Valua%on:  The  Basics  

Aswath  Damodaran  www.damodaran.com  

DCF  Choices:  Equity  Valua%on  versus  Firm  Valua%on  

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments

Equity valuation: Value just the equity claim in the business

Firm Valuation: Value the entire business

More  generally…  The  value  of  any  business  is  a  func%on  of..  

Cashflows from existing assetsCashflows before debt payments, but after taxes and reinvestment to maintain exising assets

Expected Growth during high growth period

Growth from new investmentsGrowth created by making new investments; function of amount and quality of investments

Efficiency GrowthGrowth generated by using existing assets better

Length of the high growth periodSince value creating growth requires excess returns, this is a function of- Magnitude of competitive advantages- Sustainability of competitive advantages

Stable growth firm, with no or very limited excess returns

Cost of capital to apply to discounting cashflowsDetermined by- Operating risk of the company- Default risk of the company- Mix of debt and equity used in financing

Determinants of Firm Value

How well do you manage your existing investments/assets?

Are you investing optimally forfuture growth? Is there scope for more

efficient utilization of exsting assets?

Are you building on your competitive advantages?

Are you using the right amount and kind of debt for your firm?

Es%ma%ng  cash  flows  to  a  business  

Cash flows can be measured to

All claimholders in the firm

EBIT (1- tax rate) - ( Capital Expenditures - Depreciation)- Change in non-cash working capital= Free Cash Flow to Firm (FCFF)

Just Equity Investors

Net Income- (Capital Expenditures - Depreciation)- Change in non-cash Working Capital- (Principal Repaid - New Debt Issues)- Preferred Dividend

Dividends+ Stock Buybacks

And  discount  rates…  

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

Has to be default free, in the same currency as cash flows, and defined in same terms (real or nominal) as thecash flows

Historical Premium1. Mature Equity Market Premium:Average premium earned bystocks over T.Bonds in U.S.2. Country risk premium =Country Default Spread* (σEquity/σCountry bond)

Implied PremiumBased on how equity is priced todayand a simple valuationmodel

or

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

Cost of borrowing should be based upon(1) synthetic or actual bond rating(2) default spreadCost of Borrowing = Riskfree rate + Default spread

Marginal tax rate, reflectingtax benefits of debt

Weights should be market value weightsCost of equitybased upon bottom-upbeta

Cost of Capital: Weighted rate of return demanded by all investors

Cost of Equity: Rate of Return demanded by equity investors

Let’s  do  some  valua%on…  

•  You  have  been  asked  to  value  a  business.  The  business  expects  to  $  120  million  in  aNer-­‐tax  earnings  (and  cash  flow)  next  year  and  to  con%nue  genera%ng  these  earnings  in  perpetuity.  The  firm  is  all  equity  funded  and  the  cost  of  equity  is  10%.    

•  What  is  the  value  of  the  business?  

•  What  is  the  value  of  equity  in  this  business?  

•  If  there  were  100  million  shares  outstanding,  what  is  the  value  of  equity  per  share?  

 •  What  would  happen  to  the  value  of  equity  per  share  if  the  firm  has  

granted  op%ons  to  its  managers  over  %me?  (Assume  that  there  are  20  million  op%ons  outstanding)  

Now,  let’s  try  some  growth  

•  Assume  now  that  you  were  told  that  the  firm  can  grow  earnings  at  2%  a  year  forever.  Es%mate  the  value  of  the  business.  

•  Now  what  if  you  were  told  that  the  firm  can  grow  its  earnings  at  4%  a  year  forever?  

•  What  if  the  growth  rate  were  6%  a  year  forever?  

Where  does  growth  come  from?  

•  To  grow,  a  company  has  to  reinvest.  How  much  it  will  have  to  reinvest  depends  in  large  part  on  how  fast  it  wants  to  grow  and  what  type  of  return  it  expects  to  earn  on  the  reinvestment.    –  Reinvestment  rate  =  Growth  Rate/  Return  on  Capital  

•  Assume  in  the  previous  example  that  you  were  told  that  the  return  on  capital  was  10%.  Es%mate  the  reinvestment  rate  and  the  value  of  the  business  (with  a  2%  growth  rate).  

•  What  about  with  a  4%  growth  rate?  

The  Determinants  of  Growth:  How  investment  decisions  affect  value  

•  Quality  growth  is  rare  requires  that  a  firm  be  able  to  reinvest  a  lot  and  reinvest  well  (earnings  more  than  your  cost  of  capital)  at  the  same  %me.  

•  The  larger  you  get,  the  more  difficult  it  becomes  to  maintain  quality  growth.  

