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AswathDamodaran
Aswath Damodaran
Myth1:Avaluationisanobjectivesearchfortruevalue
Truth1.1:Allvaluationsarebiased.Theonlyquestionsarehowmuchand
inwhichdirection.
Truth1.2:Thedirectionandmagnitudeofthebiasinyourvaluationis
directlyproportionaltowhopaysyouandhowmuchyouarepaid.
Myth2.:Agoodvaluationprovidesapreciseestimateofvalue
Truth2.1:Therearenoprecisevaluations
Truth2.2:Thepayofftovaluationisgreatestwhenvaluationisleast
precise.
Myth3:.Themorequantitativeamodel,thebetterthevaluation
Truth3.1:Onesunderstandingofavaluationmodelisinversely
proportionaltothenumberofinputsrequiredforthemodel.
Truth3.2:Simplervaluationmodelsdomuchbetterthancomplexones.
Aswath Damodaran
Approaches to Valuation
ValuationModels
AssetBased
Valuation
DiscountedCashflow
Models
RelativeValuation
Liquidation
Value
Equity
Stable
Current
ContingentClaim
Models
Sector
Twostage
Threestage
ornstage
EquityValuation
Models
Normalized
Earnings
Book Revenues
Value
Sector
specific
Patent
Aswath Damodaran
Optionto
liquidate
Young
firms
Equityin
troubled
firm
Undeveloped
land
FirmValuation
Models
Dividends
FreeCashflow
toFirm
Optionto
expand
Firm
Market
Replacement
Cost
Optionto
delay
Costofcapital
approach
APV
approach
Undeveloped
Reserves
ExcessReturn
Models
Theuseofvaluationmodelsininvestmentdecisions(i.e.,indecisions
onwhichassetsareundervaluedandwhichareovervalued)arebased
upon
aperceptionthatmarketsareinefficientandmakemistakesinassessing
value
anassumptionabouthowandwhentheseinefficiencieswillgetcorrected
Inanefficientmarket,themarketpriceisthebestestimateofvalue.
Thepurposeofanyvaluationmodelisthenthejustificationofthis
value.
Aswath Damodaran
Whatisit:Indiscountedcashflowvaluation,thevalueofanassetis
thepresentvalueoftheexpectedcashflowsontheasset.
PhilosophicalBasis:Everyassethasanintrinsicvaluethatcanbe
estimated,baseduponitscharacteristicsintermsofcashflows,growth
andrisk.
InformationNeeded:Tousediscountedcashflowvaluation,youneed
toestimatethelifeoftheasset
toestimatethecashflowsduringthelifeoftheasset
toestimatethediscountratetoapplytothesecashflowstogetpresentvalue
MarketInefficiency:Marketsareassumedtomakemistakesinpricing
assetsacrosstime,andareassumedtocorrectthemselvesovertime,as
newinformationcomesoutaboutassets.
Aswath Damodaran
whereCFtisthecashflowinperiodt,risthediscountrateappropriate
giventheriskinessofthecashflowandtisthelifeoftheasset.
Proposition1:Foranassettohavevalue,theexpectedcashflows
havetobepositivesometimeoverthelifeoftheasset.
Proposition2:Assetsthatgeneratecashflowsearlyintheirlifewill
beworthmorethanassetsthatgeneratecashflowslater;the
lattermayhoweverhavegreatergrowthandhighercashflowsto
compensate.
Aswath Damodaran
Valuejusttheequitystakeinthebusiness
Valuetheentirebusiness,whichincludes,besidesequity,theother
claimholdersinthefirm
Aswath Damodaran
I.Equity Valuation
Thevalueofequityisobtainedbydiscountingexpectedcashflowstoequity,i.e.,the
residualcashflowsaftermeetingallexpenses,taxobligationsandinterestandprincipal
payments,atthecostofequity,i.e.,therateofreturnrequiredbyequityinvestorsinthe
firm.
t=n CFtoEquity
ValueofEquity =
t=1
(1+ k e )
where,
CFtoEquityt=ExpectedCashflowtoEquityinperiodt
ke=CostofEquity
Forms:Thedividenddiscountmodelisaspecializedcaseofequityvaluation,andthe
valueofastockisthepresentvalueofexpectedfuturedividends.Inthemoregeneral
version,youcanconsiderthecashflowsleftoverafterdebtpaymentsandreinvestment
needsasthefreecashflowtoequity.
