Aswath Damodaran 1

Updated: January 2025

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§ In intrinsic valuation, you value an asset based upon its

fundamentals (or intrinsic characteristics).
§ For cash flow generating assets, the intrinsic value will be a
function of the magnitude of the expected cash flows on the asset
over its lifetime and the uncertainty about receiving those cash
flows.
§ Discounted cash flow (DCF) valuation is a tool for estimating
intrinsic value, where the expected value of an asset is written as the
present value of the expected cash flows on the asset, with either the
cash flows or the discount rate adjusted to reflect the risk.
§ Intrinsic valuation models predate the modern DCF model, since
investors through the ages have found ways to weight in expected
cash flows into value.

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§ The value of a risky asset can be estimated by discounting the

expected cash flows on the asset over its life at a risk-adjusted
discount rate:

where the asset has an n-year life, E(CFt) is the expected cash flow in
period t and r is a discount rate that reflects the risk of the cash flows.
§ Alternatively, we can replace the expected cash flows with the
guaranteed cash flows we would have accepted as an alternative
(certainty equivalents) and discount these at the riskfree rate:

where CE(CFt) is the certainty equivalent of E(CFt) and rf is the riskfree

rate.

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§ The value of an asset is the risk-adjusted present value of the cash

flows:

§ The “IT” proposition: If IT does not affect the expected cash flows
or the riskiness of the cash flows, IT cannot affect value.
§ The “DON’T BE A WUSS” proposition: Valuation requires that you
make estimates of expected cash flows in the future, not that you be
right about those cashflows. So, uncertainty is not an excuse for not
making estimates.
§ The “DUH” proposition: For an asset to have value, the expected
cash flows have to be positive some time over the life of the asset.
§ The “DON’T FREAK OUT” proposition: A business with negative
cash flows in the early years can still be valuable if it has more than
proportionate positive cash flows in the later years.

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Firm Valuation: Value the entire business

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Equity valuation: Value just the

equity claim in the business

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Figure 5.5: Equity Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

Present value is value of just the equity claims on the firm

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Figure 5.6: Firm Valuation

Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets, Discount rate reflects the cost
prior to any debt payments of raising both debt and equity
but after firm has financing, in proportion to their
reinvested to create growth use
assets Growth Assets Equity

Present value is value of the entire firm, and reflects the value of
all claims on the firm.

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§ To get from firm value to equity value, which of the following

would you need to do?
a. Subtract out the value of long-term debt
b. Subtract out the value of all debt
c. Subtract the value of any debt that was included in the cost of capital
calculation
d. Subtract out the value of all liabilities in the firm

§ Doing so, will give you a value for the equity which is
a. greater than the value you would have got in an equity valuation
b. lesser than the value you would have got in an equity valuation
c. equal to the value you would have got in an equity valuation

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§ Assume that you are analyzing a company with the following

cashflows for the next five years.
Year CF to Equity Interest Expense (1-t) CF to Firm
1 $ 50 $ 40 $ 90
2 $ 60 $ 40 $ 100
3 $ 68 $ 40 $ 108
4 $ 76.2 $ 40 $ 116.2
5 $ 83.49 $ 40 $ 123.49
Term Value $ 1603.0 $ 2363.008
§ Assume also that the cost of equity is 13.625% and the firm can
borrow long term at 10%. (The tax rate for the firm is 50%.)
§ The current market value of equity is $1,073 and the value of debt
outstanding is $800.

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§ Method 1: Discount CF to Equity at Cost of Equity to get

value of equity
§ Cost of Equity = 13.625%
§ Value of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 +
76.2/1.136254 + (83.49+1603)/1.136255 = $1073
§ Method 2: Discount CF to Firm at Cost of Capital to get value
of firm
§ Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
§ Cost of Capital = 13.625% (1073/1873) + 5% (800/1873) = 9.94%
§ PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944
+ (123.49+2363)/1.09945 = $1873
§ Value of Equity = Value of Firm - Market Value of Debt
§ = $ 1873 - $ 800 = $1073

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§ Discounting Consistency Principle: Never mix and match cash

flows and discount rates. If your cash flows are after debt
payments, i.e., to equity, the discount rate has to be the cost of
equity. If your cash flows are pre-debt cash flows, i.e., to the firm,
the discount rate has to be the cost of capital.
§ The Mismatch Effect: Mismatching cash flows to discount rates
is deadly.
§ Discounting cashflows after debt cash flows (equity cash flows) at the
cost of capital will lead to an upwardly biased estimate of the value of
equity.
§ Discounting pre-debt cashflows (cash flows to the firm) at the cost of
equity will yield a downward biased estimate of the value of the firm.

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§ Error 1: Discount CF to Equity at Cost of Capital to get equity

value
§ PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944 +
(83.49+1603)/1.09945 = $1248
§ Value of equity is overstated by $175.

§ Error 2: Discount CF to Firm at Cost of Equity to get firm value

§ PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 +
116.2/1.136254 + (123.49+2363)/1.136255 = $1613
§ PV of Equity = $1612.86 - $800 = $813
§ Value of Equity is understated by $ 260.

§ Error 3: Discount CF to Firm at Cost of Equity, forget to subtract

out debt, and get too high a value for equity
§ Value of Equity = $ 1613
§ Value of Equity is overstated by $ 540

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The Big Picture

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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
cash flows Grows at constant rate
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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Input Dividend FCFE (Potential FCFF (firm)

Discount Model dividend) valuation model
discount model
Cash flow Dividend FCFE = Cash FCFF = Cash
flows after taxes, flows before debt
reinvestment payments but
needs and debt after
cash flows reinvestment &
taxes.

