Valuation

AswathDamodaran

Aswath Damodaran

First Principles

Investinprojectsthatyieldareturngreaterthantheminimumacceptable
hurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthefinancingmix
usedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedandthe
timingofthesecashflows;theyshouldalsoconsiderbothpositiveandnegative
sideeffectsoftheseprojects.

Chooseafinancingmixthatminimizesthehurdlerateandmatchestheassets
beingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthecashto
stockholders.
Theformofreturnsdividendsandstockbuybackswilldependuponthe
stockholderscharacteristics.

Objective:MaximizetheValueoftheFirm
Aswath Damodaran

Discounted Cashflow Valuation: Basis for

Approach
t = n CF
t
Value =
t
t = 1 (1 + r)

where,

n=Lifeoftheasset

CFt=Cashflowinperiodt

r=Discountratereflectingtheriskinessoftheestimatedcashflows

Aswath Damodaran

Equity Valuation

Thevalueofequityisobtainedbydiscountingexpectedcashflowsto
equity,i.e.,theresidualcashflowsaftermeetingallexpenses,tax
obligationsandinterestandprincipalpayments,atthecostofequity,
i.e.,therateofreturnrequiredbyequityinvestorsinthefirm.
t=n CFtoEquity

ValueofEquity =
t=1

(1+ k e )

where,
CFtoEquityt=ExpectedCashflowtoEquityinperiodt
ke=CostofEquity

Thedividenddiscountmodelisaspecializedcaseofequityvaluation,
andthevalueofastockisthepresentvalueofexpectedfuturedividends.

Aswath Damodaran

Firm Valuation

Thevalueofthefirmisobtainedbydiscountingexpectedcashflows
tothefirm,i.e.,theresidualcashflowsaftermeetingalloperating
expensesandtaxes,butpriortodebtpayments,attheweighted
averagecostofcapital,whichisthecostofthedifferentcomponents
offinancingusedbythefirm,weightedbytheirmarketvalue
proportions.
t=n

CFtoFirmt
t
t=1 (1+ WACC)

ValueofFirm =

where,
CFtoFirmt=ExpectedCashflowtoFirminperiodt
WACC=WeightedAverageCostofCapital

Aswath Damodaran

Generic DCF Valuation Model

DISCOUNTED CASHFLOW VALUATION

Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS

Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows

Firm is in stable growth:

Grows at constant rate
forever
Terminal Value

Value
Firm: Value of Firm
Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn
.........
Forever

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity

Aswath Damodaran

Estimating Inputs:
I. Discount Rates

Criticalingredientindiscountedcashflowvaluation.Errorsin
estimatingthediscountrateormismatchingcashflowsanddiscount
ratescanleadtoseriouserrorsinvaluation.
Atanintutivelevel,thediscountrateusedshouldbeconsistentwith
boththeriskinessandthetypeofcashflowbeingdiscounted.
Thecostofequityistherateatwhichwediscountcashflowsto
equity(dividendsorfreecashflowstoequity).Thecostofcapitalis
therateatwhichwediscountfreecashflowstothefirm.

Aswath Damodaran

Estimating Aracruzs Cost of Equity

AverageUnleveredBetaforPaperandPulpfirmsis0.61
Aracruzhasacashbalancewhichwas20%ofthemarketvaluein
1997,whichismuchhigherthanthetypicalcashbalanceatotherpaper
andpulpfirms.Thebetaofcashiszero.
UnleveredBetaforAracruz=(0.8)(0.61)+0.2(0)=0.488
UsingAracruzsgrossdebtequityratioof66.67%andataxrateof
33%:
LeveredBetaforAracruz=0.49(1+(1.33)(.6667))=0.71
CostofEquityforAracruz=RealRiskfreeRate+Beta(Premium)
=5%+0.71(7.5%)=10.33%
RealRiskfreeRate=5%(LongtermGrowthrateinBrazilianeconomy)
RiskPremium=7.5%(U.S.Premium+BrazilRisk(fromrating))

Aswath Damodaran

Estimating Cost of Equity: Deutsche Bank

DeutscheBankisintwodifferentsegmentsofbusinesscommercial
bankingandinvestmentbanking.
Toestimateitscommercialbankingbeta,wewillusetheaveragebeta
ofcommercialbanksinGermany.
Toestimatetheinvestmentbankingbeta,wewillusetheaveragebetof
investmentbanksintheU.SandU.K.
ComparableFirms
AverageBeta
Weight
CommercialBanksinGermany
0.90
90%
U.K.andU.S.investmentbanks
1.30
10%
BetaforDeutscheBank=0.9(.90)+0.1(1.30)=0.94
CostofEquityforDeutscheBank(inDM)=7.5%+0.94(5.5%)
=12.67%

