Valuation

AswathDamodaran

Aswath Damodaran

First Principles

Investinprojectsthatyieldareturngreaterthantheminimumacceptable
hurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthefinancingmix
usedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedandthe
timingofthesecashflows;theyshouldalsoconsiderbothpositiveandnegative
sideeffectsoftheseprojects.

Chooseafinancingmixthatminimizesthehurdlerateandmatchestheassets
beingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthecashto
stockholders.
Theformofreturnsdividendsandstockbuybackswilldependuponthe
stockholderscharacteristics.

Objective:MaximizetheValueoftheFirm
Aswath Damodaran

Discounted Cashflow Valuation: Basis for

Approach
t = n CF
t
Value =
t
t = 1 (1 + r)

where,

n=Lifeoftheasset

CFt=Cashflowinperiodt

r=Discountratereflectingtheriskinessoftheestimatedcashflows

Aswath Damodaran

Equity Valuation

Thevalueofequityisobtainedbydiscountingexpectedcashflowsto
equity,i.e.,theresidualcashflowsaftermeetingallexpenses,tax
obligationsandinterestandprincipalpayments,atthecostofequity,
i.e.,therateofreturnrequiredbyequityinvestorsinthefirm.
t=n

CFtoEquity t
(1+ k e )t
t=1

ValueofEquity =

where,
CFtoEquityt=ExpectedCashflowtoEquityinperiodt
ke=CostofEquity

Thedividenddiscountmodelisaspecializedcaseofequityvaluation,
andthevalueofastockisthepresentvalueofexpectedfuturedividends.

Aswath Damodaran

Firm Valuation

Thevalueofthefirmisobtainedbydiscountingexpectedcashflows
tothefirm,i.e.,theresidualcashflowsaftermeetingalloperating
expensesandtaxes,butpriortodebtpayments,attheweighted
averagecostofcapital,whichisthecostofthedifferentcomponents
offinancingusedbythefirm,weightedbytheirmarketvalue
proportions.
t=n

CFtoFirm t
t
t=1 (1+ WACC)

ValueofFirm =

where,
CFtoFirmt=ExpectedCashflowtoFirminperiodt
WACC=WeightedAverageCostofCapital

Aswath Damodaran

Generic DCF Valuation Model

Value
Length
Cash
Expected
Firm
Forever
Terminal
CF
Discount
.........
inof
Value
stable
Rate
Growth
Period
growth:
of High
Growth
1 isflows
2
3
4
5
n
DISCOUNTED
CASHFLOW
GrowsValue
Firm:Cost
Firm:
Pre-debt
Growth
at constant
ofofCapital
inFirm
cashrate
flow
Operating
forever
Earnings
Equity: Value
After of
Growth
Cost
debt
ofEquity
inEquity
cashIncome/EPS
Net
flows

Aswath Damodaran

VALUATION

Estimating Inputs:
I. Discount Rates

Criticalingredientindiscountedcashflowvaluation.Errorsin
estimatingthediscountrateormismatchingcashflowsanddiscount
ratescanleadtoseriouserrorsinvaluation.
Atanintutivelevel,thediscountrateusedshouldbeconsistentwith
boththeriskinessandthetypeofcashflowbeingdiscounted.
Thecostofequityistherateatwhichwediscountcashflowsto
equity(dividendsorfreecashflowstoequity).Thecostofcapitalis
therateatwhichwediscountfreecashflowstothefirm.

Aswath Damodaran

The Cost of Equity: A Recap

or to
Cost
Has
Preferably,
Historical
ImpliedPremium
ofbe
Equity
Premium
ina the
bottom-up
= same
Riskfree
beta, Rate
+
Beta *
currency
based
1.
Basedonhowequity
Mature
upon
as
Equity
cash
otherMarket
flows,
firms inPremium:
the
and defined
business,
Average
marketispricedtoday
premium
and
in firms
same
earned
own
terms
financial
by
(real orover
leverage
stocks
andasimplevaluation
nominal)
T.Bonds
as the
in U.S.
cash
2.
model
Country
flows risk premium =
Country Default Spread* ( Equity/ Countrybond)

Aswath Damodaran

(Risk Premium)

Estimating the Cost of Capital

Cost of equity
Marginal
Weights
Capital
borrowing
should
tax rate,
=bereflecting
should
market
Cost be
ofvalue
Equity
based
weights
(Equity/(Debt
upon
+ Equity))
(1) synthetic
tax
based
benefits
upon of
bottom-up
ordebt
actual bond rating
(2) default spread
beta
Cost of Borrowing = Riskfree rate + Default spread

Aswath Damodaran

Cost of Borrowing

(1-t)

(Debt/(Debt + Equity))

Costs of Equity, Debt and Capital

Beta(Bottomup)
CostofEquity
Equity/(Debt+Equity)
Rating
AftertaxCostofDebt
Debt/(Debt+Equity)
CostofCapital

Aswath Damodaran

Boeing
1.01
10.58%
79.91%
AA
3.58%
20.09%
9.17%

TheHomeDepot
0.87
9.78%
95.45%
A+
3.77%
4.55%
9.51%

InfoSoft
1.49
13.19%
93.38%
A
3.48%
6.62%
12.55%

10

II. Estimating Cash Flows

EBIT
To
The
Equity
Firm
Strict
Broader
(1-t)
View
View
Cash
Flows
Dividends
-Net
( Cap
Income
Ex +- Depreciation)
-Stock
Net Cap
Change
Buybacks
in
ExWorking
(1-Debt Capital
Ratio)
- Chg
=
FreeWC
Cashflow
(1 - Debt
to Firm
Ratio)
= Free Cashflow to Equity

Aswath Damodaran

11

Estimating Operating Income

Thefirstadjustmentisforfinancingexpensesthataccountantstreatas
operatingexpenses.Themostsignificantexampleisoperatingleases.
The second adjustment is the treatment of some capital expenditures
as operating expenses. Here, the most dramatic example is the
treatmentofresearchanddevelopmentexpenses.
The third adjustment is to correct for the incidence of onetime or
irregularincomeandexpenses.Anyexpense(orincome)thatistrulya
onetimeexpense(orincome)shouldberemovedfromtheoperating
incomeandshouldnotbeusedinforecastingfutureoperatingincome.

Aswath Damodaran

12

Operating Income Estimates

Boeing
OperatingIncome
$1,720
+SpecialandOnetimeCharges
$0
+ResearchandDevelopmentExpenses
$1,895
AmortizationofResearchAsset
$1,382
+ImputedInterestExpenseonOperatingLeases $31
=AdjustedOperatingIncome
$2,264

Aswath Damodaran

Home
Depot
$2,661
$0
$0
$0
$154
$2,815

InfoSoft
$2,000
$0
$4,000
$2,367
$
$3,633

13

Estimating a Tax Rate

Thechoiceisbetweentheeffectiveandthemarginaltaxrate.Indoing
projections,itisfarsafertousethemarginaltaxratesincethe
effectivetaxrateisreallyareflectionofthedifferencebetweenthe
accountingandthetaxbooks.
Byusingthemarginaltaxrate,wetendtounderstatetheaftertax
operatingincomeintheearlieryears,buttheaftertaxtaxoperating
incomeismoreaccurateinlateryears
Ifyouchoosetousetheeffectivetaxrate,adjustthetaxratetowards
themarginaltaxrateovertime.

Aswath Damodaran

14

Tax Rate Estimates

Boeing
TaxableIncome
1397
Taxes
277
EffectiveTaxRate
19.83%
AverageEffectiveTaxRate:9498 20.44%
Marginaltaxrate
35%

HomeDepot
2654
1040
39.19%
38.78%
35%

InfoSoft
1685
707.7
42.00%
42%
42%

Wewillusethe35%taxratetovalueBoeingandtheHomeDepotand
42%forInfoSoft.

