Valuation

AswathDamodaran
http://www.damodaran.com

Aswath Damodaran

SomeInitialThoughts

"Onehundredthousandlemmingscannotbewrong"
Graffiti

Aswath Damodaran

MisconceptionsaboutValuation

Myth1:Avaluationisanobjectivesearchfortruevalue

Myth2.:Agoodvaluationprovidesapreciseestimateofvalue

Truth1.1:Allvaluationsarebiased.Theonlyquestionsarehowmuchandinwhich
direction.
Truth1.2:Thedirectionandmagnitudeofthebiasinyourvaluationisdirectly
proportionaltowhopaysyouandhowmuchyouarepaid.
Truth2.1:Therearenoprecisevaluations
Truth2.2:Thepayofftovaluationisgreatestwhenvaluationisleastprecise.

Myth3:.Themorequantitativeamodel,thebetterthevaluation

Aswath Damodaran

Truth3.1:Onesunderstandingofavaluationmodelisinverselyproportionalto
thenumberofinputsrequiredforthemodel.
Truth3.2:Simplervaluationmodelsdomuchbetterthancomplexones.

ApproachestoValuation

Discountedcashflowvaluation,relatesthevalueofanassettothepresent
valueofexpectedfuturecashflowsonthatasset.
Relativevaluation,estimatesthevalueofanassetbylookingatthepricingof
'comparable'assetsrelativetoacommonvariablelikeearnings,cashflows,
bookvalueorsales.
Contingentclaimvaluation,usesoptionpricingmodelstomeasurethevalue
ofassetsthatshareoptioncharacteristics.

Aswath Damodaran

DiscountedCashFlowValuation

Whatisit:Indiscountedcashflowvaluation,thevalueofanassetisthe
presentvalueoftheexpectedcashflowsontheasset.
PhilosophicalBasis:Everyassethasanintrinsicvaluethatcanbeestimated,
baseduponitscharacteristicsintermsofcashflows,growthandrisk.
InformationNeeded:Tousediscountedcashflowvaluation,youneed

toestimatethelifeoftheasset
toestimatethecashflowsduringthelifeoftheasset
toestimatethediscountratetoapplytothesecashflowstogetpresentvalue

MarketInefficiency:Marketsareassumedtomakemistakesinpricingassets
acrosstime,andareassumedtocorrectthemselvesovertime,asnew
informationcomesoutaboutassets.

Aswath Damodaran

DiscountedCashflowValuation:BasisforApproach

Valueofasset =

CF1
CF2
CF3
CF4
CFn

.....
(1 + r)1 (1 + r) 2 (1 + r) 3 (1 + r) 4
(1 + r) n

whereCFtistheexpectedcashflowinperiodt,risthediscountrateappropriategiventhe
riskinessofthecashflowandnisthelifeoftheasset.
Proposition1:Foranassettohavevalue,theexpectedcashflowshavetobepositive
sometimeoverthelifeoftheasset.
Proposition2:Assetsthatgeneratecashflowsearlyintheirlifewillbeworthmore
thanassetsthatgeneratecashflowslater;thelattermayhoweverhavegreater
growthandhighercashflowstocompensate.

Aswath Damodaran

DCFChoices:EquityValuationversusFirmValuation
FirmValuation:Valuetheentirebusiness
Assets
ExistingInvestments
Generatecashflowstoday
Includeslonglived(fixed)and
shortlived(working
capital)assets
ExpectedValuethatwillbe
createdbyfutureinvestments

Liabilities

AssetsinPlace

Debt

GrowthAssets

Equity

FixedClaimoncashflows
LittleorNoroleinmanagement
FixedMaturity
TaxDeductible

ResidualClaimoncashflows
SignificantRoleinmanagement
PerpetualLives

Equityvaluation:Valuejustthe
equityclaiminthebusiness

Aswath Damodaran

EquityValuation

Figure5.5:Equity Valuation
Assets
Cashflowsconsideredare
cashflowsfromassets,
afterdebtpaymentsand
aftermakingreinvestments
neededforfuturegrowth

AssetsinPlace

GrowthAssets

Liabilities
Debt

Equity

Discountratereflectsonlythe
costofraisingequityfinancing

Presentvalueisvalueofjusttheequityclaimsonthefirm

Aswath Damodaran

FirmValuation

Figure5.6:FirmValuation
Assets
Cashflowsconsideredare
cashflowsfromassets,
priortoanydebtpayments
butafterfirmhas
reinvestedtocreategrowth
assets

AssetsinPlace

GrowthAssets

Liabilities
Debt

Equity

Discountratereflectsthecost
ofraisingbothdebtandequity
financing,inproportiontotheir
use

Presentvalueisvalueoftheentirefirm,andreflectsthevalueof
allclaimsonthefirm.

Aswath Damodaran

DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF

Value of Operating Assets

+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity

Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)

Beta
- Measures market risk

Type of
Business

Aswath Damodaran

Firm is in stable growth:

Grows at constant rate
forever

Terminal Value= FCFF n+1 /(r-g n)

FCFF1
FCFF2
FCFF3
FCFF4
FCFF5
FCFFn
.........
Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows

Expected Growth
Reinvestment Rate
* Return on Capital

Operating
Leverage

Weights
Based on Market Value

Risk Premium
- Premium for average
risk investment

Financial
Leverage

Base Equity
Premium

Country Risk
Premium

10

Embraer: Status Quo ($)

Avg Reinvestment
rate = 25.08%
Current Cashflow to Firm
EBIT(1-t) :
$ 404
- Nt CpX
23
- Chg WC
9
= FCFF
$ 372
Reinvestment Rate = 32/404= 7.9%

Reinvestment Rate
25.08%

Return on Capital
21.85%

Expected Growth
in EBIT (1-t)
.2185*.2508=.0548
5.48 %

Terminal Value5= 288/(.0876-.0417) = 6272

$ Cashflows
Op. Assets $ 5,272
+ Cash:
795
- Debt
717
- Minor. Int.
12
=Equity
5,349
-Options
28
Value/Share $7.47
R$ 21.75

Year
EBIT(1-t)
- Reinvestment
= FCFF

1
426
107
319

3
474
119
355

4
500
126
374

Term Yr
549
- 261
= 288

5
527
132
395

Discount at$ Cost of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81%

Cost of Equity
10.52 %

Riskfree Rate:
$ Riskfree Rate= 4.17%

Cost of Debt
(4.17%+1%+4%)(1-.34)
= 6.05%

Beta
1.07

Unlevered Beta for

Sectors: 0.95

Aswath Damodaran

2
449
113
336

Stable Growth
g = 4.17%; Beta = 1.00;
Country Premium= 5%
Cost of capital = 8.76%
ROC= 8.76%; Tax rate=34%
Reinvestment Rate=g/ROC
=4.17/8.76= 47.62%

On October 6, 2003
Embraer Price = R$15.51

Weights
E = 84% D = 16%

Mature market
premium
4%
Firms D/E
Ratio: 19%

Lambda
0.27

Country Equity Risk

Premium
7.67%

Country Default
Spread
6.01%

Rel Equity
Mkt Vol
1.28

11

Kristins Kandy: Status Quo

Current Cashflow to Firm
Reinvestment Rate
EBIT(1-t) :
300,000
46.67%
- Nt CpX
100,000
- Chg WC
40,000
= FCFF
160,000
Reinvestment Rate = 46.67%

Return on Capital
13.64%

Expected Growth
in EBIT (1-t)
.4667*.1364= .0636
6.36 %

Stable Growth
g = 4%; Beta =3.00;
ROC= 12.54%
Reinvestment Rate=31.90%

Terminal Value10= 289/(.1254-.04) = 3,403

Firm Value:
2,571
+ Cash
125
- Debt:
900
=Equity
1,796
Liq. Discount 12.5%
Equity value 1572

Year
EBIT (1-t)
- Reinvestment
=FCFF

1
$319
$149
$170

2
$339
$158
$181

3
$361
$168
$193

4
$384
$179
$205

5
$408
$191
$218

Term Yr
425
136
289

Discount atCost of Capital (WACC) = 16.26% (.70) + 3.30% (.30) = 12.37%

Cost of Debt
(4.5%+1.00)(1-.40)
= 3.30%

Cost of Equity
16.26%

Weights
E =70% D = 30%

Synthetic rating = ARiskfree Rate :

Riskfree rate = 4.50%
(10-year T.Bond rate)

Beta Correlation
0.98 0.33

Total Beta
2.94

Unlevered Beta for

Sectors: 0.82

Aswath Damodaran

Risk Premium
4.00%

Firms D/E
Ratio: 1.69%

Mature risk
premium
4%

Country Risk
Premium
0%

12

Discounted Cash Flow Valuation: High Growth with Negative Earnings

Current
Operating
Margin

Current
Revenue
EBIT

Reinvestment
Stable Growth
Sales Turnover
Ratio

Competitive
Advantages

Revenue
Growth

Tax Rate
- NOLs

Expected
Operating
Margin

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

Value of Operating Assets
+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity
- Equity Options
= Value of Equity in Stock

FCFF1

FCFF4

Terminal Value= FCFF n+1/(r-g n)

FCFF5

FCFFn
.........

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)

Beta
- Measures market risk

Type of
Business

Aswath Damodaran

FCFF3

Stable
Stable
Operating Reinvestment
Margin

Forever

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows

FCFF2

Stable
Revenue
Growth

Operating
Leverage

Weights
Based on Market Value

Risk Premium
- Premium for average
risk investment

Financial
Leverage

Base Equity
Premium

Country Risk
Premium

13

Reinvestment:
Current
Revenue
$ 1,117

Current
Margin:
-36.71%
EBIT
-410m

Cap ex includes acquisitions

Working capital is 3% of revenues

Sales Turnover
Ratio: 3.00

Value of Op Assets $ 14,910

+ Cash
$
26
= Value of Firm
$14,936
- Value of Debt
$ 349
= Value of Equity $14,587
- Equity Options
$ 2,892
Value per share
$ 34.32

Revenues
EBIT
EBIT(1t)
Reinvestment
FCFF

CostofEquity
CostofDebt
ATcostofdebt
CostofCapital

$2,793 5,585
$373 $94
$373 $94
$559
$931
$931 $1,024

Riskfree Rate :
T. Bond rate = 6.5%

9,774
$407
$407
$1,396
$989

Terminal Value= 1881/(.0961-.06)

=52,148

14,661 19,059
$1,038 $1,628
$871
$1,058
$1,629 $1,466
$758 $408

Term.Year
$41,346
10.00%
35.00%
$2,688
$807
$1,881

23,862
$2,212
$1,438
$1,601
$163

28,729
$2,768
$1,799
$1,623
$177

33,211
$3,261
$2,119
$1,494
$625

36,798
$3,646
$2,370
$1,196
$1,174

39,006
$3,883
$2,524
$736
$1,788
10

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
6.71%
12.83%

12.90%
8.00%
5.20%
12.81%

12.42%
7.80%
5.07%
12.13%

12.30%
7.75%
5.04%
11.96%

12.10%
7.67%
4.98%
11.69%

11.70%
7.50%
4.88%
11.15%

Cost of Debt
6.5%+1.5%=8.0%
Tax rate = 0% -> 35%

Beta
1.60 -> 1.00

Internet/
Retail

Operating
Leverage

Stable
ROC=20%
Reinvest 30%
of EBIT(1-t)

Expected
Margin:
-> 10.00%

Cost of Equity
12.90%

Aswath Damodaran

Competitive
Advantages

Revenue
Growth:
42%

NOL:
500 m

Stable Growth
Stable
Stable
Operating
Revenue
Margin:
Growth: 6%
10.00%

10.50%
7.00%
4.55%
9.61%

Weights
Debt= 1.2% -> 15%

Amazon.com
January 2000
Stock Price = $ 84

Risk Premium
4%

Current
D/E: 1.21%

Forever

Base Equity
Premium

Country Risk
Premium

14

ChoosingaCurrencyfortheValuation

Anycompanycanbevaluedinanycurrency,aslongasyoumaintaininternal
consistencyby:

Usingthesamecurrencyforcashflows,growthrateanddiscountrateestimates
Beingconsistentininflationassumptionswhenestimatinggrowthrates,discount
ratesandexpectedfutureexchangerates.