Aswath Damodaran
Costofcapitalapproach:Thevalueofthefirmisobtainedby
discountingexpectedcashflowstothefirm,i.e.,theresidualcashflows
aftermeetingalloperatingexpensesandtaxes,butpriortodebt
payments,attheweightedaveragecostofcapital,whichisthecostof
thedifferentcomponentsoffinancingusedbythefirm,weightedby
theirmarketvalueproportions.
t= n
CFtoFirm t
t
t =1 (1+ WACC)
ValueofFirm =
APVapproach:Thevalueofthefirmcanalsobewrittenasthesum
ofthevalueoftheunleveredfirmandtheeffects(goodandbad)of
debt.
FirmValue=UnleveredFirmValue+PVoftaxbenefitsofdebtExpected
BankruptcyCost
Aswath Damodaran
Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS
Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows
Value
Firm: Value of Firm
Equity: Value of Equity
CF1
CF2
CF3
CF4
CF5
CFn
.........
Forever
Aswath Damodaran
10
VALUINGABNAMRO
Retention
Ratio=
41.56%
Dividends
EPS=
1.54Eur
*PayoutRatio58.44%
DPS= 0.90Eur
ValueofEquityper
share=20.48Eur
EPS 1.64Eur
DPS 0.96Eur
ROE=16%
ExpectedGrowth
41.56%*
16%=6.65%
g=4%:ROE=8.95%(=Costofequity)
Beta=1.00
Payout=(14/8.95)=.553
TerminalValue=EPS6*Payout/(rg)
=(2.21*.553)/(.0895.04)=24.69
1.75Eur
1.02Eur
1.87Eur
1.09Eur
1.99Eur
1.16Eur
2.12Eur
1.24Eur
.........
Forever
DiscountatCostofEquity
CostofEquity
4.95%+0.95(4%)=8.75%
RiskfreeRate:
Longtermbondratein
Euros
4.95%
Beta
0.95
AveragebetaforEuropeanbanks=
0.95
Aswath Damodaran
RiskPremium
4%
MatureMarket
4%
CountryRisk
0%
11
Aswath Damodaran
12
Avg Reinvestment
rate = 25.08%
Current Cashflow to Firm
EBIT(1-t) :
$ 404
- Nt CpX
23
- Chg WC
9
= FCFF
$ 372
Reinvestment Rate = 32/404= 7.9%
Reinvestment Rate
25.08%
Return on Capital
21.85%
Expected Growth
in EBIT (1-t)
.2185*.2508=.0548
5.48 %
$ Cashflows
Op. Assets $ 5,272
+ Cash:
795
- Debt
717
- Minor. Int.
