growth rate =

  S&P 500 on 1/1/14 =

1848.36 87.77
+
91.53
+
95.45
+
99.54
+
103.80
+
103.80(1.0304)
= 1848.36!
Riskfree rate = 3.04%
Terminal value =
103.8(1.0304)/(,08 - .0304)
(1 + !)! (1 + !)! (1 + !)! (1 + !)! (1 + !)! (! − .0304)(1 + !)!

r = Implied Expected Return on Stocks = 8.00%

Minus

Risk free rate = T.Bond rate on 1/1/14=3.04%

Equals

Aswath Damodaran! Implied Equity Risk Premium (1/1/14) = 8% - 3.04% = 4.96%

28!
 29!

2013

2012

2011

2010

Implied  Premiums  in  the  US:  1960-­‐2013  

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

Year

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1970

1969

1968

1967

1966

Aswath Damodaran!
1965

1964

1963

1962

1961

1960

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Implied Premium

The  Anatomy  of  a  Crisis:  Implied  ERP  from  
September  12,  2008  to  January  1,  2009  

Aswath Damodaran!
30!
Implied  Premium  for  India  using  the  Sensex:  
April  2010  

¨  Level  of  the  Index  =  17559  

¨  FCFE  on  the  Index  =  3.5%  (EsBmated  FCFE  for  companies  
in  index  as  %  of  market  value  of  equity)  
¨  Other  parameters  
¤  Riskfree  Rate  =  5%  (Rupee)  
¤  Expected  Growth  (in    Rupee)  
n  Next  5  years  =  20%  (Used  expected  growth  rate  in  Earnings)  
n  Axer  year  5  =    5%  

¨  Solving  for  the  expected  return:  

¤  Expected  return  on  Equity  =  11.72%  
¤  Implied  Equity  premium    for  India  =11.72%  -­‐  5%  =  6.72%  

Aswath Damodaran!
31!
Emerging  versus  Developed  Markets:  
Implied  Equity  Risk  Premiums  

Aswath Damodaran!
32!
VI.  There  is  a  downside  to  globalizaBon…  

¨  Emerging  markets  offer  growth  opportuniBes  but  they  are  also  riskier.  If  we  want  
to  count  the  growth,  we  have  to  also  consider  the  risk.  
¨  Two  ways  of  esBmaBng  the  country  risk  premium:  
¤  Sovereign  Default  Spread:  In  this  approach,  the  country  equity  risk  premium  is  set  equal  to  the  
default  spread  of  the  bond  issued  by  the  country.  
n  Equity  Risk  Premium  for  mature  market  =  4.50%  
n  Default  Spread  for  India  =  3.00%  (based  on  raBng)  
n  Equity  Risk  Premium  for  India  =  4.50%  +  3.00%  
¤  Adjusted  for  equity  risk:  The  country  equity  risk  premium  is  based  upon  the  volaBlity  of  the  
equity  market  relaBve  to  the  government  bond    rate.  
n  Country  risk  premium=  Default  Spread*  Std DeviationCountry  Equity  /  Std DeviationCountry  Bond  
n  Standard  DeviaBon  in  Sensex  =  21%  
n  Standard  DeviaBon  in  Indian  government  bond=  14%  
n  Default  spread  on  Indian  Bond=  2%  
n  AddiBonal  country  risk  premium  for  India  =  2%  (21/14)  =  3%  
n  Total  equity  risk  premium  =  US  equity  risk  premium  +  CRP  for  India  =  6%  +  3%  =  9%  

Aswath Damodaran!
33!
Indonesia’s  Country  Risk  Premium  

¨  Default  Spread  for  Indonesia  in  April  2014  

¤  CDS  Spread  for  Indonesia  in  April  2014  =2.54%  
¤  Spread  based  upon  Indonesia’s  Baa3  raBng  =  2.20%  
¨  RelaBve  VolaBlity    
¤  Standard  deviaBon  in  Indonesian  equiBes  =  16.94%  
¤  Standard  deviaBon  in  Indonesian  Government  Bond  =  10.73%%  
¤  RelaBve  standard  deviaBon  =  16.94%/10.73%  =  1.58  (approximately)  
¤  Country  risk  premium  for  Indonesia  =  2.20%  (1.58)  =  3.48%  
¤  If  you  use  the  average  relaBve  volaBlity  measure  across  all  emerging  
markets  (about  1.50),  country  risk  premium  =  2.20%  (1.50)  =  3.30%  
¨  EsBmaBng  equity  risk  premium  for  Indonesia  
¤  Mature  market  premium  on  April  1,  2014=  5.00%  (US  S&P  500)  
¤  Country  risk  premium  for  Indonesia  =  3.30%  
¤  Total  Equity  risk  premium  for  Indonesia  =  5.00%  +  3.30%  =  8.30%  

Aswath Damodaran!
34!
 Andorra
6.80%
1.80%
Liechtenstein
5.00%
0.00%

ERP : Jan 2014!
Albania
11.75%
6.75%

Austria
5.00%
0.00%
Luxembourg
5.00%
0.00%
Bangladesh
10.40%
5.40%

Armenia
9.50%
4.50%

Belgium
5.90%
0.90%
Malta
6.80%
1.80%
Cambodia
13.25%
8.25%

Azerbaijan
8.30%
3.30%

Cyprus
20.00%
15.00%
Netherlands
5.00%
0.00%
China
5.90%
0.90%

Belarus
14.75%
9.75%

Denmark
5.00%
0.00%
Norway
5.00%
0.00%
Fiji
11.75%
6.75%

Bosnia and Herzegovina
14.75%
9.75%

Finland
5.00%
0.00%
Portugal
10.40%
5.40%
Bulgaria
7.85%
2.85%
Hong Kong
5.60%
0.60%

France
5.60%
0.60%
Spain
8.30%
3.30%
Croatia
8.75%
3.75%
India
8.30%
3.30%

Germany
5.00%
0.00%
Sweden
5.00%
0.00%
Czech Republic
6.05%
1.05%
Indonesia
8.30%
3.30%

Greece
20.00%
15.00%
Switzerland
5.00%
0.00%
Estonia
6.05%
1.05%
Japan
5.90%
0.90%

Iceland
8.30%
3.30%
Turkey
8.30%
3.30%
Georgia
10.40%
5.40%
Korea
5.90%
0.90%

Ireland
8.75%
3.75%
United Kingdom
5.60%
0.60%
Hungary
8.75%
3.75%
Macao
5.90%
0.90%

Italy
7.85%
2.85%
Western Europe
6.29%
1.29%
Kazakhstan
7.85%
2.85%
Malaysia
6.80%
1.80%

Latvia
7.85%
2.85%
Mauritius
7.40%
2.40%

Canada
5.00%
0.00%
Lithuania
7.40%
2.40%

Angola
10.40%
5.40%
Mongolia
11.75%
6.75%

United States of America
5.00%
0.00%
Macedonia
10.40%
5.40%

Benin
13.25%
8.25%
Pakistan
16.25%
11.25%

North America
5.00%
0.00%
Moldova
14.75%
9.75%

Botswana
6.28%
1.28%
Papua New Guinea
11.75%
6.75%

Montenegro
10.40%
5.40%
Philippines
8.30%
3.30%

Argentina
14.75%
9.75%
Burkina Faso
13.25%
8.25%

Poland
6.28%
1.28%
Singapore
5.00%
0.00%

Belize
18.50%
13.50%
Cameroon
13.25%
8.25%

Romania
8.30%
3.30%

Bolivia
10.40%
5.40%
Cape Verde
13.25%
8.25%
Sri Lanka
11.75%
6.75%

Russia
7.40%
2.40%

Brazil
7.85%
2.85%
DR Congo
14.75%
9.75%
Taiwan
5.90%
0.90%

Serbia
11.75%
6.75%

Chile
5.90%
0.90%
Egypt
16.25%
11.25%
Thailand
7.40%
2.40%

Slovakia
6.28%
1.28%

Colombia
8.30%
3.30%
Gabon
10.40%
5.40%
Vietnam
13.25%
8.25%

Slovenia
8.75%
3.75%

Costa Rica
8.30%
3.30%
Ghana
11.75%
6.75%
Asia
6.51%
1.51%

Ukraine
16.25%
11.25%

Ecuador
16.25%
11.25%
Kenya
11.75%
6.75%
E. Europe & Russia
7.96%
2.96%

El Salvador
10.40%
5.40%
Morocco
8.75%
3.75%

Guatemala
8.75%
3.75%
Mozambique
11.75%
6.75%
Abu Dhabi
5.75%
0.75%
Australia
5.00%
0.00%

Honduras
13.25%
8.25%
Namibia
8.30%
3.30%
Bahrain
7.85%
2.85%
Cook Islands
11.75%
6.75%

Mexico
7.40%
2.40%
Nigeria
10.40%
5.40%
Israel
6.05%
1.05%
New Zealand
5.00%
0.00%

Rep Congo
10.40%
5.40%
Jordan
11.75%
6.75%
Australia & New
Nicaragua
14.75%
9.75%

Zealand
5.00%
0.00%

Panama
7.85%
2.85%
Rwanda
13.25%
8.25%
Kuwait
5.75%
0.75%

Paraguay
10.40%
5.40%
Senegal
11.75%
6.75%
Lebanon
11.75%
6.75%

Peru
7.85%
2.85%
South Africa
7.40%
2.40%
Oman
6.05%
1.05%

Suriname
10.40%
5.40%
Tunisia
10.40%
5.40%
Qatar
5.75%
0.75%

Uruguay
8.30%
3.30%
Uganda
11.75%
6.75%
Saudi Arabia
5.90%
0.90%
Black #: Total ERP

Venezuela
16.25%
11.25%
Zambia
11.75%
6.75%
United Arab Emirates
5.75%
0.75%
Red #: Country risk premium

Latin America
8.62%
3.62%
Africa
10.04%
5.04%
Middle East
6.14%
1.14%
AVG: GDP weighted average

Indonesia  country  risk  over  Bme  

Aswath Damodaran!
36!
VII.  And  it  is  not  just  emerging  market  
companies  that  are  exposed  to  this  risk..  
¨  The  “default”  approach  in  valuaBon  has  been  to  assign  
country  risk  based  upon  your  country  of  incorporaBon.  
Thus,  if  you  are  incorporated  in  a  developed  market,  the  
assumpBon  has  been  that  you  are  not  exposed  to  
emerging  market  risks.  If  you  are  incorporated  in  an  
emerging  market,  you  are  saddled  with  the  enBre  
country  risk.  
¨  As  companies  globalize  and  look  for  revenues  in  foreign  
markets,  this  pracBce  will  under  esBmate  the  costs  of  
equity  of  developed  market  companies  with  significant  
emerging  market  risk  exposure  and  over  esBmate  the  
costs  of  equity  of  emerging  market  companies  with  
significant  developed  market  risk  exposure.  

