Website: http://www.damodaran.com !

Blog: http://aswathdamodaran.blogspot.com! Aswath Damodaran!

Twitter: @AswathDamodaran!
App (iPad/iPhone): uValue (in iTunes app store)!

VALUATION:  ART,  SCIENCE,  

CRAFT  OR  MAGIC?  
Aswath  Damodaran  
www.damodaran.com  
Some  IniCal  Thoughts  

"  One  hundred  thousand  lemmings  cannot  be  wrong"      

             
 GraffiC  

Aswath Damodaran!
2!
MisconcepCons  about  ValuaCon  

¨  Myth  1:  A  valuaCon  is  an  objecCve  search  for  “true”  value  
¤  Truth  1.1:  All  valuaCons  are  biased.  The  only  quesCons  are  how  much  and  
in  which  direcCon.  
¤  Truth  1.2:  The  direcCon  and  magnitude  of  the  bias  in  your  valuaCon    is  
directly  proporConal  to  who  pays  you  and  how  much  you  are  paid.  
¨  Myth  2.:  A  good  valuaCon  provides  a  precise  esCmate  of  value  
¤  Truth  2.1:  There  are  no  precise  valuaCons  
¤  Truth  2.2:  The  payoff  to  valuaCon  is  greatest  when  valuaCon  is  least  
precise.  
¨  Myth  3:  .  The  more  quanCtaCve  a  model,  the  beTer  the  valuaCon  
¤  Truth  3.1:  One’s  understanding  of  a  valuaCon  model    is  inversely  
proporConal  to  the  number  of  inputs  required  for  the  model.  
¤  Truth  3.2:  Simpler  valuaCon  models  do  much  beTer  than  complex  ones.  

Aswath Damodaran!
3!
Approaches  to  ValuaCon  

¨  Intrinsic  valua-on,  relates  the  value  of  an  asset  to  
the  present  value  of  expected  future  cashflows  on  
that  asset.  In  its  most  common  form,  this  takes  the  
form  of  a  discounted  cash  flow  valuaCon.  
¨  Rela-ve  valua-on,  esCmates  the  value  of  an  asset  
by  looking  at  the  pricing  of  'comparable'  assets  
relaCve  to  a  common  variable  like  earnings,  
cashflows,  book  value  or  sales.    
¨  Con-ngent  claim  valua-on,  uses  opCon  pricing  
models  to  measure  the  value  of  assets  that  share  
opCon  characterisCcs.    
Aswath Damodaran!
4!
Discounted  Cash  Flow  ValuaCon  

¨  What  is  it:  In  discounted  cash  flow  valuaCon,  the  value  of  an  asset  
is  the  present  value  of  the  expected  cash  flows  on  the  asset.  
¨  Philosophical  Basis:  Every  asset  has  an  intrinsic  value  that  can  be  
esCmated,  based  upon  its  characterisCcs  in  terms  of  cash  flows,  
growth  and  risk.  
¨  Informa3on  Needed:  To  use  discounted  cash  flow  valuaCon,  you  
need  
¤  to  esCmate  the  life  of  the  asset  
¤  to  esCmate  the  cash  flows  during  the  life  of  the  asset  
¤  to  esCmate  the  discount  rate  to  apply  to  these  cash  flows  to  get  present  
value  
¨  Market  Inefficiency:  Markets  are  assumed  to  make  mistakes  in  
pricing  assets  across  Cme,  and  are  assumed  to  correct  themselves  
over  Cme,  as  new  informaCon  comes  out  about  assets.  

Aswath Damodaran!
5!
 Intrinsic  Value:  Four  Basic  ProposiCons  
6!

The  value  of  an  asset  is  the  present  value  of  the  expected  cash  flows  on  that  
asset,  over  its  expected  life:  

 
1.  The  IT  Proposi3on:  If  “it”  does  not  affect  the  cash  flows  or  alter  risk  (thus  
changing  discount  rates),  “it”  cannot  affect  value.    
2.  The  DUH  Proposi3on:  For  an  asset  to  have  value,  the  expected  cash  
flows  have  to  be  posiCve  some  Cme  over  the  life  of  the  asset.  
3.  The  DON’T  FREAK  OUT  Proposi3on:  Assets  that  generate  cash  flows  
early  in  their  life  will  be  worth  more  than  assets  that  generate  cash  
flows  later;  the  laTer  may  however  have  greater  growth  and  higher  
cash  flows  to  compensate.  
4.  The  VALUE  IS  NOT  PRICE  Proposi3on:  The  value  of  an  asset  may  be  very  
different  from  its  price.  

Aswath Damodaran

6!
DCF  Choices:  Equity  ValuaCon  versus  Firm  
ValuaCon  
Firm Valuation: Value the entire business

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Equity valuation: Value just the

equity claim in the business

Aswath Damodaran!
7!
The  Drivers  of  Value…  

Growth from new investments Efficiency Growth

Growth created by making new Growth generated by
investments; function of amount and using existing assets
quality of investments better
Terminal Value of firm (equity)
Current Cashflows
These are the cash flows from Expected Growth during high growth period
existing investment,s, net of any Stable growth firm,
reinvestment needed to sustain with no or very
future growth. They can be limited excess returns
computed before debt cashflows (to
the firm) or after debt cashflows (to Length of the high growth period
equity investors). Since value creating growth requires excess returns,
this is a function of
- Magnitude of competitive advantages
- Sustainability of competitive advantages

Cost of financing (debt or capital) to apply to

discounting cashflows
Determined by
- Operating risk of the company
- Default risk of the company
- Mix of debt and equity used in financing

Aswath Damodaran!
8!
 DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm Expected Growth

EBIT (1-t) Reinvestment Rate
- (Cap Ex - Depr) * Return on Capital
Firm is in stable growth:
- Change in WC
Grows at constant rate
= FCFF
forever

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

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn
Value of Operating Assets .........
+ Cash & Non-op Assets Forever
= Value of Firm
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
- Value of Debt
= Value of Equity

Cost of Equity Cost of Debt Weights

(Riskfree Rate Based on Market Value
+ Default Spread) (1-t)

Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
- In same currency and + - Measures market risk X
risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium Premium
Aswath Damodaran!
 Cap Ex = Acc net Cap Ex(255) +
Acquisitions (3975) + R&D (2216) Amgen: Status Quo
Return on Capital
Current Cashflow to Firm Reinvestment Rate 16%
EBIT(1-t)= :7336(1-.28)= 6058 60%
- Nt CpX= 6443 Expected Growth
in EBIT (1-t) Stable Growth
- Chg WC 37 .60*.16=.096 g = 4%; Beta = 1.10;
= FCFF - 423 9.6% Debt Ratio= 20%; Tax rate=35%
Reinvestment Rate = 6480/6058 Cost of capital = 8.08%
=106.98% ROC= 10.00%;
Return on capital = 16.71% Reinvestment Rate=4/10=40%
Growth decreases Terminal Value10 = 7300/(.0808-.04) = 179,099
First 5 years gradually to 4%
Op. Assets 94214 Year 1 2 3 4 5 6 7 8 9 10 Term Yr
+ Cash: 1283 EBIT $9,221 $10,106 $11,076 $12,140 $13,305 $14,433 $15,496 $16,463 $17,306 $17,998 18718
- Debt 8272 EBIT (1-t) $6,639 $7,276 $7,975 $8,741 $9,580 $10,392 $11,157 $11,853 $12,460 $12,958 12167
=Equity 87226 - Reinvestment $3,983 $4,366 $4,785 $5,244 $5,748 $5,820 $5,802 $5,690 $5,482 $5,183 4867
-Options 479 = FCFF $2,656 $2,911 $3,190 $3,496 $3,832 $4,573 $5,355 $6,164 $6,978 $7,775 7300
Value/Share $ 74.33
Cost of Capital (WACC) = 11.7% (0.90) + 3.66% (0.10) = 10.90%
Debt ratio increases to 20%
Beta decreases to 1.10

On May 1,2007,
Amgen was trading
Cost of Equity Cost of Debt at $ 55/share
11.70% (4.78%+..85%)(1-.35) Weights
= 3.66% E = 90% D = 10%

Riskfree Rate: Risk Premium

Riskfree rate = 4.78% Beta 4%
+ 1.73 X

Unlevered Beta for

Sectors: 1.59 D/E=11.06%
Aswath Damodaran!
 Average reinvestment rate
Tata Motors: April 2010 from 2005-09: 179.59%; Return on Capital
without acquisitions: 70% Stable Growth
17.16%
Current Cashflow to Firm g = 5%; Beta = 1.00
EBIT(1-t) : Rs 20,116 Reinvestment Rate
Expected Growth Country Premium= 3%
- Nt CpX Rs 31,590 70%
from new inv. Cost of capital = 10.39%
- Chg WC Rs 2,732 Tax rate = 33.99%
.70*.1716=0.1201
= FCFF - Rs 14,205 ROC= 10.39%;
Reinv Rate = (31590+2732)/20116 = Reinvestment Rate=g/ROC
170.61%; Tax rate = 21.00% =5/ 10.39= 48.11%
Return on capital = 17.16%

Terminal Value5= 23493/(.1039-.05) = Rs 435,686

Rs Cashflows
Op. Assets Rs210,813 Year 1 2 3 4 5 6 7 8 9 10
+ Cash: 11418 EBIT (1-t) 22533 25240 28272 31668 35472 39236 42848 46192 49150 51607 45278
+ Other NO 140576 - Reinvestment 15773 17668 19790 22168 24830 25242 25138 24482 23264 21503 21785
- Debt 109198 FCFF 6760 7572 8482 9500 10642 13994 17711 21710 25886 30104 23493
=Equity 253,628

Value/Share Rs 614
Discount at Cost of Capital (WACC) = 14.00% (.747) + 8.09% (0.253) = 12.50%
Growth declines to 5%
and cost of capital
moves to stable period
level.
Cost of Equity Cost of Debt
14.00% (5%+ 4.25%+3)(1-.3399) Weights
E = 74.7% D = 25.3% On April 1, 2010
= 8.09% Tata Motors price = Rs 781

Riskfree Rate:
Rs Riskfree Rate= 5% Beta Mature market Country Equity Risk
+ 1.20 X premium + Lambda X Premium
4.5% 0.80 4.50%

Unlevered Beta for Firmʼs D/E Rel Equity

Country Default
Aswath Damodaran! Sectors: 1.04 Ratio: 33%
Spread X Mkt Vol
1.50
3%
 Natura (February 2014) Reinvestment Rate Return on Capital Stable Growth
54.6% 39.66% g = 10%; Beta = 1.00
Current Cashflow to Firm Cost of capital = 16.35%
EBIT(1-t) = 1,338 (1-.3165) = R$ 914 Tax rate = 34.00%
Expected Growth
- Nt CpX = 603- 150 = R$ 453 ROC= 25%;
from new
- Chg WC = R$ 46 Reinvestment Rate=g/ROC
investments
= FCFF = R$415 =10%/ 25%= 40%
.546*.3966=0.2165
Reinv Rate = (453+46)/914= 54.6%
Return on capital = 914/2226 = 39.66%
Terminal Value10= 3,072/(..1635-.10) = R$48,394