Thecurrencyyouchoosetovalueacompanyinisthereforedrivenby
pragmaticconcerns.Inotherwords,inwhichcurrencywilltheestimatesof
thecashflowsanddiscountratesbeeasiesttomake.
ForEmbraer,whichderivesalmostallofitscashflowsfromdollarsources
andhasalmostalldollardenominateddebt,bothcashflowsanddiscountrates
areeasiertoestimateinUSdollars.

Aswath Damodaran

15

I.DiscountRates:CostofEquity

Preferably, a bottom-up beta,

based upon other firms in the
business, and firms own financial
leverage
Cost of Equity =

Riskfree Rate

Has to be in the same

currency as cash flows,
and defined in same terms
(real or nominal) as the
cash flows

Aswath Damodaran

Beta

(Risk Premium)

Historical Premium
1. Mature Equity Market Premium:
Average premium earned by
stocks over T.Bonds in U.S.
2. Country risk premium =
Country Default Spread* ( Equity/Countrybond)

or

Implied Premium
Based on how equity
market is priced today
and a simple valuation
model

16

ASimpleTest

YouarevaluingEmbraerinU.S.dollarsandareattemptingtoestimatearisk
freeratetouseintheanalysis.Theriskfreeratethatyoushoulduseis
TheinterestrateonanominalrealdenominatedBraziliangovernmentbond
TheinterestrateonaninflationindexedBraziliangovernmentbond
TheinterestrateonadollardenominatedBraziliangovernmentbond
(10.18%)
TheinterestrateonaU.S.treasurybond(4.17%)

Aswath Damodaran

17

Everyoneuseshistoricalpremiums,but..

Thehistoricalpremiumisthepremiumthatstockshavehistoricallyearned
overrisklesssecurities.
Practitionersneverseemtoagreeonthepremium;itissensitiveto

Howfarbackyougoinhistory
WhetheryouuseT.billratesorT.Bondrates
Whetheryouusegeometricorarithmeticaverages.

Forinstance,lookingattheUS:
Arithmeticaverage
Stocks Stocks
HistoricalPeriod
T.Bills T.Bonds
19282004
7.92% 6.53%
19642004
5.82% 4.34%
19942004
8.60% 5.82%

Aswath Damodaran

GeometricAverage
Stocks Stocks
T.Bills T.Bonds
6.02% 4.84%
4.59% 3.47%
6.85% 4.51%
18

TwoWaysofEstimatingCountryRiskPremiums

DefaultspreadonCountryBond:Inthisapproach,thecountryriskpremium
isbaseduponthedefaultspreadofthebondissuedbythecountry(butonlyif
itisdenominatedinacurrencywhereadefaultfreeentityexists.

BrazilwasratedB2byMoodysandthedefaultspreadontheBraziliandollar
denominatedC.BondattheendofSeptember2003was6.01%.(10.18%4.17%)

RelativeEquityMarketapproach:Thecountryriskpremiumisbaseduponthe
volatilityofthemarketinquestionrelativetoU.Smarket.
Countryriskpremium=RiskPremiumUS*CountryEquity/USEquity
Usinga4.53%premiumfortheUS,thisapproachwouldyield:
TotalriskpremiumforBrazil=4.53%(33.37%/18.59%)=8.13%
CountryriskpremiumforBrazil=8.13%4.53%=3.60%
(Thestandarddeviationinweeklyreturnsfrom2001to2003fortheBovespawas
33.37%whereasthestandarddeviationintheS&P500was18.59%)

Aswath Damodaran

19

Andathirdapproach

Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsandequity
riskpremiumsarehighlycorrelated,onewouldexpectequityspreadstobe
higherthandebtspreads.
Anotheristomultiplythebonddefaultspreadbytherelativevolatilityof
stockandbondpricesinthatmarket.Inthisapproach:

Countryriskpremium=Defaultspreadoncountrybond*CountryEquity/CountryBond
StandardDeviationinBovespa(Equity)=33.37%
StandardDeviationinBrazilCBond=26.15%
DefaultspreadonCBond=6.01%

Aswath Damodaran

CountryRiskPremiumforBrazil=6.01%(33.37%/26.15%)=7.67%

20

Cancountryriskpremiumschange?UpdatingBrazilin
January2005

Brazilsfinancialstandingandcountryratingimproveddramaticallytowards
theendof2004.ItsratingimprovedtoB1.InJanuary2005,theinterestrate
ontheBrazilianCBonddroppedto7.73%.TheUStreasurybondratethat
daywas4.22%,yieldingadefaultspreadof3.51%forBrazil.

Aswath Damodaran

StandardDeviationinBovespa(Equity)=25.09%
StandardDeviationinBrazilCBond=15.12%
DefaultspreadonCBond=3.51%
CountryRiskPremiumforBrazil=3.51%(25.09%/15.12%)=5.82%

21

FromCountrySpreadstoCorporateRiskpremiums

Approach1:Assumethateverycompanyinthecountryisequallyexposedto
countryrisk.Inthiscase,
E(Return)=RiskfreeRate+CountrySpread+Beta(USpremium)
Implicitly,thisiswhatyouareassumingwhenyouusethelocalGovernmentsdollar
borrowingrateasyourriskfreerate.

Approach2:Assumethatacompanysexposuretocountryriskissimilarto
itsexposuretoothermarketrisk.
E(Return)=RiskfreeRate+Beta(USpremium+CountrySpread)
Approach3:Treatcountryriskasaseparateriskfactorandallowfirmsto
havedifferentexposurestocountryrisk(perhapsbasedupontheproportionof
theirrevenuescomefromnondomesticsales)
E(Return)=RiskfreeRate+(USpremium)+CountrySpread)

Aswath Damodaran

22

EstimatingCompanyExposuretoCountryRisk:
Determinants

Sourceofrevenues:Otherthingsremainingequal,acompanyshouldbemore
exposedtoriskinacountryifitgeneratesmoreofitsrevenuesfromthat
country.ABrazilianfirmthatgeneratesthebulkofitsrevenuesinBrazil
shouldbemoreexposedtocountryriskthanonethatgeneratesasmaller
percentofitsbusinesswithinBrazil.
Manufacturingfacilities:Otherthingsremainingequal,afirmthathasallof
itsproductionfacilitiesinBrazilshouldbemoreexposedtocountryriskthan
onewhichhasproductionfacilitiesspreadovermultiplecountries.The
problemwillbeaccentedforcompaniesthatcannotmovetheirproduction
facilities(miningandpetroleumcompanies,forinstance).
Useofriskmanagementproducts:Companiescanusebothoptions/futures
marketsandinsurancetohedgesomeorasignificantportionofcountryrisk.

Aswath Damodaran

23

EstimatingLambdas:TheRevenueApproach
Theeasiestandmostaccessibledataisonrevenues.Mostcompaniesbreak
theirrevenuesdownbyregion.Onesimplisticsolutionwouldbetodothe
following:
%ofrevenuesdomesticallyfirm/%ofrevenuesdomesticallyavgfirm
Consider,forinstance,EmbraerandEmbratel,bothofwhichareincorporated
andtradedinBrazil.Embraergets3%ofitsrevenuesfromBrazilwhereas
EmbratelgetsalmostallofitsrevenuesinBrazil.TheaverageBrazilian
companygetsabout77%ofitsrevenuesinBrazil:

LambdaEmbraer=3%/77%=.04
LambdaEmbratel=100%/77%=1.30

Therearetwoimplications

Aswath Damodaran

Acompanysriskexposureisdeterminedbywhereitdoesbusinessandnotby
whereitislocated
Firmsmightbeabletoactivelymanagetheircountryriskexposures

24

EstimatingLambdas:EarningsApproach
Figure2:EPSchangesversusCountryRisk:EmbraerandEmbratel
1.5

QuarterlyEPS

0.5

0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 2002 2002 2002 2003 2003 2003
0.5

1.5

2
Quarter

Aswath Damodaran

25

EstimatingLambdas:StockReturnsversusCBondReturns
ReturnEmbraer=0.0195+0.2681ReturnCBond
ReturnEmbratel=0.0308+2.0030ReturnCBond
Embraer versus C Bond: 2000-2003

Embratel versus C Bond: 2000-2003

40

100
80
60

Return on Embrat el

Return on Embraer

20

-20

40
20
0
-20
-40

-40

-60
-60
-30

-80
-20

-10

Return on C-Bond

Aswath Damodaran

10

20

-30

-20

-10

10

20

Return on C-Bond

26

EstimatingaUSDollarCostofEquityforEmbraer
September2003
AssumethatthebetaforEmbraeris1.07,andthattheriskfreerateusedis4.17%.The
historicalriskpremiumfrom19282002fortheUSis4.53%andthecountryrisk
premiumforBrazilis7.67%.
Approach1:Assumethateverycompanyinthecountryisequallyexposedtocountry
risk.Inthiscase,
E(Return)=4.17%+1.07(4.53%)+7.67%=16.69%
Approach2:Assumethatacompanysexposuretocountryriskissimilartoitsexposure
toothermarketrisk.
E(Return)=4.17%+1.07(4.53%+7.67%)=17.22%
Approach3:Treatcountryriskasaseparateriskfactorandallowfirmstohavedifferent
exposurestocountryrisk(perhapsbasedupontheproportionoftheirrevenuescome
fromnondomesticsales)
E(Return)=4.17%+(4.53%)+%)=11.09%

Aswath Damodaran

27

ImpliedEquityPremiums

Wecanusetheinformationinstockpricestobackouthowriskaversethemarketisandhowmuch
After year 5, we will assume that
ofariskpremiumitisdemanding.

In 2004, dividends & stock

buybacks were 2.90% of
the index, generating 35.15
in cashflows

Analysts expect earnings to grow 8.5% a year for the next 5 years .

38.13

41.37

44.89

48.71

earnings on the index will grow at

4.22%, the same rate as the entire
economy

52.85

January 1, 2005
S&P 500 is at 1211.92

Ifyoupaythecurrentleveloftheindex,youcanexpecttomakeareturnof7.87%onstocks(which
isobtainedbysolvingforrinthefollowingequation)
38.13 41.37
44.89
48.71
52.85
52.85(1.0422)

1211.92

(1 r)

(1 r)

(1 r)

(1 r)

(1 r)

(r .0422)(1 r) 5

ImpliedEquityriskpremium=ExpectedreturnonstocksTreasurybondrate=7.87%4.22%=
3.65%

Aswath Damodaran

28

2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967
1966
1965
1964
1963
1962
1961
1960

0.00%

29
Aswath Damodaran

4.00%

3.00%
Implied Premium

ImpliedPremiumsintheUS

Implied Premium for US Equity Market

7.00%

6.00%

5.00%

2.00%

1.00%

Year

MonthlyPremiums:20002002

Aswath Damodaran

30

AnIntermediateSolution

Thehistoricalriskpremiumof4.53%fortheUnitedStatesistoohigha
premiumtouseinvaluation.Itismuchhigherthantheactualimpliedequity
riskpremiuminthemarket
Thecurrentimpliedequityriskpremiumrequiresustoassumethatthemarket
iscorrectlypricedtoday.(IfIwererequiredtobemarketneutral,thisisthe
premiumIwoulduse)
Theaverageimpliedequityriskpremiumbetween19602001intheUnited
Statesisabout4%.Wewillusethisasthepremiumforamatureequity
market.

