Picking the Right Projects:

Investment Analysis

Aswath Damodaran 1
 First Principles

 Invest in projects that yield a return greater than the minimum

acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners’ funds (equity) or borrowed money
(debt)
• Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.
 Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
 If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon
the stockholders’ characteristics.

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 What is a investment or a project?

 Any decision that requires the use of resources (financial or otherwise)

is a project.
 Broad strategic decisions
• Entering new areas of business
• Entering new markets
• Acquiring other companies
 Tactical decisions
 Management decisions
• The product mix to carry
• The level of inventory and credit terms
 Decisions on delivering a needed service
• Lease or buy a distribution system
• Creating and delivering a management information system

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 The notion of a benchmark

 Since financial resources are finite, there is a hurdle that projects have
to cross before being deemed acceptable.
 This hurdle will be higher for riskier projects than for safer projects.
 A simple representation of the hurdle rate is as follows:
Hurdle rate = Riskless Rate + Risk Premium
 The two basic questions that every risk and return model in finance
tries to answer are:
• How do you measure risk?
• How do you translate this risk measure into a risk premium?

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 What is Risk?

 Risk, in traditional terms, is viewed as a ‘negative’. Webster’s

dictionary, for instance, defines risk as “exposing to danger or hazard”.
The Chinese symbols for risk, reproduced below, give a much better
description of risk

 The first symbol is the symbol for “danger”, while the second is the
symbol for “opportunity”, making risk a mix of danger and
opportunity.

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 The Capital Asset Pricing Model

 Uses variance as a measure of risk

 Specifies that a portion of variance can be diversified away, and that is
only the non-diversifiable portion that is rewarded.
 Measures the non-diversifiable risk with beta, which is standardized
around one.
 Translates beta into expected return -
Expected Return = Riskfree rate + Beta * Risk Premium
 Works as well as the next best alternative in most cases.

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 The Mean-Variance Framework

 The variance on any investment measures the disparity between actual

and expected returns. Low Variance Investment

High Variance Investment

Expected Return

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 The Importance of Diversification: Risk Types

 The risk (variance) on any individual investment can be broken down

into two sources. Some of the risk is specific to the firm, and is called
firm-specific, whereas the rest of the risk is market wide and affects all
investments.
 The risk faced by a firm can be fall into the following categories –
• (1) Project-specific; an individual project may have higher or lower cash
flows than expected.
• (2) Competitive Risk, which is that the earnings and cash flows on a
project can be affected by the actions of competitors.
• (3) Industry-specific Risk, which covers factors that primarily impact the
earnings and cash flows of a specific industry.
• (4) International Risk, arising from having some cash flows in currencies
other than the one in which the earnings are measured and stock is priced
• (5) Market risk, which reflects the effect on earnings and cash flows of
macro economic factors that essentially affect all companies
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 The Effects of Diversification

 Firm-specific risk can be reduced, if not eliminated, by increasing the

number of investments in your portfolio (i.e., by being diversified).
Market-wide risk cannot. This can be justified on either economic or
statistical grounds.
 On economic grounds, diversifying and holding a larger portfolio
eliminates firm-specific risk for two reasons-
• (a) Each investment is a much smaller percentage of the portfolio, muting
the effect (positive or negative) on the overall portfolio.
• (b) Firm-specific actions can be either positive or negative. In a large
portfolio, it is argued, these effects will average out to zero. (For every
firm, where something bad happens, there will be some other firm, where
something good happens.)

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 The Role of the Marginal Investor

 The marginal investor in a firm is the investor who is most likely to be

the buyer or seller on the next trade.
 Generally speaking, the marginal investor in a stock has to own a lot of
stock and also trade a lot.
 Since trading is required, the largest investor may not be the marginal
investor, especially if he or she is a founder/manager of the firm
(Michael Dell at Dell Computers or Bill Gates at Microsoft)
 In all risk and return models in finance, we assume that the marginal
investor is well diversified.

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 The Market Portfolio

 Assuming diversification costs nothing (in terms of transactions costs),

and that all assets can be traded, the limit of diversification is to hold a
portfolio of every single asset in the economy (in proportion to market
value). This portfolio is called the market portfolio.
 Individual investors will adjust for risk, by adjusting their allocations
to this market portfolio and a riskless asset (such as a T-Bill)
Preferred risk level Allocation decision
No risk 100% in T-Bills
Some risk 50% in T-Bills; 50% in Market Portfolio;
A little more risk 25% in T-Bills; 75% in Market Portfolio
Even more risk 100% in Market Portfolio
A risk hog.. Borrow money; Invest in market portfolio;
 Every investor holds some combination of the risk free asset and the
market portfolio.
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 The Risk of an Individual Asset

 The risk of any asset is the risk that it adds to the market portfolio
 Statistically, this risk can be measured by how much an asset moves
with the market (called the covariance)
 Beta is a standardized measure of this covariance
 Beta is a measure of the non-diversifiable risk for any asset can be
measured by the covariance of its returns with returns on a market
index, which is defined to be the asset's beta.
 The cost of equity will be the required return,
Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)
where,
Rf = Riskfree rate
E(Rm) = Expected Return on the Market Index

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 Limitations of the CAPM

1. The model makes unrealistic assumptions

2. The parameters of the model cannot be estimated precisely
- Definition of a market index
- Firm may have changed during the 'estimation' period'
3. The model does not work well
- If the model is right, there should be
a linear relationship between returns and betas
the only variable that should explain returns is betas
- The reality is that
the relationship between betas and returns is weak
Other variables (size, price/book value) seem to explain differences in returns
better.