Year 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Op. Assets R$ 14,397 EBIT R$51,628 R$51,980 R$52,409 R$52,931 R$53,565 R$54,254 R$54,977 R$55,707 R$56,410 R$57,051 Terminal year (2024)
Tax5rate 31.89% 32.12% 32.36% 32.59% 32.83% 33.06% 33.30% 33.53% 33.77% 34.00%
+ Cash: R$ 960 EBIT (1-t) =R$5,119
EBIT5(1<t) R$51,109 R$51,344 R$51,629 R$51,975 R$52,395 R$52,848 R$53,320 R$53,793 R$54,246 R$54,654
- Debt R$ 2,610 5<5Reinvestment R$5605 R$5734 R$5890 R$51,079 R$51,307 R$51,472 R$51,619 R$51,739 R$51,822 R$51,862 - Reinvestment =R$2,048
- Min Int. R$ 18 5=5FCFF R$5503 R$5610 R$5740 R$5897 R$51,087 R$51,376 R$51,701 R$52,054 R$52,424 R$52,792 = FCFF = R$3,072
=Equity R$ 12,731
- Options R$ 65
Value/Share Rs 28.67 Cost of capital = 19.83% (1-.8665) + 9.56% (.1335) = 18.46%
Growth declines to 10%
and cost of capital
moves to stable period
Cost of Equity level.
Cost of Debt Weights
19.83% E = 86.65% D = On February 14, 2014
(11.28%+1.90%+1.30%)(1-.34) = 9.56%
13.35% Natura Price = $R 38.34/share

Riskfree Rate: Beta Equity Risk Premium

X
Rs Riskfree Rate= + 1.07 7.98%
11.28%
Brazil 88.72% 7.85% 88.72%
Argentina 2.57% 14.75% 2.57%
Unlevered Beta for Firm’s D/E
Chile 2.57% 5.90% 2.57%
Sectors: 0.97 Ratio: 15.4%
Peru 2.57% 7.85% 2.57%
Mexico 1.79% 7.40% 1.79%
Colombia 1.79% 8.30% 1.79%
Natura 100.00% 7.98% 100.00%

Aswath Damodaran!
 Aswath Damodaran!

DCF  INPUTS  
“Garbage  in,  garbage  out”  
I.  Measure  earnings  right..    

Operating leases R&D Expenses

Firmʼs Comparable - Convert into debt - Convert into asset
history Firms - Adjust operating income - Adjust operating income

Normalize Cleanse operating items of

Earnings - Financial Expenses
- Capital Expenses
- Non-recurring expenses

Measuring Earnings

Update
- Trailing Earnings
- Unofficial numbers

Aswath Damodaran!
14!
OperaCng  Leases  at  Amgen  in  2007  
¨  Amgen  has  lease  commitments  and  its  cost  of  debt  (based  on  it’s  A  raCng)  is  5.63%.  
Year  Commitment  Present  Value  
1    $96.00      $90.88    
2    $95.00      $85.14    
3    $102.00      $86.54    
4    $98.00      $78.72    
5    $87.00      $66.16    
6-­‐12    $107.43      $462.10  ($752  million  prorated)  
¨  Debt  Value  of  leases  =      $869.55    
¨  Debt  outstanding  at  Amgen  =  $7,402  +  $  870  =  $8,272  million  
¨  Adjusted  OperaCng  Income  =  Stated  OI  +  Lease  expense  this  year  –  DepreciaCon  
 =  5,071  m  +  69  m  -­‐  870/12  =  $5,068  million  (12  year  life  for  assets)  
¨  Approximate  OperaCng  income=  stated  OI  +  PV  of  Lease  commitment  *  Pre-­‐tax  cost  of  debt  
=  $5,071  m  +  870  m  (.0563)  =  $  5,120  million  

Aswath Damodaran!
15!
Capitalizing  R&D  Expenses:  Amgen  
¨  R  &  D  was  assumed  to  have  a  10-­‐year  life.    
Year    R&D  Expense  UnamorCzed  porCon    AmorCzaCon  this  year  
Current    3366.00    1.00  3366.00    
-­‐1    2314.00    0.90  2082.60    $231.40    
-­‐2    2028.00    0.80  1622.40    $202.80    
-­‐3    1655.00    0.70  1158.50    $165.50    
-­‐4    1117.00    0.60  670.20    $111.70    
-­‐5    865.00    0.50  432.50    $86.50    
-­‐6    845.00    0.40  338.00    $84.50    
-­‐7    823.00    0.30  246.90    $82.30    
-­‐8    663.00    0.20  132.60    $66.30    
-­‐9    631.00    0.10  63.10    $63.10    
-­‐10    558.00      0.00    $55.80    
Value  of  Research  Asset  =      $10,112.80    $1,149.90    
¨  Adjusted  OperaCng  Income  =  $5,120  +  3,366  -­‐  1,150  =  $7,336  million  

Aswath Damodaran!
16!
II.  Get  the  big  picture  (not  the  accounCng  one)  
when  it  comes  to  cap  ex  and  working  capital  

¨  Capital  expenditures  should  include  

¤  Research  and  development  expenses,  once  they  have  been  re-­‐
categorized  as  capital  expenses.    
¤  AcquisiCons  of  other  firms,  whether  paid  for  with  cash  or  stock.  

¨  Working  capital  should  be  defined  not  as  the  difference  
between  current  assets  and  current  liabiliCes  but  as  the  
difference  between  non-­‐cash  current  assets  and  non-­‐
debt  current  liabiliCes.  
¨  On  both  items,  start  with  what  the  company  did  in  the  
most  recent  year  but  do  look  at  the  company’s  history  
and  at  industry  averages.    

Aswath Damodaran!
17!
Amgen’s  Net  Capital  Expenditures  

¨  The  accounCng  net  cap  ex  at  Amgen  is  small:  
¤  AccounCng  Capital  Expenditures  =    $1,218  million  
¤  -­‐  AccounCng  DepreciaCon  =      $    963  million  
¤  AccounCng  Net  Cap  Ex  =      $    255  million  
¨  We  define  capital  expenditures  broadly  to  include  R&D  and  
acquisiCons:  
¤  AccounCng  Net  Cap  Ex  =      $    255  million  
¤  Net  R&D  Cap  Ex  =  (3366-­‐1150)  =    $2,216  million  
¤  AcquisiCons  in  2006  =      $3,975  million  
¤  Total  Net  Capital  Expenditures  =    $  6,443  million  
¨  AcquisiCons  have  been  a  volaCle  item.  Amgen  was  quiet  on  
the  acquisiCon  front  in  2004  and  2005  and  had  a  significant  
acquisiCon  in  2003.  

Aswath Damodaran!
18!
III.  The  government  bond  rate  is  not  
always  the  risk  free  rate  
¨  When  valuing  Amgen  in  US  dollars,  the  US$  ten-­‐year  bond  rate  of  
4.78%  was  used  as  the  risk  free  rate.  We  assumed  that  the  US  
treasury  was  default  free.  
¨  When  valuing  Tata  Motors  in  Indian  rupees  in  2010,  the  Indian  
government  bond  rate  of  8%  was  not  default  free.  Using  the  Indian  
government’s  local  currency  raCng  of  Ba2  yielded  a  default  spread  
of  3%  for  India  and  a  riskfree  rate  of  5%  in  Indian  rupees.  
 Risk  free  rate  in  Indian  Rupees  =  8%  -­‐  3%  =  5%  
¨  To  value  a  Brazilian  company  in  nominal  Reais,  you  would  need  a  
risk  free  rate  in  $R.  The  ten-­‐year  Brazilian  government  bond  rate  in  
$R  was  13.18%  in  January  2013.  Given  Brazil’s  local  currency  raCng  
of  Baa2,  the  default  spread  for  Brazil  is  1.90%.  
Risk  free  rate  in  $R  =  13.18%  -­‐  1.90%  =  11.28%  

Aswath Damodaran!
19!
 0.00%  
2.00%  
4.00%  
6.00%  
8.00%  
10.00%  
12.00%  
Japanese  Yen  
Taiwanese  $  
Swiss  Franc  
icelandic  Krona  
Czech  Koruna  
Phillipine  Peso  

Aswath Damodaran!
Bulgarian  Lev  
Euro  
Danish  Krone  
Hong  Kong  $  
Lithuanian  Litas  
Thai  Baht  
January  2014  

Dutch  Guilder  
CroaCan  Kuna  
Swedish  Krona  
Singapore  $  
Israeli  Shekel  
BriCsh  Pound  
Canadian  dollar  
Malaysian  Ringgit  
Hungarian  Forint  
Norwegian  Krone  
US  $  
Romanian  Leu  
Polish  Zloty  
Vietnamese  Dong  
Pakistani  Rupee  
Chinese  Remimbi  
Australian  Dollar  
Chilean  Peso  
Colombian  Peso  
Mexican  Peso  
Risk  free  rate  by  Currency:  January  2014  

Peruvian  Sul  
New  Zealand  $  
ArgenCne  Peso  
Russian  Rouble  
Venezuelan  Bolivar  
Indonesian  Rupiah  
South  African  Rand  
Indian  Rupee  
Turkish  Lira  
Kenyan  Shilling  
Nigerian  Naira  
Brazilian  Reais  
Risk  free  rates  will  vary  across  currencies:  

20!
But  valuaCons  should  not..  Tata  Motors  in  
US  dollars  

Aswath Damodaran!
21!
IV.  Betas  do  not  come  from  regressions…  and  
are  noisy…  

Aswath Damodaran!
22!
And  can  be  a  complete  mess,  when  the  market  
index  is  not  a  good  one  

Aswath Damodaran!
23!
Determinants  of  Betas  
Beta of Equity

Beta of Firm Financial Leverage:

Nature of product or
service offered by
company:
Other things remaining equal,
the more discretionary the
product or service, the higher
the beta.
Operating Leverage (Fixed
Costs as percent of total
costs):
Other things remaining equal
the greater the proportion of
the costs that are fixed, the
higher the beta of the
company.
Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
equity beta will be
Implciations
Highly levered firms should have highe betas
than firms with less debt.

Implications
1. Cyclical companies should
have higher betas than non-
cyclical companies.
2. Luxury goods firms should
have higher betas than basic
goods.
3. High priced goods/service
firms should have higher betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.
Implications
1. Firms with high infrastructure
needs and rigid cost structures
shoudl have higher betas than
firms with flexible cost structures.
2. Smaller firms should have higher
betas than larger firms.
3. Young firms should have

Aswath Damodaran!
24!
BoTom-­‐up  Betas  
Step 1: Find the business or businesses that your firm operates in.

Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
obtain their regression betas. Compute the simple average across
these regression betas to arrive at an average beta for these publicly If you can, adjust this beta for differences
traded firms. Unlever this average beta using the average debt to between your firm and the comparable
equity ratio across the publicly traded firms in the sample. firms on operating leverage and product
Unlevered beta for business = Average beta across publicly traded characteristics.
firms/ (1 + (1- t) (Average D/E ratio across firms))

While revenues or operating income

Step 3: Estimate how much value your firm derives from each of are often used as weights, it is better
the different businesses it is in. to try to estimate the value of each
business.

Step 4: Compute a weighted average of the unlevered betas of the If you expect the business mix of your
different businesses (from step 2) using the weights from step 3. firm to change over time, you can
Bottom-up Unlevered beta for your firm = Weighted average of the change the weights on a year-to-year
unlevered betas of the individual business basis.

If you expect your debt to equity ratio to

Step 5: Compute a levered beta (equity beta) for your firm, using change over time, the levered beta will
the market debt to equity ratio for your firm. change over time.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

Aswath Damodaran!
25!
Working  through  with  our  companies  

¨  Amgen  in  2007  

¤  The  unlevered  beta  for  pharmaceuCcal  firms  is  1.59.  Using  Amgen’s  debt  
to  equity  raCo  of  11%  and  the  marginal  tax  for  the  US  in  2007  of  35%,  the  
boTom  up  beta  for  Amgen    is  
¤  BoTom-­‐up  Beta  =  1.59  (1+  (1-­‐.35)(.11))  =  1.73  
¨  Tata  Motors  in  2010  
¤  The  unlevered  beta  for  global  automobile  firms  is  0.98.  Using  Tata  
Motor’s  debt  to  equity  raCo  of  33.87%  and  the  marginal  tax  rate  for  India  
of  33.99%,  the  boTom  up  beta  for  Tata  Motors    is  
¤  BoTom-­‐up  Beta  =  0.98  (1+  (1-­‐.3399)(.3387))  =  1.20  
¤  Natura  in  February  2014  
¤  The  unlevered  beta  for  cosmeCcs  companies  is  0.97.  
¤  The  debt  to  equity  raCo  for  Natura,  based  on  market  values  for  equity  and  
debt,  is  15.4%  and  the  marginal  tax  rate  for  Brazil  is  34.00%.  
¤  BoTom-­‐up  Beta  =  0.97  (1+  (1-­‐.34)(.154))  =  1.07  
 
Aswath Damodaran!
26!
V.  And  the  past  is  not  always  a  good  indicator  of  
the  future  
¨  It  is  standard  pracCce  to  use  historical  premiums  as  forward  looking  premiums.  :  
 " Arithmetic Average" Geometric Average"
 " Stocks - T. Bills" Stocks - T. Bonds" Stocks - T. Bills" Stocks - T. Bonds"
1928-2013" 7.93%" 6.29%" 6.02%" 4.62%"
 Std Error" 2.19%! 2.34%!  "  "
1964-2013" 6.18%" 4.32%" 4.83%" 3.33%"
 Std Error" 2.42%! 2.75%!  "  "
2004-2013" 7.55%" 4.41%" 5.80%" 3.07%"
   Std Error" 6.02%! 8.66%!  "  "
¨  Not  only  is  this  approach  backward-­‐looking,  but  it  yields  esCmates  which  
significant  noise  associated  with  them.  The  standard  error  in  a  historical  esCmate  
will  be  the  following:  

¨  In  most  markets,  you  will  be  hard  pressed  to  find  more  than  a  few  
decades  of  reliable  stock  market  history,  making  historical  risk  
premiums  close  to  useless.  

Aswath Damodaran!
27!
A  forward-­‐looking  alternaCve:  Back  out  an  
implied  equity  risk  premium  

Base year cash flow

Dividends (TTM): 34.32 Expected growth in next 5 years
+ Buybacks (TTM): 49.85 Top down analyst estimate of
= Cash to investors (TTM): 84.16 earnings growth for S&P 500 with
Earnings in TTM: stable payout: 4.28%
Beyond year 5
E(Cash to investors) 87.77 91.53 95.45 99.54 103.80 Expected growth rate =
Riskfree rate = 3.04%
S&P 500 on 1/1/14 = Terminal value =
1848.36 87.77 91.53 95.45 99.54 103.80 103.80(1.0304) 103.8(1.0304)/(,08 - .0304)
+ + + + + = 1848.36!
(1 + !)! (1 + !)! (1 + !)! (1 + !)! (1 + !)! (! − .0304)(1 + !)!

r = Implied Expected Return on Stocks = 8.00%

Minus

Risk free rate = T.Bond rate on 1/1/14=3.04%

Equals

Implied Equity Risk Premium (1/1/14) = 8% - 3.04% = 4.96%

Aswath Damodaran!
28!
 29!

2013

2012

2011

2010

Implied  Premiums  in  the  US:  1960-­‐2013  

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

Year

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1970

1969

1968

1967

1966

Aswath Damodaran!
1965

1964

1963

1962

1961

1960

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Implied Premium

The  Anatomy  of  a  Crisis:  Implied  ERP  from  
September  12,  2008  to  January  1,  2009  

Aswath Damodaran!
30!
Implied  ERP  for  Brazil  versus  US  

Implied  Equity  Risk  Premium  -­‐  Brazil  versus  US    

9.00%  

8.00%   0.69%  

7.00%  
0.65%  
4.00%  4.31%   1.34%  
6.00%   2.43%  
3.23%   3.70%  
0.86%  0.70%  
Risk  Premium  

5.00%   3.15%   2.28%  

4.06%   0.82%   Brazil  Country  Risk  
4.00%   7.64%   US  premium  
6.35%  
3.00%   5.59%  
5.10%  
4.55%  4.86%  
2.00%   4.05%  4.12%  3.95%  3.88%  3.95%  4.04%  
3.51%  
2.50%  
1.00%  

0.00%  

Aswath Damodaran!
31!
VI.  There  is  a  downside  to  globalizaCon…  

¨  Emerging  markets  offer  growth  opportuniCes  but  they  are  also  riskier.  If  
we  want  to  count  the  growth,  we  have  to  also  consider  the  risk.  
¨  Two  ways  of  esCmaCng  the  country  risk  premium:  
¤  Sovereign  Default  Spread:  In  this  approach,  the  country  equity  risk  premium  is  set  
equal  to  the  default  spread  of  the  bond  issued  by  the  country.  
n  Equity  Risk  Premium  for  mature  market  =  4.50%  
n  Default  Spread  for  India  =  3.00%  (based  on  raCng)  
n  Equity  Risk  Premium  for  India  =  4.50%  +  3.00%  
¤  Adjusted  for  equity  risk:  The  country  equity  risk  premium  is  based  upon  the  
volaClity  of  the  equity  market  relaCve  to  the  government  bond    rate.  
n  Country  risk  premium=  Default  Spread*  Std DeviationCountry  Equity  /  Std
DeviationCountry  Bond  
n  Standard  DeviaCon  in  Sensex  =  21%  
n  Standard  DeviaCon  in  Indian  government  bond=  14%  
n  Default  spread  on  Indian  Bond=  3%  
n  AddiConal  country  risk  premium  for  India  =  3%  (21/14)  =  4.5%  

Aswath Damodaran!
32!
 Andorra
6.80%
1.80%
Liechtenstein
5.00%
0.00%

ERP : Jan 2014!
Albania
11.75%
6.75%

Austria
5.00%
0.00%
Luxembourg
5.00%
0.00%
Bangladesh
10.40%
5.40%

Armenia
9.50%
4.50%

Belgium
5.90%
0.90%
Malta
6.80%
1.80%
Cambodia
13.25%
8.25%

Azerbaijan
8.30%
3.30%

Cyprus
20.00%
15.00%
Netherlands
5.00%
0.00%
China
5.90%
0.90%

Belarus
14.75%
9.75%

Denmark
5.00%
0.00%
Norway
5.00%
0.00%
Fiji
11.75%
6.75%

Bosnia and Herzegovina
14.75%
9.75%

Finland
5.00%
0.00%
Portugal
10.40%
5.40%
Bulgaria
7.85%
2.85%
Hong Kong
5.60%
0.60%

France
5.60%
0.60%
Spain
8.30%
3.30%
Croatia
8.75%
3.75%
India
8.30%
3.30%

Germany
5.00%
0.00%
Sweden
5.00%
0.00%
Czech Republic
6.05%
1.05%
Indonesia
8.30%
3.30%

Greece
20.00%
15.00%
Switzerland
5.00%
0.00%
Estonia
6.05%
1.05%
Japan
5.90%
0.90%

Iceland
8.30%
3.30%
Turkey
8.30%
3.30%
Georgia
10.40%
5.40%
Korea
5.90%
0.90%

Ireland
8.75%
3.75%
United Kingdom
5.60%
0.60%
Hungary
8.75%
3.75%
Macao
5.90%
0.90%

Italy
7.85%
2.85%
Western Europe
6.29%
1.29%
Kazakhstan
7.85%
2.85%
Malaysia
6.80%
1.80%

Latvia
7.85%
2.85%
Mauritius
7.40%
2.40%

Canada
5.00%
0.00%
Lithuania
7.40%
2.40%

Angola
10.40%
5.40%
Mongolia
11.75%
6.75%

United States of America
5.00%
0.00%
Macedonia
10.40%
5.40%

Benin
13.25%
8.25%
Pakistan
16.25%
11.25%

North America
5.00%
0.00%
Moldova
14.75%
9.75%

Botswana
6.28%
1.28%
Papua New Guinea
11.75%
6.75%

Montenegro
10.40%
5.40%
Philippines
8.30%
3.30%

Argentina
14.75%
9.75%
Burkina Faso
13.25%
8.25%

Poland
6.28%
1.28%
Singapore
5.00%
0.00%

Belize
18.50%
13.50%
Cameroon
13.25%
8.25%

Romania
8.30%
3.30%

Bolivia
10.40%
5.40%
Cape Verde
13.25%
8.25%
Sri Lanka
11.75%
6.75%

Russia
7.40%
2.40%

Brazil
7.85%
2.85%
DR Congo
14.75%
9.75%
Taiwan
5.90%
0.90%

Serbia
11.75%
6.75%

Chile
5.90%
0.90%
Egypt
16.25%
11.25%
Thailand
7.40%
2.40%

Slovakia
6.28%
1.28%

Colombia
8.30%
3.30%
Gabon
10.40%
5.40%
Vietnam
13.25%
8.25%

Slovenia
8.75%
3.75%

Costa Rica
8.30%
3.30%
Ghana
11.75%
6.75%
Asia
6.51%
1.51%

Ukraine
16.25%
11.25%

Ecuador
16.25%
11.25%
Kenya
11.75%
6.75%
E. Europe & Russia
7.96%
2.96%

El Salvador
10.40%
5.40%
Morocco
8.75%
3.75%

Guatemala
8.75%
3.75%
Mozambique
11.75%
6.75%
Abu Dhabi
5.75%
0.75%
Australia
5.00%
0.00%

