Valuation

Aswath Damodaran
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Details on valuations in this presentation:

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Aswath Damodaran 1
 Some Initial Thoughts

" One hundred thousand lemmings cannot be wrong"

Graffiti

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 Misconceptions about Valuation

 Myth 1: A valuation is an objective search for “true” value

• Truth 1.1: All valuations are biased. The only questions are how much and in
which direction.
• Truth 1.2: The direction and magnitude of the bias in your valuation is directly
proportional to who pays you and how much you are paid.
 Myth 2.: A good valuation provides a precise estimate of value
• Truth 2.1: There are no precise valuations
• Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
 Myth 3: . The more quantitative a model, the better the valuation
• Truth 3.1: One’s understanding of a valuation model is inversely proportional to
the number of inputs required for the model.
• Truth 3.2: Simpler valuation models do much better than complex ones.

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 Approaches to Valuation

 Discounted cashflow valuation, relates the value of an asset to the present

value of expected future cashflows on that asset.
 Relative valuation, estimates the value of an asset by looking at the pricing
of 'comparable' assets relative to a common variable like earnings, cashflows,
book value or sales.
 Contingent claim valuation, uses option pricing models to measure the value
of assets that share option characteristics.

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 Discounted Cash Flow Valuation

 What is it: In discounted cash flow valuation, 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 estimated,
based upon its characteristics in terms of cash flows, growth and risk.
 Information Needed: To use discounted cash flow valuation, you need
• to estimate the life of the asset
• to estimate the cash flows during the life of the asset
• to estimate 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 time, and are assumed to correct themselves over time, as new
information comes out about assets.

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 Equity Valuation

Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

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

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 Firm Valuation

Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets, Discount rate reflects the cost
prior to any debt payments of raising both debt and equity
but after firm has financing, in proportion to their
reinvested to create growth use
assets Growth Assets Equity

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

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 Valuation with Infinite Life

DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Net Income/EPS Firm is in stable growth:
Equity: After debt
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

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 DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm Expected Growth

EBIT (1-t) Reinvestment Rate
- (Cap Ex - Depr) * Return on Capital
- Change in WC Firm is in stable growth:
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
- Value of Debt
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
= 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

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 BMW: Status Quo (Euros) Return on Capital
Reinvestment Rate 9.17%
Current Cashflow to Firm 57% Stable Growth
EBIT(1-t) : 2,227 Expected Growth g = 2%; Beta = 1.00;
- Nt CpX 687 in EBIT (1-t) Country Premium= 1.5%
- Chg WC 583 .57*.0917=.0523 Cost of capital = 7.15%
= FCFF ! 958 5.23% ROC= 7.15%; Tax rate=37%
Reinvestment Rate=(687+583)/2227 Reinvestment Rate=g/ROC
= 57% =2/ 7.15= 27.97%

Terminal Value5= 2225/(.0715-.02) = 43,205

Euro Cashflows
Op. Assets! 34,631 Term Yr
+ Cash: 4,123 Year 1 2 3 4 5 3089
- Debt 5,597 EBIT (1-t) ! 2,344 ! 2,467 ! 2,596 ! 2,731 ! 2,874 - 864
g=2%
- Non-Debt 7,517 Reinvestment ! 1,336 ! 1,406 ! 1,479 ! 1,557 ! 1,638 = 2225
Tax rate changes
=Equity 25,640 FCFF ! 1,008 ! 1,061 ! 1,116 ! 1,174 ! 1,236

Value/Sh ! 38.07
Discount at $ Cost of Capital (WACC) = 8.52% (.8015) + 3.26% (0.1985) = 7.47%

On Sept 23, 2004

BMW Common = 33.50 Eu
Cost of Equity Cost of Debt
8.52% (3.95%+1.50%)(1-.4021) Weights
= 3.26% E = 80.15% D = 19.85%

Riskfree Rate:
Euro Riskfree Rate= 3.95% Beta Mature market Emerg Market Equity
+ 1.14 X premium + Lambda X Risk Premium
3.83 % 0.08 2.50%

Unlevered Beta for Firm’s D/E

Sectors: 0.99 Ratio: 24.77%

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 Discounted Cash Flow Valuation: High Growth with Negative Earnings
Current Reinvestment
Current Operating
Revenue Stable Growth
Margin
Sales Turnover Competitive
Ratio Advantages Stable Stable Stable
EBIT Revenue Operating Reinvestment
Revenue Expected Growth Margin
Growth Operating
Tax Rate Margin
- NOLs

FCFF = Revenue* Op Margin (1-t) - Reinvestment

Terminal Value= FCFF n+1 /(r-g n)
Value of Operating Assets FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn
+ Cash & Non-op Assets .........
= Value of Firm Forever
- Value of Debt Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
= Value of Equity
- Equity Options
= Value of Equity in Stock

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

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 Reinvestment:
Cap ex includes acquisitions Stable Growth
Current Current Working capital is 3% of revenues
Revenue Margin: 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)
EBIT
-410m Revenue Expected
Growth: Margin: Terminal Value= 1881/(.0961-.06)
NOL: 42% -> 10.00% =52,148
500 m
Term. Year
$41,346
Revenues $2,793 5,585 9,774 14,661 19,059 23,862 28,729 33,211 36,798 39,006 10.00%
EBIT -$373 -$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 35.00%
EBIT (1-t) -$373 -$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 $2,688
- Reinvestment $559 $931 $1,396 $1,629 $1,466 $1,601 $1,623 $1,494 $1,196 $736 $ 807
FCFF -$931 -$1,024 -$989 -$758 -$408 -$163 $177 $625 $1,174 $1,788 $1,881
Value of Op Assets $ 14,910
+ Cash $ 26 1 2 3 4 5 6 7 8 9 10
= Value of Firm $14,936 Forever
Cost of Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 12.30% 12.10% 11.70% 10.50%
- Value of Debt $ 349 Cost of Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00%
= Value of Equity $14,587 AT cost of debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%
- Equity Options $ 2,892 Cost of Capital 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.96% 11.69% 11.15% 9.61%
Value per share $ 34.32

Cost of Equity Cost of Debt Weights

12.90% 6.5%+1.5%=8.0% Debt= 1.2% -> 15%
Tax rate = 0% -> 35%

Riskfree Rate :
T. Bond rate = 6.5% [Link]
Risk Premium
Beta January 2000
4%
+ 1.60 -> 1.00 X Stock Price = $ 84

Internet/ Operating Current Base Equity Country Risk

Retail Leverage D/E: 1.21% Premium Premium

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 I. Discount Rates:Cost of Equity

Preferably, a bottom-up beta,

based upon other firms in the
business, and firm’s own financial
leverage

Cost of Equity = Riskfree Rate + Beta * (Risk Premium)

Has to be in the same Historical Premium Implied Premium

currency as cash flows, 1. Mature Equity Market Premium: Based on how equity
and defined in same terms Average premium earned by or market is priced today
(real or nominal) as the stocks over [Link] in U.S. and a simple valuation
cash flows 2. Country risk premium = model
Country Default Spread* ( !Equity/!Country bond)

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 A Simple Test

 You are valuing BMW in Euros for a US institutional investor and are
attempting to estimate a risk free rate to use in the analysis. The risk free rate
that you should use is
 The interest rate on a US $ denominated treasury bond (4.25%)
 The interest rate on a Euro-denominated bond issued by the German
government (3.95%)
 The lowest interest rate on a 10-year Euro-denominated bond issued by any
European government (3.95%)
 The lowest interest rate on a 10-year bond issued by a European government
(Swiss bond: 2.62%)

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 Everyone uses historical premiums, but..

 The historical risk premium is easiest to estimate in the United States, because
there is unbroken market data going back to 1870.
Arithmetic average Geometric Average
Stocks - Stocks - Stocks - Stocks -
Historical Period [Link] [Link] [Link] [Link]
1928-2003 7.92% 6.54% 5.99% 4.82%
1963-2003 6.09% 4.70% 4.85% 3.82%
1993-2003 8.43% 4.87% 6.68% 3.57%
 It is difficult to get enough historical data to estimate risk premiums in
other countries.

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 Risk Premium for a Mature Market? Broadening the sample..

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 An Alternative to Historical Risk Premiums: Implied Equity
Premium for the S&P 500: January 1, 2004

 We can use the information in stock prices to back out how risk averse the market is and how much
of a risk premium it is demanding.
After year 5, we will assume that
earnings on the index will grow at
In 2003, dividends & stock
Analysts expect earnings to grow 9.5% a year for the next 5 years as 4.25%, the same rate as the entire
buybacks were 2.81% of
the economy comes out of a recession. economy
the index, generating 31.29
in cashflows
34.26 37.52 41.08 44.98 49.26

January 1, 2004
S&P 500 is at1111.91
If you pay the current level of the index, you can expect to make a return of 7.94% on stocks (which
is obtained by solving for r in the following equation)
34.26 37.52 41.08 44.98 49.26 49.26(1.0425)
1111.91 = + 2
+ 3
+ 4
+ 5
+
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (r " .0425)(1+ r) 5
 Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 7.94% - 4.25% =
3.69%
!

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 Implied Premiums in the US

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 Choosing an Equity Risk Premium

 Historical Risk Premium: When you use the historical risk premium, you are
assuming that premiums will revert back to a historical norm and that the time
period that you are using is the right norm. You are also more likely to find
stocks to be overvalued than undervalued (Why?)
 Current Implied Equity Risk premium: You are assuming that the market is
correct in the aggregate but makes mistakes on individual stocks. If you are
required to be market neutral, this is the premium you should use. (What
types of valuations require market neutrality?)
 Average Implied Equity Risk premium: The average implied equity risk
premium between 1960-2003 in the United States is about 4%. You are
assuming that the market is correct on average but not necessarily at a point in
time.

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 Implied Equity Risk Premium for Germany: September 23,
2004

 We can use the information in stock prices to back out how risk averse the market is and how much
of a risk premium it is demanding.

Dividends and stock Analysts are estimating an expected growth rate of 11.36% in earnings
buybacks were 2.67% of over the next 5 years for stocks in the DAX (Source: IBES)
the index last year
Source: Bloomberg Expected dividends and stock buybacks over next 5 years
116.13 129.32 144.01 160.37 178.59 Assumed to grow
at 3.95% a year
forever after year 5

Buy the index for 3905.65

 If you pay the current level of the index, you can expect to make a return of 7.94% on stocks (which
is obtained by solving for r in the following equation)
116.13 129.32 144.01 160.37 178.59 178.59(1.0395)
3905.65 = + + + + +
(1+ r) (1+ r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r " .0425)(1+ r) 5
 Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 7.78% - 3.95% =
3.83%
!

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 Opportunities and Threats: The Allure of Asia and the
Risk…

Country Rating Typical Default Spread

China A2 90
Hong Kong A1 80
India Baa2 130
Indonesia B2 550
Malaysia A3 95
Pakistan B2 550
Singapore Aaa 0
Taiwan Aa3 70
Thailand Baa1 120
Vietnam B1 450
Vietnam B1 450

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 Using Country Ratings to Estimate Equity Spreads

 Country ratings measure default risk. While default risk premiums and equity
risk premiums are highly correlated, one would expect equity spreads to be
higher than debt spreads.
• One way to adjust the country spread upwards is to use information from the US
market. In the US, the equity risk premium has been roughly twice the default
spread on junk bonds.
• Another is to multiply the bond spread by the relative volatility of stock and bond
prices in that market. For example,
– Standard Deviation in BSE = 32%
– Standard Deviation in Indian Government Bond = 16%
– Adjusted Equity Spread = 1.30% (32/16) = 2.60%

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 Equity Risk Premiums in Asia

Country Rating Typical Default Spread Relative Equity Market volatility Equity Risk Premium
China A2 90 2.25 2.03%
Hong Kong A1 80 1.8 1.44%
India Baa2 130 2 2.60%
Indonesia B2 550 1.8 9.90%
Malaysia A3 95 2.5 2.38%
Pakistan B2 550 1.75 9.63%
Singapore Aaa 0 2.2 0.00%
Taiwan Aa3 70 2.5 1.75%
Thailand Baa1 120 2.2 2.64%
Vietnam B1 450 1.6 7.20%
Weighted average risk premium = 2.50%

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 Country Risk and Company Risk: Three points of view

 Approach 1: Assume that every company in the country is equally exposed to

country risk. In this case,
E(Return) = Riskfree Rate + Country premium + Beta (Mature market premium)
 Approach 2: Assume that a company’s exposure to country risk is similar to
its exposure to other market risk.
E(Return) = Riskfree Rate + Beta (Mature market premium + Country premium)
 Approach 3: Treat country risk as a separate risk factor and allow firms to
have different exposures to country risk (perhaps based upon the proportion
of their revenues come from non-domestic sales)
E(Return)=Riskfree Rate+ β (Mature market premium) + λ (Country premium)

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 Estimating Company Exposure to Country Risk:
Determinants

 Source of revenues: Other things remaining equal, a company should be more

exposed to risk in a country if it generates more of its revenues from that
country. A firm that generates the bulk of its revenues in an emerging market
should be more exposed to country risk in that market than one that generates
a smaller percent of its business within that market.
 Manufacturing facilities: Other things remaining equal, a firm that has all of
its production facilities in an emerging market should be more exposed to
country risk than one which has production facilities spread over multiple
countries. The problem will be accented for companies that cannot move their
production facilities (mining and petroleum companies, for instance).
 Use of risk management products: Companies can use both options/futures
markets and insurance to hedge some or a significant portion of country risk.

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 Estimating Lambdas: The Revenue Approach

 The easiest and most accessible data is on revenues. Most companies break
their revenues down by region. One simplistic solution would be to do the
following:
λ = % of revenues domesticallyfirm/ % of revenues domesticallyavg firm
 Consider, for instance, the fact that BMW got about 12% of its revenues from
Asia, Africa and Oceania (?). Assuming that 6% of the revenues are from
Japan and Australia, we would estimate that the remaining 6% are in
“Emerging Asia”, we can estimate a lambda for BMW for Asia (using the
assumption that the typical Asian firm gets about 75% of its revenues in Asia)
• LambdaBMW, Asia = 6%/ 75% = .08
 There are two implications
• A company’s risk exposure is determined by where it does business and
not by where it is located
• Firms might be able to actively manage their country risk exposures

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 BMW’s Cost of Equity

 BMW is a German company with substantial multinational corporation and is

exposed to emerging market risk.
 The beta measures exposure to mature market risk and should have the
mature market equity risk premium attached to it.
 The lambda measures exposure to emerging market risk.
 Cost of equity = Riskfree Rate + Beta * Mature Market Equity Risk Premium
+ Lambda * Emerging Market Risk Premioum
BMW’s Cost of Equity = 3.95% + 1.14 (3.83%) + 0.08 (2.50%) = 8.52%

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 Estimating Beta

 The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns (Rm) -
Rj = a + b Rm
• where a is the intercept and b is the slope of the regression.
 The slope of the regression corresponds to the beta of the stock, and measures
the riskiness of the stock.
 This beta has three problems:
• It has high standard error
• It reflects the firm’s business mix over the period of the regression, not the current
mix
• It reflects the firm’s average financial leverage over the period rather than the
current leverage.

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 Beta Estimation: Amazon

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 Beta Estimation for BMW: The Index Effect

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 Who is the marginal investor in BMW?