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 Alternatives to the CAPM
Step 1: Defining Risk
The risk in an investment can be measured by the variance in actual returns around an
expected return
Riskless Investment Low Risk Investment High Risk Investment

E(R) E(R) E(R)

Step 2: Differentiating between Rewarded and Unrewarded Risk
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will
be rewarded and priced.
Step 3: Measuring Market Risk
The CAPM The APM Multi-Factor Models Proxy Models
If there is If there are no Since market risk affects In an efficient market,
1. no private information arbitrage opportunities most or all investments, differences in returns
2. no transactions cost then the market risk of it must come from across long periods must
the optimal diversified any asset must be macro economic factors. be due to market risk
portfolio includes every captured by betas Market Risk = Risk differences. Looking for
traded asset. Everyone relative to factors that exposures of any variables correlated with
will hold this market portfolio affect all investments. asset to macro returns should then give
Market Risk = Risk Market Risk = Risk economic factors. us proxies for this risk.
added by any investment exposures of any Market Risk =
to the market portfolio: asset to market Captured by the
factors Proxy Variable(s)
Beta of asset relative to Betas of asset relative Betas of assets relative Equation relating
Market portfolio (from to unspecified market to specified macro returns to proxy
a regression) factors (from a factor economic factors (from variables (from a
analysis) a regression) regression)

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 Identifying the Marginal Investor in your firm…

Percent of Stock held by Percent of Stock held by Marginal Investor

Institutions Insiders
High Low Institutional Investora
High High Institutional Investor, with
insider influence
Low High (held by Insider (often undiversified)
founder/manager of firm)
Low High (held by wealthy Wealthy individual
individual investor) investor, fairly diversified
Low Low Small individual investor
with restricted
diversification

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 Looking at Disney’s top stockholders (again)

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 Analyzing Disney’s Stockholders

 Percent of stock held by insiders = 1%

 Percent of stock held by institutions = 62%
Who is the marginal investor in Disney?

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 Application Test: Who is the marginal investor
in your firm?

You can get information on insider and institutional holdings in your firm
from:
[Link]
Enter your company’s symbol and choose profile.
 Looking at the breakdown of stockholders in your firm, consider
whether the marginal investor is
a) An institutional investor
b) An individual investor
c) An insider

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 Inputs required to use the CAPM -

(a) the current risk-free rate

(b) the expected market risk premium (the premium expected for investing
in risky assets over the riskless asset)
(c) the beta of the asset being analyzed.

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 The Riskfree Rate and Time Horizon

 On a riskfree asset, the actual return is equal to the expected return.

Therefore, there is no variance around the expected return.
 For an investment to be riskfree, i.e., to have an actual return be equal
to the expected return, two conditions have to be met –
• There has to be no default risk, which generally implies that the security
has to be issued by the government. Note, however, that not all
governments can be viewed as default free.
• There can be no uncertainty about reinvestment rates, which implies that
it is a zero coupon security with the same maturity as the cash flow being
analyzed.

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 Riskfree Rate in Practice

 The riskfree rate is the rate on a zero coupon government bond

matching the time horizon of the cash flow being analyzed.
 Theoretically, this translates into using different riskfree rates for each
cash flow - the 1 year zero coupon rate for the cash flow in year 1, the
2-year zero coupon rate for the cash flow in year 2 ...
 Practically speaking, if there is substantial uncertainty about expected
cash flows, the present value effect of using time varying riskfree rates
is small enough that it may not be worth it.

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 The Bottom Line on Riskfree Rates

 Using a long term government rate (even on a coupon bond) as the

riskfree rate on all of the cash flows in a long term analysis will yield a
close approximation of the true value.
 For short term analysis, it is entirely appropriate to use a short term
government security rate as the riskfree rate.
 If the analysis is being done in real terms (rather than nominal terms)
use a real riskfree rate, which can be obtained in one of two ways –
• from an inflation-indexed government bond, if one exists
• set equal, approximately, to the long term real growth rate of the economy
in which the valuation is being done.
 Data Source: You can get riskfree rates for the US in a number of
sites. Try [Link]

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 Measurement of the risk premium

 The risk premium is the premium that investors demand for investing
in an average risk investment, relative to the riskfree rate.
 As a general proposition, this premium should be
• greater than zero
• increase with the risk aversion of the investors in that market
• increase with the riskiness of the “average” risk investment

Aswath Damodaran 23
 What is your risk premium?

 Assume that stocks are the only risky assets and that you are offered two investment
options:
• a riskless investment (say a Government Security), on which you can make 5%
• a mutual fund of all stocks, on which the returns are uncertain
How much of an expected return would you demand to shift your money from the riskless
asset to the mutual fund?
a) Less than 5%
b) Between 5 - 7%
c) Between 7 - 9%
d) Between 9 - 11%
e) Between 11- 13%
f) More than 13%
Check your premium against the survey premium on my web site.

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 Risk Aversion and Risk Premiums

 If this were the capital market line, the risk premium would be a
weighted average of the risk premiums demanded by each and every
investor.
 The weights will be determined by the magnitude of wealth that each
investor has. Thus, Warren Bufffet’s risk aversion counts more
towards determining the “equilibrium” premium than yours’ and mine.
 As investors become more risk averse, you would expect the
“equilibrium” premium to increase.

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 Risk Premiums do change..

Go back to the previous example. Assume now that you are making the
same choice but that you are making it in the aftermath of a stock
market crash (it has dropped 25% in the last month). Would you
change your answer?
a) I would demand a larger premium
b) I would demand a smaller premium
c) I would demand the same premium

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 Estimating Risk Premiums in Practice

 Survey investors on their desired risk premiums and use the average
premium from these surveys.
 Assume that the actual premium delivered over long time periods is
equal to the expected premium - i.e., use historical data
 Estimate the implied premium in today’s asset prices.