Expected growth In equity income In equity income In operating

and dividends and FCFE income and FCFF
Discount rate Cost of equity Cost of equity Cost of capital
Steady state When dividends When FCFE grow When FCFF grow
grow at constant at constant rate at constant rate
rate forever forever forever
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Expected Retention ratio

growth in net needed to
income sustain growth

Net Income Expected dividends = Expected net

* Payout ratio income * (1- Retention ratio)
= Dividends

Length of high growth period: PV of dividends during

high growth Stable Growth
Value of equity When net income and
dividends grow at constant
rate forever.
Cost of Equity
Rate of return
demanded by equity
investors

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Equity reinvestment
Expected growth in needed to sustain
net income growth
Free Cashflow to Equity
Non-cash Net Income
- (Cap Ex - Depreciation) Expected FCFE = Expected net income *
- Change in non-cash WC (1- Equity Reinvestment rate)
- (Debt repaid - Debt issued)
= Free Cashflow to equity

Length of high growth period: PV of FCFE during high

Value of Equity in non-cash Assets growth Stable Growth
+ Cash When net income and FCFE
= Value of equity grow at constant rate forever.

Cost of equity
Rate of return
demanded by equity
investors

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Reinvestment
Expected growth in needed to sustain
operating ncome growth

Free Cashflow to Firm

After-tax Operating Income
- (Cap Ex - Depreciation) Expected FCFF= Expected operating
- Change in non-cash WC income * (1- Reinvestment rate)
= Free Cashflow to firm

Value of Operatng Assets Length of high growth period: PV of FCFF during high
+ Cash & non-operating assets growth Stable Growth
- Debt When operating income and
= Value of equity FCFF grow at constant rate
forever.
Cost of capital
Weighted average of
costs of equity and
debt

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Above the fray!

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1. Get a handle on the past and the cross-section: While the past
is the past (and should have little relevance in determining value),
you can get clues about the future by looking at what your firm has
done in the past, and what other companies in the business are
doing now.
2. Risk and Discount Rates: Traditional financial theory
(unfortunately) has put too much of a focus on risk and discount
rates, but they do remain ingredients in valuing a company.
3. Estimate growth and future cash flows: This is where the
rubber meets the road in valuation. Estimating future cash flows is
never easy, should not be mechanical and should be built around
your story.
4. Apply Closure to cash flows: Since you cannot estimate cash
flows forever, you need to find a way to bring your valuation to
closure.
5. Tie up loose ends: Check to see what else in your business needs
to be valued or adjusted for to get to value per share.

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The D in the DCF..

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§ While discount rates obviously matter in DCF valuation, they don’t

matter as much as most analysts think they do.
§ At an intuitive level, the discount rate used should be consistent
with both the riskiness and the type of cashflow being discounted.
§ Equity versus Firm: If the cash flows being discounted are cash
flows to equity, the appropriate discount rate is a cost of equity. If the
cash flows are cash flows to the firm, the appropriate discount rate is
the cost of capital.
§ Currency: The currency in which the cash flows are estimated should
also be the currency in which the discount rate is estimated.
§ Nominal versus Real: If the cash flows being discounted are nominal
cash flows (i.e., reflect expected inflation), the discount rate should be
nominal

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Relative risk of Equity Risk Premium

Risk Adjusted Risk free rate in the company/equity in X
Cost of equity
=
currency of analysis + questiion
required for average risk
equity

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§ Estimation versus Economic uncertainty

§ Estimation uncertainty reflects the possibility that you could have the
“wrong model” or estimated inputs incorrectly within this model.
§ Economic uncertainty comes the fact that markets and economies can
change over time and that even the best models will fail to capture these
unexpected changes.
§ Micro uncertainty versus Macro uncertainty
§ Micro uncertainty refers to uncertainty about the potential market for a
firm’s products, the competition it will face and the quality of its
management team.
§ Macro uncertainty reflects the reality that your firm’s fortunes can be
affected by changes in the macro economic environment.
§ Discrete versus continuous uncertainty
§ Discrete risk lie dormant for periods but show up at points in time.
(Examples: A drug working its way through the FDA pipeline may fail at
some stage of the approval process or a company in Venezuela may be
nationalized)
§ Continuous risks like changes in interest rates or economic growth occur
continuously and affect value as they happen.

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§ Not all risk counts: While the notion that the cost of equity
should be higher for riskier investments and lower for safer
investments is intuitive, what risk should be built into the cost of
equity is the question.
§ Risk through whose eyes? While risk is usually defined in terms
of the variance of actual returns around an expected return, risk
and return models in finance assume that the risk that should be
rewarded (and thus built into the discount rate) in valuation
should be the risk perceived by the marginal investor in the
investment
§ The diversification effect: Most risk and return models in
finance also assume that the marginal investor is well diversified,
and that the only risk that he or she perceives in an investment is
risk that cannot be diversified away (i.e, market or non-
diversifiable risk). In effect, it is primarily economic, macro,
continuous risk that should be incorporated into the cost of equity.

