Aswath Damodaran 1

Valuation: Lecture Note Packet 1

Intrinsic Valuation
Aswath Damodaran
Updated: September 2016
 The essence of intrinsic value
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¨ In intrinsic valuation, you value an asset based upon its

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

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

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

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

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

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

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

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

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

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

Equity valuation: Value just the

equity claim in the business

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 Equity Valuation
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Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

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

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

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 Firm Valuation
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Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

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

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

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 Firm Value and Equity Value
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¨ To get from firm value to equity value, which of the following

would you need to do?
a. Subtract out the value of long term debt
b. Subtract out the value of all debt
c. Subtract the value of any debt that was included in the cost of
capital calculation
d. Subtract out the value of all liabilities in the firm
¨ Doing so, will give you a value for the equity which is
a. greater than the value you would have got in an equity valuation
b. lesser than the value you would have got in an equity valuation
c. equal to the value you would have got in an equity valuation

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

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

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

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

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

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

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

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

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DISCOUNTED CASH FLOW

VALUATION: THE INPUTS
The devil is in the details..
 Discounted Cash Flow Valuation: The Steps
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1. Estimate the discount rate or rates to use in the valuation

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

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 Generic DCF Valuation Model
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DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Equity: After debt Net Income/EPS Firm is in stable growth:
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever
Equity: Value of Equity
Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

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 Same ingredients, different approaches…
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Input Dividend Discount FCFE (Potential FCFF (firm)

Model dividend) discount valuation model
model
Cash flow Dividend Potential dividends FCFF = Cash flows
= FCFE = Cash flows before debt
after taxes, payments but after
reinvestment needs reinvestment needs
and debt cash and taxes.
flows
Expected growth In equity income In equity income In operating
and dividends and FCFE income and FCFF
Discount rate Cost of equity Cost of equity Cost of capital
Steady state When dividends When FCFE grow at When FCFF grow at
grow at constant constant rate constant rate
rate forever forever forever
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 Start easy: The Dividend Discount Model
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Expected Retention ratio

growth in net needed to
income sustain growth

Net Income Expected dividends = Expected net

* Payout ratio income * (1- Retention ratio)
= Dividends

Length of high growth period: PV of dividends during

high growth Stable Growth
Value of equity When net income and
dividends grow at constant
rate forever.
Cost of Equity
Rate of return
demanded by equity
investors

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 Moving on up: The “potential dividends” or FCFE
model
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Equity reinvestment
Expected growth in needed to sustain
net income growth
Free Cashflow to Equity
Non-cash Net Income
- (Cap Ex - Depreciation) Expected FCFE = Expected net income *
- Change in non-cash WC (1- Equity Reinvestment rate)
- (Debt repaid - Debt issued)
= Free Cashflow to equity

Length of high growth period: PV of FCFE during high

Value of Equity in non-cash Assets growth Stable Growth
+ Cash When net income and FCFE
= Value of equity grow at constant rate forever.

Cost of equity
Rate of return
demanded by equity
investors

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 To valuing the entire business: The FCFF model
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Reinvestment
Expected growth in needed to sustain
operating ncome growth

Free Cashflow to Firm

After-tax Operating Income
- (Cap Ex - Depreciation) Expected FCFF= Expected operating
- Change in non-cash WC income * (1- Reinvestment rate)
= Free Cashflow to firm

Value of Operatng Assets Length of high growth period: PV of FCFF during high
+ Cash & non-operating assets growth Stable Growth
- Debt When operating income and
= Value of equity FCFF grow at constant rate
forever.
Cost of capital
Weighted average of
costs of equity and
debt

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