Aswath Damodaran 1

Valuation: Lecture Note Packet 1

Intrinsic Valuation
Aswath Damodaran
Updated: January 2023
 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 (DCF) 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.
¤ Intrinsic valuation models predate the modern DCF model, since
investors through the ages have found ways to weight in
expected cash flows into value.

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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 “DON’T BE A WUSS” proposition: Valuation requires that you
make estimates of expected cash flows in the future, not that you
be right about those cashflows. So, uncertainty is not an excuse for
not making estimates.
3. 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.
4. 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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 1. 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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 2. Firm or Business 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 Expense (1-t) 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.
¨ The Mismatch Effect: 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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13 DCF: First Steps

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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:
cash flows Grows at constant rate
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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19 DCF: The Process

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20 Aswath Damodaran
 The Sequence
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1. Get a handle on the past and the cross-section: While the past is the
past (and should have little relevance in determining value), you can get
clues about the future by looking at what your firm has done in the
past, and what other companies in the business are doing now.
2. Risk and Discount Rates: Traditional financial theory (unfortunately) has
put too much of a focus on risk and discount rates, but they do remain
ingredients in valuing a company.
3. Estimate growth and future cash flows: This is where the rubber meets
the road in valuation. Estimating future cash flows is never easy, should
not be mechanical and should be built around your story.
4. Apply Closure to cash flows: Since you cannot estimate cash flows
forever, you need to find a way to bring your valuation to closure.
5. Tie up loose ends: Check to see what else in your business needs to be
valued or adjusted for to get to value per share.

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22 Discount Rates
The D in the DCF..

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 Estimating Inputs: Discount Rates
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¨ While discount rates obviously matter in DCF valuation, they

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

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 Risk in the DCF Model
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Relative risk of Equity Risk Premium

Risk Adjusted Risk free rate in the company/equity in X
Cost of equity
=
currency of analysis + questiion
required for average risk
equity

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 Not all risk is created equal…
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¨ Estimation versus Economic uncertainty

¤ Estimation uncertainty reflects the possibility that you could have the “wrong
model” or estimated inputs incorrectly within this model.
¤ Economic uncertainty comes the fact that markets and economies can change over
time and that even the best models will fail to capture these unexpected changes.
¨ Micro uncertainty versus Macro uncertainty
¤ Micro uncertainty refers to uncertainty about the potential market for a firm’s
products, the competition it will face and the quality of its management team.
¤ Macro uncertainty reflects the reality that your firm’s fortunes can be affected by
changes in the macro economic environment.
¨ Discrete versus continuous uncertainty
¤ Discrete risk: Risks that lie dormant for periods but show up at points in time.
(Examples: A drug working its way through the FDA pipeline may fail at some stage
of the approval process or a company in Venezuela may be nationalized)
¤ Continuous risk: Risks changes in interest rates or economic growth occur
continuously and affect value as they happen.

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

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

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

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 Classic Risk & Return: Cost of Equity
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¨ In the CAPM, the cost of equity:

Cost of Equity = Riskfree Rate + Equity Beta * (Equity Risk
Premium)
¨ In APM or Multi-factor models, you still need a risk
free rate, as well as betas and risk premiums to go
with each factor.
¨ To use any risk and return model, you need
¨ A risk free rate as a base
¨ A single equity risk premium (in the CAPM) or factor risk
premiums, in the the multi-factor models
¨ A beta (in the CAPM) or betas (in multi-factor models)
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29 Discount Rates I
The Riskfree Rate

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 The Risk Free Rate: Laying the Foundations
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¨ On a riskfree investment, the actual return is equal to the expected

return. Therefore, there is no variance around the expected return.
¨ For an investment to be riskfree, then, it has to have
¤ No default risk
¤ No reinvestment risk
¤ It follows then that if asked to estimate a risk free rate:
1. Time horizon matters: Thus, the riskfree rates in valuation will
depend upon when the cash flow is expected to occur and will
vary across time.
2. Currencies matter: A risk free rate is currency-specific and can be
very different for different currencies.
3. Not all government securities are riskfree: Some governments
face default risk and the rates on bonds issued by them will not
be riskfree.

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 Test 1: A riskfree rate in US dollars!
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¨ In valuation, we estimate cash flows forever (or at least

for very long time periods). The right risk free rate to use
in valuing a company in US dollars would be
a. A three-month Treasury bill rate (4.42%)
b. A ten-year Treasury bond rate (3.88%)
c. A thirty-year Treasury bond rate (3.97%)
d. A TIPs (inflation-indexed treasury) rate (1.53%)
e. The highest of these numbers
f. The lowest of these numbers
g. Other (Specify)
What are we implicitly assuming about the US treasury when we
use any of the treasury numbers?
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 Test 2: A Riskfree Rate in Euros?
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Government Bond Rates: 10-year Euro bonds

4.00%

3.50%

3.00%

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%
Germany Netherlands Irel and France Belgi um Fi nl and Austria Portugal Spain It aly Sl ov eni a Greece

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 Test 3: A Riskfree Rate in Indian Rupees
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¨ The Indian government had 10-year Rupee bonds

outstanding, with a yield to maturity of about 7.34% on
January 1, 2023.
¨ In January 2023, the Indian government had a local currency
sovereign rating of Baa3. The typical default spread (over a
default free rate) for Baa3 rated country bonds in early 2023
was 2.69%. The risk free rate in Indian Rupees is
a. The yield to maturity on the 10-year bond (7.34%)
b. The yield to maturity on the 10-year bond + Default spread (10.03%)
c. The yield to maturity on the 10-year bond – Default spread (4.65%)
d. None of the above

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 Sovereign Default Spread: Three paths to
the same destination…
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¨ Sovereign dollar or euro denominated bonds: Find

sovereign bonds denominated in US dollars, issued by an
emerging sovereign.
¤ Default spread = Emerging Govt Bond Rate (in US $) – US
Treasury Bond rate with same maturity.
¨ CDS spreads: Obtain the traded value for a sovereign
Credit Default Swap (CDS) for the emerging government.
¤ Default spread = Sovereign CDS spread (with perhaps an
adjustment for CDS market frictions).
¨ Sovereign-rating based spread: For countries which don’t
issue dollar denominated bonds or have a CDS spread,
you have to use the average spread for other countries
with the same sovereign rating.
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Approach 1: Default spread from Government
Bonds

Country $ Bond Rate Riskfree Rate Default Spread

$ Bonds
Peru 5.66% 3.88% 1.78%
Brazil 6.15% 3.88% 2.27%
Colombia 5.75% 3.88% 1.87%
Poland 4.68% 3.88% 0.80%
Turkey 6.83% 3.88% 2.95%
Mexico 4.95% 3.88% 1.07%
Russia 10.38% 3.88% 6.50%
Euro Bonds
Bulgaria 3.50% 2.26% 1.24%

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 Approach 2: CDS Spreads – January 2023
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 Approach 3: Typical Default Spreads: January
2022
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S&P Sovereign Rating Moody's Sovereign Rating Default Spread

AAA Aaa 0.00%
AA+ Aa1 0.49%
AA Aa2 0.60%
AA- Aa3 0.73%
A+ A1 0.86%
A A2 1.04%
A- A3 1.47%
BBB+ Baa1 1.96%
BBB Baa2 2.33%
BBB- Baa3 2.69%
BB+ Ba1 3.06%
BB Ba2 3.68%
BB Ba3 4.40%
B+ B1 5.51%
B B2 6.73%
B- B3 7.95%
CCC+ Caa1 9.17%
CCC Caa2 11.02%
CCC- Caa3 12.24%
CC+ Ca1 13.75%
CC Ca2 14.68%
CC- Ca3 15.25%
C+ C1 16.25%
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C C2 17.50%
C- C3 19.00% 37
 Getting to a risk free rate in Brazilian Reais on
January 1, 2023
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¨ The Brazilian government bond rate in nominal reais on

January 1, 2023, was 12.76%. To get to a riskfree rate in
nominal reais, we can use one of three approaches.
¨ Approach 1: Government Bond spread
¤ Default Spread = Brazil $ Bond Rate – US T.Bond Rate = 6.15% -
3.88% = 2.27%
¤ Riskfree rate in $R = 12.76% - 2.27% = 10.49%
¨ Approach 2: The CDS Spread
¤ The CDS spread for Brazil, adjusted for the US CDS spread was
3.20%.
¤ Riskfree rate in $R = 12.76% - 3.20% = 9.56%
¨ Approach 3: The Rating based spread
¤ Brazil has a Ba2 local currency rating from Moody’s. The default
spread for that rating is 2.56%
¤ Riskfree rate in $R = 12.76% - 3.68% = 9.08%

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 Test 4: A Real Riskfree Rate
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¨ In some cases, you may want a riskfree rate in real terms

(in real terms) rather than nominal terms.
¨ To get a real riskfree rate, you would like a security with
no default risk and a guaranteed real return. Treasury
indexed securities offer this combination.
¨ In January 2023, the yield on a 10-year indexed treasury
bond was 1.53%. Which of the following statements
would you subscribe to?
a. This (1.53%) is the real riskfree rate to use, if you are valuing
US companies in real terms.
b. This (1.53%) is the real riskfree rate to use, anywhere in the
world
Explain.

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 Why do risk free rates vary across currencies?
January 2023 Risk free rates
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Or across time…

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Risk free Rate: Don’t have or don’t trust
the government bond rate?
¨ You can scale up the riskfree rate in a base currency
($, Euros) by the differential inflation between the
base currency and the currency in question. In US $:
Risk free rateCurrency=

¨ Thus, if the US $ risk free rate is 2.00%, the inflation

rate in Egyptian pounds is 15% and the inflation
rate in US $ is 1.5%, the foreign currency risk free
rate is as follows:
Risk free rate = (1.02 )
("."$)
(".&"$)
− 1 = 15.57%

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 One more test on riskfree rates…
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¨ On January 1, 2022, the 10-year treasury bond rate in

the United States was 1.51%, low by historic standards.
Assume that you are valuing a company in US dollars
then but are wary about the riskfree rate being too low.
Which of the following should you do?
a. Replace the current 10-year bond rate with a more reasonable
normalized riskfree rate (the average 10-year bond rate over
the last 30 years has been about 5-6%)
b. Use the current 10-year bond rate as your riskfree rate but
make sure that your other assumptions (about growth and
inflation) are consistent with the riskfree rate.
c. Something else…

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 Some perspective on risk free rates
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 Negative Interest Rates?
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¨ In 2022, there were at least three currencies (Swiss

Franc, Japanese Yen, Euro) with negative interest
rates. Using the fundamentals (inflation and real
growth) approach, how would you explain negative
interest rates?
¤ How negative can rates get? (Is there a bound?)
¤ Would you use these negative interest rates as risk free
rates?
n If no, why not and what would you do instead?
n If yes, what else would you have to do in your valuation
to be internally consistent?

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46 Discount Rates: II
The Equity Risk Premium

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 II. The Equity Risk Premium
The ubiquitous historical risk premium
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¨ The historical premium is the premium that stocks have historically

earned over riskless securities.
¨ While the users of historical risk premiums act as if it is a fact (rather than
an estimate), it is sensitive to
¤ How far back you go in history…
¤ Whether you use T.bill rates or T.Bond rates
¤ Whether you use geometric or arithmetic averages.
¨ For instance, looking at the US:

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 The perils of trusting the past…….
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¨ Noisy estimates: Even with long time periods of history,

the risk premium that you derive will have substantial
standard error. For instance, if you go back to 1928
(about 90 years of history) and you assume a standard
deviation of 20% in annual stock returns, you arrive at a
standard error of greater than 2%:
Standard Error in Premium = 20%/√90 = 2.1%
¨ Survivorship Bias: Using historical data from the U.S.
equity markets over the twentieth century does create a
sampling bias. After all, the US economy and equity
markets were among the most successful of the global
economies that you could have invested in early in the
century.
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 The simplest way of estimating an additional
country risk premium: The country default spread
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¨ Default spread for country: In this approach, the country equity risk
premium is set equal to the default spread for the country,
estimated in one of three ways:
¤ The default spread on a dollar denominated bond issued by the country.
(In January 2023, that spread was % for the Brazilian $ bond) was 2.27%.
¤ The sovereign CDS spread for the country. In January 2023, the ten-year
CDS spread for Brazil, adjusted for the US CDS, was 3.20%.
¤ The default spread based on the local currency rating for the country.
Brazil’s sovereign local currency rating is Ba2 and the default spread for a
Ba2 rated sovereign was about 3.68% in January 2023.
¨ Add the default spread to a “mature” market premium: This default
spread is added on to the mature market premium to arrive at the
total equity risk premium for Brazil, assuming a mature market
premium of 5.94%.
¤ Country Risk Premium for Brazil = 3.68%
¤ Total ERP for Brazil = 5.94% + 3.68% = 9.62%

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 An equity volatility based approach to
estimating the country total ERP
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¨ This approach draws on the standard deviation of two equity

markets, the emerging market in question and a base market
(usually the US). The total equity risk premium for the
emerging market is then written as:
¤ Total equity risk premium = Risk PremiumUS* sCountry Equity / sUS Equity
¨ The country equity risk premium is based upon the volatility
of the market in question relative to U.S market.
¤ Assume that the equity risk premium for the US is 5.94%.
¤ Assume that the standard deviation in the Bovespa (Brazilian equity) is
30% and that the standard deviation for the S&P 500 (US equity) is
18%.
¤ Total Equity Risk Premium for Brazil = 5.94% (30%/18%) = 9.90%
¤ Country equity risk premium for Brazil = 9.90% - 5.94% = 3.96%

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 A melded approach to estimating the additional
country risk premium
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¨ Country ratings measure default risk. While default risk premiums

and equity risk premiums are highly correlated, one would expect
equity spreads to be higher than debt spreads.
¨ Another is to multiply the bond default spread by the relative
volatility of stock and bond prices in that market. Using this
approach for Brazil in January 2022, you would get:
¤ Country Equity risk premium = Default spread on country bond* sCountry
Equity / sCountry Bond
n Standard Deviation in Bovespa (Equity) = 30%
n Standard Deviation in Brazil government bond = 20%
n Default spread for Brazil= 3.68%
¤ Brazil Country Risk Premium = 3.68% (30%/20%) = 5.52%
¤ Brazil Total ERP = Mature Market Premium + CRP = 5.94% + 5.52% =
11.46%

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A Template for Estimating the ERP

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ERP : Jan 2023

Blue: Moody’s Rating

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Red: Added Country Risk
Green #: Total ERP
 From Country Equity Risk Premiums to
Corporate Equity Risk premiums
54

¨ Approach 1: Assume that every company in the country is

equally exposed to country risk. In this case,
¤ E(Return) = Riskfree Rate + CRP + Beta (Mature ERP)
¨ Approach 2: Assume that a company’s exposure to country
risk is similar to its exposure to other market risk.
¤ E(Return) = Riskfree Rate + Beta (Mature ERP+ CRP)
¨ Approach 3: Treat country risk as a separate risk factor and
allow firms to have different exposures to country risk
(perhaps based upon the proportion of their revenues come
from non-domestic sales)
¤ E(Return)=Riskfree Rate+ b (Mature ERP) + l (CRP)
Mature ERP = Mature market Equity Risk Premium
CRP = Additional country risk premium

Aswath Damodaran
54
 Estimating country risk premium exposure_
Vaiants
55

Aswath Damodaran
55
 Operation based CRP: Single versus Multiple
Emerging Markets
56

¨ Single emerging market: Embraer, in 2004, reported that it derived 3% of

its revenues in Brazil and the balance from mature markets. The mature
market ERP in 2004 was 5% and Brazil’s CRP was 7.89%.

¨ Multiple emerging markets: Ambev, the Brazilian-based beverage

company, reported revenues from the following countries during 2011.

Aswath Damodaran
56
 Extending to a multinational: Regional breakdown
Coca Cola’s revenue breakdown and ERP in 2012
57

Things to watch out for

1. Aggregation across regions. For instance, the Pacific region often includes Australia & NZ with Asia
2. Obscure aggregations including Eurasia and Oceania 57
 Two problems with these approaches..
58

¨ Focus just on revenues: To the extent that revenues are

the only variable that you consider, when weighting risk
exposure across markets, you may be missing other
exposures to country risk. For instance, an emerging
market company that gets the bulk of its revenues
outside the country (in a developed market) may still
have all of its production facilities in the emerging
market.
¨ Exposure not adjusted or based upon beta: To the extent
that the country risk premium is multiplied by a beta, we
are assuming that beta in addition to measuring
exposure to all other macro economic risk also measures
exposure to country risk.

Aswath Damodaran
58
 A Production-based ERP: Royal Dutch Shell
in 2015
59

Country Oil & Gas Production % of Total ERP

Denmark 17396 3.83% 6.20%
Italy 11179 2.46% 9.14%
Norway 14337 3.16% 6.20%
UK 20762 4.57% 6.81%
Rest of Europe 874 0.19% 7.40%
Brunei 823 0.18% 9.04%
Iraq 20009 4.40% 11.37%
Malaysia 22980 5.06% 8.05%
Oman 78404 17.26% 7.29%
Russia 22016 4.85% 10.06%
Rest of Asia & ME 24480 5.39% 7.74%
Oceania 7858 1.73% 6.20%
Gabon 12472 2.75% 11.76%
Nigeria 67832 14.93% 11.76%
Rest of Africa 6159 1.36% 12.17%
USA 104263 22.95% 6.20%
Canada 8599 1.89% 6.20%
Brazil 13307 2.93% 9.60%
Rest of Latin America 576 0.13% 10.78%
Royal Dutch Shell 454326 100.00% 8.26%

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59
 Estimate a lambda for country risk
60

¨ Country risk exposure is affected by where you get your

revenues and where your production happens, but there are
a host of other variables that also affect this exposure,
including:
¤ Use of risk management products: Companies can use both options/futures
markets and insurance to hedge some or a significant portion of country risk.
¤ Government “national” interests: There are sectors that are viewed as vital to
the national interests, and governments often play a key role in these
companies, either officially or unofficially. These sectors are more exposed to
country risk.
¨ It is conceivable that there is a richer measure of country risk
that incorporates all of the variables that drive country risk in
one measure. That way my rationale when I devised
“lambda” as my measure of country risk exposure.