Aswath Damodaran!
37!
One  way  of  dealing  with  this:  OperaBon-­‐based  
ERP  for  Indofoods  

Country
Revenues
ERP
Weight
Weighted ERP

Indonesia
44650
8.30%
92.73%
7.70%

Saudi Arabia
621
5.90%
1.29%
0.08%

Netherlands
593
5.00%
1.23%
0.06%

Korea
498
5.90%
1.03%
0.06%

China
391
5.90%
0.81%
0.05%

Nigeria
335
10.40%
0.70%
0.07%

Philippines
303
8.30%
0.63%
0.05%

Vietnam
300
13.25%
0.62%
0.08%

Malaysia
263
6.80%
0.55%
0.04%

Singapore
199
5.00%
0.41%
0.02%

Total
48153
 
100.00%
8.21%

Aswath Damodaran!
38!
 An  alternate  way:  EsBmaBng  a  company’s  
exposure  to  country  risk  (Lambda)  
¨  Just  as  beta  measures  exposure  to  macro  economic  risk,  lambda  measures  exposure  just  
to  country  risk.  Like  beta,  it  is  scaled  around  one.    
¨  The  easiest  and  most  accessible  data  is  on  revenues.  Most  companies  break  their  revenues  
down  by  region.  One  simplisBc  soluBon  would  be  to  do  the  following:  
Lambda  =  %  of  revenues  domesBcally  firm/  %  of  revenues  domesBcally  average  firm  
¨  In  2008-­‐09,  Tata  Motors  got  about  91.37%  of  its  revenues  in  India  and  TCS  got  7.62%.  The  
average  Indian  firm  gets  about  80%  of  its  revenues  in  India:  
¤    Lambda  Tata  Motors  =  91%/80%  =  1.14  
¤  The  danger  of  focusing  just  on  revenues  is  that  it  misses  other  exposures  to  risk  
(producBon  and  operaBons).    
Tata Motors TCS

% of production/operations in India High High

91.37% (in 2009)
% of revenues in India Estimated 70% (in 2010) 7.62%
Lambda 0.80 0.20
Low. Significant physical
Flexibility in moving operations assets. High. Human capital is mobile.
39!
VIII.  Growth  has  to  be  earned  (not  endowed  or  
esBmated)  
Expected Growth

Net Income Operating Income

Retention Ratio= Return on Equity Reinvestment Return on Capital =

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

Adjust EBIT for Use a marginal tax rate

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

EBIT ( 1- tax rate)

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

Adjust book equity for Adjust book value of debt for

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

Use end of prior year numbers or average over the year

Aswath Damodaran! but be consistent in your application
40!
OperaBng  income,  Reinvestment  &  Return  
on  Capital  -­‐  Indofoods  
  2009   2010   2011   2012   2013   Total  
Revenues   37397   38403   45768   50201   57732   229501  
EBIT   5004   6729   6649   6690   6222   31294  
EffecBve  tax  rate   29.70%   27.57%   23.01%   24.24%   26.83%   26.27%  
OperaBng  Margin   13.38%   17.52%   14.53%   13.33%   10.78%   13.64%  
Cap  Ex   3090   2576   2915   4779   6541   19901  
AcquisiBons   0   275   15   200   2970   3460  
DepreciaBon   1130   252   986   1134   1545   5047  
Net  Cap  Ex   1960   2599   1944   3845   7966   18314  
Chg  in  WC   26.55   40.24   294.60   177.32   301.24   839.95  
Reinvestment   1986.55   2639.24   2238.60   4022.32   8267.24   19153.95  
EBIT  (1-­‐  t)   3517.81   4873.81   5119.07   5068.34   4552.64   23131.67  
Reinvestment  rate   52.22%   51.50%   38.98%   76.63%   170.71%   78.03%  
Book  Debt   16426   16927   14326   13686   15326   76691  
Book  Equity   8572   10155   16781   19388   21206   76102  
Cash   4894   4806   10908   13630   13899   48137  
Invested  Capital   20104   22276   20199   19444   22633   104656  
ROIC   17.50%   21.88%   25.34%   26.07%   20.12%   22.10%  

Aswath Damodaran!
41!
Sounds simple, right? But companies seem to
have trouble in practice

ROIC  versus  Cost  of  Capital:  A  Global  Assessment  for  2013  

80.00%  

70.00%  

60.00%  
%  of  firms  in  the  group  

50.00%   ROC  more  than  5%  below  cost  of  capital  

ROC  between  2%  and  5%  below  cost  of  capital  

40.00%  
ROC  between  2%  and  0%  below  cost  of  capital  

ROC  between  0  and  2%  more  than  cost  of  capital  

30.00%  
ROC  between  2%  and  5%  above  cost  of  capital  
20.00%   ROC  more  than  5%  above  cost  of  capital  

10.00%  

0.00%  
Australia,   Europe   Emerging   Japan   US   Global  
NZ  &   Markets  
Canada  

42!
IX.  All  good  things  come  to  an  end..And  the  
terminal  value  is  not  an  ATM…  

This tax rate locks in Are you reinvesting enough to sustain your
forever. Does it make stable growth rate?
sense to use an Reinv Rate = g/ ROC
effective tax rate? Is the ROC that of a stable company?
EBITn+1 (1 - tax rate) (1 - Reinvestment Rate)
Terminal Valuen =
Cost of capital - Expected growth
rate
This growth rate should be
This is a mature company. less than the nomlnal
It’s cost of capital should growth rate of the economy
reflect that.

Aswath Damodaran!
43!
Terminal  Value  and  Growth  

Stable'growth'rate Amgen Tata'Motors Indofoods

0% $150,652 435,686₹ IDR/147,680
1% $154,479 435,686₹ IDR/150,142
2% $160,194 435,686₹ IDR/153,086
3% $167,784 435,686₹ IDR/156,670
4% $179,099 435,686₹ IDR/161,128
5% 435,686₹ IDR/166,824
IDR/174,358
Riskfree/rate 4.78% 5% 6.24%
ROIC 10% 10.39% 15.00%

Aswath Damodaran!
44!
 Aswath Damodaran!

THE  LOOSE  ENDS  IN  

VALUATION…  
Aswath  Damodaran  
Ge|ng  from  DCF  to  value  per  share:  The  
Loose  Ends  

The adjustments to
get to firm value Intangible assets
(Brand Name)
+ Cash & Marketable Premium
Securities Control
Discount FCFF Synergy Premium Premium
at Cost of Discount? Premium?
capital =
Operating Asset + + Value of Cross
= Value of Value per
Value
holdings Value of business
(firm) - Debt = Equity share
Book value? Market
value? Underfunded
Complexity Minority Option
+ Value of other non- pension/ Discount Overhang
discount
operating assets health care
obligations? Distress Differences
What should be here? discount in cashflow/
What should not? Lawsuits & voting rights
Contingent Liquidity across
liabilities? discount shares

Aswath Damodaran!
46!
1.  The  Value  of  Cash  
An  Exercise  in  Cash  ValuaBon  

     Company  A  Company  B  Company  C  

Enterprise  Value  $  1  billion  $  1  billion  $  1  billion  
Cash        $  100  mil  $  100  mil  $  100  mil  
Return  on  Capital  10%    5%    22%  
Cost  of  Capital    10%    10%    12%  
Trades  in      US    US    ArgenBna  

¨  In  which  of  these  companies  is  cash  most  likely  to  
trade  at  face  value,  at  a  discount  and  at  a  premium?  

Aswath Damodaran!
47!
Cash:  Discount  or  Premium?  

Aswath Damodaran!
48!
2.  Dealing  with  Holdings  in  Other  firms  

¨  Holdings  in  other  firms  can  be  categorized  into  

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

Aswath Damodaran!
49!
How  to  value  holdings  in  other  firms..  In  a  
perfect  world..  

¨  In  a  perfect  world,  we  would  strip  the  parent  

company  from  its  subsidiaries  and  value  each  one  
separately.  The  value  of  the  combined  firm  will  be  
¤  Value  of  parent  company  +  ProporBon  of  value  of  each  
subsidiary  
¨  To  do  this  right,  you  will  need  to  be  provided  
detailed  informaBon  on  each  subsidiary  to  esBmate  
cash  flows  and  discount  rates.  

Aswath Damodaran!
50!
Two  compromise  soluBons…  

¨  The  market  value  soluBon:  When  the  subsidiaries  are  

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

Aswath Damodaran!
51!
Tata  Motor’s  Cross  Holdings  

Tata  Chemicals,  2,431₹  

Tata  Steel,  
Other  publicly  held  Tata  
13,572₹  
Companies,  12,335₹  

Non-­‐public  Tata  companies,  

112,238₹  

Aswath Damodaran!
52!
 Indofoods:  From  operaBng  assets  to  
equity  value  
PV  of  cash  flows  during  high  
growth  =   18054   25.35%  
PV  of  terminal  value   53168   74.65%  
Value  of  operaBng  assets   71222   71222  
 +  Cash   18367  
Value  of  firm   89589   89589  
 -­‐  Debt   27492  
Value  of  equity  in  consolidated  
companies   62097   62097  
 -­‐  Value  of  minority  interests   14725  
Value  of  equity  in  company   47372  

Aswath Damodaran!
53!
3.  Other  Assets  that  have  not  been  counted  
yet..  
¨  UnuBlized  assets:  If  you  have  assets  or  property  that  are  not  
being  uBlized  (vacant  land,  for  example),  you  have  not  valued  
it  yet.  You  can  assess  a  market  value  for  these  assets  and  add  
them  on  to  the  value  of  the  firm.  
¨  Overfunded  pension  plans:  If  you  have  a  defined  benefit  plan  
and  your  assets  exceed  your  expected  liabiliBes,  you  could  
consider  the  over  funding  with  two  caveats:  
¤  CollecBve  bargaining  agreements  may  prevent  you  from  laying  claim  
to  these  excess  assets.  
¤  There  are  tax  consequences.  Oxen,  withdrawals  from  pension  plans  
get  taxed  at  much  higher  rates.  
¤  Do  not  double  count  an  asset.  If  you  count  the  income  from  
an  asset  in  your  cash  flows,  you  cannot  count  the  market  
value  of  the  asset  in  your  value.  

Aswath Damodaran!
54!
The  “real  estate”  play  

¨  Indofoods  has  real  estate  investments  underlying  its  plantaBons  

(which  are  being  used  to  generate  its  operaBng  income).  Assume  
that  you  esBmate  a  real  estate  value  of  40,000  billion  IDR  for  the  
real  estate.  Can  you  add  this  value  on  to  your  DCF  value?    
a.  Yes.  
b.  No.  
c.  Depends  
¨  What  would  you  do  if  the  value  of  the  land  under  the  plantaBons  
exceeds  the  present    value  that  you  have  esBmated  for  them  as  
plantaBons?  
a.  Nothing  
b.  Use  the  higher  of  the  two  values  
c.  Use  the  lower  of  the  two  values  
d.  Use  a  weighted  average  of  the  two  values    
 
Aswath Damodaran!
55!
4.  A  Discount  for  Complexity:  
An  Experiment  

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

Aswath Damodaran!
56!
Measuring  Complexity:  Volume  of  Data  in  
Financial  Statements  

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

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

Aswath Damodaran!
57!
 Measuring  Complexity:  A  Complexity  Score  

Item
Factors
Follow-up Question
Answer
Weighting factor
Gerdau Score
GE Score

Operating Income
1. Multiple Businesses
Number of businesses (with more than 10% of
revenues) =
1
2.00
2
30

2. One-time income and expenses

Percent of operating income =
10%
10.00
1
0.8

3. Income from unspecified sources

Percent of operating income =
0%
10.00
0
1.2

4. Items in income statement that are volatile

Percent of operating income =
15%
5.00
0.75
1

Tax Rate
1. Income from multiple locales

Percent of revenues from non-domestic locales =
70%
3.00
2.1
1.8

2. Different tax and reporting books

Yes or No
No
Yes=3
0
3

3. Headquarters in tax havens

Yes or No
No
Yes=3
0
0

4. Volatile effective tax rate

Yes or No
Yes
Yes=2
2
0

Capital Expenditures
1. Volatile capital expenditures

Yes or No
Yes
Yes=2
2
2

2. Frequent and large acquisitions

Yes or No
Yes
Yes=4
4
4

3. Stock payment for acquisitions and
investments
Yes or No
No
Yes=4
0
4

Working capital
1. Unspecified current assets and current
liabilities
Yes or No
No
Yes=3
0
0

2. Volatile working capital items

Yes or No
Yes
Yes=2
2
2

Expected Growth rate
1. Off-balance sheet assets and liabilities
(operating leases and R&D)

