ch 18 valclosing

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Aswath Damodaran 2

Do you have your life vests on?


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Aswath Damodaran 4

Approaches to Valuation

n Discounted cashflow valuation, where we try (sometimes

desperately) to estimate the intrinsic value of an asset by using a mix

of theory, guesswork and prayer.

n

Relative valuation, where we pick a group of assets, attach the namecomparable to them and tell a story.

n Contingent claim valuation, where we take the valuation that we did

in the DCF valuation and divvy it up between the potential thieves of

value (equity) and the potential victims of this crime (lenders)


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Aswath Damodaran 5

Basis for all valuation approaches

n We all believe market are inefficient, and that we can find under and

over valued assets because of our superior intellect, models,

information or some combination of all three.

n

Some Sobering facts: 70-80% of portfolio managers under perform market indices.

The Vanguard 500 Index fund is poised to overtake the Fidelity Magellan

fund as the largest mutual fund in the United States. In the last 5 years, it

has been the best performing large mutual fund in the United States.

The more people trade, the more they seem to lose.

A study of mutual fund portfolios discovered that they would have made ahigher return, if they had frozen their portfolios on January 1.

A study of individual investors by Terrence ODean also noted a negative

correlation between returns earned and transactions volume (and this is before

trading costs)


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Aswath Damodaran 6

Discounted Cash Flow Valuation

n What is it: In discounted cash flow valuation, the value of an asset is

the present value of the expected cash flows on the asset.

n Philosophical Basis: Every asset has an intrinsic value that can be

estimated, based upon its characteristics in terms of cash flows, growthand risk.

n Information Needed: To use discounted cash flow valuation, you

need

to estimate the life of the asset

to estimate the cash flows during the life of the asset

to estimate the discount rate to apply to these cash flows to get present

value

n Market Inefficiency: Markets are assumed to make mistakes in

pricing assets across time, and are assumed to correct themselves over

time, as new information comes out about assets.


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Aswath Damodaran 7

Cash flowsFirm: Pre-debt cashflowEquity: After debtcash flows

Expected GrowthFirm: Growth inOperating EarningsEquity: Growth inNet Income/EPS

CF1 CF2 CF3 CF4 CF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value

CFn........

Discount RateFirm:Cost of Capital

Equity: Cost of Equity

ValueFirm: Value of Firm

Equity: Value of Equity

DISCOUNTED CASHFLOW VALUATIO

Length of Period of High Growth


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Aswath Damodaran 8

Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)

- Change in WC= FCFF

Expected Growth=ROC* Reinv Rate

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:

Grows at constant rateforever

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

FCFFn........

Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity

Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity

- Equity Options= Value of Equity in Stock

Riskfree Rate : + Beta- Measures market risk

XRisk Premium- Premium for averagerisk investment

Base EquityPremium

Country RiskPremium

DISCOUNTED CASHFLOW VALUATIODid younormalizeearnings?

Did you includeacquisitions andR&D?

Did you consideronly non-cash WCand smooth?

Is your ROClikely to changein the future?

Is your stable growthrate < growth rate ineconomy?

Is your growth rateconsistent with yourreinvestment rate?

Are you reinvestingenough to createstable growth?

Is your betaand leverageconsistent withstable growth?

Will these weights changeover time?

Are you using a bottom-up beta that reflects yourbusiness risk and currentleverage?

Is your riskless rate in thesame currency and termsas the cash flows?

I s there sufficientdata for a historical

risk premium?

Is the company exposed toadditional country risk?

Is your risk premium a historicalor implied risk premium?

Is the default spreadreflective ofcompanys risk?

I s length of growth period consistent withcompetitive advantages?