Honduras
13.25%
8.25%
Namibia
8.30%
3.30%
Bahrain
7.85%
2.85%
Cook Islands
11.75%
6.75%

Mexico
7.40%
2.40%
Nigeria
10.40%
5.40%
Israel
6.05%
1.05%
New Zealand
5.00%
0.00%

Rep Congo
10.40%
5.40%
Jordan
11.75%
6.75%
Australia & New
Nicaragua
14.75%
9.75%

Zealand
5.00%
0.00%

Panama
7.85%
2.85%
Rwanda
13.25%
8.25%
Kuwait
5.75%
0.75%

Paraguay
10.40%
5.40%
Senegal
11.75%
6.75%
Lebanon
11.75%
6.75%

Peru
7.85%
2.85%
South Africa
7.40%
2.40%
Oman
6.05%
1.05%

Suriname
10.40%
5.40%
Tunisia
10.40%
5.40%
Qatar
5.75%
0.75%

Uruguay
8.30%
3.30%
Uganda
11.75%
6.75%
Saudi Arabia
5.90%
0.90%
Black #: Total ERP

Venezuela
16.25%
11.25%
Zambia
11.75%
6.75%
United Arab Emirates
5.75%
0.75%
Red #: Country risk premium

Latin America
8.62%
3.62%
Africa
10.04%
5.04%
Middle East
6.14%
1.14%
AVG: GDP weighted average

VII.  And  it  is  not  just  emerging  market  
companies  that  are  exposed  to  this  risk..  
¨  The  “default”  approach  in  valuaCon  has  been  to  assign  
country  risk  based  upon  your  country  of  incorporaCon.  
Thus,  if  you  are  incorporated  in  a  developed  market,  the  
assumpCon  has  been  that  you  are  not  exposed  to  
emerging  market  risks.  If  you  are  incorporated  in  an  
emerging  market,  you  are  saddled  with  the  enCre  
country  risk.  
¨  As  companies  globalize  and  look  for  revenues  in  foreign  
markets,  this  pracCce  will  under  esCmate  the  costs  of  
equity  of  developed  market  companies  with  significant  
emerging  market  risk  exposure  and  over  esCmate  the  
costs  of  equity  of  emerging  market  companies  with  
significant  developed  market  risk  exposure.  

Aswath Damodaran!
34!
GlobalizaCon’s  flip  side:  OperaCon-­‐based  ERP  

Coca Cola (2011)! Natura (2013)!

Vale (2013)!
% Revenues
ERP

US & Canada
4.90%
5.50%

Brazil
16.90%
8.50%

Rest of Latin Ameria
1.70%
10.09%

China
37.00%
6.94%

Japan
10.30%
6.70%

Rest of Asia
8.50%
8.61%

Europe
17.20%
6.72%

Rest of World
3.50%
10.06%

Aswath Damodaran!
Company
100.00%
7.38%
35!
An  alternate  approach:  EsCmate  a  
“country  risk  exposure  factor  (lambda)  
Tata Motors TCS
% of production/operations in
India High High
91.37% (in 2009)
Estimated 70% (in
% of revenues in India 2010) 7.62%
Lambda 0.80 0.20
Low. Significant High.
Flexibility in moving operations physical assets. Human capital is mobile.

Aswath Damodaran!
36!
VIII.  Growth  has  to  be  earned  (not  endowed  or  
esCmated):  Measuring  Investment  Quality  

Adjust EBIT for Use a marginal tax rate

a. Extraordinary or one-time expenses or income to be safe. A high ROC
b. Operating leases and R&D created by paying low
c. Cyclicality in earnings (Normalize) effective taxes is not
d. Acquisition Debris (Goodwill amortization etc.) sustainable

EBIT ( 1- tax rate)

ROC =
Book Value of Equity + Book value of debt - Cash

Adjust book equity for Adjust book value of debt for

1. Capitalized R&D a. Capitalized operating leases
2. Acquisition Debris (Goodwill)

Use end of prior year numbers or average over the year

but be consistent in your application

Aswath Damodaran!
37!
 The  Quality  of  Growth  –  A  Global  
PerspecCve  
38!

ROIC  versus  Cost  of  Capital:  A  Global  Assessment  for  2013  

80.00%  

70.00%  

60.00%  
%  of  firms  in  the  group  

50.00%   ROC  more  than  5%  below  cost  of  capital  

ROC  between  2%  and  5%  below  cost  of  capital  

40.00%  
ROC  between  2%  and  0%  below  cost  of  capital  

ROC  between  0  and  2%  more  than  cost  of  capital  

30.00%  
ROC  between  2%  and  5%  above  cost  of  capital  
20.00%   ROC  more  than  5%  above  cost  of  capital  

10.00%  

0.00%  
Australia,   Europe   Emerging   Japan   US   Global  
NZ  &   Markets  
Canada  

38!
IX.  All  good  things  come  to  an  end..And  the  
terminal  value  is  not  an  ATM…  

This tax rate locks in Are you reinvesting enough to sustain your
forever. Does it make stable growth rate?
sense to use an Reinv Rate = g/ ROC
effective tax rate? Is the ROC that of a stable company?
EBITn+1 (1 - tax rate) (1 - Reinvestment Rate)
Terminal Valuen =
Cost of capital - Expected growth
rate
This growth rate should be
This is a mature company. less than the nomlnal
It’s cost of capital should growth rate of the economy
reflect that.

Aswath Damodaran!
39!
 Terminal  Value  and  Growth  

Stable  growth  rate   Amgen   Tata  Motors   Stable  growth  rate   Natura  
0%   $150,652   435,686₹   0%   R$  21,709  
1%   $154,479   435,686₹   2%   R$  24,473  
2%   $160,194   435,686₹   4%   R$  27,989  
3%   $167,784   435,686₹   6%   R$  32,538  
4%   $179,099   435,686₹   8%   R$  38,815  
5%     435,686₹   10%   R$  48,394  
Riskfree  rate   4.78%   5%   11.28%  
ROIC   10%   10.39%   25.00%  
Cost  of  capital   8.08%   10.39%   16.35%  

Aswath Damodaran!
40!
 Aswath Damodaran!

THE  LOOSE  ENDS  IN  

VALUATION…  
Aswath  Damodaran  
Ge|ng  from  DCF  to  value  per  share:  The  
Loose  Ends  

The adjustments to
get to firm value Intangible assets
(Brand Name)
+ Cash & Marketable Premium
Securities Control
Discount FCFF Synergy Premium Premium
at Cost of Discount? Premium?
capital =
Operating Asset + + Value of Cross
= Value of Value per
Value
holdings Value of business
(firm) - Debt = Equity share
Book value? Market
value? Underfunded
Complexity Minority Option
+ Value of other non- pension/ Discount Overhang
discount
operating assets health care
obligations? Distress Differences
What should be here? discount in cashflow/
What should not? Lawsuits & voting rights
Contingent Liquidity across
liabilities? discount shares

Aswath Damodaran!
42!
1.  The  Value  of  Cash  
An  Exercise  in  Cash  ValuaCon  

     Company  A  Company  B  Company  C  

Enterprise  Value  $  1  billion  $  1  billion  $  1  billion  
Cash        $  100  mil  $  100  mil  $  100  mil  
Return  on  Capital  10%    5%    22%  
Cost  of  Capital    10%    10%    12%  
Trades  in      US    US    ArgenCna  

¨  In  which  of  these  companies  is  cash  most  likely  to  
trade  at  face  value,  at  a  discount  and  at  a  premium?  

Aswath Damodaran!
43!
Cash:  Discount  or  Premium?  

Aswath Damodaran!
44!
2.  Dealing  with  Holdings  in  Other  firms  

¨  Holdings  in  other  firms  can  be  categorized  into  

¤  Minority  passive  holdings,  in  which  case  only  the  dividend  from  the  
holdings  is  shown  in  the  balance  sheet  
¤  Minority  acCve  holdings,  in  which  case  the  share  of  equity  income  is  
shown  in  the  income  statements  
¤  Majority  acCve  holdings,  in  which  case  the  financial  statements  are  
consolidated.  
¨  We  tend  to  be  sloppy  in  pracCce  in  dealing  with  cross  
holdings.  A}er  valuing  the  operaCng  assets  of  a  firm,  using  
consolidated  statements,  it  is  common  to  add  on  the  balance  
sheet  value  of  minority  holdings  (which  are  in  book  value  
terms)  and  subtract  out  the  minority  interests  (again  in  book  
value  terms),  represenCng  the  porCon  of  the  consolidated  
company  that  does  not  belong  to  the  parent  company.    

Aswath Damodaran!
45!
How  to  value  holdings  in  other  firms..  In  a  
perfect  world..  

¨  In  a  perfect  world,  we  would  strip  the  parent  

company  from  its  subsidiaries  and  value  each  one  
separately.  The  value  of  the  combined  firm  will  be  
¤  Value  of  parent  company  +  ProporCon  of  value  of  each  
subsidiary  
¨  To  do  this  right,  you  will  need  to  be  provided  
detailed  informaCon  on  each  subsidiary  to  esCmate  
cash  flows  and  discount  rates.  

Aswath Damodaran!
46!
Two  compromise  soluCons…  

¨  The  market  value  soluCon:  When  the  subsidiaries  are  

publicly  traded,  you  could  use  their  traded  market  
capitalizaCons  to  esCmate  the  values  of  the  cross  
holdings.  You  do  risk  carrying  into  your  valuaCon  any  
mistakes  that  the  market  may  be  making  in  valuaCon.  
¨  The  relaCve  value  soluCon:  When  there  are  too  many  
cross  holdings  to  value  separately  or  when  there  is  
insufficient  informaCon  provided  on  cross  holdings,  you  
can  convert  the  book  values  of  holdings  that  you  have  
on  the  balance  sheet  (for  both  minority  holdings  and  
minority  interests  in  majority  holdings)  by  using  the  
average  price  to  book  value  raCo  of  the  sector  in  which  
the  subsidiaries  operate.  