Aswath Damodaran

31

ImpliedPremiumforBrazil:September2003

LeveloftheIndex=16889
DividendsontheIndex=4.55%of16889
Otherparameters(allinUSdollars)

RiskfreeRate=4.17%
ExpectedGrowth(indollars)
Next5years=15%(UsedexpectedgrowthrateinEarnings)
Afteryear5=5%

Solvingfortheexpectedreturn:

Aswath Damodaran

ExpectedreturnonEquity=12.17%
ImpliedEquitypremium=12.17%4.17%=8.00%
ImpliedEquitypremiumforUSonsameday=3.79%
ImpliedcountrypremiumforBrazil=4.21%

32

ImpliedPremiumforBrazil:June2005

LeveloftheIndex=26196
DividendsontheIndex=6.19%of16889
Otherparameters(allinUSdollars)

RiskfreeRate=4.08%
ExpectedGrowth(indollars)
Next5years=8%(UsedexpectedgrowthrateinEarnings)
Afteryear5=4.08%

Solvingfortheexpectedreturn:

Aswath Damodaran

ExpectedreturnonEquity=11.66%
ImpliedEquitypremium=11.66%4.08%=7.58%
ImpliedEquitypremiumforUSonsameday=3.70%
ImpliedcountrypremiumforBrazil=7.58%3.70%=3.88%

33

EstimatingBeta

Thestandardprocedureforestimatingbetasistoregressstockreturns(Rj)
againstmarketreturns(Rm)
Rj=a+bRm

whereaistheinterceptandbistheslopeoftheregression.

Theslopeoftheregressioncorrespondstothebetaofthestock,andmeasures
theriskinessofthestock.
Thisbetahasthreeproblems:

Aswath Damodaran

Ithashighstandarderror
Itreflectsthefirmsbusinessmixovertheperiodoftheregression,notthecurrent
mix
Itreflectsthefirmsaveragefinancialleverageovertheperiodratherthanthe
currentleverage.

34

BetaEstimation:Amazon

Aswath Damodaran

35

BetaEstimationforEmbraer:TheIndexEffect

Aswath Damodaran

36

DeterminantsofBetas
Beta of Equity (Levered Beta)

Beta of Firm (Unlevered Beta)

Nature of product or
service offered by
company :
Other things remaining equal,
the more discretionary the
product or service, the higher
the beta.

Operating Leverage (Fixed

Costs as percent of total
costs):
Other things remaining equal
the greater the proportion of
the costs that are fixed, the
higher the beta of the
company.

Implications
1. Cyclical companies should
have higher betas than noncyclical companies.
2. Luxury goods firms should
have higher betas than basic
goods.
3. High priced goods/service
firms should have higher betas
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Implications
1. Firms with high infrastructure
needs and rigid cost structures
should have higher betas than
firms with flexible cost structures.
2. Smaller firms should have higher
betas than larger firms.
3. Young firms should have higher
betas than more mature firms.

Aswath Damodaran

Financial Leverage:
Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
equity beta will be

Implciations
Highly levered firms should have highe betas
than firms with less debt.
Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))

37

TheSolution:BottomupBetas

Step 1: Find the business or businesses that your firm operates in.
Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
obtain their regression betas. Compute the simple average across
these regression betas to arrive at an average beta for these publicly
traded firms. Unlever this average beta using the average debt to
equity ratio across the publicly traded firms in the sample.
Unlevered beta for business = Average beta across publicly traded
firms/ (1 + (1- t) (Average D/E ratio across firms))

Step 3: Estimate how much value your firm derives from each of
the different businesses it is in.

Step 4: Compute a weighted average of the unlevered betas of the

different businesses (from step 2) using the weights from step 3.
Bottom-up Unlevered beta for your firm = Weighted average of the
unlevered betas of the individual business
Step 5: Compute a levered beta (equity beta) for your firm, using
the market debt to equity ratio for your firm.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

Aswath Damodaran

If you can, adjust this beta for differences

between your firm and the comparable
firms on operating leverage and product
characteristics.

While revenues or operating income

are often used as weights, it is better
to try to estimate the value of each
business.
If you expect the business mix of your
firm to change over time, you can
change the weights on a year-to-year
basis.
If you expect your debt to equity ratio to
change over time, the levered beta will
change over time.

38

BottomupBetaEstimates
Company

Comparable Companies

Unlevered

Levered Beta

Beta
Embraer

Global aerospace companies

0.95

0.80 (1 + (1-.34) (.1985) = 1.07

Amazon (First 5 years)

Internet Retailers

1.58

1.58 (1- (1-0) (.0121) = 1.60

Amazon (After year 5)

Specialty Retailers

Kristin Kandy

Food Processing companies with market

1.00
0.78

0.78 ( 1+(1-.4) (30/70)) = 0.98

cap < $ 250 million

Aswath Damodaran

39

GrossDebtversusNetDebtApproaches

NetDebtRatioforEmbraer=(DebtCash)/MarketvalueofEquity
=(19532320)/11,042=3.32%
LeveredBetaforEmbraer=0.95(1+(1.34)(.0332))=0.93
ThecostofEquityusingnetdebtleveredbetaforEmbraerwillbemuchlower
thanwiththegrossdebtapproach.ThecostofcapitalforEmbraer,though,
willevenoutsincethedebtratiousedinthecostofcapitalequationwillnow
beanetdebtratioratherthanagrossdebtratio.

Aswath Damodaran

40

TotalRiskversusMarketRisk

Adjustthebetatoreflecttotalriskratherthanmarketrisk.Thisadjustmentis
arelativelysimpleone,sincetheRsquaredoftheregressionmeasuresthe
proportionoftheriskthatismarketrisk.
TotalBeta=MarketBeta/Correlationofthesectorwiththemarket

ToestimatethebetaforKristinKandy,webeginwiththebottomup
unleveredbetaoffoodprocessingcompanies:

Aswath Damodaran

Unleveredbetaforpubliclytradedfoodprocessingcompanies=0.78
Averagecorrelationoffoodprocessingcompanieswithmarket=0.333
UnleveredtotalbetaforKristinKandy=0.78/0.333=2.34
DebttoequityratioforKristinKandy=0.3/0.7(assumedindustryaverage)
TotalBeta=2.34(1(1.40)(30/70))=2.94
TotalCostofEquity=4.50%+2.94(4%)=16.26%

41

FromCostofEquitytoCostofCapital

Cost of borrowing should be based upon

(1) synthetic or actual bond rating
(2) default spread
Cost of Borrowing = Riskfree rate + Default spread
Cost of Capital =

Cost of Equity (Equity/(Debt + Equity))

Cost of equity
based upon bottom-up
beta

Aswath Damodaran

Cost of Borrowing

(1-t)

Marginal tax rate, reflecting

tax benefits of debt

(Debt/(Debt + Equity))

Weights should be market value weights

42

EstimatingSyntheticRatings

Theratingforafirmcanbeestimatedusingthefinancialcharacteristicsofthe
firm.Initssimplestform,theratingcanbeestimatedfromtheinterest
coverageratio
InterestCoverageRatio=EBIT/InterestExpenses
ForEmbraersinterestcoverageratio,weusedtheinterestexpensesandEBIT
from2002.
InterestCoverageRatio=2166/222=9.74
Amazon.comhasnegativeoperatingincome;thisyieldsanegativeinterest
coverageratio,whichshouldsuggestalowrating.Wecomputedanaverage
interestcoverageratioof2.82overthenext5years.

Aswath Damodaran

43

InterestCoverageRatios,RatingsandDefaultSpreads
IfInterestCoverageRatiois EstimatedBondRating DefaultSpread(1/00) DefaultSpread(9/03)
>8.50
(>12.50)
AAA
0.20%
0.75%
6.508.50 (9.512.5)
AA
0.50%
1.00%
5.506.50 (7.59.5)
A+
0.80%
1.50%
4.255.50 (67.5)
A
1.00%
1.80%
3.004.25 (4.56)
A
1.25%
2.00%
2.503.00 (3.54.5)
BBB
1.50%
2.25%
2.002.50 ((33.5)
BB
2.00%
3.50%
1.752.00 (2.53)
B+
2.50%
4.75%
1.501.75 (22.5)
B
3.25%
6.50%
1.251.50 (1.52)
B
4.25%
8.00%
0.801.25 (1.251.5)
CCC
5.00%
10.00%
0.650.80 (0.81.25)
CC
6.00%
11.50%
0.200.65 (0.50.8)
C
7.50%
12.70%
<0.20
(<0.5)
D
10.00%
15.00%
ForEmbraerandKristinKandy,Iusedtheinterestcoverageratiotableforsmaller/riskierfirms(the
numbersinbrackets)whichyieldsalowerratingforthesameinterestcoverageratio.

Aswath Damodaran

44

Estimatingthecostofdebtforafirm
ThesyntheticratingforEmbraerisAA.Usingthe2003defaultspreadof
1.00%,weestimateacostofdebtof9.17%(usingariskfreerateof4.17%and
addingintwothirdsofthecountrydefaultspreadof6.01%):
Costofdebt=Riskfreerate+2/3(Brazilcountrydefaultspread)+Company
defaultspread
=4.17%+4.00%+1.00%=9.17%
ThesyntheticratingforKristinKandyisA.Usingthe2004defaultspreadof
1.00%andariskfreerateof4.50%,weestimateacostofdebtof5.50%.
Costofdebt=Riskfreerate+Defaultspread=4.50%+1.00%=5.50%
ThesyntheticratingforAmazon.comin2000wasBBB.Thedefaultspread
forBBBratedbondwas1.50%in2000andthetreasurybondratewas6.5%.
Costofdebt=RiskfreeRate+Defaultspread=6.50%+1.50%=8.00%

Aswath Damodaran

45

WeightsfortheCostofCapitalComputation

Theweightsusedtocomputethecostofcapitalshouldbethemarketvalue
weightsfordebtandequity.
Thereisanelementofcircularitythatisintroducedintoeveryvaluationby
doingthis,sincethevaluesthatweattachtothefirmandequityattheendof
theanalysisaredifferentfromthevalueswegavethematthebeginning.
Forprivatecompanies,neitherthemarketvalueofequitynorthemarketvalue
ofdebtisobservable.Ratherthanusebookvalueweights,youshouldtry

Aswath Damodaran

Industryaveragedebtratiosforpubliclytradedfirmsinthebusiness
Targetdebtratio(ifmanagementhassuchatarget)
Estimatedvalueofequityanddebtfromvaluation(throughaniterativeprocess)

46

EstimatingCostofCapital:Amazon.com

Equity

Debt

CostofEquity=6.50%+1.60(4.00%)=12.90%
MarketValueofEquity=$84/share*340.79milshs=$28,626mil(98.8%)
Costofdebt=6.50%+1.50%(defaultspread)=8.00%
MarketValueofDebt=$349mil(1.2%)

CostofCapital
CostofCapital=12.9%(.988)+8.00%(10)(.012))=12.84%

Aswath Damodaran

47

EstimatingCostofCapital:Embraer

Equity

CostofEquity=4.17%+1.07(4%)+0.27(7.67%)=10.52%
MarketValueofEquity=11,042millionBR($3,781million)

Debt

Costofdebt=4.17%+4.00%+1.00%=9.17%
MarketValueofDebt=2,093millionBR($717million)

CostofCapital
CostofCapital=10.52%(.84)+9.17%(1.34)(0.16))=9.81%
ThebookvalueofequityatEmbraeris3,350millionBR.
ThebookvalueofdebtatEmbraeris1,953millionBR;Interestexpenseis222mil;Average
maturityofdebt=4years
Estimatedmarketvalueofdebt=222million(PVofannuity,4years,9.17%)+$1,953
million/1.09174=2,093millionBR

Aswath Damodaran

48

Ifyouhadtodoit.ConvertingaDollarCostofCapitaltoa
NominalRealCostofCapital

Approach1:UseaBRriskfreerateinallofthecalculationsabove.For
instance,iftheBRriskfreeratewas12%,thecostofcapitalwouldbe
computedasfollows:

CostofEquity=12%+(4%)+%)=18.35%
CostofDebt=12%+1%=13%
(Thisassumestheriskfreeratehasnocountryriskpremiumembeddedinit.)