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Model Expected Return Inputs Needed

CAPM E(R) = Rf + b (Rm- Rf) Riskfree Rate
Beta relative to market portfolio
Market Risk Premium
APM E(R) = Rf + Sbj (Rj- Rf) Riskfree Rate; # of Factors;
Betas relative to each factor
Factor risk premiums
Multi E(R) = Rf + Sbj (Rj- Rf) Riskfree Rate; Macro factors
factor Betas relative to macro factors
Macro economic risk premiums
Proxy E(R) = a + Sbj Yj Proxies
Regression coefficients

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§ In the CAPM, the cost of equity:

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

§ In APM or Multi-factor models, you still need a risk free rate, as

well as betas and risk premiums to go with each factor.
§ To use any risk and return model, you need
§ A riskfree rate as a base
§ A single equity risk premium (in the CAPM) or factor risk
premiums, in the the multi-factor models
§ A beta (in the CAPM) or betas (in multi-factor models)

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The Riskfree Rate

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§ On a riskfree investment, the actual return is equal to the

expected return. Therefore, there is no variance around the
expected return.
§ For an investment to be riskfree, then, it has to have
§ No default risk
§ No reinvestment risk

§ It follows then that if asked to estimate a risk free rate:

§ Time horizon matters: Thus, the riskfree rates in valuation will depend
upon when the cash flow is expected to occur and will vary across
time.
§ Currencies matter: A risk free rate is currency-specific and can be very
different for different currencies.
§ Not all government securities are riskfree: Some governments face
default risk and the rates on bonds issued by them will not be riskfree.

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§ In valuation, we estimate cash flows forever (or at least for very

long time periods). The right risk free rate to use in valuing a
company in US dollars would be
a. A three-month Treasury bill rate (4.36%)
b. A ten-year Treasury bond rate (4.58%)
c. A thirty-year Treasury bond rate (4.80%)
d. A TIPs (inflation-indexed treasury) rate (2.26%)
e. The highest of these numbers
f. The lowest of these numbers
g. Other (Specify)

§ What are we implicitly assuming about the US treasury when we

use any of the treasury numbers?

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Ten-year Euro Government Bond Rates on 1/1/25

4.00%

3.50%

3.00%

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%
Germany Netherlands Ireland Finland Austria Portugal Spain Greece France Italy

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§ The Indian government had 10-year Rupee bonds outstanding,

with a yield to maturity of about 6.82% on January 1, 2025.
§ In January 2025, the Indian government had a local currency
sovereign rating of Baa3. The typical default spread (over a
default free rate) for Baa3 rated country bonds in early 2025 was
2.18%. The riskfree rate in Indian Rupees is
a. The yield to maturity on the 10-year bond (6.82%)
b. The yield to maturity on the 10-year bond + Default spread (4.64%)
c. The yield to maturity on the 10-year bond – Default spread (9.00%)
d. None of the above

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§ Sovereign dollar or euro denominated bonds: Find sovereign

bonds denominated in US dollars, issued by an emerging
sovereign.
§ Default spread = Emerging Govt Bond Rate (in US $) – US Treasury
Bond rate with same maturity.
§ Sovereign CDS spreads: Obtain the traded value for a
sovereign Credit Default Swap (CDS) for the emerging
government.
§ Default spread = Sovereign CDS spread (with perhaps an adjustment
for CDS market frictions).
§ Sovereign-rating based spread: For countries which don’t issue
dollar denominated bonds or have a CDS spread, you have to
use the average spread for other countries with the same
sovereign rating.

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 Country $ Bond Rate Riskfree Rate Default Spread
$ Bonds
Peru 6.15% 4.58% 1.57%
Brazil 7.75% 4.58% 3.17%
Colombia 6.95% 4.58% 2.37%
Poland 5.35% 4.58% 0.77%
Turkey 13.55% 4.58% 8.97%
Mexico 5.46% 4.58% 0.88%
Euro Bonds
Bulgaria 2.86% 2.43% 0.43%

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S&P Sovereign Rating Moody's Sovereign Rating Default Spread
AAA Aaa 0.00%
AA+ Aa1 0.38%
AA Aa2 0.46%
AA- Aa3 0.56%
A+ A1 0.66%
A A2 0.80%
A- A3 1.13%
BBB+ Baa1 1.50%
BBB Baa2 1.79%
BBB- Baa3 2.07%
BB+ Ba1 2.36%
BB Ba2 2.83%
BB Ba3 3.38%
B+ B1 4.24%
B B2 5.18%
B- B3 6.12%
CCC+ Caa1 7.06%
CCC Caa2 8.47%
CCC- Caa3 9.41%
CC+ Ca1 10.50%
CC Ca2 11.29%
CC- Ca3 13.00%
C+ C1 14.50%
C C2 16.00% 37
C- C3 18.00%
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§ The Brazilian government bond rate in nominal reais on January

1, 2025, was 12.30%. To get to a riskfree rate in nominal reais,
we can use one of three approaches.
§ Approach 1: Government Bond spread
§ Default Spread = Brazil $ Bond Rate – US T.Bond Rate = 5.75% - 3.88% =
3.17%
§ Riskfree rate in $R = 12.30% - 3.17% = 9.17%
§ Approach 2: The CDS Spread
§ The CDS spread for Brazil, adjusted for the US CDS spread was 2.82%.
§ Riskfree rate in $R = 12.30% - 2.82% = 9.48%
§ Approach 3: The Rating based spread
§ Brazil has a Ba2 local currency rating from Moody’s. The default spread for
that rating is 2.83%
§ Riskfree rate in $R = 12.30% - 2.83% = 9.47%

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§ In some cases, you may want a riskfree rate in real terms (in real
terms) rather than nominal terms.
§ To get a real riskfree rate, you would like a security with no default
risk and a guaranteed real return. Treasury indexed securities
offer this combination.
§ In January 2025, the yield on a 10-year indexed treasury bond
was 2.23%. Which of the following statements would you
subscribe to?
a. This (2.23%) is the real riskfree rate to use, if you are valuing US
companies in real terms.
b. This (2.23%) is the real riskfree rate to use, anywhere in the world
c. Explain.