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 A more reasonable assessment of market risk?

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 Determinants of Betas

Beta of Equity

Beta of Firm Financial Leverage:

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

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

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 In a perfect world… we would estimate the beta of a firm by
doing the following

Start with the beta of the business that the firm is in

Adjust the business beta for the operating leverage of the firm to arrive at the
unlevered beta for the firm.

Use the financial leverage of the firm to estimate the equity beta for the firm
Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (Debt/Equity))

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 Bottom-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))

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 BMW’s Bottom-up Beta

Business EBIT Value/EBIT Unlevered beta Value Weight

Automobiles 3052 7.15 1.02 21,822 88%
Financing 569 5.25 0.81 2,987 12%
Firm 0.99
Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (D/E Ratio)
= 0.99 ( 1 + (1-.4021) (.2531)) = 1.14

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 Amazon’s Bottom-up Beta

Unlevered beta for firms in internet retailing = 1.60

Unlevered beta for firms in specialty retailing = 1.00

 Amazon is a specialty retailer, but its risk currently seems to be determined by the fact
that it is an online retailer. Hence we will use the beta of internet companies to begin
the valuation
 By the fifth year, we are estimating substantial revenues for Amazon and we move the
beta towards to beta of the retailing business.

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 From Cost of Equity to Cost of Capital

Cost of borrowing should be based upon

(1) synthetic or actual bond rating Marginal tax rate, reflecting
(2) default spread tax benefits of debt
Cost of Borrowing = Riskfree rate + Default spread

Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + Cost of Borrowing (1-t) (Debt/(Debt + Equity))

Cost of equity
based upon bottom-up Weights should be market value weights
beta

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 Bond Rating: Synthetic versus Actual

 If a firm is rated, its bond rating represents the ratings agency’s judgment of
the default risk of a firm. BMW is rated A+ by S&P.
 The rating for a firm can be estimated using the financial characteristics of the
firm. In its simplest form, the rating can be estimated from the interest
coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
 For BMW’s interest coverage ratio, we used the interest expenses and EBIT
from 2003.
Interest Coverage Ratio = 3353/ 811 = 2.64
 [Link] has negative operating income; this yields a negative interest
coverage ratio, which should suggest a low rating. We computed an average
interest coverage ratio of 2.82 over the next 5 years.

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 Interest Coverage Ratios, Ratings and Default Spreads

If Interest Coverage Ratio is Estimated Bond Rating Default Spread(1/00) Default Spread(1/04)
> 8.50 AAA 0.20% 0.35%
6.50 - 8.50 AA 0.50% 0.50%
5.50 - 6.50 A+ 0.80% 0.70%
4.25 - 5.50 A 1.00% 0.85%
3.00 - 4.25 A– 1.25% 1.00%
2.50 - 3.00 BBB 1.50% 1.50% BMW Interest
coverage ratio
2.25 - 2.50 BB+ 1.75% 2.00%
of 2.64
2.00 - 2.25 BB 2.00% 2.50%
1.75 - 2.00 B+ 2.50% 3.25%
1.50 - 1.75 B 3.25% 4.00%
1.25 - 1.50 B– 4.25% 6.00%
0.80 - 1.25 CCC 5.00% 8.00%
0.65 - 0.80 CC 6.00% 10.00%
0.20 - 0.65 C 7.50% 12.00%
< 0.20 D 10.00% 20.00%

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 Estimating the cost of debt for a firm

 The synthetic rating for BMW is BBB, lower than the actual rating of the firm of A+.
We will use the synethetic rating to estimate the cost of debt. Using the 2004 default
spread of 1.50%, we estimate a cost of debt of 5.45% (using a riskfree rate of 3.95%):
Cost of debt = Riskfree rate + Company default spread
= 3.95% + 1.50% = 5.45%
 The synthetic rating for [Link] in 2000 was BBB. The default spread for BBB
rated bond was 1.50% in 2000 and the treasury bond rate was 6.5%.
Pre-tax cost of debt = Riskfree Rate + Default spread
= 6.50% + 1.50% = 8.00%
 The firm is paying no taxes currently. As the firm’s tax rate changes and its cost of debt
changes, the after tax cost of debt will change as well.
1 2 3 4 5 6 7 8 9 10
Pre-tax 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00%
Tax rate 0% 0% 0% 16.13% 35% 35% 35% 35% 35% 35%
After-tax 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%

Aswath Damodaran 41
 Weights for the Cost of Capital Computation

 The weights used to compute the cost of capital should be the market value
weights for debt and equity.
 There is an element of circularity that is introduced into every valuation by
doing this, since the values that we attach to the firm and equity at the end of
the analysis are different from the values we gave them at the beginning.
 As a general rule, the debt that you should subtract from firm value to arrive
at the value of equity should be the same debt that you used to compute the
cost of capital.

Aswath Damodaran 42
 Estimating Cost of Capital: [Link]

 Equity
• Cost of Equity = 6.50% + 1.60 (4.00%) = 12.90%
• Market Value of Equity = $ 84/share* 340.79 mil shs = $ 28,626 mil (98.8%)
 Debt
• Cost of debt = 6.50% + 1.50% (default spread) = 8.00%
• Market Value of Debt = $ 349 mil (1.2%)
 Cost of Capital
Cost of Capital = 12.9 % (.988) + 8.00% (1- 0) (.012)) = 12.84%

Aswath Damodaran 43
 Estimating Cost of Capital: BMW

 Equity
• Cost of Equity = 3.95% + 1.14 (3.83%) + 0.08 (2.50%) = 8.52%
• Market Value of Equity =22,596 million Euros (80.15%)
 Debt
• Cost of debt = 3.95%+1.50%= 5.45%
• Market Value of Debt = 5,597 million Euros (19.85%)
 Cost of Capital
Cost of Capital = 8.52 % (.8015) + 5.45% (1- .4021) (0.1985)) = 7.47%

The book value of equity at BMW is 16,150 million Euros

The book value of debt at BMW is 5,499 million; Interest expense is 336 mil; Average
maturity of debt = 3 years
Estimated market value of debt = 336 million (PV of annuity, 3 years, 5.45%) + 5,499
million/1.05453 = 5,597 million Euros

Aswath Damodaran 44
 II. Estimating Cash Flows to Firm

Operating leases R&D Expenses

- Convert into debt - Convert into asset
- Adjust operating income - Adjust operating income

Update Normalize Cleanse operating items of

- Trailing Earnings - History - Financial Expenses
- Unofficial numbers - Industry - Capital Expenses
- Non-recurring expenses

Earnings before interest and taxes

Tax rate
- can be effective for - Tax rate * EBIT
near future, but
move to marginal = EBIT ( 1- tax rate)
- reflect net
operating losses - (Capital Expenditures - Depreciation) Defined as
Non-cash CA
- Change in non-cash working capital - Non-debt CL
Include = Free Cash flow to the firm (FCFF)
- R&D
- Acquisitions

Aswath Damodaran 45
 The Importance of Updating

 The operating income and revenue that we use in valuation should be updated
numbers. One of the problems with using financial statements is that they are
dated.
 As a general rule, it is better to use 12-month trailing estimates for earnings
and revenues than numbers for the most recent financial year. This rule
becomes even more critical when valuing companies that are evolving and
growing rapidly.
Last 10-K Trailing 12-month
Revenues $ 610 million $1,117 million
EBIT - $125 million - $ 410 million

Aswath Damodaran 46
 Normalizing Earnings: Amazon

Year Revenues Operating Margin EBIT

Tr12m $1,117 -36.71% -$410
1 $2,793 -13.35% -$373
2 $5,585 -1.68% -$94
3 $9,774 4.16% $407
4 $14,661 7.08% $1,038
5 $19,059 8.54% $1,628
6 $23,862 9.27% $2,212
7 $28,729 9.64% $2,768
8 $33,211 9.82% $3,261
9 $36,798 9.91% $3,646
10 $39,006 9.95% $3,883
TY(11) $41,346 10.00% $4,135 Industry Average

Aswath Damodaran 47
 Operating Leases at The Home Depot in 1998

 The pre-tax cost of debt at the Home Depot is 6.25%

Yr Operating Lease Expense Present Value
1 $ 294 $ 277
2 $ 291 $ 258
3 $ 264 $ 220
4 $ 245 $ 192
5 $ 236 $ 174
6-15 $ 270 $ 1,450 (PV of 10-yr annuity)
Present Value of Operating Leases =$ 2,571
 Debt outstanding at the Home Depot = $1,205 + $2,571 = $3,776 mil
(The Home Depot has other debt outstanding of $1,205 million)
 Adjusted Operating Income = $2,016 + 2,571 (.0625) = $2,177 mil

Aswath Damodaran 48
 Capitalizing R&D Expenses: BMW

 To capitalize R&D,
• Specify an amortizable life for R&D (2 - 10 years)
• Collect past R&D expenses for as long as the amortizable life
• Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the
research asset can be obtained by adding up 1/5th of the R&D expense from five years ago,
2/5th of the R&D expense from four years ago...:
 R & D was assumed to have a 3-year life at BMW.

Year R&D Expense Unamortized portion Amortization this year

Current 2146.00 1.00 2146.00
-1 2011.00 0.67 1340.67 $670.33
-2 1663.00 0.33 554.33 $554.33
-3 1556.00 0.00 0.00 $518.67
Value of Research Asset = $4,041.00
Amortization this year = $1,743.33

Adjusted Operating Income = Operating Income + R&D - Amortization

= 3,052+ + 2,146 - 1,743 = 3,455 million

Aswath Damodaran 49
 The Effect of Net Operating Losses: [Link]’s Tax
Rate

Year 1 2 3 4 5
EBIT -$373 -$94 $407 $1,038 $1,628
Taxes $0 $0 $0 $167 $570
EBIT(1-t) -$373 -$94 $407 $871 $1,058
Tax rate 0% 0% 0% 16.13% 35%
NOL $500 $873 $967 $560 $0

After year 5, the tax rate becomes 35%.

Aswath Damodaran 50
 Estimating Actual FCFF: BMW

 EBIT = 3,455 million Euros

 Tax rate = 41.21%
 Net Capital expenditures = Cap Ex - Depreciation = 9,339 -8,652 = 687
million
 Change in Working Capital = + 583 million (Increase)
Estimating FCFF
Current EBIT * (1 - tax rate) = 3,455 (1-.4021) = 2,277 Million
- (Capital Spending - Depreciation) 687
- Change in Working Capital 583
Current FCFF 958 Million Euros

Aswath Damodaran 51
 Estimating FCFF: [Link]

 EBIT (Trailing 1999) = -$ 410 million

 Tax rate used = 0% (Assumed Effective = Marginal)
 Capital spending (Trailing 1999) = $ 243 million
 Depreciation (Trailing 1999) = $ 31 million
 Non-cash Working capital Change (1999) = - 80 million
 Estimating FCFF (1999)
Current EBIT * (1 - tax rate) = - 410 (1-0) = - $410 million
- (Capital Spending - Depreciation) = $212 million
- Change in Working Capital = -$ 80 million
Current FCFF = - $542 million

Aswath Damodaran 52
 IV. Expected Growth in EBIT and Fundamentals

 Reinvestment Rate and Return on Capital

gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC
 Proposition: No firm can expect its operating income to grow over time
without reinvesting some of the operating income in net capital expenditures
and/or working capital.
 Proposition: The net capital expenditure needs of a firm, for a given growth
rate, should be inversely proportional to the quality of its investments.

Aswath Damodaran 53
 Return on Capital Computation: BMW

Stated Book value of Equity Research Asset

13,871 million 4,041 million

Book value of debt and Book Value of Equity Book Value of Debt
equity from end of prior year 13,871+4041 = 6,769 million Euros
17,509 million Euros

After-tax Operating Income

2,227 million Euros
/ Book Value of Capital from end of prior year
17,509 + 6,769 = 24,278 million Euros

Return on Capital in 2003 = 9.17%

Aswath Damodaran 54
 Reinvestment Rate Computation: BMW

Capital Expenditures net Depreciation and

of asset divestitures other non-cash R& D net of amortization
4115+5785-2707 charges 2,146 - 1,743 = 403 million
=7,193 million 6,909 million

Net Capital Expenditures Change in non-cash working

7,193 - 6909 + 403 =
687 million + capital
583 million

Reinvestment After-tax Operating Income

Net Cap Ex + Change in WC
687 + 583 = 1270 million / 2,227 million Euros

Return on Capital = 1270/2,227 = 57.00%

Aswath Damodaran 55
 Revenue Growth and Operating Margins

 With negative operating income and a negative return on capital, the

fundamental growth equation is of little use for [Link]
 For Amazon, the effect of reinvestment shows up in revenue growth rates and
changes in expected operating margins:
Expected Revenue Growth in $ = Reinvestment (in $ terms) * (Sales/ Capital)
 The effect on expected margins is more subtle. Amazon’s reinvestments
(especially in acquisitions) may help create barriers to entry and other
competitive advantages that will ultimately translate into high operating
margins and high profits.

Aswath Damodaran 56
 Growth in Revenues, Earnings and Reinvestment: Amazon

Year Revenue Chg in Reinvestment Chg Rev/ Chg Reinvestment ROC

Growth Revenue
1 150.00% $1,676 $559 3.00 -76.62%
2 100.00% $2,793 $931 3.00 -8.96%
3 75.00% $4,189 $1,396 3.00 20.59%
4 50.00% $4,887 $1,629 3.00 25.82%
5 30.00% $4,398 $1,466 3.00 21.16%
6 25.20% $4,803 $1,601 3.00 22.23%
7 20.40% $4,868 $1,623 3.00 22.30%
8 15.60% $4,482 $1,494 3.00 21.87%
9 10.80% $3,587 $1,196 3.00 21.19%
10 6.00% $2,208 $736 3.00 20.39%
Assume that firm can earn high returns because of established economies of scale.

Aswath Damodaran 57
 V. Growth Patterns

 A key assumption in all discounted cash flow models is the period of high
growth, and the pattern of growth during that period. In general, we can make
one of three assumptions:
• there is no high growth, in which case the firm is already in stable growth
• there will be high growth for a period, at the end of which the growth rate will
drop to the stable growth rate (2-stage)
• there will be high growth for a period, at the end of which the growth rate will
decline gradually to a stable growth rate(3-stage)

Stable Growth 2-Stage Growth 3-Stage Growth

Aswath Damodaran 58
 Determinants of Growth Patterns

 Size of the firm

• Success usually makes a firm larger. As firms become larger, it becomes much
more difficult for them to maintain high growth rates
 Current growth rate
• While past growth is not always a reliable indicator of future growth, there is a
correlation between current growth and future growth. Thus, a firm growing at
30% currently probably has higher growth and a longer expected growth period
than one growing 10% a year now.
 Barriers to entry and differential advantages
• Ultimately, high growth comes from high project returns, which, in turn, comes
from barriers to entry and differential advantages.
• The question of how long growth will last and how high it will be can therefore be
framed as a question about what the barriers to entry are, how long they will stay
up and how strong they will remain.