12
=Equity
5,349
-Options
28
Value/Share $7.47
R$ 21.75
Year
EBIT(1-t)
- Reinvestment
= FCFF
1
426
107
319
3
474
119
355
4
500
126
374
Term Yr
549
- 261
= 288
5
527
132
395
Discount at$ Cost of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81%
Cost of Equity
10.52 %
Riskfree Rate:
$ Riskfree Rate= 4.17%
Cost of Debt
(4.17%+1%+4%)(1-.34)
= 6.05%
Beta
1.07
Aswath Damodaran
2
449
113
336
Stable Growth
g = 4.17%; Beta = 1.00;
Country Premium= 5%
Cost of capital = 8.76%
ROC= 8.76%; Tax rate=34%
Reinvestment Rate=g/ROC
=4.17/8.76= 47.62%
On October 6, 2003
Embraer Price = R$15.51
Weights
E = 84% D = 16%
Mature market
premium
4%
Firms D/E
Ratio: 19%
Lambda
0.27
Country Default
Spread
6.01%
Rel Equity
Mkt Vol
1.28
13
Current
Revenue
$ 3,804
Current
Margin:
-49.82%
EBIT
-1895m
NOL:
2,076m
Stable Growth
EBITDA/Sales
-> 30%
Stable
EBITDA/
Sales
30%
$10,053$11,058$11,942$12,659$13,292
$1,809 $2,322 $2,508 $3,038 $3,589
$1,074 $1,550 $1,697 $2,186 $2,694
$1,074 $1,550 $1,697 $2,186 $2,276
$736 $773 $811 $852 $894
$1,390 $1,460 $1,533 $1,609 $1,690
$27
$30
$27
$21
$19
$392 $832 $949 $1,407 $1,461
6
7
8
9
10
Beta
CostofEquity
CostofDebt
DebtRatio
CostofCapital
3.00
16.80%
12.80%
74.91%
13.80%
2.60
15.20%
11.84%
67.93%
12.92%
Riskfree Rate:
T. Bond rate = 4.8%
3.00
16.80%
12.80%
74.91%
13.80%
3.00
16.80%
12.80%
74.91%
13.80%
3.00
16.80%
12.80%
74.91%
13.80%
3.00
16.80%
12.80%
74.91%
13.80%
2.20
13.60%
10.88%
60.95%
11.94%
Cost of Debt
4.8%+8.0%=12.8%
Tax rate = 0% -> 35%
Beta
3.00> 1.10
Internet/
Retail
Stable
ROC=7.36%
Reinvest
67.93%
Revenues
EBITDA
EBIT
EBIT(1t)
+Depreciation
CapEx
ChgWC
FCFF
Cost of Equity
16.80%
Aswath Damodaran
Stable
Revenue
Growth: 5%
Operating
Leverage
1.80
12.00%
9.92%
53.96%
10.88%
1.40
10.40%
8.96%
46.98%
9.72%
Forever
1.00
8.80%
6.76%
40.00%
7.98%
Weights
Debt= 74.91% -> 40%
Global Crossing
November 2001
Stock price = $1.86
Risk Premium
4%
Current
D/E: 441%
Term.Year
$13,902
$4,187
$3,248
$2,111
$939
$2,353
$20
$677
Base Equity
Premium
Country Risk
Premium
14
Probabilityofdistress
Priceof8year,12%bondissuedbyGlobalCrossing=$653
120(1 Distress ) t 1000(1 Distress ) 8
(1.05) t
(1.05) 8
t1
t 8
653
Probabilityofdistress=13.53%ayear
Cumulativeprobabilityofsurvivalover10years=(1.1353)10=23.37%
Distresssalevalueofequity
Bookvalueofcapital=$14,531million
Distresssalevalue=15%ofbookvalue=.15*14531=$2,180million
Bookvalueofdebt=$7,647million
Distresssalevalueofequity=$0
Distressadjustedvalueofequity
ValueofGlobalCrossing=$3.22(.2337)+$0.00(.7663)=$0.75
Aswath Damodaran
15
Intheadjustedpresentvalueapproach,thevalueofthefirmiswritten
asthesumofthevalueofthefirmwithoutdebt(theunleveredfirm)
andtheeffectofdebtonfirmvalue
FirmValue=UnleveredFirmValue+(TaxBenefitsofDebt
ExpectedBankruptcyCostfromtheDebt)
Theunleveredfirmvaluecanbeestimatedbydiscountingthefree
cashflowstothefirmattheunleveredcostofequity
Thetaxbenefitofdebtreflectsthepresentvalueoftheexpectedtax
benefits.Initssimplestform,
TaxBenefit=Taxrate*Debt
Theexpectedbankruptcycostisafunctionoftheprobabilityof
bankruptcyandthecostofbankruptcy(directaswellasindirect)asa
percentoffirmvalue.
Aswath Damodaran
16
Youcanpresentanydiscountedcashflowmodelintermsofexcess
returns,withthevaluebeingwrittenas:
Value=CapitalInvested+Presentvalueofexcessreturnsoncurrent
investments+Presentvalueofexcessreturnsonfutureinvestments
Thismodelcanbestatedintermsoffirmvalue(EVA)orequity
value.