Aswath Damodaran

15

Estimating Capital Expenditures

Researchanddevelopmentexpenses,oncetheyhavebeenre
categorizedascapitalexpenses.Theadjustedcapexwillbe
AdjustedNetCapitalExpenditures=NetCapitalExpenditures+Current
yearsR&DexpensesAmortizationofResearchAsset

Acquisitionsofotherfirms,sincethesearelikecapitalexpenditures.
Theadjustedcapexwillbe
AdjustedNetCapEx=NetCapitalExpenditures+Acquisitionsofother
firmsAmortizationofsuchacquisitions
Twocaveats:
1.Mostfirmsdonotdoacquisitionseveryyear.Hence,anormalized
measureofacquisitions(lookingatanaverageovertime)shouldbeused
2.Thebestplacetofindacquisitionsisinthestatementofcashflows,
usuallycategorizedunderotherinvestmentactivities

Aswath Damodaran

16

Net Capital Expenditures: 1998

CapitalExpenditures
R&D

Boeing
$1,584
$1,895

TheHomeDepot
$2,059
$0

InfoSoft
$2,000
$4,000

Depreciation
AmortizationofR&D

$1,517
$1,382

$373
$0

$1,000
$2,367

NetCapExw/oR&D
NetCapExwithR&D

$67
$580

$1,686
$1,686

$1,000
$2,633

Aswath Damodaran

17

Estimating Net Working Capital Needs

Inaccountingterms,theworkingcapitalisthedifferencebetweencurrent
assets(inventory,cashandaccountsreceivable)andcurrentliabilities
(accountspayables,shorttermdebtanddebtduewithinthenextyear)
Acleanerdefinitionofworkingcapitalfromacashflowperspectiveisthe
differencebetweennoncashcurrentassets(inventoryandaccounts
receivable)andnondebtcurrentliabilities(accountspayable)
Anyinvestmentinthismeasureofworkingcapitaltiesupcash.
Therefore,anyincreases(decreases)inworkingcapitalwillreduce
(increase)cashflowsinthatperiod.
Whenforecastingfuturegrowth,itisimportanttoforecasttheeffectsof
suchgrowthonworkingcapitalneeds,andbuildingtheseeffectsintothe
cashflows.

Aswath Damodaran

18

Net Working Capital Estimates

Boeing
Revenues:1998
NoncashWC:1998
Workingcapital
NoncashWCas%ofRevenues
Averagefrom19941998
IndustryAverage

Aswath Damodaran

TheHomeDepot
$56,154 30219
$1,360 2028
$667
$190
2.42% 6.71%
4.12% 7.08%
18.95% 12.30%

InfoSoft
20000
2000
$500
10.00%
NA
18.00%

19

 Application Test: Estimating your firms FCFF

EstimatetheFCFFforyourfirminitsmostrecentfinancialyear:
Ingeneral,
Ifusingstatementofcashflows
EBIT(1t)
EBIT(1t)
+Depreciation
+Depreciation
CapitalExpenditures
+CapitalExpenditures
ChangeinNoncashWC
+ChangeinNoncashWC
=FCFF
=FCFF
Estimatethedollarreinvestmentatyourfirm:
Reinvestment=EBIT(1t)FCFF

Aswath Damodaran

20

Choosing a Cash Flow to Discount

Whenyoucannotestimatethefreecashfllowstoequityorthefirm,
theonlycashflowthatyoucandiscountisdividends.Forfinancial
servicefirms,itisdifficulttoestimatefreecashflows.ForDeutsche
Bank,wewillbediscountingdividends.
Ifafirmsdebtratioisnotexpectedtochangeovertime,thefreecash
flowstoequitycanbediscountedtoyieldthevalueofequity.For
Aracruz,wewilldiscountfreecashflowstoequity.
Ifafirmsdebtratiomightchangeovertime,freecashflowstoequity
becomecumbersometoestimate.Here,wewoulddiscountfreecash
flowstothefirm.ForDisney,wewilldiscountthefreecashflowto
thefirm.

Aswath Damodaran

21

III. Expected Growth

Net
Operating
Retention
Return
R
X
Income
on Ratio=
Equity
Income
Capital
=
Eeinvestment
xpected
Growth
1 - Dividends/Net
Net
Rate
EBIT(1-t)/Book
Income/Book
= (Net CapValue
Value
of of
Income
Equity
Ex
Capital
+ Chg in
WC/EBIT(1-t)

Aswath Damodaran

22

Expected Growth in EPS

gEPS =RetainedEarningst1/NIt1*ROE
=RetentionRatio*ROE
=b*ROE
Proposition 1: The expected growth rate in earnings for a company
cannotexceeditsreturnonequityinthelongterm.

Aswath Damodaran

23

Expected Growth in EBIT And Fundamentals

ReinvestmentRateandReturnonCapital
gEBIT =(NetCapitalExpenditures+ChangeinWC)/EBIT(1t)*
ROC
=ReinvestmentRate*ROC
Proposition2:Nofirmcanexpectitsoperatingincometogrowover
timewithoutreinvestingsomeoftheoperatingincomeinnetcapital
expendituresand/orworkingcapital.
Proposition3:Thenetcapitalexpenditureneedsofafirm,foragiven
growthrate,shouldbeinverselyproportionaltothequalityofits
investments.

Aswath Damodaran

24

Estimating Reinvestment Rate

NetCapEx
ChangeinNonCashWC
TotalReinvestment

Boeing
$580
$667
$1,247

TheHomeDepot
$1,686
$190
$1,876

InfoSoft
$2,633
$500
$3,133

EBIT(1t)
ReinvestmentRate

$1,651
75.52%

$1,830
102.53%

$2,793
112.17%

Average:199498
IndustryAverage

65.98%
55.48%

131.85%
88.62%

NA
73.12%

Aswath Damodaran

25

Estimating Return on Capital

AdjustedEBIT(1t)
AdjustedBVofcapital
ROC

Boeing
$1,651
$28,957
5.70%

AverageROC:19941998 6.59%
IndustryaverageROC
15.07%

Aswath Damodaran

TheHomeDepot
$1,830
$11,173
16.38%

InfoSoft
$2,793
$11800
23.67%

15.12%
14.10%

NA
17.20%

26

Expected Growth Estimates

ReturnonCapital
ReinvestmentRate
ExpectedGrowthRate

Boeing
6.59%
65.98%
4.35%

TheHomeDepot
16.38%
88.62%
14.51%

InfoSoft
23.67%
112.17%
26.55%

Boeing:Usedaveragereturnoncapitalandreinvestmentrateoverlast5
years
TheHomeDepot:UsedcurrentreturnoncapitalandIndustryaverage
reinvestmentrate
InfoSoft:Usedcurrentreturnoncapitalandreinvestmentrate

Aswath Damodaran

27

 Application Test: Estimating Expected Growth

Estimatethefollowing:
Thereinvestmentrateforyourfirm
Theaftertaxreturnoncapital
Theexpectedgrowthinoperatingincome,basedupontheseinputs

Aswath Damodaran

28

IV. Getting Closure in Valuation

Apubliclytradedfirmpotentiallyhasaninfinitelife.Thevalueis
thereforethepresentvalueofcashflowsforever.
t = CFt
Value =
t
t = 1 (1+ r)

Sincewecannotestimatecashflowsforever,weestimatecashflows
foragrowthperiodandthenestimateaterminalvalue,tocapture
thevalueattheendoftheperiod:
CF
t
Value =

t

(1 + r)

Aswath Damodaran

29

Stable Growth and Terminal Value

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

Thisconstantgrowthrateiscalledastablegrowthrateandcannotbe
higherthanthegrowthrateoftheeconomyinwhichthefirmoperates.
Whilecompaniescanmaintainhighgrowthratesforextendedperiods,
theywillallapproachstablegrowthatsomepointintime.
Whentheydoapproachstablegrowth,thevaluationformulaabovecan
beusedtoestimatetheterminalvalueofallcashflowsbeyond.

