1

Living with Noise: Valuation and Investing in the face of Uncertainty

Updated: July 2013
Aswath Damodaran
Stern School of Business
adamodar@stern.nyu.edu

Electronic copy available at: http://ssrn.com/abstract=2323621

Living with Noise: Valuation in the face of uncertainty

Uncertainty is a fact of life in business and investing, but the responses that analysts and
investors have to uncertainty is often unhealthy, ranging from denial and paralysis, at one
extreme, to rules of thumb that have no basis in common sense, at the other. In this paper,
we look at how uncertainty is embedded in all valuations, though the amount of
uncertainty you face will vary across companies, countries and across time. We
categorize uncertainty into groups, estimation versus economic, micro versus macro and
discrete versus continuous, and argue that each grouping needs a different response.
Finally, we develop tools that we can use to get a handle on uncertainty and deal with it
better in valuation.

Electronic copy available at: http://ssrn.com/abstract=2323621

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When valuing businesses, we have to make estimates in the face of uncertainty.
The amount of uncertainty that we face will vary across time, peaking during crisis
periods, across companies, with younger companies posing more challenges than mature
companies, and across countries, with challenges multiplying with emerging market
companies. In this paper, we begin by looking at the intrinsic valuation process and how
uncertainty is embedded in the process. We then look at the valuations of a few
companies that range the spectrum, with the intent of categorizing uncertainty into
different groupings. We close the paper by looking at tools that analysts and investors can
use to better deal with uncertainty.

The basics of intrinsic value

You can estimate the value of an asset as a function of the cash flows generated
by that asset, the life of the asset, the expected growth in the cash flows and the riskiness
associated with the cash flows. That principle remains intact for every business at every
point in time, no matter how much uncertainty there is in the process.
The DCF value of an asset
In its most common form, the intrinsic value of an asset or business is estimated
in a discounted cash flow (DCF) valuation, where the value can be written as the present
value of the expected cash flows on that asset, over its expected life:
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Value of asset = (!!!)!! + (!!!)!! + (!!!)!! +(!!!)!! . + (!!!)!!
Where E(CF)t is the expected cash flow in year t, r is the risk adjusted required rate of
return for investing in that asset and n is the life of the asset.
There are three very general propositions that flow from this equation, which are
obvious but still worth repeating:
Proposition 1: If it does not affect the cash flows or alter risk (thus changing
discount rates), it cannot affect value. Valuation practice is full of its
(synergy, control, brand name, illiquidity) that people attribute arbitrary premiums
or discounts to. This proposition does not posit that synergy, control and brand
name have no effect on value but it does specify these (or any other) variables
have value only to the extent that they affect the cash flows, discount rate or life
of an asset.
Proposition 2: For an asset to have positive value, the expected cash flows have to
be positive some time over the life of the asset. You should be not be paying for
assets or businesses that have negative cash flows in perpetuity.

4
Proposition 3: Assets that generate large positive cash flows early in their life will
be worth more than assets that generate negative cash flows; the latter may
however have greater growth and higher positive cash flows in the future to
compensate. Thus, when valuing young companies, early in the life cycle, you
should not be surprised to see negative cash flows in the early years, but these
companies can still be valuable if they can compensate by providing
disproportionately large cash flows later in their life.
While some of the tools and models that we use in discounted cash flow models may be
of recent origin, the notion of intrinsic value predates finance as a discipline.
A financial balance sheet
There are two ways in which you can approach discounted cash flow valuation
and they can be framed in terms of the financial balance sheet, where we look at the
market value of assets (rather than book value), classifying assets into investments
already made (assets in place) and value added from growth (growth assets). The first is
to value the entire business, with both existing assets (assets-in-place) and growth assets;
this is often termed firm or enterprise valuation.
Figure 1: Valuing a Firm (Business)
Firm Valuation
Assets
Cash flows considered are
cashflows from assets,
prior to any debt payments
but after firm has
reinvested to create
growth assets

Assets in Place

Growth Assets

Liabilities
Debt

Equity

Discount rate reflects the cost of

raising both debt and equity
financing, in proportion to their
use

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

The cash flows before debt payments and after reinvestment needs are termed free cash
flows to the firm, and the discount rate that reflects the composite cost of financing from
all sources of capital is the cost of capital.
The second way is to just value the equity stake in the business, and this is termed
equity valuation.

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Figure 2: Valuing Equity
Equity Valuation
Assets
Cash flows considered are
cashflows from assets,
after debt payments and
after making
reinvestments needed for
future growth

Assets in Place

Growth Assets

Liabilities
Debt

Equity

Discount rate reflects only the

cost of raising equity financing

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

The cash flows after debt payments and reinvestment needs are called free cash flows to
equity, and the discount rate that reflects just the cost of equity financing is the cost of
equity. With publicly traded firms, it can be argued that the only cash flow equity
investors get from the firm is dividends and that discounting expected dividends back at
the cost of equity should yield the value of equity in the firm. The dividend discount
model is therefore a special case of an equity valuation model.
The Key Drivers of Value
While you can choose to value just the equity or the entire business, there are four
basic inputs that you need for a value estimate, though how you define and measure these
inputs will be different depending upon whether you are valuing the business (firm) or
just its equity. The figure below summarizes the determinants of value.

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Figure 3: The Determinants of Value

What are the

cashflows from
existing assets?
- Equity: Cashflows
after debt payments
- Firm: Cashflows
before debt payments

What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
Firm: Growth in operating earnings/
cashflows

How risky are the cash flows from both

existing assets and growth assets?
Equity: Risk in equity in the company
Firm: Risk in the firms operations

When will the firm

become a mature
fiirm, and what are
the potential
roadblocks?