Aswath Damodaran!
47!
Tata  Motor’s  Cross  Holdings  

Tata  Chemicals,  2,431₹  

Tata  Steel,  
Other  publicly  held  Tata  
13,572₹  
Companies,  12,335₹  

Non-­‐public  Tata  companies,  

112,238₹  

Aswath Damodaran!
48!
3.  Other  Assets  that  have  not  been  counted  
yet..  
¨  UnuClized  assets:  If  you  have  assets  or  property  that  are  not  
being  uClized  (vacant  land,  for  example),  you  have  not  valued  
it  yet.  You  can  assess  a  market  value  for  these  assets  and  add  
them  on  to  the  value  of  the  firm.  
¨  Overfunded  pension  plans:  If  you  have  a  defined  benefit  plan  
and  your  assets  exceed  your  expected  liabiliCes,  you  could  
consider  the  over  funding  with  two  caveats:  
¤  CollecCve  bargaining  agreements  may  prevent  you  from  laying  claim  
to  these  excess  assets.  
¤  There  are  tax  consequences.  O}en,  withdrawals  from  pension  plans  
get  taxed  at  much  higher  rates.  
¤  Do  not  double  count  an  asset.  If  you  count  the  income  from  
an  asset  in  your  cash  flows,  you  cannot  count  the  market  
value  of  the  asset  in  your  value.  

Aswath Damodaran!
49!
4.  Brand  name,  great  management,  superb  
product  …Don’t  double  count!  

¨  There  is  o}en  a  temptaCon  to  add  on  premiums  for  
intangibles.  Here  are  a  few  examples.  
¤  Brand  name  
¤  Great  management  
¤  Loyal  workforce  
¤  Technological  prowess  

¨  There  are  two  potenCal  dangers:  

¤  For  some  assets,  the  value  may  already  be  in  your  value  
and  adding  a  premium  will  be  double  counCng.  
¤  For  other  assets,  the  value  may  be  ignored  but  
incorporaCng  it  will  not  be  easy.  

Aswath Damodaran!
50!
Valuing  Brand  Name  
     Coca  Cola
   With  Co?  Margins  
Current  Revenues  =    $21,962.00      $21,962.00    
Length  of  high-­‐growth  period    10    10  
Reinvestment  Rate    =    50%    50%  
OperaCng  Margin  (a}er-­‐tax)  15.57%    5.28%  
Sales/Capital  (Turnover  raCo)  1.34    1.34  
Return  on  capital  (a}er-­‐tax)  20.84%    7.06%  
Growth  rate  during  period  (g)  =  10.42%    3.53%  
Cost  of  Capital  during  period    =  7.65%    7.65%  
Stable  Growth  Period  
Growth  rate  in  steady  state  =  4.00%    4.00%  
Return  on  capital  =    7.65%    7.65%  
Reinvestment  Rate  =    52.28%    52.28%  
Cost  of  Capital  =    7.65%    7.65%  
Value  of  Firm  =    $79,611.25      $15,371.24    

Aswath Damodaran!
51!
5.  The  Value  of  Control:  It’s  not  always  
worth  20%!!  
¨  The  value  of  the  control  premium  that  will  be  paid  to  
acquire  a  block  of  equity  will  depend  upon  two  factors  -­‐  
¤  Probability  that  control  of  firm  will  change:  This  refers  to  the  
probability  that  incumbent  management  will  be  replaced.  this  
can  be  either  through  acquisiCon  or  through  exisCng  
stockholders  exercising  their  muscle.  
¤  Value  of  Gaining  Control  of  the  Company:  The  value  of  gaining  
control  of  a  company  arises  from  two  sources  -­‐  the  increase  in  
value  that  can  be  wrought  by  changes  in  the  way  the  company  is  
managed  and  run,  and  the  side  benefits  and  perquisites  of  being  
in  control  
¤  Value  of  Gaining  Control  =  Present  Value  (Value  of  Company  
with  change  in  control  -­‐  Value  of  company  without  change  in  
control)  +  Side  Benefits  of  Control  

Aswath Damodaran!
52!
 Increase Cash Flows
Reduce the cost of capital

Make your
More efficient product/service less Reduce
operations and Revenues Operating
discretionary
cost cuttting: leverage
Higher Margins * Operating Margin
= EBIT Reduce beta

Divest assets that - Tax Rate * EBIT

have negative EBIT Cost of Equity * (Equity/Capital) +
= EBIT (1-t) Pre-tax Cost of Debt (1- tax rate) *
Live off past over- (Debt/Capital)
Reduce tax rate + Depreciation investment
- Capital Expenditures Shift interest
- moving income to lower tax locales - Chg in Working Capital
- transfer pricing Match your financing expenses to
- risk management = FCFF higher tax locales
to your assets:
Reduce your default
risk and cost of debt
Change financing
Better inventory mix to reduce
management and cost of capital
tighter credit policies
Firm Value

Increase Expected Growth Increase length of growth period

Reinvest more in Do acquisitions

projects Build on existing Create new
Reinvestment Rate
competitive competitive
* Return on Capital advantages advantages
Increase operating Increase capital turnover ratio
margins
= Expected Growth Rate

Aswath Damodaran!
 Adris Grupa (Status Quo): 4/2010
Average from 2004-09 Average from 2004-09 Stable Growth
Current Cashflow to Firm 70.83% 9.69% g = 4%; Beta = 0.80
EBIT(1-t) : 436 HRK Expected Growth Country Premium= 2%
- Nt CpX 3 HRK Reinvestment Rate Return on Capital Cost of capital = 9.92%
- Chg WC -118 HRK from new inv.
70.83% .7083*.0969 =0.0686 9.69% Tax rate = 20.00%
= FCFF 551 HRK ROC=9.92%;
Reinv Rate = (3-118)/436= -26.35%; or 6.86%
Reinvestment Rate=g/ROC
Tax rate = 17.35% =4/9.92= 40.32%
Return on capital = 8.72%

Terminal Value5= 365/(.0992-.04) =6170 HRK

HKR Cashflows
Op. Assets 4312 Year 1 2 3 4 5
+ Cash: 1787 EBIT (1-t) HRK 466 HRK 498 HRK 532 HRK 569 HRK 608
- Debt 141 - Reinvestment HRK 330 HRK 353 HRK 377 HRK 403 HRK 431 612
- Minority int 465 FCFF HRK 136 HRK 145 HRK 155 HRK 166 HRK 177 246
365
=Equity 5,484
/ (Common + Preferred
shares)
Value non-voting share Discount at $ Cost of Capital (WACC) = 10.7% (.974) + 5.40% (0.026) = 10.55%
335 HRK/share

On May 1, 2010
AG Pfd price = 279 HRK
Cost of Equity Cost of Debt
10.70% (4.25%+ 0.5%+2%)(1-.20) Weights AG Common = 345 HRK
= 5.40 % E = 97.4% D = 2.6%

Lambda CRP for Croatia

0.68 X (3%)
Riskfree Rate:
HRK Riskfree Rate= Beta Mature market
+ 0.70 X premium +
4.25% Lambda X CRP for Central Europe
4.5%
0.42 (3%)

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.68 Ratio: 2.70% Country Default Mkt Vol
Spread X
2% 1.50
Aswath Damodaran!
Adris Grupa: 4/2010 (Restructured) Increased ROIC to cost
Average from 2004-09
of capital
e Stable Growth
Current Cashflow to Firm 70.83% g = 4%; Beta = 0.80
EBIT(1-t) : 436 HRK Expected Growth Country Premium= 2%
- Nt CpX 3 HRK Reinvestment Rate from new inv. Return on Capital Cost of capital = 9.65%
- Chg WC -118 HRK 70.83% .7083*.01054=0. 10.54% Tax rate = 20.00%
= FCFF 551 HRK or 6.86% ROC=9.94%;
Reinv Rate = (3-118)/436= -26.35%; Reinvestment Rate=g/ROC
Tax rate = 17.35% =4/9.65= 41/47%
Return on capital = 8.72%
Terminal Value5= 367/(.0965-.04) =6508 HRK
HKR Cashflows
Op. Assets 4545 Year 1 2 3 4 5
+ Cash: 1787 EBIT (1-t) HRK 469 HRK 503 HRK 541 HRK 581 HRK 623 628
- Debt 141 - Reinvestment HRK 332 HRK 356 HRK 383 HRK 411 HRK 442 246
- Minority int 465 FCFF HRK 137 HRK 147 HRK 158 HRK 169 HRK 182 367
=Equity 5,735

Value/non-voting 334
Value/voting 362 Discount at $ Cost of Capital (WACC) = 11.12% (.90) + 8.20% (0.10) = 10.55%
Changed mix of debt
and equity tooptimal
On May 1, 2010
Cost of Equity Cost of Debt AG Pfd price = 279 HRK
11.12% (4.25%+ 4%+2%)(1-.20) Weights AG Common = 345 HRK
= 8.20% E = 90 % D = 10 %

Lambda CRP for Croatia

0.68 X (3%)
Riskfree Rate:
HRK Riskfree Rate= Beta Mature market
4.25% + 0.75 X premium +
4.5% Lambda X CRP for Central Europe
0.42 (3%)

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 0.68 Ratio: 11.1% Country Default Mkt Vol
Spread X
1.50
2%
Aswath Damodaran!
Value  of  Control  and  the  Value  of  VoCng  Rights  

¨  Adris  Grupa  has  two  classes  of  shares  outstanding:  9.616  
million  voCng  shares  and  6.748  million  non-­‐voCng  shares.  
¨  To  value  a  non-­‐voCng  share,  we  assume  that  all  non-­‐voCng  shares  
essenCally  have  to  seTle  for  status  quo  value.  All  shareholders,  common  
and  preferred,  get  an  equal  share  of  the  status  quo  value.  
 Status  Quo  Value  of  Equity  =  5,484  million  HKR    
 Value  for  a  non-­‐voCng  share  =  5484/(9.616+6.748)  =  334  HKR/share  
¨  To  value  a  voCng  share,  we  first  value  control  in  Adris  Grup  as  
the  difference  between  the  opCmal  and  the  status  quo  value:  
Value  of  control  at  Adris  Grupa  =  5,735  –  5484  =  249  million  HKR  
Value  per  voCng  share  =334  HKR  +    249/9.616  =  362  HKR  

Aswath Damodaran!
56!
 Aswath Damodaran!

THE  DARK  SIDE  OF  VALUATION:  

VALUING  DIFFICULT-­‐TO-­‐VALUE  
COMPANIES  
The  Dark  Side  of  ValuaCon…  

¨  Valuing  stable,    money  making  companies  with  

consistent  and  clear  accounCng  statements,  a  long  and  
stable  history  and  lots  of  comparable  firms  is  easy  to  do.  
¨  The  true  test  of  your  valuaCon  skills  is  when  you  have  to  
value  “difficult”  companies.  In  parCcular,  the  challenges  
are  greatest  when  valuing:  
¤  Young  companies,  early  in  the  life  cycle,  in  young  businesses  
¤  Companies  that  don’t  fit  the  accounCng  mold  

¤  Companies  that  face  substanCal  truncaCon  risk  (default  or  

naConalizaCon  risk)  

Aswath Damodaran!
58!
I.  The  challenge  with  young  companies…  
Figure 5.2: Estimation Issues - Young and Start-up Companies
Making judgments on revenues/ profits difficult becaue
you cannot draw on history. If you have no product/
service, it is difficult to gauge market potential or
profitability. The company's entire value lies in future
growth but you have little to base your estimate on.