Aswath Damodaran

30

Growth Patterns

Akeyassumptioninalldiscountedcashflowmodelsistheperiodof
highgrowth,andthepatternofgrowthduringthatperiod.Ingeneral,
wecanmakeoneofthreeassumptions:
thereisnohighgrowth,inwhichcasethefirmisalreadyinstablegrowth
therewillbehighgrowthforaperiod,attheendofwhichthegrowthrate
willdroptothestablegrowthrate(2stage)
therewillbehighgrowthforaperiod,attheendofwhichthegrowthrate
willdeclinegraduallytoastablegrowthrate(3stage)

Aswath Damodaran

31

Determinants of Length of High Growth Period

Sizeofthefirm
Successusuallymakesafirmlarger.Asfirmsbecomelarger,itbecomes
muchmoredifficultforthemtomaintainhighgrowthrates

Currentgrowthrate
Whilepastgrowthisnotalwaysareliableindicatoroffuturegrowth,thereis
acorrelationbetweencurrentgrowthandfuturegrowth.Thus,afirmgrowing
at30%currentlyprobablyhashighergrowthandalongerexpectedgrowth
periodthanonegrowing10%ayearnow.

Barrierstoentryanddifferentialadvantages
Ultimately,highgrowthcomesfromhighprojectreturns,which,inturn,
comesfrombarrierstoentryanddifferentialadvantages.
Thequestionofhowlonggrowthwilllastandhowhighitwillbecan
thereforebeframedasaquestionaboutwhatthebarrierstoentryare,how
longtheywillstayupandhowstrongtheywillremain.

Aswath Damodaran

32

Analyzing the Growth Period

FirmSize/MarketSize

Boeing

TheHomeDepot

InfoSoft

Firmhasthedominantmarket

Firmhasdominantmarketshare

Firmisasmallfirminamarket

shareofaslowgrowingmarket

ofdomesticmarket,butis

thatisexperiencingsignificant

enteringnewbusinessesandnew

growth.

markets(overseas)
CurrentExcessReturns

Firmisearninglessthanitscost

Firmisearningsubstantially

Firmisearningsignificant

ofcapital,andhasdonesofor

morethanitscostofcapital.

excessreturns.

Hugecapitalrequirementsand

Significanteconomiesofscale

Hasbothagoodproductand

technologicalbarrierstonew

areusedtoestablishcost

goodsoftwareengineers.

entrants.Managementrecord

advantagesoverrivals.Hasa

Competitiveadvantageislikely

overthelastfewyearshasbeen

managementteamthatisfocused tobelimited,sinceemployees

poor.

ongrowthandefficiency.

last5years
CompetitiveAdvantages

canbehiredaway,and
competitorsareextremely
aggressive.

LengthofHighGrowth

10years,entirelybecauseof

10 years; it will be difficult for 5years.Inspiteofthefirms

period

competitiveadvantagesand

competitors to overcome the smallsize,thecompetitivenature

barrierstoentry.

economiesofscale.

ofthismarketandthelackof
barrierstocompetitionmakeus
conservativeonourestimate.

Aswath Damodaran

33

Firm Characteristics as Growth Changes

Variable
Risk
DividendPayout
NetCapEx
ReturnonCapital
Leverage

Aswath Damodaran

HighGrowthFirmstendto
beaboveaveragerisk
paylittleornodividends
havehighnetcapex
earnhighROC(excessreturn)
havelittleornodebt

StableGrowthFirmstendto
beaveragerisk
payhighdividends
havelownetcapex
earnROCclosertoWACC
higherleverage

34

Estimating Stable Growth Inputs

Startwiththefundamentals:
Profitabilitymeasuressuchasreturnonequityandcapital,instable
growth,canbeestimatedbylookingat
industryaveragesforthesemeasure,inwhichcaseweassumethatthisfirmin
stablegrowthwilllookliketheaveragefirmintheindustry
costofequityandcapital,inwhichcaseweassumethatthefirmwillstop
earningexcessreturnsonitsprojectsasaresultofcompetition.

Leverageisatoughercall.Whileindustryaveragescanbeusedhereas
well,itdependsuponhowentrenchedcurrentmanagementisandwhether
theyarestubbornabouttheirpolicyonleverage(Iftheyare,usecurrent
leverage;iftheyarenot;useindustryaverages)

Usetherelationshipbetweengrowthandfundamentalstoestimate
payoutandnetcapitalexpenditures.

Aswath Damodaran

35

Estimating Stable Period Cost of Capital

Beta
Cost of Equity
After-tax Cost of Debt
Debt Ratio
Cost of Capital

Aswath Damodaran

Boeing
The Home Depot
InfoSoft
High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth
1.014
1
0.869
0.869
1.489
1.2
10.58%
10.50%
9.78%
9.78%
13.19%
11.60%
3.58%
3.58%
3.77%
3.58%
3.48%
3.48%
20.09%
30.00%
4.55%
30.00%
6.62%
6.62%
9.17%
8.42%
9.51%
7.92%
12.55%
11.06%

36

Estimating Stable Period Net Cap Ex

gEBIT
=(NetCapitalExpenditures+ChangeinWC)/EBIT(1t)*
ROC
=ReinvestmentRate*ROC
Movingtermsaround,
ReinvestmentRate=gEBIT/ReturnonCapital
Forinstance,assumethatBoeinginstablegrowthwill
grow5%andthat
itsreturnoncapitalinstablegrowthwillbe8.42%(itscostofcapital).

ReinvestmentRateforBoeinginStableGrowth=5/8.42=59.36%
Inotherwords,
thenetcapitalexpendituresandworkingcapitalinvestmenteachyear
duringthestablegrowthperiodwillbe59.36%ofaftertaxoperating
income.

Aswath Damodaran

37

Stable Period Return on Capital and

Reinvestment Rates

Return on Capital
Reinvestment Rate
Expected Growth Rate

Aswath Damodaran

Boeing
The Home Depot
InfoSoft
High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth
6.59%
8.42%
16.38%
14.10%
23.67%
17.20%
65.98%
59.35%
88.62%
35.46%
112.17%
29.07%
4.35%
5.00%
14.51%
5.00%
26.55%
5.00%

38

Dealing with Cash and Marketable Securities

Thesimplestandmostdirectwayofdealingwithcashandmarketable
securitiesistokeepitoutofthevaluationthecashflowsshouldbe
beforeinterestincomefromcashandsecurities,andthediscountrate
shouldnotbecontaminatedbytheinclusionofcash.(Usebetasofthe
operatingassetsalonetoestimatethecostofequity).
Oncethefirmhasbeenvalued,addbackthevalueofcashand
marketablesecurities.
Ifyouhaveaparticularlyincompetentmanagement,withahistoryof
overpayingonacquisitions,marketsmaydiscountthevalueofthiscash.

Aswath Damodaran

39

Cash and Marketable Securities: Estimates

Boeing
Cash
$2,183
MarketableSecurities
$279
NonOperatingAssets
$0
ExcessofPensionAssets
$1,861
CashandNonOperatingAssets $4,323

TheHomeDepot
$62
$0
$0
$0
$62

InfoSoft
$100
$400
$0
$0
$500

Boeinghasanoverfundedpensionplan.Weconsideredonly50%ofthe
overfunding,sincethefirmwillhavetopayataxof50%ifitdecides
towithdrawthefunds.