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§ You can scale up the riskfree rate in a base currency
($, Euros) by the differential inflation between the base
currency and the currency in question. In US $:
§ Risk free rateCurrency=

§ Thus, if the US $ risk free rate is 2.00%, the inflation

rate in Egyptian pounds is 15% and the inflation rate in
US $ is 1.5%, the foreign currency risk free rate is as
follows:
( )
(1.02 ) ( "."$ ) − 1 = 15.57%
§ Risk free rate = ".&"$

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§ On January 1, 2022, the 10-year treasury bond rate in

the United States was 1.51%, low by historic
standards. Assume that you are valuing a company in
US dollars then but are wary about the riskfree rate
being too low. Which of the following should you do?
a. Replace the current 10-year bond rate with a more
reasonable normalized riskfree rate (the average 10-year
bond rate over the last 30 years has been about 5-6%)
b. Use the current 10-year bond rate as your riskfree rate but
make sure that your other assumptions (about growth and
inflation) are consistent with the riskfree rate.
c. Something else…

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§ In 2022, there were at least three currencies (Swiss

Franc, Japanese Yen, Euro) with negative interest
rates. Using the fundamentals (inflation and real
growth) approach, how would you explain negative
interest rates?
§ How negative can rates get? (Is there a lower bound?)
§ Would you use these negative interest rates as risk free rates?
a. If no, why not and what would you do instead?
b. If yes, what else would you have to do in your valuation to be
internally consistent?

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The price of risk

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§ The historical premium is the premium that stocks have

historically earned over riskless securities.
§ While the users of historical risk premiums act as if it is a fact
(rather than an estimate), it is sensitive to
§ How far back you go in history…
§ Whether you use T.bill rates or T.Bond rates
§ Whether you use geometric or arithmetic averages.

§ For instance, looking at the US:

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§ Noisy estimates: Even with long time periods of history, the risk
premium that you derive will have substantial standard error. For
instance, if you go back to 1928 (about 90 years of history) and
you assume a standard deviation of 20% in annual stock returns,
you arrive at a standard error of greater than 2%:
Standard Error in Premium = 20%/√90 = 2.1%
§ Survivorship Bias: Using historical data from the U.S. equity
markets over the twentieth century does create a sampling bias.
After all, the US economy and equity markets were among the
most successful of the global economies that you could have
invested in early in the century.

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§ Estimate default spread for country: In this approach, the country

equity risk premium is set equal to the default spread for the country,
estimated in one of three ways:
§ The default spread on a dollar denominated bond issued by the country.
(In January 2025, that spread was % for the Brazilian $ bond) was 1.817%.
§ The sovereign CDS spread for the country. In January 2025, the ten-year
CDS spread for Brazil, adjusted for the US CDS, was 3.17%.
§ The default spread based on the local currency rating for the country.
Brazil’s sovereign local currency rating is Ba2 and the default spread for a
Ba2 rated sovereign was about 2.83% in January 2025.
§ Add the default spread to a “mature” market premium: This
default spread is added on to the mature market premium to arrive at
the total equity risk premium for Brazil, assuming a mature market
premium of 4.33%.
§ Country Risk Premium for Brazil = 2.83%
§ Total ERP for Brazil = 4.33% + 2.83% = 7.16%

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§ This approach draws on the standard deviation of two equity

markets, the emerging market in question and a base market
(usually the US). The total equity risk premium for the emerging
market is then written as:
§ Equity risk premium = Risk PremiumUS × ( sCountry Equity / sUS Equity)

§ The country equity risk premium is based upon the volatility of

the market in question relative to U.S market.
§ Assume that the equity risk premium for the US is 4.33%.
§ Assume that the standard deviation in the Bovespa (Brazilian equity)
is 30% and that the standard deviation for the S&P 500 (US equity) is
18%.
§ Total Equity Risk Premium for Brazil = 4.33% (30%/18%) =7.22%
§ Country equity risk premium for Brazil = 7.22% - 4.33% = 2.89%

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§ Country ratings measure default risk. While default risk

premiums and equity risk premiums are highly correlated, one
would expect equity spreads to be higher than debt spreads.
§ Another is to multiply the bond default spread by the relative
volatility of stock and bond prices in that market. Using this
approach for Brazil in January 2025, you would get:
§ Country Equity risk premium = Default spread on country bond*
sCountry Equity / sCountry Bond
§ Standard Deviation in Bovespa (Equity) = 30%
§ Standard Deviation in Brazil government bond = 20%
§ Default spread for Brazil= 2.83%
§ Brazil Country Risk Premium = 2.83% (30%/20%) = 4.25%
§ Brazil Total ERP = Mature Market Premium + CRP = 4.33% + 4.25% =
8.58%

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ERP : January 1, 2025

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Blue: Moody’s Rating
Red: Added Country Risk
Green #: Total ERP
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§ Approach 1: Assume that every company in the country is

equally exposed to country risk. In this case,
§ E(Return) = Riskfree Rate + CRP + Beta (Mature ERP)