Aswath Damodaran

Reviewing Disneys Costs of Equity & Debt

Business
CreativeContent
Retailing
Broadcasting
ThemeParks
RealEstate
Disney

Unlevered
Beta
1.25
1.50
0.90
1.10
0.70
1.09

D/ERatio Levered
Beta
20.92% 1.42
20.92% 1.70
20.92% 1.02
20.92% 1.26
59.27% 0.92
21.97% 1.25

Riskfree
Rate
7.00%
7.00%
7.00%
7.00%
7.00%
7.00%

Risk
Premium
5.50%
5.50%
5.50%
5.50%
5.50%
5.50%

Costof
Equity
14.80%
16.35%
12.61%
13.91%
12.31%
13.85%

DisneysCostofDebt(baseduponrating)=7.50%

Aswath Damodaran

10

Estimating Cost of Capital: Disney

Equity
CostofEquity=
MarketValueofEquity=
Equity/(Debt+Equity)=

Debt
AftertaxCostofdebt=
MarketValueofDebt=
Debt/(Debt+Equity)=

13.85%
$50.88Billion
82%
7.50%(1.36)=

4.80%
$11.18Billion
18%

CostofCapital=13.85%(.82)+4.80%(.18)=12.22%

Aswath Damodaran

11

II. Estimating Cash Flows

Cash Flows

To Equity
The Strict View
Dividends +
Stock Buybacks

Aswath Damodaran

To Firm
The Broader View
Net Income
- Net Cap Ex (1-Debt Ratio)
- Chg WC (1 - Debt Ratio)
= Free Cashflow to Equity

EBIT (1-t)
- ( Cap Ex - Depreciation)
- Change in Working Capital
= Free Cashflow to Firm

12

Estimating FCFE next year: Aracruz

Allinputsarepersharenumbers:
Earnings
BR0.222
(CapExDepreciation)*(1DR) BR0.042
Chg.WorkingCapital*(1DR)
BR0.018
FreeCashflowtoEquity
BR0.170
Earnings:SinceAracruzs1996earningsareabnormallylow,Iused
theaverageearningspersharefrom1992to1996.
CapitalExpenditurespersharenextyear=0.24BR/share
Depreciationpersharenextyear=0.18BR/share
ChangeinWorkingCapital=0.03BR/share
DebtRatio=39%

Aswath Damodaran

13

Estimating FCFF: Disney

EBIT=$5,559Million
Capitalspending=$1,746Million
Depreciation=$1,134Million
IncreaseinNoncashWorkingcapital=$617Million
EstimatingFCFF
EBIT(1t)

+Depreciation
CapitalExpenditures
ChangeinWC
=FCFF

Aswath Damodaran

$3,558
$1,134
$1,746
$617
$2,329Million

14

 Application Test: Estimating your firms FCFF

EstimatetheFCFFforyourfirminitsmostrecentfinancialyear:
Ingeneral,
Ifusingstatementofcashflows
EBIT(1t)
EBIT(1t)
+Depreciation
+Depreciation
CapitalExpenditures
+CapitalExpenditures
ChangeinNoncashWC
+ChangeinNoncashWC
=FCFF
=FCFF
Estimatethedollarreinvestmentatyourfirm:
Reinvestment=EBIT(1t)FCFF

Aswath Damodaran

15

Choosing a Cash Flow to Discount

Whenyoucannotestimatethefreecashfllowstoequityorthefirm,
theonlycashflowthatyoucandiscountisdividends.Forfinancial
servicefirms,itisdifficulttoestimatefreecashflows.ForDeutsche
Bank,wewillbediscountingdividends.
Ifafirmsdebtratioisnotexpectedtochangeovertime,thefreecash
flowstoequitycanbediscountedtoyieldthevalueofequity.For
Aracruz,wewilldiscountfreecashflowstoequity.
Ifafirmsdebtratiomightchangeovertime,freecashflowstoequity
becomecumbersometoestimate.Here,wewoulddiscountfreecash
flowstothefirm.ForDisney,wewilldiscountthefreecashflowto
thefirm.