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 The Survey Approach

 Surveying all investors in a market place is impractical.

 However, you can survey a few investors (especially the larger
investors) and use these results. In practice, this translates into surveys
of money managers’ expectations of expected returns on stocks over
the next year.
 The limitations of this approach are:
• there are no constraints on reasonability (the survey could produce
negative risk premiums or risk premiums of 50%)
• they are extremely volatile
• they tend to be short term; even the longest surveys do not go beyond one
year

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 The Historical Premium Approach

 This is the default approach used by most to arrive at the premium to

use in the model
 In most cases, this approach does the following
• it defines a time period for the estimation (1926-Present, 1962-Present....)
• it calculates average returns on a stock index during the period
• it calculates average returns on a riskless security over the period
• it calculates the difference between the two
• and uses it as a premium looking forward
 The limitations of this approach are:
• it assumes that the risk aversion of investors has not changed in a
systematic way across time. (The risk aversion may change from year to
year, but it reverts back to historical averages)
• it assumes that the riskiness of the “risky” portfolio (stock index) has not
changed in a systematic way across time.

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 Historical Average Premiums for the United
States
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%
What is the right premium?
 Go back as far as you can. Otherwise, the standard error in the estimate will be large. (
Annualized Std deviation in Stock prices
Std Error in estimate = )
Number of years of historical data

 Be consistent in your use of a riskfree rate.

 Use€ arithmetic premiums for one-year estimates of costs of equity and geometric
premiums for estimates of long term costs of equity.
Data Source: Check out the returns by year and estimate your own historical premiums by
going to updated data on my web site.

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 What about historical premiums for other
markets?

 Historical data for markets outside the United States is available for
much shorter time periods. The problem is even greater in emerging
markets.
 The historical premiums that emerge from this data reflects this and
there is much greater error associated with the estimates of the
premiums.

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 One solution: Look at a country’s bond rating
and default spreads as a start

 Ratings agencies such as S&P and Moody’s assign ratings to countries

that reflect their assessment of the default risk of these countries.
These ratings reflect the political and economic stability of these
countries and thus provide a useful measure of country risk. In
September 2003, for instance, Brazil had a country rating of B2.
 If a country issues bonds denominated in a different currency (say
dollars or euros), you can also see how the bond market views the risk
in that country. In September 2003, Brazil had dollar denominated C-
Bonds, trading at an interest rate of 10.17%. The US treasury bond rate
that day was 4.16%, yielding a default spread of 6.01% for Brazil.
 Many analysts add this default spread to the US risk premium to come
up with a risk premium for a country. Using this approach would yield
a risk premium of 10.83% for Brazil, if we use 4.82% as the premium
for the US.

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 Beyond the default spread

 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. If we can compute how much
more risky the equity market is, relative to the bond market, we could
use this information. For example,
• Standard Deviation in Bovespa (Equity) = 33.37%
• Standard Deviation in Brazil C-Bond = 26.15%
• Default spread on C-Bond = 6.01%
• Country Risk Premium for Brazil = 6.01% (33.37%/26.15%) = 7.67%%
 Note that this is on top of the premium you estimate for a mature
market. Thus, if you assume that the risk premium in the US is 4.82%,
the risk premium for Brazil would be 12.49%.

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 Implied Equity Premiums

 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 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)
S&P 500 is at 1111.91

 Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 7.94% - 4.25% =
3.69% 34.26 37.52 41.08 44.98 49.26 49.26(1.0425)
1111.91 = + + + + +
(1+ r) (1+ r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r − .0425)(1+ r) 5

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 Implied Premiums in the US

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  Application Test: A Market Risk Premium

 Based upon our discussion of historical risk premiums so far, the risk
premium looking forward should be:
 About 7.92%, which is what the arithmetic average premium has been
since 1928, for stocks over [Link]
 About 4.82%, which is the geometric average premium since 1928, for
stocks over [Link]
 About 3.7%, which is the implied premium in the stock market today

Aswath Damodaran 36
 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.

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 Estimating Performance

 The intercept of the regression provides a simple measure of

performance during the period of the regression, relative to the capital
asset pricing model.
Rj = Rf + b (Rm - Rf)
= Rf (1-b) + b Rm ........... Capital Asset Pricing Model
Rj = a + b Rm ........... Regression Equation
 If
a > Rf (1-b) .... Stock did better than expected during regression period
a = Rf (1-b) .... Stock did as well as expected during regression period
a < Rf (1-b) .... Stock did worse than expected during regression period
 This is Jensen's alpha.

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 Firm Specific and Market Risk

 The R squared (R2) of the regression provides an estimate of the

proportion of the risk (variance) of a firm that can be attributed to
market risk;
 The balance (1 - R2) can be attributed to firm specific risk.

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 Setting up for the Estimation

 Decide on an estimation period

• Services use periods ranging from 2 to 5 years for the regression
• Longer estimation period provides more data, but firms change.
• Shorter periods can be affected more easily by significant firm-specific
event that occurred during the period (Example: ITT for 1995-1997)
 Decide on a return interval - daily, weekly, monthly
• Shorter intervals yield more observations, but suffer from more noise.
• Noise is created by stocks not trading and biases all betas towards one.
 Estimate returns (including dividends) on stock
• Return = (PriceEnd - PriceBeginning + DividendsPeriod)/ PriceBeginning
• Included dividends only in ex-dividend month
 Choose a market index, and estimate returns (inclusive of dividends)
on the index for each interval for the period.