§ Approach 2: Assume that a company’s exposure to country risk

is similar to its exposure to other market risk.
§ E(Return) = Riskfree Rate + Beta (Mature ERP+ CRP)

§ Approach 3: Treat country risk as a separate risk factor and

allow firms to have different exposures to country risk (perhaps
based upon the proportion of their revenues come from non-
domestic sales)
§ E(Return)= Riskfree Rate+ b (Mature ERP) + l (CRP)
§ Mature ERP = Mature market Equity Risk Premium
§ CRP = Additional country risk premium

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§ Single emerging market: Embraer, in 2004, reported that it

derived 3% of its revenues in Brazil and the balance from mature
markets. The mature market ERP in 2004 was 5% and Brazil’s
CRP was 7.89%.

§ Multiple emerging markets: Ambev, the Brazilian-based beverage

company, reported revenues from the following countries during
2011.

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Things to watch out for

1. Aggregation across regions. For instance, the Pacific region often includes Australia
& NZ with Asia
2. Obscure aggregations including Eurasia and Oceania
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§ Focus just on revenues: To the extent that revenues are the

only variable that you consider, when weighting risk exposure
across markets, you may be missing other exposures to country
risk. For instance, an emerging market company that gets the
bulk of its revenues outside the country (in a developed market)
may still have all of its production facilities in the emerging
market.
§ Exposure not adjusted or based upon beta: To the extent that
the country risk premium is multiplied by a beta, we are assuming
that beta in addition to measuring exposure to all other macro
economic risk also measures exposure to country risk.

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Oil & Gas

Country Production % of Total ERP
Denmark 17396 3.83% 6.20%
Italy 11179 2.46% 9.14%
Norway 14337 3.16% 6.20%
UK 20762 4.57% 6.81%
Rest of Europe 874 0.19% 7.40%
Brunei 823 0.18% 9.04%
Iraq 20009 4.40% 11.37%
Malaysia 22980 5.06% 8.05%
Oman 78404 17.26% 7.29%
Russia 22016 4.85% 10.06%
Rest of Asia & ME 24480 5.39% 7.74%
Oceania 7858 1.73% 6.20%
Gabon 12472 2.75% 11.76%
Nigeria 67832 14.93% 11.76%
Rest of Africa 6159 1.36% 12.17%
USA 104263 22.95% 6.20%
Canada 8599 1.89% 6.20%
Brazil 13307 2.93% 9.60%
Rest of Latin America 576 0.13% 10.78%
Royal Dutch Shell 454326 100.00% 8.26%
Aswath Damodaran 60
61

§ Country risk exposure is affected by where you get your

revenues and where your production happens, but there are a
host of other variables that also affect this exposure, including:
§ Use of risk management products: Companies can use both
options/futures markets and insurance to hedge some or a significant
portion of country risk.
§ Government “national” interests: There are sectors that are viewed as
vital to the national interests, and governments often play a key role in
these companies, either officially or unofficially. These sectors are
more exposed to country risk.
§ It is conceivable that there is a richer measure of country risk
that incorporates all the variables that drive country risk in
one measure. That way my rationale when I devised “lambda” as
my measure of country risk exposure.

Aswath Damodaran 61
§ The factor “l” measures the relative exposure of a firm to country
risk. One simplistic solution would be to do the following:
§ l = % of revenues domesticallyfirm / % of revenues domesticallyaverage
firm

§ Consider two firms – Tata Motors and Tata Consulting Services,

both Indian companies. In 2008-09, Tata Motors got about
91.37% of its revenues in India and TCS got 7.62%. The average
Indian firm gets about 80% of its revenues in India:
§ l Tata Motors= 91%/80% = 1.14
§ l TCS= 7.62%/80% = 0.09

§ There are two implications

§ A company’s risk exposure is determined by where it does business
and not by where it is incorporated.
§ Firms might be able to actively manage their country risk exposures

Aswath Damodaran 62
63

ReturnEmbraer = 0.0195 + 0.2681 ReturnC Bond

ReturnEmbratel = -0.0308 + 2.0030 ReturnC Bond

Embraer versus C Bond: 2000-2003 Embratel versus C Bond: 2000-2003

40 100

80

20
60

40

Return on Embrat el
Return on Embraer

0
20

0
-20
-20

-40 -40

-60

-60 -80
-30 -20 -10 0 10 20 -30 -20 -10 0 10 20

Return on C-Bond Return on C-Bond

Aswath Damodaran 63
64

§ Assume that the beta for Embraer is 1.07, and that the US $ riskfree
rate used is 4%. Also assume that the risk premium for the US is 5%
and the country risk premium for Brazil is 7.89%. Finally, assume that
Embraer gets 3% of its revenues in Brazil & the rest in the US.
§ There are five estimates of $ cost of equity for Embraer:
§ Approach 1: Constant exposure to CRP, Location CRP
§ E(Return) = 4% + 1.07 (5%) + 7.89% = 17.24%
§ Approach 2: Constant exposure to CRP, Operation CRP
§ E(Return) = 4% + 1.07 (5%) + (0.03*7.89% +0.97*0%)= 9.59%
§ Approach 3: Beta exposure to CRP, Location CRP
§ E(Return) = 4% + 1.07 (5% + 7.89%)= 17.79%
§ Approach 4: Beta exposure to CRP, Operation CRP
§ E(Return) = 4% + 1.07 (5% +( 0.03*7.89%+0.97*0%)) = 9.60%
§ Approach 5: Lambda exposure to CRP
§ E(Return) = 4% + 1.07 (5%) + 0.27(7.89%) = 11.48%

