Valuation by Damodaran

January 2, 2018
Valuation is a craft
• ‘One hundred thousand lemmings cannot be wrong’

• Right inputs will give you the right output  Science

• You are either a great artist or you are not. Anyone

can draw an apple, but that does not make him Picasso

• Valuation is not science or art or magic. It’s a craft.

Valuation vs Pricing
Good valuation = Story + Numbers
• Numbers give you sense of
• Control
• Precision and
• Objectivity

• Numbers can be manipulated and biased.

• Stories are easily remembered.

• But without being anchored by numbers, they are just fairy tales.
If you value something, you should be willing to
act on it…
• Theories will not get you there, they can just be guidelines. Real world needs
adaptive approach

• Pragmatism, not purity is the endgame. The era of Ready Aim Fire is gone

• Before you can act on your valuations, you need to have faith in
• In your own valuation judgments
• In markets: that prices will move towards your value estimates

• Faith needs to be earned and tested

Valuation Myths
• Myth 1: A valuation is an objective search for “true” value
• Truth: All valuations are biased.
• Truth: The direction and magnitude of bias 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: No precise valuations.
• Truth: The payoff to valuation is greatest when valuation is least precise. (Positive Surprise)

• Myth 3: The more quantitative a model, the better the valuation

• Truth: Greater the inputs, lesser the understanding.
• Truth: Simpler models do much better job.
Approaches to Valuation
• Intrinsic Valuation: PV of Cash flows accounted for growth and risk

• Relative Valuation: Use comparable but be careful

• Contingent Valuation: Option pricing model to measure option characteristics

• 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.
Risk Adjusted Value: Three Basic Propositions

• The IT Proposition: If “it” does not affect the cash flows or alter risk (thus
changing discount rates), “it” cannot affect value.

• The DUH Proposition: For an asset to have value, the expected cash flows have
to be positive some time over the life of the asset.

• The DON’T FREAK OUT Proposition: Assets that generate cash flows early in
their life will be worth more than assets that generate cash flows later; the
latter may however have greater growth and higher cash flows to compensate.
The Drivers of Value…
DCF Inputs- “Garbage in, garbage out”
• Measure earnings right

• Get the big picture (capex and working capex)

• The government bond rate is not always the risk free rate.

• Risk free rates will differ across currencies but valuation will be the same.

• Betas do not come from regressions… and are noise.

Determinants of Betas
Equity Risk Premium
• Past is not always a good indicator of the future

• When using Historical Equity Risk premium please ensure

• Long term
• Consistency
• Compounded Average

• No matter which estimate you use, recognize that it is backward looking, is noisy and
may reflect selection bias.
Dealing with Country Risk
• ERP for country = ERP for Mature Market + Default spread for country

• ERP for country = ERP for Mature Market + Default spread for country *( Std Deviation of
EquityCountry/ Std Deviation of Govt BondCountry)

• Assign country risk based upon your country of incorporation. But, under estimate the costs
of equity of developed market companies with significant emerging market risk exposure and
over estimate the costs of equity of emerging market companies with significant developed
market risk exposure.

• Alternate way is to use Lambda = % of revenues domestically firm/ % of revenues

domestically average firm
Growth has to be earned (not endowed or
estimated): Sustainable Growth
Growth has to be earned (not endowed or
estimated): Sustainable Growth
Terminal value is not an ATM
The loose ends in valuation
• Cash – premium or discount
• ROC > Cost of Capital = premium
• ROC < Cost of Capital = discount

• Valuing cross holdings –

• Value of parent company + Proportion of value of each subsidiary
• Ideal scenario would be valuing each crossholding separately, with respective discount rates
• Two practical solutions –
• Taking the Market Value of the holding is the entity is listed
• When there are many cross holdings, value each of them by using Relative Valuation approach
The loose ends in valuation
• Unutilized assets, if not considered in valuation, can be valued at their market
price and added in the valuation.

• Overfunded pension funds, when pension assets > pension liability, can be
considered in valuation but with two concerns –
• Collective bargaining agreements may prevent claiming excess assets
• Often, withdrawals from pension plans get taxed at much higher rates.