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60
A Revenue-based Lambda

¨ The factor “l” measures the relative exposure of a firm to country

risk. One simplistic solution would be to do the following:
l = % of revenues domesticallyfirm/ % of revenues domesticallyaverage firm
¨ Consider two firms – Tata Motors and Tata Consulting Services,
both Indian companies. 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:
l Tata Motors= 91%/80% = 1.14
l TCS= 7.62%/80% = 0.09
¨ There are two implications
¤ A company’s risk exposure is determined by where it does business and
not by where it is incorporated.
¤ Firms might be able to actively manage their country risk exposures

61
 A Price/Return based Lambda
62

ReturnEmbraer = 0.0195 + 0.2681 ReturnC Bond

ReturnEmbratel = -0.0308 + 2.0030 ReturnC Bond
Embraer versus C Bond: 2000-2003 Embratel versus C Bond: 2000-2003
40 100

80

20
60

40

Return on Embrat el
Return on Embraer

0
20

0
-20
-20

-40 -40

-60

-60 -80
-30 -20 -10 0 10 20 -30 -20 -10 0 10 20

Return on C-Bond Return on C-Bond

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62
 Estimating a US Dollar Cost of Equity for
Embraer - September 2004
63

¨ Assume that the beta for Embraer is 1.07, and that the US $ riskfree rate
used is 4%. Also assume that the risk premium for the US is 5% and the
country risk premium for Brazil is 7.89%. Finally, assume that Embraer
gets 3% of its revenues in Brazil & the rest in the US.
¨ There are five estimates of $ cost of equity for Embraer:
¤ Approach 1: Constant exposure to CRP, Location CRP
n E(Return) = 4% + 1.07 (5%) + 7.89% = 17.24%
¤ Approach 2: Constant exposure to CRP, Operation CRP
n E(Return) = 4% + 1.07 (5%) + (0.03*7.89% +0.97*0%)= 9.59%
¤ Approach 3: Beta exposure to CRP, Location CRP
n E(Return) = 4% + 1.07 (5% + 7.89%)= 17.79%
¤ Approach 4: Beta exposure to CRP, Operation CRP
n E(Return) = 4% + 1.07 (5% +( 0.03*7.89%+0.97*0%)) = 9.60%
¤ Approach 5: Lambda exposure to CRP
n E(Return) = 4% + 1.07 (5%) + 0.27(7.89%) = 11.48%

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63
 Valuing Emerging Market Companies with
significant exposure in developed markets
64

¨ The conventional practice in investment banking is to add the

country equity risk premium on to the cost of equity for every
emerging market company, notwithstanding its exposure to
emerging market risk. Thus, in 2004, Embraer would have
been valued with a cost of equity of 17-18% even though it
gets only 3% of its revenues in Brazil. As an investor, which of
the following consequences do you see from this approach?
a. Emerging market companies with substantial exposure in developed
markets will be significantly over valued by analysts
b. Emerging market companies with substantial exposure in developed
markets will be significantly under valued by analysts
Can you construct an investment strategy to take advantage of the
mis-valuation? What would need to happen for you to make money
of this strategy?

Aswath Damodaran
64
 Implied Equity Premiums
65

¨ For a start: If you know the price paid for an asset and have
estimates of the expected cash flows on the asset, you can
estimate the IRR of these cash flows. If you paid the price,
this is your expected return.
¨ Stock Price & Risk: If you assume that stocks are correctly
priced in the aggregate and you can estimate the expected
cashflows from buying stocks, you can estimate the expected
rate of return on stocks by finding that discount rate that
makes the present value equal to the price paid.
¨ Implied ERP: Subtracting out the riskfree rate should yield an
implied equity risk premium. This implied equity premium is
a forward-looking number and can be updated as often as
you want (every minute of every day, if you are so inclined).

Aswath Damodaran
65
 Equity Risk Premium: January 2020
66

Aswath Damodaran
66
 And in 2020.. COVID effects
67

Aswath Damodaran
67
 An Updated Estimate: ERP in 2023
68

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68
Implied Premiums in the US: 1960-2022

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69
 Implied Premium versus Risk Free Rate
70

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70
 Equity Risk Premiums and Bond Default Spreads
71

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71
 Equity Risk Premiums and Cap Rates (Real
Estate)
72

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72
 Why implied premiums matter?
73

¨ In many investment banks, it is common practice (especially in

corporate finance departments) to use historical risk premiums
(and arithmetic averages at that) as risk premiums to compute cost
of equity.
¨ If all analysts in a group used the arithmetic average premium (for
stocks over T.Bills) for 1928-2022 of 8.17% to value stocks in
January 2022, given the implied premium of 5.94%, what are they
likely to find?
a. The values they obtain will be too low (most stocks will look overvalued)
b. The values they obtain will be too high (most stocks will look under valued)
c. There should be no systematic bias as long as they use the same premium
to value all stocks.

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73
 Which equity risk premium should you use?
74
If you assume this Premium to use
Premiums revert back to historical norms Historical risk premium
and your time period yields these norms

Market is correct in the aggregate or that Current implied equity risk premium
your valuation should be market neutral

Marker makes mistakes even in the Average implied equity risk premium over
aggregate but is correct over time time.
Predictor Correlation with implied Correlation with actual Correlation with actual return
premium next year return- next 5 years – next 10 years
Current implied premium 0.763 0.427 0.500
Average implied premium: Last 5 0.718 0.326 0.450
years
Historical Premium -0.497 -0.437 -0.454
Default Spread based premium 0.047 0.143 0.160

Aswath Damodaran
74
 An ERP for the Sensex
75

¨ Inputs for the computation

¤ Sensex on 9/5/07 = 15446
¤ Dividend yield on index = 3.05%
¤ Expected growth rate - next 5 years = 14%
¤ Growth rate beyond year 5 = 6.76% (set equal to riskfree rate)
¨ Solving for the expected return:
537.06 612.25 697.86 795.67 907.07 907.07(1.0676)
15446 = + + + + +
(1+ r) (1+ r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r − .0676)(1+ r) 5

¨ Expected return on stocks = 11.18%

€ ¨ Implied equity risk premium for India = 11.18% - 6.76% =
4.42%

Aswath Damodaran
75
 The evolution of Emerging Market Risk
76

Growth Growth Cost of

Start of PBV PBV ROE ROE US T.Bond Rate Rate Equity Cost of Equity
year (Developed) (Emerging) (Developed) (Emerging) Rate (Developed) (Emerging) (Developed) (Emerging) Differential
2004 2.00 1.19 10.81% 11.65% 4.25% 3.75% 4.75% 7.28% 10.55% 3.27%
2005 2.09 1.27 11.12% 11.93% 4.22% 3.72% 4.72% 7.26% 10.40% 3.14%
2006 2.03 1.44 11.32% 12.18% 4.39% 3.89% 4.89% 7.55% 9.95% 2.40%
2007 1.67 1.67 10.87% 12.88% 4.70% 4.20% 5.20% 8.19% 9.80% 1.60%
2008 0.87 0.83 9.42% 11.12% 4.02% 3.52% 4.52% 10.30% 12.47% 2.17%
2009 1.20 1.34 8.48% 11.02% 2.21% 1.71% 2.71% 7.35% 8.91% 1.56%
2010 1.39 1.43 9.14% 11.22% 3.84% 3.34% 4.34% 7.51% 9.15% 1.64%
2011 1.12 1.08 9.21% 10.04% 3.29% 2.79% 3.79% 8.52% 9.58% 1.05%
2012 1.17 1.18 9.10% 9.33% 1.88% 1.38% 2.38% 7.98% 8.27% 0.29%
2013 1.56 1.63 8.67% 10.48% 1.76% 1.26% 2.26% 6.01% 7.30% 1.29%
2014 1.95 1.50 9.27% 9.64% 3.04% 2.54% 3.54% 5.99% 7.61% 1.62%
2015 1.88 1.56 9.69% 9.75% 2.17% 1.67% 2.67% 5.94% 7.21% 1.27%
2016 1.99 1.59 9.24% 10.16% 2.27% 1.77% 2.77% 5.52% 7.42% 1.89%
2017 1.76 1.48 8.71% 9.53% 2.68% 2.18% 3.18% 5.89% 7.47% 1.58%
2018 1.98 1.66 11.23% 11.36% 2.68% 2.18% 3.18% 6.75% 8.11% 1.36%
2019 1.64 1.31 12.09% 11.35% 2.68% 2.18% 3.18% 8.22% 9.42% 1.19%

Aswath Damodaran
76
77 Discount Rates: III
Relative Risk Measures

Aswath Damodaran
 The CAPM Beta: The Most Used (and
Misused) Risk Measure
78

¨ The standard procedure for estimating betas is to regress

stock returns (Rj) against market returns (Rm) -
Rj = a + b Rm
where a is the intercept and b is the slope of the regression.
¨ The slope of the regression corresponds to the beta of
the stock, and measures the riskiness of the stock.
¨ This beta has three problems:
• It has high standard error
• It reflects the firm’s business mix over the period of the
regression, not the current mix
• It reflects the firm’s average financial leverage over the period
rather than the current leverage.

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78
 Unreliable, when it looks bad..
79

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79
 Or when it looks good..
80

Aswath Damodaran
80
 One slice of history..
81

During 2019 and 2020, GME was an

extraordinarily volatile stock, as short
sellers and long only investors fought
out a battle.
Aswath Damodaran
 And subject to game playing
82

Aswath Damodaran
 Measuring Relative Risk: You don’t like betas or
modern portfolio theory? No problem.
83

Aswath Damodaran
83
 Don’t like the diversified investor focus,
but okay with price-based measures
84

1. Relative Standard Deviation

• Relative Volatility = Std dev of Stock/ Average Std dev across all stocks
• Captures all risk, rather than just market risk
2. Proxy Models
• Look at historical returns on all stocks and look for variables that
explain differences in returns.
• You are, in effect, running multiple regressions with returns on
individual stocks as the dependent variable and fundamentals about
these stocks as independent variables.
• This approach started with market cap (the small cap effect) and over
the last two decades has added other variables (momentum, liquidity
etc.)
3. CAPM Plus Models
• Start with the traditional CAPM (Rf + Beta (ERP)) and then add other
premiums for proxies.

Aswath Damodaran
84
 Don’t like the price-based approach..
85

1. Accounting risk measures: To the extent that you don’t trust

market-priced based measures of risk, you could compute relative
risk measures based on
• Accounting earnings volatility: Compute an accounting beta or relative volatility
• Balance sheet ratios: You could compute a risk score based upon accounting ratios
like debt ratios or cash holdings (akin to default risk scores like the Z score)
2. Qualitative Risk Models: In these models, risk assessments are
based at least partially on qualitative factors (quality of
management).
3. Debt based measures: You can estimate a cost of equity, based
upon an observable costs of debt for the company.
• Cost of equity = Cost of debt * Scaling factor
• The scaling factor can be computed from implied volatilities.

Aswath Damodaran
85
 Determinants of Betas & Relative Risk
86

Beta of Equity (Levered Beta)

Beta of Firm (Unlevered Beta) 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. Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))

Implications Implications
1. Cyclical companies should 1. Firms with high infrastructure
have higher betas than non- needs and rigid cost structures
cyclical companies. should 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 higher
firms should have higher betas betas than more mature firms.
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Aswath Damodaran
86
 In a perfect world… we would estimate the beta of a
firm by doing the following
87

Start with the beta of the business that the firm is in

Adjust the business beta for the operating leverage of the firm to arrive at the
unlevered beta for the firm.

Use the financial leverage of the firm to estimate the equity beta for the firm
Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (Debt/Equity))

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87
 Adjusting for operating leverage…
88

¨ Within any business, firms with lower fixed costs (as a

percentage of total costs) should have lower unlevered
betas. If you can compute fixed and variable costs for
each firm in a sector, you can break down the unlevered
beta into business and operating leverage components.
¤ Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable
costs))
¨ The biggest problem with doing this is informational. It is
difficult to get information on fixed and variable costs for
individual firms.
¨ In practice, we tend to assume that the operating
leverage of firms within a business are similar and use
the same unlevered beta for every firm.
Aswath Damodaran
88
 Adjusting for financial leverage…
89

¨ Conventional approach: If we assume that debt carries

no market risk (has a beta of zero), the beta of equity
alone can be written as a function of the unlevered beta
and the debt-equity ratio
bL = bu (1+ ((1-t)D/E))
In some versions, the tax effect is ignored and there is no (1-t) in
the equation.
¨ Debt Adjusted Approach: If beta carries market risk and
you can estimate the beta of debt, you can estimate the
levered beta as follows:
bL = bu (1+ ((1-t)D/E)) - bdebt (1-t) (D/E)
While the latter is more realistic, estimating betas for debt can be
difficult to do.

Aswath Damodaran
89
 Bottom-up Betas
90

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
90
 Why bottom-up betas?
91

¨ Less Noisy: The standard error in a bottom-up beta will be

significantly lower than the standard error in a single
regression beta. Roughly speaking, the standard error of a
bottom-up beta estimate can be written as follows:
Std error of bottom-up beta = Average Std Error across Betas
Number of firms in sample
¨ Updated: The bottom-up beta can be adjusted to reflect
changes in the firm’s business mix and financial leverage.
Regression betas reflect
€ the past.
¨ Don’t need prices: You can estimate bottom-up betas even
when you do not have historical stock prices. This is the case
with initial public offerings, private businesses or divisions of
companies.

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91
Estimating Bottom Up Betas & Costs of
Equity: Vale
Sample' Unlevered'beta' Peer'Group' Value'of' Proportion'of'
Business' Sample' size' of'business' Revenues' EV/Sales' Business' Vale'

Global'firms'in'metals'&'
Metals'&' mining,'Market'cap>$1'
Mining' billion' 48' 0.86' $9,013' 1.97' $17,739' 16.65%'

Iron'Ore' Global'firms'in'iron'ore' 78' 0.83' $32,717' 2.48' $81,188' 76.20%'

Global'specialty'
Fertilizers' chemical'firms' 693' 0.99' $3,777' 1.52' $5,741' 5.39%'

Global'transportation'
Logistics' firms' 223' 0.75' $1,644' 1.14' $1,874' 1.76%'
Vale'
Operations' '' '' 0.8440' $47,151' '' $106,543' 100.00%'

Aswath Damodaran
92
 Embraer’s Bottom-up Beta
93

Business Unlevered Beta D/E Ratio Levered beta

Aerospace 0.95 18.95% 1.07

¨ Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (D/E Ratio)

= 0.95 ( 1 + (1-.34) (.1895)) = 1.07

¨ Can an unlevered beta estimated using U.S. and European

aerospace companies be used to estimate the beta for a Brazilian
aerospace company?
a. Yes
b. No
What concerns would you have in making this assumption?

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93
 Gross Debt versus Net Debt Approaches
94

¨ Analysts in Europe and Latin America often take the difference between
debt and cash (net debt) when computing debt ratios and arrive at very
different values.
¨ For Embraer, using the gross debt ratio
¤ Gross D/E Ratio for Embraer = 1953/11,042 = 18.95%
¤ Levered Beta using Gross Debt ratio = 1.07
¨ Using the net debt ratio, we get
¤ Net Debt Ratio for Embraer = (Debt - Cash)/ Market value of Equity
= (1953-2320)/ 11,042 = -3.32%
¤ Levered Beta using Net Debt Ratio = 0.95 (1 + (1-.34) (-.0332)) = 0.93
¨ The cost of Equity using net debt levered beta for Embraer will be much
lower than with the gross debt approach. The cost of capital for Embraer
will even out since the debt ratio used in the cost of capital equation will
now be a net debt ratio rather than a gross debt ratio.