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 Choosing the Parameters: Disney

 Period used: 5 years

 Return Interval = Monthly
 Market Index: S&P 500 Index.
 For instance, to calculate returns on Disney in April 1992,
• Price for Disney at end of March = $ 37.87
• Price for Disney at end of April = $ 36.42
• Dividends during month = $0.05 (It was an ex-dividend month)
• Return =($36.42 - $ 37.87 + $ 0.05)/$ 37.87=-3.69%
 To estimate returns on the index in the same month
• Index level (including dividends) at end of March = 404.35
• Index level (including dividends) at end of April = 415.53
• Return =(415.53 - 404.35)/ 404.35 = 2.76%

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 Disney’s Historical Beta

Disney versus S&P 500: 1992-1996

8.00%

6.00%

4.00%

2.00%

0.00%
-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00%

-2.00%

-4.00%

-6.00%

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 The Regression Output

 ReturnsDisney = -0.01% + 1.40 ReturnsS & P 500 (R squared=32.41%)

(0.27)
 Intercept = -0.01%
 Slope = 1.40

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 Analyzing Disney’s Performance

 Intercept = -0.01%
• This is an intercept based on monthly returns. Thus, it has to be compared
to a monthly riskfree rate.
• Between 1992 and 1996,
– Monthly Riskfree Rate = 0.4% (Annual [Link] rate divided by 12)
– Riskfree Rate (1-Beta) = 0.4% (1-1.40) = -.16%
 The Comparison is then between
Intercept versus Riskfree Rate (1 - Beta)
-0.01% versus 0.4%(1-1.40)=-0.16%
• Jensen’s Alpha = -0.01% -(-0.16%) = 0.15%
 Disney did 0.15% better than expected, per month, between 1992 and
1996.
• Annualized, Disney’s annual excess return = (1.0015)12-1= 1.81%

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 More on Jensen’s Alpha

If you did this analysis on every stock listed on an exchange, what would
the average Jensen’s alpha be across all stocks?
a) Depend upon whether the market went up or down during the period
b) Should be zero
c) Should be greater than zero, because stocks tend to go up more often than
down

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 Estimating Disney’s Beta

 Slope of the Regression of 1.40 is the beta

 Regression parameters are always estimated with noise. The noise is
captured in the standard error of the beta estimate, which in the case of
Disney is 0.27.
 Assume that I asked you what Disney’s true beta is, after this
regression.
• What is your best point estimate?

• What range would you give me, with 67% confidence?

• What range would you give me, with 95% confidence?

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 The Dirty Secret of “Standard Error”

Distribution of Standard Errors: Beta Estimates for U.S. stocks

1600

1400

1200

1000
Number of Firms

800

600

400

200

0
<.10 .10 - .20 .20 - .30 .30 - .40 .40 -.50 .50 - .75 > .75

Standard Error in Beta Estimate

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 Breaking down Disney’s Risk

 R Squared = 32%
 This implies that
• 32% of the risk at Disney comes from market sources
• 68%, therefore, comes from firm-specific sources
 The firm-specific risk is diversifiable and will not be rewarded

Aswath Damodaran 48
 The Relevance of R Squared

You are a diversified investor trying to decide whether you should invest
in Disney or Amgen. They both have betas of 140, but Disney has an
R Squared of 32% while Amgen’s R squared of only 15%. Which one
would you invest in?
a) Amgen, because it has the lower R squared
b) Disney, because it has the higher R squared
c) You would be indifferent
Would your answer be different if you were an undiversified investor?

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 Beta Estimation in Practice: Bloomberg

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 Estimating Expected Returns: September 30,
1997

 Inputs to the expected return calculation

• Disney’s Beta = 1.40
• Riskfree Rate = 7.00% (Long term Government Bond rate)
• Risk Premium = 5.50% (Approximate historical premium)
 Expected Return = Riskfree Rate + Beta (Risk Premium)
= 7.00% + 1.40 (5.50%) = 14.70%

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 Use to a Potential Investor in Disney

As a potential investor in Disney, what does this expected return of

14.70% tell you?
a) This is the return that I can expect to make in the long term on Disney, if
the stock is correctly priced and the CAPM is the right model for risk,
b) This is the return that I need to make on Disney in the long term to break
even on my investment in the stock
c) Both
Assume now that you are an active investor and that your research
suggests that an investment in Disney will yield 25% a year for the
next 5 years. Based upon the expected return of 14.70%, you would
a) Buy the stock
b) Sell the stock

Aswath Damodaran 52
 How managers use this expected return

 Managers at Disney
• need to make at least 14.70% as a return for their equity investors to break
even.
• this is the hurdle rate for projects, when the investment is analyzed from
an equity standpoint
 In other words, Disney’s cost of equity is 14.70%.
 What is the cost of not delivering this cost of equity?

Aswath Damodaran 53
  Application Test: Analyzing the Risk
Regression

 Using your Bloomberg risk and return print out, answer the following
questions:
• How well or badly did your stock do, relative to the market, during the
period of the regression? (You can assume an annualized riskfree rate of
4.8% during the regression period)
Intercept - 0.4% (1- Beta) = Jensen’s Alpha
• What proportion of the risk in your stock is attributable to the market?
What proportion is firm-specific?
• What is the historical estimate of beta for your stock? What is the range
on this estimate with 67% probability? With 95% probability?
• Based upon this beta, what is your estimate of the required return on this
stock?
Riskless Rate + Beta * Risk Premium

Aswath Damodaran 54
 A Quick Test

You are advising a very risky software firm on the right cost of equity to
use in project analysis. You estimate a beta of 2.0 for the firm and
come up with a cost of equity of 18%. The CFO of the firm is
concerned about the high cost of equity and wants to know whether
there is anything he can do to lower his beta.
How do you bring your beta down?