Yes or No
No
Yes=3
0
3

2. Substantial stock buybacks

Yes or No
No
Yes=3
0
3

3. Changing return on capital over time

Is your return on capital volatile?
Yes
Yes=5
5
5

4. Unsustainably high return

Is your firm's ROC much higher than industry average?
No
Yes=5
0
0

Cost of capital
1. Multiple businesses

Number of businesses (more than 10% of revenues) =
1
1.00
1
20

2. Operations in emerging markets

Percent of revenues=
50%
5.00
2.5
2.5

3. Is the debt market traded?

Yes or No
No
No=2
2
0

4. Does the company have a rating?

Yes or No
Yes
No=2
0
0

5. Does the company have off-balance sheet
debt?
Yes or No
No
Yes=5
0
5

No-operating assets
Minority holdings as percent of book assets

Minority holdings as percent of book assets
0%
20.00
0
0.8

Firm to Equity value
Consolidation of subsidiaries

Minority interest as percent of book value of equity
63%
20.00
12.6
1.2

Per share value
Shares with different voting rights

Does the firm have shares with different voting rights?
Yes
Yes = 10
10
0

 
Aswath Damodaran! Equity options outstanding

Options outstanding as percent of shares
0%
10.00
0
58!
0.25

Complexity Score =
48.95
90.55

Dealing  with  Complexity  

¨  In  Discounted  Cashflow  ValuaBon  

¤  The  Aggressive  Analyst:  Trust  the  firm  to  tell  the  truth  and  value  the  firm  
based  upon  the  firm’s  statements  about  their  value.  
¤  The  ConservaBve  Analyst:  Don’t  value  what  you  cannot  see.  
¤  The  Compromise:  Adjust  the  value  for  complexity  
n  Adjust  cash  flows  for  complexity  
n  Adjust  the  discount  rate  for  complexity  
n  Adjust  the  expected  growth  rate/  length  of  growth  period  
n  Value  the  firm  and  then  discount  value  for  complexity  
¨  In  relaBve  valuaBon  
¤  In  a  relaBve  valuaBon,  you  may  be  able  to  assess  the  price  that  the  market  
is  charging  for  complexity:  
¤  With  the  hundred  largest  market  cap  firms,  for  instance:  
PBV  =  0.65  +  15.31  ROE  –  0.55  Beta  +  3.04  Expected  growth  rate  –  0.003  #  
Pages  in  10K  

Aswath Damodaran!
59!
 5.  The  Value  of  Synergy  

Synergy is created when two firms are combined and can be

either financial or operating

Operating Synergy accrues to the combined firm as Financial Synergy

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

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

Aswath Damodaran!
60!
Valuing  Synergy  

(1)  the  firms  involved  in  the  merger  are  valued  

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

Aswath Damodaran!
61!
Valuing  Synergy:  P&G  +  GilleSe  

Assume that $250 million in operating expenses will be cut

immediately. Translates into an after-tax increase in
operating income of approximately $158 million.!

Assume that the combined company

will grow at a faster rate (for the next
decade) starting immediately.!

Aswath Damodaran!
62!
6.  Brand  name,  great  management,  superb  
product  …Are  we  short  changing    intangibles?  

¨  There  is  oxen  a  temptaBon  to  add  on  premiums  for  
intangibles.  Here  are  a  few  examples.  
¤  Brand  name  
¤  Great  management  
¤  Loyal  workforce  
¤  Technological  prowess  

¨  There  are  two  potenBal  dangers:  

¤  For  some  assets,  the  value  may  already  be  in  your  value  
and  adding  a  premium  will  be  double  counBng.  
¤  For  other  assets,  the  value  may  be  ignored  but  
incorporaBng  it  will  not  be  easy.  

Aswath Damodaran!
63!
Valuing  Brand  Name  
     Coca  Cola
   With  CoK  Margins  
Current  Revenues  =    $21,962.00      $21,962.00    
Length  of  high-­‐growth  period    10    10  
Reinvestment  Rate    =    50%    50%  
OperaBng  Margin  (axer-­‐tax)  15.57%    5.28%  
Sales/Capital  (Turnover  raBo)  1.34    1.34  
Return  on  capital  (axer-­‐tax)  20.84%    7.06%  
Growth  rate  during  period  (g)  =  10.42%    3.53%  
Cost  of  Capital  during  period    =  7.65%    7.65%  
Stable  Growth  Period  
Growth  rate  in  steady  state  =  4.00%    4.00%  
Return  on  capital  =    7.65%    7.65%  
Reinvestment  Rate  =    52.28%    52.28%  
Cost  of  Capital  =    7.65%    7.65%  
Value  of  Firm  =    $79,611.25      $15,371.24    

Aswath Damodaran!
64!
7.  Be  circumspect  about  defining  debt  for  cost  
of  capital  purposes…  

¨  General  Rule:  Debt  generally  has  the  following  

characterisBcs:  
¤  Commitment  to  make  fixed  payments  in  the  future  
¤  The  fixed  payments  are  tax  deducBble  
¤  Failure  to  make  the  payments  can  lead  to  either  default  or  loss  
of  control  of  the  firm  to  the  party  to  whom  payments  are  due.  
¨  Defined  as  such,  debt  should  include    
¤  All  interest  bearing  liabiliBes,  short  term  as  well  as  long  term  
¤  All  leases,  operaBng  as  well  as  capital  

¨  Debt  should  not  include  

¤  Accounts  payable  or  supplier  credit  

Aswath Damodaran!
65!
But  should  consider  other  potenBal  liabiliBes  
when  ge|ng  to  equity  value…  
¨  If  you  have  under  funded  pension  fund  or  health  care  
plans,  you  should  consider  the  under  funding  at  this  
stage  in  ge|ng  to  the  value  of  equity.  
¤  If  you  do  so,  you  should  not  double  count  by  also  including  a  
cash  flow  line  item  reflecBng  cash  you  would  need  to  set  aside  
to  meet  the  unfunded  obligaBon.  
¤  You  should  not  be  counBng  these  items  as  debt  in  your  cost  of  
capital  calculaBons….  
¨  If  you  have  conBngent  liabiliBes  -­‐  for  example,  a  
potenBal  liability  from  a  lawsuit  that  has  not  been  
decided  -­‐  you  should  consider  the  expected  value  of  
these  conBngent  liabiliBes  
¤  Value  of  conBngent  liability  =  Probability  that  the  liability  will  
occur  *  Expected  value  of  liability  
Aswath Damodaran!
66!
8.  The  Value  of  Control  

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

Aswath Damodaran!
67!
 Increase Cash Flows
Reduce the cost of capital

Make your
More efficient product/service less Reduce
operations and Revenues Operating
discretionary
cost cuttting: leverage
Higher Margins * Operating Margin
= EBIT Reduce beta

Divest assets that - Tax Rate * EBIT

have negative EBIT Cost of Equity * (Equity/Capital) +
= EBIT (1-t) Pre-tax Cost of Debt (1- tax rate) *
Live off past over- (Debt/Capital)
Reduce tax rate + Depreciation investment
- Capital Expenditures Shift interest
- moving income to lower tax locales - Chg in Working Capital
- transfer pricing Match your financing expenses to
- risk management = FCFF higher tax locales
to your assets:
Reduce your default
risk and cost of debt
Change financing
Better inventory mix to reduce
management and cost of capital
tighter credit policies
Firm Value

Increase Expected Growth Increase length of growth period

Reinvest more in Do acquisitions

projects Build on existing Create new
Reinvestment Rate
competitive competitive
* Return on Capital advantages advantages
Increase operating Increase capital turnover ratio
margins
= Expected Growth Rate

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

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

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

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

Lambda CRP for Croatia

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

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.68 Ratio: 2.70% Country Default Mkt Vol
Spread X
2% 1.50
Aswath Damodaran!
Adris Grupa: 4/2010 (Restructured) Increased ROIC to cost
Average from 2004-09
of capital
e Stable Growth
Current Cashflow to Firm 70.83% g = 4%; Beta = 0.80
EBIT(1-t) : 436 HRK Expected Growth Country Premium= 2%
- Nt CpX 3 HRK Reinvestment Rate from new inv. Return on Capital Cost of capital = 9.65%
- Chg WC -118 HRK 70.83% .7083*.01054=0. 10.54% Tax rate = 20.00%
= FCFF 551 HRK or 6.86% ROC=9.94%;
Reinv Rate = (3-118)/436= -26.35%; Reinvestment Rate=g/ROC
Tax rate = 17.35% =4/9.65= 41/47%
Return on capital = 8.72%
Terminal Value5= 367/(.0965-.04) =6508 HRK
HKR Cashflows
Op. Assets 4545 Year 1 2 3 4 5
+ Cash: 1787 EBIT (1-t) HRK 469 HRK 503 HRK 541 HRK 581 HRK 623 628
- Debt 141 - Reinvestment HRK 332 HRK 356 HRK 383 HRK 411 HRK 442 246
- Minority int 465 FCFF HRK 137 HRK 147 HRK 158 HRK 169 HRK 182 367
=Equity 5,735

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

Lambda CRP for Croatia

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

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.68 Ratio: 11.1% Country Default Mkt Vol
Spread X
1.50
2%
Aswath Damodaran!
Value  of  Control  and  the  Value  of  VoBng  Rights  

¨  Adris  Grupa  has  two  classes  of  shares  outstanding:  9.616  
million  voBng  shares  and  6.748  million  non-­‐voBng  shares.  
¨  To  value  a  non-­‐voBng  share,  we  assume  that  all  non-­‐voBng  shares  
essenBally  have  to  seSle  for  status  quo  value.  All  shareholders,  common  
and  preferred,  get  an  equal  share  of  the  status  quo  value.  
 Status  Quo  Value  of  Equity  =  5,484  million  HKR    
 Value  for  a  non-­‐voBng  share  =  5484/(9.616+6.748)  =  334  HKR/share  
¨  To  value  a  voBng  share,  we  first  value  control  in  Adris  Grup  as  
the  difference  between  the  opBmal  and  the  status  quo  value:  
Value  of  control  at  Adris  Grupa  =  5,735  –  5484  =  249  million  HKR  
Value  per  voBng  share  =334  HKR  +    249/9.616  =  362  HKR  

Aswath Damodaran!
71!
 Aswath Damodaran!

THE  DARK  SIDE  OF  VALUATION:  

VALUING  DIFFICULT-­‐TO-­‐VALUE  
COMPANIES  
The  fundamental  determinants  of  value…  

What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
Firm: Growth in operating earnings/
What are the cashflows
cashflows from When will the firm
existing assets? become a mature
- Equity: Cashflows firm, and what are
after debt payments How risky are the cash flows from both the potential
- Firm: Cashflows existing assets and growth assets? roadblocks?
before debt payments Equity: Risk in equity in the company
Firm: Risk in the firm’s operations

Aswath Damodaran!
73!
The  Dark  Side  of  ValuaBon…  

¨  Valuing  stable,    money  making  companies  with  

consistent  and  clear  accounBng  statements,  a  long  and  
stable  history  and  lots  of  comparable  firms  is  easy  to  do.  
¨  The  true  test  of  your  valuaBon  skills  is  when  you  have  to  
value  “difficult”  companies.  In  parBcular,  the  challenges  
are  greatest  when  valuing:  
¤  Young  companies,  early  in  the  life  cycle,  in  young  businesses  
¤  Companies  that  don’t  fit  the  accounBng  mold  

¤  Companies  that  face  substanBal  truncaBon  risk  (default  or  

naBonalizaBon  risk)  

Aswath Damodaran!
74!
Difficult  to  value  companies…  

¨  Across  the  life  cycle:  

¤  Young,  growth  firms:  Limited  history,  small  revenues  in  conjuncBon  with  big  operaBng  losses  
and  a  propensity  for  failure  make  these  companies  tough  to  value.  
¤  Mature  companies  in  transiBon:  When  mature  companies  change  or  are  forced  to  change,  
history  may  have  to  be  abandoned  and  parameters  have  to  be  reesBmated.  
¤  Declining  and  Distressed  firms:  A  long  but  irrelevant  history,  declining  markets,  high  debt  loads  
and  the  likelihood  of  distress  make  them  troublesome.  
¨  Across  sectors  
¤  Financial  service  firms:  Opacity  of  financial  statements  and  difficulBes  in  esBmaBng  basic  
inputs  leave  us  trusBng  managers  to  tell  us  what’s  going  on.  
¤  Commodity  and  cyclical  firms:  Dependence  of  the  underlying  commodity  prices  or  overall  
economic  growth  make  these  valuaBons  suscepBble  to  macro  factors.  
¤  Firms  with  intangible  assets:  AccounBng  principles  are  lex  to  the  wayside  on  these  firms.  
¨  Across  the  ownership  cycle  
¤  Privately  owned  businesses:  Exposure  to  firm  specific  risk  and  illiquidity  bedevil  valuaBons.  
¤  Venture  Capital  (VC)  and  private  equity:  Different  equity  investors,  with  different  percepBons  
of  risk.  
¤  Closely  held  public  firms:  Part  private  and  part  public,  sharing  the  troubles  of  both.  