Aswath Damodaran

16

III. Expected Growth

Expected Growth

Net Income
Retention Ratio=
1 - Dividends/Net
Income

Aswath Damodaran

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

17

Expected Growth in EPS

gEPS =RetainedEarningst1/NIt1*ROE
=RetentionRatio*ROE
=b*ROE
Proposition 1: The expected growth rate in earnings for a company
cannotexceeditsreturnonequityinthelongterm.

Aswath Damodaran

18

Estimating Expected Growth in EPS: Disney,

Aracruz and Deutsche Bank
Company

ROE

Retention Exp.
Forecast
Ratio
Growth ROE
Disney
24.95% 77.68% 19.38% 25%
Aracruz
2.22% 65.00% 1.44% 13.91%
DeutscheBank 7.25% 39.81% 2.89% 14.00%
ROE:ReturnonEquityformostrecentyear
ForecastedROE=ExpectedROEforthenext5years

Retention
Ratio
77.68%
65.00%
45.00%

Exp
Growth
19.42%
9.04%
6.30%

ForDisney,forecastedROEisexpectedtobeclosetocurrentROE
ForAracruz,theaverageROEbetween1994and1996isused,since1996
wasaabnormallybadyear
ForDeutscheBank,theforecastROEissetequaltotheaverageROEfor
Germanbanks
Aswath Damodaran

19

ROE and Leverage

ROE=ROC+D/E(ROCi(1t))
where,
ROC=(EBIT(1taxrate))/BookValueofCapital
=EBIT(1t)/BookValueofCapital
D/E=BVofDebt/BVofEquity
i=InterestExpenseonDebt/BookValueofDebt
t=Taxrateonordinaryincome
NotethatBVofCapital=BVofDebt+BVofEquity.

Aswath Damodaran

20

Decomposing ROE: Disney in 1996

ReturnonCapital
=(EBIT(1taxrate)/(BV:Debt+BV:Equity)
=5559(1.36)/(7663+11668)=18.69%
DebtEquityRatio
=BookValueofDebt/BookValueofEquity=45%
InterestRateonDebt=7.50%
ExpectedReturnonEquity=ROC+D/E(ROCi(1t))
=18.69%+.45(18.69%7.50(1.36))=24.95%

Aswath Damodaran

21

Expected Growth in EBIT And Fundamentals

ReinvestmentRateandReturnonCapital
gEBIT =(NetCapitalExpenditures+ChangeinWC)/EBIT(1t)*
ROC
=ReinvestmentRate*ROC
Proposition2:Nofirmcanexpectitsoperatingincometogrowover
timewithoutreinvestingsomeoftheoperatingincomeinnetcapital
expendituresand/orworkingcapital.
Proposition3:Thenetcapitalexpenditureneedsofafirm,foragiven
growthrate,shouldbeinverselyproportionaltothequalityofits
investments.

Aswath Damodaran

22

Estimating Growth in EBIT: Disney

Actualreinvestmentratein1996=(NetCapEx+ChginWC)/EBIT(1t)

NetCapExin1996=(17451134)
ChangeinWorkingCapital=617
EBIT(1taxrate)=5559(1.36)
ReinvestmentRate=(17451134+617)/(5559*.64)=34.5%

ForecastedReinvestmentRate=50%
ReturnonCapital=20%(Higherthanthisyears18.69%)
ExpectedGrowthinEBIT=.5(20%)=10%
Theforecastedreinvestmentrateismuchhigherthantheactual
reinvestmentratein1996,becauseitincludesprojectedacquisition.
Between1992and1996,addingintheCapitalCitiesacquisitiontoall
capitalexpenditureswouldhaveyieldedareinvestmentrateofroughly
50%.

Aswath Damodaran

23

 Application Test: Estimating Expected Growth

Estimatethefollowing:
Thereinvestmentrateforyourfirm
Theaftertaxreturnoncapital
Theexpectedgrowthinoperatingincome,basedupontheseinputs

Aswath Damodaran

24

IV. Getting Closure in Valuation

Apubliclytradedfirmpotentiallyhasaninfinitelife.Thevalueis
thereforethepresentvalueofcashflowsforever.
t = CFt
Value =
t
t = 1 (1+ r)

Sincewecannotestimatecashflowsforever,weestimatecashflows
foragrowthperiodandthenestimateaterminalvalue,tocapture
thevalueattheendoftheperiod:
t = N CF
t TerminalValue
Value =
N
t
(1 + r)
t = 1 (1 + r)