Approach2:Usethedifferentialinflationratetoestimatethecostofcapital.
Forinstance,iftheinflationrateinBRis8%andtheinflationrateintheU.S.
is2%
1 Inflation
BR
(1 CostofCapital$ )

Costofcapital=

1 Inflation$

=1.0981(1.08/1.02)1=1627.or16.27%

Aswath Damodaran

49

II.EstimatingCashflowsandGrowth

Aswath Damodaran

50

DefiningCashflow
Cashflowscanbemeasuredto
Allclaimholdersinthefirm
EBIT(1taxrate)
(CapitalExpendituresDepreciation)
Changeinnoncashworkingcapital
=FreeCashFlowtoFirm(FCFF)

Aswath Damodaran

JustEquityInvestors
NetIncome
(CapitalExpendituresDepreciation)
ChangeinnoncashWorkingCapital
(PrincipalRepaidNewDebtIssues)
PreferredDividend

Dividends
+StockBuybacks

51

FromReportedtoActualEarnings

Firms
history

Comparable
Firms

Operating leases
- Convert into debt
- Adjust operating income

R&D Expenses
- Convert into asset
- Adjust operating income

Cleanse operating items of

- Financial Expenses
- Capital Expenses
- Non-recurring expenses

Normalize
Earnings

Measuring Earnings
Update
- Trailing Earnings
- Unofficial numbers

Aswath Damodaran

52

DealingwithOperatingLeaseExpenses

OperatingLeaseExpensesaretreatedasoperatingexpensesincomputing
operatingincome.Inreality,operatingleaseexpensesshouldbetreatedas
financingexpenses,withthefollowingadjustmentstoearningsandcapital:
DebtValueofOperatingLeases=PresentvalueofOperatingLease
Commitmentsatthepretaxcostofdebt
Whenyouconvertoperatingleasesintodebt,youalsocreateanassetto
counteritofexactlythesamevalue.
AdjustedOperatingEarnings
AdjustedOperatingEarnings=OperatingEarnings+OperatingLeaseExpenses
DepreciationonLeasedAsset
Asanapproximation,thisworks:
AdjustedOperatingEarnings=OperatingEarnings+PretaxcostofDebt*PVof
OperatingLeases.

Aswath Damodaran

53

OperatingLeasesatTheGapin2003

TheGaphasconventionaldebtofabout$1.97billiononitsbalancesheetanditspre
taxcostofdebtisabout6%.Itsoperatingleasepaymentsinthe2003were$978million
anditscommitmentsforthefuturearebelow:

Year
1
2
3
4
5
6&7

Commitment(millions)

$899.00

$846.00

$738.00

$598.00

$477.00
$982.50eachyear

DebtValueofleases=

PresentValue(at6%)
$848.11
$752.94
$619.64
$473.67
$356.44
$1,346.04
$4,396.85(Alsovalueofleasedasset)

DebtoutstandingatTheGap=$1,970m+$4,397m=$6,367m
AdjustedOperatingIncome=StatedOI+OLexpthisyearDeprecn
=$1,012m+978m4397m/7=$1,362million(7yearlifeforassets)
ApproximateOI=$1,012m+$4397m(.06)=$1,276m

Aswath Damodaran

54

TheCollateralEffectsofTreatingOperatingLeasesasDebt
Conventional Accounting
Income Statement
EBIT& Leases = 1,990
- Op Leases
= 978
EBIT
= 1,012

Balance Sheet
Off balance sheet (Not shown as debt or as an
asset). Only the conventional debt of $1,970
million shows up on balance sheet
Cost of capital = 8.20%(7350/9320) + 4%
(1970/9320) = 7.31%
Cost of equity for The Gap = 8.20%
After-tax cost of debt = 4%
Market value of equity = 7350
Return on capital = 1012 (1-.35)/(3130+1970)
= 12.90%

Aswath Damodaran

Operating Leases Treated as Debt

Income Statement
EBIT& Leases = 1,990
- Deprecn: OL=
628
EBIT
= 1,362
Interest expense will rise to reflect the conversion
of operating leases as debt. Net income should
not change.
Balance Sheet
Asset
Liability
OL Ass et
4397
OL Debt 4397
Total debt = 4397 + 1970 = $6,367 million
Cost of capital = 8.20%(7350/13717) + 4%
(6367/13717) = 6.25%

Return on capital = 1362 (1-.35)/(3130+6367)

= 9.30%

55

R&DExpenses:OperatingorCapitalExpenses

AccountingstandardsrequireustoconsiderR&Dasanoperatingexpense
eventhoughitisdesignedtogeneratefuturegrowth.Itismorelogicaltotreat
itascapitalexpenditures.
TocapitalizeR&D,

Aswath Damodaran

SpecifyanamortizablelifeforR&D(210years)
CollectpastR&Dexpensesforaslongastheamortizablelife
SumuptheunamortizedR&Dovertheperiod.(Thus,iftheamortizablelifeis5
years,theresearchassetcanbeobtainedbyaddingup1/5thoftheR&Dexpense
fromfiveyearsago,2/5thoftheR&Dexpensefromfouryearsago...:

56

CapitalizingR&DExpenses:Ciscoin1999

R&Dwasassumedtohavea5yearlife.

Year
1999(current)
1998
1997
1996
1995
1994
Total

R&DExpense
1594.00
1026.00
698.00
399.00
211.00
89.00

Unamortizedportion
1.00
1594.00
0.80
820.80
0.60
418.80
0.40
159.60
0.20
42.20
0.00
0.00
$3,035.40

Amortizationthisyear
$205.20
$139.60
$79.80
$42.20
$17.80
$484.60

Valueofresearchasset=
$3,035.4million
Amortizationofresearchassetin1998= $484.6million
IncreaseinOperatingIncome=$1,594million484.6million=1,109.4million

Aswath Damodaran

57

TheEffectofCapitalizingR&D
Conventional Accounting
Income Statement
EBIT& R&D = 5,049
- R&D
= 1,594
EBIT
= 3,455
EBIT (1-t)
= 2,246

Balance Sheet
Off balance sheet asset. Book value of equity at
$11,722 million is understated because biggest
asset is off the books.
Capital Expenditures
Conventional net cap ex of $98 million
Cash Flows
EBIT (1-t)
= 2246
- Net Cap Ex
= 98
FCFF
= 2148
Return on capital = 2246/11722 (no debt)
= 19.16%

Aswath Damodaran

R&D treated as capital expenditure

Income Statement
EBIT& R&D = 5,049
- Amort: R&D = 485
EBIT
= 4,564 (Increase of 1,109)
EBIT (1-t)
= 2,967
Ignored tax benefit = (1594-485)(.35) = 388
Adjusted EBIT (1-t) = 2967 + 388 = 3354
(Increase of $1,109 million)
Net Income will also increase by $1,109 million
Balance Sheet
Asset
Liability
R&D Asset 3035
Book Equity +3035
Total Book Equity = 11722+3035 = 14757
Capital Expenditures
Net Cap ex = 98 + 1594 485 = 1206
Cash Flows
EBIT (1-t)
= 3354
- Net Cap Ex
= 1206
FCFF
= 2148
Return on capital = 3354/14757
= 22.78%

58

Whattaxrate?

Thetaxratethatyoushoulduseincomputingtheaftertaxoperatingincome
shouldbe
Theeffectivetaxrateinthefinancialstatements(taxespaid/Taxableincome)
ThetaxratebasedupontaxespaidandEBIT(taxespaid/EBIT)
Themarginaltaxrateforthecountryinwhichthecompanyoperates
Theweightedaveragemarginaltaxrateacrossthecountriesinwhichthe
companyoperates
Noneoftheabove
Anyoftheabove,aslongasyoucomputeyouraftertaxcostofdebtusingthe
sametaxrate

Aswath Damodaran

59

Capitalexpendituresshouldinclude

Researchanddevelopmentexpenses,oncetheyhavebeenrecategorizedas
capitalexpenses.Theadjustednetcapexwillbe
AdjustedNetCapitalExpenditures=NetCapitalExpenditures+CurrentyearsR&D
expensesAmortizationofResearchAsset

Acquisitionsofotherfirms,sincethesearelikecapitalexpenditures.The
adjustednetcapexwillbe
AdjustedNetCapEx=NetCapitalExpenditures+Acquisitionsofotherfirms
Amortizationofsuchacquisitions
Twocaveats:
1.Mostfirmsdonotdoacquisitionseveryyear.Hence,anormalizedmeasureof
acquisitions(lookingatanaverageovertime)shouldbeused
2.Thebestplacetofindacquisitionsisinthestatementofcashflows,usually
categorizedunderotherinvestmentactivities

Aswath Damodaran

60

NormalizingEarnings:Amazon
Year
Tr12m
1
2
3
4
5
6
7
8
9
10
TY(11)

Aswath Damodaran

Revenues
$1,117
$2,793
$5,585
$9,774
$14,661
$19,059
$23,862
$28,729
$33,211
$36,798
$39,006
$41,346

Operating Margin
-36.71%
-13.35%
-1.68%
4.16%
7.08%
8.54%
9.27%
9.64%
9.82%
9.91%
9.95%
10.00%

EBIT
-$410
-$373
-$94
$407
$1,038
$1,628
$2,212
$2,768
$3,261
$3,646
$3,883
$4,135

Industry Average

61

EstimatingActualFCFF:Embraer
EBIT=2,166millionBR
Taxrate=34%
NetCapitalexpenditures=CapExDepreciation=271.22191.30=79.92
millionBR
ChangeinWorkingCapital=+33millionBR
Averageexchangerateduring2002=3.54BR/US$
BR
USdollars
CurrentEBIT*(1taxrate)=
1,430m
404m
(CapitalSpendingDepreciation) 80m
23m
ChangeinWorkingCapital
33m
9m
CurrentFCFF
1,317m
372m

Aswath Damodaran

62

GrowthinEarnings

Lookatthepast

Lookatwhatothersareestimating

Thehistoricalgrowthinearningspershareisusuallyagoodstartingpointfor
growthestimation
Analystsestimategrowthinearningspershareformanyfirms.Itisusefultoknow
whattheirestimatesare.

Lookatfundamentals

Aswath Damodaran

Ultimately,allgrowthinearningscanbetracedtotwofundamentalshowmuch
thefirmisinvestinginnewprojects,andwhatreturnstheseprojectsaremakingfor
thefirm.

63

FundamentalGrowthwhenReturnsarestable
Expected Growth

Net Income
Retention Ratio=
1 - Dividends/Net
Income

Aswath Damodaran

Return on Equity
Net Income/Book Value of
Equity

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

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

64

MeasuringReturnonCapital(Equity)
Adjust EBIT for
a. Extraordinary or one-time expenses or income
b. Operating leases and R&D
c. Cyclicality in earnings (Normalize)
d. Acquisition Debris (Goodwill amortization etc.)
ROC =

Use a marginal tax rate

to be safe. A high ROC
created by paying low
effective taxes is not
sustainable

EBIT ( 1- tax rate)

Book Value of Equity + Book value of debt - Cash

Adjust book equity for

1. Capitalized R&D
2. Acquisition Debris (Goodwill)

Adjust book value of debt for

a. Capitalized operating leases

Use end of prior year numbers or average over the year

but be consistent in your application

Aswath Damodaran

65

NormalizingReinvestment:Embraer
-5
Revenues
EBIT
Operating Margin
Net Cap ex
Non-cash WC

824
91.86
11.15%

-4
1570
230.51
14.68%

-3
3367
588.63
17.48%

-2
5099
944.64
18.53%

-5.6
26.07

2.59
305.82

68.2
915.03

151.76
-222.74

NetCapexas%ofEBIT(1t)

16.54%

NoncashWCas%of
Revenue

14.24%

Aswath Damodaran

-1

Total

6891
1927
27.96%

17751
3782.64
21.31%

196.02
1502.9

412.97
2527.08

66

ExpectedGrowthEstimate:Embraer

Estimatingnormalizedreinvestmentrate

Estimatingreturnoncapitalin$terms

NormalizedChangeinworkingcapital=(Workingcapitalaspercentofrevenues)
*Changeinrevenuesin2002=.1424(77486891)=122milBR
NormalizedNetCapEx=NetCapexas%ofEBIT(1t)*EBIT(1t)in2001=.
1654*(2166(1.34))=236millionBR
Normalizedreinvestmentrate=(236+122)/(2166(1.34))=25.04%(Thiswillbe
thesame,ifestimatedinU.S.dollars)
Estimateaftertaxoperatingincomeindollars=2166(1.34))/3.54=$404m
Dividebydollarvaluebookvalueofcapitalatstartofperiod=Bookvalueof
equity(1073)+Bookvalueofdebt(776)=$1,849million
Returnoncapital=404/1,849=21.85%