Aswath Damodaran!
75!
I.  The  challenge  with  young  companies…  
Figure 5.2: Estimation Issues - Young and Start-up Companies
Making judgments on revenues/ profits difficult becaue
you cannot draw on history. If you have no product/
service, it is difficult to gauge market potential or
profitability. The company's entire value lies in future
growth but you have little to base your estimate on.

Cash flows from existing

assets non-existent or What is the value added by growth
negative. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Different claims on existing assets and growth assets? roadblocks?
cash flows can
affect value of
equity at each Limited historical data on earnings, Will the firm make it through
and no market prices for securities the gauntlet of market demand
stage.
makes it difficult to assess risk. and competition? Even if it
What is the value of does, assessing when it will
equity in the firm? become mature is difficult
because there is so little to go
on.

Aswath Damodaran!
76!
Upping  the  ante..  Young  companies  in  young  
businesses…  
¨  When  valuing  a  business,  we  generally  draw  on  three  sources  of  informaBon  
¤  The  firm’s  current  financial  statement  
n  How  much  did  the  firm  sell?  
n  How  much  did  it  earn?  
¤  The  firm’s  financial  history,  usually  summarized  in  its  financial  statements.    
n  How  fast  have  the  firm’s  revenues  and  earnings  grown  over  Bme?    
n  What  can  we  learn  about  cost  structure  and  profitability  from  these  trends?  
n  SuscepBbility  to  macro-­‐economic  factors  (recessions  and  cyclical  firms)  
¤  The  industry  and  comparable  firm  data  
n  What  happens  to  firms  as  they  mature?  (Margins..  Revenue  growth…  Reinvestment  
needs…  Risk)  
¨  It  is  when  valuing  these  companies  that  you  find  yourself  tempted  by  the  dark  
side,  where  
¤  “Paradigm  shixs”  happen…  
¤  New  metrics  are  invented  …  
¤  The  story  dominates  and  the  numbers  lag…  

Aswath Damodaran!
77!
 Amazon in January 2000 Sales to capital ratio and
expected margin are retail Stable Growth
Current Current
Revenue Margin: industry average numbers Stable Stable
Stable Operating ROC=20%
$ 1,117 -36.71% Revenue
Sales Turnover Competitive Margin: Reinvest 30%
Ratio: 3.00 Advantages Growth: 6% 10.00% of EBIT(1-t)
From previous
EBIT
years Revenue Expected
-410m
Growth: Margin: Terminal Value= 1881/(.0961-.06)
NOL:
42% -> 10.00% =52,148
500 m

Term. Year
Revenue&Growth 150.00% 100.00% 75.00% 50.00% 30.00% 25.20% 20.40% 15.60% 10.80% 6.00% 6%
Revenues $&&2,793 $&&5,585 $&9,774 $&14,661 $&19,059 $&23,862 $&28,729 $&33,211 $&36,798 $&39,006 $(((((41,346
Operating&Margin B13.35% B1.68% 4.16% 7.08% 8.54% 9.27% 9.64% 9.82% 9.91% 9.95% 10.00%
Value of Op Assets $ 15,170 EBIT B$373 B$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 $4,135
+ Cash $ 26 EBIT(1Bt) B$373 B$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 $2,688
= Value of Firm $15,196 &B&Reinvestment $600 $967 $1,420 $1,663 $1,543 $1,688 $1,721 $1,619 $1,363 $961 $155
FCFF B$931 B$1,024 B$989 B$758 B$408 B$163 $177 $625 $1,174 $1,788 $1,881
- Value of Debt $ 349 1 2 3 4 5 6 7 8 9 10
= Value of Equity $14,847
Forever
- Equity Options $ 2,892 Cost%of%Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 11.94% 11.46% 10.98% 10.50%
Value per share $ 35.08 Cost%of%Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00%
All existing options valued After<tax%cost%of%debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%
as options, using current Cost%of%Capital% 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.62% 11.08% 10.49% 9.61%
stock price of $84. Amazon was
Used average trading at $84 in
Cost of Equity interest coverage Cost of Debt Weights January 2000.
12.90% ratio over next 5 6.5%+1.5%=8.0% Debt= 1.2% -> 15%
years to get BBB Tax rate = 0% -> 35%
rating. Pushed debt ratio
Dot.com retailers for firrst 5 years to retail industry
Convetional retailers after year 5 average of 15%.
Beta
Riskfree Rate: + 1.60 -> 1.00 X Risk Premium
T. Bond rate = 6.5% 4%

Aswath Damodaran! Internet/

Retail
Operating
Leverage
Current D/
E: 1.21%
Base Equity
Premium
Country Risk
Premium
Lesson  1:  Don’t  trust  regression  betas….  

Aswath Damodaran!
79!
Lesson  2:  Work  backwards  and  keep  it  simple…  

Aswath Damodaran!
80!
Lesson  3:  Scaling  up  is  hard  to  do…  

Aswath Damodaran!
81!
Lesson  4:  Don’t  forget  to  pay  for  growth…  

Aswath Damodaran!
82!
Lesson  5:  There  are  always  scenarios  where  the  
market  price  can  be  jusBfied…  

Aswath Damodaran!
83!
Lesson  6:  Don’t  forget  to  mop  up…  

¨  Watch  out  for  “other”  equity  claims:  If  you  buy  equity  in  
a  young,  growth  company,  watch  out  for  other  (oxen  
hidden)  claims  on  the  equity  that  don’t  take  the  form  of  
common  shares.  In  parBcular,  watch  for  opBons  granted  
to  managers,  employees,  venture  capitalists  and  others  
(you  will  be  surprised…).    
¤  Value  these  opBons  as  opBons  (not  at  exercise  value)  
¤  Take  into  consideraBon  expectaBons  of  future  opBon  grants  
when  compuBng  expected  future  earnings/cash  flows.  
¨  Not  all  shares  are  equal:  If  there  are  differences  in  cash  
flow  claims  (dividends  or  liquidaBon)  or  voBng  rights  
across  shares,  value  these  differences.  
¤  VoBng  rights  maSer  even  at  well  run  companies  

Aswath Damodaran!
84!
Lesson  7:  You  will  be  wrong  100%  of  the  Bme…  
and  it  really  is  not  (always)  your  fault…  
¨  No  maSer  how  careful  you  are  in  ge|ng  your  inputs  and  
how  well  structured  your  model  is,  your  esBmate  of  
value  will  change  both  as  new  informaBon  comes  out  
about  the  company,  the  business  and  the  economy.  
¨  As  informaBon  comes  out,  you  will  have  to  adjust  and  
adapt  your  model  to  reflect  the  informaBon.  Rather  than  
be  defensive  about  the  resulBng  changes  in  value,  
recognize  that  this  is  the  essence  of  risk.    
¨  A  test:  If  your  valuaBons  are  unbiased,  you  should  find  
yourself  increasing  esBmated  values  as  oxen  as  you  are  
decreasing  values.  In  other  words,  there  should  be  equal  
doses  of  good  and  bad  news  affecBng  valuaBons  (at  
least  over  Bme).  
Aswath Damodaran!
85!
And  the  market  is  oxen  “more  wrong”….  

Amazon: Value and Price

$90.00

$80.00

$70.00

$60.00

$50.00

Value per share

$40.00 Price per share

$30.00

$20.00

$10.00

$0.00
2000 2001 2002 2003
Time of analysis

Aswath Damodaran!
86!
II.  Mature  Companies  in  transiBon..  

¨  Mature  companies  are  generally  the  easiest  group  to  

value.  They  have  long,  established  histories  that  can  be  
mined  for  inputs.  They  have  investment  policies  that  are  
set  and  capital  structures  that  are  stable,  thus  making  
valuaBon  more  grounded  in  past  data.  
¨  However,  this  stability  in  the  numbers  can  mask  real  
problems  at  the  company.  The  company  may  be  set  in  a  
process,  where  it  invests  more  or  less  than  it  should  and  
does  not  have  the  right  financing  mix.  In  effect,  the  
policies  are  consistent,  stable  and  bad.  
¨  If  you  expect  these  companies  to  change  or  as  is  more  
oxen  the  case  to  have  change  thrust  upon  them,    

Aswath Damodaran!
87!
The  perils  of  valuing  mature  companies…  
Figure 7.1: Estimation Issues - Mature Companies
Lots of historical data Growth is usually not very high, but firms may still be
on earnings and generating healthy returns on investments, relative to
cashflows. Key cost of funding. Questions include how long they can
questions remain if generate these excess returns and with what growth
these numbers are rate in operations. Restructuring can change both
volatile over time or if inputs dramatically and some firms maintain high
the existing assets are growth through acquisitions.
not being efficiently What is the value added by growth
utilized. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
existing assets and growth assets? roadblocks?
Equity claims can
vary in voting
Operating risk should be stable, but Maintaining excess returns or
rights and
the firm can change its financial high growth for any length of
dividends.
leverage This can affect both the time is difficult to do for a
cost of equtiy and capital. mature firm.
What is the value of
equity in the firm?

Aswath Damodaran!
88!
 Hormel Foods: The Value of Control Changing
Hormel Foods sells packaged meat and other food products and has been in existence as a publicly traded company for almost 80 years.
In 2008, the firm reported after-tax operating income of $315 million, reflecting a compounded growth of 5% over the previous 5 years.
The Status Quo
Run by existing management, with conservative reinvestment policies (reinvestment rate = 14.34% and debt ratio = 10.4%.
Anemic growth rate and short growth period, due to reinvestment policy Low debt ratio affects cost of capital

Expected value =$31.91 (.90) + $37.80 (.10) = $32.50

Probability of management change = 10%
New and better management
More aggressive reinvestment which increases the reinvestment rate (to 40%) and tlength of growth (to 5 years), and higher debt ratio (20%).
Operating Restructuring 1
Financial restructuring 2
Expected growth rate = ROC * Reinvestment Rate
Cost of capital = Cost of equity (1-Debt ratio) + Cost of debt (Debt ratio)
Expected growth rae (status quo) = 14.34% * 19.14% = 2.75%
Status quo = 7.33% (1-.104) + 3.60% (1-.40) (.104) = 6.79%
Expected growth rate (optimal) = 14.00% * 40% = 5.60%
Optimal = 7.75% (1-.20) + 3.60% (1-.40) (.20) = 6.63%
ROC drops, reinvestment rises and growth goes up.
Cost of equity rises but cost of capital drops.

Aswath Damodaran!
Lesson  1:  Cost  cu|ng  and  increased  efficiency  
are  easier  accomplished  on  paper  than  in  
pracBce…    

Aswath Damodaran!
90!
Lesson  2:  Increasing  growth  is  not  always  an  
opBon  (or  at  least  not  a  good  opBon)  

Aswath Damodaran!
91!
Lesson  3:  Financial  leverage  is  a  double-­‐edged  
sword..  
Exhibit 7.1: Optimal Financing Mix: Hormel Foods in January 2009

As debt ratio increases, equity

As firm borrows more money,
becomes riskier.(higher beta)
its ratings drop and cost of
and cost of equity goes up. 2
1 debt rises

Current Cost
of Capital Optimal: Cost of
capital lowest
between 20 and
30%.