• Do not double count an asset. If you count the income from an asset in your
cash flows, you cannot count the market value of the asset in your value.

• The value of a business can be derived from an uncounted assets (playboy

mansion)
The loose ends in valuation
• A company with complex and opaque corporate structure is likely to get a
discounted value compared to a similar company with simple and transparent
structure. To measure complexity, the number of pages in financial statements
can be considered as proxy.

• Dealing with complexity –

• In DCF –
• Adjust cash flows, discount rates, growth rates or length of growth period for complexity
• Value the firm then discount for complexity
• In relative valuation –
• It’s may be possible to assess the correlation between market value and complexity variable.
The loose ends in valuation
• In a synergy, Value of Synergy = Value of the combined firm, with synergy -
Value of the combined firm*, without synergy
• * Value of the combined firm = the firms involved in the merger are valued
independently, by discounting expected cash flows to each firm at the weighted average cost of
capital for that firm.
• The synergy must create any operating (higher return, more scale, more investments, longer growth
period) or financial (tax benefit, added deb capacity, diversification) value to claim such higher
valuation.
• Brand valuation –
• The value of the brand may be already in the price; giving a premium will result in double counting
• Difference between valuation of a branded and non branded product is the valuation of the brand
• The brand value should reflect in higher cash flow through higher sales growth or margin
The loose ends in valuation
• Consider underfunded pension or health liability, contingent liability claim
(probability adjusted) while doing valuation

• The value of control premium depend on two factors –

• The probability that the control would change
• Value of Gaining Control of the company. Depends on
• New changes in how the business in run (leadership and management)
• Side benefits and perquisites

• Closing thought: Rather than being accurate in valuation, it is more important

to understand the direction.
Dark side: valuing difficult companies
• Valuing young companies. Pitfalls include –
• When the paradigm shift will happen
• New matrices of valuation are introduced
• The story dominates, the numbers lag
• Things to remember –
• Making adjustments in regression beta
• Keeping valuation model simple. Doing valuation with most critical parameters. Projecting
revenue/margin in long term (5 years, 10 years) and then working backwards for the intermittent
period.
• New IPO companies may initially (usually 5 years) outpace industry growth. But they cannot outpace
industry forever
• Additional growth requires additional capital expenditure. Sales growth may result in lower margin
• There are always scenarios where the market price can be justified.
Dark side: valuing difficult companies
• You will be wrong 100% of the time –
• Valuation is a continuous process
• always changing the valuation with new available information rather than justifying current
valuation.
• Upward revision is possible, so is downward revision
• And the market can be ‘more often’ wrong.
Dark side: valuing difficult companies
• Mature companies with transition –
• Mature companies may have stable historical numbers but if change is expected, these numbers
become less reliable.
• Key lessons –
• Cost cutting and increased efficiency are easier said than done
• Increasing growth may not be good always. Not al types of growth measures are equal. Developing
new product/market is better than acquisition in terms creating incremental shareholder value.
Dark side: valuing difficult companies
• Distressed companies –
• Value of Equity = DCF value of equity (1 – Probability of distress) + Distress sale value of equity
(Probability of distress)
• the sales value of distressed company is usually best estimated at a discount to book value. This
discount will be higher if economy is doing badly.

• The “sunny” side of distress: Equity as a call option to liquidate the firm
Dark side: valuing difficult companies
• Valuing cyclical and commodity companies –
• The best (though not easiest) thing to do is to separate your macro views from your micro
views. Use current market based numbers for your valuation, but then provide a separate
assessment of what you think about those market numbers

• Do valuation based on normalized assumptions (margins) derived from a long cycle including both
economic and down trend. But don’t average out things that cannot be averaged out.

• With expected commodity price you may find the company undervalued but it’s not the value of the
company, it’s the value of commodity.

• To incorporate commodity price in valuation – use probabilities tools like Monte Carlo

• Underdeveloped reserve to included in valuation.