Should you focus your attention on bringing your beta down?

a) Yes
b) No

Aswath Damodaran 55
 Disney’s Beta Calculation: An Update from
2002

Jensen’s alpha = -0.39% -

0.30 (1 - 0.94) = -0.41%
Annualized = (1-
.0041)^12-1 = -4.79%

Aswath Damodaran 56
 Aracruz’s Beta?

Aswath Damodaran 57
 Telebras: High R Squared?

Aswath Damodaran 58
 A Few Questions

 The R squared for Telebras is very high (70%), at least relative to U.S.
firms. Why is that?
 The beta for Telebras is 1.11.
• Is this an appropriate measure of risk?
• If not, why not?
 The beta for every other stock in the index is also misestimated. Is
there a way to get a better estimate?

Aswath Damodaran 59
 Try different indices?

 The Local Solution: Estimate the beta relative to a local index, that is
equally weighted or more diverse than the one in use.
 The U.S. Solution: If the stock has an ADR listed on the U.S.
exchanges, estimate the beta relative to the S&P 500.
 The Global Solution: Use a global index to estimate the beta
 For Aracruz,
Index Beta Standard Error
Brazil I-Senn 0.69 0.18
S & P 500 (with ADR) 0.46 0.30
Morgan Stanley Capital Index (with ADR) 0.35 0.32
 As your index gets broader, your standard error gets larger.

Aswath Damodaran 60
 Beta: Exploring Fundamentals

Real Networks: 3.24

Qwest Communications: 2.60

Beta > 1

Microsoft: 1..25

General Electric: 1.10

Beta = 1
Enron: 0.95

Philip Morris: 0.65

Beta < 1

Exxon Mobil: 0.40

Beta = 0

Harmony Gold Mining: - 0.10

Aswath Damodaran 61
 Determinant 1: Product Type

 Industry Effects: The beta value for a firm depends upon the
sensitivity of the demand for its products and services and of its costs
to macroeconomic factors that affect the overall market.
• Cyclical companies have higher betas than non-cyclical firms
• Firms which sell more discretionary products will have higher betas than
firms that sell less discretionary products

Aswath Damodaran 62
 A Simple Test

Consider an investment in Tiffany’s. What kind of beta do you think this

investment will have?
a) Much higher than one
b) Close to one
c) Much lower than one

Aswath Damodaran 63
 Determinant 2: Operating Leverage Effects

 Operating leverage refers to the proportion of the total costs of the firm
that are fixed.
 Other things remaining equal, higher operating leverage results in
greater earnings variability which in turn results in higher betas.

Aswath Damodaran 64
 Measures of Operating Leverage

Fixed Costs Measure = Fixed Costs / Variable Costs

 This measures the relationship between fixed and variable costs. The
higher the proportion, the higher the operating leverage.
EBIT Variability Measure = % Change in EBIT / % Change in Revenues
 This measures how quickly the earnings before interest and taxes
changes as revenue changes. The higher this number, the greater the
operating leverage.

Aswath Damodaran 65
 A Look at Disney’s Operating Leverage

Year Net Sales % Change EBIT % Change

in Sales in EBIT
1987 2877 756
1988 3438 19.50% 848 12.17%
1989 4594 33.62% 1177 38.80%
1990 5844 27.21% 1368 16.23%
1991 6182 5.78% 1124 -17.84%
1992 7504 21.38% 1429 27.14%
1993 8529 13.66% 1232 -13.79%
1994 10055 17.89% 1933 56.90%
1995 12112 20.46% 2295 18.73%
1996 18739 54.71% 2540 10.68%
Average 23.80% 16.56%

Aswath Damodaran 66
 Reading Disney’s Operating Leverage

 Operating Leverage = % Change in EBIT/ % Change in Sales

= 16.56% / 23.80 % = 0.70
 This is lower than the operating leverage for other entertainment firms,
which we computed to be 1.15. This would suggest that Disney has
lower fixed costs than its competitors.
 The acquisition of Capital Cities by Disney in 1996 may be skewing
the operating leverage downwards. For instance, looking at the
operating leverage for 1987-1995:
Operating Leverage1987-95 = 17.29%/19.94% = 0.87

Aswath Damodaran 67
 A Test

Assume that you are comparing a European automobile manufacturing

firm with a U.S. automobile firm. European firms are generally much
more constrained in terms of laying off employees, if they get into
financial trouble. What implications does this have for betas, if they
are estimated relative to a common index?
a) European firms will have much higher betas than U.S. firms
b) European firms will have similar betas to U.S. firms
c) European firms will have much lower betas than U.S. firms

Aswath Damodaran 68
 Determinant 3: Financial Leverage

 As firms borrow, they create fixed costs (interest payments) that make
their earnings to equity investors more volatile.
 This increased earnings volatility which increases the equity beta

Aswath Damodaran 69
 Equity Betas and Leverage

 The beta of equity alone can be written as a function of the unlevered

beta and the debt-equity ratio
βL = βu (1+ ((1-t)D/E))
where
βL = Levered or Equity Beta
βu = Unlevered Beta
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity

Aswath Damodaran 70
 Effects of leverage on betas: Disney

 The regression beta for Disney is 1.40. This beta is a levered beta
(because it is based on stock prices, which reflect leverage) and the
leverage implicit in the beta estimate is the average market debt equity
ratio during the period of the regression (1992 to 1996)
 The average debt equity ratio during this period was 14%.
 The unlevered beta for Disney can then be estimated:(using a marginal
tax rate of 36%)
= Current Beta / (1 + (1 - tax rate) (Average Debt/Equity))
= 1.40 / ( 1 + (1 - 0.36) (0.14)) = 1.28

