Valuation: Closing

Thoughts
Aswath Damodaran

Aswath Damodaran 1
 Do you have your life vests on?

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 Truths about Valuation

n Truth 1: All valuations are biased.

n Truth 2.: There are no precise valuations.
n Truth 3: Complexity comes with a cost; More information is not
always better than less information.

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 Approaches to Valuation

n Discounted cashflow valuation, where we try (sometimes

desperately) to estimate the intrinsic value of an asset by using a mix
of theory, guesswork and prayer.
n Relative valuation, where we pick a group of assets, attach the name
“comparable” to them and tell a story.
n Contingent claim valuation, where we take the valuation that we did
in the DCF valuation and divvy it up between the potential thieves of
value (equity) and the potential victims of this crime (lenders)

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 Basis for all valuation approaches

n We all believe market are inefficient, and that we can find under and
over valued assets because of our superior intellect, models,
information or some combination of all three.
n Some Sobering facts:
• 70-80% of portfolio managers under perform market indices.
• The Vanguard 500 Index fund is poised to overtake the Fidelity Magellan
fund as the largest mutual fund in the United States. In the last 5 years, it
has been the best performing large mutual fund in the United States.
• The more people trade, the more they seem to lose.
– A study of mutual fund portfolios discovered that they would have made a
higher return, if they had frozen their portfolios on January 1.
– A study of individual investors by Terrence O”Dean also noted a negative
correlation between returns earned and transactions volume (and this is before
trading costs)

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 Discounted Cash Flow Valuation

n What is it: In discounted cash flow valuation, the value of an asset is

the present value of the expected cash flows on the asset.
n Philosophical Basis: Every asset has an intrinsic value that can be
estimated, based upon its characteristics in terms of cash flows, growth
and risk.
n Information Needed: To use discounted cash flow valuation, you
need
• to estimate the life of the asset
• to estimate the cash flows during the life of the asset
• to estimate the discount rate to apply to these cash flows to get present
value
n 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.
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 DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Net Income/EPS Firm is in stable growth:
Equity: After debt
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

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 Did you DISCOUNTED CASHFLOW VALUATION
normalize Is your ROC Is your growth rate Is your stable growth Are you reinvesting
earnings? likely to change consistent with your rate < growth rate in enough to create
Cashflow to Firm in the future? reinvestment rate? economy? stable growth?
Did you include EBIT (1-t)
acquisitions and - (Cap Ex - Depr) Expected Growth= Is your beta
R&D? ROC* Reinv Rate Firm is in stable growth: and leverage
- Change in WC
Grows at constant rate consistent with
= FCFF
Did you consider forever stable growth?
only non-cash WC
and smooth?
I s length of growth period consistent with
competitive advantages? Terminal Value= FCFF n+1 /(r-gn)
Value of Operating Assets
+ Cash & Non-op Assets FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn
.........
= Value of Firm
Forever
- Value of Debt
= Value of Equity Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
- Equity Options
= Value of Equity in Stock

Cost of Equity Cost of Debt Weights

(Riskfree Rate Based on Market Value
+ Default Spread) (1-t)
Is the default spread
reflective of Will these weights change
company’s risk? over time?

Riskfree Rate :
Is your riskless rate in the
same currency and terms
as the cash flows?
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Risk Premium
+ Beta X - Premium for average Is your risk premium a historical
- Measures market risk risk investment or implied risk premium?
Are you using a bottom-
up beta that reflects your Base Equity Country Risk
business risk and current Premium Premium
leverage?
I s there sufficient Is the company exposed to
data for a historical additional country risk?
risk premium? 8
 Relative Valuation

n What is it?: The value of any asset can be estimated by looking at

how the market prices “similar” or ‘comparable” assets.
n Philosophical Basis: The intrinsic value of an asset is impossible (or
close to impossible) to estimate. The value of an asset is whatever the
market is willing to pay for it (based upon its characteristics)
n Information Needed: To do a relative valuation, you need
• an identical 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
n Market Inefficiency: Pricing errors made across similar or
comparable assets are easier to spot, easier to exploit and are much
more quickly corrected.
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 The Four Steps to Understanding Multiples

n Define the multiple

• In use, the same multiple can be defined in different ways by different
users. When comparing and using multiples, estimated by someone else, it
is critical that we understand how the multiples have been estimated
n Describe the multiple
• Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of
a multiple is, it is difficult to look at a number and pass judgment on
whether it is too high or low.
n Analyze the multiple
• It is critical that we understand the fundamentals that drive each multiple,
and the nature of the relationship between the multiple and each variable.
n Apply the multiple
• Defining the comparable universe and controlling for differences is far
more difficult in practice than it is in theory.
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 Value of Stock = DPS 1/(ke - g)

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

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

Equity Multiples

Firm Multiples

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

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

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

Value of Firm = FCFF1/(WACC -g)

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 Estimating a Multiple

n Use comparable firms, compute the average multiple and adjust

subjectively for differences
n Use comparable firms, run a regression of multiple against
fundamentals and estimate predicted multiple for firm
n Use market, run a regression of multiple against fundamentals and
estimate a predicted multiple for firm

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 What approach would work for you?

n As an investor, given your investment philosophy, time horizon and

beliefs about markets (that you will be investing in), which of the the
approaches to valuation would you choose?
o Discounted Cash Flow Valuation
o Relative Valuation
o Neither. I believe that markets are efficient.

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 Contingent Claim (Option) Valuation

n Options have several features

• They derive their value from an underlying asset, which has value
• The payoff on a call (put) option occurs only if the value of the underlying
asset is greater (lesser) than an exercise price that is specified at the time
the option is created. If this contingency does not occur, the option is
worthless.
• They have a fixed life
n Any security that shares these features can be valued as an option.

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 Indirect Examples of Options

n Equity in a deeply troubled firm - a firm with negative earnings and

high leverage - can be viewed as an option to liquidate that is held by
the stockholders of the firm. Viewed as such, it is a call option on the
assets of the firm.
n The reserves owned by natural resource firms can be viewed as call
options on the underlying resource, since the firm can decide whether
and how much of the resource to extract from the reserve,
n The patent owned by a firm or an exclusive license issued to a firm can
be viewed as an option on the underlying product (project). The firm
owns this option for the duration of the patent.

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 Value Enhancement

n For an action to create value, it has to

• Increase cash flows from assets in place
• Increase the expected growth rate
• Increase the length of the growth period
• Reduce the cost of capital
n The value enhancement measures that have been widely promoted as
new and different are neither.
• EVA and CFROI have their roots in traditional discounted cash flow
models
• Measures (like EVA and CFROI) do not create value; managers do.

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 Some Not Very Profound Advice

n Its all in the fundamentals

n Focus on the big picture; don’t let the details trip you up.
n Keep your perspective; it is only a valuation.

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 Or maybe you can fly….

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