Intrinsic Valuation in a Relative Valuation

World….

Aswath Damodaran

Aswath Damodaran 1
 The Essence of relative valuation?

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

by the market for similar or comparable assets.
n 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 2
 Relative valuation is pervasive…

n 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.
n 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 3
 The Reasons for the allure…

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

“ A 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 4
 The Market Imperative….

n Relative valuation is much more likely to reflect market perceptions and

moods than discounted cash flow valuation. This can be an advantage when it
is important that the price reflect these perceptions as is the case when
• the objective is to sell a security at that price today (as in the case of an IPO)
• investing on “momentum” based strategies
n With relative valuation, there will always be a significant proportion of
securities that are under valued and over valued.
n Since portfolio managers are judged based upon how they perform on a
relative basis (to the market and other money managers), relative valuation is
more tailored to their needs
n Relative valuation generally requires less information than discounted cash
flow valuation (especially when multiples are used as screens)

Aswath Damodaran 5
 Relative Valuation in an Intrinsic value world….

n 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.
n In some cases, relative valuation can help find weak spots in discounted cash
flow valuations and fix them.
n 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 6
 The Four Steps to Deconstructing Multiples

n 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
n 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.
n 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.
n Apply the multiple
• Defining the comparable universe and controlling for differences is far more
difficult in practice than it is in theory.

Aswath Damodaran 7
 Definitional Tests

n 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.
n 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 8
 An Example: Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share

n 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.
n Price: is usually the current price
is sometimes the average price for the year
n 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 9
 Enterprise Value /EBITDA Multiple

n The enterprise value to EBITDA multiple is obtained by netting cash out

against debt to arrive at enterprise value and dividing by EBITDA.
Enterprise Value Market Value of Equity + Market Value of Debt - Cash
=
EBITDA Earnings before Interest, Taxes and Depreciation

n Why do we net out cash from firm value?

n What happens if a firm has cross holdings which are categorized as:
• Minority interests?
• Majority active interests?

Aswath Damodaran 10
 Descriptive Tests

n What is the average and standard deviation for this multiple, across the
universe (market)?
n What is the median for this multiple?
• The median for this multiple is often a more reliable comparison point.
n 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.
n Are there cases where the multiple cannot be estimated? Will ignoring these
cases lead to a biased estimate of the multiple?
n How has this multiple changed over time?

Aswath Damodaran 11
 PE Ratio: Descriptive Statistics for US

Current, Trailing and Forward PE_ January 2003

800

700

600

500

400 Current PE
Trailing PE
Forward PE
300

200

100

0
0-4 4-8 8-12 12-16 16-20 20- 25 25-30 35-40 40-50 50-100 >100
PE Range

Aswath Damodaran 12
 PE: Deciphering the Distribution
Current PE Trailing PE Forward PE
Mean 33.36 32.75 24.46
Standard Error 2.02 2.21 1.20
Median 16.68 15.42 15.29
Skewness 23.78 18.98 15.42
Minimum 0.81 0.92 2.72
Maximum 4382.00 4008.00 1364.00
Count 3721 2973 2035
100th largest 135.33 119.41 55.88
100th smallest 2.18 0.03 7.45

Aswath Damodaran 13
 Enterprise Value/EBITDA Distribution

EV to EBIT (and EBITDA) multiples - US Companies in January 2003

1200

1000

800

600
EV/EBITDA
EV/EBIT

400

200

0
0-2 2-4 4-6 6-8 8-10 10-12 12-16 16-20 20-25 25-30 30-50 50-100 >100
Multiple Range

Aswath Damodaran 14
 Analytical Tests

n 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
n 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 15
 Relative Value and Fundamentals: Equity Multiples

DPS1
P0 =
r - gn
n Gordon Growth Model:
n Dividing both sides by the earnings,
P0 Payout Ratio * (1 + g n )
= PE =
EPS0 r-gn

n Dividing both sides by the book value of equity,

P0 ROE * Payout Ratio * (1 + g n )
= PBV =
BV 0 r-g n
n If the return on equity is written in terms of the retention ratio and the
expected growth rate P 0 = PBV = ROE - gn
BV 0 r-gn

n Dividing by the Sales per share,

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

Aswath Damodaran 16
 The Determinants of Multiples…

Value of Stock = DPS 1/(k e - g)