Aswath Damodaran
94
 The Cost of Equity: A Recap
95

Preferably, a bottom-up beta,

based upon other firms in the
business, and firmʼs own financial
leverage

Cost of Equity = Riskfree Rate + Beta * (Risk Premium)

Has to be in the same Historical Premium Implied Premium

currency as cash flows, 1. Mature Equity Market Premium: Based on how equity
and defined in same terms Average premium earned by or market is priced today
(real or nominal) as the stocks over T.Bonds in U.S. and a simple valuation
cash flows 2. Country risk premium = model
Country Default Spread* ( σEquity/σCountry bond)

Aswath Damodaran
95
96 Discount Rates: IV
Mopping up

Aswath Damodaran
 Estimating the Cost of Debt
97

¨ The cost of debt is the rate at which you can borrow at

currently, It will reflect not only your default risk but also the
level of interest rates in the market.
¨ The two most widely used approaches to estimating cost of
debt are:
¤ Looking up the yield to maturity on a straight bond outstanding from
the firm. The limitation of this approach is that very few firms have
long term straight bonds that are liquid and widely traded
¤ Looking up the rating for the firm and estimating a default spread
based upon the rating. While this approach is more robust, different
bonds from the same firm can have different ratings. You have to use a
median rating for the firm
¨ When in trouble (either because you have no ratings or
multiple ratings for a firm), estimate a synthetic rating for
your firm and the cost of debt based upon that rating.
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97
 Estimating Synthetic Ratings
98

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

characteristics of the firm. In its simplest form, the rating
can be estimated from the interest coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
¨ For Embraer’s interest coverage ratio, we used the
interest expenses from 2003 and the average EBIT from
2001 to 2003. (The aircraft business was badly affected
by 9/11 and its aftermath. In 2002 and 2003, Embraer
reported significant drops in operating income)
Interest Coverage Ratio = 462.1 /129.70 = 3.56

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98
 Interest Coverage Ratios, Ratings and Default
Spreads: 2004
99

If Interest Coverage Ratio is Estimated Bond Rating Default Spread(2004)

> 8.50 (>12.50) AAA 0.35%
6.50 - 8.50 (9.5-12.5) AA 0.50%
5.50 - 6.50 (7.5-9.5) A+ 0.70%
4.25 - 5.50 (6-7.5) A 0.85%
3.00 - 4.25 (4.5-6) A– 1.00%
2.50 - 3.00 (4-4.5) BBB 1.50%
2.25- 2.50 (3.5-4) BB+ 2.00%
2.00 - 2.25 ((3-3.5) BB 2.50%
1.75 - 2.00 (2.5-3) B+ 3.25%
1.50 - 1.75 (2-2.5) B 4.00%
1.25 - 1.50 (1.5-2) B– 6.00%
0.80 - 1.25 (1.25-1.5) CCC 8.00%
0.65 - 0.80 (0.8-1.25) CC 10.00%
0.20 - 0.65 (0.5-0.8) C 12.00%
< 0.20 (<0.5) D 20.00%

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99
 Cost of Debt computations
100

¨ Based on the interest coverage ratio of 3.56, the synthetic

rating for Embraer is A-, giving it a default spread of 1.00%
¨ Companies in countries with low bond ratings and high
default risk might bear the burden of country default risk,
especially if they are smaller or have all of their revenues
within the country.
¨ If I assume that Embraer bears all of the country risk burden, I would
add on the country default spread for Brazil in 2004 of 6.01%.
¨ Larger companies that derive a significant portion of their revenues in
global markets may be less exposed to country default risk. I am going
to add only two thirds of the Brazilian country risk (based upon traded
bond spreads of other large Brazilian companies in 2004)
Cost of debt
= Riskfree rate + 2/3(Brazil country default spread) + Company default
spread =4.29% + 2/3 (6.01%)+ 1.00% = 9.29%

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100
 Synthetic Ratings: Some Caveats
101

¨ The relationship between interest coverage ratios and

ratings, developed using US companies, tends to travel
well, as long as we are analyzing large manufacturing
firms in markets with interest rates close to the US
interest rate
¨ They are more problematic when looking at smaller
companies in markets with higher interest rates than the
US. One way to adjust for this difference is modify the
interest coverage ratio table to reflect interest rate
differences (For instances, if interest rates in an
emerging market are twice as high as rates in the US,
halve the interest coverage ratio).
Aswath Damodaran
101
 Default Spreads: Change is a constant
102

102
Default Spreads – January 2023

Corporate Bond Default Spreads

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
Baa2/BB
Aaa/AAA Aa2/AA A1/A+ A2/A A3/A- Ba1/BB+ Ba2/BB B1/B+ B2/B B3/B- Caa/CCC Ca2/CC C2/C D2/D
B
Spread 2023 0.69% 0.85% 1.23% 1.42% 1.62% 2.00% 2.42% 3.13% 4.55% 5.26% 7.37% 11.57% 15.78% 17.50% 20.00%
Spread 2022 0.67% 0.82% 1.03% 1.14% 1.29% 1.59% 1.93% 2.15% 3.15% 3.78% 4.62% 7.78% 8.80% 10.76% 14.34%
Spread 2021 0.69% 0.85% 1.07% 1.18% 1.33% 1.71% 2.31% 2.77% 4.05% 4.86% 5.94% 9.46% 9.97% 13.09% 17.44%
Spread 2020 0.63% 0.78% 0.98% 1.08% 1.22% 1.56% 2.00% 2.40% 3.51% 4.21% 5.15% 8.20% 8.64% 11.34% 15.12%

Spread 2023 Spread 2022 Spread 2021 Spread 2020

Aswath Damodaran
103
 Subsidized Debt: What should we do?
104

¨ Assume that the Brazilian government lends money to

Embraer at a subsidized interest rate (say 6% in dollar
terms). In computing the cost of capital to value
Embraer, should be we use the cost of debt based upon
default risk or the subsidized cost of debt?
a. The subsidized cost of debt (6%). That is what the
company is paying.
b. The fair cost of debt (9.25%). That is what the company
should require its projects to cover.
c. A number in the middle.

Aswath Damodaran
104
 Weights for the Cost of Capital Computation
105

¨ In computing the cost of capital for a publicly traded

firm, the general rule for computing weights for debt
and equity is that you use market value weights (and
not book value weights). Why?
a. Because the market is usually right
b. Because market values are easy to obtain
c. Because book values of debt and equity are meaningless
d. None of the above

Aswath Damodaran
105
 Estimating Cost of Capital: Embraer in 2004
106

¨ Equity
¤ Cost of Equity = 4.29% + 1.07 (4%) + 0.27 (7.89%) = 10.70%
¤ Market Value of Equity =11,042 million BR ($ 3,781 million)
¨ Debt
¤ Cost of debt = 4.29% + 4.00% +1.00%= 9.29%
¤ Market Value of Debt = 2,083 million BR ($713 million)
¨ Cost of Capital = 10.70 % (.84) + 9.29% (1- .34) (0.16)) = 9.97%
¤ The book value of equity at Embraer is 3,350 million BR.
¤ The book value of debt at Embraer is 1,953 million BR; Interest
expense is 222 mil BR; Average maturity of debt = 4 years
¤ Estimated market value of debt = 222 million (PV of annuity, 4
years, 9.29%) + $1,953 million/1.09294 = 2,083 million BR

Aswath Damodaran
106
 If you had to do it….Converting a Dollar Cost of
Capital to a Nominal Real Cost of Capital
107

¨ Approach 1: Use a BR riskfree rate in all of the calculations

above. For instance, if the BR riskfree rate was 12%, the cost
of capital would be computed as follows:
¤ Cost of Equity = 12% + 1.07(4%) + 0.27 (7. 89%) = 18.41%
¤ Cost of Debt = 12% + 1% = 13%
¤ (This assumes the riskfree rate has no country risk premium
embedded in it.)
¨ Approach 2: Use the differential inflation rate to estimate the
cost of capital. For instance, if the inflation rate in BR is 8%
and the inflation rate in the U.S. is 2%
" 1+ Inflation %
BR
Cost of capital= (1+ Cost of Capital$ )$ '
# 1+ Inflation$ &

= 1.0997 (1.08/1.02)-1 = 0.1644 or 16.44%

Aswath Damodaran
€ 107
 Dealing with Hybrids and Preferred Stock
108

¨ When dealing with hybrids (convertible bonds, for

instance), break the security down into debt and equity
and allocate the amounts accordingly. Thus, if a firm has
$ 125 million in convertible debt outstanding, break the
$125 million into straight debt and conversion option
components. The conversion option is equity.
¨ When dealing with preferred stock, it is better to keep it
as a separate component. The cost of preferred stock is
the preferred dividend yield. (As a rule of thumb, if the
preferred stock is less than 5% of the outstanding market
value of the firm, lumping it in with debt will make no
significant impact on your valuation).
Aswath Damodaran
108
 Decomposing a convertible bond…
109

¨ Assume that the firm that you are analyzing has $125 million
in face value of convertible debt with a stated interest rate of
4%, a 10 year maturity and a market value of $140 million. If
the firm has a bond rating of A and the interest rate on A-
rated straight bond is 8%, you can break down the value of
the convertible bond into straight debt and equity portions.
¤ Straight debt = (4% of $125 million) (PV of annuity, 10 years, 8%) + 125
million/1.0810 = $91.45 million
¤ Equity portion = $140 million - $91.45 million = $48.55 million
¨ The debt portion ($91.45 million) gets added to debt and the
option portion ($48.55 million) gets added to the market
capitalization to get to the debt and equity weights in the cost
of capital.
Aswath Damodaran
109
 Recapping the Cost of Capital
110

Cost of borrowing should be based upon

(1) synthetic or actual bond rating Marginal tax rate, reflecting
(2) default spread tax benefits of debt
Cost of Borrowing = Riskfree rate + Default spread

Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + Cost of Borrowing (1-t) (Debt/(Debt + Equity))

Cost of equity
based upon bottom-up Weights should be market value weights
beta

Aswath Damodaran
110
111
Estimating Cash Flows
Cash is king…

Aswath Damodaran
 Free Cash Flow: FCFE and FCFF
112

Aswath Damodaran
112
 Steps in Cash Flow Estimation
113

¨ Estimate the current earnings of the firm

¤ If looking at cash flows to equity, look at earnings after interest
expenses - i.e. net income
¤ If looking at cash flows to the firm, look at operating earnings after
taxes
¨ Consider how much the firm invested to create future growth
¤ If the investment is not expensed, it will be categorized as capital
expenditures. To the extent that depreciation provides a cash flow, it
will cover some of these expenditures.
¤ Increasing working capital needs are also investments for future
growth
¨ If looking at cash flows to equity, consider the cash flows from
net debt issues (debt issued - debt repaid)

Aswath Damodaran
113
 Measuring Free Cash Flow to the Firm:
Three pathways to the same end game
114

Where are the tax savings from interest expenses?

Aswath Damodaran
114
 Measuring Free Cash Flow to Equity:
Alternative Pathways
115

Aswath Damodaran
115
 Microsoft in 2021: FCFE and FCFF
116

Aswath Damodaran
116
117 Cash Flows I
Accounting Earnings, Flawed but Important

Aswath Damodaran
 From Reported to Actual Earnings
118

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
118
 1. Updating Earnings
119

¨ When valuing companies, we often depend upon financial

statements for inputs on earnings and assets. Annual reports
are often outdated and can be updated by using-
¤ Trailing 12-month data, constructed from quarterly earnings reports.
¤ Informal and unofficial news reports, if quarterly reports are
unavailable.
¨ Updating makes the most difference for smaller and more
volatile firms, as well as for firms that have undergone
significant restructuring.
¨ Time saver: To get a trailing 12-month number, all you need is
one 10K and one 10Q (example third quarter). For example,
to get trailing revenues from a third quarter 10Q:
¤ Trailing 12-month Revenue = Revenues (in last 10K) - Revenues from
first 3 quarters of last year + Revenues from first 3 quarters of this year.

Aswath Damodaran
119
 2. Correcting Accounting Earnings
120

¨ Make sure that there are no financial expenses mixed in

with operating expenses
¤ Financial expense: Any commitment that is tax deductible that
you have to meet no matter what your operating results: Failure
to meet it leads to loss of control of the business.
¤ Until 2019, accounting convention treated operating leases as
operating expenses, skewing income statements & balance
sheets.
¨ Make sure that there are no capital expenses mixed in
with the operating expenses
¤ Capital expense: Any expense that is expected to generate
benefits over multiple periods.
¤ There are a shole host of expenses (like R&D) that meet this
description that accountants treat as operating expenses.
Aswath Damodaran
120
 A. The Magnitude of Operating Leases
121

Aswath Damodaran
121
 Dealing with Operating Lease Expenses
122

¨ Since they give rise to contractual commitments,

operating lease expenses should be treated as financing
expenses, with the following adjustments to earnings
and capital:
¨ Debt Value of Operating Leases = Present value of Operating
Lease Commitments at the pre-tax cost of debt
¨ Lease Asset: When you convert operating leases into debt, you
also create an asset to counter it of exactly the same value.
¨ Adjusted Operating Earnings = Operating Earnings + Operating
Lease Expenses - Depreciation on Leased Asset
As an approximation, this works:
¤ Adjusted Operating Earnings = Operating Earnings + Pre-tax cost
of Debt * PV of Operating Leases.

Aswath Damodaran
122
 Operating Leases at The Gap in 2003
123

¨ The Gap has conventional debt of about $ 1.97 billion on its balance sheet and its
pre-tax cost of debt is about 6%. Its operating lease payments in the 2003 were
$978 million and its commitments for the future are below:
Year Commitment (millions) Present Value (at 6%)
1 $899.00 $848.11
2 $846.00 $752.94
3 $738.00 $619.64
4 $598.00 $473.67
5 $477.00 $356.44
6&7 $982.50 each year $1,346.04
¨ Debt Value of leases = $4,396.85 (Also value of leased asset)
¨ Debt outstanding at The Gap = $1,970 m + $4,397 m = $6,367 m
¨ Adjusted Operating Income = Stated OI + OL exp this year - Deprec’n
= $1,012 m + 978 m - 4397 m /7 = $1,362 million (7-year life for assets)
¨ Approximate OI = $1,012 m + $ 4397 m (.06) = $1,276 m

Aswath Damodaran
123
 The Collateral Effects of Treating Operating
Leases as Debt
124

! Conventional!Accounting! Operating!Leases!Treated!as!Debt!
Income!Statement! !Income!Statement!
EBIT&&Leases&=&1,990& EBIT&&Leases&=&1,990&
0&Op&Leases&&&&&&=&&&&978& 0&Deprecn:&OL=&&&&&&628&
EBIT&&&&&&&&&&&&&&&&=&&1,012& EBIT&&&&&&&&&&&&&&&&=&&1,362&
Interest&expense&will&rise&to&reflect&the&
conversion&of&operating&leases&as&debt.&Net&
income&should&not&change.&
Balance!Sheet! Balance!Sheet!
Off&balance&sheet&(Not&shown&as&debt&or&as&an& Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&
asset).&Only&the&conventional&debt&of&$1,970& OL&Asset&&&&&&&4397&&&&&&&&&&&OL&Debt&&&&&4397&
million&shows&up&on&balance&sheet& Total&debt&=&4397&+&1970&=&$6,367&million&
&
Cost&of&capital&=&8.20%(7350/9320)&+&4%& Cost&of&capital&=&8.20%(7350/13717)&+&4%&
(1970/9320)&=&7.31%& (6367/13717)&=&6.25%&
Cost&of&equity&for&The&Gap&=&8.20%& &
After0tax&cost&of&debt&=&4%&
Market&value&of&equity&=&7350&
Return&on&capital&=&1012&(10.35)/(3130+1970)& Return&on&capital&=&1362&(10.35)/(3130+6367)&
&&&&&&&&&=&12.90%& &&&&&&&&&=&9.30%&
&

Aswath Damodaran
124
125 Aswath Damodaran
 Accounting comes to its senses on
operating leases
126

¨ In 2019, both IFRS and GAAP made a major shift on

operating leases, requiring companies to capitalize
leases and show the resulting debt (and counter
asset) on the balance sheets.
¨ That said, the accounting rules for capitalizing leases
are far more complex than the simple calculations
that I have used, for two reasons:
¤ Accounting has to balance its desire to do the right thing
with maintaining some connection to its legacy rules.
¤ Companies have lobbied to modify rules in their sectors to
cushion the impact.

Aswath Damodaran
126
 Checking on Accountants…. My lease
estimate vs Accountants’ Estimate
127

Aswath Damodaran
127
 B. The Magnitude of R&D Expenses
128

Aswath Damodaran
128
 R&D Expenses: Operating or Capital Expenses
129

¨ Accounting standards require us to consider R&D as an

operating expense even though it is designed to
generate future growth. It is more logical to treat it as
capital expenditures.
¨ To capitalize R&D,
¤ Specify an amortizable life for R&D (2 - 10 years)
¤ Collect past R&D expenses for as long as the amortizable life
¤ Sum up the unamortized R&D over the period. (Thus, if the
amortizable life is 5 years, the research asset can be obtained by
adding up 1/5th of the R&D expense from five years ago, 2/5th
of the R&D expense from four years ago...:

Aswath Damodaran
129
 Capitalizing R&D Expenses: SAP
130

¨ R & D was assumed to have a 5-year life.

Year R&D Expense Unamortized Amortization this year
Current 1020.02 1.00 1020.02
-1 993.99 0.80 795.19 € 198.80
-2 909.39 0.60 545.63 € 181.88
-3 898.25 0.40 359.30 € 179.65
-4 969.38 0.20 193.88 € 193.88
-5 744.67 0.00 0.00 € 148.93
Value of research asset = € 2,914 million
Amortization of research asset in 2004 = € 903 million
Increase in Operating Income = 1020 - 903 = € 117 million

Aswath Damodaran
130
 The Effect of Capitalizing R&D at SAP
131

! Conventional!Accounting! R&D!treated!as!capital!expenditure!
Income!Statement! !Income!Statement!
EBIT&&R&D&&&=&&3045& EBIT&&R&D&=&&&3045&
.&R&D&&&&&&&&&&&&&&=&&1020& .&Amort:&R&D&=&&&903&
EBIT&&&&&&&&&&&&&&&&=&&2025& EBIT&&&&&&&&&&&&&&&&=&2142&(Increase&of&117&m)&
EBIT&(1.t)&&&&&&&&=&&1285&m& EBIT&(1.t)&&&&&&&&=&1359&m&
Ignored&tax&benefit&=&(1020.903)(.3654)&=&43&
Adjusted&EBIT&(1.t)&=&1359+43&=&1402&m&
(Increase&of&117&million)&
Net&Income&will&also&increase&by&117&million&&
Balance!Sheet! Balance!Sheet!
Off&balance&sheet&asset.&Book&value&of&equity&at& Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&
3,768&million&Euros&is&understated&because& R&D&Asset&&&&2914&&&&&Book&Equity&&&+2914&
biggest&asset&is&off&the&books.& Total&Book&Equity&=&3768+2914=&6782&mil&&
Capital!Expenditures! Capital!Expenditures!
Conventional&net&cap&ex&of&2&million& Net&Cap&ex&=&2+&1020&–&903&=&119&mil&
Euros&
Cash!Flows! Cash!Flows!
EBIT&(1.t)&&&&&&&&&&=&&1285&& EBIT&(1.t)&&&&&&&&&&=&&&&&1402&&&
.&Net&Cap&Ex&&&&&&=&&&&&&&&2& .&Net&Cap&Ex&&&&&&=&&&&&&&119&
FCFF&&&&&&&&&&&&&&&&&&=&&1283&&&&&& FCFF&&&&&&&&&&&&&&&&&&=&&&&&1283&m&
Return&on&capital&=&1285/(3768+530)& Return&on&capital&=&1402/(6782+530)&
Aswath Damodaran
131
132 Aswath Damodaran
 3. One-Time and Non-recurring Charges
133

¨ Assume that you are valuing a firm that is reporting a

loss of $ 500 million, due to a one-time charge of $ 1
billion. What is the earnings you would use in your
valuation?
a. A loss of $ 500 million
b. A profit of $ 500 million
¨ Would your answer be any different if the firm had
reported one-time losses like these once every five
years?
a. Yes
b. No

Aswath Damodaran
133
 4. Accounting Malfeasance….
134

¨ Though all firms may be governed by the same accounting

standards, the fidelity that they show to these standards can vary.
More aggressive firms will show higher earnings than more
conservative firms.
¨ While you will not be able to catch outright fraud, you should look
for warning signals in financial statements and correct for them:
¤ Income from unspecified sources - holdings in other businesses that are
not revealed or from special purpose entities.
¤ Income from asset sales or financial transactions (for a non-financial firm)
¤ Sudden changes in standard expense items - a big drop in S,G &A or R&D
expenses as a percent of revenues, for instance.
¤ Frequent accounting restatements
¤ Accrual earnings that run ahead of cash earnings consistently
¤ Big differences between tax income and reported income

Aswath Damodaran
134
 5. Dealing with Negative or Abnormally Low
Earnings
135

Reason for losses/low Valuation Response

earnings
One-time or extraordinary Add back the one-time expense to get
Quick fixes

charge corrected earnings

Macro factor (commodity Use earnings across the commodity or
price drop or recession) economic cycle as normalized earnings.
Young company working on Estimate the profit margin that mature
Long term fixes

business model companies in the business earn and target

that margin in the long term.
Structural problems at Use an industry average margin as a target
company and move towards that margin over time,
as structural problems are fixed.