Aswath Damodaran 64
65

§ The conventional practice in investment banking is to add the

country equity risk premium on to the cost of equity for every
emerging market company, notwithstanding its exposure to
emerging market risk.
§ Thus, in 2004, Embraer would have been valued with a cost of
equity of 17-18% even though it gets only 3% of its revenues in
Brazil. As an investor, which of the following consequences do
you see from this approach?
§ Emerging market companies with substantial exposure in developed
markets will be significantly over valued by analysts
§ Emerging market companies with substantial exposure in developed
markets will be significantly under valued by analysts
§ Can you construct an investment strategy to take advantage of
the mis-valuation? What would need to happen for you to make
money of this strategy?

Aswath Damodaran 65
66

§ For a start: If you know the price paid for an asset and have
estimates of the expected cash flows on the asset, you can
estimate the IRR of these cash flows. If you paid the price, this is
your expected return.
§ Stock Price & Risk: If you assume that stocks are correctly
priced in the aggregate and you can estimate the expected
cashflows from buying stocks, you can estimate the expected rate
of return on stocks by finding that discount rate that makes the
present value equal to the price paid.
§ Implied ERP: Subtracting out the riskfree rate should yield an
implied equity risk premium. This implied equity premium is a
forward-looking number and can be updated as often as you want
(every minute of every day, if you are so inclined).

Aswath Damodaran 66
Aswath Damodaran 67
68

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69

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70

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Aswath Damodaran 71
72

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73

Aswath Damodaran 73
74

Aswath Damodaran 74
75

§ In many investment banks, it is common practice (especially in

corporate finance departments) to use historical risk
premiums (and arithmetic averages at that) as risk premiums to
compute cost of equity. Often, the defense they offer is that as
long as everyone uses the same premium, there is no cost to
being wrong.
§ If all analysts in a group used the arithmetic average premium (for
stocks over T.Bills) for 1928-2024 of 8.44% to value stocks in
January 2025, given the implied premium of 4.33%, what are they
likely to find?
a. The values they obtain will be too low (most stocks will look
overvalued)
b. The values they obtain will be too high (most stocks will look under
valued)
c. There should be no systematic bias as long as they use the same
premium to value all stocks.

Aswath Damodaran 75
76

If you assume this Premium to use

Premiums revert back to historical Historical risk premium
norms and your time period yields
these norms
Market is correct in the aggregate or Current implied equity risk premium
that your valuation should be market
neutral
Marker makes mistakes even in the Average implied equity risk premium
aggregate but is correct over time over time.
Predictor Correlation with implied Correlation with actual Correlation with actual
premium next year return- next 5 years return – next 10 years

Current implied premium 0.763 0.427 0.500

Average implied premium: 0.718 0.326 0.450
Last 5 years
Historical Premium -0.497 -0.437 -0.454
DefaultAswath
Spread based premium
Damodaran 0.047 0.143 0.160 76
77

§ Inputs for the computation

§ Sensex on 9/5/07 = 15446
§ Dividend yield on index = 3.05%
§ Expected growth rate - next 5 years = 14%
§ Growth rate beyond year 5 = 6.76% (set equal to riskfree rate)

§ Solving for the expected return:

537.06 612.25 697.86 795.67 907.07 907.07(1.0676)

15446 = + + + + +
(1+ r) (1+ r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r − .0676)(1+ r) 5

§ Expected return on stocks = 11.18%

€
§ Implied equity risk premium for India = 11.18% - 6.76% = 4.42%

Aswath Damodaran 77
78

Aswath Damodaran 78
79

Relative Risk Measures

Aswath Damodaran
80

§ The standard procedure for estimating betas is to regress stock

returns (Rj) against market returns (Rm) -
§ Rj = a + b Rm
§ where a is the intercept and b is the slope of the regression.

§ The slope of the regression corresponds to the beta of the stock

and measures the riskiness of the stock.
§ This beta has three problems:
§ It has high standard error
§ It reflects the firm’s business mix over the period of the regression, not
the current mix
§ It reflects the firm’s average financial leverage over the period rather
than the current leverage.

Aswath Damodaran 80
81

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82

Aswath Damodaran 82
During 2019 and 2020, GME was an extraordinarily volatile stock, as
short sellers and long only investors fought out a battle.

Aswath Damodaran 83
Aswath Damodaran 84
85

Aswath Damodaran 85
86

§ Relative Standard Deviation

§ Relative Volatility = Std dev of Stock/ Average Std dev across all stocks
§ Captures all risk, rather than just market risk

§ Proxy Models
§ Look at historical returns on all stocks and look for variables that explain
differences in returns.
§ You are, in effect, running multiple regressions with returns on individual
stocks as the dependent variable and fundamentals about these stocks as
independent variables.
§ This approach started with market cap (the small cap effect) and over the
last two decades has added other variables (momentum, liquidity etc.)

§ CAPM Plus Models

§ Start with the traditional CAPM (Rf + Beta (ERP)) and then add other
premiums for proxies.