Aswath Damodaran 71
 Disney : Beta and Leverage

Debt to Capital Debt/Equity Ratio Beta Effect of Leverage

0.00% 0.00% 1.28 0.00
10.00% 11.11% 1.38 0.09
20.00% 25.00% 1.49 0.21
30.00% 42.86% 1.64 0.35
40.00% 66.67% 1.83 0.55
50.00% 100.00% 2.11 0.82
60.00% 150.00% 2.52 1.23
70.00% 233.33% 3.20 1.92
80.00% 400.00% 4.57 3.29
90.00% 900.00% 8.69 7.40

Aswath Damodaran 72
 Betas are weighted Averages

 The beta of a portfolio is always the market-value weighted average of

the betas of the individual investments in that portfolio.
 Thus,
• the beta of a mutual fund is the weighted average of the betas of the stocks
and other investment in that portfolio
• the beta of a firm after a merger is the market-value weighted average of
the betas of the companies involved in the merger.

Aswath Damodaran 73
 The Disney/Cap Cities Merger: Pre-Merger

Disney:
 Beta = 1.15
 Debt = $ 3,186 million Equity = $ 31,100 million Firm = $34,286
 D/E = 0.10
ABC:
 Beta = 0.95
 Debt = $ 615 million Equity = $ 18,500 million Firm= $ 19,115
 D/E = 0.03

Aswath Damodaran 74
 Disney Cap Cities Beta Estimation: Step 1

 Calculate the unlevered betas for both firms

• Disney’s unlevered beta = 1.15/(1+0.64*0.10) = 1.08
• Cap Cities unlevered beta = 0.95/(1+0.64*0.03) = 0.93
 Calculate the unlevered beta for the combined firm
• Unlevered Beta for combined firm
= 1.08 (34286/53401) + 0.93 (19115/53401)
= 1.026
[Remember to calculate the weights using the firm values of the two firms]

Aswath Damodaran 75
 Disney Cap Cities Beta Estimation: Step 2

 If Disney had used all equity to buy Cap Cities

• Debt = $ 615 + $ 3,186 = $ 3,801 million
• Equity = $ 18,500 + $ 31,100 = $ 49,600
• D/E Ratio = 3,801/49600 = 7.66%
• New Beta = 1.026 (1 + 0.64 (.0766)) = 1.08
 Since Disney borrowed $ 10 billion to buy Cap Cities/ABC
• Debt = $ 615 + $ 3,186 + $ 10,000 = $ 13,801 million
• Equity = $ 39,600
• D/E Ratio = 13,801/39600 = 34.82%
• New Beta = 1.026 (1 + 0.64 (.3482)) = 1.25

Aswath Damodaran 76
 Firm Betas versus divisional Betas

 Firm Betas as weighted averages: The beta of a firm is the weighted

average of the betas of its individual projects.
 At a broader level of aggregation, the beta of a firm is the weighted
average of the betas of its individual division.

Aswath Damodaran 77
 Bottom-up versus Top-down Beta

 The top-down beta for a firm comes from a regression

 The bottom up beta can be estimated by doing the following:
• Find out the businesses that a firm operates in
• Find the unlevered betas of other firms in these businesses
• Take a weighted (by sales or operating income) average of these
unlevered betas
• Lever up using the firm’s debt/equity ratio
 The bottom up beta will give you a better estimate of the true beta
when
• the standard error of the beta from the regression is high (and) the beta for
a firm is very different from the average for the business
• the firm has reorganized or restructured itself substantially during the
period of the regression
• when a firm is not traded
Aswath Damodaran 78
 Decomposing Disney’s Beta in 1997

Business Unlevered D/E Ratio Levered Riskfree Risk Cost of

Beta Beta Rate Premium Equity
Creative Content 1.25 20.92% 1.42 7.00% 5.50% 14.80%
Retailing 1.50 20.92% 1.70 7.00% 5.50% 16.35%
Broadcasting 0.90 20.92% 1.02 7.00% 5.50% 12.61%
Theme Parks 1.10 20.92% 1.26 7.00% 5.50% 13.91%
Real Estate 0.70 59.27% 0.92 7.00% 5.50% 12.31%
Disney 1.09 21.97% 1.25 7.00% 5.50% 13.85%

Business Estimated Value

Comparable Firms Unlevered Beta
Division Weight
Creative Content $ 22,167 Motion Picture and TV program producers 1.25 35.71%
Retailing $ 2,217 High End Specialty Retailers 1.5 3.57%
Broadcasting $ 18,842 TV Broadcasting companies 0.9 30.36%
Theme Parks $ 16,625 Theme Park and Entertainment Complexes 1.1 26.79%
Real Estate $ 2,217 REITs specializing in hotel and vacation propertiers 0.7 3.57%
Firm $ 62,068 100.00%

Aswath Damodaran 79
 Discussion Issue

 If you were the chief financial officer of Disney, what cost of equity
would you use in capital budgeting in the different divisions?
a) The cost of equity for Disney as a company
b) The cost of equity for each of Disney’s divisions?