Aswath Damodaran

40

The Value of Cash

Implicitly,weareassumingherethatthemarketwillvaluecashat
facevalue.Assumenowthatyouarebuyingafirmwhoseonlyasset
ismarketablesecuritiesworth$100million.Canyoueverconsidera
scenariowhereyouwouldnotbewillingtopay$100millionforthis
firm?
Yes
No
Whatisorarethescenario(s)?

Aswath Damodaran

41

Dealing with Holdings in Other firms

Holdingsinotherfirmscanbecategorizedinto
Minoritypassiveholdings,inwhichcaseonlythedividendfromthe
holdingsisshowninthebalancesheet
Minorityactiveholdings,inwhichcasetheshareofequityincomeis
shownintheincomestatements
Majorityactiveholdings,inwhichcasethefinancialstatementsare
consolidated.

Aswath Damodaran

42

How to value holdings in other firms

FinStatement
Notconsolidated

Valuing
Equity

Notconsolidated

Firm

Consolidated

Firm

Aswath Damodaran

Whattodo
Valueequityinsubsidiaryandtake
shareofholding.
Valuesubsidiaryasafirmandadd
portionoffirmvalue.Addportionof
debtin subsidiarytothedebtin
estimatingequityvalue.
Stripoperatingincomeofsubsidiary
andvaluesubsidiaryseparately.Add
portionofthisvaluetovalueof
parentfirm.

43

How some deal with subsidiaries...

Whenfinancialstatementsareconsolidated,someanalystsvaluethe
firmwiththeconsolidatedoperatingincomeandthensubtract
minorityinterestsfromthefirmvaluetoarriveatthevalueofthe
equityinthefirm.Whatiswrongwiththisapproach?

Aswath Damodaran

44

Equity Value and Per Share Value: A Test

AssumethatyouhavedoneanequityvaluationofMicrosoft.Thetotal
valueforequityisestimatedtobe$400billionandthereare5billion
sharesoutstanding.Whatisthevaluepershare?

Aswath Damodaran

45

An added fact

In1999,Microsofthad500millionoptionsoutstanding,grantedto
employeesovertime.Theseoptionshadanaverageexercisepriceof$
20(thecurrentstockpriceis$80).Estimatethevaluepershare.

Aswath Damodaran

46

Equity Value and Per Share Value

Theconventionalwayofgettingfromequityvaluetopersharevalueis
todividetheequityvaluebythenumberofsharesoutstanding.This
approachassumes,however,thatcommonstockistheonlyequity
claimonthefirm.
Inmanyfirms,thereareotherequityclaimsaswellincluding:
warrants,thatarepubliclytraded
managementandemployeeoptions,thathavebeengranted,butdonot
trade
conversionoptionsinconvertiblebonds
contingentvaluerights,thatarealsopubliclytraded.

Thevalueofthesenonstockequityclaimshastobesubtractedfrom
thevalueofequitybeforedividingbythenumberofsharesoutstanding.

Aswath Damodaran

47

Factors in Using Option Pricing Models to Value

Convertibles and Warrants

Optionpricingmodelscanbeusedtovaluetheconversionoptionwith
threecaveats
conversionoptionsarelongterm,makingtheassumptionsaboutconstant
varianceandconstantdividendyieldsmuchshakier,
conversionoptionsresultinstockdilution,and
conversionoptionsareoftenexercisedbeforeexpiration,makingit
dangeroustouseEuropeanoptionpricingmodels.

Theseproblemscanbepartiallyalleviatedbyusingabinomialoption
pricingmodel,allowingforshiftsinvarianceandearlyexercise,and
factoringinthedilutioneffect

Aswath Damodaran

48

Options Outstanding: Boeing

ExercisePrice

Number Life
(in000s)

BlackScholes
Value/option

$16.35
4315
4.5
$17.71
$23.32
8480
5
$14.23
$38.44
1779
7.1
$10.75
$41.25
4598
7.4
$10.34
$53.37
9481
8.7
$9.12
TotalValueofOptionsOutstandingatBoeing=

Aswath Damodaran

TotalValue(in
000s)
$76,418.65
$120,670.40
$19,124.25
$47,543.32
$86,466.72
$350,223.34

49

Options Outstanding: The Home Depot

AverageExercisePriceofOptionsOutstanding=$20.17
StockPriceattimeofanalysis=$37.00
AverageMaturityofOptionsOutstanding=7.6years
NumberofOptionsOutstanding=47.728million
StandardDeviationofTheHomeDepotstock=30%
ValueofOptionsOutstanding=$2,021million

Aswath Damodaran

50

Steps in Getting to Value Per Share

Step1:Valuethefirm,usingdiscountedcashfloworothervaluation
models.
Step2:Subtractoutthevalueoftheoutstandingdebttoarriveatthe
valueofequity.Alternatively,skipstep1andestimatetheofequity
directly.
Step3:Subtractoutthemarketvalue(orestimatedmarketvalue)of
otherequityclaims:
ValueofWarrants=MarketPriceperWarrant*NumberofWarrants :
AlternativelyestimatethevalueusingOPM
ValueofConversionOption=MarketValueofConvertibleBondsValue
ofStraightDebtPortionofConvertibleBonds

Step4:Dividetheremainingvalueofequitybythenumberofshares
outstandingtogetvaluepershare.

Aswath Damodaran

51

Boeing: Valuation - Summary of Inputs

Length
GrowthInputs
ReinvestmentRate
ReturnonCapital
ExpectedGrowthrate
CostofCapitalInputs
Beta
CostofDebt
DebtRatio
CostofCapital
GeneralInformation
TaxRate

Aswath Damodaran

HighGrowthPhase
10years

StableGrowthPhase
Foreverafteryear10

65.98%
6.59%%
4.35%

59.36%
8.42%
5.00%

1.01
5.50%
19.92%
9.17%

1.00
5.50%
30.00%
8.42%

35%

35%

52

+
Boeing:
A Valuation

Terminal
EBIT(1-t)
$1,723
year
$1,798
$1,876
$1,958
$2,043
$2,132 (0.80)
$2,225
$2,321
$2,528
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Firm
Riskfree
Beta
R
X
Unlevered
Firms
Historical
Country
Reinvestment
Return
isk Value:
Premium
ofD/E
Growth
on
Equity
Debt
Risk
Cashflow
Value
at
Rate
US
Capital
Growth
Beta
Cost
17,500
Rate
:for
of=to
Capital
1078/(.0842-.05)
Firm
(WACC)
==10.58%
31,496
+ 3.58%
(0.20)$2,422
= 9.17%
10
- Reinv
$1,137
$1,186
$1,238
$1,292
$1,348 $1,407 $1,468
$1,532
$1,598 $1,668
EBIT(1-t)
in
g
10.58%
(5%+
E
+
Government
1.01
5.5%
Sectors:
Ratio:
Premium
65.98%
6.59%
=
Cash:
=EBIT
5%;
80.08%
0.50%)(1-.35)
25.14%
(1-t)
0.88
Beta
: DBond
==
1,651
4,323
1.00;
19.92%
FCFF
$586
$612
$638
$695 $725
$757
$790
$824 $860
.6598*
D/(D+E)
-=
Rate
5.5%
0%
Nt
Debt:
3.58%
CpX
= .0659
5%
= 30%;ROC=8.42%
=8,194
.0435
568 $666

$2,654
$1,576
$1,078

-=Equity
4.35
Reinvestment
Chg%WC
13,630
Rate=59.36%
667
= FCFF
-Options
350
417
Reinvestment$13.14
Value/Share
Rate = 74.77%

Aswath Damodaran

53

The Home Depot: Valuation Inputs

Length
GrowthInputs
ReinvestmentRate
ReturnonCapital
ExpectedGrowthrate
CostofCapitalInputs
Beta
CostofDebt
DebtRatio
CostofCapital
GeneralInformation
TaxRate