The first input is the cash flow from existing assets, defined either as pre-debt (and to the
firm) or as post-debt (and to equity) earnings, net of reinvestment to generate future
growth. With equity cash flows, we can use an even stricter definition of cash flow and
consider only dividends paid. The second input is expected growth, with growth in
operating income being the key input when valuing the entire business and growth in
equity income (net income or earnings per share) becoming the focus when valuing
equity. However, since this growth will require reinvestment, the value effect of growth
will depend upon whether the how efficiently that growth is generated. The same growth
is worth more with less reinvestment than more, and a simple proxy for the quality of
growth is the return that businesses make on their invested capital. The third input is the
discount rate, defined as the cost of the overall capital of the firm, when valuing the
business, and as cost of equity, when valuing equity. Other things remaining equal,
companies that operate in riskier business or riskier countries should have higher costs of
equity and capital than companies in stable businesses and developed markets. The final
input, allowing for closure, is the terminal value, defined as the estimated value of firm
(equity) at the end of the forecast period in firm (equity) valuation. To make this
estimate, we generally have to assume that cash flows will grow at a constant rate forever
beyond that point, which in turn, requires the firm to be a mature firm, i.e., a firm that is
growing at a rate less than overall economic growth.

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Valuation Illustrations
While the drivers of value remain the same for every business in every market and
at every point in time, it is an undeniable truth that the degree of difficulty and
uncertainty that you face can vary widely across companies, time and markets. In this
section, we will present the big picture valuations of four companies, not with the intent
of exploring the details of valuation, but focusing on the uncertainties in each valuation.
The first company that we value is Minnesota Mining and Manufacturing
Corporation (3M), a large office products manufacturing company, in early September
2008, in the week before the market crisis of 2008.
Valuation 1: Mature Company in a Developed Market, Pre-Crisis

Though there is uncertainty, the estimates of cash flows, growth and risk are relatively
simple to make in this valuation. The company (3M) has a well-established product line
(office and household products) and a long history of stable profits. Thus, the current
financial statements provide a reliable basis for estimating cash flows from existing assets
and the accounting/market data allow us to forecast the expected growth and cost of
capital within narrow bounds. Finally, this valuation predated the crisis of 2008, and
reflected the belief (misplaced in hindsight) that risk premiums and interest rates did not
change drastically over short periods in mature markets like the United States.
The second company that we evaluate is Tata Motors, an Indian automobile
company in May 2010, after a year in which the company had made two momentous

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decisions: the acquisition of a developed market luxury auto maker (Land Rover Jaguar)
and investment in plant and equipment to build the cheapest car in the world (Tata
Nano).
Valuation 2: Mature Company in an Emerging Market

On the surface, the inputs to this valuation resemble those in the 3M valuation. However,
there are three areas of additional uncertainty. The first is that the acquisition of Land
Rover and the Tata Nano investment will change the cash flow, growth and risk
characteristics of the company in unpredictable ways. The second is that Tata Motors is
incorporated in India, an emerging market, and is dependent on economic
growth/stability in the country. The third is the fact that Tata Motors is part of the Tata
family group of companies, and has cross holdings in dozens of other Tata companies.
These cross holdings are recorded at accounting value on the balance sheet (which may
or may not reflect their fair value) and account for a third of the overall value of the
company.
The third valuation is in early 2000 of Amazon.com, a small, money-losing
retailer at the time, that nevertheless had acquired a large market cap and become the
poster child for the dot.com boom occurring in markets at that time.

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Valuation 3: Young Growth Company in a Developed Market Pre-Crisis

This valuation is fraught with uncertainties both about the whether online retailing will
make significant inroads into retailing as a business and how much Amazon will be a
beneficiary of that success. The fact that Amazon is a small company that is losing
money at the time of the valuation exposes it to the risk of failure, i.e., that the company
will be unable to raise the capital needed to make it through the early years of negative
cash flows. Finally, the paltry (and uninformative) history of the company at the time
make the estimation of discount rates and growth rates much more problematic.
The final analysis is in May 2012 of the value of Facebook, the social media
company that took the world by storm earlier in the year with the announcement that it
would go public, on the day before its IPO.

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Valuation 4: Young Growth Company in a Developed Market- Post-Crisis

In the Facebook valuation, we face many of the same issues that we faced when valuing
Amazon, with three added problems. The first is that unlike Amazon, which was clearly
in the retail business, Facebooks business model is still in flux, with advertising being
the most likely source of revenues. The second is that while Facebook had been traded on
private share markets, it has never been traded in public markets, thus making it
impossible to get market-based estimates of risk parameters. The third is that the four
years prior to this valuation had seen developed markets acquire some of the worst traits
of emerging markets, with risk premiums becoming more volatile across all markets.

Value uncertainty: Response and Analysis

The valuations in the last section range the spectrum from mature to high growth
companies, from developed to emerging markets, and from periods of stability to periods
of crisis. What they share in common is that they all require estimates for the future and
that all of these estimates are made in the face of uncertainty. In this section, we start by
looking at the unhealthy ways in which analysts and investors deal with uncertainty and
start our search for a healthier response by breaking down uncertainty down into
groupings.
Unhealthy responses to uncertainty
For centuries, economics has been premised on the notion of rational investors
who when faced with uncertainty, collect information, process it with the best tools at

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their disposal and deal with it sensibly. If we lived in a world of rational investors,
improving access to information, teaching analysts the basics of valuation and giving
them access to more sophisticated valuation tools should lead to better valuations. Policy
makers (central banks, governments, securities regulators, accounting rule writers) have
essentially worked with this premise in writing rules and developing regulations over the
last few decades. Information is far richer and more accessible than ever before, more
analysts have valuation training and it is easier than ever before to build sophisticated
valuation models. The irony is that in spite of these developments, investors have become
no better at dealing with uncertainty than they were a few decades ago and, in some
ways, they have become worse.
The problem is not in the rules, information or models, but in the investors who use
them and in the fundamental assumption of rationality in the face of uncertainty.
Psychologists and behavioral finance researchers have spent the last few decades
showing that investors and analysts behave in irrational ways when confronted with
uncertainty, with five of the most common ones listed below:
1. Paralysis: When faced with uncertainty, some are unable to move on. It is not
uncommon to see analysts get stuck on a valuation or investment analysis on a
particularly difficult input to estimate and give up.
2. Denial: The other extreme reaction is denial, where investors or analysts confronted
with uncertainty refuse to acknowledge its existence. They prefer to maintain the
illusion that they can estimate cash flows and discount rates with certainty and hide
behind the false precision of big numerical models.
3. Mental short cuts (rules of thumb): Behavioral economists note that investors faced
with uncertainty adopt rules of thumb or short cuts that have no basis in reality.
Richard Thaler called this mental accounting and its prevalence in investing has been
well documented.1 In valuation, it usually takes the form of rules of thumb, madeup multiples of revenues, book value, earnings or customer being applied to estimate
value. The most troublesome aspect of mental accounting is that it becomes more
prevalent, not less, as analysts get more experienced and intelligent.
4. Herding: The herding instinct is deeply engrained and very difficult to fight for
investors, especially as uncertainty mounts. Thus, the pricing of companies when
there are large doses of uncertainty is based more on momentum and the behavior of
other investors (buying or selling) than it is on fundamentals.