Aswath Damodaran 80
 Estimating Aracruz’s Bottom Up Beta

Comparable Firms Beta D/E Ratio Unlevered beta

Latin American Paper & Pulp (5) 0.70 65.00% 0.49
U.S. Paper and Pulp (45) 0.85 35.00% 0.69
Global Paper & Pulp (187) 0.80 50.00% 0.61
 Aracruz has a cash balance which was 20% of the market value in
1997, much higher than the typical cash balance at other paper firms
Unlevered Beta for Aracruz = (0.8) ( 0.61) + 0.2 (0) = 0.488
 Using Aracruz’s gross D/E ratio of 66.67% & a tax rate of 33%:
Levered Beta for Aracruz = 0.49 (1+ (1-.33) (.6667)) = 0.71
 Real Cost of Equity for Aracruz = 5% + 0.71 (7.5%) = 10.33%
Real Riskfree Rate = 5% (Long term Growth rate in Brazilian economy)
Risk Premium = 5.5% (US premium) + 2% (1996 Brazil default spread)

Aswath Damodaran 81
 Estimating Bottom-up Beta: Deutsche Bank

 Deutsche Bank is in two different segments of business - commercial

banking and investment banking.
 To estimate its commercial banking beta, we will use the average beta
of commercial banks in Germany.
 To estimate the investment banking beta, we will use the average bet
of investment banks in the U.S and U.K.
Comparable Firms Average Beta Weight
Commercial Banks in Germany 0.90 90%
U.K. and U.S. investment banks 1.30 10%
 Beta for Deutsche Bank = 0.9 (.90) + 0.1 (1.30)= 0.94
 Cost of Equity for Deutsche Bank (in DM) = 7.5% + 0.94 (5.5%)
= 12.67%

Aswath Damodaran 82
 Estimating Betas for Non-Traded Assets

 The conventional approaches of estimating betas from regressions do

not work for assets that are not traded.
 There are two ways in which betas can be estimated for non-traded
assets
• using comparable firms
• using accounting earnings

Aswath Damodaran 83
 Using comparable firms to estimate betas

Assume that you are trying to estimate the beta for a independent
bookstore in New York City.
Company Name Beta D/E Ratio Market Cap $ (Mil )
Barnes & Noble 1.10 23.31% $ 1,416
Books-A-Million 1.30 44.35% $ 85
Borders Group 1.20 2.15% $ 1,706
Crown Books 0.80 3.03% $ 55
Average 1.10 18.21% $ 816
 Unlevered Beta of comparable firms 1.10/(1 + (1-.36) (.1821)) = 0.99
 If independent bookstore has similar leverage, beta = 1.10
 If independent bookstore decides to use a debt/equity ratio of 25%:
Beta for bookstore = 0.99 (1+(1-..42)(.25)) = 1.13 (Tax rate used=42%)

Aswath Damodaran 84
 Using Accounting Earnings to Estimate Beta

Year S&P 500 Bookscape Year S&P 500 Bookscape

1980 -2.10% 3.55% 1989 2.60% 3.50%
1981 -6.70% 4.05% 1990 -18.00% -10.50%
1982 -45.50% -14.33% 1991 -47.40% -32.00%
1983 37.00% 47.55% 1992 64.50% 55.00%
1984 41.80% 65.00% 1993 20.00% 31.00%
1985 -11.80% 5.05% 1994 25.30% 21.06%
1986 7.00% 8.50% 1995 15.50% 11.55%
1987 41.50% 37.00% 1996 24.00% 19.88%
1988 41.80% 45.17%

Aswath Damodaran 85
 The Accounting Beta for Bookscape

 Regressing the changes in profits at Bookscape against changes in

profits for the S&P 500 yields the following:
Bookscape Earnings Change = 0.09 + 0.80 (S & P 500 Earnings Change)
 Based upon this regression, the beta for Bookscape’s equity is 0.80.
 Using operating earnings for both the firm and the S&P 500 should
yield the equivalent of an unlevered beta.

Aswath Damodaran 86
 Is Beta an Adequate Measure of Risk for a
Private Firm?

 The owners of most private firms are not diversified. Beta measures
the risk added on to a diversified portfolio. Therefore, using beta to
arrive at a cost of equity for a private firm will
a) Under estimate the cost of equity for the private firm
b) Over estimate the cost of equity for the private firm
c) Could under or over estimate the cost of equity for the private firm

Aswath Damodaran 87
 Total Risk versus Market Risk

 Adjust the beta to reflect total risk rather than market risk. This
adjustment is a relatively simple one, since the R squared of the
regression measures the proportion of the risk that is market risk.
Total Beta = Market Beta / Correlation of the sector with the market
 In the Bookscapes example, where the market beta is 1.10 and the
average correlation of the comparable publicly traded firms is 33%,
• Total Beta = 1.10/0.33 = 3.30
• Total Cost of Equity = 7% + 3.30 (5.5%)= 25.05%

Aswath Damodaran 88
  Application Test: Estimating a Bottom-up
Beta

 Based upon the business or businesses that your firm is in right now,
and its current financial leverage, estimate the bottom-up unlevered
beta for your firm.

 Data Source: You can get a listing of unlevered betas by industry on

my web site by going to updated data.

Aswath Damodaran 89
 From Cost of Equity to Cost of Capital

 The cost of capital is a composite cost to the firm of raising financing

to fund its projects.
 In addition to equity, firms can raise capital from debt

Aswath Damodaran 90
 What is debt?

 General Rule: Debt generally has the following characteristics:

• Commitment to make fixed payments in the future
• The fixed payments are tax deductible
• Failure to make the payments can lead to either default or loss of control
of the firm to the party to whom payments are due.
 As a consequence, debt should include
• Any interest-bearing liability, whether short term or long term.
• Any lease obligation, whether operating or capital.