Aswath Damodaran
17
Expected Growth
.60 * 20% =12%
$ 3104
$ 1645
$ 1459
Net Income
$3,599
- Equity Cost (see below) $1,908
Excess Equity Return
$1,692
$4,031
$2,137
$1,895
Cost of Equity
10.60%
Riskfree Rate:
5.00%
Beta
1.40
Risk Premium
4.00%
Base Equity
Premium = 4%
Aswath Damodaran
Country Risk
Premium=0%
18
No
Is leverage stable or
likely to change over
time?
Use dividend
discount model
No
Use current
earnings as
base
Is the cause
temporary?
Yes
Stable
leverage
Unstable
leverage
FCFE
FCFF
Stable growth
model
No
Replace current
earnings with
normalized
earnings
Is the firm
likely to
survive?
Yes
2-stage
model
Yes
No
3-stage or
n-stage
model
No
Adjust
margins over
time to nurse
firm to financial
health
Yes
Value Equity
as an option
to liquidate
Aswath Damodaran
No
Estimate
liquidation
value
19
Relative Valuation
Whatisit?:Thevalueofanyassetcanbeestimatedbylookingathowthe
marketpricessimilarorcomparableassets.
PhilosophicalBasis:Theintrinsicvalueofanassetisimpossible(orcloseto
impossible)toestimate.Thevalueofanassetiswhateverthemarketis
willingtopayforit(baseduponitscharacteristics)
InformationNeeded:Todoarelativevaluation,youneed
anidenticalasset,oragroupofcomparableorsimilarassets
astandardizedmeasureofvalue(inequity,thisisobtainedbydividingtheprice
byacommonvariable,suchasearningsorbookvalue)
andiftheassetsarenotperfectlycomparable,variablestocontrolforthe
differences
MarketInefficiency:Pricingerrorsmadeacrosssimilarorcomparable
assetsareeasiertospot,easiertoexploitandaremuchmorequickly
corrected.
Aswath Damodaran
20
Variations on Multiples
EquityversusFirmValue
Scalingvariable
Earnings(EPS,NetIncome,EBIT,EBITDA)
Bookvalue(Bookvalueofequity,Bookvalueofassets,Bookvalueofcapital)
Revenues
Sectorspecificvariables
Baseyear
Equitymultiples(PricepershareorMarketvalueofequity)
Firmvaluemultiplies(FirmvalueorEnterprisevalue)
Mostrecentfinancialyear(Current)
Lastfourquarters(Trailing)
Averageoverlastfewyears(Normalized)
Expectedfutureyear(Forward)
Comparables
Aswath Damodaran
Sector
Market
21
Definitional Tests
Isthemultipleconsistentlydefined?
Proposition1:Boththevalue(thenumerator)andthestandardizing
variable(thedenominator)shouldbetothesameclaimholdersinthe
firm.Inotherwords,thevalueofequityshouldbedividedbyequity
earningsorequitybookvalue,andfirmvalueshouldbedividedby
firmearningsorbookvalue.
Isthemultipleuniformallyestimated?
Thevariablesusedindefiningthemultipleshouldbeestimateduniformly
acrossassetsinthecomparablefirmlist.
Ifearningsbasedmultiplesareused,theaccountingrulestomeasure
earningsshouldbeappliedconsistentlyacrossassets.Thesamerule
applieswithbookvaluebasedmultiples.
Aswath Damodaran
22
ThereareanumberofvariantsonthebasicPEratioinuse.Theyare
baseduponhowthepriceandtheearningsaredefined.
Price:
isusuallythecurrentprice
issometimestheaveragepricefortheyear
EPS:
earningspershareinmostrecentfinancialyear
earningspershareintrailing12months(TrailingPE)
forecastedearningspersharenextyear(ForwardPE)
forecastedearningspershareinfutureyear
Aswath Damodaran
23
Descriptive Tests
Whatistheaverageandstandarddeviationforthismultiple,across
theuniverse(market)?
Whatisthemedianforthismultiple?
Themedianforthismultipleisoftenamorereliablecomparisonpoint.
Howlargearetheoutlierstothedistribution,andhowdowedealwith
theoutliers?