Aswath Damodaran

HighGrowthPhase
10years

StableGrowthPhase
Foreverafteryear10

88.62%
16.37%
14.51%

35.46%
14.10%
5.00%

0.87
5.80%
4.55%
9.52%

0.87
5.50%
30.00%
7.92%

35%

35%

54

EBIT(1-t)
2095
2399
2747
3146
3602
4125
4723
5409
6194
7092
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Firm
Riskfree
Beta
R
X
Unlevered
Firms
Historical
Country
Reinvestment
Return
Premium
ofD/E
Growth
on
Equity
Debt
Risk
Cashflow
Value
at
Rate
US
Capital
Growth
Beta
Cost
68,949
Rate
:for
of=to
Capital
4806/(.0792-.05)
Firm A
(WACC)
==9.79%
164,486
(0.9555) + 3.77% (0.0445) = 9.52%
10
+isk Value:
The
Home
Depot:
Valuation
1857
2126
2434
2788
3192
3655
4186
4793
5489
6285
EBIT(1-t)
in
g
9.79%
(5%+
E
+
Government
0.87
5.5%
Sectors:
Ratio:
Premium
88.62%
-16.37%
Reinv
=
Cash:
=EBIT
5%;
95.55%
0.80%)(1-.35)
4.76%
(1-t)
0.86
Beta
: DBond
==
1,829
0.87;
4.45%
62
.8862*.1637=
D/(D+E)
-=
Rate
5.5%
0%
FCFF
238
273
313
358
410
469
538
616
705
807
Nt
Debt:
3.77%
CpX
= 5%
= 30%;ROC=14.1%
.1451
4,081
1,799
- Chg WC
14.51
Reinvestment
=Equity
%
64,930
Rate=35.46%
190
= FCFF
-Options
2,021
<160>
Reinvestment$42.55
Value/Share
Rate =108.75%

Aswath Damodaran

55

InfoSoft: Valuation Estimates

Length
GrowthInputs
ReinvestmentRate
ReturnonCapital
ExpectedGrowthrate
CostofCapitalInputs
Beta
CostofDebt
DebtRatio
CostofCapital
GeneralInformation
TaxRate

Aswath Damodaran

HighGrowthPhase
5years

StableGrowthPhase
Foreverafteryear5

112.17%
23.67%
26.55%

29.07%
17.2%
5.00%

1.49
6.00%
6.62%
12.54%

1.20
6.00%
6.62%
11.05%

42%

42%

56

9520
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Firm
Riskfree
Beta
R
X
Unlevered
Firms
Historical
Country
Reinvestment
Return
EBIT(1-t)
3535
4474
5661
7165
isk Value:
Premium
ofD/E
Growth
on
Equity
Debt
Risk
Cashflow
Value
at
Rate
US
Capital
Growth
Beta
Cost
59,218
Rate
:for
of=in
to
Capital
6753/(.1106-.05)
Firm (WACC) ==13.2%
111,384
(0.9338) + 3.36% (0.0662) = 12.55%
10
+9067
InfoSoft:
A
Valuation
EBIT(1-t)
EBIT
g
13.20%
(5%+
E
+
Government
1.49
5.5%
Sectors:
Ratio:
Premium
112.17%
-23.67%
3965
5029
6350
7937
10071
2773
Reinv
=
Cash:
= 5%;
93.38%
(1-t)
1.00%)(1-.42)
7.09%
1.43
Beta
: DBond
==
2,793
1.20;
6.62%
500
1.1217*.2367
D/(D+E)
-=
Rate
5.5%
0%
FCFF
6753
-430
-545
-689
-872
-1104
Nt
Debt:
3.36%
CpX
= 5%
= 6.62%;ROC=17.2%
=4,583
2,633
.2655
- Chg WC
26.55
Reinvestment
=Equity
%
55,135
Rate=29.07%
500
= FCFF
<340>
Reinvestment Rate = 112.17%

Aswath Damodaran

57

Relative Valuation

Inrelativevaluation,thevalueofanassetisderivedfromthepricing
of'comparable'assets,standardizedusingacommonvariablesuchas
earnings,cashflows,bookvalueorrevenues.Examplesinclude
Price/Earnings(P/E)ratios
andvariants(EBITmultiples,EBITDAmultiples,CashFlowmultiples)

Price/Book(P/BV)ratios
andvariants(Tobin'sQ)

Price/Salesratios

Aswath Damodaran

58

Equity Multiples: Determinants

P0
GordonGrowthModel:

Dividingbothsidesbytheearnings,

P0

EPS 0

Dividingbothsidesbythebookvalueofequity,
P0



BV 0

Ifthereturnonequityiswrittenintermsoftheretentionratioandthe
expectedgrowthrate P

0

BV 0

DividingbytheSalespershare,
P0

Sales 0

Aswath Damodaran

59

Firm Value Multiples

Thevalueofafirminstablegrowthcanbewrittenas:

V
ValueofFirm=

0

Dividingbothsidesbytheexpectedfreecashflowtothefirmyields
theValue/FCFFmultipleforastablegrowthfirm:
V0

FCFF1

Thevalue/EBITDAmultiple,forinstance,canbewrittenasfollows:
Value
(1- t)
Depr (t)/EBITDA CEx/EBITDA
Working Capital/EBITDA
=
+
EBITDA
kc - g
kc - g
kc - g
kc - g

Aswath Damodaran

60

Determinants of Multiples
Multiple
Price/EarningsRatio
Price/BookValueRatio
Price/SalesRatio
Value/EBITDA

DeterminingVariables
Growth,Payout,Risk
Growth,Payout,Risk,ROE
Growth,Payout,Risk,NetMargin
Growth,NetCapitalExpenditureneeds,
Leverage,Risk
Value/Sales
Growth,NetCapitalExpenditureneeds,
Leverage,Risk,OperatingMargin
Value/BookCapital
Growth,Leverage,RiskandROC
Companionvariableisinitalics.

Aswath Damodaran

61

Using Multiples based upon Comparables

SimpleAverages:Theaveragemultipleofcomparablefirmsisusedto
valueanyfirm.Thisworksonlyifthefirmissimilartotheaverage
firminthesector.
AdjustedAverages:Here,theaveragemultipleisadjustedusingone
variable.Forinstance,thePEratiomaybedividedbygrowthtoarrive
ataPEGratio.
RegressionEstimates:Here,themultipleisregressedagainstoneor
morevariables,andtheregressionisusedtoestimatethevalueany
firm.

Aswath Damodaran

62

PE Ratios and Growth Rates: Software Firms

CompanyName
SpanlinkCommunications
ExpertSoftware
AppliedMicrosystems
Tripos
MathSoft
Comshare
EaglePointSoftware
TSR
ComputerOutsourcingServices
DataResearchAssociates
Mecon
Forsoft
HIE
CFIProServices
AdeptTechnology
TechForce
InVisionTechnologies
AmericanSoftwareA
Viasoft
Micrografx
Orcad
MySoftware
IntegratedMeasurementSystems
Jetform
AladdinKnowledgeSystems
Average

Aswath Damodaran

PE

ExpectedGrowth

PEG

51.00
11.18
10.74
9.73
14.14
6.06
46.57
12.56
16.04
12.14
46.55
16.86
39.53
13.54
23.96
23.15
9.83
8.33
9.05
122.17
18.14
153.00
15.71
10.87
9.53
28.41

50%
15%
20%
25%
30%
10%
5%
20%
40%
15%
30%
25%
38%
22%
19%
15%
23%
30%
17%
35%
16%
30%
11%
20%
18%
23%