Cash flows from existing

assets non-existent or What is the value added by growth
negative. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Different claims on existing assets and growth assets? roadblocks?
cash flows can
affect value of
equity at each Limited historical data on earnings, Will the firm make it through
and no market prices for securities the gauntlet of market demand
stage.
makes it difficult to assess risk. and competition? Even if it
What is the value of does, assessing when it will
equity in the firm? become mature is difficult
because there is so little to go
on.

Aswath Damodaran!
59!
 Amazon in January 2000 Sales to capital ratio and
expected margin are retail Stable Growth
Current Current
Revenue Margin: industry average numbers Stable Stable
Stable Operating ROC=20%
$ 1,117 -36.71% Revenue
Sales Turnover Competitive Margin: Reinvest 30%
Ratio: 3.00 Advantages Growth: 6% 10.00% of EBIT(1-t)
From previous
EBIT
years Revenue Expected
-410m
Growth: Margin: Terminal Value= 1881/(.0961-.06)
NOL:
42% -> 10.00% =52,148
500 m

Term. Year
Revenue&Growth 150.00% 100.00% 75.00% 50.00% 30.00% 25.20% 20.40% 15.60% 10.80% 6.00% 6%
Revenues $&&2,793 $&&5,585 $&9,774 $&14,661 $&19,059 $&23,862 $&28,729 $&33,211 $&36,798 $&39,006 $(((((41,346
Operating&Margin B13.35% B1.68% 4.16% 7.08% 8.54% 9.27% 9.64% 9.82% 9.91% 9.95% 10.00%
Value of Op Assets $ 15,170 EBIT B$373 B$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 $4,135
+ Cash $ 26 EBIT(1Bt) B$373 B$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 $2,688
= Value of Firm $15,196 &B&Reinvestment $600 $967 $1,420 $1,663 $1,543 $1,688 $1,721 $1,619 $1,363 $961 $155
FCFF B$931 B$1,024 B$989 B$758 B$408 B$163 $177 $625 $1,174 $1,788 $1,881
- Value of Debt $ 349 1 2 3 4 5 6 7 8 9 10
= Value of Equity $14,847
Forever
- Equity Options $ 2,892 Cost%of%Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 11.94% 11.46% 10.98% 10.50%
Value per share $ 35.08 Cost%of%Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00%
All existing options valued After<tax%cost%of%debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%
as options, using current Cost%of%Capital% 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.62% 11.08% 10.49% 9.61%
stock price of $84. Amazon was
Used average trading at $84 in
Cost of Equity interest coverage Cost of Debt Weights January 2000.
12.90% ratio over next 5 6.5%+1.5%=8.0% Debt= 1.2% -> 15%
years to get BBB Tax rate = 0% -> 35%
rating. Pushed debt ratio
Dot.com retailers for firrst 5 years to retail industry
Convetional retailers after year 5 average of 15%.
Beta
Riskfree Rate: + 1.60 -> 1.00 X Risk Premium
T. Bond rate = 6.5% 4%

Aswath Damodaran! Internet/

Retail
Operating
Leverage
Current D/
E: 1.21%
Base Equity
Premium
Country Risk
Premium
 Starting numbers
Twitter Pre-IPO Valuation: October 27, 2013
Trailing%12%
Last%10K month
Revenue Pre-tax Sales to Stable Growth
Revenues $316.93 $534.46
growth of 51.5% operating capital ratio of g = 2.5%; Beta = 1.00;
Operating income :$77.06 :$134.91
a year for 5 margin 1.50 for Cost of capital = 8%
Adjusted Operating Income $7.67 ROC= 12%;
years, tapering increases to incremental
Invested Capital $955.00 down to 2.5% in 25% over the Reinvestment Rate=2.5%/12% = 20.83%
sales
Adjusted Operatng Margin 1.44% year 10 next 10 years
Sales/ Invested Capital 0.56
Terminal Value10= 1466/(.08-.025) = $26,657
Interest expenses $2.49 $5.30

1 2 3 4 5 6 7 8 9 10
Operating assets $9,705 Revenues $ 810 $1,227 $1,858 $2,816 $4,266 $6,044 $7,973 $9,734 $10,932 $11,205 Terminal year (11)
+ Cash 321 Operating Income $ 31 $ 75 $ 158 $ 306 $ 564 $ 941 $1,430 $1,975 $ 2,475 $ 2,801 EBIT (1-t) $ 1,852
+ IPO Proceeds 1295 Operating Income after tax $ 31 $ 75 $ 158 $ 294 $ 395 $ 649 $ 969 $1,317 $ 1,624 $ 1,807 - Reinvestment $ 386
- Debt 214 - Reinvestment $ 183 $ 278 $ 421 $ 638 $ 967 $1,186 $1,285 $1,175 $ 798 $ 182 FCFF $ 1,466
Value of equity 11,106 FCFF $(153) $ (203) $ (263) $ (344) $ (572) $ (537) $ (316) $ 143 $ 826 $ 1,625
- Options 713
Value in stock 10,394
/ # of shares 582.46 Cost of capital = 11.12% (.981) + 5.16% (.019) = 11.01% Cost of capital decreases to
Value/share $17.84 8% from years 6-10

Cost of Equity Cost of Debt Weights

11.12% (2.5%+5.5%)(1-.40) E = 98.1% D = 1.9%
= 5.16%

Risk Premium
Riskfree Rate:
Beta 6.15%
Riskfree rate = 2.5% X
+ 1.40
75% from US(5.75%) + 25%
from rest of world (7.23%)

90% advertising D/E=1.71%

(1.44) + 10% info
svcs (1.05)

61
Aswath Damodaran

 1.  Less  is  more  
62!

Principle of parsimony: Estimate

Use “auto pilot” approaches to fewer inputs when faced with
estimate future years
uncertainty.
62!
 A  tougher  task  at  TwiTer  
63!

My estimate for Twitter:

My estimate for 2023: Overall market will be close Operating margin of 25% in
to $200 billion and Twitter will about 5.7% ($11.5 year 10

billion)

Aswath Damodaran

63!
 2.  Build  in  “internal”  checks  for  
reasonableness…  
64!

Check total revenues, relative to the market that it serves… Are the margins
Your market share obviously cannot exceed 100% but there and imputed
may be tighter constraints.
returns on capital
‘reasonable’ in the
Aswath Damodaran
outer years?

64!
Lesson  3:  Scaling  up  is  hard  to  do…  

Aswath Damodaran!
65!
Lesson  4:  Don’t  forget  to  pay  for  growth…  

Aswath Damodaran!
66!
Lesson  5:  Don’t  sweat  the  small  stuff:  The  
discount  rate  is  not  the  “big”  number  
Twitter’s cost of capital!
Cost of capital = 11.12% (.981) + 5.16% (.019) = 11.01%

Cost of Equity
11.12% Cost of Debt Weights
(2.5%+5.5%)(1-.40) E = 98.11% D = 1.89%
= 5.16%

Risk Premium
Riskfree Rate:
Beta 6.15%
Riskfree rate = 2.5% X
+ 1.40
75% from US(5.75%) + 25%
from rest of world (7.23%)

90% advertising D/E=1.71%

(1.44) + 10% info
svcs (1.05)

67!
Lesson  5:  There  are  always  scenarios  where  the  
market  price  can  be  jusCfied…  

Aswath Damodaran!
68!
Lesson  6:  You  will  be  wrong  100%  of  the  Cme…  
and  it  really  is  not  (always)  your  fault…  
¨  No  maTer  how  careful  you  are  in  ge|ng  your  inputs  and  
how  well  structured  your  model  is,  your  esCmate  of  
value  will  change  both  as  new  informaCon  comes  out  
about  the  company,  the  business  and  the  economy.  
¨  As  informaCon  comes  out,  you  will  have  to  adjust  and  
adapt  your  model  to  reflect  the  informaCon.  Rather  than  
be  defensive  about  the  resulCng  changes  in  value,  
recognize  that  this  is  the  essence  of  risk.    
¨  A  test:  If  your  valuaCons  are  unbiased,  you  should  find  
yourself  increasing  esCmated  values  as  o}en  as  you  are  
decreasing  values.  In  other  words,  there  should  be  equal  
doses  of  good  and  bad  news  affecCng  valuaCons  (at  
least  over  Cme).  
Aswath Damodaran!
69!
And  the  market  is  o}en  “more  wrong”….  

Amazon: Value and Price

$90.00

$80.00

$70.00

$60.00

$50.00

Value per share

$40.00 Price per share

$30.00

$20.00

$10.00

$0.00
2000 2001 2002 2003
Time of analysis

Aswath Damodaran!
70!
II.  Dealing  with  decline  and  distress…  

Historial data often Growth can be negative, as firm sheds assets and
reflects flat or declining shrinks. As less profitable assets are shed, the firm’s
revenues and falling remaining assets may improve in quality.
margins. Investments
often earn less than the What is the value added by growth
cost of capital. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Underfunded pension existing assets and growth assets? roadblocks?
obligations and
litigation claims can
lower value of equity. Depending upon the risk of the There is a real chance,
Liquidation assets being divested and the use of especially with high financial
preferences can affect the proceeds from the divestuture (to leverage, that the firm will not
value of equity pay dividends or retire debt), the risk make it. If it is expected to
in both the firm and its equity can survive as a going concern, it
What is the value of change. will be as a much smaller
equity in the firm? entity.