Throwingouttheoutliersmayseemlikeanobvioussolution,butifthe
outliersalllieononesideofthedistribution(theyusuallyarelarge
positivenumbers),thiscanleadtoabiasedestimate.
Aretherecaseswherethemultiplecannotbeestimated?Willignoring
thesecasesleadtoabiasedestimateofthemultiple?
Howhasthismultiplechangedovertime?
Aswath Damodaran
24
Aswath Damodaran
25
Mean
Standard Error
Median
Standard Deviation
Skewness
Minimum
Maximum
Count
Largest(500)
Smallest(500)
Aswath Damodaran
Current PE
36.04
1.94
18.25
123.36
23.13
0.65
5103.50
4024
48.00
9.38
Trailing PE
34.14
2.93
17.25
176.34
28.40
1.35
6914.50
3627
39.60
9.62
Forward PE
30.79
1.15
18.52
57.56
13.66
3.30
1414.00
2491
34.49
12.94
26
Aswath Damodaran
27
Analytical Tests
Whatarethefundamentalsthatdetermineanddrivethesemultiples?
Proposition2:Embeddedineverymultipleareallofthevariablesthat
driveeverydiscountedcashflowvaluationgrowth,riskandcashflow
patterns.
Infact,usingasimplediscountedcashflowmodelandbasicalgebra
shouldyieldthefundamentalsthatdriveamultiple
Howdochangesinthesefundamentalschangethemultiple?
Therelationshipbetweenafundamental(likegrowth)andamultiple
(suchasPE)isseldomlinear.Forexample,iffirmAhastwicethegrowth
rateoffirmB,itwillgenerallynottradeattwiceitsPEratio
Proposition3:Itisimpossibletoproperlycomparefirmsona
multiple,ifwedonotknowthenatureoftherelationshipbetween
fundamentalsandthemultiple.
Aswath Damodaran
28
PE=Payout Ratio
(1+g)/(r-g)
PE=f(g, payout, risk)
PEG=Payout ratio
(1+g)/g(r-g)
PBV=f(ROE,payout, g, risk)
Equity Multiples
Firm Multiples
V/FCFF=f(g, WACC)
Value/FCFF=(1+g)/
(WACC-g)
Aswath Damodaran
29
Variablesthatdetermineit
PERatio
PBVRatio
PSRatio
EVV/EBITDA
EV/Sales
ExpectedGrowth,Risk,PayoutRatio
ReturnonEquity,ExpectedGrowth,Risk,Payout
NetMargin,ExpectedGrowth,Risk,PayoutRatio
ExpectedGrowth,Reinvestmentrate,Costofcapital
OperatingMargin,ExpectedGrowth,Risk,Reinvestment
Aswath Damodaran
30
Application Tests
Giventhefirmthatwearevaluing,whatisacomparablefirm?
Whiletraditionalanalysisisbuiltonthepremisethatfirmsinthesame
sectorarecomparablefirms,valuationtheorywouldsuggestthata
comparablefirmisonewhichissimilartotheonebeinganalyzedin
termsoffundamentals.
Proposition4:Thereisnoreasonwhyafirmcannotbecompared
withanotherfirminaverydifferentbusiness,ifthetwofirmshave
thesamerisk,growthandcashflowcharacteristics.
Giventhecomparablefirms,howdoweadjustfordifferencesacross
firmsonthefundamentals?
Proposition5:Itisimpossibletofindanexactlyidenticalfirmtothe
oneyouarevaluing.
Aswath Damodaran
31
Aswath Damodaran
PE
7.8
8.9
11.2
12.5
12.8
16.6
18.3
19.6
20.8
21.1
21.5
21.7
22.7
24.6
25.7
27
28.4
29.8
31
32.5
35.7
42.2
44.3
45.2
71.3
Growth
0.06
0.075
0.11
0.08
0.12
0.08
0.11
0.16
0.13
0.14
0.22
0.12
0.31
0.11
0.07
0.09
0.32
0.14
0.33
0.18
0.13
0.14
0.2
0.19
0.44
32
PE
Rsquared=66.2%Rsquared(adjusted)=63.1%
Variable
Coefficient SE
tratio
Constant
13.1151
3.471
3.78
Growthrate
121.223
19.27
6.29
EmergingMarket
13.8531
3.606
3.84
EmergingMarketisadummy:1ifemergingmarket
0ifnot
Aswath Damodaran
prob
0.0010
0.0001
0.0009
33
PredictedPE=13.12+121.22(.075)13.85(1)=8.35
Atanactualpricetoearningsratioof8.9,Telebrasisslightly
overvalued.