Expectedgrowthrate=.2504*.2185=5.48%

Aswath Damodaran

67

FundamentalGrowthwhenreturnonequity(capital)is
changing

Whenthereturnonequityorcapitalischanging,therewillbeasecond
componenttogrowth,positiveifthereturnisincreasingandnegativeifthe
returnisdecreasing.
IfROCtisthereturnoncapitalinperiodtandROCt+1isthereturnoncapital
inperiodt+1,theexpectedgrowthrateinoperatingincomewillbe:
ExpectedGrowthRate=ROCt+1*Reinvestmentrate

+(ROCt+1ROCt)/ROCt

Aswath Damodaran

68

Anexample:Motorola

Motorolascurrentreturnoncapitalis12.18%anditsreinvestmentrateis52.99%.
WeexpectMotorolasreturnoncapitaltoriseto17.22%overthenext5years(whichis
halfwaytowardstheindustryaverage)
ExpectedGrowthRate
=ROCNewInvestments*ReinvestmentRatecurrent+{[1+(ROCIn5yearsROCCurrent)/ROCCurrent]1/51}
=.1722*.5299+{[1+(.1722.1218)/.1218]1/51}
=.174or17.40%
OnewaytothinkaboutthisistodecomposeMotorolasexpectedgrowthinto
Growthfromnewinvestments:.1722*5299=9.12%
Growthfrommoreefficientlyusingexistinginvestments:17.40%9.12%=8.28%

Aswath Damodaran

69

RevenueGrowthandOperatingMargins

Withnegativeoperatingincomeandanegativereturnoncapital,the
fundamentalgrowthequationisoflittleuseforAmazon.com
ForAmazon,theeffectofreinvestmentshowsupinrevenuegrowthratesand
changesinexpectedoperatingmargins:
ExpectedRevenueGrowthin$=Reinvestment(in$terms)*(Sales/Capital)
Theeffectonexpectedmarginsismoresubtle.Amazonsreinvestments
(especiallyinacquisitions)mayhelpcreatebarrierstoentryandother
competitiveadvantagesthatwillultimatelytranslateintohighoperating
marginsandhighprofits.

Aswath Damodaran

70

GrowthinRevenues,EarningsandReinvestment:Amazon
Year

Revenue
Growth
1 150.00%
2 100.00%
3 75.00%
4 50.00%
5 30.00%
6 25.20%
7 20.40%
8 15.60%
9 10.80%
10 6.00%

Chgin
Revenue
$1,676
$2,793
$4,189
$4,887
$4,398
$4,803
$4,868
$4,482
$3,587
$2,208

Reinvestment ChgRev/ChgReinvestment

ROC

$559
$931
$1,396
$1,629
$1,466
$1,601
$1,623
$1,494
$1,196
$736

76.62%
8.96%
20.59%
25.82%
21.16%
22.23%
22.30%
21.87%
21.19%
20.39%

3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00

Assumethatfirmcanearnhighreturnsbecauseofestablishedeconomiesofscale.

Aswath Damodaran

71

III.TheTailthatwagsthedogTerminal
Value

Aswath Damodaran

72

WaysofEstimatingTerminalValue
Terminal Value

Liquidation
Value

Most useful
when assets
are separable
and
marketable

Aswath Damodaran

Multiple Approach

Easiest approach but

makes the valuation
a relative valuation

Stable Growth
Model

Technically soundest,
but requires that you
make judgments about
when the firm will grow
at a stable rate which it
can sustain forever,
and the excess returns
(if any) that it will earn
during the period.
73

StableGrowthandTerminalValue

Whenafirmscashflowsgrowataconstantrateforever,thepresentvalue
ofthosecashflowscanbewrittenas:
Value=ExpectedCashFlowNextPeriod/(rg)
where,
r=Discountrate(CostofEquityorCostofCapital)
g=Expectedgrowthrate

Thisconstantgrowthrateiscalledastablegrowthrateandcannotbehigher
thanthegrowthrateoftheeconomyinwhichthefirmoperates.
Whilecompaniescanmaintainhighgrowthratesforextendedperiods,they
willallapproachstablegrowthatsomepointintime.

Aswath Damodaran

74

LimitsonStableGrowth

Thestablegrowthratecannotexceedthegrowthrateoftheeconomybutit
canbesetlower.

Ifyouassumethattheeconomyiscomposedofhighgrowthandstablegrowth
firms,thegrowthrateofthelatterwillprobablybelowerthanthegrowthrateof
theeconomy.
Thestablegrowthratecanbenegative.Theterminalvaluewillbelowerandyou
areassumingthatyourfirmwilldisappearovertime.
Ifyouusenominalcashflowsanddiscountrates,thegrowthrateshouldbenominal
inthecurrencyinwhichthevaluationisdenominated.

Onesimpleproxyforthenominalgrowthrateoftheeconomyistheriskfree
rate.

Aswath Damodaran

75

StableGrowthandExcessReturns

Strangethoughthismayseem,theterminalvalueisnotasmuchafunctionof
stablegrowthasitisafunctionofwhatyouassumeaboutexcessreturnsin
stablegrowth.
Inthescenariowhereyouassumethatafirmearnsareturnoncapitalequalto
itscostofcapitalinstablegrowth,theterminalvaluewillnotchangeasthe
growthratechanges.
Ifyouassumethatyourfirmwillearnpositive(negative)excessreturnsin
perpetuity,theterminalvaluewillincrease(decrease)asthestablegrowthrate
increases.

Aswath Damodaran

76

DeterminantsofGrowthPatterns

Sizeofthefirm

Currentgrowthrate

Successusuallymakesafirmlarger.Asfirmsbecomelarger,itbecomesmuch
moredifficultforthemtomaintainhighgrowthrates
Whilepastgrowthisnotalwaysareliableindicatoroffuturegrowth,thereisa
correlationbetweencurrentgrowthandfuturegrowth.Thus,afirmgrowingat30%
currentlyprobablyhashighergrowthandalongerexpectedgrowthperiodthanone
growing10%ayearnow.

Barrierstoentryanddifferentialadvantages

Aswath Damodaran

Ultimately,highgrowthcomesfromhighprojectreturns,which,inturn,comes
frombarrierstoentryanddifferentialadvantages.
Thequestionofhowlonggrowthwilllastandhowhighitwillbecanthereforebe
framedasaquestionaboutwhatthebarrierstoentryare,howlongtheywillstayup
andhowstrongtheywillremain.

77

StableGrowthCharacteristics

Instablegrowth,firmsshouldhavethecharacteristicsofotherstablegrowth
firms.Inparticular,

Theriskofthefirm,asmeasuredbybetaandratings,shouldreflectthatofastable
growthfirm.
Betashouldmovetowardsone
Thecostofdebtshouldreflectthesafetyofstablefirms(BBBorhigher)

Thedebtratioofthefirmmightincreasetoreflectthelargerandmorestable
earningsofthesefirms.
Thedebtratioofthefirmmightmovedtotheoptimaloranindustryaverage
Ifthemanagersofthefirmaredeeplyaversetodebt,thismayneverhappen

Thereinvestmentrateofthefirmshouldreflecttheexpectedgrowthrateandthe
firmsreturnoncapital
ReinvestmentRate=ExpectedGrowthRate/ReturnonCapital

Aswath Damodaran

78

StableGrowthCharacteristics

Instablegrowth,firmsshouldhavethecharacteristicsofotherstablegrowth
firms.Inparticular,

Theriskofthefirm,asmeasuredbybetaandratings,shouldreflectthatofastable
growthfirm.
Betashouldmovetowardsone
Thecostofdebtshouldreflectthesafetyofstablefirms(BBBorhigher)

Thedebtratioofthefirmmightincreasetoreflectthelargerandmorestable
earningsofthesefirms.
Thedebtratioofthefirmmightmovedtotheoptimaloranindustryaverage
Ifthemanagersofthefirmaredeeplyaversetodebt,thismayneverhappen

Thereinvestmentrateofthefirmshouldreflecttheexpectedgrowthrateandthe
firmsreturnoncapital
ReinvestmentRate=ExpectedGrowthRate/ReturnonCapital

Aswath Damodaran

79

EmbraerandAmazon.com:StableGrowthInputs

Embraer

Beta
Lambda
Counryriskpremium
DebtRatio
ReturnonCapital
CostofCapital
ExpectedGrowthRate
ReinvestmentRate

HighGrowth

StableGrowth

1.07
0.27
7.67%
15.93%
21.85%
9.81%
5.48%
25.04%

1.00
0.27
5.00%
15.93%
8.76%
8.76%
4.17%
4.17%/8.76%=47.62%

1.60
1.20%
Negative
NMF
>100%

1.00
15%
20%
6%
6%/20%=30%

Amazon.com

Aswath Damodaran

Beta
DebtRatio
ReturnonCapital
ExpectedGrowthRate
ReinvestmentRate

80

IV.LooseEndsinValuation:Fromfirm
valuetovalueofequitypershare

Aswath Damodaran

81

Butwhatcomesnext?
Value of Operating Assets

Since this is a discounted cashflow valuation, should there be a real option

premium?

+ Cash and Marketable

Securities

Operating versus Non-opeating cash

Should cash be discounted for earning a low return?

+ Value of Cross Holdings

How do you value cross holdings in other companies?

What if the cross holdings are in private businesses?

+ Value of Other Assets

Value of Firm

- Value of Debt

What about other valuable assets?

How do you consider under utlilized assets?
Should you discount this value for opacity or complexity?
How about a premium for synergy?
What about a premium for intangibles (brand name)?
What should be counted in debt?
Should you subtract book or market value of debt?
What about other obligations (pension fund and health care?
What about contingent liabilities?
What about minority interests?

= Value of Equity

Should there be a premium/discount for control?

Should there be a discount for distress

- Value of Equity Options

What equity options should be valued here (vested versus non-vested)?

How do you value equity options?

= Value of Common Stock

Should you divide by primary or diluted shares?

/ Number of shares
= Value per share

Aswath Damodaran

Should there be a discount for illiquidity/ marketability?

Should there be a discount for minority interests?

82

1.TheValueofCash

Thesimplestandmostdirectwayofdealingwithcashandmarketable
securitiesistokeepitoutofthevaluationthecashflowsshouldbebefore
interestincomefromcashandsecurities,andthediscountrateshouldnotbe
contaminatedbytheinclusionofcash.(Usebetasoftheoperatingassetsalone
toestimatethecostofequity).
Oncetheoperatingassetshavebeenvalued,youshouldaddbackthevalueof
cashandmarketablesecurities.
Inmanyequityvaluations,theinterestincomefromcashisincludedinthe
cashflows.Thediscountratehastobeadjustedthenforthepresenceofcash.
(Thebetausedwillbeweighteddownbythecashholdings).Unlesscash
remainsafixedpercentageofoverallvalueovertime,thesevaluationswill
tendtobreakdown.

Aswath Damodaran

83

Shouldyoueverdiscountcashforitslowreturns?

Therearesomeanalystswhoarguethatcompanieswithalotofcashontheir
balancesheetsshouldbepenalizedbyhavingtheexcesscashdiscountedto
reflectthefactthatitearnsalowreturn.

Excesscashisusuallydefinedasholdingcashthatisgreaterthanwhatthefirm
needsforoperations.
Alowreturnisdefinedasareturnlowerthanwhatthefirmearnsonitsnoncash
investments.

Thisisthewrongreasonfordiscountingcash.Ifthecashisinvestedin
risklesssecurities,itshouldearnalowrateofreturn.Aslongasthereturnis
highenough,giventherisklessnatureoftheinvestment,cashdoesnotdestroy
value.
Thereisarightreason,though,thatmayapplytosomecompanies
Managerscandostupidthingswithcash(overpricedacquisitions,pieinthe
skyprojects.)andyouhavetodiscountforthispossibility.