Aswath Damodaran

25

Stable Growth and Terminal Value

Whenafirmscashflowsgrowataconstantrateforever,thepresent
valueofthosecashflowscanbewrittenas:
Value=ExpectedCashFlowNextPeriod/(rg)
where,
r=Discountrate(CostofEquityorCostofCapital)
g=Expectedgrowthrate

Thisconstantgrowthrateiscalledastablegrowthrateandcannotbe
higherthanthegrowthrateoftheeconomyinwhichthefirmoperates.
Whilecompaniescanmaintainhighgrowthratesforextendedperiods,
theywillallapproachstablegrowthatsomepointintime.
Whentheydoapproachstablegrowth,thevaluationformulaabovecan
beusedtoestimatetheterminalvalueofallcashflowsbeyond.

Aswath Damodaran

26

Growth Patterns

Akeyassumptioninalldiscountedcashflowmodelsistheperiodof
highgrowth,andthepatternofgrowthduringthatperiod.Ingeneral,we
canmakeoneofthreeassumptions:
thereisnohighgrowth,inwhichcasethefirmisalreadyinstablegrowth
therewillbehighgrowthforaperiod,attheendofwhichthegrowthrate
willdroptothestablegrowthrate(2stage)
therewillbehighgrowthforaperiod,attheendofwhichthegrowthrate
willdeclinegraduallytoastablegrowthrate(3stage)

Theassumptionofhowlonghighgrowthwillcontinuewilldependupon
severalfactorsincluding:
thesizeofthefirm(largerfirm>shorterhighgrowthperiods)
currentgrowthrate(ifhigh>longerhighgrowthperiod)
barrierstoentryanddifferentialadvantages(ifhigh>longergrowthperiod)

Aswath Damodaran

27

Length of High Growth Period

Assumethatyouareanalyzingtwofirms,bothofwhichareenjoying
highgrowth.ThefirstfirmisEarthlinkNetwork,aninternetservice
provider,whichoperatesinanenvironmentwithfewbarrierstoentry
andextraordinarycompetition.ThesecondfirmisBiogen,abio
technologyfirmwhichisenjoyinggrowthfromtwodrugstowhichit
ownspatentsforthenextdecade.Assumingthatbothfirmsarewell
managed,whichofthetwofirmswouldyouexpecttohavealonger
highgrowthperiod?
EarthlinkNetwork
Biogen
Botharewellmanagedandshouldhavethesamehighgrowthperiod

Aswath Damodaran

28

Choosing a Growth Pattern: Examples

Company
Valuationin
Disney
NominalU.S.$
Firm
(3stage)
economy
Aracruz
RealBR
Equity:FCFE
realgrowthratefor
DeutscheBank NominalDM
Equity:Dividends
intheworldeconomy

Aswath Damodaran

GrowthPeriod StableGrowth
10years
5%(longterm
nominalgrowthrate
intheU.S.
5years
(2stage)
0years

5%:basedupon
expectedlongterm
Brazilianeconomy
5%:setequalto
nominalgrowthrate

29

Firm Characteristics as Growth Changes

Variable
Risk
DividendPayout
NetCapEx
ReturnonCapital
Leverage

Aswath Damodaran

HighGrowthFirmstendto
beaboveaveragerisk
paylittleornodividends
havehighnetcapex
earnhighROC(excessreturn)
havelittleornodebt

StableGrowthFirmstendto
beaveragerisk
payhighdividends
havelownetcapex
earnROCclosertoWACC
higherleverage

30

Estimating Stable Growth Inputs

Startwiththefundamentals:
Profitabilitymeasuressuchasreturnonequityandcapital,instable
growth,canbeestimatedbylookingat
industryaveragesforthesemeasure,inwhichcaseweassumethatthisfirmin
stablegrowthwilllookliketheaveragefirmintheindustry
costofequityandcapital,inwhichcaseweassumethatthefirmwillstop
earningexcessreturnsonitsprojectsasaresultofcompetition.

Leverageisatoughercall.Whileindustryaveragescanbeusedhereas
well,itdependsuponhowentrenchedcurrentmanagementisandwhether
theyarestubbornabouttheirpolicyonleverage(Iftheyare,usecurrent
leverage;iftheyarenot;useindustryaverages)

Usetherelationshipbetweengrowthandfundamentalstoestimate
payoutandnetcapitalexpenditures.