Thaler, R. H. , 1985, "Mental accounting and consumer choice", Marketing Science, 4, 199-214.

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5. Outsourcing: Investors faced with the task of valuing a particularly difficult-to-value
company often turn to the experts. In some cases, these experts are the equity research
analysts who supply target prices for investors to use and in others, it is the managers
of the companies themselves. It is not that investors trust these experts to be right but
that it allows them to pass on the blame, in case their decisions turn out to be wrong.
In summary, in the face of uncertainty, investors abandon common sense and first
principles in valuation.
Classifying uncertainty
The first step in developing a more healthy response to uncertainty is recognizing
that not all uncertainty is created alike. In this section, we will use the valuations from the
last part to illustrate the different types of uncertainty you face in valuation and the
different responses that they should evoke.
Estimation versus Economic uncertainty
If you accept the proposition that almost all of your inputs into a valuation are
estimates, it then follows that you can be wrong on these estimates and that you would
prefer to be less wrong rather than more so. This intuitive proposition than leads to a
follow up, where analysts assume that collecting more information and processing it
better will make their estimates more precise and your valuation a better one.
That may be true, but only if the error in your inputs comes from not using all of
the information that you have access to and/or not using the best model to process that
information. That type of error is estimation uncertainty and more diligent data collection
and better models/metrics will reduce this uncertainty. The problem, though, is even if
you make estimation uncertainty disappear, you will still be faced with real economic
uncertainty that cannot be diminished by any amount of information or sophisticated
model building. Economic uncertainty comes from the fact that markets and economies
change over time in unexpected and unpredictable ways. Thus, even if you had collected
every piece of information available on online retailing and on Amazon as a company in
early 2000, you would still be faced with the problem that no one at that time would have
been able to forecast the exact path that online retailing would take over the following
decade.
Put simply, if the bulk of the uncertainty that you face in a valuation is economic
rather than estimation uncertainty, it is hubris to believe that building better models that
incorporate more information is somehow going to make your valuation more precise.

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Micro uncertainty versus Macro uncertainty
When valuing a firm, some uncertainties emanate from actions that the firm takes
(or fails to take) that affect just that firm and its immediate peer group. Other
uncertainties come from macroeconomic developments that affect most or all firms. The
balance between the two types of risk will vary across firms and across time. Looking
across the valuations in the last section, here is my assessment of the breakdown of micro
and macro uncertainties in each valuation:
Company
Micro uncertainty
Macro uncertainty
3M
in Low, because of 3Ms long and Low, because its revenues come
September
stable history.
primarily from developed markets.a
2008
Tata Motors Low, for existing business, but High, because the company gets
in 2010
higher going forward, because of 80% of its revenues from an
Jaguar acquisition and Tata Nano emerging market (India). Global
development. Opacity of cross markets have collectively become
holdings makes them difficult to more volatile, post crisis.
value.
Amazon in High, since it is a small company in Low, since it derived its revenues
early 2000
a
nascent
business
(online entirely
from
a
developed
retailing).
market/economy that was booming.
Facebook in High, since the companys business High, since the valuation is post2012
model is in flux and it is in a crisis and the line between
nascent sector (social media).
developed and emerging markets
has blurred.
a

The valuation was done pre-crisis, when the assumption was that developed markets have stable risk
premiums, inflation, interest rates and other macro indicators.

The breakdown of risk into micro and macro sources matters for two reasons. First, and
this is connected to the previous issue of estimative versus economic uncertainty, micro
uncertainty is more likely to be reduced by collecting more information about the firm
and building better models than macro uncertainty. Second, micro uncertainty is also
much more easily eliminated in a portfolio, since for every company that performs worse
than expected in your portfolio, there will be another company that performs better than
expected. Macro uncertainty on the other hand is unlikely to be dented by diversification.
The risk and return models used to estimate discount rates in valuation are, for the most
part, built on the premise that the marginal investors who price stocks are diversified and
that the only risk that should be incorporated into discount rates is a firms exposure to
macroeconomic risk.

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Discrete versus continuous uncertainty
The third classification of risk is into discrete and continuous risk. Continuous
risk affects a companys fundamentals (cash flows, discount rates and/or growth) every
minute of every day. Thus, a US company that derives 40% of its revenues in Germany
will be exposed to the risk that the Euro/$ exchange rate changes continuously over time,
and as it does, affects profitability and cash flows. In contrast, discrete risks lie dormant
for long periods but show up at points in time, often unexpectedly and with catastrophic
consequences. Using the exchange rate example again, assume that you are looking at a
US company that derives 40% of its revenues from Indonesia and that the rupiah/US $
exchange rate is fixed. While the fixed exchange rate eliminates the minute-to-minute
variation in cash flows that the company with revenues in Germany is exposed to, it is
replaced with the risk of a revaluation of the currency, which may occur once every few
years but when it does happen, is extreme. Included in the discrete risk column are the
risks that a company will be nationalized, that it will be victimized by acts of God (or
man) and that a company may default on its debt and be forced into bankruptcy.
We make this categorization for two reasons. The first is that we are far better at
dealing with continuous risk both in terms of businesses managing the risk (using
options, futures or forward contracts) and incorporating it into valuation models than
discrete risk. Discount rates can be easily adapted to incorporate continuous exchange
rate risk but there is no easy mechanism for incorporating nationalization risk or
devaluation risk. The second is that the irrational responses that we noted in the face of
uncertainty become even more so, when the uncertainty is of the large, discrete variety
than when it is continuous.
Looking back at the four companies that we valued, 3M is mostly exposed to
continuous risk but the other companies have significant discrete risk exposures. For Tata
Motors, the risk can take the form of the Indian government making significant changes
to the rules governing foreign investment in India (which will change Tatas competitive
environment). For Amazon in 2000, with its significant losses and negative cash flows, it
can be the possibility that capital markets will shut down, putting the companys survival
at risk. For Facebook, the risk can come from the legal environment, where lawsuits that
revolve around user privacy and personal information may put at risk one of the
companys most significant competitive advantages.