As cost of capital drops,

Debt ratio is percent of overall At debt ratios > 80%, firm does not have enough firm value rises (as
market value of firm that comes operating income to cover interest expenses. Tax operating cash flows
from debt financing. rate goes down to reflect lost tax benefits. 3 remain unchanged)

Aswath Damodaran!
92!
III.  Dealing  with  decline  and  distress…  

Historial data often Growth can be negative, as firm sheds assets and
reflects flat or declining shrinks. As less profitable assets are shed, the firm’s
revenues and falling remaining assets may improve in quality.
margins. Investments
often earn less than the What is the value added by growth
cost of capital. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Underfunded pension existing assets and growth assets? roadblocks?
obligations and
litigation claims can
lower value of equity. Depending upon the risk of the There is a real chance,
Liquidation assets being divested and the use of especially with high financial
preferences can affect the proceeds from the divestuture (to leverage, that the firm will not
value of equity pay dividends or retire debt), the risk make it. If it is expected to
in both the firm and its equity can survive as a going concern, it
What is the value of change. will be as a much smaller
equity in the firm? entity.

Aswath Damodaran!
93!
Dealing  with  the  “downside”  of  Distress  

¨  A  DCF    valuaBon  values  a  firm  as  a  going  concern.  If  there  is  a  significant  
likelihood  of  the  firm  failing  before  it  reaches  stable  growth  and  if  the  
assets  will  then  be  sold  for  a  value  less  than  the  present  value  of  the  
expected  cashflows  (a  distress  sale  value),  DCF  valuaBons  will  understate  
the  value  of  the  firm.  
¨  Value  of  Equity=  DCF  value  of  equity  (1  -­‐  Probability  of  distress)  +  Distress  
sale  value  of  equity  (Probability  of  distress)  
¨  There  are  three  ways  in  which  we  can  esBmate  the  probability  of  distress:  
¤  Use  the  bond  raBng  to  esBmate  the  cumulaBve  probability  of  distress  over  10  years  
¤  EsBmate  the  probability  of  distress  with  a  probit  
¤  EsBmate  the  probability  of  distress  by  looking  at  market  value  of  bonds..  
¨  The  distress  sale  value  of  equity  is  usually  best  esBmated  as  a  percent  of  
book  value  (and  this  value  will  be  lower  if  the  economy  is  doing  badly  and  
there  are  other  firms  in  the  same  business  also  in  distress).  

Aswath Damodaran!
94!
 Reinvestment:
Capital expenditures include cost of Stable Growth
Current Current new casinos and working capital Stable Stable
Revenue Margin: Stable Operating ROC=10%
$ 4,390 4.76% Revenue Margin: Reinvest 30%
Extended Industry Growth: 3% 17% of EBIT(1-t)
reinvestment average
EBIT break, due ot
$ 209m investment in Expected
past Margin: Terminal Value= 758(.0743-.03)
-> 17% =$ 17,129

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

Cost of Equity Cost of Debt Weights

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

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

Aswath Damodaran! Casino Current Base Equity Country Risk

1.15 D/E: 277% Premium Premium
AdjusBng  the  value  of  LVS  for  distress..  

¨  In  February  2009,  LVS  was  rated  B+  by  S&P.  Historically,  28.25%  of  B+  
rated  bonds  default  within  10  years.  LVS  has  a  6.375%  bond,  maturing  in  
February  2015  (7  years),  trading  at  $529.  If  we  discount  the  expected  cash  
flows  on  the  bond  at  the  riskfree  rate,  we  can  back  out  the  probability  of  
distress  from  the  bond  price:  
t =7
63.75(1− ΠDistress )t 1000(1− ΠDistress )7
529 = ∑ t +
t =1 (1.03) (1.03)7
¨  Solving  for  the  probability  of  bankruptcy,  we  get:  
¨  πDistress    =  Annual  probability  of  default  =  13.54%  
¤  CumulaBve  €probability  of  surviving  10  years  =  (1  -­‐  .1354)10  =  23.34%  
¤  CumulaBve  probability  of  distress  over  10  years  =  1  -­‐  .2334  =  .7666  or  76.66%  
¨  If  LVS  is  becomes  distressed:  
¤  Expected  distress  sale  proceeds  =  $2,769  million  <  Face  value  of  debt  
¤  Expected  equity  value/share  =  $0.00  
¨  Expected  value  per  share  =  $8.12  (1  -­‐  .7666)  +  $0.00  (.7666)  =  $1.92  

Aswath Damodaran!
96!
The  “sunny”  side  of  distress:  Equity  as  a  call  
opBon  to  liquidate  the  firm  

Net Payoff
on Equity

Face Value
of Debt

Value of firm

Aswath Damodaran!
97!
ApplicaBon  to  valuaBon:  A  simple  example  

¨  Assume  that  you  have  a  firm  whose  assets  are  

currently  valued  at  $100  million  and  that  the  
standard  deviaBon  in  this  asset  value  is  40%.  
¨  Further,  assume  that  the  face  value  of  debt  is  $80  

million  (It  is  zero  coupon  debt  with  10  years  lex  to  
maturity).    
¨  If  the  ten-­‐year  treasury  bond  rate  is  10%,    

¤  how  much  is  the  equity  worth?    

¤  What  should  the  interest  rate  on  debt  be?  

Aswath Damodaran!
98!
Model  Parameters  &  ValuaBon  

¨  The  inputs  

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

Aswath Damodaran!
99!
Firm  value  drops..    

¨  Assume  now  that  a  catastrophe  wipes  out  half  the  value  of  
this  firm  (the  value  drops  to  $  50  million),  while  the  face  
value  of  the  debt  remains  at  $  80  million.    
¨  The  inputs  
¤  Value  of  the  underlying  asset  =  S  =  Value  of  the  firm  =  $  50  million  
¤  All  the  other  inputs  remain  unchanged  
¨  The  output  
¤  Based  upon  these  inputs,  the  Black-­‐Scholes  model  provides  the  
following  value  for  the  call:  
n  d1  =  1.0515    N(d1)  =  0.8534  
n  d2  =  -­‐0.2135    N(d2)  =  0.4155  
¤  Value  of  the  call  =  50  (0.8534)  -­‐  80  exp(-­‐0.10)(10)  (0.4155)  =  $30.44  million  
¤  Value  of  the  bond=  $50  -­‐  $30.44  =  $19.56  million  

Aswath Damodaran!
100!
Equity  value  persists  ..  As  firm  value  declines..  

Value of Equity as Firm Value Changes

80

70

60

50
Value of Equity

40

30

20

10

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

Aswath Damodaran!
101!
IV.  Valuing  Financial  Service  Companies  
Defining capital expenditures and working capital is a
Existing assets are challenge.Growth can be strongly influenced by
usually financial regulatory limits and constraints. Both the amount of
assets or loans, often new investments and the returns on these investments
marked to market. can change with regulatory changes.
Earnings do not
provide much What is the value added by growth
information on assets?
underlying risk.
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
existing assets and growth assets? roadblocks?
Preferred stock is a
significant source of
capital. For financial service firms, debt is In addition to all the normal
raw material rather than a source of constraints, financial service
capital. It is not only tough to define firms also have to worry about
What is the value of but if defined broadly can result in maintaining capital ratios that
equity in the firm? high financial leverage, magnifying are acceptable ot regulators. If
the impact of small operating risk they do not, they can be taken
changes on equity risk. over and shut down.

Aswath Damodaran!
102!
 2b. Goldman Sachs: August 2008 Left return on equity at 2008
levels. well below 16% in
Rationale for model 2007 and 20% in 2004-2006.
Why dividends? Because FCFE cannot be estimated
Why 3-stage? Because the firm is behaving (reinvesting, growing) like a firm with potential.
ROE = 13.19%
Retention
Ratio =
Dividends 91.65% Expected Growth in g =4%: ROE = 10%(>Cost of equity)
EPS = $16.77 *
Payout Ratio 8.35% first 5 years = Beta = 1.20
DPS =$1.40 91.65%*13.19% = Payout = (1- 4/10) = .60 or 60%
(Updated numbers for 2008 12.09%
financial year ending 11/08)
Terminal Value= EPS10*Payout/(r-g)
= (42.03*1.04*.6)/(.095-.04) = 476.86
Year 1 2 3 4 5 6 7 8 9 10
EPS $18.80 $21.07 $23.62 $26.47 $29.67 $32.78 $35.68 $38.26 $40.41 $42.03
Payout ratio 8.35% 8.35% 8.35% 8.35% 8.35% 18.68% 29.01% 39.34% 49.67% 60.00%
DPS $1.57 $1.76 $1.97 $2.21 $2.48 $6.12 $10.35 $15.05 $20.07 $25.22
Value of Equity per Forever
share = PV of Discount at Cost of Equity
Dividends &
Terminal value = Between years 6-10, as growth drops
$222.49 to 4%, payout ratio increases and cost In August 2008, Goldman
of equity decreases. was trading at $ 169/share.

Cost of Equity
4.10% + 1.40 (4.5%) = 10.4%

Riskfree Rate:
Treasury bond rate Risk Premium
4.10% Beta 4.5%
+ 1.40 X Impled Equity Risk
premium in 8/08

Average beta for inveestment

banks= 1.40 Mature Market Country Risk
Aswath Damodaran! 4.5% 0%
Lesson  1:  Financial  service  companies  are  
opaque…  

¨  With  financial  service  firms,  we  enter  into  a  FausBan  

bargain.  They  tell  us  very  liSle  about  the  quality  of  their  
assets  (loans,  for  a  bank,  for  instance  are  not  broken  
down  by  default  risk  status)  but  we  accept  that  in  return  
for  assets  being  marked  to  market  (by  accountants  who  
presumably  have  access  to  the  informaBon  that  we  
don’t  have).  
¨  In  addiBon,  esBmaBng  cash  flows  for  a  financial  service  
firm  is  difficult  to  do.  So,  we  trust  financial  service  firms  
to  pay  out  their  cash  flows  as  dividends.  Hence,  the  use  
of  the  dividend  discount  model.  

Aswath Damodaran!
104!
Lesson  2:  For  financial  service  companies,  book  
value  maSers…  
¨  The  book  value  of  assets  and  equity  is  mostly  irrelevant  when  valuing  
non-­‐financial  service  companies.  Axer  all,  the  book  value  of  equity  is  a  
historical  figure  and  can  be  nonsensical.  (The  book  value  of  equity  can  be  
negaBve  and  is  so  for  more  than  a  1000  publicly  traded  US  companies)  
¨  With  financial  service  firms,  book  value  of  equity  is  relevant  for  two  
reasons:  
¤  Since  financial  service  firms  mark  to  market,  the  book  value  is  more  likely  to  reflect  
what  the  firms  own  right  now  (rather  than  a  historical  value)  
¤  The  regulatory  capital  raBos  are  based  on  book  equity.  Thus,  a  bank  with  negaBve  
or  even  low  book  equity  will  be  shut  down  by  the  regulators.  
¨  From  a  valuaBon  perspecBve,  it  therefore  makes  sense  to  pay  heed  to  
book  value.  In  fact,  you  can  argue  that  reinvestment  for  a  bank  is  the  
amount  that  it  needs  to  add  to  book  equity  to  sustain  its  growth  
ambiBons  and  safety  requirements:  
¤  FCFE  =  Net  Income  –  Reinvestment  in  regulatory  capital  (book  equity)  

Aswath Damodaran!
105!
Aswath Damodaran!
V.  Valuing  cyclical  and  commodity  companies  

Company growth often comes from movements in the

economic cycle, for cyclical firms, or commodity prices,
for commodity companies.