Aswath Damodaran

84

2.DealingwithHoldingsinOtherfirms

Holdingsinotherfirmscanbecategorizedinto

Minoritypassiveholdings,inwhichcaseonlythedividendfromtheholdingsis
showninthebalancesheet
Minorityactiveholdings,inwhichcasetheshareofequityincomeisshowninthe
incomestatements
Majorityactiveholdings,inwhichcasethefinancialstatementsareconsolidated.

Wetendtobesloppyinpracticeindealingwithcrossholdings.Aftervaluing
theoperatingassetsofafirm,usingconsolidatedstatements,itiscommonto
addonthebalancesheetvalueofminorityholdings(whichareinbookvalue
terms)andsubtractouttheminorityinterests(againinbookvalueterms),
representingtheportionoftheconsolidatedcompanythatdoesnotbelongto
theparentcompany.

Aswath Damodaran

85

Twocompromisesolutions

Themarketvaluesolution:Whenthesubsidiariesarepubliclytraded,you
couldusetheirtradedmarketcapitalizationstoestimatethevaluesofthecross
holdings.Youdoriskcarryingintoyourvaluationanymistakesthatthe
marketmaybemakinginvaluation.
Therelativevaluesolution:Whentherearetoomanycrossholdingstovalue
separatelyorwhenthereisinsufficientinformationprovidedoncross
holdings,youcanconvertthebookvaluesofholdingsthatyouhaveonthe
balancesheet(forbothminorityholdingsandminorityinterestsinmajority
holdings)byusingtheaveragepricetobookvalueratioofthesectorinwhich
thesubsidiariesoperate.

Aswath Damodaran

86

EmbraersCashandCrossHoldings
Embraerhasa60%interestinanequipmentcompanyandthefinancialstatementsof
thatcompanyareconsolidatedwiththoseofEmbraer.Theminorityinterests
(representingtheequityinthesubsidiarythatdoesnotbelongtoEmbraer)areshownon
thebalancesheetat23millionBR.
Estimatedmarketvalueofminorityinterests=Bookvalueofminorityinterest*P/BV
ofsectorthatsubsidiarybelongsto=23.12*1.5=34.68millionBR
PresentValueofFCFFinhighgrowthphase=
$1,342.97
PresentValueofTerminalValueofFirm=
$3,928.67
Valueofoperatingassetsofthefirm=
$5,271.64
ValueofCash,MarketableSecurities=
$794.52
ValueofFirm=
$6,066.16
MarketValueofoutstandingdebt=
$716.74
MinorityInterestinconsolidatedholdings=34.68/2.92=
$11.88
MarketValueofEquity=
$5,349.42

Aswath Damodaran

87

3.OtherAssetsthathavenotbeencountedyet..

Unutilizedassets:Ifyouhaveassetsorpropertythatarenotbeingutilized(vacantland,
forexample),youhavenotvaluedityet.Youcanassessamarketvaluefortheseassets
andaddthemontothevalueofthefirm.
Overfundedpensionplans:Ifyouhaveadefinedbenefitplanandyourassetsexceed
yourexpectedliabilities,youcouldconsidertheoverfundingwithtwocaveats:

Collectivebargainingagreementsmaypreventyoufromlayingclaimtotheseexcessassets.
Therearetaxconsequences.Often,withdrawalsfrompensionplansgettaxedatmuchhigher
rates.

Donotdoublecountanasset.Ifyoucounttheincomefromanassetinyourcashflows,
youcannotcountthemarketvalueoftheassetinyourvalue.

Aswath Damodaran

88

4.ADiscountforComplexity:
AnExperiment
CompanyA
OperatingIncome $1billion
Taxrate
40%
ROIC
10%
ExpectedGrowth 5%
Costofcapital
8%
BusinessMix
SingleBusiness
Holdings
Simple
Accounting
Transparent
Whichfirmwouldyouvaluemorehighly?

Aswath Damodaran

CompanyB
$1billion
40%
10%
5%
8%
MultipleBusinesses
Complex
Opaque

89

MeasuringComplexity:VolumeofDatainFinancial
Statements

Company
General Electric
Microsoft
Wal-mart
Exxon Mobil
Pfizer
Citigroup
Intel
AIG
Johnson & Johnson
IBM

Aswath Damodaran

Number of pages in last 10Q

65
63
38
86
171
252
69
164
63
85

Number of pages in last 10K

410
218
244
332
460
1026
215
720
218
353

90

MeasuringComplexity:AComplexityScore
Item
Factors
Operating Income 1. Multiple Businesses
2. One-time income and expenses
3. Income from unspecified sources
4. Items in income statement that are volatile
Tax Rate

1. Income from multiple locales

2. Different tax and reporting books
3. Headquarters in tax havens
4. Volatile effective tax rate

Capital
Expenditures

1. Volatile capital expenditures

2. Frequent and large acquisitions

Working capital

3. Stock payment for acquisitions and investments

1. Unspecified current assets and current liabilities
2. Volatile working capital items

Follow-up Question
Number of businesses (with more than 10% of revenues) =
Percent of operating income =

Answer
2
20%

Complexity score
4
1

Percent of operating income =

15%

0.75

Percent of operating income =

Percent of revenues from non-domestic locales =
Yes or No
Yes or No

5%
100%
Yes
Yes

0.25
3
3
3

Yes or No
Yes or No
Yes or No
Yes or No

Yes
Yes
Yes
Yes

2
2
4
4

Yes or No
Yes or No

Yes
Yes

3
2

Yes
Yes
Yes

3
3
5
5
2
1.5
0

Expected Growth 1. Off-balance sheet assets and liabilities (operating

rate
leases and R&D)
Yes or No
2. Substantial stock buybacks
Yes or No
3. Changing return on capital over time
Is your return on capital volatile?
4. Unsustainably high return
Is your firm's ROC much higher than industry average?
Cost of capital
1. Multiple businesses
Number of businesses (more than 10% of revenues) =
2. Operations in emerging markets
3. Is the debt market traded?

Percent of revenues=
Yes or No

Yes
2
30%
Yes

4. Does the company have a rating?

5. Does the company have off-balance sheet debt?

Yes or No

Yes

Yes or No

No

Complexity Score =

Aswath Damodaran

51.5

91

DealingwithComplexity
InDiscountedCashflowValuation
TheAggressiveAnalyst:Trustthefirmtotellthetruthandvaluethefirmbasedupon
thefirmsstatementsabouttheirvalue.
TheConservativeAnalyst:Dontvaluewhatyoucannotsee.
TheCompromise:Adjustthevalueforcomplexity

Adjustcashflowsforcomplexity
Adjustthediscountrateforcomplexity
Adjusttheexpectedgrowthrate/lengthofgrowthperiod
Valuethefirmandthendiscountvalueforcomplexity

Inrelativevaluation
Inarelativevaluation,youmaybeabletoassessthepricethatthemarketischargingforcomplexity:
Withthehundredlargestmarketcapfirms,forinstance:
PBV=0.65+15.31ROE0.55Beta+3.04Expectedgrowthrate0.003#Pagesin10K

Aswath Damodaran

92

4.TheValueofSynergy

Synergycanbevalued.Infact,ifyouwanttopayforit,itshouldbevalued.
Tovaluesynergy,youneedtoanswertwoquestions:
(a)Whatformisthesynergyexpectedtotake?Willitreducecostsasapercentageof
salesandincreaseprofitmargins(asisthecasewhenthereareeconomiesofscale)?
Will it increase future growth (as is the case when there is increased market
power)?)
(b) When can the synergy be reasonably expected to start affecting cashflows?
(Willthegainsfromsynergyshowupinstantaneouslyafterthetakeover?Ifitwill
taketime,whencanthegainsbeexpectedtostartshowingup?)

If you cannot answer these questions, you need to go back to the drawing
board

Aswath Damodaran

93

SourcesofSynergy

Synergy is created when two firms are combined and can be

either financial or operating

Operating Synergy accrues to the combined firm as

Strategic Advantages

Higher returns on
new investments

More new
Investments

Higher ROC

Higher Reinvestment

Higher Growth
Rate

Higher Growth Rate

Aswath Damodaran

Economies of Scale

More sustainable
excess returns

Cost Savings in
current operations

Longer Growth
Period

Higher Margin

Financial Synergy

Tax Benefits

Added Debt
Capacity

Lower taxes on
earnings due to
- higher
depreciaiton
- operating loss
carryforwards

Higher debt
May reduce
raito and lower cost of equity
cost of capital for private or
closely held
firm

Diversification?

Higher Baseyear EBIT

94

ValuingSynergy
(1) 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
thatfirm.
(2)thevalueofthecombinedfirm,withnosynergy,isobtainedbyaddingthe
valuesobtainedforeachfirminthefirststep.
(3)Theeffectsofsynergyarebuiltintoexpectedgrowthratesandcashflows,
andthecombinedfirmisrevaluedwithsynergy.
ValueofSynergy=Valueofthecombinedfirm,withsynergyValueofthe
combinedfirm,withoutsynergy

Aswath Damodaran

95

ValuingSynergy:P&G+Gillette
Free Cashflow to Equity
Growth rate for first 5 years
Growth rate after five years
Beta
Cost of Equity
Value of Equity

Aswath Damodaran

P&G
Gillette
Piglet: No Synergy Piglet: Synergy
$5,864.74 $1,547.50
$7,412.24 $7,569.73 Annual operating expenses reduced by $250 million
12%
10%
11.58% 12.50% Slighly higher growth rate
4%
4%
4.00% 4.00%
0.90
0.80
0.88
0.88
7.90%
7.50%
7.81% 7.81%
Value of synergy
$221,292
$59,878
$281,170
$298,355
$17,185

96

5.Brandname,greatmanagement,superbproduct

Thereisoftenatemptationtoaddonpremiumsforintangibles.Amongthem
are

Brandname
Greatmanagement
Loyalworkforce
Technologicalprowess

Ifyourdiscountedcashflowvaluationisdoneright,yourinputsshould
alreadyreflectthesestrengths.
Ifyouaddapremium,youwillbedoublecountingthestrength.

Aswath Damodaran

97

ValuingBrandName

ATOperatingMargin
Sales/BVofCapital
ROC
ReinvestmentRate
ExpectedGrowth
Length
CostofEquity
E/(D+E)
ATCostofDebt
D/(D+E)
CostofCapital
Value

Aswath Damodaran

CocaCola
18.56%
1.67
31.02%
65.00%(19.35%)
20.16%
10years
12.33%
97.65%
4.16%
2.35%
12.13%
$115

GenericColaCompany
7.50%
1.67
12.53%
65.00%(47.90%)
8.15%
10yea
12.33%
97.65%
4.16%
2.35%
12.13%
$13

98

6.Becircumspectaboutdefiningdebtforcostofcapital
purposes

GeneralRule:Debtgenerallyhasthefollowingcharacteristics:

Definedassuch,debtshouldinclude

Commitmenttomakefixedpaymentsinthefuture
Thefixedpaymentsaretaxdeductible
Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrolofthefirm
tothepartytowhompaymentsaredue.
Allinterestbearingliabilities,shorttermaswellaslongterm
Allleases,operatingaswellascapital

Debtshouldnotinclude

Aswath Damodaran

Accountspayableorsuppliercredit

99

BookValueorMarketValue
Forsomefirmsthatareinfinancialtrouble,thebookvalueofdebtcanbe
substantiallyhigherthanthemarketvalueofdebt.Analystsworrythat
subtractingoutthemarketvalueofdebtinthiscasecanyieldtoohighavalue
forequity.
Adiscountedcashflowvaluationisdesignedtovalueagoingconcern.Ina
goingconcern,itisthemarketvalueofdebtthatshouldcount,evenifitis
muchlowerthanbookvalue.
Inaliquidationvaluation,youcansubtractoutthebookvalueofdebtfrom
theliquidationvalueoftheassets.
Convertingbookdebtintomarketdebt,,,,,

Aswath Damodaran

100

Butyoushouldconsiderotherpotentialliabilitieswhen
gettingtoequityvalue

Ifyouhaveunderfundedpensionfundorhealthcareplans,youshould
considertheunderfundingatthisstageingettingtothevalueofequity.