Aswath Damodaran
34
R
R Square
.856 b
.73 3
Adjusted R
Square
.73 2
B
Expected Growth in
EPS: next 5 year s
Payout Ratio
Value Line Beta
Std. Error
Standardized
Coefficients
Beta
Sig.
Lower Bound
Upper Bound
1.228
.05 5
.514
22.187
.000
1.119
1.336
- 1.1E- 02
.01 4
- .013
- .768
.443
- .039
.017
11. 705
.82 5
.384
14.184
.000
10. 087
13.324
Aswath Damodaran
35
Aswath Damodaran
36
Optionshaveseveralfeatures
Theyderivetheirvaluefromanunderlyingasset,whichhasvalue
Thepayoffonacall(put)optionoccursonlyifthevalueofthe
underlyingassetisgreater(lesser)thananexercisepricethatisspecified
atthetimetheoptioniscreated.Ifthiscontingencydoesnotoccur,the
optionisworthless.
Theyhaveafixedlife
Anysecuritythatsharesthesefeaturescanbevaluedasanoption.
Aswath Damodaran
37
StrikePrice
ValueofAsset
PutOption
CallOption
Aswath Damodaran
38
Traditionaldiscountedcashflowmodelsunderestimatethevalueof
investments,wherethereareoptionsembeddedintheinvestmentsto
Delayordefermakingtheinvestment(delay)
Adjustoralterproductionschedulesaspricechanges(flexibility)
Expandintonewmarketsorproductsatlaterstagesintheprocess,based
uponobservingfavorableoutcomesattheearlystages(expansion)
Stopproductionorabandoninvestmentsiftheoutcomesareunfavorable
atearlystages(abandonment)
Putanotherway,realoptionadvocatesbelievethatyoushouldbe
payingapremiumondiscountedcashflowvalueestimates.
Aswath Damodaran
39
Whenistherearealoptionembeddedinadecisionoranasset?
Whendoesthatrealoptionhavesignificanteconomicvalue?
Therehastobeaclearlydefinedunderlyingassetwhosevaluechangesovertimein
unpredictableways.
Thepayoffsonthisasset(realoption)havetobecontingentonanspecifiedevent
occurringwithinafiniteperiod.
Foranoptiontohavesignificanteconomicvalue,therehastobearestrictionon
competitionintheeventofthecontingency.
Atthelimit,realoptionsaremostvaluablewhenyouhaveexclusivityyouandonly
youcantakeadvantageofthecontingency.Theybecomelessvaluableasthebarriersto
competitionbecomelesssteep.
Canthatvaluebeestimatedusinganoptionpricingmodel?
Aswath Damodaran
Theunderlyingassetistradedthisyieldnotonlyobservablepricesandvolatilityas
inputstooptionpricingmodelsbutallowsforthepossibilityofcreatingreplicating
portfolios
Anactivemarketplaceexistsfortheoptionitself.
Thecostofexercisingtheoptionisknownwithsomedegreeofcertaint
40
TheOptionTest:
TheExclusivityTest:
Naturalresourcereservesarelimited(atleastfortheshortterm)
Ittakestimeandresourcestodevelopnewreserves
TheOptionPricingTest
UnderlyingAsset:Oilorgoldinreserve
Contingency:Ifvalue>Costofdevelopment:ValueDevCost
Ifvalue<Costofdevelopment:0
UnderlyingAsset:Whilethereserveorminemaynotbetraded,thecommodityis.Ifwe
assumethatweknowthequantitywithafairdegreeofcertainty,youcantradetheunderlying
asset
Option:Oilcompaniesbuyandsellreservesfromeachotherregularly.