Aswath Damodaran 59
 Stable Growth Characteristics

 In stable growth, firms should have the characteristics of other stable growth
firms. In particular,
• The risk of the firm, as measured by beta and ratings, should reflect that of a stable
growth firm.
– Beta should move towards one
– The cost of debt should reflect the safety of stable firms (BBB or higher)
• The debt ratio of the firm might increase to reflect the larger and more stable
earnings of these firms.
– The debt ratio of the firm might moved to the optimal or an industry average
– If the managers of the firm are deeply averse to debt, this may never happen
• The reinvestment rate of the firm should reflect the expected growth rate and the
firm’s return on capital
– Reinvestment Rate = Expected Growth Rate / Return on Capital

Aswath Damodaran 60
 BMW and [Link]: Stable Growth Inputs

 High Growth Stable Growth

 BMW
• Beta 1.14 1.00
• Debt Ratio 19.85% 19.85%
• Return on Capital 9.17% 7.15%
• Cost of Capital 7.43% 7.15%
• Expected Growth Rate 5.23% 2.00%
• Reinvestment Rate 57% 2/7.15% = 27.97%
 [Link]
• Beta 1.60 1.00
• Debt Ratio 1.20% 15%
• Return on Capital Negative 20%
• Expected Growth Rate NMF 6%
• Reinvestment Rate >100% 6%/20% = 30%

Aswath Damodaran 61
 Dealing with Cash and Marketable Securities

 The simplest and most direct way of dealing with cash and marketable
securities is to keep them out of the valuation - the cash flows should be
before interest income from cash and securities, and the discount rate should
not be contaminated by the inclusion of cash. (Use betas of the operating
assets alone to estimate the cost of equity).
 Once the firm has been valued, add back the value of cash and marketable
securities.
• If you have a particularly incompetent management, with a history of overpaying
on acquisitions, markets may discount the value of this cash.

Aswath Damodaran 62
 Dealing with Cross Holdings

 When the holding is a majority, active stake, the value that we obtain from the
cash flows includes the share held by outsiders. While their holding is
measured in the balance sheet as a minority interest, it is at book value. To get
the correct value, we need to subtract out the estimated market value of the
minority interests from the firm value.
 When the holding is a minority, passive interest, the problem is a different
one. The firm shows on its income statement only the share of dividends it
receives on the holding. Using only this income will understate the value of
the holdings. In fact, we have to value the subsidiary as a separate entity to
get a measure of the market value of this holding.
 Proposition 1: It is almost impossible to correctly value firms with minority,
passive interests in a large number of private subsidiaries.

Aswath Damodaran 63
 Non-debt Obligations

 Pension fund obligations: If pension fund assets are not intermingled with
other assets, only the underfunded portion of pension fund liabilities should
be considered. If pension fund assets are intermingled, all of the pension fund
obligations should be considered.
 Lawsuit obligations: If lawsuits are pending against the firm, the expected
value (based on the likelihood of losing the lawsuits and the penalty if that
occurs) of the lawsuits should be deducted.
 Other obligations: Deferred tax liabilities, employee health care benefits and
social cost obligations can also be deducted, though the rationale has to be
clearly specified.

Aswath Damodaran 64
 BMW: Towards the final value

Present Value of FCFF in high growth phase = $4,497.35

Present Value of Terminal Value of Firm = $30,133.44
Value of operating assets of the firm = $34,630.79
Value of Cash, Marketable Securities & Non-operating assets = $4,123.00
Value of Firm = $38,753.79
Market Value of outstanding debt = $5,597.04
Non-debt obligations and liabilities = $7,517.00
Market Value of Equity = $25,639.75

Market Value of Equity/share = $38.07

Aswath Damodaran 65
 Amazon: Estimating the Value of Equity Options

 Details of options outstanding

• Average strike price of options outstanding = $ 13.375
• Average maturity of options outstanding = 8.4 years
• Standard deviation in ln(stock price) = 50.00%
• Annualized dividend yield on stock = 0.00%
• Treasury bond rate = 6.50%
• Number of options outstanding = 38 million
• Number of shares outstanding = 340.79 million
 Value of options outstanding (using dilution-adjusted Black-Scholes model)
• Value of equity options = $ 2,892 million

Aswath Damodaran 66
 Reinvestment:
Cap ex includes acquisitions
Stable Growth
Current Current Working capital is 3% of revenues
Revenue Margin: 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)
EBIT
-410m Revenue Expected
Growth: Margin: Terminal Value= 1881/(.0961-.06)
NOL: 42% -> 10.00% =52,148
500 m
Term. Year
$41,346
Revenues $2,793 5,585 9,774 14,661 19,059 23,862 28,729 33,211 36,798 39,006 10.00%
EBIT -$373 -$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 35.00%
EBIT (1-t) -$373 -$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 $2,688
- Reinvestment $559 $931 $1,396 $1,629 $1,466 $1,601 $1,623 $1,494 $1,196 $736 $ 807
FCFF -$931 -$1,024 -$989 -$758 -$408 -$163 $177 $625 $1,174 $1,788 $1,881
Value of Op Assets $ 14,910
+ Cash $ 26 1 2 3 4 5 6 7 8 9 10
= Value of Firm $14,936 Forever
Cost of Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 12.30% 12.10% 11.70% 10.50%
- Value of Debt $ 349 Cost of Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00%
= Value of Equity $14,587 AT cost of debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%
- Equity Options $ 2,892 Cost of Capital 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.96% 11.69% 11.15% 9.61%
Value per share $ 34.32

Cost of Equity Cost of Debt Weights

12.90% 6.5%+1.5%=8.0% Debt= 1.2% -> 15%
Tax rate = 0% -> 35%

Riskfree Rate :
T. Bond rate = 6.5% [Link]
Risk Premium January 2000
Beta 4%
+ 1.60 -> 1.00 X Stock Price = $ 84

Internet/ Operating Current Base Equity Country Risk

Aswath Damodaran Retail Leverage D/E: 1.21% Premium Premium 67
 [Link]: Break Even at $84?

6% 8% 10% 12% 14%

30% $ (1.94) $ 2.95 $ 7.84 $ 12.71 $ 17.57
35% $ 1.41 $ 8.37 $ 15.33 $ 22.27 $ 29.21
40% $ 6.10 $ 15.93 $ 25.74 $ 35.54 $ 45.34
45% $ 12.59 $ 26.34 $ 40.05 $ 53.77 $ 67.48
50% $ 21.47 $ 40.50 $ 59.52 $ 78.53 $ 97.54
55% $ 33.47 $ 59.60 $ 85.72 $ 111.84 $ 137.95
60% $ 49.53 $ 85.10 $ 120.66 $ 156.22 $ 191.77

Aswath Damodaran 68
 Reinvestment:
Cap ex includes acquisitions Stable Growth
Current Current Working capital is 3% of revenues
Revenue Margin: Stable Stable
Stable Operating ROC=16.94%
$ 2,465 -34.60% Revenue
Sales Turnover Competitive Margin: Reinvest 29.5%
Ratio: 3.02 Advantages Growth: 5% 9.32% of EBIT(1-t)
EBIT
-853m Revenue Expected
Growth: Margin: Terminal Value= 1064/(.0876-.05)
NOL: 25.41% -> 9.32% =$ 28,310
1,289 m
Term. Year
Revenues $4,314 $6,471 $9,059 $11,777 $14,132 $16,534 $18,849 $20,922 $22,596 $23,726 $24,912 $24,912
EBIT -$703 -$364 $54 $499 $898 $1,255 $1,566 $1,827 $2,028 $2,164 $2,322 $2,322
EBIT(1-t) -$703 -$364 $54 $499 $898 $1,133 $1,018 $1,187 $1,318 $1,406 $1,509 $1,509
- Reinvestment $612 $714 $857 $900 $780 $796 $766 $687 $554 $374 $445 $ 445
FCFF -$1,315 -$1,078 -$803 -$401 $118 $337 $252 $501 $764 $1,032 $1,064
$1,064
Value of Op Assets $ 7,967
+ Cash & Non-op $ 1,263 1 2 3 4 5 6 7 8 9 10
= Value of Firm $ 9,230 Forever
Debt Ratio 27.27% 27.27% 27.27% 27.27% 27.27% 24.81% 24.20% 23.18% 21.13% 15.00%
- Value of Debt $ 1,890 Beta 2.18 2.18 2.18 2.18 2.18 1.96 1.75 1.53 1.32 1.10
= Value of Equity $ 7,340 Cost of Equity 13.81% 13.81% 13.81% 13.81% 13.81% 12.95% 12.09% 11.22% 10.36% 9.50%
- Equity Options $ 748 AT cost of debt 10.00% 10.00% 10.00% 10.00% 9.06% 6.11% 6.01% 5.85% 5.53% 4.55%
Value per share $ 18.74 Cost of Capital 12.77% 12.77% 12.77% 12.77% 12.52% 11.25% 10.62% 9.98% 9.34% 8.76%

Cost of Equity Cost of Debt Weights

13.81% 5.1%+4.75%= 9.85% Debt= 27.38% -> 15%
Tax rate = 0% -> 35%

Riskfree Rate :
T. Bond rate = 5.1% [Link]
Risk Premium
Beta January 2001
4%
+ 2.18-> 1.10 X Stock price = $14

Internet/ Operating Current Base Equity Country Risk

Aswath Damodaran Retail Leverage D/E: 37.5% Premium Premium 69
 BMW: Status Quo (Euros) Return on Capital
Reinvestment Rate 9.17%
Current Cashflow to Firm 57% Stable Growth
EBIT(1-t) : 2,227 Expected Growth g = 2%; Beta = 1.00;
- Nt CpX 687 in EBIT (1-t) Country Premium= 1.5%
- Chg WC 583 .57*.0917=.0523 Cost of capital = 7.15%
= FCFF ! 958 5.23% ROC= 7.15%; Tax rate=37%
Reinvestment Rate=(687+583)/2227 Reinvestment Rate=g/ROC
= 57% =2/ 7.15= 27.97%

Terminal Value5= 2225/(.0715-.02) = 43,205

Euro Cashflows
Op. Assets! 34,631 Term Yr
+ Cash: 4,123 Year 1 2 3 4 5 3089
- Debt 5,597 EBIT (1-t) ! 2,344 ! 2,467 ! 2,596 ! 2,731 ! 2,874 - 864
g=2%
- Non-Debt 7,517 Reinvestment ! 1,336 ! 1,406 ! 1,479 ! 1,557 ! 1,638 = 2225
Tax rate changes
=Equity 25,640 FCFF ! 1,008 ! 1,061 ! 1,116 ! 1,174 ! 1,236

Value/Sh ! 38.07
Discount at $ Cost of Capital (WACC) = 8.52% (.8015) + 3.26% (0.1985) = 7.47%

On Sept 23, 2004

BMW Common = 33.50 Eu
Cost of Equity Cost of Debt
8.52% (3.95%+1.50%)(1-.4021) Weights
= 3.26% E = 80.15% D = 19.85%

Riskfree Rate:
Euro Riskfree Rate= 3.95% Beta Mature market Emerg Market Equity
+ 1.14 X premium + Lambda X Risk Premium
3.83 % 0.08 2.50%

Unlevered Beta for Firm’s D/E

Sectors: 0.99 Ratio: 24.77%

Aswath Damodaran 70
 Value Enhancement: Back to Basics

Aswath Damodaran
[Link]

Aswath Damodaran 71
 Price Enhancement versus Value Enhancement

Aswath Damodaran 72
 The Paths to Value Creation

 Using the DCF framework, there are four basic ways in which the value of a
firm can be enhanced:
• The cash flows from existing assets to the firm can be increased, by either
– increasing after-tax earnings from assets in place or
– reducing reinvestment needs (net capital expenditures or working capital)
• The expected growth rate in these cash flows can be increased by either
– Increasing the rate of reinvestment in the firm
– Improving the return on capital on those reinvestments
• The length of the high growth period can be extended to allow for more years of
high growth.
• The cost of capital can be reduced by
– Reducing the operating risk in investments/assets
– Changing the financial mix
– Changing the financing composition

Aswath Damodaran 73
 A Basic Proposition

 For an action to affect the value of the firm, it has to

• Affect current cash flows (or)
• Affect future growth (or)
• Affect the length of the high growth period (or)
• Affect the discount rate (cost of capital)
 Proposition 1: Actions that do not affect current cash flows, future
growth, the length of the high growth period or the discount rate cannot
affect value.

Aswath Damodaran 74
 Value-Neutral Actions

 Stock splits and stock dividends change the number of units of equity in a firm, but
cannot affect firm value since they do not affect cash flows, growth or risk.
 Accounting decisions that affect reported earnings but not cash flows should have no
effect on value.
• Changing inventory valuation methods from FIFO to LIFO or vice versa in financial reports
but not for tax purposes
• Changing the depreciation method used in financial reports (but not the tax books) from
accelerated to straight line depreciation
• Major non-cash restructuring charges that reduce reported earnings but are not tax deductible
• Using pooling instead of purchase in acquisitions cannot change the value of a target firm.
 Decisions that create new securities on the existing assets of the firm (without altering
the financial mix) such as tracking stock cannot create value, though they might affect
perceptions and hence the price.

Aswath Damodaran 75
 I. Ways of Increasing Cash Flows from Assets in Place

More efficient
operations and Revenues
cost cuttting:
Higher Margins * Operating Margin

= EBIT
Divest assets that
have negative EBIT - Tax Rate * EBIT

= EBIT (1-t) Live off past over-

Reduce tax rate investment
- moving income to lower tax locales + Depreciation
- transfer pricing - Capital Expenditures
- risk management - Chg in Working Capital Better inventory
= FCFF management and
tighter credit policies

Aswath Damodaran 76
 II. Value Enhancement through Growth

Reinvest more in Do acquisitions

projects Reinvestment Rate

Increase operating * Return on Capital Increase capital turnover ratio

margins
= Expected Growth Rate

Aswath Damodaran 77
 III. Building Competitive Advantages: Increase length of the
growth period

Increase length of growth period

Build on existing Find new

competitive competitive
advantages advantages

Brand Legal Switching Cost

name Protection Costs advantages

Aswath Damodaran 78
 3.1: The Brand Name Advantage

 Some firms are able to sustain above-normal returns and growth because they
have well-recognized brand names that allow them to charge higher prices
than their competitors and/or sell more than their competitors.
 Firms that are able to improve their brand name value over time can increase
both their growth rate and the period over which they can expect to grow at
rates above the stable growth rate, thus increasing value.

Aswath Damodaran 79
 Illustration: Valuing a brand name: Coca Cola

Coca Cola Generic Cola Company

AT Operating Margin 18.56% 7.50%
Sales/BV of Capital 1.67 1.67
ROC 31.02% 12.53%
Reinvestment Rate 65.00% (19.35%) 65.00% (47.90%)
Expected Growth 20.16% 8.15%
Length 10 years 10 yea
Cost of Equity 12.33% 12.33%
E/(D+E) 97.65% 97.65%
AT Cost of Debt 4.16% 4.16%
D/(D+E) 2.35% 2.35%
Cost of Capital 12.13% 12.13%
Value $115 $13

Aswath Damodaran 80
 3.2: Patents and Legal Protection

 The most complete protection that a firm can have from competitive pressure
is to own a patent, copyright or some other kind of legal protection allowing it
to be the sole producer for an extended period.
 Note that patents only provide partial protection, since they cannot protect a
firm against a competitive product that meets the same need but is not covered
by the patent protection.
 Licenses and government-sanctioned monopolies also provide protection
against competition. They may, however, come with restrictions on excess
returns; utilities in the United States, for instance, are monopolies but are
regulated when it comes to price increases and returns.