Ifyoudoso,youshouldnotdoublecountbyalsoincludingacashflowlineitem
reflectingcashyouwouldneedtosetasidetomeettheunfundedobligation.
Youshouldnotbecountingtheseitemsasdebtinyourcostofcapital
calculations.

Ifyouhavecontingentliabilitiesforexample,apotentialliabilityfroma
lawsuitthathasnotbeendecidedyoushouldconsidertheexpectedvalueof
thesecontingentliabilities

Aswath Damodaran

Valueofcontingentliability=Probabilitythattheliabilitywilloccur*Expected
valueofliability

101

7.TheValueofControl

Thevalueofthecontrolpremiumthatwillbepaidtoacquireablockofequity
willdependupontwofactors

Probabilitythatcontroloffirmwillchange:Thisreferstotheprobabilitythat
incumbentmanagementwillbereplaced.thiscanbeeitherthroughacquisitionor
throughexistingstockholdersexercisingtheirmuscle.
ValueofGainingControloftheCompany:Thevalueofgainingcontrolofa
companyarisesfromtwosourcestheincreaseinvaluethatcanbewroughtby
changesinthewaythecompanyismanagedandrun,andthesidebenefitsand
perquisitesofbeingincontrol
ValueofGainingControl=PresentValue(ValueofCompanywithchangeincontrol
Valueofcompanywithoutchangeincontrol)+SideBenefitsofControl

Aswath Damodaran

102

Wherecontrolmatters

Inpubliclytradedfirms,controlisafactor

Inthepricingofeverypubliclytradedfirm,sinceaportionofeverystockcanbe
attributedtothemarketsviewsaboutcontrol.
Inacquisitions,itwilldeterminehowmuchyoupayasapremiumforafirmto
controlthewayitisrun.
Whenshareshavevotingandnonvotingshares,thevalueofcontrolwilldetermine
thepricedifference.

Inprivatefirms,controlusuallybecomesanissuewhenyouconsiderhow
muchtopayforaprivatefirm.

Aswath Damodaran

Youmaypayapremiumforabadlymanagedprivatefirmbecauseyouthinkyou
couldrunitbetter.
Thevalueofcontrolisdirectlyrelatedtothediscountyouwouldattachtoa
minorityholding(<50%)asopposedtoamajorityholding.
Thevalueofcontrolalsobecomesafactorinhowmuchofanownershipstakeyou
willdemandinexchangeforaprivateequityinvestment.

103

ValueofGainingControl..Youcouldenhanceafirmsvalue
by

UsingtheDCFframework,therearefourbasicwaysinwhichthevalueofafirmcanbe
enhanced:

Thecashflowsfromexistingassetstothefirmcanbeincreased,byeither

Theexpectedgrowthrateinthesecashflowscanbeincreasedbyeither

Increasingtherateofreinvestmentinthefirm
Improvingthereturnoncapitalonthosereinvestments

Thelengthofthehighgrowthperiodcanbeextendedtoallowformoreyearsofhighgrowth.
Thecostofcapitalcanbereducedby

Aswath Damodaran

increasingaftertaxearningsfromassetsinplaceor
reducingreinvestmentneeds(netcapitalexpendituresorworkingcapital)

Reducingtheoperatingriskininvestments/assets
Changingthefinancialmix
Changingthefinancingcomposition

104

I.WaysofIncreasingCashFlowsfromAssetsinPlace

More efficient
operations and
cost cuttting:
Higher Margins
Divest assets that
have negative EBIT
Reduce tax rate
- moving income to lower tax locales
- transfer pricing
- risk management

Aswath Damodaran

Revenues
* Operating Margin
= EBIT
- Tax Rate * EBIT
= EBIT (1-t)
+ Depreciation
- Capital Expenditures
- Chg in Working Capital
= FCFF

Live off past overinvestment

Better inventory
management and
tighter credit policies

105

II.ValueEnhancementthroughGrowth

Reinvest more in
projects
Increase operating
margins

Aswath Damodaran

Do acquisitions
Reinvestment Rate
* Return on Capital

Increase capital turnover ratio

= Expected Growth Rate

106

III.BuildingCompetitiveAdvantages:Increaselengthofthe
growthperiod
Increase length of growth period
Build on existing
competitive
advantages

Brand
name

Aswath Damodaran

Legal
Protection

Find new
competitive
advantages

Switching
Costs

Cost
advantages

107

IV.ReducingCostofCapital
Outsourcing

Flexible wage contracts &

cost structure

Reduce operating
leverage

Change financing mix

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

Make product or service
less discretionary to
customers
Changing
product
characteristics

Aswath Damodaran

More
effective
advertising

Match debt to
assets, reducing
default risk
Swaps

Derivatives

Hybrids

108

Embraer:OptimalCapitalStructure

DebtRatio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%

Aswath Damodaran

Beta
0.95
1.02
1.11
1.22
1.37
1.58
1.89
2.42
3.48
6.95

CostofEquity
10.05%
10.32%
10.67%
11.12%
11.72%
12.56%
13.81%
15.90%
20.14%
34.05%

BondRating
AAA
AAA
AA
A
A
B
CCC
CC
CC
CC

Interestrateondebt
8.92%
8.92%
9.17%
9.97%
10.17%
14.67%
18.17%
19.67%
19.67%
19.67%

TaxRate
34.00%
34.00%
34.00%
34.00%
34.00%
34.00%
34.00%
34.00%
33.63%
29.90%

CostofDebt(aftertax)
5.89%
5.89%
6.05%
6.58%
6.71%
9.68%
11.99%
12.98%
13.05%
13.79%

WACC
10.05%
9.88%
9.75%
9.76%
9.72%
11.12%
12.72%
13.86%
14.47%
15.81%

FirmValue(G)
$3,577
$3,639
$3,690
$3,686
$3,703
$3,218
$2,799
$2,562
$2,450
$2,236

109

Embraer: Restructured ($)

Current Cashflow to Firm
EBIT(1-t) :
$ 404
- Nt CpX
23
- Chg WC
9
= FCFF
$ 372
Reinvestment Rate = 32/404= 7.9%

Reinvestment Rate
40.00%

Return on Capital
20%

Stable Growth
g = 4.17%; Beta = 1.00;
Country Premium= 5%
Cost of capital = 7.87%
ROC= 7.87%; Tax rate=34%
Reinvestment Rate=g/ROC
=4.17/7.87= 52.99%

Expected Growth
in EBIT (1-t)
.40*.20=.08
8.00 %

Terminal Value5= 291/(.0876-.0417) = 7855

$ Cashflows
Op. Assets $ 6,096
+ Cash:
795
- Debt
717
- Minor. Int.
12
=Equity
6,196
-Options
28
Value/Share $8.66
R$ 25.21

Year
EBIT(1-t)
- Reinvestment
= FCFF

1
436
174
262

3
509
204
305

4
549
219
330

Term Yr
618
- 327
= 291

5
593
237
356

Discount at$ Cost of Capital (WACC) = 11.72% (.60) + 6.71% (0.40) = 9.72%

Cost of Equity
11.72 %

Riskfree Rate :
$ Riskfree Rate= 4.17%

On October 6, 2003
Embraer Price = R$15

Cost of Debt
(4.17%+2%+4%)(1-.34)
= 6.71%

Beta
1.37

Unlevered Beta for

Sectors: 0.95

Aswath Damodaran

2
471
188
283

Weights
E = 60% D = 40%

Mature market
premium
4%
Firms D/E
Ratio: 19%

Lambda
0.27

Country Equity Risk

Premium
7.67%

Country Default
Spread
6.01%

Rel Equity
Mkt Vol
1.28

110

TheValueofControlinapubliclytradedfirm..

Ifthevalueofafirmrunoptimallyissignificantlyhigherthanthevalueofthe
firmwiththestatusquo(orincumbentmanagement),youcanwritethevalue
thatyoushouldbewillingtopayas:
Valueofcontrol=ValueoffirmoptimallyrunValueoffirmwithstatusquo
ValueofcontrolatEmbraer=25.21Reaispershare21.75Reaispershare=3.46
Reaispershare

Implications:

Aswath Damodaran

Inanacquisition,thisisthemostthatyouwouldbewillingtopayasapremium
(assumingnoothersynergy)
Asastockholder,youwillbewillingtopayavaluebetween21.75and25.21,
dependinguponyourviewsonwhethercontrolwillchange.
Iftherearevotingandnonvotingshares,thedifferenceinpricesbetweenthetwo
shouldreflectthevalueofcontrol.

111

MinorityandMajorityinterestsinaprivatefirm

Whenyougetacontrollinginterestinaprivatefirm(generally>51%,but
couldbeless),youwouldbewillingtopaytheappropriateproportionof
theoptimalvalueofthefirm.
Whenyoubuyaminorityinterestinafirm,youwillbewillingtopaythe
appropriatefractionofthestatusquovalueofthefirm.
Forbadlymanagedfirms,therecanbeasignificantdifferenceinvalue
between51%ofafirmand49%ofthesamefirm.Thisistheminority
discount.
Ifyouownaprivatefirmandyouaretryingtogetaprivateequityorventure
capitalinvestortoinvestinyourfirm,itmaybeinyourbestintereststooffer
themashareofcontrolinthefirmeventhoughtheymayhavewellbelow
51%.

Aswath Damodaran

112

8.DistressandtheGoingConcernAssumption

Traditionalvaluationtechniquesarebuiltontheassumptionofagoing
concern,i.e.,afirmthathascontinuingoperationsandthereisnosignificant
threattotheseoperations.

Indiscountedcashflowvaluation,thisgoingconcernassumptionfindsitsplace
mostprominentlyintheterminalvaluecalculation,whichusuallyisbaseduponan
infinitelifeandevergrowingcashflows.
Inrelativevaluation,thisgoingconcernassumptionoftenshowsupimplicitly
becauseafirmisvaluedbaseduponhowotherfirmsmostofwhicharehealthy
arepricedbythemarkettoday.

Whenthereisasignificantlikelihoodthatafirmwillnotsurvivethe
immediatefuture(nextfewyears),traditionalvaluationmodelsmayyieldan
overoptimisticestimateofvalue.

Aswath Damodaran

113

Current
Revenue
$ 3,804

Current
Margin:
-49.82%
EBIT
-1895m

Cap ex growth slows

and net cap ex
decreases
Revenue
Growth:
13.33%

NOL:
2,076m

Value of Op Assets $ 5,530

+ Cash & Non-op $ 2,260
= Value of Firm
$ 7,790
- Value of Debt
$ 4,923
= Value of Equity $ 2867
- Equity Options
$
14
Value per share
$ 3.22

Stable Growth

EBITDA/Sales
-> 30%

Stable
EBITDA/
Sales
30%

$3,804 $5,326 $6,923 $8,308 $9,139

($95) $0
$346 $831 $1,371
($1,675) ($1,738) ($1,565) ($1,272) $320
($1,675) ($1,738) ($1,565) ($1,272) $320
$1,580 $1,738 $1,911 $2,102 $1,051
$3,431 $1,716 $1,201 $1,261 $1,324
$0
$46
$48
$42
$25
($3,526) ($1,761) ($903) ($472) $22
1
2
3
4
5

$10,053$11,058$11,942$12,659$13,292
$1,809 $2,322 $2,508 $3,038 $3,589
$1,074 $1,550 $1,697 $2,186 $2,694
$1,074 $1,550 $1,697 $2,186 $2,276
$736 $773 $811 $852 $894
$1,390 $1,460 $1,533 $1,609 $1,690
$27
$30
$27
$21
$19
$392 $832 $949 $1,407 $1,461
6
7
8
9
10

Beta
CostofEquity
CostofDebt
DebtRatio
CostofCapital

3.00
16.80%
12.80%
74.91%
13.80%

2.60
15.20%
11.84%
67.93%
12.92%

Riskfree Rate:
T. Bond rate = 4.8%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

3.00
16.80%
12.80%
74.91%
13.80%

2.20
13.60%
10.88%
60.95%
11.94%

Cost of Debt
4.8%+8.0%=12.8%
Tax rate = 0% -> 35%

Beta
3.00> 1.10

Internet/
Retail

Stable
ROC=7.36%
Reinvest
67.93%

Terminal Value= 677(.0736-.05)