Aswath Damodaran
135
136 Cash Flows II
Taxes and Reinvestment

Aswath Damodaran
 1. What tax rate?
137

¨ The tax rate that you should use in computing the after-
tax operating income should be
a. The effective tax rate in the financial statements (taxes
paid/Taxable income)
b. The tax rate based upon taxes paid and EBIT (taxes paid/EBIT)
c. The marginal tax rate for the country in which the company
operates
d. The weighted average marginal tax rate across the countries in
which the company operates
e. None of the above
f. Any of the above, as long as you compute your after-tax cost of
debt using the same tax rate.

Aswath Damodaran
137
 The Right Tax Rate to Use
138

¨ The free cash flow to the firm starts with after-tax operating
income, where:
¨ After-tax Operating Income = Operating Income (1- tax rate)
¨ In computing free cash flow to the firm, the choice really is
between the effective and the marginal tax rate.
¨ By using the marginal tax rate, we tend to understate the after-tax
operating income in the earlier years, but the after-tax tax operating
income is more accurate in later years.
¨ By using the effective tax rate, we tend to overstate the after-tax
operating income in the later years, as effective tax rates move toward
the marginal tax rate.
¨ You can have your cake and eat it too, by starting with the
effective tax rate, and adjusting towards the marginal tax rate
over time.

Aswath Damodaran
138
 A Tax Rate for a Money Losing Firm
139

¨ Assume that you are trying to estimate the after-tax

operating income for a firm with $ 1 billion in net
operating losses carried forward.
¨ This firm is expected to have operating income of $ 500
million each year for the next 3 years, and the marginal
tax rate on income for all firms that make money is 40%.
Estimate the after-tax operating income each year for
the next 3 years.
Year 1 Year 2 Year 3
EBIT 500 500 500
Taxes
EBIT (1-t)
Tax rate

Aswath Damodaran
139
 2. Net Capital Expenditures
140

¨ Net capital expenditures represent the difference

between capital expenditures and depreciation.
Net Cap Ex = Capital Expenditures - Depreciation
Depreciation is a cash inflow that pays for some or a lot (or
sometimes all of) the capital expenditures.
¨ In general, the net capital expenditures will be a function
of how fast a firm is growing or expecting to grow.
¨ High growth firms will usually have much higher net capital
expenditures than low growth firms.
¨ Assumptions about net capital expenditures can therefore never
be made independently of assumptions about growth in the
future.

Aswath Damodaran
140
 Capital expenditures should include
141

¨ Research and development expenses, once they have been

re-categorized as capital expenses. The adjusted net cap ex
will be
¤ Adjusted Net Capital Expenditures = Net Capital Expenditures +
Current year’s R&D expenses - Amortization of Research Asset
¨ Acquisitions of other firms, since these are like capital
expenditures. The adjusted net cap ex will be
¤ Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other
firms - Amortization of such acquisitions
¨ Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized
measure of acquisitions (looking at an average over time) should be
used
2. The best place to find acquisitions is in the statement of cash flows,
usually categorized under other investment activities

Aswath Damodaran
141
 Cisco’s Acquisitions: 1999
142

Acquired Method of Acquisition Price Paid

GeoTel Pooling $1,344
Fibex Pooling $318
Sentient Pooling $103
American Internet Purchase $58
Summa Four Purchase $129
Clarity Wireless Purchase $153
Selsius Systems Purchase $134
PipeLinks Purchase $118
Amteva Tech Purchase $159
$2,516

Aswath Damodaran
142
 Cisco’s Net Capital Expenditures in 1999
143

Cap Expenditures (from statement of CF) = $ 584 mil

- Depreciation (from statement of CF) = $ 486 mil
Net Cap Ex (from statement of CF) = $ 98 mil
+ R & D expense = $ 1,594 mil
- Amortization of R&D = $ 485 mil
+ Acquisitions = $ 2,516 mil
Adjusted Net Capital Expenditures = $3,723 mil

¨ (Amortization was included in the depreciation number)

Aswath Damodaran
143
 3. Working Capital Investments
144

¨ Accounting definition: Working capital is the

difference between current assets (inventory, cash
and accounts receivable) and current liabilities
(accounts payables, short term debt and debt due
within the next year).
¨ Valuation definition: A cleaner definition of working
capital from a cash flow perspective is the difference
between non-cash current assets (inventory and
accounts receivable) and non-debt current liabilities
(accounts payable).
Aswath Damodaran
144
 Working Capital: General Propositions
145

1. Working Capital Detail: While some analysts break down working

capital into detail, it is a pointless exercise unless you feel that
you can bring some specific information that lets you forecast the
details.
2. Working Capital Volatility: Changes in non-cash working capital
from year to year tend to be volatile. It is better to either
estimate the change based on working capital as a percent of
sales, while keeping an eye on industry averages.
3. Negative Working Capital: Some firms have negative non-cash
working capital. Assuming that this will continue into the future
will generate positive cash flows for the firm and will get more
positive as growth increases.

Aswath Damodaran
145
146 Cash Flows III
From the firm to equity

Aswath Damodaran
 Dividends and Cash Flows to Equity
147

¨ In the strictest sense, the only cash flow from an equity

investment in a publicly traded firm is the dividend that
will be paid on the stock.
¨ Actual dividends, however, are set by the managers of
the firm and may be much lower than the potential
dividends (that could have been paid out)
¤ managers are conservative and try to smooth out dividends
¤ managers like to hold on to cash to meet unforeseen future
contingencies and investment opportunities
¨ When actual dividends are less (more) than potential
dividends, using a model that focuses only on dividends
will under (over) state the true value of the equity in a
firm.
Aswath Damodaran
147
 Measuring Potential Dividends
148

¨ Some analysts assume that the earnings of a firm represent its

potential dividends. This cannot be true for several reasons:
¤ Earnings are not cash flows, since there are both non-cash revenues and
expenses in the earnings calculation
¤ Even if earnings were cash flows, a firm that paid its earnings out as
dividends would not be investing in new assets and thus could not grow
¤ Valuation models, where earnings are discounted back to the present, will
over estimate the value of the equity in the firm
¨ The potential dividends of a firm are the cash flows left over after
the firm has made any “investments” it needs to make to create
future growth and net debt repayments (debt repayments - new
debt issues)
¤ The common categorization of capital expenditures into discretionary and
non-discretionary loses its basis when there is future growth built into the
valuation.

Aswath Damodaran
148
 Estimating Cash Flows: FCFE
149

¨ Cash flows to Equity for a Levered Firm

Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
+ (New Debt Issues – Debt Repaid)
= Free Cash flow to Equity
¨ Cash flows to equity represent residual cash flows for
equity investors, i.e., cash flows left over after every
conceivable need has been met.
¨ That cash flow can be paid out without damaging the
operating business of the company and its growth
potential. It is thus a potential dividend.

Aswath Damodaran
149
 FCFE from the statement of cash flows
150

¨ The statement of cash flows can be used to back into a

FCFE, if you are willing to navigate your way through it
and not trust it fully.
¨ FCFE
= Cashflow from Operations
- Capital Expenditures (from the cash flow from investments)
- Cash Acquisitions (from the cash flow from investments)
- (Debt Repaid – Debt Issued) (from financing cash flows)
= FCFE
¨ Alternatively, you can also do the following:
¤ FCFE – Dividends + Stock Buybacks – Stock Issuances + Change
in Cash Balance

Aswath Damodaran
150
 FCFE across the life cycle
151

Aswath Damodaran
151
 FCFE over time: Tesla
152

Aswath Damodaran
152
Dividends versus FCFE: Across the globe

Aswath Damodaran
153
 Estimating FCFE when Leverage is Stable
154

Net Income
- (1- DR) (Capital Expenditures - Depreciation)
- (1- DR) Working Capital Needs
= Free Cash flow to Equity
DR = Debt/Capital Ratio
For this firm,
¤ Proceeds from new debt issues = Principal Repayments +
(Capital Expenditures - Depreciation + Working Capital Needs)
¨ In computing FCFE, the book value debt to capital ratio
should be used when looking back in time but can be
replaced with the market value debt to capital ratio,
looking forward.
Aswath Damodaran
154
 Estimating FCFE: Disney
155

¨ Net Income=$ 1533 Million

¨ Capital spending = $ 1,746 Million
¨ Depreciation per Share = $ 1,134 Million
¨ Increase in non-cash working capital = $ 477 Million
¨ Debt to Capital Ratio (DR) = 23.83%
¨ Estimating FCFE (1997):
Net Income $1,533 Mil
- (Cap. Exp - Depr)*(1-DR) $465.90 [(1746-1134)(1-.2383)]
Chg. Working Capital*(1-DR) $363.33 [477(1-.2383)]
= Free CF to Equity $ 704 Million

Dividends Paid $ 345 Million

Aswath Damodaran
155
 FCFE and Leverage: Is this a free lunch?
156

Debt Ratio and FCFE: Disney

1600

1400

1200

1000
FCFE

800

600

400

200

0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio

Aswath Damodaran
156
 FCFE and Leverage: The Other Shoe Drops
157

Debt Ratio and Beta

8.00

7.00

6.00

5.00
Beta

4.00

3.00

2.00

1.00

0.00
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio

Aswath Damodaran
157
 Leverage, FCFE and Value
158

¨ In a discounted cash flow model, increasing the debt/equity

ratio will generally increase the expected free cash flows to
equity investors over future time periods and also the cost of
equity applied in discounting these cash flows. Which of the
following statements relating leverage to value would you
subscribe to?
a. Increasing leverage will increase value because the cash flow effects
will dominate the discount rate effects
b. Increasing leverage will decrease value because the risk effect will be
greater than the cash flow effects
c. Increasing leverage will not affect value because the risk effect will
exactly offset the cash flow effect
d. Any of the above, depending upon what company you are looking at
and where it is in terms of current leverage

Aswath Damodaran
158
159
Estimating Growth
Growth can be good, bad or neutral…

Aswath Damodaran
 The Value of Growth
160

¨ When valuing a company, it is easy to get caught up in

the details of estimating growth and start viewing
growth as a “good”, i.e., that higher growth translates
into higher value.
¨ Growth, though, is a double-edged sword.
¤ The good side of growth is that it pushes up revenues and
operating income, perhaps at different rates (depending on how
margins evolve over time).
¤ The bad side of growth is that you have to set aside money to
reinvest to create that growth.
¤ The net effect of growth is whether the good outweighs the bad.

Aswath Damodaran
160
 Ways of Estimating Growth in Earnings
161

¨ Look at the past

¤ The historical growth in earnings per share is usually a
good starting point for growth estimation
¨ Look at what others are estimating
¤ Analysts estimate growth in earnings per share for many
firms. It is useful to know what their estimates are.
¨ Look at fundamentals
¤ With stable margins, operating income growth can be tied
to how much a firm reinvests, and the returns it earns.
¤ With changing margins, you have to start with revenue
growth, forecast margins and estimate reinvestment.

Aswath Damodaran
161
162 Growth I
Historical Growth

Aswath Damodaran
 Historical Growth
163

¨ Historical growth rates can be estimated in a number of

different ways
¤ Arithmetic versus Geometric Averages
¤ Simple versus Regression Models
¨ Historical growth rates can be sensitive to
¤ The period used in the estimation (starting and ending points)
¤ The metric that the growth is estimated in..
¨ In using historical growth rates, you have to wrestle with
the following:
¤ How to deal with negative earnings
¤ The effects of scaling up

Aswath Damodaran
163
 Motorola: Arithmetic versus Geometric Growth
Rates
164

Aswath Damodaran
164
 A Test
165

¨ You are trying to estimate the growth rate in

earnings per share at Time Warner from 1996 to
1997. In 1996, the earnings per share was a deficit of
$0.05. In 1997, the expected earnings per share is $
0.25. What is the growth rate?
a. -600%
b. +600%
c. +120%
d. Cannot be estimated

Aswath Damodaran
165
 Dealing with Negative Earnings
166

¨ When the earnings in the starting period are negative,

the growth rate cannot be estimated. (0.30/-0.05 = -
600%)
¨ There are three solutions:
¤ Use the higher of the two numbers as the denominator (0.30/0.25 =
120%)
¤ Use the absolute value of earnings in the starting period as the
denominator (0.30/0.05=600%)
¤ Use a linear regression model and divide the coefficient by the average
earnings.
¨ When earnings are negative, the growth rate is
meaningless. Thus, while the growth rate can be
estimated, it does not tell you much about the future.

Aswath Damodaran
166
 The Effect of Size on Growth: Callaway Golf
167

Year Net Profit Growth Rate

1990 1.80
1991 6.40 255.56%
1992 19.30 201.56%
1993 41.20 113.47%
1994 78.00 89.32%
1995 97.70 25.26%
1996 122.30 25.18%
¨ Geometric Average Growth Rate = 102%

Aswath Damodaran
167
 Extrapolation and its Dangers
168

Year Net Profit

1996 $ 122.30
1997 $ 247.05
1998 $ 499.03
1999 $ 1,008.05
2000 $ 2,036.25
2001 $ 4,113.23
¨ If net profit continues to grow at the same rate as it has
in the past 6 years, the expected net income in 5 years
will be $ 4.113 billion.

Aswath Damodaran
168
169 Growth II
Analyst Estimates

Aswath Damodaran
 Analyst Forecasts of Growth
170

¨ While the job of an analyst is to find under and over

valued stocks in the sectors that they follow, a significant
proportion of an analyst’s time (outside of selling) is
spent forecasting earnings per share.
¤ Most of this time, in turn, is spent forecasting earnings per share
in the next earnings report
¤ While many analysts forecast expected growth in earnings per
share over the next 5 years, the analysis and information
(generally) that goes into this estimate is far more limited.
¨ Analyst forecasts of earnings per share and expected
growth are widely disseminated by services such as
Zacks and IBES, at least for U.S companies.

Aswath Damodaran
170
 How good are analysts at forecasting growth?
171

¨ Analysts forecasts of EPS tend to be closer to the actual EPS than

simple time series models, but the differences tend to be small
Study Group tested Analyst Time Series
Error Model Error
Collins & Hopwood Value Line Forecasts 31.7% 34.1%
Brown & Rozeff Value Line Forecasts 28.4% 32.2%
Fried & Givoly Earnings Forecaster 16.4% 19.8%
¨ The advantage that analysts have over time series models
¤ tends to decrease with the forecast period (next quarter versus 5 years)
¤ tends to be greater for larger firms than for smaller firms
¤ tends to be greater at the industry level than at the company level
¨ Forecasts of growth (and revisions thereof) tend to be highly
correlated across analysts.

Aswath Damodaran
171
 Are some analysts more equal than others?
172

¨ A study of All-America Analysts (chosen by Institutional

Investor) found that
¤ There is no evidence that analysts who are chosen for the All-America
Analyst team were chosen because they were better forecasters of
earnings. (Their median forecast error in the quarter prior to being
chosen was 30%; the median forecast error of other analysts was 28%)
¤ However, in the calendar year following being chosen as All-America
analysts, these analysts become slightly better forecasters than their
less fortunate brethren. (The median forecast error for All-America
analysts is 2% lower than the median forecast error for other analysts)
¤ Earnings revisions made by All-America analysts tend to have a much
greater impact on the stock price than revisions from other analysts
¤ The recommendations made by the All America analysts have a
greater impact on stock prices (3% on buys; 4.7% on sells). For these
recommendations the price changes are sustained, and they continue
to rise in the following period (2.4% for buys; 13.8% for the sells).

Aswath Damodaran
172
 The Five Deadly Sins of an Analyst
173

¨ Tunnel Vision: Becoming so focused on the sector and

valuations within the sector that you lose sight of the bigger
picture.
¨ Lemmingitis: Strong urge felt to change recommendations &
revise earnings estimates when other analysts do the same.
¨ Stockholm Syndrome: Refers to analysts who start identifying
with the managers of the firms that they are supposed to
follow.
¨ Factophobia (generally is coupled with delusions of being a
famous story teller): Tendency to base a recommendation on
a “story” coupled with a refusal to face the facts.
¨ Dr. Jekyll/Mr.Hyde: Analyst who thinks his primary job is to
bring in investment banking business to the firm.

Aswath Damodaran
173
 Propositions about Analyst Growth Rates
174

¨ Proposition 1: There if far less private information and far more

public information in most analyst forecasts than is generally
claimed.
¨ Proposition 2: The biggest source of private information for
analysts remains the company itself which might explain
¤ why there are more buy recommendations than sell recommendations
(information bias and the need to preserve sources)
¤ why there is such a high correlation across analysts forecasts and revisions
¤ why All-America analysts become better forecasters than other analysts
after they are chosen to be part of the team.
¨ Proposition 3: There is value to knowing what analysts are
forecasting as earnings growth for a firm. There is, however, danger
when they agree too much (lemmingitis) and when they agree to
little (in which case the information that they have is so noisy as to
be useless).