Aswath Damodaran!
71!
 Reinvestment:
Capital expenditures include cost of Stable Growth
Current Current new casinos and working capital Stable Stable
Revenue Margin: Stable Operating ROC=10%
$ 4,390 4.76% Revenue Margin: Reinvest 30%
Extended Industry Growth: 3% 17% of EBIT(1-t)
reinvestment average
EBIT break, due ot
$ 209m investment in Expected
past Margin: Terminal Value= 758(.0743-.03)
-> 17% =$ 17,129

Term. Year
Revenues $4,434 $4,523 $5,427 $6,513 $7,815 $8,206 $8,616 $9,047 $9,499 $9,974 $10,273
Oper margin 5.81% 6.86% 7.90% 8.95% 10% 11.40% 12.80% 14.20% 15.60% 17% 17%
EBIT $258 $310 $429 $583 $782 $935 $1,103 $1,285 $1,482 $1,696 $ 1,746
Tax rate 26.0% 26.0% 26.0% 26.0% 26.0% 28.4% 30.8% 33.2% 35.6% 38.00% 38%
EBIT * (1 - t) $191 $229 $317 $431 $578 $670 $763 $858 $954 $1,051 $1,083
- Reinvestment -$19 -$11 $0 $22 $58 $67 $153 $215 $286 $350 $ 325
Value of Op Assets $ 9,793 FCFF $210 $241 $317 $410 $520 $603 $611 $644 $668 $701 $758
+ Cash & Non-op $ 3,040 1 2 3 4 5 6 7 8 9 10
= Value of Firm $12,833 Forever
- Value of Debt $ 7,565 Beta 3.14 3.14 3.14 3.14 3.14 2.75 2.36 1.97 1.59 1.20
= Value of Equity $ 5,268 Cost of equity 21.82% 21.82% 21.82% 21.82% 21.82% 19.50% 17.17% 14.85% 12.52% 10.20%
Cost of debt 9% 9% 9% 9% 9% 8.70% 8.40% 8.10% 7.80% 7.50%
Value per share $ 8.12 Debtl ratio 73.50% 73.50% 73.50% 73.50% 73.50% 68.80% 64.10% 59.40% 54.70% 50.00%
Cost of capital 9.88% 9.88% 9.88% 9.88% 9.88% 9.79% 9.50% 9.01% 8.32% 7.43%

Cost of Equity Cost of Debt Weights

21.82% 3%+6%= 9% Debt= 73.5% ->50%
9% (1-.38)=5.58%

Riskfree Rate:
T. Bond rate = 3% Las Vegas Sands
Risk Premium
Beta 6% Feburary 2009
+ 3.14-> 1.20 X Trading @ $4.25

Aswath Damodaran! Casino Current Base Equity Country Risk

1.15 D/E: 277% Premium Premium
AdjusCng  the  value  of  LVS  for  distress..  

¨  In  February  2009,  LVS  was  rated  B+  by  S&P.  Historically,  28.25%  of  B+  
rated  bonds  default  within  10  years.  LVS  has  a  6.375%  bond,  maturing  in  
February  2015  (7  years),  trading  at  $529.  If  we  discount  the  expected  cash  
flows  on  the  bond  at  the  riskfree  rate,  we  can  back  out  the  probability  of  
distress  from  the  bond  price:  
t =7
63.75(1− ΠDistress )t 1000(1− ΠDistress )7
529 = ∑ t +
t =1 (1.03) (1.03)7
¨  Solving  for  the  probability  of  bankruptcy,  we  get:  
¨  πDistress    =  Annual  probability  of  default  =  13.54%  
¤  CumulaCve  €probability  of  surviving  10  years  =  (1  -­‐  .1354)10  =  23.34%  
¤  CumulaCve  probability  of  distress  over  10  years  =  1  -­‐  .2334  =  .7666  or  76.66%  
¨  If  LVS  is  becomes  distressed:  
¤  Expected  distress  sale  proceeds  =  $2,769  million  <  Face  value  of  debt  
¤  Expected  equity  value/share  =  $0.00  
¨  Expected  value  per  share  =  $8.12  (1  -­‐  .7666)  +  $0.00  (.7666)  =  $1.92  

Aswath Damodaran!
73!
III.  Valuing  cyclical  and  commodity  companies  

Company growth often comes from movements in the

economic cycle, for cyclical firms, or commodity prices,
for commodity companies.

What is the value added by growth

assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Historial revenue and existing assets and growth assets? roadblocks?
earnings data are
volatile, as the
Primary risk is from the economy for For commodity companies, the
economic cycle and
cyclical firms and from commodity fact that there are only finite
commodity prices
price movements for commodity amounts of the commodity may
change.
companies. These risks can stay put a limit on growth forever.
dormant for long periods of apparent For cyclical firms, there is the
prosperity. peril that the next recession
may put an end to the firm.

Aswath Damodaran!
74!
 Valuing Vale in November 2013 (in US dollars)
Let's start with some history & estimate what a normalized year will look like
Year Operating+Income+($) Effective+tax+rate+ BV+of+Debt BV+of+Equity Cash Invested+capital Return+on+capital
2009 $6,057 27.79% $18,168 $42,556 $12,639 $48,085 9.10%
2010 $23,033 18.67% $23,613 $59,766 $11,040 $72,339 25.90%
2011 $30,206 18.54% $27,668 $70,076 $9,913 $87,831 28.01%
2012 $13,346 18.96% $23,116 $78,721 $3,538 $98,299 11.00%
2013+(TTM) $15,487 20.65% $30,196 $75,974 $5,818 $100,352 12.25%
Normalized $17,626 20.92% 17.25%

Estimate the costs of equity & capital for Vale

%"of"revenues ERP
Unlevered, US & Canada 4.90% 5.50%
beta,of, Peer,Group, Value,of, Proportion, Brazil 16.90% 8.50%
Business Sample,size business Revenues EV/Sales Business of,Vale Rest of Latin America 1.70% 10.09%
Metals'&'Mining 48 0.86 $9,013 1.97 $17,739 16.65% China 37.00% 6.94%
Iron'Ore 78 0.83 $32,717 2.48 $81,188 76.20% Japan 10.30% 6.70%
Fertilizers 693 0.99 $3,777 1.52 $5,741 5.39% Rest of Asia 8.50% 8.61%
Logistics 223 0.75 $1,644 1.14 $1,874 1.76% Europe 17.20% 6.72%
Vale,Operations 0.8440 $47,151 $106,543 100.00% Rest of World 3.50% 10.06%
Market D/E = 54.99% Vale ERP 100.00% 7.38%
Marginal tax rate = 34.00% (Brazil)
Vale's rating: A-
Levered Beta = 0.844 (1+(1-.34)(.5499) = 1.10
Default spread based on rating = 1.30%
Cost of equity = 2.75% + 1.10 (7.38%) = 11.23%
Cost of debt (pre-tax) = 2.75% + 1.30% = 4.05%

Cost of capital = 11.23% (.6452) + 4.05% (1-.34) (.3548) = 8.20%

Assume that the company is in stable growth, growing 2% a year in perpetuity
! 2% Value of operating assets = $202,832
!"#$%"&'("$'!!"#$ = ! =! = 11.59%!
!"# 17.25% + Cash & Marketable Securities = $ 7,133
- Debt = $ 42,879
17,626! 1 − .2092 1 − !. 1159
!"#$%!!"!!"#$%&'()!!""#$" = ! = $202,832! Value of equity = $167,086
. 082 − .02 Value per share =$ 32.44
Aswath Damodaran! Stock price (11/2013) = $ 13.57
 Aswath Damodaran!

RELATIVE  VALUATION  
Aswath  Damodaran  
RelaCve  valuaCon  is  pervasive…  

¨  Most  asset  valuaCons  are  relaCve.  

¨  Most  equity  valuaCons  on  Wall  Street  are  relaCve  valuaCons.    
¤  Almost  85%  of  equity  research  reports  are  based  upon  a  mulCple  and  
comparables.  
¤  More  than  50%  of  all  acquisiCon  valuaCons  are  based  upon  mulCples  
¤  Rules  of  thumb  based  on  mulCples  are  not  only  common  but  are  o}en  
the  basis  for  final  valuaCon  judgments.  
¨  While  there  are  more  discounted  cashflow  valuaCons  in  
consulCng  and  corporate  finance,  they  are  o}en  relaCve  
valuaCons  masquerading  as  discounted  cash  flow  valuaCons.  
¤  The  objecCve  in  many  discounted  cashflow  valuaCons  is  to  back  into  a  
number  that  has  been  obtained  by  using  a  mulCple.  
¤  The  terminal  value  in  a  significant  number  of  discounted  cashflow  
valuaCons  is  esCmated  using  a  mulCple.  

Aswath Damodaran!
77!
The  Reasons  for  the  allure…  

¨  “If  you  think  I’m  crazy,  you  should  see  the  guy  who  lives  
across  the  hall”  
 Jerry  Seinfeld  talking  about  Kramer  in  a  Seinfeld  episode  

¨  “  A  liTle  inaccuracy  someCmes  saves  tons  of  

explanaCon”  
           H.H.  Munro  

¨  “  If  you  are  going  to  screw  up,  make  sure  that  you  have  
lots  of  company”  
     Ex-­‐por€olio  manager  

Aswath Damodaran!
78!
The  Four  Steps  to  DeconstrucCng  MulCples  

¨  Define  the  mulCple  

¤  In  use,  the  same  mulCple  can  be  defined  in  different  ways  by  different  
users.  When  comparing  and  using  mulCples,  esCmated  by  someone  else,  it  
is  criCcal  that  we  understand  how  the  mulCples  have  been  esCmated  
¨  Describe  the  mulCple  
¤  Too  many  people  who  use  a  mulCple  have  no  idea  what  its  cross  secConal  
distribuCon  is.  If  you  do  not  know  what  the  cross  secConal  distribuCon  of  
a  mulCple  is,  it  is  difficult  to  look  at  a  number  and  pass  judgment  on  
whether  it  is  too  high  or  low.  
¨  Analyze  the  mulCple  
¤  It  is  criCcal  that  we  understand  the  fundamentals  that  drive  each  mulCple,  
and  the  nature  of  the  relaConship  between  the  mulCple  and  each  variable.  
¨  Apply  the  mulCple  
¤  Defining  the  comparable  universe  and  controlling  for  differences  is  far  
more  difficult  in  pracCce  than  it  is  in  theory.  

Aswath Damodaran!
79!
DefiniConal  Tests  

¨  Is  the  mulCple  consistently  defined?  

¤  ProposiCon  1:  Both  the  value  (the  numerator)  and  the  
standardizing  variable  (  the  denominator)  should  be  to  the  same  
claimholders  in  the  firm.  In  other  words,  the  value  of  equity  
should  be  divided  by  equity  earnings  or  equity  book  value,  and  
firm  value  should  be  divided  by  firm  earnings  or  book  value.  
¨  Is  the  mulCple  uniformly  esCmated?  
¤  The  variables  used  in  defining  the  mulCple  should  be  esCmated  
uniformly  across  assets  in  the  “comparable  firm”  list.  
¤  If  earnings-­‐based  mulCples  are  used,  the  accounCng  rules  to  
measure  earnings  should  be  applied  consistently  across  assets.  
The  same  rule  applies  with  book-­‐value  based  mulCples.  