Tools for dealing with value uncertainty

Having broken uncertainty into groupings, it is time to return to the basic mission
of this paper, which is improving the way in which we deal with uncertainty. Using the

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valuations of the four companies as the basis, there are ten simple rules that will allow us
to do a better job of incorporating uncertainty into investment decisions.
1. Less is more
When faced with valuing companies where there is a great deal of uncertainty, the
natural response on the part of many analysts is to collect more information and to break
down valuations into more detail. The best response to uncertainty, however, is to
minimize the number of inputs into the valuation and the detail in your output. After all,
you have to estimate these inputs and having fewer will allow you to focus on what
matters.
To illustrate, consider the challenge of estimating expected cash flows for a
company like Amazon in early 2000, when the company had small revenues, large
operating losses and very little history to base forecasts on. Rather than forecast dozens
of expense items to arrive at operating income estimates, I estimated operating income
using two inputs: a compounded growth rate of 42% in revenues for the next decade and
a target pre-tax operating margin of 10%. The table below summarizes my estimates
for revenues, operating income and after-tax operating income for the company:
Table 1: Revenues and Operating Income (EBIT): Amazon
Year

Revenue Growth

Trailing 12 months

Sales

Operating Margin

EBIT

$1,117

-36.71%

-$410

EBIT (1-t)
-$410
-$373

150.00%

$2,793

-13.35%

-$373

100.00%

$5,585

-1.68%

-$94

-$94

75.00%

$9,774

4.16%

$407

$407

50.00%

$14,661

7.08%

$1,038

$871

30.00%

$19,059

8.54%

$1,628

$1,058

25.20%

$23,862

9.27%

$2,212

$1,438

20.40%

$28,729

9.64%

$2,768

$1,799

15.60%

$33,211

9.82%

$3,261

$2,119

10.80%

$36,798

9.91%

$3,646

$2,370

10

6.00%

$39,006

9.95%

$3,883

$2,524

TY

6.00%

$41,346

10.00%

$4,135

$2,688

To estimate the compounded revenue growth rate, I went through an exercise of

forecasting revenues in 2010 (ten years out from the point that the valuation was done),
for the largest retailers in 2000, and assessing where I thought Amazon would fall on the
list in 2010. In making the judgment that Amazons revenues would jump to about $41
billion in 2010, I was guided by what I perceive to be the companys good management
team and solid business model. I must confess that the revenue growth rates in the
intermediate years, to get from the existing revenues of $1.1 billion to the expected

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revenues of $41 billion in year 11 were just assumed, with the only guidance being that
the growth rates would become lower as the company became bigger. To get the target
pre-tax operating margin, I estimated the average margin across all specialty retailers in
2000, and assumed that Amazons margin would converge on the average over time,
again using a very simplistic adjustment process for estimating margins in the
intermediate years.2
In estimating revenues for Facebook, I adopted an even simpler approach. Given that
the prevailing wisdom was that Facebook would make the bulk of its revenues from
advertising and that its immense user base of almost a billion would provide a pathway to
success, I used the revenue growth path of Google over the first eight years of its
existence for guidance as can be seen in figure 4:

There are two cautionary notes that need to be added to these predictions. First, while
Facebook user base gives it a significant advantage, it is unclear that the company can use
it to generate the advertising revenues, without violating privacy constraints and driving

To get the margin each year, I assumed that the improvement would be half the distance between the
margin in the prior year and the target margin. Thus, to get the margin in year 1, I took the difference
between the starting margin of -36.71% and the target margin of 10%, and assumed an improvement of
23.36% to get a new margin of -13.35% (-36.71 +23.36% = 13.35%).

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away users. Second, Facebooks business model is still in flux and it is possible that its
revenues may come from products and services, rather than advertising.3
2. Internal Checks for reasonableness
When estimates inputs into a valuation, especially when uncertainty surrounds
each input, you cannot check (except in hindsight) whether an input is correct, but you
can check to see whether your inputs are delivering forecasted values for your company
that are reasonable in future years. It is therefore worth keeping track of your companys
key indicators over time, as your assumptions unfold, to ensure that you are comfortable
with the company that you are building on paper as you go through time.
Return to the valuation of Amazon in 2000, the revenue growth that I am
forecasting in table 1 for the company will come neither easily nor for free. To estimate
how much the company would have to reinvest each year to sustain its revenue growth, I
used the average sales to capital ratio of retail companies (revenues divided by invested
capital) of 3.00 to estimate the reinvestment each year. That reinvestment adds on to the
invested capital base for the company and in conjunction with my forecasted after-tax
operating income each year allows me to compute the imputed return on capital each
year:
Table 2: Reinvestment, Invested Capital and Imputed ROIC: Amazon
Revenue

Sales/
Cap

Investment

Invested
Capital

EBIT
(1-t)

$487

-$410

$2,793

$1,676

3.00

$559

$1,045

-$373

-76.62%

$5,585

$2,793

3.00

$931

$1,976

-$94

-8.96%

$9,774

$4,189

3.00

$1,396

$3,372

$407

20.59%

$14,661

$4,887

3.00

$1,629

$5,001

$871

25.82%

$19,059

$4,398

3.00

$1,466

$6,467

$1,058

21.16%

$23,862

$4,803

3.00

$1,601

$8,068

$1,438

22.23%

$28,729

$4,868

3.00

$1,623

$9,691

$1,799

22.30%

$33,211

$4,482

3.00

$1,494

$11,185

$2,119

21.87%

$36,798

$3,587

3.00

$1,196

$12,380

$2,370

21.19%

10

$39,006

$2,208

3.00

$736

$13,116

$2,524

20.39%

TY

$41,346

$2,340

NA

Year

Revenues

LTM

$1,117

1
2

Assumed to be =

Imputed
ROC

20.00%

TY: Terminal year (year 11)

Based on my inputs, I am giving Amazon a return on invested capital of 20.39% in year

10. While that is a high value, I feel optimistic enough about the company to stay with
my assumptions. If, in contrast, the imputed return on capital in year 10 had been 80%, I

In the year prior to its IPO, Facebook derived 12% of its revenues from Zynga, an online gaming
company that sells virtual products for its games.