CostofExercisingtheOption:Thisisthecostofdevelopingareserve.Giventheexperience
thatcommoditycompanieshavewiththis,theycanestimatethiscostwithafairdegreeof
precision.
BottomLine:Realoptionpricingmodelsworkwellwithnaturalresourceoptions.
Aswath Damodaran
41
TheOptionTest:
UnderlyingAsset:Productthatwouldbegeneratedbythepatent
Contingency:
IfPVofCFsfromdevelopment>Costofdevelopment:PVCost
IfPVofCFsfromdevelopment<Costofdevelopment:0
TheExclusivityTest:
ThePricingTest
Patentsrestrictcompetitorsfromdevelopingsimilarproducts
Patentsdonotrestrictcompetitorsfromdevelopingotherproductstotreatthesamedisease.
UnderlyingAsset:Patentsarenottraded.Notonlydoyouthereforehavetoestimatethe
presentvaluesandvolatilitiesyourself,youcannotconstructreplicatingpositionsordo
arbitrage.
Option:Patentsareboughtandsold,thoughnotasfrequentlyasoilreservesormines.
CostofExercisingtheOption:Thisisthecostofconvertingthepatentforcommercial
production.Here,experiencedoeshelpanddrugfirmscanmakefairlypreciseestimatesofthe
cost.
BottomLine:Userealoptionpricingargumentswithcaution.
Aswath Damodaran
42
TheOptionsTest
UnderlyingAsset:ExpansionProject
Contingency
IfPVofCFfromexpansion>ExpansionCost:PVExpansionCost
IfPVofCFfromexpansion<ExpansionCost:0
TheExclusivityTest
ThePricingTest
Barriersmayrangefromstrong(exclusivelicensesgrantedbythegovernment)toweaker
(brandname,knowledgeofthemarket)toweakest(firstmover).
UnderlyingAsset:Aswithpatents,thereisnotradingintheunderlyingassetandyouhaveto
estimatevalueandvolatility.
Option:Licensesaresometimesboughtandsold,butmorediffuseexpansionoptionsarenot.
CostofExercisingtheOption:Notknownwithanyprecisionandmayitselfevolveovertime
asthemarketevolves.
BottomLine:Usingoptionpricingmodelstovalueexpansionoptionswillnotonly
yieldextremelynoisyestimates,butmayattachinappropriatepremiumstodiscounted
cashflowestimates.
Aswath Damodaran
43
Therearerealoptionseverywhere.
Mostofthemhavenosignificanteconomicvaluebecausethereisno
exclusivityassociatedwithusingthem.
Whenoptionshavesignificanteconomicvalue,theinputsneededto
valuetheminabinomialmodelcanbeusedinmoretraditional
approaches(decisiontrees)toyieldequivalentvalue.
Therealvaluefromrealoptionsliesin
Recognizingthatbuildinginflexibilityandescapehatchesintolarge
decisionshasvalue
Insightswegetonunderstandinghowandwhycompaniesbehavethe
waytheydoininvestmentanalysisandcapitalstructurechoices.
Aswath Damodaran
44
ValuationModels
AssetBased
Valuation
DiscountedCashflow
Models
RelativeValuation
Liquidation
Value
Equity
Stable
Current
ContingentClaim
Models
Sector
Twostage
Threestage
ornstage
EquityValuation
Models
Normalized
Earnings
Book Revenues
Value
Sector
specific
Dividends
Costofcapital
approach
Aswath Damodaran
Optionto
liquidate
Young
firms
Equityin
troubled
firm
Undeveloped
land
FirmValuation
Models
Patent
FreeCashflow
toFirm
Optionto
expand
Firm
Market
Replacement
Cost
Optionto
delay
APV
approach
Undeveloped
Reserves
ExcessReturn
Models
45
Liquidation &
Replacement cost
valuation
Growth businesses
Linked and non-marketable assets
Cashflows currently or
expected in near future
Discounted cashflow
or relative valuation
models
Cashflows if a contingency
occurs
Discounted cashflow
or option pricing
models
Aswath Damodaran
46
Liquidation value
Option pricing
models
Relative valuation
Liquidation value
Aswath Damodaran
47