Aswath Damodaran 91
 Estimating the Cost of Debt

 If the firm has bonds outstanding, and the bonds are traded, the yield
to maturity on a long-term, straight (no special features) bond can be
used as the interest rate.
 If the firm is rated, use the rating and a typical default spread on bonds
with that rating to estimate the cost of debt.
 If the firm is not rated,
• and it has recently borrowed long term from a bank, use the interest rate
on the borrowing or
• estimate a synthetic rating for the company, and use the synthetic rating to
arrive at a default spread and a cost of debt
 The cost of debt has to be estimated in the same currency as the cost of
equity and the cash flows in the valuation.

Aswath Damodaran 92
 Estimating Synthetic Ratings

 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 a firm, which has earnings before interest and taxes of $ 3,500
million and interest expenses of $ 700 million
Interest Coverage Ratio = 3,500/700= 5.00
• Based upon the relationship between interest coverage ratios and ratings,
we would estimate a rating of A for the firm.

Aswath Damodaran 93
 Interest Coverage Ratios, Ratings and Default
Spreads

If Interest Coverage Ratio is Estimated Bond Rating Default Spread

> 8.50 AAA 0.75%
6.50 - 8.50 AA 1.00%
5.50 - 6.50 A+ 1.50%
4.25 - 5.50 A 1.80%
3.00 - 4.25 A– 2.00%
2.50 - 3.00 BBB 2.25%
2.00 - 2.50 BB 3.50%
1.75 - 2.00 B+ 4.75%
1.50 - 1.75 B 6.50%
1.25 - 1.50 B– 8.00%
0.80 - 1.25 CCC 10.00%
0.65 - 0.80 CC 11.50%
0.20 - 0.65 C 12.70%
< 0.20 D 14.00%

Aswath Damodaran 94
  Application Test: Estimating a Cost of Debt

 Based upon your firm’s current earnings before interest and taxes, its
interest expenses, estimate
• An interest coverage ratio for your firm
• A synthetic rating for your firm (use the table from previous page)
• A pre-tax cost of debt for your firm
• An after-tax cost of debt for your firm

Aswath Damodaran 95
 Estimating Market Value Weights

 Market Value of Equity should include the following

• Market Value of Shares outstanding
• Market Value of Warrants outstanding
• Market Value of Conversion Option in Convertible Bonds
 Market Value of Debt is more difficult to estimate because few firms
have only publicly traded debt. There are two solutions:
• Assume book value of debt is equal to market value
• Estimate the market value of debt from the book value
• For Disney, with book value of $12.342 million, interest expenses of $479
million, a current cost of borrowing of 7.5% and an weighted average
maturity of 3 years.
 (1− 1 
3
Estimated MV of Disney Debt = 479
 (1.075)  12,342
+ 3 = $11,180
 .075  (1.075)
 

Aswath Damodaran 96
 Converting Operating Leases to Debt

 The “debt value” of operating leases is the present value of the lease
payments, at a rate that reflects their risk.
 In general, this rate will be close to or equal to the rate at which the
company can borrow.

Aswath Damodaran 97
 Operating Leases at The Home Depot

 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)

Aswath Damodaran 98
  Application Test: Estimating Market Value

 Estimate the
• Market value of equity at your firm and Book Value of equity
• Market value of debt and book value of debt (If you cannot find the
average maturity of your debt, use 3 years): Remember to capitalize the
value of operating leases and add them on to both the book value and the
market value of debt.
 Estimate the
• Weights for equity and debt based upon market value
• Weights for equity and debt based upon book value

Aswath Damodaran 99
 Current Cost of Capital: Disney

 Equity
• Cost of Equity = Riskfree rate + Beta * Risk Premium
= 7% + 1.25 (5.5%) = 13.85%
• Market Value of Equity = $50.88 Billion
• Equity/(Debt+Equity ) = 82%
 Debt
• After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t)
= (7% +0.50) (1-.36) = 4.80%
• Market Value of Debt = $ 11.18 Billion
• Debt/(Debt +Equity) = 18%
 Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%

50.88/(50.88
+11.18)

Aswath Damodaran 100

 Disney’s Divisional Costs of Capital

Business E/(D+E) Cost of D/(D+E) After-tax Cost of Capital

Equity Cost of Debt
Creative Content 82.70% 14.80% 17.30% 4.80% 13.07%
Retailing 82.70% 16.35% 17.30% 4.80% 14.36%
Broadcasting 82.70% 12.61% 17.30% 4.80% 11.26%
Theme Parks 82.70% 13.91% 17.30% 4.80% 12.32%
Real Estate 62.79% 12.31% 37.21% 4.80% 9.52%
Disney 81.99% 13.85% 18.01% 4.80% 12.22%

Aswath Damodaran 101

  Application Test: Estimating Cost of Capital

 Using the bottom-up unlevered beta that you computed for your firm,
and the values of debt and equity you have estimated for your firm,
estimate a bottom-up levered beta and cost of equity for your firm.

 Based upon the costs of equity and debt that you have estimated, and
the weights for each, estimate the cost of capital for your firm.

 How different would your cost of capital have been, if you used book
value weights?

Aswath Damodaran 102

 Choosing a Hurdle Rate

 Either the cost of equity or the cost of capital can be used as a hurdle
rate, depending upon whether the returns measured are to equity
investors or to all claimholders on the firm (capital)
 If returns are measured to equity investors, the appropriate hurdle rate
is the cost of equity.
 If returns are measured to capital (or the firm), the appropriate hurdle
rate is the cost of capital.

Aswath Damodaran 103

 Back to First Principles

 Invest in projects that yield a return greater than the minimum

acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners’ funds (equity) or borrowed money
(debt)
• Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.
 Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
 If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon
the stockholders’ characteristics.

Aswath Damodaran 104