18
would have been inclined to lower my revenue growth and/or reduce my sales to capital
ratio to get a lower return on capital.
If your estimates of revenue growth are not based upon the peer group, you should
also check your revenues in year 10 against the largest companies in the sector and the
overall market, with the intent of at least ruling out obvious errors, say, a market share
that exceeds 100%.
3. Consistency Tests
When valuing companies, you make assumptions about growth, risk and cash flows
and these assumptions, even if made independently, are interrelated. Thus, high growth
companies generally are high risk and require high reinvestment (which reduces near
term cash flows). The simplest way to preserve consistency between growth and
reinvestment is to estimate the growth as a function of how the company reinvests back
into the business (a reinvestment rate or retention ratio) and how well it reinvests (a
return on capital or equity), as seen in figure 5:
Figure 5: Sustainable Growth
Expected Growth

Net Income

Retention Ratio=
1 - Dividends/Net
Income

Return on Equity
Net Income/Book Value of
Equity

Operating Income

Reinvestment
Rate = (Net Cap
Ex + Chg in
WC/EBIT(1-t)

Return on Capital =
EBIT(1-t)/Book Value of
Capital

This is the process I use to estimate the expected growth rate for 3M, where the expected
growth rate of 7.5% is estimated as the product of the reinvestment rate (30%) and the
return on capital (25%), and for Tata Motors, where the expected growth rate of 12% is
the product of the reinvestment rate (70%) and the return on capital (17.16%). For
Amazon and Facebook, the growth rates during the high growth period are untethered to
this sustainable growth equation, because of changing margins, but the growth rate in
perpetuity is strictly constrained to this equation (as you will see in the next section).
When working with different currencies, the consistency test also has to be
applied at a more general level, with both the cash flows and discount rates being
estimated in the same currency. Thus, if your cash flows are in Euros, your discount rate
has to be estimated in Euros. While risk free rates will vary across currencies, they do so
because of differences in expected inflation across currencies. Thus, using a higher
inflation currency will result in both higher discount rates and higher expected growth
rates, with the net effect being neutralized (if you are internally consistent). The valuation

19
of Tata Motors, which was done in Indian rupees, could have been done in US dollars,
with the resulting output in table 3:
Table 3: Tata Motors: Indian Rupee versus US $ Valuations

While the discount rate in US dollars is lower than the discount rates in rupees, that effect
is exactly offset by the higher growth rate in rupees. The valuation in US dollars yields
exactly the same value per share as the valuation in rupees.
4. Economic first principles
When doing valuation, you are free to make assumptions about how your company
will evolve over time in the market that it operates, but you are not free to violate first
principles in economics and mathematics. Put differently, there are assumptions in
valuation that are either mathematically impossible or violate basic laws of economics
and cannot be ever justified, no matter how special a company or circumstances may be.
There is no number more susceptible to violations of economic first principles
that the terminal value, where the assumption of a growth rate forever has to be
reconciled with a growth rate in the overall economy and the reinvestment requirements
for stable growth rate to be sustained. Using the four companies that we valued to
illustrate, we estimate the terminal value of each company, while varying the stable
growth rate:

20
Table 4: Terminal Value Estimates and Expected Growth

There are two things to note about this table. The first is that the stable growth rates
are capped at different levels with each company, with the caps being driven by the
differences in risk free rates in the valuations. Thus, in the 3M valuation, where the risk
free rate is 3.72%, the growth rate is capped at 3% whereas the growth rate for Amazon is
allowed to go up to 6%, since the risk free rate at the time of the valuation was 6.5%.
This is my simplistic rule for preventing companies from growing at rates that exceed the
growth rate of the economy forever (a mathematical impossibility) and it is based on the
assumption that the risk free rate is a good proxy for the nominal growth rate of the
economy. The second is that the terminal values dont change for 3M and Tata Motors, as
the growth rates change, reflecting an economic first principle that growth cannot have
value unless it is accompanied by excess returns (captured as the difference between the
return on invested capital and cost of capital). For these two companies, the gain from
having a higher growth rate is exactly offset by the higher reinvestment (and lower cash
flows) that the higher growth entails. For Amazon and Facebook, higher growth does
generate higher terminal values, but only because I am assuming that they will generate
excess returns in perpetuity.
5. The Market as a crutch
When valuing companies, analysts are faced with the challenge of estimating dozens
of inputs. On some of these inputs, it is not just easier but it is also prudent to accept
market inputs for numbers, especially when you (as an investor) have to be a price taker
on these variables. Consider the equity risk premium (the premium that you expect to

21
earn investing in stocks as opposed to the riskfree security), a key input into the cost of
equity and capital. It is common practice for analysts to try to estimate this number using
historical data on stock and government security returns. In table 5, I report on the
historical premiums earned by stocks over US treasury bills and bonds:
Table 5: Historical Equity Risk Premiums: United States (1928-2012)
Arithmetic Average
Geometric Average
Stocks - T. Bills
Stocks - T. Bonds
Stocks - T. Bills
Stocks - T. Bonds
1928-2012

7.65%
(2.20%)

5.88%
(2.33%)

5.74%

4.20%

1962-2012

5.93%
(2.38%)

3.91%
(2.66%)

4.60%

2.93%

2002-2012

7.06%
(5.82%)

3.08%
(8.11%)

5.38%

1.71%

*Standard errors in brackets below arithmetic averages

Note that if you decide to use historical risk premiums, not only do you have to make a
judgment on which equity risk premium (ranging from 1.71% to 7.65%) from this table
to use but no matter which number you pick, that estimate is going to come with a large
standard error. Even with the longest time period (1928-2012), the standard error of
2.33% suggests a range of between 1% and 10% for the equity risk premium.
There is a way that you can use the market as a crutch, when computing this
number. If you look at how stocks are priced collectively and are willing to estimate the
expected collective cash flows from investing in stocks, you can solve for the internal
rate of return that will make the present value of cash flows equal to the level of stock
prices today. That will, in turn, yield an implied equity risk premium. That is what I do in
figure 6, where I estimate an imputed expected return of 7.54%, at the start of 2013, for
the S&P 500, resulting in an implied equity risk premium of 5.78%.
Figure 6: Implied ERP for S&P 500: January 2013
In 2012, the actual cash
returned to stockholders was
72.25. Using the average total
yield for the last decade yields
69.46

After year 5, we will assume that

earnings on the index will grow at
1.76%, the same rate as the entire
economy (= riskfree rate).