Aswath Damodaran 81
 3.3: Switching Costs

 Another potential barrier to entry is the cost associated with switching from
one firm’s products to another.
 The greater the switching costs, the more difficult it is for competitors to
come in and compete away excess returns.
 Firms that devise ways to increase the cost of switching from their products to
competitors’ products, while reducing the costs of switching from competitor
products to their own will be able to increase their expected length of growth.

Aswath Damodaran 82
 3.4: Cost Advantages

 There are a number of ways in which firms can establish a cost advantage
over their competitors, and use this cost advantage as a barrier to entry:
• In businesses, where scale can be used to reduce costs, economies of scale can give
bigger firms advantages over smaller firms
• Owning or having exclusive rights to a distribution system can provide firms with
a cost advantage over its competitors.
• Owning or having the rights to extract a natural resource which is in restricted
supply (The undeveloped reserves of an oil or mining company, for instance)
 These cost advantages will show up in valuation in one of two ways:
• The firm may charge the same price as its competitors, but have a much higher
operating margin.
• The firm may charge lower prices than its competitors and have a much higher
capital turnover ratio.

Aswath Damodaran 83
 Gauging Barriers to Entry

 Which of the following barriers to entry are most likely to work for BMW?
 Brand Name
 Patents and Legal Protection
 Switching Costs
 Cost Advantages
 What about for [Link]?
 Brand Name
 Patents and Legal Protection
 Switching Costs
 Cost Advantages

Aswath Damodaran 84
 Reducing Cost of Capital

Outsourcing Flexible wage contracts &

cost structure

Reduce operating Change financing mix

leverage

Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital

Make product or service Match debt to

less discretionary to assets, reducing
customers default risk

Changing More Swaps Derivatives Hybrids

product effective
characteristics advertising

Aswath Damodaran 85
 [Link]: Optimal Debt Ratio

Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)
0% 1.58 12.82% AAA 6.80% 0.00% 6.80% 12.82% $29,192
10% 1.76 13.53% D 18.50% 0.00% 18.50% 14.02% $24,566
20% 1.98 14.40% D 18.50% 0.00% 18.50% 15.22% $21,143
30% 2.26 15.53% D 18.50% 0.00% 18.50% 16.42% $18,509
40% 2.63 17.04% D 18.50% 0.00% 18.50% 17.62% $16,419
50% 3.16 19.15% D 18.50% 0.00% 18.50% 18.82% $14,719
60% 3.95 22.31% D 18.50% 0.00% 18.50% 20.02% $13,311
70% 5.27 27.58% D 18.50% 0.00% 18.50% 21.22% $12,125
80% 7.90 38.11% D 18.50% 0.00% 18.50% 22.42% $11,112
90% 15.81 69.73% D 18.50% 0.00% 18.50% 23.62% $10,237

Aswath Damodaran 86
 BMW : Optimal Capital Structure

Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)
0% 0.99 7.95% AAA 4.30% 40.21% 2.57% 7.95% $25,604
10% 1.06 8.22% AAA 4.30% 40.21% 2.57% 7.65% $26,945
20% 1.14 8.55% AAA 4.30% 40.21% 2.57% 7.35% $28,432
30% 1.25 8.98% A+ 4.65% 40.21% 2.78% 7.12% $29,725
40% 1.39 9.55% A- 4.95% 40.21% 2.96% 6.91% $30,953
50% 1.59 10.34% BB+ 5.95% 40.21% 3.56% 6.95% $30,713
60% 1.88 11.54% B+ 7.20% 40.21% 4.30% 7.20% $29,268
70% 2.38 13.53% B- 9.95% 40.21% 5.95% 8.22% $24,488
80% 3.42 17.71% CC 13.95% 39.00% 8.51% 10.35% $18,247
90% 6.83 31.48% CC 13.95% 34.67% 9.11% 11.35% $16,275

Aswath Damodaran 87
 Grow more in
BMW: Restructured emerging Return on Capital
Reinvestment Rate markets 12.00%
Current Cashflow to Firm 70% Stable Growth
EBIT(1-t) : 2,227 Expected Growth g = 2%; Beta = 1.00;
- Nt CpX 687 in EBIT (1-t) Country Premium= 1.5%
- Chg WC 583 .70*.12=.084 Cost of capital = 6.49%
= FCFF ! 958 8.40% ROC= 6.49%; Tax rate=37%
Reinvestment Rate=(687+583)/2227 Reinvestment Rate=g/ROC
= 57% =2/ 6.49= 30.80%

Terminal Value5= 2480/(.0649-.02) = 43,205

Euro Cashflows
Op. Assets! 42,118 Term Yr
+ Cash: 4,123 Year 1 2 3 4 5 3583
- Debt 5,523 EBIT (1-t) ! 2,415 ! 2,617 ! 2,837 ! 3,076 ! 3,334 g=2% -1103
- Non-Debt 7,517 - Reinvestment! 1,690 ! 1,832 ! 1,986 ! 2,153 ! 2,334 Tax rate changes = 2480
=Equity 33,201 = FCFF ! 724 ! 785 ! 851 ! 923 ! 1,000

Value/Sh ! 49.30
Discount at $ Cost of Capital (WACC) = 9.90% (.60) + 3.56% (0.40) = 7.36%

On Sept 23, 2004

BMW Common = 33.50 Eu
Cost of Equity Cost of Debt
9.90% (3.95%+2.00%)(1-.4021) Weights
= 3.56% E = 60% D = 40% Change financing mix

Riskfree Rate:
Euro Riskfree Rate= 3.95% Beta Mature market Emerg Market Equity
+ 1.39 X premium + Lambda X Risk Premium
3.83 % 0.25 2.50%
Increased risk
Unlevered Beta for Firm’s D/E from
Sectors: 0.99 Ratio: 24.77% emerging markets

Aswath Damodaran 88
 The Value of Control?

 If the value of a firm run optimally is significantly higher than the value of the
firm with the status quo (or incumbent management), you can write the value
that you should be willing to pay as:
 Value of control = Value of firm optimally run - Value of firm with status quo
 Implications:
• The value of control is greatest at poorly run firms.
• Voting shares in poorly run firms should trade at a premium on non-voting shares
if the votes associated with the shares will give you a chance to have a say in a
hostile acquisition.
• When valuing private firms, your estimate of value will vary depending upon
whether you gain control of the firm. For example, 49% of a private firm may be
worth less than 51% of the same firm.
49% stake = 49% of status quo value
51% stake = 51% of optimal value

Aswath Damodaran 89
 Relative Valuation

Aswath Damodaran

Aswath Damodaran 90
 What is relative valuation?

 In relative valuation, the value of an asset is compared to the values assessed

by the market for similar or comparable assets.
 To do relative valuation then,
• we need to identify comparable assets and obtain market values for these assets
• convert these market values into standardized values, since the absolute prices
cannot be compared This process of standardizing creates price multiples.
• compare the standardized value or multiple for the asset being analyzed to the
standardized values for comparable asset, controlling for any differences between
the firms that might affect the multiple, to judge whether the asset is under or over
valued

Aswath Damodaran 91
 Relative valuation is pervasive…

 Most valuations on Wall Street are relative valuations.

• Almost 85% of equity research reports are based upon a multiple and comparables.
• More than 50% of all acquisition valuations are based upon multiples
• Rules of thumb based on multiples are not only common but are often the basis for
final valuation judgments.
 While there are more discounted cashflow valuations in consulting and
corporate finance, they are often relative valuations masquerading as
discounted cash flow valuations.
• The objective in many discounted cashflow valuations is to back into a number that
has been obtained by using a multiple.
• The terminal value in a significant number of discounted cashflow valuations is
estimated using a multiple.

Aswath Damodaran 92
 Why relative valuation?

“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 little inaccuracy sometimes saves tons of explanation”

H.H. Munro

“ If you are going to screw up, make sure that you have lots of company”
Ex-portfolio manager
Aswath Damodaran 93
 So, you believe only in intrinsic value? Here’s why you
should still care about relative value

 Even if you are a true believer in discounted cashflow valuation, presenting

your findings on a relative valuation basis will make it more likely that your
findings/recommendations will reach a receptive audience.
 In some cases, relative valuation can help find weak spots in discounted cash
flow valuations and fix them.
 The problem with multiples is not in their use but in their abuse. If we can
find ways to frame multiples right, we should be able to use them better.

Aswath Damodaran 94
 Standardizing Value

 You can standardize either the equity value of an asset or the value of the asset itself, which goes in
the numerator.
 You can standardize by dividing by the
• Earnings of the asset
– Price/Earnings Ratio (PE) and variants (PEG and Relative PE)
– Value/EBIT
– Value/EBITDA
– Value/Cash Flow
• Book value of the asset
– Price/Book Value(of Equity) (PBV)
– Value/ Book Value of Assets
– Value/Replacement Cost (Tobin’s Q)
• Revenues generated by the asset
– Price/Sales per Share (PS)
– Value/Sales
• Asset or Industry Specific Variable (Price/kwh, Price per ton of steel ....)

Aswath Damodaran 95
 The Four Steps to Understanding Multiples

 Define the multiple

• In use, the same multiple can be defined in different ways by different users. When
comparing and using multiples, estimated by someone else, it is critical that we
understand how the multiples have been estimated
 Describe the multiple
• Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a
multiple is, it is difficult to look at a number and pass judgment on whether it is too
high or low.
 Analyze the multiple
• It is critical that we understand the fundamentals that drive each multiple, and the
nature of the relationship between the multiple and each variable.
 Apply the multiple
• Defining the comparable universe and controlling for differences is far more
difficult in practice than it is in theory.

Aswath Damodaran 96
 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.
 Is the multiple uniformly estimated?
• The variables used in defining the multiple should be estimated uniformly across
assets in the “comparable firm” list.
• If earnings-based multiples are used, the accounting rules to measure earnings
should be applied consistently across assets. The same rule applies with book-
value based multiples.

Aswath Damodaran 97
 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?

Aswath Damodaran 98
 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
 How do changes in these fundamentals change the multiple?
• The relationship between a fundamental (like growth) and a multiple (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 ratio
• Proposition 3: It is impossible to properly compare firms on a multiple, if we
do not know the nature of the relationship between fundamentals and the
multiple.

Aswath Damodaran 99
 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.

Aswath Damodaran 100

 Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share

 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

Aswath Damodaran 101

 PE Ratio: Distribution for the US: January 2004

Aswath Damodaran 102

 PE: Deciphering the Distribution

Current PE Trailing PE Forward PE

Mean 41.41 41.53 30.90
Standard Error 2.42 3.64 1.10
Median 20.76 19.39 19.21
Kurtosis 1062.81 700.63 252.62
Skewness 27.78 24.21 12.48
Minimum 0.40 1.22 2.57
Maximum 6841.25 7184.00 1430.00
Count 4032 3492 2281
500th largest 54.50 43.98 31.13
500th smallest 11.31 11.13 14.29

Aswath Damodaran 103

 Comparing PE Ratios: Europe, Japan and Emerging Markets

Median PE
Japan = 24.74
US = 20.76
Em. Mkts = 18.87
Europe = 15.99

Aswath Damodaran 104

 PE Ratio: Germany in September 2004

Aswath Damodaran 105

 PE Ratio: 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 earnings per share,

P0 Payout Ratio * (1 + g n )
= PE =
EPS0 r-gn
 If this had been a FCFE Model,

FCFE1
P0 =
r ! gn

P0 (FCFE/Earnings) * (1 + g n )
= PE =
EPS0 r-g n
Aswath Damodaran 106
 PE Ratio and Fundamentals

 Proposition: Other things held equal, higher growth firms will have
higher PE ratios than lower growth firms.
 Proposition: Other things held equal, higher risk firms will have lower
PE ratios than lower risk firms
 Proposition: Other things held equal, firms with lower reinvestment
needs will have higher PE ratios than firms with higher reinvestment
rates.
 Of course, other things are difficult to hold equal since high growth firms,
tend to have risk and high reinvestment rats.

Aswath Damodaran 107

 Using the Fundamental Model to Estimate PE For a High
Growth Firm

 The price-earnings ratio for a high growth firm can also be related to
fundamentals. In the special case of the two-stage dividend discount model,
this relationship can be made explicit fairly simply:
" (1+ g)n %
EPS0 * Payout Ratio *(1+ g)* $1 !
# (1+ r) n & EPS0 * Payout Ratio n *(1+ g)n *(1+ g n )
P0 = +
r-g (r -g n )(1+ r)n

• For a firm that does not pay what it can afford to in dividends, substitute
FCFE/Earnings for the payout ratio.
 Dividing both sides by the earnings per share:
" (1 + g)n %
Payout Ratio * (1 + g) * $ 1 ! '
P0 # (1+ r) n & Payout Ratio n *(1+ g) n * (1 + gn )
= +
EPS0 r -g (r - g n )(1+ r) n

Aswath Damodaran 108

 Expanding the Model

 In this model, the PE ratio for a high growth firm is a function of growth, risk
and payout, exactly the same variables that it was a function of for the stable
growth firm.
 The only difference is that these inputs have to be estimated for two phases -
the high growth phase and the stable growth phase.
 Expanding to more than two phases, say the three stage model, will mean that
risk, growth and cash flow patterns in each stage.

Aswath Damodaran 109

 A Simple Example

 Assume that you have been asked to estimate the PE ratio for a firm which
has the following characteristics:
Variable High Growth Phase Stable Growth Phase
Expected Growth Rate 25% 8%
Payout Ratio 20% 50%
Beta 1.00 1.00
Number of years 5 years Forever after year 5
 Riskfree rate = [Link] Rate = 6%
 Required rate of return = 6% + 1(5.5%)= 11.5%

# (1.25) 5 &
0.2 * (1.25) * %1" 5( 5
$ (1.115) ' 0.5 * (1.25) * (1.08)
PE = + = 28.75
(.115 - .25) (.115 - .08) (1.115) 5

!
Aswath Damodaran 110
 PE and Growth: Firm grows at x% for 5 years, 8% thereafter

PE Ratios and Expected Growth: Interest Rate Scenarios

180

160

140

120

100 r=4%
PE Ratio

r=6%
r=8%
80 r=10%

60

40

20

0
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expected Growth Rate

Aswath Damodaran 111

 PE Ratios and Length of High Growth: 25% growth for n
years; 8% thereafter

Aswath Damodaran 112

 PE and Risk: Effects of Changing Betas on PE Ratio:
Firm with x% growth for 5 years; 8% thereafter

PE Ratios and Beta: Growth Scenarios

50

45

40

35

30
g=25%
Ratio

g=20%
25
g=15%
PE

g=8%
20

15

10

0
0.75 1.00 1.25 1.50 1.75 2.00
Beta

Aswath Damodaran 113

 PE and Payout

Aswath Damodaran 114

 I. Comparisons of PE across time: PE Ratio for the S&P 500

Aswath Damodaran 115

 Is low (high) PE cheap (expensive)?

 A market strategist argues that stocks are over priced because the PE ratio
today is too high relative to the average PE ratio across time. Do you agree?
 Yes
 No
 If you do not agree, what factors might explain the higher PE ratio today?