1.02
0.75
0.54
0.39
0.47
0.61
9.31
0.63
0.40
0.81
1.55
0.67
1.04
0.62
1.26
1.54
0.43
0.28
0.53
3.49
1.13
5.10
1.43
0.54
0.53
1.40

63

Valuing InfoSoft

UsingSimpleAverage
ValueofEquity
=InfoSoftNetEarningsin1998*AveragePEratioforsector
=$977,300*28.41=$27.765million

UsingAverageAdjustedforGrowth
PEGRatio=1.40
ExpectedGrowthRateforInfoSoft=27.03%
ValueofEquity=$977,300million*1.40*27.03=$37.056million

Aswath Damodaran

64

Boeing: Price to Book Ratios for

Aerospace/Defense Firms
Company
AARCorp.
OrbitalSciCorp
CAEInc.
AlliantTechsystems
PrecisionCastparts
HowmetIntl
CordantTechn.
LittonInds.
SundstrandCorp.
NorthropGrumman
RaytheonCo.'A'
Gen'lDynamics
BombardierInc.'B'
LockheedMartin
Boeing

PBV
1.83
2.32
3.66
3.93
1.77
6.00
3.33
2.49
7.17
1.59
0.65
4.22
4.46
2.83
3.50

ROE
11.85%
3.28%
25.41%
25.57%
14.46%
27.10%
13.95%
15.38%
33.03%
11.02%
10.51%
16.40%
16.23%
19.29%
9.09%

StandaradDeviationinStockPrices
61.19%
32.46%
36.63%
26.07%
47.02%
27.62%
27.15%
35.62%
18.15%
37.59%
36.12%
19.48%
22.16%
39.07%
34.32%

Average

3.32

16.84%

33.38%

Aswath Damodaran

65

PBV Regression

Regressingpricetobookratiosagainstreturnsonequityandrisk
(standarddeviation),weget

PBV=3.54+ 12.69ROE6.97StandardDeviationR2=76.15%
(2.97) (3.35)
(2.41)
Usingthisregression,wegetapredictedpricetobookvalueratiofor
Boeing, based upon its return on equity of 9.09% and a standard
deviationof34.32%:
PredictedPBVBoeing=3.54+ 12.69(.0909)6.97(.3432)=2.27

Boeing,whichistradingat3.50timesbookvalue,looksovervalued.

Aswath Damodaran

66

Is Boeing fairly valued?

BaseduponthePBVratio,isBoeingunder,overorcorrectlyvalued?
UnderValued
OverValued
CorrectlyValued
Willthisvaluationgiveyouahigherorlowervaluationthanthe
discountedcashflowvaluation?
Higher
Lower

Aswath Damodaran

67

Relative Valuation Assumptions

Assumethatyouarereadinganequityresearchreportwhereabuy
recommendationforacompanyisbeingbaseduponthefactthatits
PEratioislowerthantheaveragefortheindustry.Implicitly,whatis
theunderlyingassumptionorassumptionsbeingmadebythisanalyst?
Thesectoritselfis,onaverage,fairlypriced
Theearningsofthefirmsinthegrouparebeingmeasuredconsistently
Thefirmsinthegroupareallofequivalentrisk
Thefirmsinthegroupareallatthesamestageinthegrowthcycle
Thefirmsinthegroupareofequivalentriskandhavesimilarcash
flowpatterns
Alloftheabove

Aswath Damodaran

68

Value Enhancement: Back to Basics

AswathDamodaran
http://www.stern.nyu.edu/~adamodar

Aswath Damodaran

69

Price Enhancement versus Value

Enhancement

Aswath Damodaran

70

The Paths to Value Creation

UsingtheDCFframework,therearefourbasicwaysinwhichthevalue
ofafirmcanbeenhanced:
Thecashflowsfromexistingassetstothefirmcanbeincreased,byeither
increasingaftertaxearningsfromassetsinplaceor
reducingreinvestmentneeds(netcapitalexpendituresorworkingcapital)

Theexpectedgrowthrateinthesecashflowscanbeincreasedbyeither
Increasingtherateofreinvestmentinthefirm
Improvingthereturnoncapitalonthosereinvestments

Thelengthofthehighgrowthperiodcanbeextendedtoallowformoreyears
ofhighgrowth.
Thecostofcapitalcanbereducedby
Reducingtheoperatingriskininvestments/assets
Changingthefinancialmix
Changingthefinancingcomposition

Aswath Damodaran

71

A Basic Proposition

Foranactiontoaffectthevalueofthefirm,ithasto

Affectcurrentcashflows(or)
Affectfuturegrowth(or)
Affectthelengthofthehighgrowthperiod(or)
Affectthediscountrate(costofcapital)

Proposition1:Actionsthatdonotaffectcurrentcashflows,future
growth,thelengthofthehighgrowthperiodorthediscountrate
cannotaffectvalue.

Aswath Damodaran

72

Value-Neutral Actions

Stocksplitsandstockdividendschangethenumberofunitsofequityinafirm,
butcannotaffectfirmvaluesincetheydonotaffectcashflows,growthorrisk.
Accountingdecisionsthataffectreportedearningsbutnotcashflowsshouldhave
noeffectonvalue.
ChanginginventoryvaluationmethodsfromFIFOtoLIFOorviceversainfinancial
reportsbutnotfortaxpurposes
Changingthedepreciationmethodusedinfinancialreports(butnotthetaxbooks)
fromacceleratedtostraightlinedepreciation
Majornoncashrestructuringchargesthatreducereportedearningsbutarenottax
deductible
Usingpoolinginsteadofpurchaseinacquisitionscannotchangethevalueofatarget
firm.

Decisionsthatcreatenewsecuritiesontheexistingassetsofthefirm(without
alteringthefinancialmix)suchastrackingstockcannotcreatevalue,thoughthey
mightaffectperceptionsandhencetheprice.

Aswath Damodaran

73

Value Creation 1: Increase Cash Flows from

Assets in Place

Theassetsinplaceforafirmreflectinvestmentsthathavebeenmade
historicallybythefirm.Totheextentthattheseinvestmentswere
poorlymadeand/orpoorlymanaged,itispossiblethatvaluecanbe
increasedbyincreasingtheaftertaxcashflowsgeneratedbythese
assets.
Thecashflowsdiscountedinvaluationareaftertaxesand
reinvestmentneedshavebeenmet:
EBIT(1t)
(CapitalExpendituresDepreciation)
ChangeinNoncashWorkingCapital
=FreeCashFlowtoFirm

Proposition2:Afirmthatcanincreaseitscurrentcashflows,without
significantlyimpactingfuturegrowthorrisk,willincreaseitsvalue.

Aswath Damodaran

74

Ways of Increasing Cash Flows from Assets in

Place
Better
Revenues
Divest
More
Reduce
Live
off
efficient
inventory
assets
past
tax rate
overthat
have
-operations
investment
management
moving
negative
income
and
and
EBIT
to lower tax locales
* transfer
-cost
tighter
Operating
cuttting:
credit
pricing
Margin
policies
-Higher
risk management
Margins
= EBIT
- Tax Rate * EBIT
= EBIT (1-t)
+ Depreciation
- Capital Expenditures
- Chg in Working Capital
= FCFF

Aswath Damodaran

75

Operating Margin and Value Per Share: Boeing

$140.00

$120.00

$100.00

$80.00

$60.00

$40.00

$20.00

$0.00
3%

Aswath Damodaran

5%

7%

9%

11%

13%

15%

76

Tax Rate and Value: InfoSoft

Figure 25.3: Tax Rate and InfoSoft Value

$60,000

$59,000

$58,000

$57,000

$56,000

$55,000

$54,000

$53,000

$52,000
0%

Aswath Damodaran

10%

20%

30%

40%

50%

77

Working Capital and Value: The Home Depot

$50.00

$45.00

$40.00

$35.00

$30.00

$25.00

$20.00

$15.00

$10.00

$5.00

$0.00
0%

Aswath Damodaran

5%

10%

15%

20%

78

Value Creation 2: Increase Expected Growth

Keepingallelseconstant,increasingtheexpectedgrowthinearnings
willincreasethevalueofafirm.
Theexpectedgrowthinearningsofanyfirmisafunctionoftwo
variables:
Theamountthatthefirmreinvestsinassetsandprojects
Thequalityoftheseinvestments