Analysts expect earnings to grow 7.67% in 2013, 7.28% in 2014,

scaling down to 1.76% in 2017, resulting in a compounded annual
growth rate of 5.27% over the next 5 years. We will assume that
dividends & buybacks will tgrow 5.27% a year for the next 5 years.

73.12

76.97

81.03

85.30

89.80

73.12 76.97 81.03 85.30 89.80

89.80(1.0176)
1426.19 =
+
+
+
+
+
January 1, 2013
(1+ r) (1+ r)2 (1+ r)3 (1+ r)4 (1+ r)5 (r .0176)(1+ r)5
S&P 500 is at 1426.19
Expected Return on Stocks (1/1/13)
= 7.54%
Adjusted Dividends & Buybacks
T.Bond rate on 1/1/13
= 1.76%
for base year = 69.46
Equity Risk Premium = 7.54% - 1.76%
= 5.78%

Data Sources:
Dividends and Buybacks
last year: S&P
Expected growth rate:
S&P, Media reports,
Factset, ThomsonReuters

22
By using this premium to value individual companies in early 2013, you are in
effect making your valuations market neutral. Put differently, using any equity risk
premium other than 5.78% to value US companies at the start of 2013 will result in your
incorporating your views on whether the entire market is being priced right into your
individual company valuations. This is the process that I used to estimate the mature
market equity risk premiums in the valuations of the four companies earlier in the paper:
4% for Amazon in 2000 and 3M in September 2008, 4.5% for Tata in 2010 and 6% for
Facebook in 2012.
It is true that Tata Motors, in particular, is exposed to emerging market risk. To
estimate equity risk premiums by market, I again use the market as a crutch. Using local
currency sovereign ratings, I estimated default spreads for individual countries as a
starting point and convert these spreads into country risk premiums. The July 2013
update, with a mature market premium of 5.75% as the base, is provided in figure 7:
Figure 7: Country and Total Equity Risk Premiums: July 2013

Incidentally, the equity risk premiums estimated for emerging markets in this figure
apply not just to emerging market companies but also should be used to compute equity
risk premiums for developed market companies that derive revenues from emerging
markets. Thus, if a company derives 60% of its revenues in the United States and 40%

23
from Brazil, the equity risk premium that you will use to value the company will be
6.95%.
6. The Law of Large Numbers
When faced with an uncertain future, every estimate you makes comes with error but
it is a statistical reality that if your estimates are unbiased and independent, the mistakes
will average out. This law of large numbers can be used to great effect on inputs where
you are faced with uncertainty.
Consider, for instance, the challenge of estimating the relative risk measure (beta)
for a company. The conventional practice is to run a regression of returns on the stock
against a market index, as is the case in figure 8 for Tata Motors in 2010:
Figure 8: A Regression Beta for Tata Motors

Not only is this regression beta subject to choices on the index to use (Sensex, S&P 500,
MSCI Global), the time period for the regression (2years, 5 years) and the time intervals
used (daily, weekly, monthly) but it comes with significant noise (with the beta of 1.405
accompanied by a standard error of 0.129). To get around the estimation problem, I
estimated a beta for Tata Motors by first estimating the average unlevered beta (0.98) for
automobile companies listed globally and then applying Tata Motors debt to equity ratio
(33.87%) and the marginal tax rate for India (33.99%) to obtain a levered beta of 1.20 for
the company.
Unlevered beta for an automobile company = 0.98 (Global average)
D/E ratio for Tata Motors = 33.87% (Market values)
Marginal tax rate in India = 33.99%
Levered beta = 0.98 (1+ (1-.3399)(.3387)) = 1.20

24
I used the same process to estimate betas for 3M, Amazon and Facebook. These sectoraverage betas have much lower standard errors (since they are based on larger samples)
and less susceptible to measurement choices.4
7. Not all risk is meant for the discount rate
It is human nature, when confronted with uncertainty, to try to incorporate that
uncertainty into the discount rate. That can be dangerous in two cases. The first is when
the risk is firm-specific or estimation risk, which is likely to be diversified away in a
portfolio. Here, pushing the discount rate up to incorporate the risk will reduce value
unnecessarily. The other is when the risk is a discrete one (nationalization, default).
Denial is not an option, especially when the likelihood of the event occurring is nontrivial and the consequences are catastrophic to investors. Here, the risk may affect value
but the discount rate is not easily adjusted for this risk.
Assume that you are valuing a very young business, and are worried that the business
may not survive. You are right to worry, since there is a high probability that young
businesses will not make it. Figure 9 summarizes the survival rates, by type of business,
for young startups in different sectors:
Figure 9: Survival Rates by Sector for Startups

Only a third of the companies overall make through the first seven years of existence.
Venture capitalists who confront this problem in their investments try to incorporate the

The unlevered betas, by sector/industry, for US, emerging market, Europe and Japanese companies are
reported on my website, http://www.damodaran.com, under updated data.

25
survival risk into their discount rates by demanding arbitrarily high target rates of return5,
which when used to discount the values at which they expect to get when they exit (by
selling the business or taking it public) reduces the values of the businesses.
Rather than try to hike up the discount rate to a point where it becomes more a
negotiating tool than a measure of required return, I would suggest using a more
reasonable discount rate (which reflects business but not failure risk) to come up with a
going concern value and then estimating the likelihood and consequences of failure
separately to arrive at an expected value:
Risk adjusted Value = Going concern value (Probability of survival) + Liquidation value
(Probability of failure)
Thus, if you value a business at $1 billion as a going concern (from a discounted cash
flow valuation) and then estimate that there is a 40% chance that the business will not
make it (and $100 million in liquidation value), your expected value will be $ 640
million:
Expected value = $ 1 billion (.60) + $100 million (.40) = $640 million
This approach can be generalized to cover any kind of discrete risk including
nationalization (probability of nationalization and expected proceeds from
nationalization).
8. Confront uncertainty
Rather than hide from uncertainty or wish it away, it is often freeing to face up to
uncertainty, using statistical tools. One effective tool is to a simulation, where you allow
inputs to take the form of distributions, rather than be single numbers. These distributions
can then be used to extract values (rather than a single value) that can be plotted on a
distribution. Take the Facebook valuation from earlier, where I assume three key inputs,
revenue growth of 40% a year for the next 5 years, the target operating margin of 35%
and the sales to capital ratio of 1.50, to arrive at a value per share of $25.39. I replaced
the single values for the three key inputs with the distributions shown in figure 10.6

It is not uncommon to see venture capitalists use target rates of return in excess of 50% for young, start up
businesses.
6 I used Crystal Ball, an Oracle product that is add-in into Excel to do this simulation. If you are unsure
about the distribution choices in a simulation, you may find a paper that I have on using statistics in
valuation useful.