Aswath Damodaran

31

Estimating Stable Period Net Cap Ex

gEBIT
=(NetCapitalExpenditures+ChangeinWC)/EBIT(1t)*
ROC
=ReinvestmentRate*ROC
Movingtermsaround,
ReinvestmentRate=gEBIT/ReturnonCapital
Forinstance,assumethatDisneyinstablegrowthwillgrow5%and
thatitsreturnoncapitalinstablegrowthwillbe16%.The
reinvestmentratewillthenbe:
ReinvestmentRateforDisneyinStableGrowth=5/16=31.25%
Inotherwords,
thenetcapitalexpendituresandworkingcapitalinvestmenteachyear
duringthestablegrowthperiodwillbe31.25%ofaftertaxoperating
income.

Aswath Damodaran

32

Valuation: Deutsche Bank

SustainablegrowthatDeutscheBank=ROE*RetentionRatio
=14%(.45)=6.30% {Iusedthenormalizednumbersforthis]
Costofequity=7.5%+0.94(5.5%)=12.67%.
CurrentDividendspershare=2.61DM
ModelUsed:
StableGrowth(Largefirm;Growthisclosetostablegrowthalready)
DividendDiscountModel(FCFEistoughtoestimate)

Valuation
ExpectedDividendsperSharenextyear=2.61DM(1.063)=2.73DM
ValueperShare=2.73DM/(.1267.063)=42.89DM

DeutscheBankwastradingfor119DMonthedayofthisanalysis.

Aswath Damodaran

33

What does the valuation tell us?

Stockistremendouslyovervalued:Thisvaluationwouldsuggestthat
DeutscheBankissignificantlyovervalued,givenourestimatesof
expectedgrowthandrisk.
DividendsmaynotreflectthecashflowsgeneratedbyDeutscheBank.
TheFCFEcouldhavebeensignificantlyhigherthanthedividends
paid.
Estimatesofgrowthandriskarewrong:Itisalsopossiblethatwe
haveunderestimatedgrowthoroverestimatedriskinthemodel,thus
reducingourestimateofvalue.

Aswath Damodaran

34

Valuation: Aracruz Cellulose

ThecurrentearningspershareforAracruzCelluloseis0.044BR.
Theseearningsareabnormallylow.Tonormalizeearnings,weusethe
averageearningspersharebetween1994and1996of0.204BRper
shareasameasureofthenormalizedearningspershare.
ModelUsed:
Realvaluation(sinceinflationisstillindoubledigits)
2StageGrowth(Firmisstillgrowinginahighgrowtheconomy)
FCFEDiscountModel(DividendsarelowerthanFCFE:SeeDividend
section)

Aswath Damodaran

35

Aracruz Cellulose: Inputs for Valuation

Length
ExpectedGrowth
CostofEquity

HighGrowthPhase
5years
RetentionRatio*ROE
=0.65*13.91%=8.18%
5%+0.71(7.5%)=10.33%
(Beta=0.71;Rf=5%)

StableGrowthPhase
Forever,afteryear5
5%(RealGrowthRateinBrazil)
5%+1(7.5%)=12.5%
(Assumesbetamovesto1)

NetCapitalExpenditures Netcapitalexgrowsatsame Capitalexpendituresareassumed

rateasearnings.Nextyear, tobe120%ofdepreciation
capitalexwillbe0.24BR
anddeprecnwillbe0.18BR.
WorkingCapital
32.15%ofRevenues;
32.15%ofRevenues;
Revenuesgrowatsamerateasearningsinbothperiods.
DebtRatio
39.01%ofnetcapitalexandworkingcapitalinvestmentscome
fromdebt.

Aswath Damodaran

36

Aracruz: Estimating FCFE for next 5 years

Earnings
(CapExDepreciation)*(1DR)
Chg.WorkingCapital*(1DR)
FreeCashflowtoEquity
PresentValue

Terminal

BR0.222
BR0.042
BR0.010
BR0.170
BR0.154

BR0.243
BR0.046
BR0.011
BR0.186
BR0.152

BR0.264
BR0.050
BR0.012
BR0.202
BR0.150

BR0.288BR0.314BR0.330
BR0.055BR0.060BR0.052
BR0.013BR0.014BR0.008
BR0.221BR0.241BR0.269
BR0.149BR0.147

ThepresentvalueiscomputedbydiscountingtheFCFEatthecurrent
costofequityof10.33%.