Aswath Damodaran
174
175 Growth III
Sustainable growth and Fundamentals

Aswath Damodaran
 Fundamental Growth Rates
176

Investment Current Return on

in Existing Investment on Current
Projects
X Projects
= Earnings
$ 1000 12% $120

Investment Next Periodʼs Investment Return on

Next
in Existing
Projects
$1000
X Return on
Investment
12%
+ in New
Projects
$100
X Investment on
New Projects
12%
= Periodʼs
Earnings
132

Investment Change in Investment Return on

in Existing
Projects
$1000
X ROI from
current to next
period: 0%
+ in New
Projects
$100
X Investment on
New Projects
12% =
Change in Earnings
$ 12

Aswath Damodaran
176
 Growth Rate Derivations
177

In the special case where ROI on existing projects remains unchanged and is equal to the ROI on new projects

Investment in New Projects Change in Earnings

Current Earnings X Return on Investment = Current Earnings
100 $12
120 X 12% = $120

Reinvestment Rate X Return on Investment = Growth Rate in Earnings

83.33% X 12% = 10%

in the more general case where ROI can change from period to period, this can be expanded as follows:

Investment in Existing Projects*(Change in ROI) + New Projects (ROI) Change in Earnings

Investment in Existing Projects* Current ROI = Current Earnings

For instance, if the ROI increases from 12% to 13%, the expected growth rate can be written as follows:

$1,000 * (.13 - .12) + 100 (13%) $23

$ 1000 * .12 = $120
= 19.17%

Aswath Damodaran
177
 Estimating Fundamental Growth from new
investments: Three variations
178

Earnings Measure Reinvestment Measure Return Measure

Earnings per share Retention Ratio = % of net Return on Equity = Net
income retained by the Income/ Book Value of
company = 1 – Payout Equity
ratio
Net Income from non-cash Equity reinvestment Rate = Non-cash ROE = Net
assets (Net Cap Ex + Change in Income from non-cash
non-cash WC – Change in assets/ (Book value of
Debt)/ (Net Income) equity – Cash)

Operating Income Reinvestment Rate = (Net Return on Capital or ROIC

Cap Ex + Change in non- = After-tax Operating
cash WC)/ After-tax Income/ (Book value of
Operating Income equity + Book value of
debt – Cash)

Aswath Damodaran
178
 I. Expected Long Term Growth in EPS
179

¨ When looking at growth in earnings per share, these inputs can be cast as
follows:
¤ Reinvestment Rate = Retained Earnings/ Current Earnings = Retention Ratio
¤ Return on Investment = ROE = Net Income/Book Value of Equity
¨ In the special case where the current ROE is expected to remain
unchanged
gEPS = Retained Earnings t-1/ NI t-1 * ROE
= Retention Ratio * ROE
= b * ROE
¨ In 2008, using this approach on Wells Fargo:
¨ Return on equity (based on 2008 earnings)= 17.56%
¨ Retention Ratio (based on 2008 earnings and dividends) = 45.37%
¨ Expected growth rate in earnings per share for Wells Fargo, if it can maintain these
numbers.
Expected Growth Rate = 0.4537 (17.56%) = 7.97%

Aswath Damodaran
179
 One way to pump up ROE: Use more debt
180

Return on Equity = Return on capital + D/E (ROC - i (1-tax rate))

where
Return on capital = EBITt (1 - tax rate) / Book value of Capitalt-1
D/E = BV of Debt/ BV of Equity
i = Interest Expense on Debt / BV of Debt
¨ In 1998, Brahma (now Ambev) had an extremely high return on equity,
partly because it borrowed money at a rate well below its return on
capital
¤ Return on Capital = 19.91%
¤ Debt/Equity Ratio = 77%
¤ After-tax Cost of Debt = 5.61%
¤ Return on Equity = ROC + D/E (ROC - i(1-t))
= 19.91% + 0.77 (19.91% - 5.61%) = 30.92%

Aswath Damodaran
180
 II. Expected Growth in Net Income from non-
cash assets
181

¨ A more general version of expected growth in earnings can be

obtained by substituting in the equity reinvestment into real
investments (net capital expenditures and working capital) and
modifying the return on equity definition to exclude cash:
¤ Net Income from non-cash assets = Net income – Interest income from
cash (1- t)
¤ Equity Reinvestment Rate = (Net Capital Expenditures + Change in Working
Capital) (1 - Debt Ratio)/ Net Income from non-cash assets
¤ Non-cash ROE = Net Income from non-cash assets/ (BV of Equity – Cash)
¤ Expected GrowthNet Income = Equity Reinvestment Rate * Non-cash ROE
¨ Th equity reinvestment rate, unlike the retention ratio, can be
higher than 100%, and if it is, the expected growth rate in net
income can exceed the return on equity.

Aswath Damodaran
181
 Estimating expected growth in net income from
non-cash assets: Coca Cola in 2010
182

¨ In 2010, Coca Cola reported net income of $11,809 million. It had a total
book value of equity of $25,346 million at the end of 2009. Coca Cola had
a cash balance of $7,021 million at the end of 2009, on which it earned
income of $105 million in 2010.
¤ Non-cash Net Income = $11,809 - $105 = $ 11,704 million
¤ Non-cash book equity = $25,346 - $7021 = $18,325 million
¤ Non-cash ROE = $11,704 million/ $18,325 million = 63.87%
¨ Coca Cola had capital expenditures of $2,215 million, depreciation of
$1,443 million and reported an increase in working capital of $335
million. Coca Cola’s total debt increased by $150 million during 2010.
¤ Equity Reinvestment = 2215- 1443 + 335-150 = $957 million
¤ Reinvestment Rate = $957 million/ $11,704 million= 8.18%
¨ Expected growth rate in non-cash Net Income = 8.18% * 63.87% = 5.22%

Aswath Damodaran
182
 III. Expected Growth in EBIT And Fundamentals:
Stable ROC and Reinvestment Rate
183

¨ When looking at growth in operating income, the

definitions are
¤ Reinvestment Rate = (Net Capital Expenditures + Change in
WC)/EBIT(1-t)
¤ Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of
Equity-Cash)
¨ Reinvestment Rate and Return on Capital
Expected Growth rate in Operating Income
= (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC
¨ Proposition: The net capital expenditure needs of a firm,
for a given growth rate, should be inversely proportional
to the quality of its investments.
Aswath Damodaran
183
 Estimating Growth in Operating Income, if
fundamentals stay locked in…
184

¨ In 1999, Cisco’s fundamentals were as follows:

¤ Reinvestment Rate = 106.81%
¤ Return on Capital =34.07%
¤ Expected Growth in EBIT =(1.0681)(.3407) = 36.39%
¨ As a potential investor in Cisco, what would worry you
the most about this forecast?
a. That Cisco’s return on capital may be overstated (why?)
b. That Cisco’s reinvestment comes mostly from acquisitions
(why?)
c. That Cisco is getting bigger as a firm (why?)
d. That Cisco is viewed as a star (why?)
e. All of the above

Aswath Damodaran
184
 The Magical Number: ROIC (or any
accounting return) and its limits
185

Aswath Damodaran
185
 IV. Operating Income Growth when Return on
Capital is Changing
186

¨ When the return on capital is changing, there will be a

second component to growth, positive if the return on
capital is increasing and negative if the return on capital
is decreasing.
¨ If ROCt is the return on capital in period t and ROC t+1 is
the return on capital in period t+1, the expected growth
rate in operating income will be:
Expected Growth Rate = ROC t+1 * Reinvestment rate
+(ROC t+1 – ROCt) / ROCt
¨ In general, if return on capital and margins are changing
and/or expected to change at a company, you are
better off not using any of the sustainable growth
equations to estimate growth.
Aswath Damodaran
186
 The Value of Growth
187

Expected growth = Growth from new investments + Efficiency growth

= Reinv Rate * ROC + (ROCt-ROCt-1)/ROCt-1
Assume that your cost of capital is 10%. As an investor, rank these
firms in the order of most value growth to least value growth.

Aswath Damodaran
187
188 Growth IV
Top Down Growth

Aswath Damodaran
 Estimating Growth when Operating Income is
Negative or Margins are changing
189

¨ All of the fundamental growth equations assume that the firm has a
return on equity or return on capital it can sustain in the long term.
¨ When operating income is negative or margins are expected to change
over time, we use a three-step process to estimate growth:
¤ Estimate growth rates in revenues over time
n Determine the total market (given your business model) and estimate the
market share that you think your company will earn.
n Decrease the growth rate as the firm becomes larger
n Keep track of absolute revenues to make sure that the growth is feasible
¤ Estimate expected operating margins each year
n Set a target margin that the firm will move towards
n Adjust the current margin towards the target margin
¤ Estimate the capital that needs to be invested to generate revenue growth and
expected margins
n Estimate a sales to capital ratio that you will use to generate reinvestment needs
each year.

Aswath Damodaran
189
 1. Revenue Growth
190

Aswath Damodaran
190
 Airbnb: Total Market
191

In its prospectus, Airbnb has expanded its estimate of market potential to $3.4 trillion, as
evidenced in this excerpt from the prospectus:
We have a substantial market opportunity in the growing travel market and experience
economy. We estimate our serviceable addressable market (“SAM”) today to be $1.5
trillion, including $1.2 trillion for short-term stays and $239 billion for experiences. We
estimate our total addressable market (“TAM”) to be $3.4 trillion, including $1.8 trillion
for short-term stays, $210 billion for long-term stays, and $1.4 trillion for experiences.

Aswath Damodaran
191
 Airbnb: Market Share
192

Aswath Damodaran
192
 2. Target Margins (and path there)…
193

Aswath Damodaran
193
 Airbnb in November 2020: Growth and
Profitability
194

Aswath Damodaran
194
 3. Sales to Invested Capital: A Pathway to
estimating Reinvestment
195

Aswath Damodaran
195
 Airbnb: Reinvestment and Profitability
196

Aswath Damodaran
196
197
Closure in Valuation
The Big Enchilada

Aswath Damodaran
 Getting Closure in Valuation
198

¨ A publicly traded firm potentially has an infinite life. The

value is therefore the present value of cash flows forever.
t=∞ CF
Value = ∑ t
t
t=1 (1+r)

¨ Since we cannot estimate cash flows forever, we estimate

cash flows for a “growth period” and then estimate a
terminal value, to capture the value at the end of the period:
t=N CF
Value = ∑ t + Terminal Value
t (1+r) N
t=1 (1+r)

Aswath Damodaran
198
 Ways of Estimating Terminal Value
199

Approach Inputs and Value Types of business

Liquidation Liquidation value of assets held Businesses built around
Value by the firm in the terminal year. a key person or a time-
limited competitive
advantage (license or
patent)
Going Concern TV in year n = CFn+1/ (r – g), where Going concerns with
(Perpetuity) g = growth rate forever long lives (>40 years)
Going Concern TV in year n = PV of CF in years Going concerns with
(Finite) n+1 to n+ k, where k is finite shorter lives
Pricing Terminal Year Operating Metric * Never appropriate in an
Estimated Multiple of Metric intrinsic valuation.

Aswath Damodaran
199
 1. With perpetual growth, obey the growth cap
200

¨ When a firm’s cash flows grow at a “constant” rate forever, the

present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
¨ The stable growth rate cannot exceed the growth rate of the
economy but it can be lower.
• If the economy is composed of high growth and stable growth firms, the
growth rate of the latter will be lower than the growth rate of the
economy.
• The stable growth rate can be negative, for companies in declining
businesses.
• If you use nominal cashflows and discount rates, the growth rate should
be nominal in the currency in which the valuation is denominated.

Aswath Damodaran
200
Risk free Rates and Nominal GDP Growth

¨ Risk free Rate = Expected Inflation + ¨ Nominal GDP Growth = Expected Inflation
Expected Real Interest Rate + Expected Real Growth
¨ The real interest rate is what borrowers ¨ The real growth rate in the economy
agree to return to lenders in real measures the expected growth in the
goods/services. production of goods and services.

The argument for Risk free rate = Nominal GDP growth

1. In the long term, the real growth rate cannot be lower than the real interest rate,
since the growth in goods/services has to be enough to cover the promised rate.
2. In the long term, the real growth rate can be higher than the real interest rate, to
compensate risk taking. However, as economies mature, the difference should get
smaller and since there will be growth companies in the economy, it is prudent to
assume that the extra growth comes from these companies.
 A Practical Reason for using the Risk free
Rate Cap – Preserve Consistency
202

¨ You are implicitly making assumptions about nominal growth

in the economy, with your risk free rate. Thus, with a low risk
free rate, you are assuming low nominal growth in the
economy (with low inflation and low real growth) and with a
high risk free rate, a high nominal growth rate in the
economy.
¨ If you make an explicit assumption about nominal growth in
cash flows that is at odds with your implicit growth
assumption in the denominator, you are being inconsistent
and bias your valuations:
¤ If you assume high nominal growth in the economy, with a low risk
free rate, you will over value businesses.
¤ If you assume low nominal growth rate in the economy, with a high
risk free rate, you will under value businesses.

Aswath Damodaran
202
 Heineken: September 2019 (in Euros)
Maturty and Closure
Cash flows from existing assets The Payoff from growth
LTM 2013-2018
Revenues will
Revenues € 23,119 Growth rate = 3.22% grow 3.22% a Sales/Invested Stable Growth
Operatng margin
Operating Margin 14.86% 14.44% year for next 5
(per-tax) will drop
Capital will stay g = -0.5%;
Sales/Invested Capital 0.71 0.79 years, tapering
to 14.00%
at five-year Cost of capital = 5%
down to -0.5% average of 0.79. ROC= 5%;
ROIC 7.46% 8.32% growth in year 10 Reinvestment Rate=-.5%/5% = -10%
Effective Tax Rate 29.70% 27.00%

Euro Cashflows Terminal Value = 2972/(.05-..-(.005)) = 54,034

PV(Terminal value) € 36,390.85
PV (CF over next 10 years) € 15,300.34 1 2 3 4 5 6 7 8 9 10 Terminal year
Value of operating assets = € 51,691.19 Revenue growth rate 3.22% 3.22% 3.22% 3.22% 3.22% 2.48% 1.73% 0.99% 0.24% -0.50% -0.50%
- Debt € 19,709.52 Revenues € 23,863 € 24,632 € 25,425 € 26,244 € 27,089 € 27,759 € 28,240 € 28,519 € 28,589 € 28,446 € 28,304
EBIT (Operating) margin 14.38% 14.34% 14.30% 14.26% 14.21% 14.17% 14.13% 14.09% 14.04% 14.00% 14.00%
- Minority interests € 1,069.00
EBIT (Operating income) € 3,432 € 3,532 € 3,635 € 3,741 € 3,850 € 3,934 € 3,990 € 4,017 € 4,015 € 3,982 $ 3,963
+ Cash € 1,751.60 Tax rate 29.70% 29.70% 29.70% 29.70% 29.70% 28.76% 27.82% 26.88% 25.94% 25.00% $ 0
+ Non-operating assets € 1,401.00 EBIT(1-t) € 2,413 € 2,483 € 2,556 € 2,630 € 2,707 € 2,802 € 2,880 € 2,937 € 2,973 € 2,987 $ 2,972
Value of equity € 34,065.26 - Reinvestment € 942 € 973 € 1,004 € 1,036 € 1,070 € 849 € 609 € 353 € 88 € (181) $ (297)
Number of shares 571.10 FCFF € 1,471 € 1,511 € 1,552 € 1,594 € 1,637 € 1,953 € 2,271 € 2,584 € 2,885 € 3,168 $ 3,269
Estimated value /share € 59.65
Price € 93.25
Price as % of value 56.33% Discount at Euro Cost of Capital (WACC) = 7.66% (.599) + 1.13% (0.401) = 5.04% The Risk in the Cash flows

On September 1, 2019,
Cost of Equity
Heineken was trading at Weights
7.66% Cost of Debt
93.25 Euros/share E = 59.9% D = 40.1%
(-0.5%+2%)(1-.25) = 1.13%

Riskfree Rate: ERP = 6.83%

Euro Risk free rate = + X
-0.50% Beta = 1.20 Region Revenues Weight ERP
Europe 10348 50.24% 6.90%
North America 5920 28.74% 5.75%
Firm’s D/E Asia 2919 14.17% 7.22%
RaSo: 66.98%
Latin America & Caribbean 781 3.79% 10.53%
Unlevered beta of Africa & Mid East 631 3.06% 9.30%
alcoholic beverage Total 20599 100.00% 6.83%
business = 0.80

203 Aswath Damodaran

 2. Don’t wait too long…
204

¨ Most growth firms have difficulty sustaining their

growth for long periods, especially while earning
excess returns. Assuming long growth periods for all
firms is ignoring this reality.
¨ It is not growth per se that creates value but growth
with excess returns. For growth firms to continue to
generate value-creating growth, they have to be able
to keep the competition at bay.
¤ Proposition 1: The stronger and more sustainable the
competitive advantages, the longer a growth company can
sustain “value creating” growth.
¤ Proposition 2: Growth companies with strong and
sustainable competitive advantages are rare.

Aswath Damodaran
204
 3. Do not forget that growth has to be earned..
205

¨ The reinvestment rate in stable growth will be a function of the

stable growth rate and return on capital in perpetuity
¤ Reinvestment Rate = Stable growth rate/ Stable period ROC = g/ ROC
$
!"#$!"# %&' (%& )
%&'
¤ Terminal Value in year n =
(*+,' +- *./0'.1&2)

Return on capital in perpetuity

6% 8% 10% 12% 14%
0.0% $1,000 $1,000 $1,000 $1,000 $1,000
Growth rate forever

0.5% $965 $987 $1,000 $1,009 $1,015

1.0% $926 $972 $1,000 $1,019 $1,032
1.5% $882 $956 $1,000 $1,029 $1,050
2.0% $833 $938 $1,000 $1,042 $1,071
2.5% $778 $917 $1,000 $1,056 $1,095
3.0% $714 $893 $1,000 $1,071 $1,122

Aswath Damodaran
205
 Excess Returns to Zero?
206

¨ There are some (McKinsey, for instance) who argue that the return on
capital should always be equal to cost of capital in stable growth.
¨ But excess returns seem to persist for very long time periods.