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

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

Equity Multiples

Firm Multiples

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

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

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

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

Aswath Damodaran 17
 Using the Fundamental Model to Estimate PE For a High
Growth Firm

n 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:
Ê (1+ g)n ˆ
EPS0 * Payout Ratio *(1+ g)* Á1 -
Ë (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.
n Dividing both sides by the earnings per share:
Ê (1 + g)n ˆ˜
Payout Ratio * (1 + g) * Á 1 -
P0 Ë (1+ r) n ¯ Payout Ratio n *(1+ g) n * (1 + gn )
= +
EPS0 r -g (r - g n )(1+ r) n

Aswath Damodaran 18
 A Simple Example

n 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
n Riskfree rate = T.Bond Rate = 6%
n Required rate of return = 6% + 1(5.5%)= 11.5%

Ê (1.25) 5 ˆ
0.2 * (1.25) * Á1- 5˜ 5
Ë (1.115) ¯ 0.5 * (1.25) * (1.08)
PE = + = 28.75
(.115 - .25) (.115 - .08) (1.115)5

†
Aswath Damodaran 19
 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 20
 PE Ratios and Length of High Growth: 25% growth for n
years; 8% thereafter

PE Ratios and Length of High Growth Period

60

50

40

g=25%
PE Ratio

g=20%
30
g=15%
g=10%

20

10

0
0 1 2 3 4 5 6 7 8 9 10
Length of High Growth Period

Aswath Damodaran 21
 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 22
 PE and Payout

PE Ratios and Payour Ratios: Growth Scenarios

35

30

25

20 g=25%
g=20%
PE

g=15%
15 g=10%

10

0
0% 20% 40% 60% 80% 100%
Payout Ratio

Aswath Damodaran 23
 Application Tests

n 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.
n 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 24
 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 25
 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 26
 Is Telebras under valued?

n Predicted PE = 13.12 + 121.22 (.075) - 13.85 (1) = 8.35

n At an actual price to earnings ratio of 8.9, Telebras is slightly overvalued.
n Consider Hellenic Telecom:
• Predicted PE as a developed market company = 13.12 + 121.22 (.12)
= 27.66
• Predicted PE as an emerging market company =13.12+121.22(.12) - 13.85
= 13.82
• At its actual PE ratio of 12.8, Hellenic is massively undervalued as a developed
market company but close to fairly valued as an emerging market company.

Aswath Damodaran 27
 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 28
 PBV versus ROE regression

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

Aswath Damodaran 29
 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 30
 Using the entire crosssection: A regression approach

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

cross-section of firms can be used to predict PE ratios.
n 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 31
 PE versus Growth

PE versus Expected Growth Rate- January 2003

All companies in the US
5 00

4 00

3 00
Current PE

2 00

1 00

-100 R sq = 0.0814
-.4 -.2 0 .0 .2 .4 .6 .8 1.0

Expected Growth in E PS: next 5 y ears

Aswath Damodaran 32
 PE Ratio: Standard Regression

Model Su mmar y

Adjusted R
Mode l R R Square Square Std. Er ror of the Estimate
1 .572 a .32 7 .325 2229.487353015641000
a. Pr edictors: (Constant), Value Line Beta, Expected G rowth in EPS:
next 5 years, Payout Ra tio

Coefficientsa ,b

Unstandardized Standar dized 95% Confidence Interval

Coefficie nts Coefficie nts for B Correlations
Lower Uppe r Zero-
Mode l B Std. Er ror Beta t Sig. Bou nd Bound order Partial Par t
1 (Constant) -22.234 3.670 -6.059 .000 -29.436 -15.033
Payout Ratio 45.637 3.194 .376 14.289 .000 39.370 51.90 4 .303 .40 9 .368
Expected G rowth in
EPS: next 5 years 262.095 13. 954 .490 18.782 .000 234.713 289.47 7 .435 .50 8 .484

Va lue Line Be ta .882 2.835 .008 .311 .756 -4.682 6.446 -.018 .01 0 .008
a. Dependent Var iable: Cur rent PE
b. Weighted Least Squares Regre ssion - Weighted by Marke t Cap $ (Mil)

Aswath Damodaran 33
 The value of growth

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

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 34