Aswath Damodaran

37

Aracruz: Estimating Terminal Price and Value

per share

Theterminalvalueattheendofyear5isestimatedusingtheFCFEin
theterminalyear.
TheFCFEinyear6reflectsthedropinnetcapitalexpendituresafteryear
5.
TerminalValue=0.269/(.125.05)=3.59BR
ValueperShare=0.154+0.152+0.150+0.149+0.147+3.59/1.10335
=2.94BR

Thestockwastradingat2.40BRinSeptember1997.
Thevaluepershareisbaseduponnormalizedearnings.Totheextent
thatitwilltakesometimetogettnormalearnings,discountthisvalue
persharebacktothepresentatthecostofequityof10.33%.

Aswath Damodaran

38

Disney Valuation

ModelUsed:
CashFlow:FCFF(sinceIthinkleveragewillchangeovertime)
GrowthPattern:3stageModel(eventhoughgrowthinoperatingincome
isonly10%,therearesubstantialbarrierstoentry)

Aswath Damodaran

39

Disney: Inputs to Valuation

LengthofPeriod

HighGrowthPhase

TransitionPhase

5years

5years

StableGrowthPhase
Foreverafter10years

Revenues

Current Revenues: $ 18,739; Continues to grow at same rate Growsatstablegrowthrate

Expectedtogrowatsamerate a asoperatingearnings
operatingearnings

PretaxOperatingMargin

29.67%ofrevenues, basedupon Increases gradually to 32% of Stablemargin is assumed to be

1996EBITof$5,559million.
revenues, due to economies of 32%.
scale.

TaxRate

36%

ReturnonCapital

20%(approximately1996level) Declineslinearlyto16%

StableROCof16%

WorkingCapital

5%ofRevenues

5%ofRevenues

36%
5%ofRevenues

36%

ReinvestmentRate
50% of aftertax operating Declinesto31.25%asROCand 31.25% of aftertax operating
(NetCapEx+ WorkingCapital income;Depreciationin1996 is growthratesdrop:
income; this is estimated from
Investments/EBIT)
$1,134million,andis assumed ReinvestmentRate=g/ROC
thegrowthrateof5%
togrowatsamerateasearnings
Reinvestmentrate=g/ROC
ExpectedGrowthRateinEBIT

ROC * Reinvestment Rate = Lineardeclineto Stable Growth 5%,baseduponoverall nominal

20%*.5=10%
Rate
economicgrowth

Debt/CapitalRatio

18%

Increaseslinearlyto30%

RiskParameters

Beta=1.25,ke =13.88%
CostofDebt=7.5%
(LongTermBondRate=7%)

Beta decreases linearly to 1.00; Stablebetais1.00.

Costofdebtstaysat7.5%
Costofdebtstaysat7.5%

Aswath Damodaran

Stabledebtratioof30%

40

Disney: FCFF Estimates

Base
ExpectedGrowth
Revenues
Oper.Margin

2
10%

3
10%

4
10%

5
10%

6
10%

7
9%

8
8%

9
7%

10
6%

5%

$18,739 $20,613 $22,674 $24,942 $27,436 $30,179 $32,895 $35,527 $38,014 $40,295 $42,310
29.67%

29.67%

29.67%

29.67%

29.67%

29.67%

30.13%

30.60%

31.07%

31.53%

32.00%

EBIT

$5,559 $6,115 $6,726 $7,399 $8,139 $8,953 $9,912 $10,871 $11,809 $12,706 $13,539

EBIT(1t)

$3,558 $3,914 $4,305 $4,735 $5,209 $5,730 $6,344 $6,957 $7,558 $8,132 $8,665

+Depreciation

$1,134 $1,247 $1,372 $1,509 $1,660 $1,826 $2,009 $2,210 $2,431 $2,674 $2,941

CapitalExp.