Aswath Damodaran

79

Value Enhancement through Growth

Reinvestment
Reinvest
Do
Increase
acquisitions
operating
capital
moreRate
inturnover ratio
projects
margins
* Return on Capital
= Expected Growth Rate

Aswath Damodaran

80

Reviewing the Valuation Inputs

CostofCapital
ReturnonCapital
ReinvestmentRate
ExpectedGrowthRate
ValuePerShare

Aswath Damodaran

Boeing
9.17%
6.59%
65.98%
5.72%
$13.14

TheHomeDepot
9.51%
16.38%
88.62%
14.51%
$42.55

InfoSoft
12.55%
23.67%
112.17%
27.03%
$55.15

81

Changing the Reinvestment Rate

30.00%

20.00%

10.00%

0.00%
20%

10%

10%

20%

10.00%

20.00%

30.00%

Boeing

Aswath Damodaran

TheHomeDepot

InfoSoft

82

Reinvestment Rate and Value

IncreasingthereinvestmentrateincreasesvaluepershareatThe
HomeDepotandInfoSoft,butreducesitatBoeing.Why?

Aswath Damodaran

83

Value Creation 3: Increase Length of High

Growth Period

Everyfirm,atsomepointinthefuture,willbecomeastablegrowth
firm,growingatarateequaltoorlessthantheeconomyinwhichit
operates.
Thehighgrowthperiodreferstotheperiodoverwhichafirmisable
tosustainagrowthrategreaterthanthisstablegrowthrate.
Ifafirmisabletoincreasethelengthofitshighgrowthperiod,other
thingsremainingequal,itwillincreasevalue.
Thelengthofthehighgrowthperiodisadirectfunctionofthe
competitiveadvantagesthatafirmbringsintotheprocess.Creating
newcompetitiveadvantageoraugmentingexistingonescancreate
value.

Aswath Damodaran

84

3.1: The Brand Name Advantage

Somefirmsareabletosustainabovenormalreturnsandgrowth
becausetheyhavewellrecognizedbrandnamesthatallowthemto
chargehigherpricesthantheircompetitorsand/orsellmorethantheir
competitors.
Firmsthatareabletoimprovetheirbrandnamevalueovertimecan
increaseboththeirgrowthrateandtheperiodoverwhichtheycan
expecttogrowatratesabovethestablegrowthrate,thusincreasing
value.

Aswath Damodaran

85

Illustration: Valuing a brand name: Coca Cola

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

GenericColaCompany
18.56%
7.50%
1.67
1.67
31.02%
12.53%
65.00%(19.35%)
65.00%(47.90%)
20.16%
8.15%
10years
10yea
12.33%
12.33%
97.65%
97.65%
4.16%
4.16%
2.35%
2.35%
12.13%
12.13%
$115
$13
86

3.2: Patents and Legal Protection

Themostcompleteprotectionthatafirmcanhavefromcompetitive
pressureistoownapatent,copyrightorsomeotherkindoflegal
protectionallowingittobethesoleproducerforanextendedperiod.
Notethatpatentsonlyprovidepartialprotection,sincetheycannot
protectafirmagainstacompetitiveproductthatmeetsthesameneed
butisnotcoveredbythepatentprotection.
Licensesandgovernmentsanctionedmonopoliesalsoprovide
protectionagainstcompetition.Theymay,however,comewith
restrictionsonexcessreturns;utilitiesintheUnitedStates,for
instance,aremonopoliesbutareregulatedwhenitcomestoprice
increasesandreturns.

Aswath Damodaran

87

3.3: Switching Costs

Anotherpotentialbarriertoentryisthecostassociatedwithswitching
fromonefirmsproductstoanother.
Thegreatertheswitchingcosts,themoredifficultitisforcompetitors
tocomeinandcompeteawayexcessreturns.
Firmsthatdevisewaystoincreasethecostofswitchingfromtheir
productstocompetitorsproducts,whilereducingthecostsof
switchingfromcompetitorproductstotheirownwillbeableto
increasetheirexpectedlengthofgrowth.

Aswath Damodaran

88

3.4: Cost Advantages

Thereareanumberofwaysinwhichfirmscanestablishacostadvantage
overtheircompetitors,andusethiscostadvantageasabarriertoentry:
Inbusinesses,wherescalecanbeusedtoreducecosts,economiesofscalecan
givebiggerfirmsadvantagesoversmallerfirms
Owningorhavingexclusiverightstoadistributionsystemcanprovidefirms
withacostadvantageoveritscompetitors.
Owningorhavingtherightstoextractanaturalresourcewhichisinrestricted
supply(Theundevelopedreservesofanoilorminingcompany,forinstance)

Thesecostadvantageswillshowupinvaluationinoneoftwoways:
Thefirmmaychargethesamepriceasitscompetitors,buthaveamuchhigher
operatingmargin.
Thefirmmaychargelowerpricesthanitscompetitorsandhaveamuchhigher
capitalturnoverratio.

Aswath Damodaran

89

Growth Period and Value: InfoSoft

Figure 25.7: Value of InfoSoft and Expected Growth Period

120

100

80

60

40

20

0
1

Aswath Damodaran

10

90

Gauging Barriers to Entry

Whichofthefollowingbarrierstoentryaremostlikelytoworkfor
thefirmthatyouareanalyzing?
BrandName
PatentsandLegalProtection
SwitchingCosts
CostAdvantages

Aswath Damodaran

91

Value Creation 4: Reduce Cost of Capital

Thecostofcapitalforafirmcanbewrittenas:
CostofCapital=ke(E/(D+E))+kd(D/(D+E))

Where,
ke=CostofEquityforthefirm
kd=Borrowingrate(1taxrate)

Thecostofequityreflectstherateofreturnthatequityinvestorsinthe
firmwoulddemandtocompensateforrisk,whiletheborrowingrate
reflectsthecurrentlongtermrateatwhichthefirmcanborrow,given
currentinterestratesanditsowndefaultrisk.
Thecashflowsgeneratedovertimearediscountedbacktothepresent
atthecostofcapital.Holdingthecashflowsconstant,reducingthe
costofcapitalwillincreasethevalueofthefirm.

Aswath Damodaran

92

Reducing Cost of Capital

Swaps
Cost
Change
Make
Reduce
Match
Changing
More
Flexible
Outsourcing
Hybrids
Derivatives
ofproduct
debt
Equity
wage
operating
financing
to or
contracts
(E/(D+E)
service
mix &
+ Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital
less discretionary
leverage
assets,
product
effective
cost
structure
reducing to
customers
default
characteristics
advertising
risk

Aswath Damodaran

93

Actual versus Optimal Debt Ratios

Boeing
TheHomeDepot
InfoSoft

Aswath Damodaran

Current
Optimal
CostofCapital DebtRatio CostofCapital
DebtRatio
20.09%
9.17%
30%
9.16%
4.55%
9.51%
20%
9.23%
6.55%
12.55%
20%
12.28%

94

Changing Financing Type

Thefundamentalprincipleindesigningthefinancingofafirmisto
ensurethatthecashflowsonthedebtshouldmatchascloselyaspossible
thecashflowsontheasset.
Bymatchingcashflowsondebttocashflowsontheasset,afirm
reducesitsriskofdefaultandincreasesitscapacitytocarrydebt,which,
inturn,reducesitscostofcapital,andincreasesvalue.
Firmswhichmismatchcashflowsondebtandcashflowsonassetsby
using
Shorttermdebttofinancelongtermassets
Dollardebttofinancenondollarassets
Floatingratedebttofinanceassetswhosecashflowsarenegativelyornot
affectedbyinflation
willendupwithhigherdefaultrisk,highercostsofcapitalandlowerfirmvalue.