Aswath Damodaran 116

 E/P Ratios , [Link] Rates and Term Structure

Aswath Damodaran 117

 Regression Results

 There is a strong positive relationship between E/P ratios and [Link] rates, as
evidenced by the correlation of 0.69 between the two variables.,
 In addition, there is evidence that the term structure also affects the PE ratio.
 In the following regression, using 1960-2003 data, we regress E/P ratios
against the level of [Link] rates and a term structure variable ([Link] -
[Link] rate)
E/P = 2.03% + 0.753 [Link] Rate - 0.355 ([Link] [Link] Rate)
(2.19) (6.38) (-1.38)
R squared = 50.85%

Aswath Damodaran 118

 II. Comparing PE Ratios across a Sector

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 119

 PE, Growth and Risk

Dependent variable is: PE

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

Variable Coefficient SE t-ratio prob

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

Aswath Damodaran 120

 Is Telebras under valued?

 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.

 What about Deutsche Telecom?

• If viewed as a developed market telecom
13.12 + 121.22 (0.11) -13.85 (0) = 26.45
It is slightly undervalued at 24.6 times earnings

Aswath Damodaran 121

 Using the entire crosssection: A regression approach

 In contrast to the 'comparable firm' approach, the information in the entire

cross-section of firms can be used to predict PE ratios.
 The simplest way of summarizing this information is with a multiple
regression, with the PE ratio as the dependent variable, and proxies for risk,
growth and payout forming the independent variables.

Aswath Damodaran 122

 PE versus Growth

Current PE vs Expected Growth in EPS

January 2004: US Companies
1 20

1 00

80

60

40
Current PE

20

0
-20 0 20 40 60 80

Expected Growth in E PS: next 5 y ears

Aswath Damodaran 123

 PE Ratio: Standard Regression for US stocks - January 2004

Mod el Summary

Adjusted R Std. Er ror of the

Mode l R R Square Square Estimate
1 .467 a .21 8 .217 1049.7506205 340
a. Predictor s: ( Constant), PAYOUT, Regre ssion Be ta , Expected
Gr owth in EPS: next 5 years

Co effici entsa,b

Unstandardized Standar dized

Coefficients Coefficients
Mode l B Std. Error Beta t Sig.
1 (Constant) 9.475 .96 1 9.862 .000
Expected G rowth in
EPS: next 5 years .814 .04 6 .375 17.55 8 .000

Regr ession B eta 6.283 .43 7 .298 14.37 5 .000

PAYOUT 6.E-02 .01 4 .092 4.161 .000
a. Dependent Va riable: Current PE
b. Weighted Least Square s Regression - We ighted by Mar ket Cap

Aswath Damodaran 124

 Problems with the regression methodology

 The basic regression assumes a linear relationship between PE ratios and the
financial proxies, and that might not be appropriate.
 The basic relationship between PE ratios and financial variables itself might
not be stable, and if it shifts from year to year, the predictions from the model
may not be reliable.
 The independent variables are correlated with each other. For example, high
growth firms tend to have high risk. This multi-collinearity makes the
coefficients of the regressions unreliable and may explain the large changes in
these coefficients from period to period.

Aswath Damodaran 125

 The Multicollinearity Problem
Correlatio ns

Expected
Growth in
Revenues: Regr ession
next 5 ye ars Beta PAYOUT
Expected G rowth in Pear son Correlation 1 .031 -.325**
Reven ues: next 5 year s Sig. (2 -tailed) . .228 .000
N 147 2 1472 1185
Regression Bet a Pear son Correlation .03 1 1 -.183**
Sig. (2 -tailed) .22 8 . .000
N 147 2 6933 4187
PAYOUT Pear son Correlation -.325** -.183** 1
Sig. (2 -tailed) .00 0 .000 .
N 118 5 4187 4187
**. Correlation is significa nt at the 0.01 level (2-tailed).

Aswath Damodaran 126

 Using the PE ratio regression

 Assume that you were given the following information for Dell. The firm has
an expected growth rate of 10%, a beta of 1.20 and pays no dividends. Based
upon the regression, estimate the predicted PE ratio for Dell.
Predicted PE =

 Dell is actually trading at 22 times earnings. What does the predicted PE tell
you?

Aswath Damodaran 127

 The value of growth

Time Period Value of extra 1% of growth Equity Risk Premium

January 2004 0.812 3.69%
July 2003 1.228 3.88%
January 2003 2.621 4.10%
July 2002 0.859 4.35%
January 2002 1.003 3.62%
July 2001 1.251 3.05%
January 2001 1.457 2.75%
July 2000 1.761 2.20%
January 2000 2.105 2.05%
The value of growth is in terms of additional PE…

Aswath Damodaran 128

 PE Regression: Germany in September 2004

Model Summary

Adjusted R
Mode l R R Square Square Std. Er ror of the Estimate
1 .58 0a .33 6 .32 2 1113.202 1491486830 0
a. Predictor s: ( Constant), IBES Est Long Term Growth, RAW_BETA

Co effici en tsa,b

Unstandardized Standar dized

Coefficie nts Coefficie nts
Mode l B Std. Error Be ta t Sig.
1 (Constant) 3.535 4.983 .70 9 .480
RAW_BET A 5.452 4.085 .11 4 1.335 .185
IBES Est Long
1.697 .251 .57 7 6.774 .000
Term Growth
a. Dependent Va riable: PE
b. Weighted Least Square s Regression - We ighted by Mar ket Cap

Aswath Damodaran 129

 Value/Earnings and Value/Cashflow Ratios

 While Price earnings ratios look at the market value of equity relative to earnings to equity investors,
Value earnings ratios look at the market value of the firm relative to operating earnings. Value to
cash flow ratios modify the earnings number to make it a cash flow number.
 The form of value to cash flow ratios that has the closest parallels in DCF valuation is the value to
Free Cash Flow to the Firm, which is defined as:
Value/FCFF = (Market Value of Equity + Market Value of Debt-Cash)
EBIT (1-t) - (Cap Ex - Deprecn) - Chg in WC
 Consistency Tests:
• If the numerator is net of cash (or if net debt is used, then the interest income from the cash should not be in
denominator
• The interest expenses added back to get to EBIT should correspond to the debt in the numerator. If only long
term debt is considered, only long term interest should be added back.

Aswath Damodaran 130

 Value of Firm/FCFF: Determinants

 Reverting back to a two-stage FCFF DCF model, we get:

! (1 + g)n $
FCFF (1 + g) # 1- &
0 " (1+ WACC) % n FCFF (1+ g)n (1+ g )
V0 = + 0 n
WACC - g (WACC - g )(1 + WACC)n
n
• V0 = Value of the firm (today)
• FCFF0 = Free Cashflow to the firm in current year
• g = Expected growth rate in FCFF in extraordinary growth period (first n years)
• WACC = Weighted average cost of capital
• gn = Expected growth rate in FCFF in stable growth period (after n years)

Aswath Damodaran 131

 Value Multiples

 Dividing both sides by the FCFF yields,

!# (1 + g)n $
(1 + g) 1-
V0 " (1 + WACC)n % (1+ g)n (1+ gn )
= + n
FCFF0 WACC - g (WACC - gn )(1 + WACC)

 The value/FCFF multiples is a function of

• the cost of capital
• the expected growth

Aswath Damodaran 132

 Value/FCFF Multiples and the Alternatives

 Assume that you have computed the value of a firm, using discounted cash
flow models. Rank the following multiples in the order of magnitude from
lowest to highest?
 Value/EBIT
 Value/EBIT(1-t)
 Value/FCFF
 Value/EBITDA
 What assumption(s) would you need to make for the Value/EBIT(1-t) ratio to
be equal to the Value/FCFF multiple?

Aswath Damodaran 133

 Illustration: Using Value/FCFF Approaches to value a firm:
MCI Communications

 MCI Communications had earnings before interest and taxes of $3356 million
in 1994 (Its net income after taxes was $855 million).
 It had capital expenditures of $2500 million in 1994 and depreciation of
$1100 million; Working capital increased by $250 million.
 It expects free cashflows to the firm to grow 15% a year for the next five years
and 5% a year after that.
 The cost of capital is 10.50% for the next five years and 10% after that.
 The company faces a tax rate of 36%.

æ
ç (1.15)5 ö
(1.15) è1-
(1.105)5 ø
5
V0 (1.15) (1.05)
= + 5
= 31.28
FCFF0 .105 -.15 (.10 - .05)(1.105)

Aswath Damodaran 134

 Multiple Magic

 In this case of MCI there is a big difference between the FCFF and short cut
measures. For instance the following table illustrates the appropriate multiple
using short cut measures, and the amount you would overpay by if you used
the FCFF multiple.
Free Cash Flow to the Firm
= EBIT (1-t) - Net Cap Ex - Change in Working Capital
= 3356 (1 - 0.36) + 1100 - 2500 - 250 = $ 498 million
$ Value Correct Multiple
FCFF $498 31.28382355
EBIT (1-t) $2,148 7.251163362
EBIT $ 3,356 4.640744552
EBITDA $4,456 3.49513885

Aswath Damodaran 135

 Reasons for Increased Use of Value/EBITDA

1. The multiple can be computed even for firms that are reporting net losses, since earnings before
interest, taxes and depreciation are usually positive.
2. For firms in certain industries, such as cellular, which require a substantial investment in infrastructure
and long gestation periods, this multiple seems to be more appropriate than the price/earnings ratio.
3. In leveraged buyouts, where the key factor is cash generated by the firm prior to all discretionary
expenditures, the EBITDA is the measure of cash flows from operations that can be used to support
debt payment at least in the short term.
4. By looking at cashflows prior to capital expenditures, it may provide a better estimate of “optimal
value”, especially if the capital expenditures are unwise or earn substandard returns.
5. By looking at the value of the firm and cashflows to the firm it allows for comparisons across firms
with different financial leverage.

Aswath Damodaran 136

 Value/EBITDA Multiple

 The Classic Definition

Value Market Value of Equity + Market Value of Debt
=
EBITDA Earnings before Interest, Taxes and Depreciation

 The No-Cash Version

Enterprise Value Market Value of Equity + Market Value of Debt - Cash

=
EBITDA Earnings before Interest, Taxes and Depreciation
 When cash and marketable securities are netted out of value, none of the
income from the cash and securities should be reflected in the denominator.

Aswath Damodaran 137

 Enterprise Value/EBITDA Distribution - Germany in
September 2004

Aswath Damodaran 138

 Value/EBITDA Distribution: Rest of the World

Aswath Damodaran 139

 The Determinants of Value/EBITDA Multiples: Linkage to
DCF Valuation

 Firm value can be written as:

FCFF1
V0 =
WACC - g
 The numerator can be written as follows:
FCFF = EBIT (1-t) - (Cex - Depr) - Δ Working Capital
= (EBITDA - Depr) (1-t) - (Cex - Depr) - Δ Working Capital
= EBITDA (1-t) + Depr (t) - Cex - Δ Working Capital

Aswath Damodaran 140

 From Firm Value to EBITDA Multiples

 Now the Value of the firm can be rewritten as,

EBITDA (1- t) + Depr (t) - Cex - ! Working Capital
Value =
WACC - g

 Dividing both sides of the equation by EBITDA,

Value (1- t) Depr (t)/EBITDA CEx/EBITDA ! Working Capital/EBITDA
= + - -
EBITDA WACC- g WACC -g WACC - g WACC - g

Aswath Damodaran 141

 A Simple Example

 Consider a firm with the following characteristics:

• Tax Rate = 36%
• Capital Expenditures/EBITDA = 30%
• Depreciation/EBITDA = 20%
• Cost of Capital = 10%
• The firm has no working capital requirements
• The firm is in stable growth and is expected to grow 5% a year forever.

Aswath Damodaran 142

 Calculating Value/EBITDA Multiple

 In this case, the Value/EBITDA multiple for this firm can be estimated as
follows:
Value (1- .36) (0.2)(.36) 0.3 0
= + - - = 8.24
EBITDA .10 -.05 .10 -.05 .10 - .05 .10 - .05

Aswath Damodaran 143

 Value/EBITDA Multiples and Taxes

Aswath Damodaran 144

 Value/EBITDA and Net Cap Ex

Aswath Damodaran 145

 Value/EBITDA Multiples and Return on Capital

Value/EBITDA and Return on Capital

12

10

8
Value/EBITDA

WACC=10%
6 WACC=9%
WACC=8%

0
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Return on Capital

Aswath Damodaran 146

 Value/EBITDA Multiple: Trucking Companies

Company Name Value EBITDA Value/EBITDA

KLLM Trans. Svcs. $ 114.32 $ 48.81 2.34
Ryder System $ 5,158.04 $ 1,838.26 2.81
Rollins Truck Leasing $ 1,368.35 $ 447.67 3.06
Cannon Express Inc. $ 83.57 $ 27.05 3.09
Hunt (J.B.) $ 982.67 $ 310.22 3.17
Yellow Corp. $ 931.47 $ 292.82 3.18
Roadway Express $ 554.96 $ 169.38 3.28
Marten Transport Ltd. $ 116.93 $ 35.62 3.28
Kenan Transport Co. $ 67.66 $ 19.44 3.48
M.S. Carriers $ 344.93 $ 97.85 3.53
Old Dominion Freight $ 170.42 $ 45.13 3.78
Trimac Ltd $ 661.18 $ 174.28 3.79
Matlack Systems $ 112.42 $ 28.94 3.88
XTRA Corp. $ 1,708.57 $ 427.30 4.00
Covenant Transport Inc $ 259.16 $ 64.35 4.03
Builders Transport $ 221.09 $ 51.44 4.30
Werner Enterprises $ 844.39 $ 196.15 4.30
Landstar Sys. $ 422.79 $ 95.20 4.44
AMERCO $ 1,632.30 $ 345.78 4.72
USA Truck $ 141.77 $ 29.93 4.74
Frozen Food Express $ 164.17 $ 34.10 4.81
Arnold Inds. $ 472.27 $ 96.88 4.87
Greyhound Lines Inc. $ 437.71 $ 89.61 4.88
USFreightways $ 983.86 $ 198.91 4.95
Golden Eagle Group Inc. $ 12.50 $ 2.33 5.37
Arkansas Best $ 578.78 $ 107.15 5.40
Airlease Ltd. $ 73.64 $ 13.48 5.46
Celadon Group $ 182.30 $ 32.72 5.57
Amer. Freightways $ 716.15 $ 120.94 5.92
Transfinancial Holdings $ 56.92 $ 8.79 6.47
Vitran Corp. 'A' $ 140.68 $ 21.51 6.54
Interpool Inc. $ 1,002.20 $ 151.18 6.63
Intrenet Inc. $ 70.23 $ 10.38 6.77
Swift Transportation $ 835.58 $ 121.34 6.89
Landair Services $ 212.95 $ 30.38 7.01
CNF Transportation $ 2,700.69 $ 366.99 7.36
Budget Group Inc $ 1,247.30 $ 166.71 7.48
Caliber System $ 2,514.99 $ 333.13 7.55
Knight Transportation Inc $ 269.01 $ 28.20 9.54
Heartland Express $ 727.50 $ 64.62 11.26
Greyhound CDA Transn Corp $ 83.25 $ 6.99 11.91
Mark VII $ 160.45 $ 12.96 12.38
Coach USA Inc $ 678.38 $ 51.76 13.11
US 1 Inds Inc. $ 5.60 $ (0.17) NA
Average 5.61

Aswath Damodaran 147

 A Test on EBITDA

 Ryder System looks very cheap on a Value/EBITDA multiple basis, relative

to the rest of the sector. What explanation (other than misvaluation) might
there be for this difference?

