Class 3 Part 2

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.
Aswath Damodaran
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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.
Aswath Damodaran
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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.
Aswath Damodaran
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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
Aswath Damodaran
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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
Aswath Damodaran
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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.
Aswath Damodaran
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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
Aswath Damodaran
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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.
Aswath Damodaran
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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
Aswath Damodaran
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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.
Aswath Damodaran
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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
Aswath Damodaran
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Aswath Damodaran 1

Valuation: Lecture Note Packet 1

¨ In intrinsic valuation, you value an asset based upon its

¨ The value of a risky asset can be estimated by discounting the

¨ The value of an asset is the risk-adjusted present value of the

Firm Valuation: Value the entire business

Equity valuation: Value just the

Figure 5.5: Equity Valuation

Assets in Place Debt

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

Figure 5.6: Firm Valuation

Assets in Place Debt

¨ To get from firm value to equity value, which of the

¨ Assume that you are analyzing a company with the following

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

¨ Discounting Consistency Principle: Never mix and

¨ Error 1: Discount CF to Equity at Cost of Capital to get equity

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