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Aswath Damodaran
Aswath Damodaran
Aswath Damodaran
Approaches to Valuation
Valuation Models
Relative Valuation
Liquidation Value
Stable Current
Equity
Firm
Sec tor
Option to delay
Market
Tw o-s tage
Three-stage or n-stage
Normalized
Undeveloped land
APV approach
Aswath Damodaran
In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.
Aswath Damodaran
Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.
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where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.
Aswath Damodaran
Aswath Damodaran
I.Equity Valuation
The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm.
Value of Equity =
t=n
Forms: The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. In the more general version, you can consider the cashflows left over after debt payments and reinvestment needs as the free cashflow to equity.
Aswath Damodaran
APV approach: The value of the firm can also be written as the sum of the value of the unlevered firm and the effects (good and bad) of debt.
Firm Value = Unlevered Firm Value + PV of tax benefits of debt - Expected Bankruptcy Cost
Aswath Damodaran
Cash flows Firm: Pre-debt cash flow Equity: After debt cash flows
Expe cte d Growth Firm: Growth in Operating Earnings Equity: Growth in Net Income/EPS
Terminal Value
CF1
CF2
CF3
CF4
CF5
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ROE = 16%
g =4%: ROE = 8.95%(=Cos t of equity) Beta = 1.00 Payout = (1- 4/8.95) = .553
Terminal Value= EPS *Payout/(r-g) 6 = (2.21*.553)/(.0895-.04) = 24.69 Value of Equity per share = 20.48 Eur EPS 1.64 Eur DPS 0.96 Eur 1.75 Eur 1.02 Eur 1.87 Eur 1.09 Eur 1.99 Eur 1.16 Eur 2.12 Eur 1.24 Eur ......... Forever
Discount at Cost of Equity
Beta 0.95
Ris k Premium 4%
Mature Market 4%
Country Risk 0%
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Retu rn on Capital 21.85% Stable Growth g = 4.17%; Beta = 1.00; Country Premium= 5% Cost of capital = 8.76% ROC= 8.76%; Tax rate=34% Reinvestme nt Rate=g /ROC =4.17/8 .76= 47.62% Terminal Value= 288/(.0 876-.0417) = 6272 5
Curre nt Cashflow to Firm EBIT(1-t) : $ 4 04 - Nt CpX 23 - Chg WC 9 = FCFF $ 372 Reinvestme nt Rate = 32/404= 7.9%
$ Ca shflows Op. Assets $ 5,2 72 + Ca sh: 795 - Debt 717 - Mino r. Int. 12 =Equity 5,34 9 -Optio ns 28 Value/Sh are $7.47 R$ 2 1.75 Year EBIT(1-t) - Reinve stment = FCFF 1 426 107 319 2 449 113 336 3 474 119 355
Discount at$ Cost o f Ca pital (WACC) = 10 .52% (.8 4) + 6.05% (0.16) = 9.81%
Be ta 1.07
Lambda 0.27
Country Equity Risk Premium 7.67% Rel Equity Mkt Vol 1.28
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Stable Growth Cap ex growth slows and net cap ex decreases Revenue Growth: 13.33% EBITDA/Sales -> 30% Stable Stable Revenue EBITDA/ Growth: 5% Sales 30% Stable ROC=7.36% Reinvest 67.93%
EBIT -1 895m
NOL: 2,076m
Revenues EBITDA EBIT EBIT (1-t ) + Depreciat ion - Cap Ex - Chg WC FCFF
Value o f Op Assets $ + Ca sh & Non-op $ = Value of Firm $ - Value o f De bt $ = Value of Equity $ - Equity Options $ Value p er share $
Fore ver
Be ta 3.00> 1.10
Internet/ Reta il
Operating Leverage
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Probability of distress
Price of 8 year, 12% bond issued by Global Crossing = $ 653
653
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Probability of distress = 13.53% a year Cumulative probability of survival over 10 years = (1- .1353)10 = 23.37%
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In the adjusted present value approach, the value of the firm is written as the sum of the value of the firm without debt (the unlevered firm) and the effect of debt on firm value Firm Value = Unlevered Firm Value + (Tax Benefits of Debt Expected Bankruptcy Cost from the Debt)
The unlevered firm value can be estimated by discounting the free cashflows to the firm at the unlevered cost of equity The tax benefit of debt reflects the present value of the expected tax benefits. In its simplest form, Tax Benefit = Tax rate * Debt The expected bankruptcy cost is a function of the probability of bankruptcy and the cost of bankruptcy (direct as well as indirect) as a percent of firm value.