What is the value added by growth

assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Historial revenue and existing assets and growth assets? roadblocks?
earnings data are
volatile, as the
Primary risk is from the economy for For commodity companies, the
economic cycle and
cyclical firms and from commodity fact that there are only finite
commodity prices
price movements for commodity amounts of the commodity may
change.
companies. These risks can stay put a limit on growth forever.
dormant for long periods of apparent For cyclical firms, there is the
prosperity. peril that the next recession
may put an end to the firm.

Aswath Damodaran!
107!
 Valuing a Cyclical Company - Toyota in Early 2009
In early 2009, Toyota Motors had the
Year Revenues Operating Income
EBITDA Operating Margin highest market share in the sector.
FY1 1992 ¥10,163,380 ¥218,511 ¥218,511 2.15% However, the global economic
FY1 1993 ¥10,210,750 ¥181,897 ¥181,897 1.78% recession in 2008-09 had pulled
FY1 1994 ¥9,362,732 ¥136,226 ¥136,226 1.45% earnings down.
FY1 1995 ¥8,120,975 ¥255,719 ¥255,719 3.15%
FY1 1996 ¥10,718,740 ¥348,069 ¥348,069 3.25%
FY1 1997 ¥12,243,830 ¥665,110 ¥665,110 5.43%
Normalized Return on capital and
Reinvestment 2
FY1 1998 ¥11,678,400 ¥779,800 ¥1,382,950 6.68%
FY1 1999 ¥12,749,010 ¥774,947 ¥1,415,997 6.08% Once earnings bounce back to normal, we
FY1 2000 ¥12,879,560 ¥775,982 ¥1,430,982 6.02% assume that Toyota will be able to earn a
FY1 2001 ¥13,424,420 ¥870,131 ¥1,542,631 6.48% return on capital equal to its cost of capital
FY1 2002 ¥15,106,300 ¥1,123,475 ¥1,822,975 7.44% (5.09%). This is a sector, where earning
FY1 2003 ¥16,054,290 ¥1,363,680 ¥2,101,780 8.49% excess returns has proved to be difficult
FY1 2004 ¥17,294,760 ¥1,666,894 ¥2,454,994 9.64% even for the best of firms.
FY1 2005 ¥18,551,530 ¥1,672,187 ¥2,447,987 9.01% To sustain a 1.5% growth rate, the
FY1 2006 ¥21,036,910 ¥1,878,342 ¥2,769,742 8.93% reinvestment rate has to be:
FY1 2007 ¥23,948,090 ¥2,238,683 ¥3,185,683 9.35% Reinvestment rate = 1.5%/5.09%
FY1 2008 ¥26,289,240 ¥2,270,375 ¥3,312,775 8.64%
= 29.46%
FY 2009 (Estimate)
¥22,661,325 ¥267,904 ¥1,310,304 1.18%
¥1,306,867 7.33%
Normalized Earnings 1
As a cyclical company, Toyota’s earnings have been volatile and 2009 earnings reflect the Operating Assets 19,640
troubled global economy. We will assume that when economic growth returns, the + Cash 2,288
operating margin for Toyota will revert back to the historical average. + Non-operating assets 6,845
Normalized Operating Income = Revenues in 2009 * Average Operating Margin (98--09) - Debt 11,862
= 22661 * .0733 =1660.7 billion yen - Minority Interests 583
Value of Equity
/ No of shares /3,448
Value per share ¥4735

1660.7 (1.015) (1- .407) (1- .2946)

Value of operating assets = = 19,640 billion
(.0509 - .015)

Normalized Cost of capital € 3

The cost of capital is computed using the average beta of Stable Growth 4
automobile companies (1.10), and Toyota’s cost of debt (3.25%) Once earnings are normalized, we
and debt ratio (52.9% debt ratio. We use the Japanese marginal assume that Toyota, as the largest
tax rate of 40.7% for computing both the after-tax cost of debt market-share company, will be able
and the after-tax operating income to maintain only stable growth
(1.5% in Yen terms)
Aswath Damodaran!
Cost of capital = 8.65% (.471) + 3.25% (1-.407) (.529) = 5.09%
 Valuing a commodity company - Exxon in Early 2009

Historical data: Exxon Operating Income vs Oil

Price

Regressing Exxonʼs operating income against the oil price per barrel
from 1985-2008:
Operating Income = -6,395 + 911.32 (Average Oil Price) R2 = 90.2%
(2.95) (14.59)
Exxon Mobil's operating income increases about $9.11 billion for every
$ 10 increase in the price per barrel of oil and 90% of the variation in
Exxon's earnings over time comes from movements in oil prices.

Estimate return on capital and reinvestment rate

Estiimate normalized income based on current oil price 1 based on normalized income 2
At the time of the valuation, the oil price was $ 45 a barrel. Exxonʼs This%operating%income%translates%into%a%return%on%capital%
operating income based on thisi price is of%approximately%21%%and%a%reinvestment%rate%of%9.52%,%
Normalized Operating Income = -6,395 + 911.32 ($45) = $34,614 based%upon%a%2%%growth%rate.%%
Reinvestment%Rate%=%g/%ROC%=%2/21%%=%9.52%

Exxonʼs cost of capital 4

Exxon has been a predominantly equtiy funded company, and is Expected growth in operating income 3
explected to remain so, with a deb ratio of onlly 2.85%: Itʼs cost of Since Exxon Mobile is the largest oil company in the world, we
equity is 8.35% (based on a beta of 0.90) and its pre-tax cost of debt will assume an expected growth of only 2% in perpetuity.
is 3.75% (given AAA rating). The marginal tax rate is 38%.
Aswath
Cost of capital Damodaran!
= 8.35% (.9715) + 3.75% (1-.38) (.0285) = 8.18%.
Lesson  1:  With  “macro”  companies,  it  is  easy  to  
get  lost  in  “macro”  assumpBons…  
¨  With  cyclical  and  commodity  companies,  it  is  undeniable  that  
the  value  you  arrive  at  will  be  affected  by  your  views  on  the  
economy  or  the  price  of  the  commodity.    
¨  Consequently,  you  will  feel  the  urge  to  take  a  stand  on  these  
macro  variables  and  build  them  into  your  valuaBon.  Doing  so,  
though,  will  create  valuaBons  that  are  jointly  impacted  by  
your  views  on  macro  variables  and  your  views  on  the  
company,  and  it  is  difficult  to  separate  the  two.  
¨  The  best  (though  not  easiest)  thing  to  do  is  to  separate  your  
macro  views  from  your  micro  views.  Use    current  market  
based  numbers  for  your  valuaBon,  but  then  provide  a  
separate  assessment  of  what  you  think  about  those  market  
numbers.  

Aswath Damodaran!
110!
Lesson  2:  Use  probabilisBc  tools  to  assess  value  
as  a  funcBon  of  macro  variables…  
¨  If  there  is  a  key  macro  variable  affecBng  the  value  of  your  
company  that  you  are  uncertain  about  (and  who  is  not),  why  
not  quanBfy  the  uncertainty  in  a  distribuBon  (rather  than  a  
single  price)  and  use  that  distribuBon  in  your  valuaBon.  
¨  That  is  exactly  what  you  do  in  a  Monte  Carlo  simulaBon,  
where  you  allow  one  or  more  variables  to  be  distribuBons  
and  compute  a  distribuBon  of  values  for  the  company.    
¨  With  a  simulaBon,  you  get  not  only  everything  you  would  get  
in  a  standard  valuaBon  (an  esBmated  value  for  your  
company)  but  you  will  get  addiBonal  output  (on  the  variaBon  
in  that  value  and  the  likelihood  that  your  firm  is  under  or  
over  valued)  

Aswath Damodaran!
111!
Exxon  Mobil  ValuaBon:  SimulaBon  

Aswath Damodaran!
112!
The  opBonality  in  commodiBes:  Undeveloped  
reserves  as  an  opBon  

Net Payoff on

Extraction

Cost of Developing

Reserve

Value of estimated reserve

of natural resource

Aswath Damodaran!
113!
Valuing  Gulf  Oil    

¨  Gulf  Oil  was  the  target  of  a  takeover  in  early  1984  at  $70  
per  share  (It  had  165.30  million  shares  outstanding,  and  
total  debt  of  $9.9  billion).    
¤  It  had  esBmated  reserves  of  3038  million  barrels  of  oil  and  the  
average  cost  of  developing  these  reserves  was  esBmated  to  be    
$10  a  barrel  in  present  value  dollars  (The  development  lag  is  
approximately  two  years).    
¤  The  average  relinquishment  life  of  the  reserves  is  12  years.    
¤  The  price  of  oil  was  $22.38  per  barrel,  and  the  producBon  cost,  
taxes  and  royalBes  were  esBmated  at  $7  per  barrel.    
¤  The  bond  rate  at  the  Bme  of  the  analysis  was  9.00%.    
¤  Gulf  was  expected  to  have  net  producBon  revenues  each  year  of  
approximately  5%  of  the  value  of  the  developed  reserves.  The  
variance  in  oil  prices  is  0.03.    

Aswath Damodaran!
114!
Valuing  Undeveloped  Reserves  

¨  Inputs  for  valuing  undeveloped  reserves  

¤  Value  of  underlying  asset  =  Value  of  esBmated  reserves  discounted  back  for  period  
of  development  lag=  3038  *  ($  22.38  -­‐  $7)  /  1.052  =  $42,380.44  
¤  Exercise  price  =  EsBmated  development  cost  of  reserves  =  3038  *  $10  =  $30,380  
million  
¤  Time  to  expiraBon  =  Average  length  of  relinquishment  opBon  =  12  years  
¤  Variance  in  value  of  asset  =  Variance  in  oil  prices  =  0.03  
¤  Riskless  interest  rate  =  9%  
¤  Dividend  yield  =  Net  producBon  revenue/  Value  of  developed  reserves  =  5%  
¨  Based  upon  these  inputs,  the  Black-­‐Scholes  model  provides  the  following  
value  for  the  call:  
¤  d1  =  1.6548  N(d1)  =  0.9510  
¤  d2  =  1.0548  N(d2)  =  0.8542  
¨  Call  Value=  42,380.44  exp(-­‐0.05)(12)  (0.9510)  -­‐30,380  (exp(-­‐0.09)(12)  (0.8542)  =  $  
13,306  million  

Aswath Damodaran!
115!
The  composite  value…  

¨  In  addiBon,  Gulf  Oil  had  free  cashflows  to  the  firm  from  its  oil  and  
gas  producBon  of  $915  million  from  already  developed  reserves  
and  these  cashflows  are  likely  to  conBnue  for  ten  years  (the  
remaining  lifeBme  of  developed  reserves).    
¨  The  present  value  of  these  developed  reserves,  discounted  at  the  
weighted  average  cost  of  capital  of  12.5%,  yields:  
¤  Value  of  already  developed  reserves  =  915  (1  -­‐  1.125-­‐10)/.125  =  $5065.83  
¨  Adding  the  value  of  the  developed  and  undeveloped  reserves    
¤    Value  of  undeveloped  reserves      =  $  13,306  million  
¤    Value  of  producBon  in  place    =  $      5,066  million  
¤    Total  value  of  firm        =  $  18,372  million  
¤    Less  Outstanding  Debt      =  $      9,900  million  
¤    Value  of  Equity        =  $    8,472  million  
¤    Value  per  share        =  $  8,472/165.3  =  $51.25  

Aswath Damodaran!
116!
VII.  Valuing  Companies  across  the  ownership  
cycle  
Reported income and balance sheet are
heavily affected by tax considerations rather
than information disclosure requirements. The
line between the personal and business
expenses is a fine one.