$1,754 $3,101 $3,411 $3,752 $4,128 $4,540 $4,847 $5,103 $5,313 $5,464 $5,548

ChangeinWC $94 $94 $103 $113 $125 $137 $136 $132 $124 $114 $101
=FCFF
ROC

$1,779 $1,966 $2,163 $2,379 $2,617 $2,879 $3,370 $3,932 $4,552 $5,228 $5,957
20%

Reinv.Rate

Aswath Damodaran

20%

20%

20%

20%

20%

19.2%

18.4%

17.6%

16.8%

16%

50%

50%

50%

50%

50% 46.875%

43.48%

39.77%

35.71%

31.25%

41

Disney: Costs of Capital

Year

CostofEquity

CostofDebt

10

13.88% 13.88% 13.88% 13.88% 13.88% 13.60% 13.33% 13.05% 12.78% 12.50%

4.80%

4.80%

4.80%

4.80%

4.80%

4.80%

4.80%

4.80%

4.80%

4.80%

DebtRatio

18.00% 18.00% 18.00% 18.00% 18.00% 20.40% 22.80% 25.20% 27.60% 30.00%

CostofCapital

12.24% 12.24% 12.24% 12.24% 12.24% 11.80% 11.38% 10.97% 10.57% 10.19%

Aswath Damodaran

42

Disney: Terminal Value

Theterminalvalueattheendofyear10isestimatedbaseduponthe
freecashflowstothefirminyear11andthecostofcapitalinyear11.
FCFF11=EBIT(1t)EBIT(1t)ReinvestmentRate
=$13,539(1.05)(1.36)$13,539(1.05)(1.36)(.3125)
=$6,255million
Notethatthereinvestmentrateisestimatedfromthecostofcapitalof
16%andtheexpectedgrowthrateof5%.
CostofCapitalinterminalyear=10.19%
TerminalValue=$6,255/(.1019.05)=$120,521million

Aswath Damodaran

43

Disney: Present Value

Year
FCFF
TermValue

10

$1,966 $2,163 $2,379 $2,617 $2,879 $3,370 $3,932 $4,552 $5,228 $5,957
120,521

PresentValue

$1,752 $1,717 $1,682 $1,649 $1,616 $1,692 $1,773 $1,849 $1,920 42,167

CostofCapital

12.24% 12.24% 12.24% 12.24% 12.24% 11.80% 11.38% 10.97% 10.57% 10.19%

Aswath Damodaran

44

Present Value Check

TheFCFFandcostsofcapitalareprovidedforall10years.Confirm
thepresentvalueoftheFCFFinyear7.

Aswath Damodaran

45

Disney: Value Per Share

ValueoftheFirm=
+ValueofCash=
ValueofDebt=
=ValueofEquity=
/NumberofShares
ValuePerShare=

Aswath Damodaran

$57,817million
$0(almostnononoperatingcash
$11,180million
$46,637million
675.13
$69.08

46

Disney: A Valuation
Cashflow to Firm
EBIT(1-t) :
3,558
- Nt CpX
612
- Chg WC
617
= FCFF
2,329

57,817
- 11,180= 46,637
Per Share: 69.08

1,966

Reinvestment Rate
50.00%

2,163

2,379

2,617

Expected Growth
in EBIT (1-t)
.50*.20 = .10
10.00 %

Return on Capital
20%
Stable Growth
g = 5%; Beta = 1.00;
D/(D+E) = 30%; ROC=16%
Reinvestment Rate=31.25%

Terminal Value 10= 6255/(.1019-.05) = 120,521

ROC drops to 16%
Reinv. rate drops to 31.25%
2,879 3,370
3,932
4,552 5,228 5,957
Forever

Discount at Cost of Capital (WACC) = 13.85% (0.82) + 4.8% (0.18) = 12.22%

Cost of Equity
13.85%

Riskfree Rate :
Government Bond
Rate = 7%

Cost of Debt
(7%+ 0.50%)(1-.36)
= 4.80%

Beta
1.25

Unlevered Beta for

Sectors: 1.09

Aswath Damodaran

Transition
Beta drops to 1.00
Debt ratio rises to 30%

Weights
E = 82% D = 18%

Risk Premium
5.5%

Firms D/E
Ratio: 21.95%

Historical US
Premium
5.5%

Country Risk
Premium
0%

47

Determine the business risk of the firm (Beta, Default Risk)

The Investment Decision
Invest in projects that yield a return
greater than the minimum acceptable
hurdle rate

The Dividend Decision

If there are not enough
investments that earn the
hurdle rate, return the cash to
the owners

Return on Capital
20.00%

Current
EBIT(1-t) =
$3,558 million

Transition to
stable growth
inputs

Aswath Damodaran

Year
1
2
3
4
5
6
7
8
9
10

Reinvestment Rate
50%

Expected Growth = ROC * RR

= .50 * 20%= 10%

EBIT(1t)
$3,914
$4,305
$4,735
$5,209
$5,730
$6,344
$6,957
$7,558
$8,132
$8,665

Reinvestment
$1,947
$2,142
$2,356
$2,343
$2,851
$2,974
$2,762
$3,006
$2,904
$2,708