Aswath Damodaran 148

 US Market: Cross Sectional Regression
January 2004
Model Summary

Adjusted R Std. Er ror of the

Mode l R R Square Square Estimate
1 a
.583 .34 0 .33 8 653 .801855 07239
a. Predictor s: ( Constant), Reinvestment Rate, Expected Gr owth
in Revenues: next 5 years, Eff Tax Rat e

Co ef fici entsa,b

Unstandardized Standardized
Coefficie nts Coefficie nts
Mode l B Std. Er ror Be ta t Sig.
1 (Constant) 10. 073 .768 13.121 .00 0
Eff T ax Rate -.152 .022 -.174 -6.878 .00 0
Expected G rowth in
.907 .039 .563 23.464 .00 0
Revenues: next 5 year s
Reinvestment Rate -.015 .006 -.062 -2.420 .01 6
a. Dependent Va riable: EV /EBITDA
b. Weighted Least Square s Regression - We ighte d by Mar ket Cap

Aswath Damodaran 149

 Europe: Cross Sectional Regression
January 2004

Model Summary

Adjusted R
Mode l R R Square Square Std. Er ror of the Estimate
1 .542 a .293 .292 1581.333005721082 000
a. Predictors: ( Constant), Tax Rate , Reinv Rate , Market Debt to Ca pital

Coefficientsa,b

Unstandardized Standardized
Coefficie nts Coefficie nts
Mode l B Std. Er ror Be ta t Sig.
1 (Constant) 8.419 1.2 79 6.580 .00 0
Mar ket Debt t o Capital .58 9 .021 .511 28. 035 .00 0
Reinv Ra te -.051 .009 -.099 -5.472 .00 0
Tax Rat e -.152 .029 -.095 -5.236 .00 0
a. Dependent Va riable: EV/EBITDA
b. Weighted Least Square s Regression - Weig hted by Marke t Capitalization

Aswath Damodaran 150

 Price-Book Value Ratio: Definition

 The price/book value ratio is the ratio of the market value of equity to the
book value of equity, i.e., the measure of shareholders’ equity in the balance
sheet.
 Price/Book Value = Market Value of Equity
Book Value of Equity
 Consistency Tests:
• If the market value of equity refers to the market value of equity of common stock
outstanding, the book value of common equity should be used in the denominator.
• If there is more that one class of common stock outstanding, the market values of
all classes (even the non-traded classes) needs to be factored in.

Aswath Damodaran 151

 Price to Book Value: German Stocks in September 2004

Aswath Damodaran 152

 Price to Book Value: Europe, Japan and Emerging Markets

Aswath Damodaran 153

 Price Book Value Ratio: Stable Growth Firm

 Going back to a simple dividend discount model,

DPS1
P0 =
r ! gn

 Defining the return on equity (ROE) = EPS0 / Book Value of Equity, the value
of equity can be written as:
BV 0 * ROE * Payout Ratio * (1 + gn )
P0 =
r-gn
P0 ROE * Payout Ratio * (1 + g n )
= PBV =
BV 0 r-g n

 If the return on equity is based upon expected earnings in the next time
period, this can be simplified to,

P0 ROE * Payout Ratio

= PBV =
BV 0 r-g n

Aswath Damodaran 154

 PBV/ROE: European Banks
Bank Symbol PBV ROE
Banca di Roma SpA BAHQE 0.60 4.15%
Commerzbank AG COHSO 0.74 5.49%
Bayerische Hypo und Vereinsbank AG BAXWW 0.82 5.39%
Intesa Bci SpA BAEWF 1.12 7.81%
Natexis Banques Populaires NABQE 1.12 7.38%
Almanij NV Algemene Mij voor Nijver ALPK 1.17 8.78%
Credit Industriel et Commercial CIECM 1.20 9.46%
Credit Lyonnais SA CREV 1.20 6.86%
BNL Banca Nazionale del Lavoro SpA BAEXC 1.22 12.43%
Banca Monte dei Paschi di Siena SpA MOGG 1.34 10.86%
Deutsche Bank AG DEMX 1.36 17.33%
Skandinaviska Enskilda Banken SKHS 1.39 16.33%
Nordea Bank AB NORDEA 1.40 13.69%
DNB Holding ASA DNHLD 1.42 16.78%
ForeningsSparbanken AB FOLG 1.61 18.69%
Danske Bank AS DANKAS 1.66 19.09%
Credit Suisse Group CRGAL 1.68 14.34%
KBC Bankverzekeringsholding KBCBA 1.69 30.85%
Societe Generale SODI 1.73 17.55%
Santander Central Hispano SA BAZAB 1.83 11.01%
National Bank of Greece SA NAGT 1.87 26.19%
San Paolo IMI SpA SAOEL 1.88 16.57%
BNP Paribas BNPRB 2.00 18.68%
Svenska Handelsbanken AB SVKE 2.12 21.82%
UBS AG UBQH 2.15 16.64%
Banco Bilbao Vizcaya Argentaria SA BBFUG 2.18 22.94%
ABN Amro Holding NV ABTS 2.21 24.21%
UniCredito Italiano SpA UNCZA 2.25 15.90%
Rolo Banca 1473 SpA ROGMBA 2.37 16.67%
Dexia DECCT 2.76 14.99%
Average 1.60 14.96%
Aswath Damodaran 155
 PBV versus ROE regression

 Regressing PBV ratios against ROE for banks yields the following regression:
PBV = 0.81 + 5.32 (ROE) R2 = 46%
 For every 1% increase in ROE, the PBV ratio should increase by 0.0532.

Aswath Damodaran 156

 Under and Over Valued Banks?

Bank Actual Predicted Under or Over

Banca di Roma SpA 0.60 1.03 -41.33%
Commerzbank AG 0.74 1.10 -32.86%
Bayerische Hypo und Vereinsbank AG 0.82 1.09 -24.92%
Intesa Bci SpA 1.12 1.22 -8.51%
Natexis Banques Populaires 1.12 1.20 -6.30%
Almanij NV Algemene Mij voor Nijver 1.17 1.27 -7.82%
Credit Industriel et Commercial 1.20 1.31 -8.30%
Credit Lyonnais SA 1.20 1.17 2.61%
BNL Banca Nazionale del Lavoro SpA 1.22 1.47 -16.71%
Banca Monte dei Paschi di Siena SpA 1.34 1.39 -3.38%
Deutsche Bank AG 1.36 1.73 -21.40%
Skandinaviska Enskilda Banken 1.39 1.68 -17.32%
Nordea Bank AB 1.40 1.54 -9.02%
DNB Holding ASA 1.42 1.70 -16.72%
ForeningsSparbanken AB 1.61 1.80 -10.66%
Danske Bank AS 1.66 1.82 -9.01%
Credit Suisse Group 1.68 1.57 7.20%
KBC Bankverzekeringsholding 1.69 2.45 -30.89%
Societe Generale 1.73 1.74 -0.42%
Santander Central Hispano SA 1.83 1.39 31.37%
National Bank of Greece SA 1.87 2.20 -15.06%
San Paolo IMI SpA 1.88 1.69 11.15%
BNP Paribas 2.00 1.80 11.07%
Svenska Handelsbanken AB 2.12 1.97 7.70%
UBS AG 2.15 1.69 27.17%
Banco Bilbao Vizcaya Argentaria SA 2.18 2.03 7.66%
ABN Amro Holding NV 2.21 2.10 5.23%
UniCredito Italiano SpA 2.25 1.65 36.23%
Rolo Banca 1473 SpA 2.37 1.69 39.74%
Dexia 2.76 1.61 72.04%

Aswath Damodaran 157

 Looking for undervalued securities - PBV Ratios and ROE :
The Valuation Matrix

MV/BV

Overvalued
Low ROE High ROE
High MV/BV High MV/BV

ROE-r

Undervalued
Low ROE High ROE
Low MV/BV Low MV/BV

Aswath Damodaran 158

 Price to Book vs ROE: German Stocks in September 2004

10 LEC PUM
SGS
WAD AQU
DEE
8
GAL
RAA

KER
US A
6

4
EUX

2 KOT
DC G
LB R
AX3
SAH
PBV

0 Rsq = 0.2355
-20 0 20 40 60 80 100 120

ROE

Aswath Damodaran 159

 PBV Matrix: Telecom Companies

12
TelAzteca

10

TelNZ Vimple
8 Carlton

Teleglobe
FranceTel Cable&W
6
DeutscheTel
BritTel
TelItalia
Portugal AsiaSat
HongKong
BCE Royal
4 Hellenic
Nippon
DanmarkChinaTel
Espana Indast
Telmex
TelArgFrance
PhilTel Televisas
TelArgentina
2 TelIndo
TelPeru

APT
CallNet
Anonima GrupoCentro

0
0 10 20 30 40 50 60

ROE

Aswath Damodaran 160

 PBV, ROE and Risk: Large Cap US firms

16
BUD G
14
PFE
12
O RCL
10 MMM EBAY

PBV R atio PG
8 MDT D
UL MRK
6 WMT T SM
QCOM
FNMK MB AMAT
4

2 FRE
AOL
SC V IA/B
70 60 4
50 40 3
30 20 2
10 0 1
0 Regressio n Beta
ROE

Aswath Damodaran 161

 IBM: The Rise and Fall and Rise Again

10.00 50.00%

9.00
40.00%

8.00
30.00%

7.00
20.00%

6.00

10.00%

Return on Equity
Price to Book

5.00

0.00%

4.00

-10.00%
3.00

-20.00%
2.00

-30.00%
1.00

0.00 -40.00%
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year

PBV ROE

Aswath Damodaran 162

 PBV Ratio Regression: US
January 2004
Mod el Su mmar y

Adjusted R Std. Er ror of the

a
Mode l R R Square Square Estimate
1 .943 b .889 .889 117.0574933200291
a. For r egression through the origin (the no-intercept model) , R
Square measures the proportion of the variability in the
dependent varia ble about the origin explained by regre ssion.
This CANNOT b e compared to R Squar e for models which
include an intercept.
b. Predictors: ROE, R egr ession B eta, PAYOU T, Expected Growth
in EPS: next 5 year s

Co effici entsa,b,c

Unstandardized Standar dized

Coefficients Coefficients
Mode l B Std. Error Beta t Sig.
1 Expected G rowth in
8.E-02 .00 4 .256 21.93 5 .000
EPS: next 5 years
PAYOUT 2.E-03 .00 1 .017 1.551 .121
Regr ession B eta .599 .04 2 .151 14.24 9 .000
ROE .140 .00 3 .628 50.73 1 .000
a. Dependent Va riable: PBV Ratio
b. Linear Regr ession through the Origin
c. Weighted Least Squares R egre ssion - Weig hted by Marke t Cap

Aswath Damodaran 163

 PBV Ratio Regression- Europe
January 2004
Mod el Summary

Adjusted R
a
Mode l R R Square Squar e Std. Error of the Estimate
1 .830 b .689 .689 154.4404 7748882220
a. For r egression through the origin (the no-intercept model) , R Squar e
mea sur es the prop or tion of the va riability in the depende nt variable
about the origin explained by regression. This CA NNOT be compare d
to R Square for models which include an inter cept.
b. Predictors: ROE, Payout Ra tio, B ETA

Coefficientsa ,b,c

Unstandardized Standardized
Coefficie nts Coefficie nts
Mode l B Std. Er ror Be ta t Sig.
1 Payout Ratio 8.E-03 .002 .074 3.667 .00 0
BE TA 1.399 .114 .291 12. 279 .00 0
ROE .10 4 .004 .537 28. 148 .00 0
a. Dependent Va riable: PB V
b. Linear Regr ession through the Origin
c. Weighted Least Squares R egre ssion - Weighted by Marke t Capitalization

Aswath Damodaran 164

 Price Sales Ratio: Definition

 The price/sales ratio is the ratio of the market value of equity to the sales.
 Price/ Sales= Market Value of Equity
Total Revenues
 Consistency Tests
• The price/sales ratio is internally inconsistent, since the market value of equity is
divided by the total revenues of the firm.

Aswath Damodaran 165

 Price/Sales Ratio: German Stocks in January 2004

Aswath Damodaran 166

 Price to Sales: Europe, Japan and Emerging Markets

Aswath Damodaran 167

 Price/Sales Ratio: Determinants

 The price/sales ratio of a stable growth firm can be estimated beginning with a
2-stage equity valuation model:
DPS1
P0 =
r ! gn

 Dividing both sides by the sales per share:

P0 Net Profit Margin* Payout Ratio *(1+ g n )
= PS =
Sales 0 r-g n

Aswath Damodaran 168

 PS/Margins: European Retailers - September 2003

Aswath Damodaran 169

 Regression Results: PS Ratios and Margins

 Regressing PS ratios against net margins,

PS = -.39 + 0.6548 (Net Margin) R2 = 43.5%
 Thus, a 1% increase in the margin results in an increase of 0.6548 in the price
sales ratios.
 The regression also allows us to get predicted PS ratios for these firms

Aswath Damodaran 170

 Current versus Predicted Margins

 One of the limitations of the analysis we did in these last few pages is the
focus on current margins. Stocks are priced based upon expected margins
rather than current margins.
 For most firms, current margins and predicted margins are highly correlated,
making the analysis still relevant.
 For firms where current margins have little or no correlation with expected
margins, regressions of price to sales ratios against current margins (or price
to book against current return on equity) will not provide much explanatory
power.
 In these cases, it makes more sense to run the regression using either
predicted margins or some proxy for predicted margins.

Aswath Damodaran 171

 A Case Study: The Internet Stocks

30

PKSI

LCOS SPYG
20
INTM MMXI
SCNT

MQST FFIV ATHM

A
CNET DCLK
d
j INTW RAMP
P 10 CSGP CBIS NTPA
S NETO SONEPCLN
APNT CLKS
EDGRPSIX ATHY AMZN
SPLN BIDS ALOY ACOM EGRP
BIZZ IIXL
ITRA ANET
ONEM FATB ABTL INFO TMNT GEEK
RMII
-0 TURF PPOD BUYX ELTX
GSVI ROWE

-0.8 -0.6 -0.4 -0.2

AdjMargin

Aswath Damodaran 172

 PS Ratios and Margins are not highly correlated

 Regressing PS ratios against current margins yields the following

PS = 81.36 - 7.54(Net Margin) R2 = 0.04
(0.49)
 This is not surprising. These firms are priced based upon expected margins,
rather than current margins.

Aswath Damodaran 173

 Solution 1: Use proxies for survival and growth: Amazon in
early 2000

 Hypothesizing that firms with higher revenue growth and higher cash
balances should have a greater chance of surviving and becoming profitable,
we ran the following regression: (The level of revenues was used to control
for size)
PS = 30.61 - 2.77 ln(Rev) + 6.42 (Rev Growth) + 5.11 (Cash/Rev)
(0.66) (2.63) (3.49)
R squared = 31.8%
Predicted PS = 30.61 - 2.77(7.1039) + 6.42(1.9946) + 5.11 (.3069) = 30.42
Actual PS = 25.63
Stock is undervalued, relative to other internet stocks.