=$ 28,683

Revenues
EBITDA
EBIT
EBIT(1t)
+Depreciation
CapEx
ChgWC
FCFF

Cost of Equity
16.80%

Aswath Damodaran

Stable
Revenue
Growth: 5%

Operating
Leverage

1.80
12.00%
9.92%
53.96%
10.88%

1.40
10.40%
8.96%
46.98%
9.72%

Forever

1.00
8.80%
6.76%
40.00%
7.98%

Weights
Debt= 74.91% -> 40%

Global Crossing
November 2001
Stock price = $1.86

Risk Premium
4%

Current
D/E: 441%

Term.Year
$13,902
$4,187
$3,248
$2,111
$939
$2,353
$20
$677

Base Equity
Premium

Country Risk
Premium

114

ValuingGlobalCrossingwithDistress

Probabilityofdistress

Priceof8year,12%bondissuedbyGlobalCrossing=$653

120(1 Distress ) t 1000(1 Distress ) 8

653

t
8
(1.05)
(1.05)
t1
t 8

Distresssalevalueofequity

Probabilityofdistress=13.53%ayear
Cumulativeprobabilityofsurvivalover10years=(1.1353)10=23.37%
Bookvalueofcapital=$14,531million
Distresssalevalue=15%ofbookvalue=.15*14531=$2,180million
Bookvalueofdebt=$7,647million
Distresssalevalueofequity=$0

Distressadjustedvalueofequity

Aswath Damodaran

ValueofGlobalCrossing=$3.22(.2337)+$0.00(.7663)=$0.75

115

9.EquityValueandPerShareValue

Theconventionalwayofgettingfromequityvaluetopersharevalueisto
dividetheequityvaluebythenumberofsharesoutstanding.Thisapproach
assumes,however,thatcommonstockistheonlyequityclaimonthefirm.
Inmanyfirms,thereareotherequityclaimsaswellincluding:

warrants,thatarepubliclytraded
managementandemployeeoptions,thathavebeengranted,butdonottrade
conversionoptionsinconvertiblebonds
contingentvaluerights,thatarealsopubliclytraded.

Thevalueofthesenonstockequityclaimshastobesubtractedfromthevalue
ofequitybeforedividingbythenumberofsharesoutstanding.

Aswath Damodaran

116

Amazon:EstimatingtheValueofEquityOptions

Detailsofoptionsoutstanding

Averagestrikepriceofoptionsoutstanding=
Averagematurityofoptionsoutstanding=
Standarddeviationinln(stockprice)=
Annualizeddividendyieldonstock=
Treasurybondrate=
Numberofoptionsoutstanding=
Numberofsharesoutstanding=

$13.375
8.4years
50.00%
0.00%
6.50%
38million
340.79million

Valueofoptionsoutstanding(usingdilutionadjustedBlackScholesmodel)

Aswath Damodaran

Valueofequityoptions=$2,892million

117

10.AnalyzingtheEffectofIlliquidityonValue

Investmentswhicharelessliquidshouldtradeforlessthanotherwisesimilar
investmentswhicharemoreliquid.
Thesizeoftheilliquiditydiscountshoulddependupon

Aswath Damodaran

TypeofAssetsownedbytheFirm:Themoreliquidtheassetsownedbythefirm,thelower
shouldbetheliquiditydiscountforthefirm
SizeoftheFirm:Thelargerthefirm,thesmallershouldbesizeoftheliquiditydiscount.
HealthoftheFirm:Stockinhealthierfirmsshouldsellforasmallerdiscountthanstockin
troubledfirms.
CashFlowGeneratingCapacity:Securitiesinfirmswhicharegeneratinglargeamountsof
cashfromoperationsshouldsellforasmallerdiscountsthansecuritiesinfirmswhichdonot
generatelargecashflows.
SizeoftheBlock:Theliquiditydiscountshouldincreasewiththesizeoftheportionofthe
firmbeingsold.

118

IlliquidityDiscount:RestrictedStockStudies

Restrictedsecuritiesaresecuritiesissuedbyacompany,butnotregistered
withtheSEC,thatcanbesoldthroughprivateplacementstoinvestors,but
cannotberesoldintheopenmarketforatwoyearholdingperiod,andlimited
amountscanbesoldafterthat.Studiesofrestrictedstockovertimehave
concludedthatthediscountisbetween25and35%.Manypractitionersuse
thisastheilliquiditydiscountforallprivatefirms.
Amorenuancedusedofrestrictedstockstudiesistorelatethediscountto
fundamentalcharacteristicsofthecompanylevelofrevenues,healthofthe
companyetc..Andtoadjustthediscountforanyfirmtoreflectits
characteristics:

Aswath Damodaran

Thediscountwillbesmallerforlargerfirms
Thediscountwillbesmallerforhealthierfirms

119

IlliquidityDiscountsfromBidAskSpreads
Using data from the end of 2000, for instance, we regressed the bid-ask spread against
annual revenues, a dummy variable for positive earnings (DERN: 0 if negative and 1 if
positive), cash as a percent of firm value and trading volume.
Spread = 0.145 0.0022 ln (Annual Revenues) -0.015 (DERN) 0.016 (Cash/Firm Value)
0.11 ($ Monthly trading volume/ Firm Value)
We could substitute in the revenues of Kristin Kandy ($5 million), the fact that it has
positive earnings and the cash as a percent of revenues held by the firm (8%):
Spread = 0.145 0.0022 ln (Annual Revenues) -0.015 (DERN) 0.016 (Cash/Firm Value)
0.11 ($ Monthly trading volume/ Firm Value)
= 0.145 0.0022 ln (5) -0.015 (1) 0.016 (.08) 0.11 (0) = .12.52%
Based on this approach, we would estimate an illiquidity discount of 12.52% for Kristin
Kandy.

Aswath Damodaran

120

V.Value,PriceandInformation:
ClosingtheDeal

Aswath Damodaran

121

Reinvestment:
Current
Revenue
$ 1,117

Current
Margin:
-36.71%
EBIT
-410m

Cap ex includes acquisitions

Working capital is 3% of revenues

Sales Turnover
Ratio: 3.00

Value of Op Assets $ 14,910

+ Cash
$
26
= Value of Firm
$14,936
- Value of Debt
$ 349
= Value of Equity $14,587
- Equity Options
$ 2,892
Value per share
$ 34.32

Revenues
EBIT
EBIT(1t)
Reinvestment
FCFF

CostofEquity
CostofDebt
ATcostofdebt
CostofCapital

$2,793 5,585
$373 $94
$373 $94
$559
$931
$931 $1,024

Riskfree Rate :
T. Bond rate = 6.5%

9,774
$407
$407
$1,396
$989

Terminal Value= 1881/(.0961-.06)

=52,148

14,661 19,059
$1,038 $1,628
$871
$1,058
$1,629 $1,466
$758 $408

Term.Year
$41,346
10.00%
35.00%
$2,688
$807
$1,881

23,862
$2,212
$1,438
$1,601
$163

28,729
$2,768
$1,799
$1,623
$177

33,211
$3,261
$2,119
$1,494
$625

36,798
$3,646
$2,370
$1,196
$1,174

39,006
$3,883
$2,524
$736
$1,788
10

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
8.00%
12.84%

12.90%
8.00%
6.71%
12.83%

12.90%
8.00%
5.20%
12.81%

12.42%
7.80%
5.07%
12.13%

12.30%
7.75%
5.04%
11.96%

12.10%
7.67%
4.98%
11.69%

11.70%
7.50%
4.88%
11.15%

Cost of Debt
6.5%+1.5%=8.0%
Tax rate = 0% -> 35%

Beta
1.60 -> 1.00

Internet/
Retail

Operating
Leverage

Stable
ROC=20%
Reinvest 30%
of EBIT(1-t)

Expected
Margin:
-> 10.00%

Cost of Equity
12.90%

Aswath Damodaran

Competitive
Advantages

Revenue
Growth:
42%

NOL:
500 m

Stable Growth
Stable
Stable
Operating
Revenue
Margin:
Growth: 6%
10.00%

10.50%
7.00%
4.55%
9.61%

Weights
Debt= 1.2% -> 15%

Amazon.com
January 2000
Stock Price = $ 84

Risk Premium
4%

Current
D/E: 1.21%

Forever

Base Equity
Premium

Country Risk
Premium

122

Amazon.com:BreakEvenat$84?
30%
35%
40%
45%
50%
55%
60%

Aswath Damodaran

$
$
$
$
$
$
$

6%
(1.94)
1.41
6.10
12.59
21.47
33.47
49.53

$
$
$
$
$
$
$

8%
2.95
8.37
15.93
26.34
40.50
59.60
85.10

$
$
$
$
$
$
$

10%
7.84
15.33
25.74
40.05
59.52
85.72
120.66

$
$
$
$
$
$
$

12%
12.71
22.27
35.54
53.77
78.53
111.84
156.22

$
$
$
$
$
$
$

14%
17.57
29.21
45.34
67.48
97.54
137.95
191.77

123

Reinvestment:
Current
Revenue
$ 2,465

Cap ex includes acquisitions

Working c apital is 3% of revenues

Current
Margin:
-34.60%

Sales Turnover
Ratio: 3.02

EBIT
-853m

Competitive
Advantages

Revenue
Growth:
25.41%

NOL:
1,289 m

Stab le Growth
Stable
Stable
Operating
Revenue
Margin:
Growth: 5%
9.32%

Expected
Margin:
-> 9.32%

Stable
ROC=16.94%
Reinvest 29.5%
of EBIT(1-t)

Terminal Value= 1064/(.0876-.05)

=$ 28,310
Term. Year

Value of Op Assets
+ Cash & Non-op
= Value of Firm
- Value of Debt
= Value of Equity
- Equity Options
Value per share

$ 7,967
$ 1,263
$ 9,230
$ 1,890
$ 7,340
$ 748
$ 18.74

Rev enues
EBIT
EBIT(1-t)
- Reinv estment
FCFF

$4,314
-$703
-$703
$612
-$1,315

Debt Ratio
Beta
Cost of Equity
AT cost of debt
Cost of Capital

$6,471
-$364
-$364
$714
-$1,078

Aswath Damodaran

$11,777
$499
$499
$900
-$401

$14,132
$898
$898
$780
$118

$16,534
$1,255
$1,133
$796
$337

$18,849
$1,566
$1,018
$766
$252

$20,922
$1,827
$1,187
$687
$501

$23,726
$2,164
$1,406
$374
$1,032

27.27%
2.18
13.81%
10.00%
12.77%

27.27%
2.18
13.81%
10.00%
12.77%

27.27%
2.18
13.81%
10.00%
12.77%

27.27%
2.18
13.81%
10.00%
12.77%

27.27%
2.18
13.81%
9.06%
12.52%

24.81%
1.96
12.95%
6.11%
11.25%

24.20%
1.75
12.09%
6.01%
10.62%

23.18%
1.53
11.22%
5.85%
9.98%

21.13%
1.32
10.36%
5.53%
9.34%

Cost of Debt
5.1%+4.75%= 9.85%
Tax rate = 0% -> 35%

Beta
2.18-> 1.10

Internet/
Retail

$22,596
$2,028
$1,318
$554
$764

Cost of Equity
13.81%

Riskfree Rate :
T. Bond rate = 5.1%

$9,059
$54
$54
$857
-$803

Operating
Leverage

$24,912
$2,322
$1,509
$ 445
$1,064

10

Forever

15.00%
1.10
9.50%
4.55%
8.76%

Weights
Debt= 27.38% -> 15%

Amazon.com
January 2001
Stock price = $14

Risk Premium
4%

Current
D/E: 37.5%

$24,912
$2,322
$1,509
$445
$1,064

Base Equity
Premium

Country Risk
Premium

124

Amazonovertime
Amazon: Value and Price

$90.00

$80.00

$70.00

$60.00

$50.00
Value per share
Price per share

$40.00

$30.00

$20.00

$10.00

$0.00
2000

Aswath Damodaran

2001
2002
Time of analysis

2003

125

BacktoLemmings...

Aswath Damodaran

126