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You can present any discounted cashflow model in terms of excess returns, with the value being written as:
Value = Capital Invested + Present value of excess returns on current investments + Present value of excess returns on future investments
This model can be stated in terms of firm value (EVA) or equity value.
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Terminal Value= $2220/(.094-.05)=50,45 9 Net Income $3,599 - Eq uity Co st (se e below)$1,908 Exce ss Eq uity Re turn $1,692 Book Equity= 17997 + PV of EVA= 38334 = Equity EVA=56331 Value/sh = $50.26 $4,031 $2,137 $1,895 $4,515 $2,393 $2,122 $5,057 $2,680 $2,377 $5,664 $3,002 $2,662 Fore ver Discount atCost of Equity
Be ta 1.40
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FCFE
FCFF
Replace current Is the firm earning s with likely to normalized survive? earning s
2-stage model No
Yes Adjust margins over time to nurse firm to finan cia l health Yes
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Relative Valuation
What is it?: The value of any asset can be estimated by looking at how the market prices similar or comparable assets. Philosophical Basis: The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics) Information Needed: To do a relative valuation, you need
an identical asset, or a group of comparable or similar assets a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value) and if the assets are not perfectly comparable, variables to control for the differences
Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected.
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Variations on Multiples
Scaling variable
Base year
Comparables
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Definitional Tests
Is the multiple consistently defined?
Proposition 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.
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There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined. Price: is usually the current price is sometimes the average price for the year EPS: earnings per share in most recent financial year earnings per share in trailing 12 months (Trailing PE) forecasted earnings per share next year (Forward PE) forecasted earnings per share in future year
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Descriptive Tests
What is the average and standard deviation for this multiple, across the universe (market)? What is the median for this multiple?
The median for this multiple is often a more reliable comparison point.
How large are the outliers to the distribution, and how do we deal with the outliers?
Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on one side of the distribution (they usually are large positive numbers), this can lead to a biased estimate.
Are there cases where the multiple cannot be estimated? Will ignoring these cases lead to a biased estimate of the multiple? How has this multiple changed over time?
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Mean Standard Error Median Standard Deviation Skewness Minimum Maximum Count Largest(500) Smallest(500)
Current PE 36.04 1.94 18.25 123.36 23.13 0.65 5103.50 4024 48.00 9.38
Trailing PE 34.14 2.93 17.25 176.34 28.40 1.35 6914.50 3627 39.60 9.62
Forward PE 30.79 1.15 18.52 57.56 13.66 3.30 1414.00 2491 34.49 12.94
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Analytical Tests
What are the fundamentals that determine and drive these multiples?
Proposition 2: Embedded in every multiple are all of the variables that drive every discounted cash flow valuation - growth, risk and cash flow patterns. In fact, using a simple discounted cash flow model and basic algebra should yield the fundamentals that drive a multiple
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PS= Net Ma rgin (Payout ratio) (1 +g)/(r-g) PS=f(Net Mgn, payout, g, risk)
Firm M ultiple s V/FCFF=f(g, WACC) Value/FCFF=(1+g)/ (WACC-g) V/EBIT(1-t)=f(g, RIR, WACC) Value/EBIT(1 -t) = (1+g) (1 - RIR)/(WACC-g) V/EBIT=f(g, RIR, WACC, t) Value/EBIT=(1+g)(1RiR)/(1-t)(WACC-g) VS=f(Oper Mgn, RIR, g , WACC) VS= Ope r Margin (1RIR) (1+g)/(WACC-g)
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Application Tests
Given the firm that we are valuing, what is a comparable firm?
While traditional analysis is built on the premise that firms in the same sector are comparable firms, valuation theory would suggest that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals. Proposition 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 characteristics.
Given the comparable firms, how do we adjust for differences across firms on the fundamentals?