Aswath Damodaran!
80!
Example  1:  Price  Earnings  RaCo:  DefiniCon  

PE  =  Market  Price  per  Share  /  Earnings  per  Share  

¨  There  are  a  number  of  variants  on  the  basic  PE  raCo  in  
use.  They  are  based  upon  how  the  price  and  the  
earnings  are  defined.  
Price:  is  usually  the  current  price  
 is  someCmes  the  average  price  for  the  year  
EPS:  EPS  in  most  recent  financial  year  
 EPS  in  trailing  12  months  (Trailing  PE)  
 Forecasted  EPSnnext  year  (Forward  PE)  
 Forecasted  EPS  in  future  year  

Aswath Damodaran!
81!
Example  2:  Enterprise  Value  /EBITDA  MulCple  

¨  The  enterprise  value  to  EBITDA  mulCple  is  obtained  by  
ne|ng  cash  out  against  debt  to  arrive  at  enterprise  
value  and  dividing  by  EBITDA.  
Enterprise Value Market Value of Equity + Market Value of Debt - Cash
=
EBITDA Earnings before Interest, Taxes and Depreciation

¨  Why  do  we  net  out  cash  from  firm  value?  
¨  What  happens  if  a  firm  has  cross  holdings  which  are  
categorized  as:  
¤  Minority  interests?  
¤  Majority  acCve  interests?  

Aswath Damodaran!
82!
DescripCve  Tests  

¨  What  is  the  average  and  standard  deviaCon  for  this  mulCple,  
across  the  universe  (market)?  
¨  What  is  the  median  for  this  mulCple?    
¤  The  median  for  this  mulCple  is  o}en  a  more  reliable  comparison  point.  
¨  How  large  are  the  outliers  to  the  distribuCon,  and  how  do  we  
deal  with  the  outliers?  
¤  Throwing  out  the  outliers  may  seem  like  an  obvious  soluCon,  but  if  the  
outliers  all  lie  on  one  side  of  the  distribuCon  (they  usually  are  large  
posiCve  numbers),  this  can  lead  to  a  biased  esCmate.  
¨  Are  there  cases  where  the  mulCple  cannot  be  esCmated?  Will  
ignoring  these  cases  lead  to  a  biased  esCmate  of  the  
mulCple?  
¨  How  has  this  mulCple  changed  over  Cme?  

Aswath Damodaran!
83!
1.  MulCples  have  skewed  distribuCons…  

PE  Ra-os  for  US  stocks:  January  2014  

700.  

600.  

500.  

400.  
Current  

Trailing  
300.  
Forward  

200.  

100.  

0.  
0.01  To   4  To  8   8  To  12   12  To   16  To   20  To   24  To   28  To   32  To   36  To   40  To   50  To   75  To   More  
4   16   20   24   28   32   36   40   50   75   100  

Aswath Damodaran!
84!
2.  Making  staCsCcs  “dicey”  

Current PE Trailing PE Forward PE

Number of firms 7766 7766 7766
Number with PE 3248 3186 2699
Average 52.13 50.14 38.62
Median 20.78 19.75 18.54
Minimum 0.25 0.4 0.52
Maximum 7,117.43 7,117.43 16,820.

Standard deviation 242.03 249.64 349.38

Standard error 4.25 4.42 6.72
Skewness 18.29 17.62 42.99
25th percentile 13.004 12.97 14.7
75th percentile 33.66 30.47 25.13
Aswath Damodaran!
85!
 3.  Markets  have  a  lot  in  common  :  Comparing  Global  PEs  
86!

PE  Ra-o  Distribu-on:  Global  Comparison  in  January  2014  

25.00%  

20.00%  

Aus,  Ca  &  NZ  

15.00%  
US  

Emerg  Mkts  

Europe  
10.00%  
Japan  

Global  

5.00%  

0.00%  
0.01  To   4  To  8   8  To  12   12  To   16  To   20  To   24  To   28  To   32  To   36  To   40  To   50  To   75  To   More  
4   16   20   24   28   32   36   40   50   75   100  

Aswath Damodaran

86!
4.  SimplisCc  rules  almost  always  break  down…6  
Cmes  EBITDA  may  not  be  cheap…    

EV/EBITDA:  A  Global  Comparison  -­‐  January  2014  

25.00%  

20.00%  

US  
15.00%  
A,C  &  NZ  

Emerg  Mkts  

Europe  
10.00%  
Japan  

Global  
5.00%  

0.00%  
0.01   2  To  4   4  To  6   6  To  8   8  To   10  To   12  To   16  To   20  To   25  To   30  To   35  To   40  To   45  To   50  To   75  To   More  
To  2   10   12   16   20   25   30   35   40   45   50   75   100  

Aswath Damodaran!
87!
AnalyCcal  Tests  

¨  What  are  the  fundamentals  that  determine  and  drive  these  
mulCples?  
¤  ProposiCon  2:  Embedded  in  every  mulCple  are  all  of  the  variables  that  
drive  every  discounted  cash  flow  valuaCon  -­‐  growth,  risk  and  cash  flow  
paTerns.  
¤  In  fact,  using  a  simple  discounted  cash  flow  model  and  basic  algebra  
should  yield  the  fundamentals  that  drive  a  mulCple  
¨  How  do  changes  in  these  fundamentals  change  the  mulCple?  
¤  The  relaConship  between  a  fundamental  (like  growth)  and  a  mulCple  
(such  as  PE)  is  seldom  linear.  For  example,  if  firm  A  has  twice  the  
growth  rate  of  firm  B,  it  will  generally  not  trade  at  twice  its  PE  raCo  
¤  ProposiCon  3:  It  is  impossible  to  properly  compare  firms  on  a  mulCple,  
if  we  do  not  know  the  nature  of  the  relaConship  between  
fundamentals  and  the  mulCple.  

Aswath Damodaran!
88!
PE  RaCo:  Understanding  the  Fundamentals  

¨  To  understand  the  fundamentals,  start  with  a  basic  

equity  discounted  cash  flow  model.    
¨  With  the  dividend  discount  model,  
DPS1
P0 =
r − gn

¨  Dividing  both  sides  by  the  current  earnings  per  share,  
P0 Payout Ratio * (1 + g n )
= PE =
EPS0 r-gn

¨  If  this  had  been  a  FCFE  Model,  

    P0 =
FCFE1
r − gn
P0 (FCFE/Earnings) * (1+ g n )
Aswath Damodaran! = PE =
EPS0 r-g n 89!
The  Determinants  of  MulCples…  
Value of Stock = DPS 1/(k e - g)

PE=Payout Ratio PEG=Payout ratio PBV=ROE (Payout ratio) PS= Net Margin (Payout ratio)
(1+g)/(r-g) (1+g)/g(r-g) (1+g)/(r-g) (1+g)/(r-g)

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

Equity Multiples

Firm Multiples

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

Value/FCFF=(1+g)/ Value/EBIT(1-t) = (1+g) Value/EBIT=(1+g)(1- VS= Oper Margin (1-

(WACC-g) (1- RIR)/(WACC-g) RiR)/(1-t)(WACC-g) RIR) (1+g)/(WACC-g)

Value of Firm = FCFF 1/(WACC -g)

Aswath Damodaran!
90!
ApplicaCon  Tests  

¨  Given  the  firm  that  we  are  valuing,  what  is  a  
“comparable”  firm?  
¤  While  tradiConal  analysis  is  built  on  the  premise  that  firms  in  
the  same  sector  are  comparable  firms,  valuaCon  theory  would  
suggest  that  a  comparable  firm  is  one  which  is  similar  to  the  one  
being  analyzed  in  terms  of  fundamentals.  
¤  ProposiCon  4:  There  is  no  reason  why  a  firm  cannot  be  
compared  with  another  firm  in  a  very  different  business,  if  the  
two  firms  have  the  same  risk,  growth  and  cash  flow  
characterisCcs.  
¨  Given  the  comparable  firms,  how  do  we  adjust  for  
differences  across  firms  on    the  fundamentals?  
¤  ProposiCon  5:  It  is  impossible  to  find  an  exactly  idenCcal  firm  to  
the  one  you  are  valuing.  

Aswath Damodaran!
91!
An  Example:  Comparing  PE  RaCos  across  a  
Sector:  PE  
Company Name PE Growth
PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zealand ADR 11.2 0.11
Telecom Argentina Stet - France Telecom SA ADR B 12.5 0.08
Hellenic Telecommunication Organization SA ADR 12.8 0.12
Telecomunicaciones de Chile ADR 16.6 0.08
Swisscom AG ADR 18.3 0.11
Asia Satellite Telecom Holdings ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexico ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gilat Communications 22.7 0.31
Deutsche Telekom AG ADR 24.6 0.11
British Telecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomunikasi Indonesia ADR 28.4 0.32
Cable & Wireless PLC ADR 29.8 0.14
APT Satellite Holdings ADR 31 0.33
Telefonica SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Italia SPA ADR 42.2 0.14
Nippon Telegraph & Telephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Telecom ADR 71.3 0.44

Aswath Damodaran!
92!
PE,  Growth  and  Risk  

¨  Dependent  variable  is:  PE      

¨  R  squared  =  66.2%          R  squared  (adjusted)  =  63.1%  

Variable    Coefficient  SE  t-­‐raCo  Probability  

Constant    13.1151  3.471  3.78  0.0010  
Growth  rate    121.223  19.27  6.29    ≤  0.0001  
Emerging  Market    -­‐13.8531  3.606  -­‐3.84  0.0009  
Emerging  Market  is  a  dummy:    1  if  emerging  market  
                           0  if  not  
Applying  to  Telebras,  
Predicted  PE  =  13.15  +  121.22  (.075)  –  13.85  =  8.39  
A}er  controlling  for  lower  growth  &  higher  risk,  the  stock  is  overvalued.  

Aswath Damodaran!
93!
 Comparisons  across  the  market  
94!

Region
Regression – January 2014
R2

US
PE = 4.20 + 149.0 gEPS + 13.40 Payout - 2.86 Beta
33.6%

Europe
PE = 11.51 + 41.73 gEPS + 14.36 Payout - 1.75 Beta
37.7%

Japan
PE = 11.01+ 17.30 gEPS + 31.22 Payout
16.9%

Emerging PE = 8.52 + 56.2 gEPS + 10.04 Payout - 1.43 Beta

20.0%

Markets

Global
PE = 11.79 + 50.39 gEPS + 15.86 Payout - 1.01 Beta - 61.15 ERP
33.1%

gEPS=Expected Growth: Expected growth in EPS or Net Income: Next 5 years

Beta: Regression or Bottom up Beta

Payout ratio: Dividends/ Net income from most recent year. Set to zero, if net income < 0

ERP: Equity Risk Premium (total) for country in which company is incorporated

Aswath Damodaran

94!
ConvenConal  usage…  

Sector
Multiple Used
Rationale

Cyclical Manufacturing
PE, Relative PE
Often with normalized
earnings

Growth firms
PEG ratio
Big differences in growth
rates

Young growth firms w/ Revenue Multiples
What choice do you have?

losses

Infrastructure
EV/EBITDA
Early losses, big DA

REIT
P/CFE (where CFE = Net Big depreciation charges
income + Depreciation)
on real estate

Financial Services
Price/ Book equity
Marked to market?

Retailing
Revenue multiples
Margins equalize sooner
or later

Aswath Damodaran!
95!
A  closing  thought…  

Aswath Damodaran!
96!