FCFF
TerminalValue PV
$1,966
$1,752
$2,163
$1,717
$2,379
$1,682
$2,866
$1,649
$2,879
$1,616
$3,370
$1,692
$4,196
$1,773
$4,552
$1,849
$5,228
$1,920
$5,957 $120,521 $42,167
ValueofDisney= $57,817
ValueofDebt= $11,180
=ValueofEquity $46,637
ValueofDisney/share= $69.08

The Financing Decision

Choose a financing mix that
maximizes the value of the projects
taken, and matches the assets being
financed.
Equity:
Beta=1.25

Debt::
Default Risk

Cost of Capital
12.22%

In stable growth:
Reinvestment Rate=31.67%
Return on Capital = 16%
Beta = 1.00
Debt Ratio = 30.00%
Cost of Capital = 10.19%
48

Relative Valuation

Inrelativevaluation,thevalueofanassetisderivedfromthepricing
of'comparable'assets,standardizedusingacommonvariablesuchas
earnings,cashflows,bookvalueorrevenues.Examplesinclude
Price/Earnings(P/E)ratios
andvariants(EBITmultiples,EBITDAmultiples,CashFlowmultiples)

Price/Book(P/BV)ratios
andvariants(Tobin'sQ)

Price/Salesratios

Aswath Damodaran

49

MULTIPLES AND DCF VALUATION

P0

DPS1
r gn

GordonGrowthModel:
Dividingbothsidesbytheearnings,
P0
PayoutRatio * (1 g n )
PE =
EPS 0
rg
n

Dividingbothsidesbythebookvalueofequity,
P0
ROE * PayoutRatio * (1 g n )
PBV =
BV 0
rg

Ifthereturnonequityiswrittenintermsoftheretentionratioandthe
expectedgrowthrate
P0
ROE gn
PBV =
BV 0
rg

DividingbytheSalespershare,

P0
ProfitMargin * PayoutRatio * (1 g n )
PS =
Sales 0
rg
n

Aswath Damodaran

50

Disney: Relative Valuation

Company
KingWorldProductions
Aztar
Viacom
AllAmericanCommunications
GCCompanies
CircusCircusEnterprises
PolygramNVADR
RegalCinemas
WaltDisney
AMCEntertainment
PremierParks
FamilyGolfCenters
CINARFilms
Average

Aswath Damodaran

PE
10.4
11.9
12.1
15.8
20.2
20.8
22.6
25.8
27.9
29.5
32.9
33.1
48.4
22.19

ExpectedGrowth
7.00%
12.00%
18.00%
20.00%
15.00%
17.00%
13.00%
23.00%
18.00%
20.00%
28.00%
36.00%
25.00%
18.56%

PEG
1.49
0.99
0.67
0.79
1.35
1.22
1.74
1.12
1.55
1.48
1.18
0.92
1.94
1.20

51

Is Disney fairly valued?

BaseduponthePEratio,isDisneyunder,overorcorrectlyvalued?
UnderValued
OverValued
CorrectlyValued
BaseduponthePEGratio,isDisneyundervalued?
UnderValued
OverValued
CorrectlyValued
Willthisvaluationgiveyouahigherorlowervaluationthanthe
discountedCFvalutaion?
Higher
Lower

Aswath Damodaran

52

Relative Valuation Assumptions

Assumethatyouarereadinganequityresearchreportwhereabuy
recommendationforacompanyisbeingbaseduponthefactthatits
PEratioislowerthantheaveragefortheindustry.Implicitly,whatis
theunderlyingassumptionorassumptionsbeingmadebythisanalyst?
Thesectoritselfis,onaverage,fairlypriced
Theearningsofthefirmsinthegrouparebeingmeasuredconsistently
Thefirmsinthegroupareallofequivalentrisk
Thefirmsinthegroupareallatthesamestageinthegrowthcycle
Thefirmsinthegroupareofequivalentriskandhavesimilarcash
flowpatterns
Alloftheabove

Aswath Damodaran

53

First Principles

Investinprojectsthatyieldareturngreaterthantheminimumacceptable
hurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthefinancingmix
usedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedandthe
timingofthesecashflows;theyshouldalsoconsiderbothpositiveandnegative
sideeffectsoftheseprojects.

Chooseafinancingmixthatminimizesthehurdlerateandmatchestheassets
beingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthecashto
stockholders.
Theformofreturnsdividendsandstockbuybackswilldependuponthe
stockholderscharacteristics.

Objective:MaximizetheValueoftheFirm
Aswath Damodaran

54