Aswath Damodaran

95

TheValueEnhancementChain
AssetsinPlace

Expected Growth

Length of High Growth Peri od

Cost of Financing

Aswath Damodaran

Gimme
1. Divest assets/projects with
Divestiture Value >
Continuing Value
2. Terminate projects with
Liquidation Value >
Continuing Value
3. Eliminate operating
expensesthat generate no
current revenues and no
growth.
Eliminate new capital
expenditures that are expected
to earn less than the cost of
capital
If any of the fi rms products or
services canbe patented and
protected, do so

Oddson.
Couldworkif..
1. Reducenet working capital 1. Changepricing strategy to
requirements, by reducing
maximize the product of
inventory andaccounts
profit margins andturnover
receivable, or by increasing
ratio.
accounts payable.
2. Reducecapital maintenance
expenditureson assets in
place.

1. Use swaps and de

rivatives
to match debt more closely
to fir ms assets
2. Recapitali ze to move the
fi rm towards its optimal
debt ratio.

1. Changefi nancing type and

use innovative securiti es to
reflect the typesof assets
being financed
2. Use the optimal fi nancing
mix to finance new
investments.
3. Make cost structure more
fl exible to reduce operating
leverage.

Increase reinvestment rate or

marginal return on capital or
both in firm s existing
businesses.
Use economies of scale or cost
advantages to create higher
return on capital.

Increase reinvestment rate or

marginal return on capital or
both in new businesses.
1. Buil d up brand name
2. Increase the cost of
switching from product and
reducecost of switching to
it.
Reducethe operating risk of the
fi rm, by making products less
discretionary to customers.

96

3830
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Firm
Riskfree
Beta
R
X
Unlevered
Firms
Historical
Country
Reinvestment
Return
EBIT(1-t)
1788
1935
2095
2267
2454
2657
2876
3113
3370
3648
Premium
ofD/E
Growth
on
Equity
Debt
Risk
Cashflow
Value
at
Rate
US
Capital
Growth
Beta
Cost
Rate
:for
of=to
Capital
2,298(.0842-.05)
Firm (WACC) Valuation
==10.56%
67,148 (0.80) + 3.58% (0.20) = 9.16%
10
+isk Value:
Boeing:
A33,254
Restructured
EBIT(1-t)
in
g
13.85%
(5%+
E
+
Government
1.01
5.5%
Sectors:
Ratio:
Premium
65.98%
-12.50%
1179
1277
1382
1496
1619
1753
1898
2054
2223
2407
1532
Reinv
=
Cash:
=EBIT
5%;
80.08%
0.50%)(1-.35)
25.14%
(1-t)
0.88
Beta
: DBond
==
2,123
4,323
1.00;
19.92%
.6598*.125
D/(D+E)
-=
Rate
5.5%
0%
FCFF
608
658
713
1059
1146
1241
2298
771
835
904
978
Nt
Debt:
3.58%
CpX
= 5%
= 30%;ROC=12.5%
= .08
8,194
1,039
- Chg%WC
8.25
Reinvestment
=Equity
40,776
Rate=40%
667
= FCFF
-Options
350
417
Reinvestment$28.73
Value/Share
Rate = 80.38%

Aswath Damodaran

97

5950
7036
8320
9837
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Firm
Riskfree
Beta
R
X
Unlevered
Firms
Historical
Country
Reinvestment
Return
EBIT(1-t)
2177
2574
3044
3599
4256
5032
Premium
ofD/E
Growth
on
Equity
Debt
Risk
Cashflow
Value
at
Rate
US
Capital
Growth
Beta
Cost
89,850
Rate
:for
of=to
Capital
6666/(.0792-.05)
Firm A
(WACC)
==10.39%
228,146(0.80)
+ 4.55% (0.20) = 9.23%
10
+isk Value:
The
Home
Depot:
Restructured
Valuation
8122
9604
11356
EBIT(1-t)
in
g
10.39%
(5%+
E
+
Government
0.98
5.5%
Sectors:
Ratio:
Premium
108.76%
-16.77%
2513
2972
3514
4155
4913
5809
6869
Reinv
=
Cash:
=EBIT
5%;
80%
2.00%)(1-.35)
25%
(1-t)
0.86
Beta
D: = Bond
20%
=1,841
0.87;
62
-1086
-1284
1.0876*.1677=
D/(D+E)
-=
Rate
5.5%
0%
FCFF
-1519
-336
-397
-470
-556
-657
-777
-919
Nt
Debt:
4.55%
CpX
= 5%
= 30%;ROC=14.1%
3,885
1,813
.1824
- Chg WC
18.24
Reinvestment
=Equity
%
86,027
Rate=35.46%
190
= FCFF
-Options
2,021
<161>
Reinvestment$56.81
Value/Share
Rate =108.76%

Aswath Damodaran

98

7165
11474
14521
18376
23255
29429
Current
Expected
Stable
Terminal
Cost
Weights
Discount
Firm
Riskfree
Beta
R
X
Unlevered
Firms
Historical
Country
Reinvestment
Return
EBIT(1-t)
3535
4474
5661
isk Value:
Premium
ofD/E
Growth
on
Equity
Debt
Risk
Cashflow
Value
at
Rate
US
Capital
Growth
Beta
121522
Cost
for
: Restructured
of=in
to
Capital
21918/(.1035-.05)
Firm (WACC) =Valuation
14.02%
= 409453
(0.80) + 5.37% (0.20) = 12.29%
10
+9067
InfoSoft:
ARate
12871
16288
20613
26086
33011
EBIT(1-t)
EBIT
g
14.02%
(5%+
E
+
Government
1.64
5.5%
Sectors:
Ratio:
Premium
112.17%
-23.67%
3965
5018
6350
8047
10170
Reinv
=
Cash:
= 5%;
80%
(1-t)
4.00%)(1-.42)
7.09%
1.43
Beta
D: = Bond
20%
=2,793
1.20;
500
-1397
-1767
-2237
-2831
-3582
1.1217*.2367=
D/(D+E)
-=
Rate
5.5%
0%
FCFF
-430
-544
-689
-872
-1103
Nt
Debt:
5.37%
CpX
= 5%
=20%;ROC=17.2%
4,583
2,633
.2655
- Chg WC
26.55
Reinvestment
=Equity
%
117439
Rate=29.07%
500
= FCFF
<340>
Reinvestment Rate = 112.17%

Aswath Damodaran

99

First Principles

Investinprojectsthatyieldareturngreaterthantheminimumacceptable
hurdlerate.
Thehurdlerateshouldbehigherforriskierprojectsandreflectthefinancingmix
usedownersfunds(equity)orborrowedmoney(debt)
Returnsonprojectsshouldbemeasuredbasedoncashflowsgeneratedandthe
timingofthesecashflows;theyshouldalsoconsiderbothpositiveandnegative
sideeffectsoftheseprojects.

Chooseafinancingmixthatminimizesthehurdlerateandmatchestheassets
beingfinanced.
Iftherearenotenoughinvestmentsthatearnthehurdlerate,returnthecashto
stockholders.
Theformofreturnsdividendsandstockbuybackswilldependuponthe
stockholderscharacteristics.

Objective:MaximizetheValueoftheFirm
Aswath Damodaran

100