26
Figure 10: Probability Distributions Key Inputs for Facebook valuation

These distributions were used to generate a distribution of values for Facebook shares,
rather than a single estimate of value:

27
Figure 11: Facebook Simulated Values per Share

Note that while the median value stays around the base case value of $25.39, there is
substantially more information in this output than in the DCF valuation. For instance, if
you were asked to assess the likelihood that the firm was under valued at its IPO offering
price of $38, you could draw on the distribution in table 6 to make your judgment.
Table 6: Distribution of Simulated Values: Facebook

At a $38 offering price, there is about a 75% chance that the stock is over valued.
Simulations are not the only statistical tools that allow you to handle uncertainty
better. If the risk is sequential, as is the case for a pharmaceutical company facing the

28
three-stage FDA approval process for a new drug, you can use decision trees. You could
also do scenario analysis, if a companys value is likely to be different under clearly
defined scenarios.
9. Dont look for precision
Investors who look for precision in valuation are setting themselves up for failure and
self-flagellation. A little humility helps ease the pain of failure and so does the
recognition that no matter how careful you are in getting your inputs and how well
structured your model is, you will be wrong almost all of the time.
That does not mean that your valuations are a waste of your time and effort. After all,
you dont have to be right to make money. You just have to be less wrong than the rest of
the market. With Amazon, a company that I valued from 1999 through the middle of the
last decade, this can be seen in figure 12 that compares my valuations of the company
with the market prices:
Amazon: Value and Price
Figure 12: Amazon Intrinsic Value versus Market Price
$90.00
$80.00

$70.00

$60.00

$50.00
Value per share
Price per share

$40.00

$30.00
$20.00

$10.00

$0.00
2000

2001

2002

2003

Time ofvalue
analysischanged over the years as new information
Note that my estimate of Amazons
comes out about the company, the sector and the economy. However, the market changed
its mind much more than I did over this same time period. Put differently, if your intent is
to make money off market mistakes, you have a much better shot of doing so with
companies like Amazon or Facebook where there is a great deal of uncertainty about the
future than with a company like 3M.

29
10. Mistakes are okay but bias is not
When you are wrong on individual company valuations, as you inevitably will be,
recognize that while those mistakes may cause the value to be very different from the
price for an individual company, the mistakes should average out across companies. Put
differently, if you are an investor, you have can make the law of large numbers work
for you by diversifying across companies, with the degree of diversification increasing as
uncertainty increases. If you are bringing something to the table in your valuations, your
portfolio will reflect that value added over time.
If you are biased on individual company valuations, your mistakes will not average
out, no matter how diversified you get. The bottom line is that you are better off making
large mistakes and being unbiased than making smaller mistakes, with bias. How do you
minimize bias? First, dont spend too much time reading other peoples opinions on the
company (equity research reports, for instance). Even if these analysts have good reasons
for their views, it will inevitably seep into your valuations and make it difficult for you to
be objective. Second, do not get too close to the managers of a company. While they may
know far more about the company than you do, they are also biased and unlikely to be
good sources of information. Third, be honest with yourself about your biases. If you
really love (or hate) a company, being aware of this will help you counter some of the
bias that will find its way into your final numbers.

Pricing Uncertainty
In the last section, we focused on the uncertainties associated with the estimation
of the value of a business or asset. In this section, we will look at the additional
uncertainty that investors face when they invest in traded assets, where they not only
have to be right on value but also have to be right on price.
The Pricing Process
Every traded asset has a price. While we can theorize about what drives that price
and relate it to fundamentals, the price itself is determined by demand and supply. If there
is anything that we have learned (or should have learned) from behavioral finance over
the last three decades, it is that investors are driven by more than just fundamentals, when
pricing assets. Momentum, herd behavior and behavioral quirks can all affect the demand
and supply for investments, and through them the price. Consequently, the pricing
process can, and often is, disconnected from the intrinsic value process and the
disconnect gets wider when there is more uncertainty. In figure 13, we illustrate this
disconnect:

30
Figure 13: Value Process versus Price Process

Note that there are three key components to this picture. The first is there can be a gap
between the estimated value for an asset and its price, which can be caused by
information gaps/mistakes, illiquidity and corporate governance concerns, on the one
hand, and behavioral factors, on the other. The second is that the tools that are
instrumental in assessing value are not necessarily the tools that are most useful in
understanding price. Thus, while intrinsic value investors are often disdainful of the use
of multiples (PE ratio, EV to EBITDA etc.) and charts in investing, they can be handy in
understanding price movements.
Mind the Gap
If the value for an asset is driven by its fundamentals and the price is set by
demand and supply, the question of whether there is a gap between and price and value,
and what may cause this gap is at the heart of the debate about efficient markets and the
payoff to active investing.
Views of the Gap
Each investment philosophy takes a different view about the magnitude of the gap
between price and value and the potential for the gap to close.
The Efficient Marketer: If you are a true believer in efficient markets, you are not
assuming that price will be always equal to value but you are assuming that any
gaps between price and value occur randomly. Consequently, any resources that
investors expend to identify and exploit the gap, whether it be looking at charts or
valuing companies, will be wasted.

31

The value investing purist: If you are a value-investing purist, you view the
market as fickle and subject to moods and fancies. You also believe that your
superior assessments of value allow you to identify gaps between the market-set
price and the value and that the price will adjust to your value, sooner or later.
With a long enough time horizon, you believe that you will be able to win against
the market.
The pricer/trader: At the other end of the spectrum from the value investor is the
pricer or trader, who believes that intrinsic valuation is impossible to do well,
largely because of the assumptions that are required to get to an estimate of value.
If you are a pricer, you believe that the key to investing success is to get an edge
in the pricing game, using charts (technical analysis) or relative valuation
(multiples with comparable companies) to assess where the price will move next.
In its more sophisticated forms, it can also take the form of arbitrage, where you
try to find the same or similar assets (in terms of cash flows and risk) priced
differently in different markets.