•  You  can  grow  while  destroying  value  at  the  same  %me.  

Expected Growth

Net Income Operating Income

Retention Ratio=1 - Dividends/Net Income

Return on EquityNet Income/Book Value of Equity

XReinvestment Rate = (Net Cap Ex + Chg in WC/EBIT(1-t)

Return on Capital =EBIT(1-t)/Book Value of Capital

X

Rela%ve  Valua%on  

•  What  is  it?:  The  value  of  any  asset  can  be  es%mated  by  looking  at  how  the  market  prices  “similar”  or  ‘comparable”  assets.  

•  Philosophical  Basis:  The  intrinsic  value  of  an  asset  is  impossible  (or  close  to  impossible)  to  es%mate.  The  value  of  an  asset  is  whatever  the  market  is  willing  to  pay  for  it  (based  upon  its  characteris%cs)  

•  Informa%on  Needed:  To  do  a  rela%ve  valua%on,  you  need    –  an  iden%cal  asset,  or  a  group  of  comparable  or  similar  assets  –  a  standardized  measure  of  value  (in  equity,  this  is  obtained  by  dividing  

the  price  by  a  common  variable,  such  as  earnings  or  book  value)  –  and  if  the  assets  are  not  perfectly  comparable,  variables  to  control  for  

the  differences  •  Market  Inefficiency:  Pricing  errors  made  across  similar  or  

comparable  assets  are  easier  to  spot,  easier  to  exploit  and  are  much  more  quickly  corrected.  

Let’s  do  some  rela%ve  valua%on..  

Company Name PEPT Indosat ADR 7.8Telebras ADR 8.9Telecom Corporation of New Zealand ADR 11.2Telecom Argentina Stet - France Telecom SA ADR B 12.5Hellenic Telecommunication Organization SA ADR 12.8Telecomunicaciones de Chile ADR 16.6Swisscom AG ADR 18.3Asia Satellite Telecom Holdings ADR 19.6Portugal Telecom SA ADR 20.8Telefonos de Mexico ADR L 21.1Matav RT ADR 21.5Telstra ADR 21.7Gilat Communications 22.7Deutsche Telekom AG ADR 24.6British Telecommunications PLC ADR 25.7Tele Danmark AS ADR 27Telekomunikasi Indonesia ADR 28.4Cable & Wireless PLC ADR 29.8APT Satellite Holdings ADR 31Telefonica SA ADR 32.5Royal KPN NV ADR 35.7Telecom Italia SPA ADR 42.2Nippon Telegraph & Telephone ADR 44.3France Telecom SA ADR 45.2Korea Telecom ADR 71.3

The  first  missing  component…    

Company Name PE Expected Growth in EPS - Next 5 yearsPT Indosat ADR 7.8 6.00%Telebras ADR 8.9 7.50%Telecom Corporation of New Zealand ADR 11.2 11.00%Telecom Argentina Stet - France Telecom SA ADR B 12.5 8.00%Hellenic Telecommunication Organization SA ADR 12.8 12.00%Telecomunicaciones de Chile ADR 16.6 8.00%Swisscom AG ADR 18.3 11.00%Asia Satellite Telecom Holdings ADR 19.6 16.00%Portugal Telecom SA ADR 20.8 13.00%Telefonos de Mexico ADR L 21.1 14.00%Matav RT ADR 21.5 22.00%Telstra ADR 21.7 12.00%Gilat Communications 22.7 31.00%Deutsche Telekom AG ADR 24.6 11.00%British Telecommunications PLC ADR 25.7 7.00%Tele Danmark AS ADR 27 9.00%Telekomunikasi Indonesia ADR 28.4 32.00%Cable & Wireless PLC ADR 29.8 14.00%APT Satellite Holdings ADR 31 33.00%Telefonica SA ADR 32.5 18.00%Royal KPN NV ADR 35.7 13.00%Telecom Italia SPA ADR 42.2 14.00%Nippon Telegraph & Telephone ADR 44.3 20.00%France Telecom SA ADR 45.2 19.00%Korea Telecom ADR 71.3 44.00%

Closing  Thoughts  on  Valua%on  

•  Valua%on  is  simple.  We  choose  to  make  it  complex.  

•  The  biggest  enemies  of  good  valua%ons  are  biases  and  preconcep%ons  that  you  bring  into  the  valua%ons.    

•  You  cannot  value  equity  precisely.  Be  ready  to  be  wrong  and  do  not  take  it  personally.  

•  Making  a  model  bigger  will  not  necessarily  make  it  beeer.