Aswath Damodaran 86
87

§ Accounting risk measures: To the extent that you don’t trust

market-priced based measures of risk, you could compute relative
risk measures based on
§ Accounting earnings volatility: Compute an accounting beta or relative
volatility
§ Balance sheet ratios: You could compute a risk score based upon
accounting ratios like debt ratios or cash holdings (akin to default risk
scores like the Z score)
§ Qualitative Risk Models: In these models, risk assessments are
based at least partially on qualitative factors (quality of
management).
§ Debt based measures: You can estimate a cost of equity, based
upon an observable costs of debt for the company.
§ Cost of equity = Cost of debt * Scaling factor
§ The scaling factor can be computed from implied volatilities.

Aswath Damodaran 87
88

Beta of Equity (Levered Beta)

Beta of Firm (Unlevered Beta) Financial Leverage:

Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
Nature of product or Operating Leverage (Fixed equity beta will be
service offered by Costs as percent of total
company: costs):
Other things remaining equal, Other things remaining equal
the more discretionary the the greater the proportion of
product or service, the higher the costs that are fixed, the Implciations
Highly levered firms should have highe betas
the beta. higher the beta of the than firms with less debt.
company.
Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))

Implications Implications
1. Cyclical companies should 1. Firms with high infrastructure
have higher betas than non- needs and rigid cost structures
cyclical companies. should have higher betas than
2. Luxury goods firms should firms with flexible cost structures.
have higher betas than basic 2. Smaller firms should have higher
goods. betas than larger firms.
3. High priced goods/service 3. Young firms should have higher
firms should have higher betas betas than more mature firms.
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Aswath Damodaran 88
89

Start with the beta of the business that the firm is in

Adjust the business beta for the operating leverage of the firm to arrive at the
unlevered beta for the firm.

Use the financial leverage of the firm to estimate the equity beta for the firm
Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (Debt/Equity))

Aswath Damodaran 89
90

§ Within any business, firms with lower fixed costs (as a

percentage of total costs) should have lower unlevered
betas. If you can compute fixed and variable costs for each firm
in a sector, you can break down the unlevered beta into business
and operating leverage components.
§ Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable
costs))
§ The biggest problem with doing this is informational. It is difficult
to get information on fixed and variable costs for individual firms.
§ In practice, we tend to assume that the operating leverage of
firms within a business are similar and use the same
unlevered beta for every firm.

Aswath Damodaran 90
91

§ Conventional approach: If we assume that debt carries no

market risk (has a beta of zero), the beta of equity alone can be
written as a function of the unlevered beta and the debt-equity
ratio
§ bL = bu (1+ ((1-t)D/E))
§ In some versions, the tax effect is ignored and there is no (1-t) in the
equation.
§ Debt Adjusted Approach: If beta carries market risk and you can
estimate the beta of debt, you can estimate the levered beta as
follows:
§ bL = bu (1+ ((1-t)D/E)) − bdebt (1-t) (D/E)
§ While the latter is more realistic, estimating betas for debt can be
difficult to do.

Aswath Damodaran 91
92

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 If you can, adjust this beta for differences
traded firms. Unlever this average beta using the average debt to between your firm and the comparable
equity ratio across the publicly traded firms in the sample. firms on operating leverage and product
Unlevered beta for business = Average beta across publicly traded characteristics.
firms/ (1 + (1- t) (Average D/E ratio across firms))

While revenues or operating income

Step 3: Estimate how much value your firm derives from each of are often used as weights, it is better
the different businesses it is in. to try to estimate the value of each
business.

Step 4: Compute a weighted average of the unlevered betas of the If you expect the business mix of your
different businesses (from step 2) using the weights from step 3. firm to change over time, you can
Bottom-up Unlevered beta for your firm = Weighted average of the change the weights on a year-to-year
unlevered betas of the individual business basis.

If you expect your debt to equity ratio to

Step 5: Compute a levered beta (equity beta) for your firm, using change over time, the levered beta will
the market debt to equity ratio for your firm. change over time.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

Aswath Damodaran 92
93

§ Less Noisy: The standard error in a bottom-up beta will be

significantly lower than the standard error in a single regression
beta. Roughly speaking, the standard error of a bottom-up beta
estimate can be written as follows:
§ Std error of bottom-up beta =
Average Std Error across Betas
Number of firms in sample

§ Updated: The bottom-up beta can be adjusted to reflect changes

in the firm’s business mix and financial leverage. Regression
betas reflect the past. €
§ Don’t need prices: You can estimate bottom-up betas even when
you do not have historical stock prices. This is the case with initial
public offerings, private businesses or divisions of companies.

Aswath Damodaran 93
 Sample' Unlevered'beta' Peer'Group' Value'of' Proportion'of'
Business' Sample' size' of'business' Revenues' EV/Sales' Business' Vale'

Global'firms'in'metals'&'
Metals'&' mining,'Market'cap>$1'
Mining' billion' 48' 0.86' $9,013' 1.97' $17,739' 16.65%'

Iron'Ore' Global'firms'in'iron'ore' 78' 0.83' $32,717' 2.48' $81,188' 76.20%'

Global'specialty'
Fertilizers' chemical'firms' 693' 0.99' $3,777' 1.52' $5,741' 5.39%'

Global'transportation'
Logistics' firms' 223' 0.75' $1,644' 1.14' $1,874' 1.76%'
Vale'
Operations' '' '' 0.8440' $47,151' '' $106,543' 100.00%'

Aswath Damodaran 94
95

Business Unlevered Beta D/E Ratio Levered beta

Aerospace 0.95 18.95% 1.07

Levered BetaEmbraer= Unlevered Beta ( 1 + (1- tax rate) (D/E Ratio)

= 0.95 ( 1 + (1-.34) (.1895)) = 1.07

§ Can an unlevered beta estimated using U.S. and European

aerospace companies be used to estimate the beta for a Brazilian
aerospace company?
a. Yes
b. No
What concerns would you have in making this assumption?