What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
Firm: Growth in operating earnings/
What are the cashflows
cashflows from When will the firm
existing assets? become a mature
- Equity: Cashflows fiirm, and what are
after debt payments the potential
How risky are the cash flows from both
- Firm: Cashflows roadblocks?
existing assets and growth assets?
before debt payments
Equity: Risk in equity in the company
Firm: Risk in the firm’s operations
Reversing Many private
investment Different buyers can perceive risk businesses are finite
mistakes is differently in the same private business, life enterprises, not
difficult to do. largely because what they see as risk will expected to last into
The need for be a function of how diversified they are. perpetuity
and the cost of The fall back positions of using market
illiquidity has to prices to extract risk measures does not
be incorporated
into current

Aswath Damodaran!
117!
 Kristinʼs Kandy: Valuation in March 2006
Return on Capital
Current Cashflow to Firm Reinvestment Rate 13.64%
EBIT(1-t) : 300 46.67% Expected Growth
- Nt CpX 100 Stable Growth
in EBIT (1-t)
- Chg WC 40 g = 4%; Beta =3.00;
.4667*.1364= .0636
= FCFF 160 ROC= 12.54%
6.36%
Reinvestment Rate = 46.67% Reinvestment Rate=31.90%

Terminal Value5= 289/(.1254-.04) = 3,403

Year 1 2 3 4 5 Term Yr
Firm Value: 2,571 EBIT (1-t) $319 $339 $361 $384 $408 425
+ Cash 125 - Reinvestment $149 $158 $168 $179 $191 136
- Debt: 900 =FCFF $170 $181 $193 $205 $218 289
=Equity 1,796
- Illiq Discount 12.5%
Adj Value 1,571
Discount at Cost of Capital (WACC) = 16.26% (.70) + 3.30% (.30) = 12.37%

Cost of Debt
Cost of Equity (4.5%+1.00)(1-.40)
16.26% Weights
= 3.30% E =70% D = 30%
Synthetic rating = A-

Riskfree Rate:
Riskfree rate = 4.50% Total Beta Risk Premium
(10-year T.Bond rate) 2.94 4.00%
+ X
1/3 of risk is Adjusted for ownrer
market risk non-diversification

Market Beta: 0.98 Mature risk Country Risk

premium Premium
4% 0%
Aswath Damodaran!
Unlevered Beta for Firmʼs D/E
Sectors: 0.78 Ratio: 30/70
Lesson  1:  In  private  businesses,  risk  in  the  eyes  
of  the  “beholder”  (buyer)  

Private business Public company

Venture capitalist, with
owner with entire investor with
multiple holdings in
wealth invested diversified portfolio
the sector.
in the business

Firm-specific risk is
Exposed to all risk in Partially diversified. diversified away.
the company. Total Diversify away some Market or macro risk
beta measures firm specific risk but not exposure captured in
exposure to total risk. all. Beta will fall a market beta or
Total Beta = Market berbetween total and betas.
Beta/ Correlation of market beta.
firm with market

Aswath Damodaran!
119!
 Private Owner versus Publicly Traded Company Perceptions of Risk in an Investment

Total Beta measures all risk

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

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

20 units Publicly traded company

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

Aswath Damodaran!
Total  Risk  versus  Market  Risk  

¨  Adjust  the  beta  to  reflect  total  risk  rather  than  market  risk.  
This  adjustment  is  a  relaBvely  simple  one,  since  the  R  
squared  of  the  regression  measures  the  proporBon  of  the  risk  
that  is  market  risk.    
¤   Total  Beta  =  Market  Beta  /  CorrelaBon  of  the  sector  with  the  market  
¨   To    esBmate  the  beta  for  KrisBn  Kandy,  we  begin  with  the  
boSom-­‐up  unlevered  beta  of  food  processing  companies:  
¤  Unlevered  beta  for  publicly  traded  food  processing  companies  =  0.78  
¤  Average  correlaBon  of  food  processing  companies  with  market  =  0.333  
¤  Unlevered  total  beta  for  KrisBn  Kandy  =  0.78/0.333  =  2.34  
¤  Debt  to  equity  raBo  for  KrisBn  Kandy  =  0.3/0.7  (assumed  industry  
average)  
¤  Total  Beta  =  2.34  (  1-­‐  (1-­‐.40)(30/70))  =  2.94  
¤  Total  Cost  of  Equity  =  4.50%  +  2.94  (4%)  =  16.26%  

Aswath Damodaran!
121!
Lesson  2:  With  financials,  trust  but  verify..  

¨  Different  AccounBng  Standards:  The  accounBng  statements  

for  private  firms  are  oxen  based  upon  different  accounBng  
standards  than  public  firms,  which  operate  under  much  
Bghter  constraints  on  what  to  report  and  when  to  report.  
¨  Intermingling  of  personal  and  business  expenses:  In  the  case  
of  private  firms,  some  personal  expenses  may  be  reported  as  
business  expenses.  
¨  SeparaBng  “Salaries”  from  “Dividends”:  It  is  difficult  to  tell  
where  salaries  end  and  dividends  begin  in  a  private  firm,  
since  they  both  end  up  with  the  owner.  
¨  The  Key  person  issue:  In  some  private  businesses,  with  a  
personal  component,  the  cashflows  may  be  intertwined  with  
the  owner  being  part  of  the  business.    

Aswath Damodaran!
122!
Lesson  3:  Illiquidity  is  a  clear  and  present  
danger..  
¨  In  private  company  valuaBon,  illiquidity  is  a  constant  
theme.  All  the  talk,  though,  seems  to  lead  to  a  rule  of  
thumb.  The  illiquidity  discount  for  a  private  firm  is  
between  20-­‐30%  and  does  not  vary  across  private  firms.  
¨  But  illiquidity  should  vary  across:  
¤  Companies:  Healthier  and  larger  companies,  with  more  liquid  
assets,  should  have  smaller  discounts  than  money-­‐losing  smaller  
businesses  with  more  illiquid  assets.  
¤  Time:  Liquidity  is  worth  more  when  the  economy  is  doing  badly  
and  credit  is  tough  to  come  by  than  when  markets  are  booming.    
¤  Buyers:  Liquidity  is  worth  more  to  buyers  who  have  shorter  Bme  
horizons  and  greater  cash  needs  than  for  longer  term  investors  
who  don’t  need  the  cash  and  are  willing  to  hold  the  investment.  

Aswath Damodaran!
123!
 Aswath Damodaran!

RELATIVE  VALUATION  
Aswath  Damodaran  
RelaBve  valuaBon  is  pervasive…  

¨  Most  asset  valuaBons  are  relaBve.  

¨  Most  equity  valuaBons  on  Wall  Street  are  relaBve  valuaBons.    
¤  Almost  85%  of  equity  research  reports  are  based  upon  a  mulBple  and  
comparables.  
¤  More  than  50%  of  all  acquisiBon  valuaBons  are  based  upon  mulBples  
¤  Rules  of  thumb  based  on  mulBples  are  not  only  common  but  are  oxen  
the  basis  for  final  valuaBon  judgments.  
¨  While  there  are  more  discounted  cashflow  valuaBons  in  
consulBng  and  corporate  finance,  they  are  oxen  relaBve  
valuaBons  masquerading  as  discounted  cash  flow  valuaBons.  
¤  The  objecBve  in  many  discounted  cashflow  valuaBons  is  to  back  into  a  
number  that  has  been  obtained  by  using  a  mulBple.  
¤  The  terminal  value  in  a  significant  number  of  discounted  cashflow  
valuaBons  is  esBmated  using  a  mulBple.  

Aswath Damodaran!
125!
The  Reasons  for  the  allure…  

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

¨  “  A  liSle  inaccuracy  someBmes  saves  tons  of  

explanaBon”  
           H.H.  Munro  

¨  “  If  you  are  going  to  screw  up,  make  sure  that  you  have  
lots  of  company”  
     Ex-­‐por•olio  manager  

Aswath Damodaran!
126!
The  Four  Steps  to  DeconstrucBng  MulBples  

¨  Define  the  mulBple  

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

Aswath Damodaran!
127!
DefiniBonal  Tests  

¨  Is  the  mulBple  consistently  defined?  

¤  ProposiBon  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  mulBple  uniformly  esBmated?  
¤  The  variables  used  in  defining  the  mulBple  should  be  esBmated  
uniformly  across  assets  in  the  “comparable  firm”  list.  
¤  If  earnings-­‐based  mulBples  are  used,  the  accounBng  rules  to  
measure  earnings  should  be  applied  consistently  across  assets.  
The  same  rule  applies  with  book-­‐value  based  mulBples.  

Aswath Damodaran!
128!
Example  1:  Price  Earnings  RaBo:  DefiniBon  

PE  =  Market  Price  per  Share  /  Earnings  per  Share  

¨  There  are  a  number  of  variants  on  the  basic  PE  raBo  in  
use.  They  are  based  upon  how  the  price  and  the  
earnings  are  defined.  
Price:  is  usually  the  current  price  
 is  someBmes  the  average  price  for  the  year  
EPS:  EPS  in  most  recent  financial  year  
 EPS  in  trailing  12  months  (Trailing  PE)  
 Forecasted  EPSnnext  year  (Forward  PE)  
 Forecasted  EPS  in  future  year  

Aswath Damodaran!
129!
Example  2:  Enterprise  Value  /EBITDA  MulBple  

¨  The  enterprise  value  to  EBITDA  mulBple  is  obtained  by  
ne|ng  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

¨  Why  do  we  net  out  cash  from  firm  value?  
¨  What  happens  if  a  firm  has  cross  holdings  which  are  
categorized  as:  
¤  Minority  interests?  
¤  Majority  acBve  interests?  

Aswath Damodaran!
130!
DescripBve  Tests  

¨  What  is  the  average  and  standard  deviaBon  for  this  mulBple,  
across  the  universe  (market)?  
¨  What  is  the  median  for  this  mulBple?    
¤  The  median  for  this  mulBple  is  oxen  a  more  reliable  comparison  point.  
¨  How  large  are  the  outliers  to  the  distribuBon,  and  how  do  we  
deal  with  the  outliers?  
¤  Throwing  out  the  outliers  may  seem  like  an  obvious  soluBon,  but  if  the  
outliers  all  lie  on  one  side  of  the  distribuBon  (they  usually  are  large  
posiBve  numbers),  this  can  lead  to  a  biased  esBmate.  
¨  Are  there  cases  where  the  mulBple  cannot  be  esBmated?  Will  
ignoring  these  cases  lead  to  a  biased  esBmate  of  the  
mulBple?  
¨  How  has  this  mulBple  changed  over  Bme?  

Aswath Damodaran!
131!
1.  MulBples  have  skewed  distribuBons…  

PE  Ra-os  for  US  stocks:  January  2014  

700.  

600.  

500.  

400.  
Current  

Trailing  
300.  
Forward  

200.  

100.  

0.  
0.01  To   4  To  8   8  To  12   12  To   16  To   20  To   24  To   28  To   32  To   36  To   40  To   50  To   75  To   More  
4   16   20   24   28   32   36   40   50   75   100  

Aswath Damodaran!
132!
2.  Making  staBsBcs  “dicey”  

Current PE Trailing PE Forward PE

Number of firms 7766 7766 7766
Number with PE 3248 3186 2699
Average 52.13 50.14 38.62
Median 20.78 19.75 18.54
Minimum 0.25 0.4 0.52
Maximum 7,117.43 7,117.43 16,820.

Standard deviation 242.03 249.64 349.38

Standard error 4.25 4.42 6.72
Skewness 18.29 17.62 42.99
25th percentile 13.004 12.97 14.7
75th percentile 33.66 30.47 25.13
Aswath Damodaran!
133!
 3.  Markets  have  a  lot  in  common  :  Comparing  Global  PEs  
134!