Proposition 5: It is impossible to find an exactly identical firm to the one you are valuing.
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Variable Coefficient SE t-ratio Constant 13.1151 3.471 3.78 Growth rate 121.223 19.27 6.29 Emerging Market -13.8531 3.606 -3.84 Emerging Market is a dummy: 1 if emerging market 0 if not
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Predicted PE = 13.12 + 121.22 (.075) - 13.85 (1) = 8.35 At an actual price to earnings ratio of 8.9, Telebras is slightly overvalued.
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Adjus t e d R Sq ua r e .73 2
St d. Er ro r o f th e Es tim a te 13 5 0.6 77 6 1 93 1 3
a . Fo r r e g re ss io n t hr ou gh th e or igin (th e n o - int e rc e pt m od e l), R Squ a r e m e a su r e s t he pr o po rt ion of t he va r ia b ility in th e de p e n de n t va ria ble a b ou t th e o rig in ex pla ine d b y r e gr e s sion . T his CANNOT b e c o m p ar ed to R Sq ua r e fo r m od e ls whic h inc lu d e a n int er c e p t. b . Pr e d ic tor s: Valu e Line Bet a , P a you t Ra tio , Ex pe c te d Gr owt h in EPS: ne x t 5 ye a rs
Co e f fici e n ts a,b ,c Uns t an d ar d iz ed Coe f fic ie nt s Mo de l 1 B Exp e ct e d Gro wth in EPS: n e xt 5 ye ar s Pa yo ut Ra tio Va lu e Lin e B ta e 1 .2 28 - 1 .1 E- 0 2 1 1. 70 5 Std . Er r or .05 5 .01 4 .82 5 St a nd a r diz e d C oe ffic ie n ts Be t a .51 4 - .01 3 .38 4 t 22 .1 87 - .7 68 14 .1 84 Sig . .0 0 0 .4 4 3 .0 0 0 9 5% Co nf ide n ce Int e rva l f or B Lo wer Bo un d 1 .1 19 - .03 9 1 0. 08 7 Up pe r Bo un d 1.3 3 6 .0 1 7 13 .3 24
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Value of Ass et
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Traditional discounted cashflow models under estimate the value of investments, where there are options embedded in the investments to
Delay or defer making the investment (delay) Adjust or alter production schedules as price changes (flexibility) Expand into new markets or products at later stages in the process, based upon observing favorable outcomes at the early stages (expansion) Stop production or abandon investments if the outcomes are unfavorable at early stages (abandonment)
Put another way, real option advocates believe that you should be paying a premium on discounted cashflow value estimates.
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Aswath Damodaran
Underlying Asset: While the reserve or mine may not be traded, the commodity is. If we assume that we know the quantity with a fair degree of certainty, you can trade the underlying asset Option: Oil companies buy and sell reserves from each other regularly. Cost of Exercising the Option: This is the cost of developing a reserve. Given the experience that commodity companies have with this, they can estimate this cost with a fair degree of precision.
Bottom Line: Real option pricing models work well with natural resource options.
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Bottom Line: Using option pricing models to value expansion options will not only yield extremely noisy estimates, but may attach inappropriate premiums to discounted cashflow estimates.
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There are real options everywhere. Most of them have no significant economic value because there is no exclusivity associated with using them. When options have significant economic value, the inputs needed to value them in a binomial model can be used in more traditional approaches (decision trees) to yield equivalent value. The real value from real options lies in
Recognizing that building in flexibility and escape hatches into large decisions has value Insights we get on understanding how and why companies behave the way they do in investment analysis and capital structure choices.
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Valuation Models
Relative Valuation
Liquidation Value
Stable Current
Equity
Firm
Sec tor
Option to delay
Market
Tw o-s tage
Three-stage or n-stage
Normalized
Undeveloped land
APV approach
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Which approach should you use? Depends upon the asset being valued..
Asset Marketab ility and Valua tion App roache s
Mature businesses Separable & marketable assets Growth bu sin esses Linked and non-marketable assets
Uniqueness of Asset and Va luation Approaches Large number of simila r asse ts tha t are priced
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Liquidation value
Relative valuation
Liquidation value
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