Aswath Damodaran
206
 And don’t fall for sleight of hand…
207

¨ A typical assumption in many DCF valuations, when it

comes to stable growth, is that capital expenditures
offset depreciation and there are no working capital
needs. Stable growth firms, we are told, just have to
make maintenance cap ex (replacing existing assets ) to
deliver growth.
a. If you make this assumption, what expected growth rate
can you use in your terminal value computation?

b. What if the stable growth rate = inflation rate? Is it okay

to make this assumption then?

Aswath Damodaran
207
 4. Be internally consistent
208

¨ Risk and costs of equity and capital: Stable growth firms tend
to
¤ Have betas closer to one
¤ Have debt ratios closer to industry averages (or mature company
averages)
¤ Country risk premiums (especially in emerging markets should evolve
over time)
¨ The excess returns at stable growth firms should approach (or
become) zero. ROC -> Cost of capital and ROE -> Cost of
equity
¨ The reinvestment needs and dividend payout ratios should
reflect the lower growth and excess returns:
¤ Stable period payout ratio = 1 - g/ ROE
¤ Stable period reinvestment rate = g/ ROC

Aswath Damodaran
208
209
Beyond Inputs: Choosing and Using
the Right Model
Choosing the right model

Aswath Damodaran
 Summarizing the Inputs
210

¨ In summary, at this stage in the process, we should have

an estimate of the
¤ the current cash flows on the investment, either to equity
investors (dividends or free cash flows to equity) or to the firm
(cash flow to the firm)
¤ the current cost of equity and/or capital on the investment
¤ the expected growth rate in earnings, based upon historical
growth, analysts forecasts and/or fundamentals
¨ The next step in the process is deciding
¤ which cash flow to discount, which should indicate
¤ which discount rate needs to be estimated and
¤ what pattern we will assume growth to follow

Aswath Damodaran
210
 Which cash flow should I discount?
211

¨ Use Equity Valuation

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

Aswath Damodaran
211
 Given cash flows to equity, should I discount
dividends or FCFE?
212

¨ Use the Dividend Discount Model

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

Aswath Damodaran
212
 What discount rate should I use?
213

¨ Cost of Equity versus Cost of Capital

¤ If discounting cash flows to equity -> Cost of Equity
¤ If discounting cash flows to the firm -> Cost of Capital
¨ What currency should the discount rate (risk free rate)
be in?
¤ Match the currency in which you estimate the risk free rate to
the currency of your cash flows
¨ Should I use real or nominal cash flows?
¤ If discounting real cash flows -> real cost of capital
¤ If nominal cash flows -> nominal cost of capital
¤ If inflation is low (<10%), stick with nominal cash flows since
taxes are based upon nominal income
¤ If inflation is high (>10%) switch to real cash flows
Aswath Damodaran
213
 Which Growth Pattern Should I use?
214

¨ If your firm is
¤ large and growing at a rate close to or less than growth rate of the economy, or
¤ constrained by regulation from growing at rate faster than the economy
¤ has the characteristics of a stable firm (average risk & reinvestment rates)
Use a Stable Growth Model
¨ If your firm
¤ is large & growing at a moderate rate (≤ Overall growth rate + 10%) or
¤ has a single product & barriers to entry with a finite life (e.g. patents)
Use a 2-Stage Growth Model
¨ If your firm
¤ is small and growing at a very high rate (> Overall growth rate + 10%) or
¤ has significant barriers to entry into the business
¤ has firm characteristics that are very different from the norm
Use a 3-Stage or n-stage Model

Aswath Damodaran
214
 The Building Blocks of Valuation
215

Choose a
Cash Flow Dividends Cashflows to Equity Cashflows to Firm
Expected Dividends to
Net Income EBIT (1- tax rate)
Stockholders
- (1- δ) (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n)
- (1- δ) Change in Work. Capital - Change in Work. Capital
= Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF)
[δ = Debt Ratio]
& A Discount Rate Cost of Equity Cost of Capital
• Basis: The riskier the investment, the greater is the cost of equity. WACC = ke ( E/ (D+E))
• Models: + kd ( D/(D+E))
CAPM: Riskfree Rate + Beta (Risk Premium) kd = Current Borrowing Rate (1-t)
APM: Riskfree Rate + Σ Betaj (Risk Premiumj): n factors E,D: Mkt Val of Equity and Debt
& a growth pattern Stable Growth Two-Stage Growth Three-Stage Growth
g g g

| |
t High Growth Stable High Growth Transition Stable

Aswath Damodaran
215
216
Tying up Loose Ends
The trouble starts after you tell me you are
done..

Aswath Damodaran
 But what comes next?
217

Since this is a discounted cashflow valuation, should there be a real option

Value of Operating Assets premium?

+ Cash and Marketable Operating versus Non-opeating cash

Securities Should cash be discounted for earning a low return?
+ Value of Cross Holdings How do you value cross holdings in other companies?
What if the cross holdings are in private businesses?
+ Value of Other Assets What about other valuable assets?
How do you consider under utlilized assets?
Should you discount this value for opacity or complexity?
Value of Firm How about a premium for synergy?
What about a premium for intangibles (brand name)?
What should be counted in debt?
- Value of Debt Should you subtract book or market value of debt?
What about other obligations (pension fund and health care?
What about contingent liabilities?
What about minority interests?
= Value of Equity Should there be a premium/discount for control?
Should there be a discount for distress

- Value of Equity Options What equity options should be valued here (vested versus non-vested)?
How do you value equity options?

= Value of Common Stock Should you divide by primary or diluted shares?

/ Number of shares

= Value per share

Should there be a discount for illiquidity/ marketability?
Should there be a discount for minority interests?

Aswath Damodaran
217
 1. The Value of Cash
218

¨ The simplest and most direct way of dealing with cash and
marketable securities is to keep it out of the valuation - the
cash flows should be before interest income from cash and
securities, and the discount rate should not be contaminated
by the inclusion of cash. (Use betas of the operating assets
alone to estimate the cost of equity).
¨ Once the operating assets have been valued, you should add
back the value of cash and marketable securities.
¨ In many equity valuations, the interest income from cash is
included in the cashflows. The discount rate has to be
adjusted then for the presence of cash. (The beta used will be
weighted down by the cash holdings). Unless cash remains a
fixed percentage of overall value over time, these valuations
will tend to break down.

Aswath Damodaran
218
 An Exercise in Cash Valuation
219

Company A Company B Company C

Enterprise Value $1,000.0 $1,000.0 $1,000.0

Cash $100.0 $100.0 $100.0

Return on invested capital 10% 5% 22%

Cost of capital 10% 10% 12%

Trades in US US Argentina
In which of these companies is cash most likely to be
a) A Neutral Asset (worth $100 million)
b) A Wasting Asset (worth less than $100 million)
c) A Potential Value Creator (worth >$100 million)
Aswath Damodaran
219
 Should you ever discount cash for its low
returns?
220

¨ There are some analysts who argue that companies with a lot of
cash on their balance sheets should be penalized by having the
excess cash discounted to reflect the fact that it earns a low return.
¤ Excess cash is usually defined as holding cash that is greater than what the
firm needs for operations.
¤ A low return is defined as a return lower than what the firm earns on its
non-cash investments.
¨ This is the wrong reason for discounting cash. If the cash is invested
in riskless securities, it should earn a low rate of return. As long as
the return is high enough, given the riskless nature of the
investment, cash does not destroy value.
¨ There is a right reason, though, that may apply to some
companies… Managers can do stupid things with cash (overpriced
acquisitions, pie-in-the-sky projects….) and you have to discount for
this possibility.

Aswath Damodaran
220
 Cash: Discount or Premium?
221

Aswath Damodaran
221
 A Detour: Closed End Mutual Funds
222

¨ Assume that you have

a closed-end fund that
invests in ‘average
risk” stocks. Assume
also that you expect
the market (average
risk investments) to
make 11.5% annually
over the long term. If
the closed end fund
underperforms the
market by 0.50%,
estimate the discount
on the fund.

Aswath Damodaran
 The Most Famous Closed End Fund in History?
223

Aswath Damodaran
223
 2. Dealing with Holdings in Other firms
224

¨ 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 active holdings, in which case the share of equity
income is shown in the income statements
¤ Majority active holdings, in which case the financial
statements are consolidated.
¨ In an intrinsic valuation, you would like to estimate
the intrinsic value of these holdings and including
them in your overall intrinsic valuation of the
company.

Aswath Damodaran
224
 If you really want to value cross holdings right….
225

¨ Step 1: Value the parent company without any cross

holdings. This will require using unconsolidated financial
statements rather than consolidated ones.
¨ Step 2: Value each of the cross holdings individually. (If
you use the market values of the cross holdings, you will
build in errors the market makes in valuing them into
your valuation).
¨ Step 3: The final value of the equity in the parent
company with N cross holdings will be:
Value of unconsolidated parent company
– Debt of unconsolidated parent company
+ j= N% owned of Company j * (Value of Company j - Debt of Company j)
∑
j=1

Aswath Damodaran
225
€
 Valuing Yahoo as the sum of its intrinsic
pieces
226

Aswath Damodaran
226
 If you have to settle for an approximation, try this…
227

¨ For majority holdings, with full consolidation, convert the

minority interest from book value to market value by applying
a price to book ratio (based upon the sector average for the
subsidiary) to the minority interest.
¤ Estimated market value of minority interest = Minority interest on
balance sheet * Price to Book ratio for sector (of subsidiary)
¤ Subtract this from the estimated value of the consolidated firm to get
to value of the equity in the parent company.
¨ For minority holdings in other companies, convert the book
value of these holdings (which are reported on the balance
sheet) into market value by multiplying by the price to book
ratio of the sector(s). Add this value on to the value of the
operating assets to arrive at total firm value.
Aswath Damodaran
227
 Yahoo: A pricing game?
228

Aswath Damodaran
228
 3. Other Assets that have not been counted
yet..
229

¨ Assets that you should not be counting (or adding on to DCF

values)
¤ If an asset is contributing to your cashflows, you cannot count the market
value of the asset in your value.
¨ Assets that you can count (or add on to your DCF valuation)
¤ Overfunded pension plans: If you have a defined benefit plan and your assets
exceed your expected liabilities, you could consider the over funding with two
caveats:
n Collective bargaining agreements may prevent you from laying claim to
these excess assets.
n There are tax consequences. Often, withdrawals from pension plans get
taxed at much higher rates.
¤ Unutilized assets: If you have assets or property that are not being utilized to
generate cash flows (vacant land, for example), you have not valued them yet.
You can assess a market value for these assets and add them on to the value of
the firm.

Aswath Damodaran
229
 An Uncounted Asset?
230

Price tag: $200 million

Aswath Damodaran
230
 4. A Discount for Complexity:
An Experiment
231

Company A Company B
Operating Income $ 1 billion $ 1 billion
Tax rate 40% 40%
ROIC 10% 10%
Expected Growth 5% 5%
Cost of capital 8% 8%
Business Mix Single Multiple
Holdings Simple Complex
Accounting Transparent Opaque
Which firm would you value more highly?
Aswath Damodaran
231
 Measuring Complexity: Volume of Data in
Financial Statements
232

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
232
 Measuring Complexity: A Complexity Score
233

Aswath Damodaran
233
 Dealing with Complexity
234

¨ In Discounted Cashflow Valuation

¤ The Aggressive Analyst: Trust the firm to tell the truth and value the firm
based upon the firm’s statements about their value.
¤ The Conservative 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 relative valuation
¤ In a relative valuation, 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
234
 5. Be circumspect about defining debt for cost of
capital purposes…
235

¨ General Rule: Debt generally has the following characteristics:

¤ Commitment to make fixed payments in the future
¤ The fixed payments are tax deductible
¤ Failure to make the payments can lead to either default or loss of
control of the firm to the party to whom payments are due.
¨ Defined as such, debt should include
¤ All interest bearing liabilities, short term as well as long term
¤ All leases, operating as well as capital
¨ Debt should not include
¤ Accounts payable or supplier credit
¨ Be wary of your conservative impulses which will tell you to
count everything as debt. That will push up the debt ratio and
lead you to understate your cost of capital.

Aswath Damodaran
235
 Book Value or Market Value
236

¨ You are valuing a distressed telecom company and have

arrived at an estimate of $ 1 billion for the enterprise value
(using a discounted cash flow valuation). The company has $
1 billion in face value of debt outstanding but the debt is
trading at 50% of face value (because of the distress). What is
the value of the equity to you as an investor?
a. The equity is worth nothing (EV minus Face Value of Debt)
b. The equity is worth $ 500 million (EV minus Market Value of Debt)

¨ Would your answer be different if you were told that the

liquidation value of the assets of the firm today is $1.2 billion
and that you were planning to liquidate the firm today?

Aswath Damodaran
236
 But you should consider other potential
liabilities when getting to equity value
237

¨ If you have under funded pension fund or health care

plans, you should consider the under funding at this
stage in getting to the value of equity.
¤ If you do so, you should not double count by also including a
cash flow line item reflecting cash you would need to set aside
to meet the unfunded obligation.
¤ You should not be counting these items as debt in your cost of
capital calculations….
¨ If you have contingent liabilities - for example, a
potential liability from a lawsuit that has not been
decided - you should consider the expected value of
these contingent liabilities
¤ Value of contingent liability = Probability that the liability will
occur * Expected value of liability

Aswath Damodaran
237
6. Equity to Employees: Effect on Value

¨ In recent years, firms have turned to giving employees (and

especially top managers) equity option or restricted stock
packages as part of compensation. If they are options, they
usually are long term and on volatile stocks. If restricted
stock, the restrictions are usually on trading.
¨ These equity compensation packages are clearly valuable and
the question becomes how best to deal with them in
valuation.
¨ Two key issues with employee options:
¤ How do options or restricted stock granted in the past affect equity
value per share today?
¤ How do expected grants of either, in the future, affect equity value
today?

238
 The Easier Problem: Restricted Stock Grants
239
Aswath
Damodaran

¨ When employee compensation takes the form of

restricted stock grants, the solution is relatively simple.
¨ To account for restricted stock grants in the past, make
sure that you count the restricted stock that have
already been granted in shares outstanding today. That
will reduce your value per share.
¨ To account for expected stock grants in the future,
estimate the value of these grants as a percent of
revenue and forecast that as expense as part of
compensation expenses. That will reduce future income
and cash flows.

239
 The Bigger Challenge: Employee Options
240

¨ It is true that options can increase the number of shares

outstanding but dilution per se is not the problem.
¨ Options affect equity value at exercise because
¤ Shares are issued at below the prevailing market price. Options
get exercised only when they are in the money.
¤ Alternatively, the company can use cashflows that would have
been available to equity investors to buy back shares which are
then used to meet option exercise. The lower cashflows reduce
equity value.
¨ Options affect equity value before exercise because we
have to build in the expectation that there is a
probability of and a cost to exercise.
Aswath Damodaran
240
 A simple example…
241

¨ XYZ company has $ 100 million in free cashflows to the firm, growing 3% a
year in perpetuity and a cost of capital of 8%. It has 100 million shares
outstanding and $ 1 billion in debt. Its value can be written as follows:
Value of firm = 100 / (.08-.03) = 2000
Debt = 1000
= Equity = 1000
Value per share = 1000/100 = $10
¨ XYZ decides to give 10 million options at the money (with a strike price of
$10) to its CEO. What effect will this have on the value of equity per
share?
a. None. The options are not in-the-money.
b. Decrease by 10%, since the number of shares could increase by 10 million
c. Decrease by less than 10%. The options will bring in cash into the firm but they
have time value.

Aswath Damodaran
241
 I. The Diluted Share Count Approach
242

¨ The simplest way of dealing with options is to try to

adjust the denominator for shares that will become
outstanding if the options get exercised. In the example
cited, this would imply the following:
Value of firm = 100 / (.08-.03) = 2000
Debt = 1000
= Equity = 1000
Number of diluted shares = 110
Value per share = 1000/110 = $9.09
¨ The diluted approach fails to consider that exercising
options will bring in cash into the firm. Consequently,
they will overestimate the impact of options and
understate the value of equity per share.
Aswath Damodaran
242
 II. The Treasury Stock Approach
243

¨ The treasury stock approach adds the proceeds from the exercise of
options to the value of the equity before dividing by the diluted number
of shares outstanding.
¨ In the example cited, this would imply the following:
Value of firm = 100 / (.08-.03) = 2000
Debt = 1000
= Equity = 1000
Number of diluted shares = 110
Proceeds from option exercise = 10 * 10 = 100
Value per share = (1000+ 100)/110 = $ 10
¨ The treasury stock approach fails to consider the time premium on the
options. The treasury stock approach also has problems with out-of-the-
money options. If considered, they can increase the value of equity per
share. If ignored, they are treated as non-existent.

Aswath Damodaran
243
 III. Option Value Drag
244

¨ Step 1: Value the firm, using discounted cash flow or other

valuation models.
¨ Step 2: Subtract out the value of the outstanding debt to arrive at
the value of equity. Alternatively, skip step 1 and estimate the of
equity directly.
¨ Step 3:Subtract out the market value (or estimated market value)
of other equity claims:
¤ Value of Warrants = Market Price per Warrant * Number of Warrants
: Alternatively estimate the value using option pricing model
¤ Value of Conversion Option = Market Value of Convertible Bonds - Value of
Straight Debt Portion of Convertible Bonds
¤ Value of employee Options: Value using the average exercise price and
maturity.
¨ Step 4:Divide the remaining value of equity by the number of
shares outstanding to get value per share.