Aswath Damodaran 174

 Solution 2: Use forward multiples

 Global Crossing lost $1.9 billion in 2001 and is expected to continue to lose money for
the next 3 years. In a discounted cashflow valuation (see notes on DCF valuation) of
Global Crossing, we estimated an expected EBITDA for Global Crossing in five years
of $ 1,371 million.
 The average enterprise value/ EBITDA multiple for healthy telecomm firms is 7.2
currently.
 Applying this multiple to Global Crossing’s EBITDA in year 5, yields a value in year 5
of
• Enterprise Value in year 5 = 1371 * 7.2 = $9,871 million
• Enterprise Value today = $ 9,871 million/ 1.1385 = $5,172 million
(The cost of capital for Global Crossing is 13.80%)
• The probability that Global Crossing will not make it as a going concern is 77%.
• Expected Enterprise value today = 0.23 (5172) = $1,190 million

Aswath Damodaran 175

 PS Regression: United States - January 2004
Mod el Summary

Adjusted R Std. Error of the

a
Mode l R R Square Square Estimate
1 .932 b .869 .868 114.3056698264723 0
a. For r egression through the origin (the no-intercept model) , R
Square measures the proport ion of the variability in the
dependent varia ble about the origin explained by regre ssion.
This CANNOT be compared to R Squar e for models which
include an intercept.
b. Predictors: Net Mar gin, Regression Beta, PAYOUT, Expe cted
Growth in EPS: Co
next 5 years
effici entsa,b,c

Unstandardized Standar dized

Coefficients Coefficients
Mode l B Std. Error Beta t Sig.
1 Expected G rowth in
4.E-02 .00 4 .136 10.19 5 .000
EPS: next 5 years
PAYOUT -.011 .00 1 -.110 -9.425 .000
Regr ession B eta .549 .04 3 .156 12.65 8 .000
Net Margin .234 .00 4 .799 59.92 6 .000
a. Dependent Va riable: PS_RATIO
b. Linear Regr ession through the Origin
c. Weighted Least Squares R egre ssion - Weig hted by Marke t Cap

Aswath Damodaran 176

 PS Regression: Europe in January 2004
Model Summary

Adjusted R Std. Er ror of the

a
Mode l R R Square Square Estimate
1 .757 b .57 4 .573 134.938678072015
a. For r egression through the origin (the no-intercept m odel) ,
R Sq uare measures the proportion of the variab ility in the
dependent varia ble about the origin explained by
regression. This CANNO T be compar ed to R Square for
models which include an intercept.
b. Predictors: Net Mar gin, Payout Ra tio, BETA
Coefficientsa ,b,c

Unstandardized Standardized
Coefficie nts Coefficie nts
Mode l B Std. Er ror Be ta t Sig.
1 Payout Ratio 5.E-03 .002 .065 2.777 .00 6
BE TA .93 7 .095 .261 9.909 .00 0
Net Margin .11 0 .004 .516 26. 153 .00 0
a. Dependent Va riable: PS
b. Linear Regr ession through the Origin
c. Weighted Least Squares R egre ssion - Weighted by Marke t Capitalization

Aswath Damodaran 177

 Choosing Between the Multiples

 As presented in this section, there are dozens of multiples that can be

potentially used to value an individual firm.
 In addition, relative valuation can be relative to a sector (or comparable firms)
or to the entire market (using the regressions, for instance)
 Since there can be only one final estimate of value, there are three choices at
this stage:
• Use a simple average of the valuations obtained using a number of different
multiples
• Use a weighted average of the valuations obtained using a nmber of different
multiples
• Choose one of the multiples and base your valuation on that multiple

Aswath Damodaran 178

 Picking one Multiple

 This is usually the best way to approach this issue. While a range of values
can be obtained from a number of multiples, the “best estimate” value is
obtained using one multiple.
 The multiple that is used can be chosen in one of two ways:
• Use the multiple that best fits your objective. Thus, if you want the company to be
undervalued, you pick the multiple that yields the highest value.
• Use the multiple that has the highest R-squared in the sector when regressed
against fundamentals. Thus, if you have tried PE, PBV, PS, etc. and run
regressions of these multiples against fundamentals, use the multiple that works
best at explaining differences across firms in that sector.
• Use the multiple that seems to make the most sense for that sector, given how
value is measured and created.

Aswath Damodaran 179

 A More Intuitive Approach

 Managers in every sector tend to focus on specific variables when analyzing

strategy and performance. The multiple used will generally reflect this focus.
Consider three examples.
• In retailing: The focus is usually on same store sales (turnover) and profit margins.
Not surprisingly, the revenue multiple is most common in this sector.
• In financial services: The emphasis is usually on return on equity. Book Equity is
often viewed as a scarce resource, since capital ratios are based upon it. Price to
book ratios dominate.
• In technology: Growth is usually the dominant theme. PEG ratios were invented in
this sector.

Aswath Damodaran 180

 In Practice…

 As a general rule of thumb, the following table provides a way of picking a

multiple for a sector
Sector Multiple Used Rationale
Cyclical Manufacturing PE, Relative PE Often with normalized earnings
High Tech, High Growth PEG Big differences in growth across
firms
High Growth/No Earnings PS, VS Assume future margins will be good
Heavy Infrastructure VEBITDA Firms in sector have losses in early
years and reported earnings can vary
depending on depreciation method
REITa P/CF Generally no cap ex investments
from equity earnings
Financial Services PBV Book value often marked to market
Retailing PS If leverage is similar across firms
VS If leverage is different

Aswath Damodaran 181

 Reviewing: The Four Steps to Understanding Multiples

 Define the multiple

• Check for consistency
• Make sure that they are estimated uniformly
 Describe the multiple
• Multiples have skewed distributions: The averages are seldom good indicators of
typical multiples
• Check for bias, if the multiple cannot be estimated
 Analyze the multiple
• Identify the companion variable that drives the multiple
• Examine the nature of the relationship
 Apply the multiple

Aswath Damodaran 182

 Real Options: Fact and Fantasy

Aswath Damodaran

Aswath Damodaran 183

 Underlying Theme: Searching for an Elusive Premium

 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.

Aswath Damodaran 184

 Three Basic Questions

 When is there a real option embedded in a decision or an asset?

 When does that real option have significant economic value?
 Can that value be estimated using an option pricing model?

Aswath Damodaran 185

 When is there an option embedded in an action?

 An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or an
exercise price) at or before the expiration date of the option.
 There has to be a clearly defined underlying asset whose value changes over
time in unpredictable ways.
 The payoffs on this asset (real option) have to be contingent on an specified
event occurring within a finite period.

Aswath Damodaran 186

 Payoff Diagram on a Call

Net Payoff
on Call

Strike
Price

Price of underlying asset

Aswath Damodaran 187

 Example 1: Product Patent as an Option

PV of Cash Flows
from Project

Initial Investment in
Project

Present Value of Expected

Cash Flows on Product
Project's NPV turns
Project has negative positive in this section
NPV in this section

Aswath Damodaran 188

 Example 2: Undeveloped Oil Reserve as an option

Net Payoff on
Extraction

Cost of Developing
Reserve

Value of estimated reserve

of natural resource

Aswath Damodaran 189

 Example 3: Expansion of existing project as an option

PV of Cash Flows
from Expansion

Additional Investment
to Expand

Present Value of Expected

Cash Flows on Expansion
Expansion becomes
Firm will not expand in attractive in this section
this section

Aswath Damodaran 190

 Example 4: Equity in a Deeply Troubled firm (losing money
with substantial debt) as a Liquidation Optiion

Aswath Damodaran 191

 When does the option have significant economic value?

 For an option to have significant economic value, there has to be a restriction

on competition in the event of the contingency. In a perfectly competitive
product market, no contingency, no matter how positive, will generate
positive net present value.
 At the limit, real options are most valuable when you have exclusivity - you
and only you can take advantage of the contingency. They become less
valuable as the barriers to competition become less steep.

Aswath Damodaran 192

 Exclusivity: Putting Real Options to the Test

 Product Options: Patent on a drug

• Patents restrict competitors from developing similar products
• Patents do not restrict competitors from developing other products to treat the
same disease.
 Natural Resource options: An undeveloped oil reserve or gold mine.
• Natural resource reserves are limited.
• It takes time and resources to develop new reserves
 Growth Options: Expansion into a new product or market
• Barriers may range from strong (exclusive licenses granted by the government - as
in telecom businesses) to weaker (brand name, knowledge of the market) to
weakest (first mover).
 Equity in a Deeply Troubled Firm as a Liquidation Option
• Option value greatest when equity investors have the exclusive power to decide on
whether to liquidate or not
• Option value is reduced if lenders or the court get some or much of the power.

Aswath Damodaran 193

 Determinants of option value

 Variables Relating to Underlying Asset

• Value of Underlying Asset; as this value increases, the right to buy at a fixed price (calls) will
become more valuable and the right to sell at a fixed price (puts) will become less valuable.
• Variance in that value; as the variance increases, both calls and puts will become more
valuable because all options have limited downside and depend upon price volatility for upside.
• Expected dividends on the asset, which are likely to reduce the price appreciation component
of the asset, reducing the value of calls and increasing the value of puts.
 Variables Relating to Option
• Strike Price of Options; the right to buy (sell) at a fixed price becomes more (less) valuable at a
lower price.
• Life of the Option; both calls and puts benefit from a longer life.
 Level of Interest Rates; as rates increase, the right to buy (sell) at a fixed price in the
future becomes more (less) valuable.

Aswath Damodaran 194

 When can you use an option pricing model to value a real
option?

 All option pricing models are built on the premise of replication and arbitrage.
 Replication: The objective in creating a replicating portfolio is to use a
combination of riskfree borrowing/lending and the underlying asset to create
the same cashflows as the option being valued.
• Call = Borrowing + Buying D of the Underlying Stock
• Put = Selling Short D on Underlying Asset + Lending
• The number of shares bought or sold is called the option delta.
 Arbitrage: If two assets have the same cashflows, they cannot sell at different
prices. If they do, the principles of arbitrage then apply, and the value of the
option has to be equal to the value of the replicating portfolio.

Aswath Damodaran 195

 The Black Scholes Model

Value of call = S N (d1) - K e-rt N(d2)

where,
! S# %2
ln" $ + (r + )t
K 2
d1 =
% t
• d2 = d1 - σ √t
 The replicating portfolio is embedded in the Black-Scholes model. To
replicate this call, you would need to
• Buy N(d1) shares of stock; N(d1) is called the option delta
• Borrow K e-rt N(d2)

Aswath Damodaran 196

 The Normal Distribution
d N(d) d N(d) d N(d)
-3.00 0.0013 -1.00 0.1587 1.05 0.8531
-2.95 0.0016 -0.95 0.1711 1.10 0.8643
-2.90 0.0019 -0.90 0.1841 1.15 0.8749
-2.85 0.0022 -0.85 0.1977 1.20 0.8849
-2.80 0.0026 -0.80 0.2119 1.25 0.8944
-2.75 0.0030 -0.75 0.2266 1.30 0.9032
-2.70 0.0035 -0.70 0.2420 1.35 0.9115
-2.65 0.0040 -0.65 0.2578 1.40 0.9192
-2.60 0.0047 -0.60 0.2743 1.45 0.9265
-2.55 0.0054 -0.55 0.2912 1.50 0.9332
N(d 1) -2.50 0.0062 -0.50 0.3085 1.55 0.9394
-2.45 0.0071 -0.45 0.3264 1.60 0.9452
-2.40 0.0082 -0.40 0.3446 1.65 0.9505
-2.35 0.0094 -0.35 0.3632 1.70 0.9554
-2.30 0.0107 -0.30 0.3821 1.75 0.9599
-2.25 0.0122 -0.25 0.4013 1.80 0.9641
-2.20 0.0139 -0.20 0.4207 1.85 0.9678
-2.15 0.0158 -0.15 0.4404 1.90 0.9713
-2.10 0.0179 -0.10 0.4602 1.95 0.9744
-2.05 0.0202 -0.05 0.4801 2.00 0.9772
-2.00 0.0228 0.00 0.5000 2.05 0.9798
-1.95 0.0256 0.05 0.5199 2.10 0.9821
-1.90 0.0287 0.10 0.5398 2.15 0.9842
-1.85 0.0322 0.15 0.5596 2.20 0.9861
-1.80 0.0359 0.20 0.5793 2.25 0.9878
-1.75 0.0401 0.25 0.5987 2.30 0.9893
-1.70 0.0446 0.30 0.6179 2.35 0.9906
d1 -1.65 0.0495 0.35 0.6368 2.40 0.9918
-1.60 0.0548 0.40 0.6554 2.45 0.9929
-1.55 0.0606 0.45 0.6736 2.50 0.9938
-1.50 0.0668 0.50 0.6915 2.55 0.9946
-1.45 0.0735 0.55 0.7088 2.60 0.9953
-1.40 0.0808 0.60 0.7257 2.65 0.9960
-1.35 0.0885 0.65 0.7422 2.70 0.9965
-1.30 0.0968 0.70 0.7580 2.75 0.9970
-1.25 0.1056 0.75 0.7734 2.80 0.9974
-1.20 0.1151 0.80 0.7881 2.85 0.9978
-1.15 0.1251 0.85 0.8023 2.90 0.9981
-1.10 0.1357 0.90 0.8159 2.95 0.9984
-1.05 0.1469 0.95 0.8289 3.00 0.9987
-1.00 0.1587 1.00 0.8413

Aswath Damodaran 197

 Adjusting for Dividends

 If the dividend yield (y = dividends/ Current value of the asset) of the

underlying asset is expected to remain unchanged during the life of the
option, the Black-Scholes model can be modified to take dividends into
account.
C = S e-yt N(d -rt 2
! S # 1) - K e %N(d 2)
ln" $ + (r - y + )t
where, K 2
d1 =
% t

d2 = d1 - σ √t
 The value of a put can also be derived:
P = K e-rt (1-N(d2)) - S e-yt (1-N(d1))

Aswath Damodaran 198

 Example 1: Valuing a Product Patent as an option: Avonex

 Biogen, a bio-technology firm, has a patent on Avonex, a drug to treat

multiple sclerosis, for the next 17 years, and it plans to produce and sell the
drug by itself. The key inputs on the drug are as follows:
PV of Cash Flows from Introducing the Drug Now = S = $ 3.422 billion
PV of Cost of Developing Drug for Commercial Use = K = $ 2.875 billion
Patent Life = t = 17 years Riskless Rate = r = 6.7% (17-year [Link] rate)
Variance in Expected Present Values =s 2 = 0.224 (Industry average firm variance for
bio-tech firms)
Expected Cost of Delay = y = 1/17 = 5.89%
d1 = 1.1362 N(d1) = 0.8720
d2 = -0.8512 N(d2) = 0.2076
Call Value= 3,422 exp(-0.0589)(17) (0.8720) - 2,875 (exp(-0.067)(17) (0.2076)= $ 907
million

Aswath Damodaran 199

 Valuing a firm with patents

 The value of a firm with a substantial number of patents can be derived using
the option pricing model.
Value of Firm = Value of commercial products (using DCF value
+ Value of existing patents (using option pricing)
+ (Value of New patents that will be obtained in the
future – Cost of obtaining these patents)
 The last input measures the efficiency of the firm in converting its R&D into
commercial products. If we assume that a firm earns its cost of capital from
research, this term will become zero.
 If we use this approach, we should be careful not to double count and allow
for a high growth rate in cash flows (in the DCF valuation).