The Dark Side of Valuation
• Private business valuation – measuring risk will depend on the investor

• Private owner fully invested in private company can’t diversify firm specific risk

• Market beta calculated from market data needs to be adjusted to get total
beta
• Total Beta = Market Beta/Correlation of the sector with the market
The Dark Side of Valuation
• The reported financials need to be verified
• Different Accounting Standards
• Intermingling of personal and business expenses
• Separating “Salaries” from “Dividends
• The Key Person issue

• Illiquidity is a clear and present danger

• Illiquidity should vary across –

• Companies
• Time
• Buyers
NARRATIVE AND NUMBERS: VALUATION AS A
BRIDGE
• A good valuation forms a bridge between number and story

• Every valuation starts with a narrative

• Keep it simple
• Keep it focused

• Check the narrative against history, economic first principles & common sense
• Possible event – Value as option
• Plausible event – Show as expected growth, adjusting from risk in expected return
• Probable event – Show in base year number and expected cash flow
NARRATIVE AND NUMBERS: VALUATION AS A
BRIDGE
• The impossible
• Bigger than the economy
• Bigger than the total market
• Profit margin > 100%
• Depreciation without capex

• The implausible
• Growth without reinvestment
• Profits without competition
• Returns without risk

• The improbable
• High growth and low risk
• High growth and low reinvestment
• Low risk and high reinvestment
NARRATIVE AND NUMBERS: VALUATION AS A
BRIDGE
• Keep the feedback loop

• Modify narrative as events unfold

• Some events like regulatory change can cause the narrative to break
• Valuation estimates are no longer operative
• Estimate a probability that it will occur and consequences
• Improvement/deterioration of initial business model or industry dynamics can shift the narrative
• Valuation estimates will have to be modified
• Monte Carlo simulation or scenario analysis
• Unexpected entry/exit in an existing market can change the narrative
• Valuation estimate have to be redone
• Real options
USER AND SUBSCRIBER ECONOMICS: VALUE
DYNAMICS
• User and subscriber based valuation is a form of disaggregated valuation

• Benefits of disaggregated valuation are –

• Incorporate key differences
• Connect stories to value
• Connect to better business decisions
USER AND SUBSCRIBER ECONOMICS: VALUE
DYNAMICS
• Value an individual user first and then estimate the cost of acquiring new
users.
• Value of existing user = present value of expected net cash flow over the lifetime of the user
• Value of new user = present value of expected net cash flow over the lifetime of the use – net cost of
acquiring the user

• Value of company = aggregate value of users – other non user specific costs
Valuing Financial Service Companies
• Financial service companies are opaque (no clue about asset quality and
assumption is cash flow will be disburse as dividend)

• For financial service companies, book value matters

• Financial service firms mark to market
• The regulatory capital ratios are based on book equity

• FCFE = Net Income – Reinvestment in regulatory capital (book equity)

• Financial services are most dynamic companies hence valuation should

regularly be updated considering asset quality and regulatory requirement.
Valuation vs Pricing
• Most of the valuation around the world is actually pricing.

• Even most of the valuations claimed to be DCF are actually hidden multiple
valuations

• Determinants of valuation – cash flow, growth and risk

• Determinants of pricing – market momentum and stories about fundamentals

Why use Pricing

• No one is going to listen if you starts telling your assumption in your sell
speech

• Everyone wants to listen that this asset is cheaper than most of the assets
How to Price
• 4 steps of deconstructing
• Define Multiple
• Describe the Multiple
• Analyze the Multiple
• Apply the Multiple

• 2 Definitional Test
• Is the multiple consistently defined

• Is the multiple uniformly estimated

• Analytical test
• What are the fundamentals that determine and drive these multiples
• How do changes in these fundamentals change the multiple
Conventional Usage
Sector Multiple Used Rationale
Cyclical Manufacturing PE, Relative PE Often with normalized earnings
Growth firms PEG Ratio Big differences in growth ratio
Young growth firms w/losses Revenue Multiples What choices do you have?
Infrastrucre EV/EBITDA Early losses, high DA
REIT P/CFE ( CFE = NI+ Dep) Big dep charges in Real Estate
Financial Services Price / Book Equity Market to Market?
Retailing Revenue Multiples Margin equalize or sooner
Closing Thought