Aswath Damodaran
244
 Valuing Equity Options issued by firms… The Dilution
Problem
245

¨ Option pricing models can be used to value employee options

with four caveats –
¤ Employee options are long term, making the assumptions about
constant variance and constant dividend yields much shakier,
¤ Employee options result in stock dilution, and
¤ Employee options are often exercised before expiration, making it
dangerous to use European option pricing models.
¤ Employee options cannot be exercised until the employee is vested.
¨ These problems can be partially alleviated by using an option
pricing model, allowing for shifts in variance and early
exercise, and factoring in the dilution effect. The resulting
value can be adjusted for the probability that the employee
will not be vested.
Aswath Damodaran
245
 Valuing Employee Options
246

¨ To value employee options, you need the following

inputs into the option valuation model:
¤ Stock Price = $ 10, Adjusted for dilution = $9.58
¤ Strike Price = $ 10
¤ Maturity = 10 years (Can reduce to reflect early exercise)
¤ Standard deviation in stock price = 40%
¤ Riskless Rate = 4%
¨ Using a dilution-adjusted Black Scholes model, we arrive
at the following inputs:
¤ N (d1) = 0.8199
¤ N (d2) = 0.3624
¤ Value per call = $ 9.58 (0.8199) - $10 e -(0.04) (10)(0.3624) = $5.42

Aswath Damodaran
246
 Value of Equity to Value of Equity per share
247

¨ Using the value per call of $5.42, we can now estimate the
value of equity per share after the option grant:
Value of firm = 100 / (.08-.03) = 2000
Debt = 1000
= Equity = 1000
Value of options granted = $ 54.2
= Value of Equity in stock = $945.8
/ Number of shares outstanding / 100
= Value per share = $ 9.46
¨ Note that this approach yields a higher value than the
diluted share count approach (which ignores exercise
proceeds) and a lower value than the treasury stock
approach (which ignores the time premium on the options)

Aswath Damodaran
247
 Option grants in the future…
248

¨ Assume now that this firm intends to continue granting

options each year to its top management as part of
compensation. These expected option grants will also
affect value.
¨ The simplest mechanism for bringing in future option
grants into the analysis is to do the following:
¤ Estimate the value of options granted each year over the last
few years as a percent of revenues.
¤ Forecast out the value of option grants as a percent of revenues
into future years, allowing for the fact that as revenues get
larger, option grants as a percent of revenues will become
smaller.
¤ Consider this line item as part of operating expenses each year.
This will reduce the operating margin and cashflow each year.
Aswath Damodaran
248
NARRATIVE AND NUMBERS:
VALUATION AS A BRIDGE
Tell me a story..
Valuation as a bridge

Number Crunchers Story Tellers

250
Step 1: Survey the landscape

¨ Every valuation starts with a narrative, a story that

you see unfolding for your company in the future.
¨ In developing this narrative, you will be making
assessments of
¤ Your company (its products, its management and its
history.
¤ The market or markets that you see it growing in.

¤ The competition it faces and will face.

¤ The macro environment in which it operates.

251
Step 2: Create a narrative for the future

¨ Every valuation starts with a narrative, a story that

you see unfolding for your company in the future.
¨ In developing this narrative, you will be making
assessments of your company (its products, its
management), the market or markets that you see it
growing in, the competition it faces and will face and
the macro environment in which it operates.
¤ Rule 1: Keep it simple.
¤ Rule 2: Keep it focused.

¤ Rule 3: Stay grounded in reality.

253
The Uber Narrative

In June 2014, my initial narrative for Uber was that it would be

1. An urban car service business: I saw Uber primarily as a
force in urban areas and only in the car service business.
2. Which would expand the business moderately (about 40%
over ten years) by bringing in new users.
3. With local networking benefits: If Uber becomes large
enough in any city, it will quickly become larger, but that will
be of little help when it enters a new city.
4. Maintain its revenue sharing (20%) system due to strong
competitive advantages (from being a first mover).
5. And its existing low-capital business model, with drivers as
contractors and very little investment in infrastructure.

254
 Step 3: Check the narrative against history,
economic first principles & common sense
255

Aswath Damodaran
255
 The Impossible, The Implausible and the
Improbable
256

Aswath Damodaran
256
Uber: Possible, Plausible and Probable

257
The Runaway Story: When you want a
story to be true…
¨ With a runaway business story, you usually have three
ingredients:
1. Charismatic, likeable Narrator: The narrator of the business
story is someone that you want to see succeed, either because
you like the narrator or because he/she will be a good role
model.
2. Telling a story about disrupting a much business, where you
dislike the status quo: The status quo in the business that the
story is disrupting is dissatisfying (to everyone involved)>
3. With a societal benefit as bonus: And if the story holds, society
and humanity will benefit.
¨ Since you want this story to work out, you stop asking
questions, because the answers may put the story at
risk.

258
 The Impossible: The Runaway Story
The Story The Checks (?)

+ +
+ Money
 When runaway stories melt down..
260

The Meltdown Story

Bad Business Model

Story at war with numbers The business model has a
Untrustworthy Storyteller Meltdown Story
The company's narrative fundamental flaw that can Investors, lenders
A narrator, who through
conflicts with its own affect either future and observers
his/her words or actions
+ actions and/or with the + profitability or survival, but = question story,
has become unwilling to accept
actual results/numbers the management is either in
untrustworthy. the company's spin
reported by the company. denial about the flaw or on number, pushing
opaque in how it plans to pricing down.
deal with it.

Aswath Damodaran
260
The Implausible: The Big Market Delusion
The Improbable: Willy Wonkitis
Step 4: Connect your narrative to key
drivers of value
The Uber narrative (June 2014)

Uber is an urban car service company,

competing against taxis & limos in urban areas,
but it may expand demand for car service.
Total Market The global taxi/limo business is $100 billion in
2013, growing at 6% a year.
X

Market Share Uber will have competitive advantages against

traditional car companies & against newcomers in
=
this business, but no global networking benefits.
Target market share is 10%
Revenues (Sales)

-
Uber will maintain its current model of keeping 20%
Operating Expenses of car service payments, even in the face of
competition, because of its first mover advantages. It
= will maintain its current low-infrastructure cost model,
allowing it to earn high margins.
Operating Income Target pre-tax operating margin is 40%.
-

Taxes

After-tax Operating Income Uber has a low capital intensity model, since it
does not own cars or other infrastructure,
- allowing it to maintain a high sales to capital
ratio for the sector (5.00)
Reinvestment

After-tax Cash Flow The company is young and still trying to establish
a business model, leading to a high cost of
Adjust for time value & risk capital (12%) up front. As it grows, it will become
safer and its cost of capital will drop to 8%.
Adjusted for operating risk
with a discount rate and
VALUE OF
for failure with a
OPERATING
probability of failure.
ASSETS

Uber has cash & capital, but

Cash there is a chance of failure.
10% probability of failure.

263
 Step 4: Value the company (Uber)
264

Aswath Damodaran
264
 Step 5: Keep the feedback loop open…
265

1. Not just car service company.: Uber is a car company,

not just a car service company, and there may be a day
when consumers will subscribe to a Uber service,
rather than own their own cars. It could also expand
into logistics, i.e., moving and transportation
businesses.
2. Not just urban: Uber can create new demands for car
service in parts of the country where taxis are not used
(suburbia, small towns).
3. Global networking benefits: By linking with technology
and credit card companies, Uber can have global
networking benefits.

Aswath Damodaran
265
Valuing Bill Gurley’s Uber narrative

266
Different narratives, Different Numbers

267
 Step 6: Be ready to modify narrative as
events unfold
268

Narrative Break/End Narrative Shift Narrative Change

(Expansion or Contraction)
Events, external (legal, Improvement or Unexpected entry/success
political or economic) or deterioration in initial in a new market or
internal (management, business model, changing unexpected exit/failure in
competitive, default), that market size, market share an existing market.
can cause the narrative to and/or profitability.
break or end.
Your valuation estimates Your valuation estimates Valuation estimates have
(cash flows, risk, growth & will have to be modified to to be redone with new
value) are no longer reflect the new data about overall market potential
operative the company. and characteristics.
Estimate a probability that Monte Carlo simulations or Real Options
it will occur & scenario analysis
consequences

Aswath Damodaran
268
 Aswath Damodaran 269

Let the games begin… Time to

value companies..
Let’s have some fun!
 Equity Risk Premiums in Valuation
270

¨ The equity risk premiums that I have used in the valuations

that follow reflect my thinking (and how it has evolved) on
the issue.
¤ Pre-1998 valuations: In the valuations prior to 1998, I use a risk
premium of 5.5% for mature markets (close to both the historical and
the implied premiums then)
¤ Between 1998 and Sept 2008: In the valuations between 1998 and
September 2008, I used a risk premium of 4% for mature markets,
reflecting my belief that risk premiums in mature markets do not
change much and revert back to historical norms (at least for implied
premiums).
¤ Valuations done in 2009: After the 2008 crisis and the jump in equity
risk premiums to 6.43% in January 2008, I have used a higher equity
risk premium (5-6%) for the next 5 years and will assume a reversion
back to historical norms (4%) only after year 5.
¤ After 2009: I have used updated equity risk premiums, as of the time
that I did the valuations.

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270
 The Valuation Set up
271

¨ With each company that I value in this next section, I

will try to start with a story about the company and
use that story to construct a valuation.
¨ With each valuation, rather than focus on all of the
details (which will follow the blueprint already laid
out), I will focus on a specific component of the
valuation that is unique or different.

Aswath Damodaran
271
272 Training Wheels On?
Stocks that look like Bonds, Things Change and
Market Valuations

Aswath Damodaran
 Test 1: Is the firm paying Training Wheels valuation: Test 2: Is the stable growth rate
dividends like a stable growth Con Ed in August 2008 consistent with fundamentals?
firm? Retention Ratio = 27%
Dividend payout ratio is 73% ROE =Cost of equity = 7.7%
In trailing 12 months, through June Expected growth = 2.1%
2008
Earnings per share = $3.17 Growth rate forever = 2.1%
Dividends per share = $2.32

Value per share today= Expected Dividends per share next year / (Cost of equity - Growth rate)
= 2.32 (1.021)/ (.077 - ,021) = $42.30

Cost of Equity = 4.1% + 0.8 (4.5%) = 7.70% On August 12, 2008

Con Ed was trading at $
40.76.
Riskfree rate Beta Equity Risk
4.10% 0.80 Premium
10-year T.Bond rate Beta for regulated 4.5%
power utilities Implied Equity Risk
Premium - US
market in 8/2008
Test 3: Is the firm’s risk and cost of equity consistent with a stable growith firm?
Beta of 0.80 is at lower end of the range of stable company betas: 0.8 -1.2

Why a stable growth dividend discount model?

1. Why stable growth: Company is a regulated utility, restricted from investing in new
growth markets. Growth is constrained by the fact that the population (and power
needs) of its customers in New York are growing at very low rates.
Growth rate forever = 2%
2. Why equity: Company’s debt ratio has been stable at about 70% equity, 30% debt
for decades.
3. Why dividends: Company has paid out about 97% of its FCFE as dividends over
273 the last five years.
 From DCF value to target price and returns…
274

¨ Assume that you believe that your valuation of Con Ed

($42.30) is a fair estimate of the value, 7.70% is a
reasonable estimate of Con Ed’s cost of equity and that
your expected dividends for next year (2.32*1.021) is a
fair estimate, what is the expected stock price a year
from now (assuming that the market corrects its
mistake?)

¨ If you bought the stock today at $40.76, what return can

you expect to make over the next year (assuming again
that the market corrects its mistake)?

Aswath Damodaran
274
 Current Cashflow to Firm
3M: A Pre-crisis valuation
Return on Capital
EBIT(1-t)= 5344 (1-.35)= 3474 Reinvestment Rate 25%
- Nt CpX= 350 30% Stable Growth
- Chg WC 691 Expected Growth in g = 3%; Beta = 1.10;
= FCFF 2433 EBIT (1-t) Debt Ratio= 20%; Tax rate=35%
.30*.25=.075 Cost of capital = 6.76%
Reinvestment Rate = 1041/3474
=29.97% 7.5% ROC= 6.76%;
Return on capital = 25.19% Reinvestment Rate=3/6.76=44%

Terminal Value5= 2645/(.0676-.03) = 70,409

First 5 years
Op. Assets 60607 Year 1 2 3 4 5 Term Yr
+ Cash: 3253 EBIT (1-t) $3,734 $4,014 $4,279 $4,485 $4,619 $4,758
- Debt 4920 - Reinvestment $1,120 $1,204 $1,312 $1,435 $1,540 , $2,113
=Equity 58400 = FCFF $2,614 $2,810 $2,967 $3,049 $3,079 $2,645

Value/Share $ 83.55
Cost of capital = 8.32% (0.92) + 2.91% (0.08) = 7.88%

On September 12,
Cost of Equity Cost of Debt 2008, 3M was
8.32% (3.72%+.75%)(1-.35) Weights trading at $70/share
= 2.91% E = 92% D = 8%

Riskfree Rate: Risk Premium

Riskfree rate = 3.72% Beta 4%
+ 1.15 X

Unlevered Beta for

Sectors: 1.09 D/E=8.8%

275 Aswath Damodaran

 Did not increase debt
Lowered base operating income by 10% 3M: Post-crisis valuation ratio in stable growth
Current Cashflow to Firm Reduced growth Return on Capital to 20%
Reinvestment Rate rate to 5% 20%
EBIT(1-t)= 4810 (1-.35)= 3,180 Stable Growth
25% Expected Growth in
- Nt CpX= 350 g = 3%; Beta = 1.00;; ERP =4%
- Chg WC 691 EBIT (1-t)
Debt Ratio= 8%; Tax rate=35%
= FCFF 2139 .25*.20=.05
Cost of capital = 7.55%
Reinvestment Rate = 1041/3180 5%
ROC= 7.55%;
=33% Reinvestment Rate=3/7.55=40%
Return on capital = 23.06%
Terminal Value5= 2434/(.0755-.03) = 53,481
First 5 years
Op. Assets 43,975 Year 1 2 3 4 5 Term Yr
+ Cash: 3253 EBIT (1-t) $3,339 $3,506 $3,667 $3,807 $3,921 $4,038
- Debt 4920 - Reinvestment $835 $877 $1,025 $1,288 $1,558 $1,604
=Equity 42308 = FCFF $2,504 $2,630 $2,642 $2,519 $2,363 $2,434

Value/Share $ 60.53
Cost of capital = 10.86% (0.92) + 3.55% (0.08) = 10.27%

Higher default spread for next 5 years On October 16, 2008,

Cost of Equity Cost of Debt MMM was trading at
10.86% (3.96%+.1.5%)(1-.35) Weights $57/share.
= 3.55% E = 92% D = 8%

Increased risk premium to 6% for next 5 years

Riskfree Rate: Risk Premium
Riskfree rate = 3.96% Beta 6%
+ 1.15 X

Unlevered Beta for

Sectors: 1.09 D/E=8.8%

276 Aswath Damodaran

Valuing the S&P 500 Index (September
2022)

277
1. Earnings

278
2. Cash Return

279
My S&P 500 Story

280
What if?

281
282 The Dark Side of Valuation
Anyone can value a company that is stable,
makes money and has an established
business model!

Aswath Damodaran
 The fundamental determinants of value…
283

What is the value added by growth assets?

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

Aswath Damodaran
283
 The Dark Side of Valuation…
284

¨ Valuing stable, money making companies with

consistent and clear accounting statements, a long and
stable history and lots of comparable firms is easy to do.
¨ The true test of your valuation skills is when you have to
value “difficult” companies. In particular, the challenges
are greatest when valuing:
¤ Young companies, early in the life cycle, in young businesses
¤ Companies that don’t fit the accounting mold
¤ Companies that face substantial truncation risk (default or
nationalization risk)

Aswath Damodaran
284
 Difficult to value companies…
285

¨ Across the life cycle:

¤ Young, growth firms: Limited history, small revenues in conjunction with big operating losses
and a propensity for failure make these companies tough to value.
¤ Mature companies in transition: When mature companies change or are forced to change,
history may have to be abandoned and parameters have to be reestimated.
¤ Declining and Distressed firms: A long but irrelevant history, declining markets, high debt loads
and the likelihood of distress make them troublesome.
¨ Across markets
¤ Emerging market companies are often difficult to value because of the way they are
structured, their exposure to country risk and poor corporate governance.
¨ Across sectors
¤ Financial service firms: Opacity of financial statements and difficulties in estimating basic
inputs leave us trusting managers to tell us what’s going on.
¤ Commodity and cyclical firms: Dependence of the underlying commodity prices or overall
economic growth make these valuations susceptible to macro factors.
¤ Firms with intangible assets: Accounting principles are left to the wayside on these firms.

Aswath Damodaran
285
 I. The challenge with young companies…
286

Aswath Damodaran
286
 Upping the ante.. Young companies in young
businesses…
287

¨ When valuing a business, we generally draw on three sources of information

¤ 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 time?
n What can we learn about cost structure and profitability from these trends?
n Susceptibility 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 shifts” happen…
¤ New metrics are invented …
¤ The story dominates and the numbers lag…

Aswath Damodaran
287
288 Aswath Damodaran
Lesson 1: Don’t sweat the small stuff

¨ Spotlight the business the

company is in & use the beta of
that business.
¨ Don’t try to incorporate failure
risk into the discount rate.
¨ Let the cost of capital change
over time, as the company
changes.
¨ If you are desperate, use the
cross section of costs of capital
to get your estimation going
(use the 90th or 95th percentile
across all companies).
Lesson 2: Work backwards and keep it simple…

290
Lesson 3: Scaling up is hard to do & failure
is common
¨ Lower revenue growth
rates, as revenues
scale up.
¨ Keep track of dollar
revenues, as you go
through time,
measuring against
market size.
Lesson 4: Don’t forget to pay for growth…

292
Lesson 5: The dilution is taken care off..

¨ With young growth companies, it is almost a given that the number of

shares outstanding will increase over time for two reasons:
¤ To grow, the company will have to issue new shares either to raise cash to take
projects or to offer to target company stockholders in acquisitions
¤ Many young, growth companies also offer options to managers as compensation
and these options will get exercised, if the company is successful.
¨ Both effects are already incorporated into the value per share, even
though we use the current number of shares in estimating value per share
¤ The need for new equity issues is captured in negative cash flows in the earlier
years. The present value of these negative cash flows will drag down the current
value of equity and this is the effect of future dilution. In the Amazon valuation, the
value of equity is reduced by $3.09 billion (the present value of negative FCFF in the
first 6 years), about a 16% reduction. That takes care of new issues in the future.
¤ The existing options are valued and netted out against the current value, taking
care of the option overhang. The future earnings are after stock based
compensation expenses (don’t fall for the “its not a cash expense” ploy) to take
care of future option grants.