Aswath Damodaran 200

 Value of Biogen’s existing products

· Biogen had two commercial products (a drug to treat Hepatitis B and Intron)
at the time of this valuation that it had licensed to other pharmaceutical firms.
· The license fees on these products were expected to generate $ 50 million in
after-tax cash flows each year for the next 12 years. To value these cash
flows, which were guaranteed contractually, the pre-tax cost of debt of the
guarantors (6.7%) was used:
Present Value of License Fees = $ 50 million (1 – (1.067)-12)/.067
= $ 403.56 million

Aswath Damodaran 201

 Value of Biogen’s Future R&D

· Biogen continued to fund research into new products, spending about $ 100
million on R&D in the most recent year. These R&D expenses were expected
to grow 20% a year for the next 10 years, and 5% thereafter.
· It was assumed that every dollar invested in research would create $ 1.25 in
value in patents (valued using the option pricing model described above) for
the next 10 years, and break even after that (i.e., generate $ 1 in patent value
for every $ 1 invested in R&D).
· There was a significant amount of risk associated with this component and the
cost of capital was estimated to be 15%.

Aswath Damodaran 202

 Value of Future R&D

Yr Value of R&D Cost Excess Value Present Value

Patents (at 15%)
1 $ 150.00 $ 120.00 $ 30.00 $ 26.09
2 $ 180.00 $ 144.00 $ 36.00 $ 27.22
3 $ 216.00 $ 172.80 $ 43.20 $ 28.40
4 $ 259.20 $ 207.36 $ 51.84 $ 29.64
5 $ 311.04 $ 248.83 $ 62.21 $ 30.93
6 $ 373.25 $ 298.60 $ 74.65 $ 32.27
7 $ 447.90 $ 358.32 $ 89.58 $ 33.68
8 $ 537.48 $ 429.98 $ 107.50 $ 35.14
9 $ 644.97 $ 515.98 $ 128.99 $ 36.67
10 $ 773.97 $ 619.17 $ 154.79 $ 38.26
$ 318.30

Aswath Damodaran 203

 Value of Biogen

 The value of Biogen as a firm is the sum of all three components – the present
value of cash flows from existing products, the value of Avonex (as an
option) and the value created by new research:
Value = Existing products + Existing Patents + Value: Future R&D
= $ 403.56 million + $ 907 million + $ 318.30 million
= $1628.86 million
 Since Biogen had no debt outstanding, this value was divided by the number
of shares outstanding (35.50 million) to arrive at a value per share:
Value per share = $ 1,628.86 million / 35.5 = $ 45.88

Aswath Damodaran 204

 Example 2: Valuing an Oil Reserve

 Consider an offshore oil property with an estimated oil reserve of 50 million

barrels of oil, where the present value of the development cost is $12 per
barrel and the development lag is two years.
 The firm has the rights to exploit this reserve for the next twenty years and the
marginal value per barrel of oil is $12 per barrel currently (Price per barrel -
marginal cost per barrel).
 Once developed, the net production revenue each year will be 5% of the value
of the reserves.
 The riskless rate is 8% and the variance in ln(oil prices) is 0.03.

Aswath Damodaran 205

 Valuing an oil reserve as a real option

 Current Value of the asset = S = Value of the developed reserve discounted

back the length of the development lag at the dividend yield = $12 * 50
/(1.05)2 = $ 544.22
 (If development is started today, the oil will not be available for sale until two
years from now. The estimated opportunity cost of this delay is the lost
production revenue over the delay period. Hence, the discounting of the
reserve back at the dividend yield)
 Exercise Price = Present Value of development cost = $12 * 50 = $600 million
 Time to expiration on the option = 20 years
 Variance in the value of the underlying asset = 0.03
 Riskless rate =8%
 Dividend Yield = Net production revenue / Value of reserve = 5%

Aswath Damodaran 206

 Valuing one oil reserve to valuing an oil company: Valuing
Gulf Oil in 1984

 Gulf Oil was the target of a takeover in early 1984 at $70 per share (It had
165.30 million shares outstanding, and total debt of $9.9 billion).
• It had estimated reserves of 3038 million barrels of oil and the average cost of
developing these reserves was estimated to be $10 a barrel in present value dollars
(The development lag is approximately two years).
• The average relinquishment life of the reserves is 12 years.
• The price of oil was $22.38 per barrel, and the production cost, taxes and royalties
were estimated at $7 per barrel.
• The bond rate at the time of the analysis was 9.00%.
• Gulf was expected to have net production revenues each year of approximately 5%
of the value of the developed reserves. The variance in oil prices is 0.03.

Aswath Damodaran 207

 Valuing Undeveloped Reserves

 Inputs for valuing undeveloped reserves

• Value of underlying asset = Value of estimated reserves discounted back for period
of development lag= 3038 * ($ 22.38 - $7) / 1.052 = $42,380.44
• Exercise price = Estimated development cost of reserves = 3038 * $10 = $30,380
million
• Time to expiration = Average length of relinquishment option = 12 years
• Variance in value of asset = Variance in oil prices = 0.03
• Riskless interest rate = 9%
• Dividend yield = Net production revenue/ Value of developed reserves = 5%
 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
d1 = 1.6548 N(d1) = 0.9510
d2 = 1.0548 N(d2) = 0.8542
 Call Value= 42,380.44 exp(-0.05)(12) (0.9510) -30,380 (exp(-0.09)(12) (0.8542)= $
13,306 million

Aswath Damodaran 208

 Valuing Gulf Oil

 In addition, Gulf Oil had free cashflows to the firm from its oil and gas
production of $915 million from already developed reserves and these
cashflows are likely to continue for ten years (the remaining lifetime of
developed reserves).
 The present value of these developed reserves, discounted at the weighted
average cost of capital of 12.5%, yields:
• Value of already developed reserves = 915 (1 - 1.125-10)/.125 = $5065.83
 Adding the value of the developed and undeveloped reserves
Value of undeveloped reserves = $ 13,306 million
Value of production in place = $ 5,066 million
Total value of firm = $ 18,372 million
Less Outstanding Debt = $ 9,900 million
Value of Equity = $ 8,472 million
Value per share = $ 8,472/165.3 = $51.25

Aswath Damodaran 209

 Example 3: Valuing an Expansion Option

 Ambev is considering introducing a soft drink to the U.S. market. The drink
will initially be introduced only in the metropolitan areas of the U.S. and the
cost of this “limited introduction” is $ 500 million.
 A financial analysis of the cash flows from this investment suggests that the
present value of the cash flows from this investment to Ambev will be only $
400 million. Thus, by itself, the new investment has a negative NPV of $ 100
million.
 If the initial introduction works out well, Ambev could go ahead with a full-
scale introduction to the entire market with an additional investment of $
1 billion any time over the next 5 years. While the current expectation is that
the cash flows from having this investment is only $ 750 million, there is
considerable uncertainty about both the potential for the drink, leading to
significant variance in this estimate.

Aswath Damodaran 210

 Valuing the Expansion Option

 Value of the Underlying Asset (S) = PV of Cash Flows from Expansion to

entire U.S. market, if done now =$ 750 Million
 Strike Price (K) = Cost of Expansion into entire U.S market = $ 1000 Million
 We estimate the standard deviation in the estimate of the project value by
using the annualized standard deviation in firm value of publicly traded firms
in the beverage markets, which is approximately 34.25%.
• Standard Deviation in Underlying Asset’s Value = 34.25%
 Time to expiration = Period for which expansion option applies = 5 years
Call Value= $ 234 Million

Aswath Damodaran 211

 Example 4: Valuing Equity in a Deeply Troubled Firm

 Assume that you have a firm whose assets are currently valued at $100
million and that the standard deviation in this asset value is 40%.
 Further, assume that the face value of debt is $80 million (It is zero coupon
debt with 10 years left to maturity).
 If the ten-year treasury bond rate is 10%,
• how much is the equity worth?
• What should the interest rate on debt be?

Aswath Damodaran 212

 Model Parameters

 Value of the underlying asset = S = Value of the firm = $ 100 million

 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Variance in the value of the underlying asset = σ2 = Variance in firm value =
0.16
 Riskless rate = r = Treasury bond rate corresponding to option life = 10%

Aswath Damodaran 213

 Valuing Equity as a Call Option

 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
• d1 = 1.5994 N(d1) = 0.9451
• d2 = 0.3345 N(d2) = 0.6310
 Value of the call = 100 (0.9451) - 80 exp(-0.10)(10) (0.6310) = $75.94 million
 Value of the outstanding debt = $100 - $75.94 = $24.06 million
 Interest rate on debt = ($ 80 / $24.06)1/10 -1 = 12.77%

Aswath Damodaran 214

 The Effect of Catastrophic Drops in Value

 Assume now that a catastrophe wipes out half the value of this firm (the value
drops to $ 50 million), while the face value of the debt remains at $ 80
million. What will happen to the equity value of this firm?
 It will drop in value to $ 25.94 million [ $ 50 million - market value of debt
from previous page]
 It will be worth nothing since debt outstanding > Firm Value
 It will be worth more than $ 25.94 million

Aswath Damodaran 215

 Valuing Equity in the Troubled Firm

 Value of the underlying asset = S = Value of the firm = $ 50 million

 Exercise price = K = Face Value of outstanding debt = $ 80 million
 Life of the option = t = Life of zero-coupon debt = 10 years
 Variance in the value of the underlying asset = σ2 = Variance in firm value =
0.16
 Riskless rate = r = Treasury bond rate corresponding to option life = 10%

Aswath Damodaran 216

 The Value of Equity as an Option

 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
• d1 = 1.0515 N(d1) = 0.8534
• d2 = -0.2135 N(d2) = 0.4155
 Value of the call = 50 (0.8534) - 80 exp(-0.10)(10) (0.4155) = $30.44 million
 Value of the bond= $50 - $30.44 = $19.56 million
 The equity in this firm drops by, because of the option characteristics of
equity.
 This might explain why stock in firms, which are in Chapter 11 and
essentially bankrupt, still has value.

Aswath Damodaran 217

 Equity value persists ..

Value of Equity as Firm Value Changes

80

70

60

50
Value of Equity

40

30

20

10

0
100 90 80 70 60 50 40 30 20 10
Value of Firm ($ 80 Face Value of Debt)

Aswath Damodaran 218

 Obtaining option pricing inputs - Some real world problems

 The examples that have been used to illustrate the use of option pricing theory
to value equity have made some simplifying assumptions. Among them are
the following:
(1) There were only two claim holders in the firm - debt and equity.
(2) There is only one issue of debt outstanding and it can be retired at face value.
(3) The debt has a zero coupon and no special features (convertibility, put clauses etc.)
(4) The value of the firm and the variance in that value can be estimated.

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 Real World Approaches to Getting inputs

Input Estimation Process

Value of the Firm • Cumulate market values of equity and debt (or)
• Value the assets in place using FCFF and WACC (or)
• Use cumulated market value of assets, if traded.
Variance in Firm Value • If stocks and bonds are traded,
!2firm = we2 !e2 + wd2 !d2 + 2 we wd "ed !e !d
where !e2 = variance in the stock price
we = MV weight of Equity
!d2 = the variance in the bond price w d = MV weight of debt
• If not traded, use variances of similarly rated bonds.
• Use average firm value variance from the industry in which
company operates.
Value of the Debt • If the debt is short term, you can use only the face or book value
of the debt.
• If the debt is long term and coupon bearing, add the cumulated
nominal value of these coupons to the face value of the debt.
Maturity of the Debt • Face value weighted duration of bonds outstanding (or)
• If not available, use weighted maturity

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 Valuing Equity as an option - Eurotunnel in early 1998

 Eurotunnel has been a financial disaster since its opening

• In 1997, Eurotunnel had earnings before interest and taxes of -£56 million and net
income of -£685 million
• At the end of 1997, its book value of equity was -£117 million
 It had £8,865 million in face value of debt outstanding
• The weighted average duration of this debt was 10.93 years
Debt Type Face Value Duration
Short term 935 0.50
10 year 2435 6.7
20 year 3555 12.6
Longer 1940 18.2
Total £8,865 mil 10.93 years

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 The Basic DCF Valuation

 The value of the firm estimated using projected cashflows to the firm,
discounted at the weighted average cost of capital was £2,312 million.
 This was based upon the following assumptions –
• Revenues will grow 5% a year in perpetuity.
• The COGS which is currently 85% of revenues will drop to 65% of revenues in yr
5 and stay at that level.
• Capital spending and depreciation will grow 5% a year in perpetuity.
• There are no working capital requirements.
• The debt ratio, which is currently 95.35%, will drop to 70% after year 5. The cost
of debt is 10% in high growth period and 8% after that.
• The beta for the stock will be 1.10 for the next five years, and drop to 0.8 after the
next 5 years.
• The long term bond rate is 6%.

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 Other Inputs

 The stock has been traded on the London Exchange, and the annualized std
deviation based upon ln (prices) is 41%.
 There are Eurotunnel bonds, that have been traded; the annualized std
deviation in ln(price) for the bonds is 17%.
• The correlation between stock price and bond price changes has been 0.5. The
proportion of debt in the capital structure during the period (1992-1996) was 85%.
• Annualized variance in firm value
= (0.15)2 (0.41)2 + (0.85)2 (0.17)2 + 2 (0.15) (0.85)(0.5)(0.41)(0.17)= 0.0335
 The 15-year bond rate is 6%. (I used a bond with a duration of roughly 11
years to match the life of my option)

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 Valuing Eurotunnel Equity and Debt

 Inputs to Model
• Value of the underlying asset = S = Value of the firm = £2,312 million
• Exercise price = K = Face Value of outstanding debt = £8,865 million
• Life of the option = t = Weighted average duration of debt = 10.93 years
• Variance in the value of the underlying asset = σ2 = Variance in firm value =
0.0335
• Riskless rate = r = Treasury bond rate corresponding to option life = 6%
 Based upon these inputs, the Black-Scholes model provides the following
value for the call:
d1 = -0.8337 N(d1) = 0.2023
d2 = -1.4392 N(d2) = 0.0751
 Value of the call = 2312 (0.2023) - 8,865 exp(-0.06)(10.93) (0.0751) = £122
million
 Appropriate interest rate on debt = (8865/2190)(1/10.93)-1= 13.65%

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 Key Tests for Real Options

 Is there an option embedded in this asset/ decision?

• Can you identify the underlying asset?
• Can you specify the contigency under which you will get payoff?
 Is there exclusivity?
• If yes, there is option value.
• If no, there is none.
• If in between, you have to scale value.
 Can you use an option pricing model to value the real option?
• Is the underlying asset traded?
• Can the option be bought and sold?
• Is the cost of exercising the option known and clear?

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 In Closing…

 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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 Back to Lemmings...

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