PE  Ra-o  Distribu-on:  Global  Comparison  in  January  2014  

25.00%  

20.00%  

Aus,  Ca  &  NZ  

15.00%  
US  

Emerg  Mkts  

Europe  
10.00%  
Japan  

Global  

5.00%  

0.00%  
0.01  To   4  To  8   8  To  12   12  To   16  To   20  To   24  To   28  To   32  To   36  To   40  To   50  To   75  To   More  
4   16   20   24   28   32   36   40   50   75   100  

Aswath Damodaran

134!
4.  SimplisBc  rules  almost  always  break  down…6  
Bmes  EBITDA  may  not  be  cheap…    

Aswath Damodaran!
135!
 But  it  may  be  in  2014,  unless  you  are  in  Japan  or  
in  some  emerging  markets…  
136!

EV/EBITDA:  A  Global  Comparison  -­‐  January  2014  

25.00%  

20.00%  

US  
15.00%  
A,C  &  NZ  

Emerg  Mkts  

Europe  
10.00%  
Japan  

Global  

5.00%  

0.00%  
0.01   2  To  4   4  To  6   6  To  8   8  To   10  To   12  To   16  To   20  To   25  To   30  To   35  To   40  To   45  To   50  To   75  To   More  
To  2   10   12   16   20   25   30   35   40   45   50   75   100  

Aswath Damodaran

136!
AnalyBcal  Tests  

¨  What  are  the  fundamentals  that  determine  and  drive  these  
mulBples?  
¤  ProposiBon  2:  Embedded  in  every  mulBple  are  all  of  the  variables  that  
drive  every  discounted  cash  flow  valuaBon  -­‐  growth,  risk  and  cash  flow  
paSerns.  
¤  In  fact,  using  a  simple  discounted  cash  flow  model  and  basic  algebra  
should  yield  the  fundamentals  that  drive  a  mulBple  
¨  How  do  changes  in  these  fundamentals  change  the  mulBple?  
¤  The  relaBonship  between  a  fundamental  (like  growth)  and  a  mulBple  
(such  as  PE)  is  seldom  linear.  For  example,  if  firm  A  has  twice  the  
growth  rate  of  firm  B,  it  will  generally  not  trade  at  twice  its  PE  raBo  
¤  ProposiBon  3:  It  is  impossible  to  properly  compare  firms  on  a  mulBple,  
if  we  do  not  know  the  nature  of  the  relaBonship  between  
fundamentals  and  the  mulBple.  

Aswath Damodaran!
137!
PE  RaBo:  Understanding  the  Fundamentals  

¨  To  understand  the  fundamentals,  start  with  a  basic  

equity  discounted  cash  flow  model.    
¨  With  the  dividend  discount  model,  
DPS1
P0 =
r − gn

¨  Dividing  both  sides  by  the  current  earnings  per  share,  
P0 Payout Ratio * (1 + g n )
= PE =
EPS0 r-gn

¨  If  this  had  been  a  FCFE  Model,  

    P0 =
FCFE1
r − gn
P0 (FCFE/Earnings) * (1+ g n )
Aswath Damodaran! = PE =
EPS0 r-g n 138!
The  Determinants  of  MulBples…  
Value of Stock = DPS 1/(k e - g)

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

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

Equity Multiples

Firm Multiples

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

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

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

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

Aswath Damodaran!
139!
ApplicaBon  Tests  

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

Aswath Damodaran!
140!
An  Example:  Comparing  PE  RaBos  across  a  
Sector:  PE  
Company Name PE Growth
PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zealand ADR 11.2 0.11
Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunication Organization SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Satellite Telecom Holdings ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexico ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gilat Communications 22.7 0.31
Deutsche Telekom AG ADR 24.6 0.11
British Telecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomunikasi Indonesia ADR 28.4 0.32
Cable & Wireless PLC ADR 29.8 0.14
APT Satellite Holdings ADR 31 0.33
Telefonica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Italia SPA ADR 42.2 0.14
Nippon Telegraph & Telephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Telecom ADR 71.3 0.44

Aswath Damodaran!
141!
PE,  Growth  and  Risk  

¨  Dependent  variable  is:  PE      

¨  R  squared  =  66.2%          R  squared  (adjusted)  =  63.1%  
Variable      Coefficient  SE  t-­‐ra3o  Probability  
Constant    13.1151    3.471  3.78  0.0010  
Growth  rate    121.223    19.27  6.29    ≤  0.0001  
Emerging  Market    -­‐13.853  1  3.606  -­‐3.84  0.0009  
Emerging  Market  is  a  dummy:    1  if  emerging  market  
                           0  if  not  
¨ Is  Indosat  cheap?  
PE  =  13.13  +  121.22  (.06)  -­‐13.85  (1)  =  6.55  
At  7.8  Bmes  earnings,  Indosat  is  over  valued.  

Aswath Damodaran!
142!
 Indofoods:  A  RelaBve  ValuaBon  

EV/ Expected Effective Operating

Company Name PE PBV EBITDA EV/Sales ROE ROIC growth tax rate Margin Net Margin
Sampoerna Agro Tbk (JKSE:SGRO) 40.64 1.79 13.27 2.33 4.41% 4.27% -26.20% 30.70% 9.22%   4.65%  
PT Charoen Pokphand Indonesia Tbk 25.38 6.45 15.23 2.57 25.43% 25.07% 6.40% 26.70%
(JKSE:CPIN)
15.59%   9.86%  
PT Indofood Sukses Makmur Tbk (JKSE:INDF) 26.17 1.71 9.54 1.37 6.52% 8.75% 9.63% 26.80%
10.78%   4.34%  
PT Indofood CBP Sukses Makmur Tbk 27.67 4.64 17.92 2.33 16.77% 20.26% 11.60% 24.70%
(JKSE:ICBP)
11.00%   8.87%  
PT Japfa Comfeed Indonesia tbk (JKSE:JPFA) 23.38 2.65 9.08 0.92 11.34% 11.60% 12.00% 28.50% 8.42%   2.78%  
PT Malindo Feedmill Tbk (JKSE:MAIN) 22.74 6.35 11.08 1.52 27.93% 21.29% 15.00% 22.30% 11.58%   5.74%  
PT Astra Agro Lestari Tbk (JKSE:AALI) 20.54 4.14 13.12 3.49 20.17% 19.20% 16.40% 28.00% 25.39%   16.30%  
Mayora Indah PT (JKSE:MYOR) 25.97 6.87 17.41 2.42 26.44% 17.10% 17.80% 22.00% 10.86%   8.66%  
PT Perusahaan Perkebunan London Sumatra 22.31 2.60 14.01 3.82 11.64% 12.33% 24.60% 22.90%
Indonesia Tbk (JKSE:LSIP)
20.16%   18.63%  
PT Sawit Sumbermas Sarana Tbk (JKSE:SSMS) 21.68 5.40 12.15 6.47 24.89% 26.95% 28.00% 26.00%
46.56%   29.39%  
Bumitama Agri Ltd (SGX:P8Z) 22.44 3.13 15.50 5.62 13.93% 10.60% 29.70% 22.60% 33.05%   21.05%  
PT Nippon Indosari Corpindo Tbk (JKSE:ROTI) 37.43 7.52 21.82 4.30 20.09% 13.04% 30.00% 25.00%
15.51%   10.50%  
PT Tiga Pilar Sejahtera Food Tbk (JKSE:AISA) 22.26 2.93 12.06 2.15 13.16% 11.39% 30.70% 22.90%
15.17%   7.65%  
PT. BW Plantation, Tbk (JKSE:BWPT) 36.55 3.03 21.05 8.88 8.30% 4.06% 54.70% 28.70% 28.48%   15.83%  
Median 24.38   3.63   13.64   2.49   15.35%   12.68%   17.10%   25.50%   15.34%   9.36%  
Aswath Damodaran!
143!
PBV  and  Return  on  Equity:  Food  
companies  
¨  On  a  price  to  book  raBo  basis,  Indofoods  looks  cheap,  
trading  at  1.71  Bmes  book  value,  whereas  the  median  
for  the  sector  is  3.63.  However,  Indofoods  also  has  a  ROE  
of  6.52%,  below  the  median  for  the  sector  of  15.35%.  
¨  Regressing  PBV  against  ROE  across  the  15  companies:  
 PBV  =    0.47  +  22.80  (ROE)    R2  =  81%  
   (.81)  (7.13)  
¨  Plugging  in  Indofoods  return  on  equity  of  6.52%  
 PBV  for  Indofoods  =  0.47  +  22.8  (.0652)  =  1.96  
(At  1.71  Bmes  book  value,  Indofoods  is  undervalued  (by  about  
13%).  

Aswath Damodaran!
144!
Comparisons  to  the  enBre  market:  Why  not?  

¨  In  contrast  to  the  'comparable  firm'  approach,  the  

informaBon  in  the  enBre  cross-­‐secBon  of  firms  can  
be  used  to  predict  PE  raBos.    
¨  The  simplest  way  of  summarizing  this  informaBon  is  

with  a  mulBple  regression,  with  the  PE  raBo  as  the  

dependent  variable,  and  proxies  for  risk,  growth  and  
payout  forming  the  independent  variables.  

Aswath Damodaran!
145!
 PE  RaBo:  Standard  Regression  for  US  stocks  -­‐  
January  2014  
146!

The regression is run with

growth and payout entered as
decimals, i.e., 25% is entered
as 0.25)

Aswath Damodaran

146!
 PE  raBo  regressions  across  markets  
147!

Region
Regression – January 2014
R2

US
PE = 4.20 + 149.0 gEPS + 13.40 Payout - 2.86 Beta
33.6%

Europe
PE = 11.51 + 41.73 gEPS + 14.36 Payout - 1.75 Beta
37.7%

Japan
PE = 11.01+ 17.30 gEPS + 31.22 Payout
16.9%

Emerging PE = 8.52 + 56.2 gEPS + 10.04 Payout - 1.43 Beta

20.0%

Markets

Global
PE = 11.79 + 50.39 gEPS + 15.86 Payout - 1.01 Beta - 61.15 ERP
33.1%

gEPS=Expected Growth: Expected growth in EPS or Net Income: Next 5 years

Beta: Regression or Bottom up Beta

Payout ratio: Dividends/ Net income from most recent year. Set to zero, if net income < 0

ERP: Equity Risk Premium (total) for country in which company is incorporated

Aswath Damodaran

147!
Choosing  Between  the  MulBples  

¨  As  presented  in  this  secBon,  there  are  dozens  of  mulBples  
that  can  be  potenBally  used  to  value  an  individual  firm.    
¨  In  addiBon,  relaBve  valuaBon  can  be  relaBve  to  a  sector  (or  
comparable  firms)  or  to  the  enBre  market  (using  the  
regressions,  for  instance)  
¨  Since  there  can  be  only  one  final  esBmate  of  value,  there  are  
three  choices  at  this  stage:  
¤  Use  a  simple  average  of  the  valuaBons  obtained  using  a  number  of  
different  mulBples  
¤  Use  a  weighted  average  of  the  valuaBons  obtained  using  a  nmber  of  
different  mulBples  
¤  Choose  one  of  the  mulBples  and  base  your  valuaBon  on  that  mulBple  

Aswath Damodaran!
148!
Picking  one  MulBple  

¨  This  is  usually  the  best  way  to  approach  this  issue.  While  a  
range  of  values  can  be  obtained  from  a  number  of  mulBples,  
the  “best  esBmate”  value  is  obtained  using  one  mulBple.  
¨  The  mulBple  that  is  used  can  be  chosen  in  one  of  two  ways:  
¤  Use  the  mulBple  that  best  fits  your  objecBve.  Thus,  if  you  want  the  
company  to  be  undervalued,  you  pick  the  mulBple  that  yields  the  
highest  value.  
¤  Use  the  mulBple  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  mulBples  against  fundamentals,  use  
the  mulBple  that  works  best  at  explaining  differences  across  firms  in  
that  sector.  
¤  Use  the  mulBple  that  seems  to  make  the  most  sense  for  that  sector,  
given  how  value  is  measured  and  created.  

Aswath Damodaran!
149!
ConvenBonal  usage…  

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

Aswath Damodaran!
150!
A  closing  thought…  

Aswath Damodaran!
151!