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Aswath Damodaran 9

Relative Valuation

n What is it?: The value of any asset can be estimated by looking at

how the market prices similar or comparable assets.

n Philosophical Basis: The intrinsic value of an asset is impossible (or

close to impossible) to estimate. The value of an asset is whatever themarket is willing to pay for it (based upon its characteristics)

n Information Needed: To do a relative valuation, you need

an identical asset, or a group of comparable or similar assets

a standardized measure of value (in equity, this is obtained by dividing the

price by a common variable, such as earnings or book value)

and if the assets are not perfectly comparable, variables to control for the

differences

n Market Inefficiency: Pricing errors made across similar or

comparable assets are easier to spot, easier to exploit and are much

more quickly corrected.


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Aswath Damodaran 10

The Four Steps to Understanding Multiples

n Define the multiple

In use, the same multiple can be defined in different ways by different

users. When comparing and using multiples, estimated by someone else, it

is critical that we understand how the multiples have been estimated

n Describe the multiple

Too many people who use a multiple have no idea what its cross sectional

distribution is. If you do not know what the cross sectional distribution of

a multiple is, it is difficult to look at a number and pass judgment on

whether it is too high or low.

n Analyze the multiple It is critical that we understand the fundamentals that drive each multiple,

and the nature of the relationship between the multiple and each variable.

n Apply the multiple

Defining the comparable universe and controlling for differences is far

more difficult in practice than it is in theory.


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Aswath Damodaran 11

Value of Stock = DPS1/(k

e- g)

PE=Payout Ratio(1+g)/(r-g)

PEG=Payout ratio(1+g)/g(r-g)

PBV=ROE (Payout ratio)(1+g)/(r-g)

PS= Net Margin (Payout ratio)(1+g)/(r-g)

Value of Firm = FCFF1/(WACC -g

Value/FCFF=(1+g)/(WACC-g)

Value/EBIT(1-t) = (1+g)(1- RIR)/(WACC-g)

Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)

VS= Oper Margin (1-RIR) (1+g)/(WACC-g)

Equity Multiples

Firm Multiples

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

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


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Aswath Damodaran 12

Estimating a Multiple

n Use comparable firms, compute the average multiple and adjust

subjectively for differences

n Use comparable firms, run a regression of multiple against

fundamentals and estimate predicted multiple for firmn Use market, run a regression of multiple against fundamentals and

estimate a predicted multiple for firm


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Aswath Damodaran 13

What approach would work for you?

n As an investor, given your investment philosophy, time horizon and

beliefs about markets (that you will be investing in), which of the the

approaches to valuation would you choose?

o

Discounted Cash Flow Valuationo Relative Valuation

o Neither. I believe that markets are efficient.


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Aswath Damodaran 14

Contingent Claim (Option) Valuation

n Options have several features

They derive their value from an underlying asset, which has value

The payoff on a call (put) option occurs only if the value of the underlying

asset is greater (lesser) than an exercise price that is specified at the time

the option is created. If this contingency does not occur, the option is

worthless.

They have a fixed life

n Any security that shares these features can be valued as an option.


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Aswath Damodaran 15

Indirect Examples of Options

n Equity in a deeply troubled firm - a firm with negative earnings and

high leverage - can be viewed as an option to liquidate that is held by

the stockholders of the firm. Viewed as such, it is a call option on the

assets of the firm.

n The reserves owned by natural resource firms can be viewed as call

options on the underlying resource, since the firm can decide whether

and how much of the resource to extract from the reserve,

n The patent owned by a firm or an exclusive license issued to a firm can

be viewed as an option on the underlying product (project). The firm

owns this option for the duration of the patent.


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Aswath Damodaran 16

Value Enhancement

n For an action to create value, it has to

Increase cash flows from assets in place

Increase the expected growth rate

Increase the length of the growth period Reduce the cost of capital

n The value enhancement measures that have been widely promoted as

new and different are neither.

EVA and CFROI have their roots in traditional discounted cash flow

models

Measures (like EVA and CFROI) do not create value; managers do.


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Aswath Damodaran 17

Some Not Very Profound Advice

n Its all in the fundamentals

n Focus on the big picture; dont let the details trip you up.

n Keep your perspective; it is only a valuation.


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Aswath Damodaran 18

Or maybe you can fly.

ch 18 valclosing

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