293
Lesson 6: If you are worried about failure,
incorporate into value

294
 A 2019 Update: Sector Comparison
295

Aswath Damodaran
295
Lesson 7: There are always scenarios
where the market price can be justified…

6% 8% 10% 12% 14%

30% $ (1.94) $ 2.95 $ 7.84 $ 12.71 $ 17.57
35% $ 1.41 $ 8.37 $ 15.33 $ 22.27 $ 29.21
40% $ 6.10 $ 15.93 $ 25.74 $ 35.54 $ 45.34
45% $ 12.59 $ 26.34 $ 40.05 $ 53.77 $ 67.48
50% $ 21.47 $ 40.50 $ 59.52 $ 78.53 $ 97.54
55% $ 33.47 $ 59.60 $ 85.72 $ 111.84 $ 137.95
60% $ 49.53 $ 85.10 $ 120.66 $ 156.22 $ 191.77

296
Lesson 8: You will be wrong 100% of the
time and it really is not your fault…
¨ No matter how careful you are in getting your inputs and
how well structured your model is, your estimate of
value will change both as new information comes out
about the company, the business and the economy.
¨ As information comes out, you will have to adjust and
adapt your model to reflect the information. Rather than
be defensive about the resulting changes in value,
recognize that this is the essence of risk.
¨ A test: If your valuations are unbiased, you should find
yourself increasing estimated values as often as you are
decreasing values. In other words, there should be equal
doses of good and bad news affecting valuations (at least
over time).

297
And the market is often “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

298
 Assessing my 2000 forecasts, in 2014
299

Aswath Damodaran
299
300 Aswath Damodaran
 II. Mature Companies in transition..
301

¨ 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
valuation 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
often the case to have change thrust upon them,

Aswath Damodaran
301
 The perils of valuing mature companies…
302

Aswath Damodaran
302
 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.

303 Aswath Damodaran

 Financial leverage is a double-edged sword..
304
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
304
 III. Dealing with decline and distress…
305

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
305
 a. Dealing with Decline
306

¨ In decline, firms often see declining revenues and lower margins,

translating in negative expected growth over time.
¨ If these firms are run by good managers, they will not fight decline.
Instead, they will adapt to it and shut down or sell investments that
do not generate the cost of capital. This can translate into negative
net capital expenditures (depreciation exceeds cap ex), declining
working capital and an overall negative reinvestment rate. The best
case scenario is that the firm can shed its bad assets, make itself a
much smaller and healthier firm and then settle into long-term
stable growth.
¨ As an investor, your worst case scenario is that these firms are run
by managers in denial who continue to expand the firm by making
bad investments (that generate lower returns than the cost of
capital). These firms may be able to grow revenues and operating
income but will destroy value along the way.

Aswath Damodaran
306
 Figure 14.5: A Valuation of JC Penney
Margins
Declining business: Revenues expected to drop by 3% a year fo next 5 years improve
gradually to
Base year 1 2 3 4 5 6 7 8 9 10 median for
Revenue growth rate -3.00% -3.00% -3.00% -3.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% US retail
sector
Revenues $ 12,522 $ 12,146 $ 11,782 $ 11,428 $ 11,086 $ 10,753 $ 10,538 $ 10,433 $ 10,433 $ 10,537 $ 10,748
(6.25%)
EBIT (Operating) margin 1.32% 1.82% 2.31% 2.80% 3.29% 3.79% 4.28% 4.77% 5.26% 5.76% 6.25%
EBIT (Operating income) $ 166 $ 221 $ 272 $ 320 $ 365 $ 407 $ 451 $ 498 $ 549 $ 607 $ 672 As stores
Tax rate 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 36.00% 37.00% 38.00% 39.00% 40.00% shut down,
EBIT(1-t) $ 108 $ 143 $ 177 $ 208 $ 237 $ 265 $ 289 $ 314 $ 341 $ 370 $ 403 cash
- Reinvestment $ (188) $ (182) $ (177) $ (171) $ (166) $ (108) $ (53) $ - $ 52 $ 105 released from
FCFF $ 331 $ 359 $ 385 $ 409 $ 431 $ 396 $ 366 $ 341 $ 318 $ 298 real estate.
Cost of capital 9.00% 9.00% 9.00% 9.00% 9.00% 8.80% 8.60% 8.40% 8.20% 8.00% The cost of
PV(FCFF) $ 304 $ 302 $ 297 $ 290 $ 280 $ 237 $ 201 $ 173 $ 149 $ 129 capital is at
Terminal value $ 5,710 9%, higher
PV(Terminal value) $ 2,479 because of
PV (CF over next 10 years) $ 2,362 high cost of
Sum of PV $ 4,841 debt.
Probability of failure = 20.00% High debt load and poor earnings put
Proceeds if firm fails = $2,421 survival at risk. Based on bond rating,
Value of operating assets = $4,357 20% chance of failure and liquidation will
bring in 50% of book value

307 Aswath Damodaran

 b. Dealing with the “downside” of Distress
308

¨ A DCF valuation 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 valuations will overstate
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 estimate the probability of distress:
¤ Use the bond rating to estimate the cumulative probability of distress over 10 years
¤ Estimate the probability of distress with a probit
¤ Estimate the probability of distress by looking at market value of bonds..
¨ The distress sale value of equity is usually best estimated 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
308
 Reinvestment:
Capital expenditures include cost of Stable Growth
Current Current new casinos and working capital
Revenue Margin: Stable Stable
Stable Operating ROC=10%
$ 4,390 4.76% Revenue
Extended Industry Margin: Reinvest 30%
reinvestment average Growth: 3% 17% of EBIT(1-t)
EBIT break, due ot
$ 209m investment in Expected
past Margin:
-> 17% Terminal Value= 758(.0743-.03)
=$ 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%
Risk Premium
Las Vegas Sands
Beta 6% Feburary 2009
+ 3.14-> 1.20 X Trading @ $4.25

309 Aswath Damodaran Casino Current Base Equity Country Risk

1.15 D/E: 277% Premium Premium
Adjusting the value of LVS for distress..
¨ Ratings based approach: In February 2009, Las Vegas Sands was rated B+, and based upon
history (previous ten years), the likelihood of default is 28.25%.
¨ Bond Price based: 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
pDistress = Annual probability of default = 13.54%
Cumulative probability of surviving 10 years = (1 - .1354)10 = 23.34%
Cumulative €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
¨ With ratings-based approach: $8.12 (.7175) + $ 0 (.2825) = $5.83
¨ With bond-based approach: $8.12 (1 - .7666) + $0.00 (.7666) = $1.92

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310
 IV. Emerging Market Companies
311

Estimation Issues - Emerging Market Companies

Big shifts in economic
environment (inflation,
itnerest rates) can affect
operating earnings history. Growth rates for a company will be affected heavily be
Poor corporate growth rate and political developments in the country
governance and weak in which it operates.
accounting standards can What is the value added by growth
lead to lack of
assets?
transparency on earnings.
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
roadblocks?
Cross holdings can existing assets and growth assets?
affect value of
equity Even if the company’s risk is stable, Economic crises can put
there can be significant changes in many companies at risk.
country risk over time. Government actions
What is the value of
(nationalization) can affect
equity in the firm?
long term value.

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311
 Lesson 1: Country risk has to be incorporated… but
with a scalpel, not a bludgeon
312

¨ Emerging market companies are undoubtedly exposed to

additional country risk because they are incorporated in
countries that are more exposed to political and
economic risk.
¨ Not all emerging market companies are equally exposed
to country risk and many developed markets have
emerging market risk exposure because of their
operations.
¨ You can use either the “weighted country risk premium”,
with the weights reflecting the countries you get your
revenues from or the lambda approach (which may
incorporate more than revenues) to capture country risk
exposure.
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312
 Lesson 2: Currency should not matter
313

¨ You can value any company in any currency. Thus, you

can value a Brazilian company in nominal reais, US
dollars or Swiss Francs.
¨ For your valuation to stay invariant and consistent, your
cash flows and discount rates have to be in the same
currency. Thus, if you are using a high inflation currency,
both your growth rates and discount rates will be much
higher.
¨ For your cash flows to be consistent, you have to use
expected exchange rates that reflect purchasing power
parity (the higher inflation currency has to depreciate by
the inflation differential each year).

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313
Valuing Infosys: In US$ and Indian Rupees

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314
 Lesson 3: The “corporate governance” drag
315

¨ Stockholders in Asian, Latin American and many European

companies have little or no power over the managers of the
firm. In many cases, insiders own voting shares and control
the firm and the potential for conflict of interests is huge.
¨ This weak corporate governance is often a reason for given
for using higher discount rates or discounting the estimated
value for these companies.
¨ Would you discount the value that you estimate for an
emerging market company to allow for this absence of
stockholder power?
a. Yes
b. No.
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315
 Where is the
corporate
governance
discount in this
valuation?

316 Aswath Damodaran

 Lesson 4: Watch out for cross holdings…
317

¨ Emerging market companies are more prone to having

cross holdings that companies in developed markets.
¤ This is partially the result of history (since many of the larger
public companies used to be family owned businesses until a
few decades ago)
¤ And partly because those who run these companies value
control (and use cross holdings to preserve this control).
¨ In many emerging market companies, the real process of
valuation begins when you have finished your DCF
valuation, since the cross holdings (which can be
numerous) have to be valued, often with minimal
information.

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317
 Tata Companies in 2010: Value Breakdown
318

1.62% 2.97% 0.22%

100.00% 5.32% 4.64%

80.00% 36.62%
47.45%
47.06%

60.00% % of value from cash

% of value from holdings
95.13%
% of value from operating assets
40.00%
60.41%
47.62% 50.94%

20.00%

0.00%
Tata Chemicals Tata Steel Tata Motors TCS

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318
 Lesson 5: Truncation risk can come in many forms…
319

¨ Natural disasters: Small companies in some economies

are much exposed to natural disasters (hurricanes,
earthquakes), without the means to hedge against that
risk (with insurance or derivative products).
¨ Terrorism risk: Companies in some countries that are
unstable or in the grips of civil war are exposed to
damage or destruction.
¨ Nationalization risk: While less common than it used to
be, there are countries where businesses may be
nationalized, with owners receiving less than fair value
as compensation.

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319
Valuing Aramco: Potential Dividends

320
Adjusting for regime change

¨ If you believe that there is no chance of regime change, your expected

value will remain $1.65 trillion.
¨ If you believe that regime change is imminent, and that your equity will
be fully expropriated, your expected value will be zero.
¨ If you believe that there remains a non-trivial chance (perhaps as high as
20%) that there will be a regime change and that if there is one, there will
be changes that reduce, but not extinguish, your equity claim:

321
 V. Valuing Financial Service Companies
322

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.

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322
323 Aswath Damodaran
 Lesson 1: Financial service companies are opaque…
324

¨ With financial service firms, we enter into a Faustian bargain.

They tell us very little 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 information that we don’t have).
¨ In addition, estimating 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.
¨ During times of crises or when you don’t trust banks to pay
out what they can afford to in dividends, using the dividend
discount model may not give you a “reliable” value.

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324
 Lesson 2: For financial service companies, book value
matters…
325

¨ The book value of assets and equity is mostly irrelevant when valuing
non-financial service companies. After all, the book value of equity is a
historical figure and can be nonsensical. (The book value of equity can be
negative 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 ratios are based on book equity. Thus, a bank with negative
or even low book equity will be shut down by the regulators.
¨ From a valuation perspective, 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
ambitions and safety requirements:
¤ FCFE = Net Income – Reinvestment in regulatory capital (book equity)

Aswath Damodaran
325
Aswath Damodaran
 Lesson 3: Not all financial service firms are
built alike..
327

¨ Financial service is a broad category, and while banks

may be its most substantive component, there are a
range of other companies, with very different business
models.
¨ For instance, payment processing companies and credit
card companies are also financial service companies, but
they derive their value from
¤ Getting consumers to use their platforms to make payments to
businesses or to each other, resulting in transactions on the
platform (called Gross Merchandising Value or GMV)
¤ Keeping a slice, called a take rate, of the GMV for themselves.
Aswath Damodaran
327
328 Aswath Damodaran
 VI. Valuing Companies with “intangible” assets
329

If capital expenditures are miscategorized as

operating expenses, it becomes very difficult to
assess how much a firm is reinvesting for future
growth and how well its investments are doing.

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
The capital existing assets and growth assets? roadblocks?
expenditures
associated with
acquiring intangible It ican be more difficult to borrow Intangbile assets such as
assets (technology, against intangible assets than it is brand name and customer
against tangible assets. The risk in loyalty can last for very long
himan capital) are
operations can change depending periods or dissipate
mis-categorized as
upon how stable the intangbiel asset overnight.
operating expenses,
leading to inccorect is.
accounting earnings
and measures of
capital invested.

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329
 Lesson 1: Accounting rules are cluttered with
inconsistencies…
330

¨ If we start with accounting first principles, capital expenditures are

expenditures designed to create benefits over many periods. They
should not be used to reduce operating income in the period that
they are made, but should be depreciated/amortized over their
life. They should show up as assets on the balance sheet.
¨ Accounting is consistent in its treatment of cap ex with
manufacturing firms, but is inconsistent with firms that do not fit
the mold.
¤ With pharmaceutical and technology firms, R&D is the ultimate cap ex but
is treated as an operating expense.
¤ With consulting firms and other firms dependent on human capital,
recruiting and training expenses are your long term investments that are
treated as operating expenses.
¤ With brand name consumer product companies, a portion of the
advertising expense is to build up brand name and is the real capital
expenditure. It is treated as an operating expense.

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330
 Lesson 2: And fixing those inconsistencies can
alter your view of a company and affect its value
331

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331
 VII. Valuing cyclical and commodity companies
332
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
economic cycle and Primary risk is from the economy for For commodity companies, the
commodity prices cyclical firms and from commodity fact that there are only finite
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
332
 Lesson 1: With “macro” companies, it is easy to get
lost in “macro” assumptions…
333

¨ 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 valuation. Doing so,
though, will create valuations 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 valuation, but then provide a
separate assessment of what you think about those market
numbers.

Aswath Damodaran
333
 Lesson 2: Use probabilistic tools to assess value as a
function of macro variables…
334

¨ If there is a key macro variable affecting the value of your

company that you are uncertain about (and who is not), why
not quantify the uncertainty in a distribution (rather than a
single price) and use that distribution in your valuation.
¨ That is exactly what you do in a Monte Carlo simulation,
where you allow one or more variables to be distributions
and compute a distribution of values for the company.
¨ With a simulation, you get not only everything you would get
in a standard valuation (an estimated value for your
company) but you will get additional output (on the variation
in that value and the likelihood that your firm is under or over
valued)

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334
335 Aswath Damodaran
Shell’s Revenues & Oil Prices

Shell: Revenues vs Oil Price

500,000.0 $120.00

450,000.0

$100.00
400,000.0
Revenues = 39,992.77 + 4,039.39 * Average Oil Price
350,000.0 R squared = 96.44%

Average Oil Price during year

Revenues (in millions of $)

$80.00

300,000.0

250,000.0 $60.00

200,000.0

$40.00
150,000.0

100,000.0
$20.00

50,000.0

0 $-
198919901991199219931994199519961997199819992000200120022003200420052006200720082009201020112012201320142015

Revenue Oil price

336
337 Aswath Damodaran
 Aswath Damodaran 338

VALUE, PRICE AND

INFORMATION:
CLOSING THE DEAL
Value versus Price
 Are you valuing or pricing?
339

Tools for pricing

Tools for intrinsic analysis Tools for "the gap" - Multiples and comparables
- Discounted Cashflow Valuation (DCF) - Behavioral finance - Charting and technical indicators
- Intrinsic multiples - Price catalysts - Pseudo DCF
- Book value based approaches
- Excess Return Models

Value of cashflows, INTRINSIC THE GAP

adjusted for time PRICE
VALUE Value Is there one? Price
and risk Will it close?

Drivers of intrinsic value

Drivers of "the gap" Drivers of price
- Cashflows from existing assets
- Information - Market moods & momentum
- Growth in cash flows
- Liquidity - Surface stories about fundamentals
- Quality of Growth
- Corporate governance

Aswath Damodaran
339
Value versus Price

View of the gap Investment Strategies

The Efficient The gaps between price and value, if Index funds
Marketer they do occur, are random.
The “value” You view pricers as dilettantes who Buy and hold stocks
extremist will move on to fad and fad. where value < price
Eventually, the price will converge on
value.
The pricing Value is only in the heads of the (1) Look for mispriced
extremist “eggheads”. Even if it exists (and it is securities.
questionable), price may never (2) Get ahead of shifts in
converge on value. demand/momentum.

340
The valuer’s dilemma and ways of dealing with it…

¨ Uncertainty about the magnitude of the gap:

¤ Margin of safety: Many value investors swear by the notion of the
“margin of safety” as protection against risk/uncertainty.
¤ Collect more information: Collecting more information about the
company is viewed as one way to make your investment less risky.
¤ Ask what if questions: Doing scenario analysis or what if analysis gives
you a sense of whether you should invest.
¤ Confront uncertainty: Face up to the uncertainty, bring it into the
analysis and deal with the consequences.
¨ Uncertainty about gap closing: This is tougher and you can
reduce your exposure to it by
¤ Lengthening your time horizon
¤ Providing or looking for a catalyst that will cause the gap to close.

341
Strategies for managing the risk in the “closing” of
the gap

¨ The “karmic” approach: In this one, you buy (sell short) under
(over) valued companies and sit back and wait for the gap to
close. You are implicitly assuming that given time, the market
will see the error of its ways and fix that error.
¨ The catalyst approach: For the gap to close, the price has to
converge on value. For that convergence to occur, there
usually has to be a catalyst.
¤ If you are an activist investor, you may be the catalyst yourself. In fact,
your act of buying the stock may be a sufficient signal for the market to
reassess the price.
¤ If you are not, you have to look for other catalysts. Here are some to
watch for: a new CEO or management team, a “blockbuster” new
product or an acquisition bid where the firm is targeted.

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342
342
 An example: Apple – Price versus Value
(my estimates) from 2011 to 2020
343

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343
 A closing thought…
344

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344