The Weakest links

So, should you be a believer in efficient markets, a true value investor or a pricer?
Each approach comes with its pluses and minuses, and requires an assessment of the
trade off.
If you go the efficient markets route, you will save yourself a substantial amount
of time, money and stress, but you have to accept the fact that you will never beat the
market. To the extent that none of us want to be average investors, this is a difficult fate
to accept for many investors, even though it may be the sensible one.
If you decide to play the pricing game, you are avoiding the hard questions that
you will be forced to confront in the pursuit of value, but there are three potential costs:
You have no anchor: If you do not believe in intrinsic value and make no attempt to
estimate it, you have no moorings when you invest. You will therefore be pushed
back and forth as the price moves from high to low. In other words, everything
becomes relative and you can lose perspective. In sectors where there is substantial
uncertainty about the future (dot com companies in the last 1990s or social media
companies in 2012) or in periods of market crisis (2008 banking crisis), this can
translate into massive mispricing across the board.
You will be reactive: Without a core measure of value, your investment strategy will
often be reactive rather than proactive. As a consequence, whether you buy or sell an

32
asset will be driven by what has happened in the past and what others think about the
investment right now.
Crowds are fickle and tough to read: The key to being successful in the pricing game
is to be able to read the crowd mood and to detect shifts in that mood early in the
process. By their nature, crowds are tough to read and almost impossible to model
systematically.
Looking at the market, it is clear that most investors (including many who claim to be
value investors) play the pricing game, that many of these investors dont play it well and
even those who play it well have trouble maintaining consistency.
If you determine that the value game is your best choice, you face a different set
of risks. First, since the gap is between your estimate of value and the price, you face
uncertainty about the magnitude of the gap. After all, you can be wrong on your value
estimate and there may be no gap to begin with. Second, even if you feel comfortable
with your value estimate and believe that there is a gap between price and value, you
make money only as the gap closes, and there is the risk that the gap may not close. In
fact, there is the real chance that the gap will widen, at least in the near term. In the next
section, we will look at strategies and techniques that you can use to manage the gap.
Managing Gap Risk
If the two primary risks that you face as a value investor are uncertainty about the
magnitude of the gap (between price and value) and how it will behave over time, there
are ways you can reduce your exposure to one or both risks.
1. Give yourself a margin for error: If you accept the proposition that your estimate
of value comes with error, it behooves you to look for some protection against
your mistakes. The simplest technique to do so is to build in a margin of safety,
where your investment decisions are triggered only when the difference between
price and value exceeds a specified amount. Thus, you may decide to buy a stock
only if the value exceeds the price by more than 25%, giving yourself an
equivalent margin for error. In fact, value investors have long used a margin of
safety (MOS) as a protective device, arguing that it is a better way to control for
risk than conventional risk measures. While the MOS is intuitively appealing, we
would add a few cautionary notes:
The margin of safety comes into play at the end of the investment process, not
at the beginning. In other words, to use the margin of safety, you need an
estimate of intrinsic value, which in turn requires you to be able to assess risk
during your valuation process. Since the intrinsic value has to be estimated

33
first, the margin of safety does not substitute for risk assessment and intrinsic
valuation, but augments them.
The margin of safety cannot and should not be a fixed number, but should be
reflective of the uncertainty in the assessment of intrinsic value. In fact, one
way to tie in your valuation uncertainty to the margin of safety is to use
simulations, as suggested in the earlier section on valuation, to get
distributions of estimated value, and then demanding higher margins of safety
for investments with more volatile distributions. Thus, you would have
demanded a smaller margin of safety for 3M in September 2008 than for the
Facebook IPO in May 2012.
There is a cost to setting the margin of safety at too high a number, because
you increase the likelihood of inaction errors (where you dont buy
stocks/assets that you should be buying) at the expense of action errors (where
you buy stocks/assets that you should not be buying). If you are a small
investor with an extensive set of great investment opportunities, the cost may
be small but it will rise as your investment portfolio becomes bigger and your
opportunity set gets smaller. A large portfolio manager in a relatively well
priced market who adopts a large margin of safety may not find much to
invest in.
2. Make time your ally: If you are right in your assessment that there is a gap
between price and value, the disconnect between the price and the underlying
fundamentals will eventually become clear to the market, as the company reports
its operating results over time. The longer your time horizon, as an investor, the
more likely it is that you will be able to profit from this market correction.
3. Price catalysts: If you are a value investor who has bought (sold short on) a stock,
because you believe that the value is greater (lower) than the price, you improve
your odds of success if you can provide a catalyst for the market to correct its
mistake. One advantage that activist investors with a substantial fund base have
over the rest of the market is that they can act as catalysts, both because of the
size of their investments and their capacity to make their case public (in the news
media or at annual meetings). As smaller investors, though, you can improve your
odds by looking for catalysts at the companies you invest in. In addition to the
entry of activist investors, these could include the replacement of a top
management team or a hostile acquisition bid for your company.

34

Conclusion
There are four key points that I hope that I was able to make in this paper. The
first is that uncertainty, in valuation and investing, is a feature and not a bug. It may make
you uncomfortable but it is also the reason that you earn risk premiums. Put differently, if
you want the absolute comfort that comes with certainty, then you should be willing to
settle for the risk free rate as your return. The second is that the most common responses
to uncertainty, which include denial, paralysis, outsourcing, herding and rules of thumb,
all too often lead to bad conclusions. The third is that you can still value companies in the
face of large uncertainties, if you keep your valuations simple and internally consistent,
though you should not expect precision in your final valuation. In fact, the best
opportunities for investing are often in companies where the uncertainties are
overwhelming. The final point is that the uncertainty you feel about your estimate of
value is augmented by the risk that the market price will not adjust to that value, even if
you are right in your assessment. That uncertainty can be mitigated by building in a
margin of safety into your investment decisions, having a longer time horizon or looking
for price catalysts, but it cannot be eliminated.