Aswath Damodaran 95
96

§ Analysts in Europe and Latin America often take the difference

between debt and cash (net debt) when computing debt ratios and
arrive at very different values.
§ For Embraer, using the gross debt ratio
§ Gross D/E Ratio for Embraer = 1953/11,042 = 18.95%
§ Levered Beta using Gross Debt ratio = 1.07

§ Using the net debt ratio, we get

§ Net Debt Ratio for Embraer = (Debt - Cash)/ Market value of Equity
= (1953-2320)/ 11,042 = -3.32%
§ Levered Beta using Net Debt Ratio = 0.95 (1 + (1-.34) (-.0332)) = 0.93

§ The cost of Equity using net debt levered beta for Embraer will be
much lower than with the gross debt approach. The cost of capital for
Embraer will even out since the debt ratio used in the cost of capital
equation will now be a net debt ratio rather than a gross debt ratio.

Aswath Damodaran 96
97

Preferably, a bottom-up beta,

based upon other firms in the
business, and firmʼs own financial
leverage

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

Has to be in the same Historical Premium Implied Premium

currency as cash flows, 1. Mature Equity Market Premium: Based on how equity
and defined in same terms Average premium earned by or market is priced today
(real or nominal) as the stocks over T.Bonds in U.S. and a simple valuation
cash flows 2. Country risk premium = model
Country Default Spread* ( σEquity/σCountry bond)

Aswath Damodaran 97
98

Mopping up

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99

§ The cost of debt is the rate at which you can borrow money,
long term right now, It will reflect not only your default risk but also
the level of interest rates in the market.
§ The cost of debt is not the rate at which you have borrowed money in
the past or a current book interest rate (interest expense/debt).
§ The two most widely used approaches to estimating cost of debt are:
§ Looking up the yield to maturity on a straight bond outstanding from
the firm. The limitation of this approach is that very few firms have long
term straight bonds that are liquid and widely traded
§ Looking up the rating for the firm and estimating a default spread based
upon the rating. While this approach is more robust, different bonds from
the same firm can have different ratings. You have to use a median rating
for the firm
§ When in trouble (either because you have no ratings or multiple
ratings for a firm), estimate a synthetic rating for your firm and the
cost of debt based upon that rating.

Aswath Damodaran 99
100

§ The rating for a firm can be estimated using the financial

characteristics of the firm. In its simplest form, the rating can be
estimated from the interest coverage ratio
§ Interest Coverage Ratio = EBIT / Interest Expenses

§ For Embraer’s interest coverage ratio, we used the interest

expenses from 2003 and the average EBIT from 2001 to 2003.
(The aircraft business was badly affected by 9/11 and its
aftermath. In 2002 and 2003, Embraer reported significant drops
in operating income)
§ Interest Coverage Ratio = 462.1 /129.70 = 3.56

Aswath Damodaran 100

101

If Interest Coverage Ratio is Estimated Bond Rating Default

Spread
> 8.50 (>12.50) AAA 0.35%
6.50 - 8.50 (9.5-12.5) AA 0.50%
5.50 - 6.50 (7.5-9.5) A+ 0.70%
4.25 - 5.50 (6-7.5) A 0.85%
3.00 - 4.25 (4.5-6) A– 1.00%
2.50 - 3.00 (4-4.5) BBB 1.50%
2.25- 2.50 (3.5-4) BB+ 2.00%
2.00 - 2.25 ((3-3.5) BB 2.50%
1.75 - 2.00 (2.5-3) B+ 3.25%
1.50 - 1.75 (2-2.5) B 4.00%
1.25 - 1.50 (1.5-2) B– 6.00%
0.80 - 1.25 (1.25-1.5) CCC 8.00%
0.65 - 0.80 (0.8-1.25) CC 10.00%
0.20 - 0.65 (0.5-0.8) C 12.00%
< 0.20 (<0.5) D 20.00%

Aswath Damodaran 101

102

§ Based on the interest coverage ratio of 3.56, the synthetic rating

for Embraer is A-, giving it a default spread of 1.00%
§ Companies in countries with low bond ratings and high default
risk might bear the burden of country default risk, especially if
they are smaller or have all of their revenues within the country.
§ If I assume that Embraer bears all of the country risk burden, I would
add on the country default spread for Brazil in 2004 of 6.01%.
§ Larger companies that derive a significant portion of their
revenues in global markets may be less exposed to country
default risk. I am going to add only two thirds of the Brazilian country
risk (based upon traded bond spreads of other large Brazilian
companies in 2004)
Cost of debt = Riskfree rate + 2/3(Brazil country default spread) +
Company default spread =4.29% + 2/3 (6.01%)+ 1.00% = 9.29%

Aswath Damodaran 102

103

§ The relationship between interest coverage ratios and ratings,

developed using US companies, tends to travel well, as long as
we are analyzing large manufacturing firms in markets with
interest rates close to the US interest rate
§ They are more problematic when looking at smaller companies in
markets with higher interest rates than the US. One way to
adjust for this difference is modify the interest coverage ratio table
to reflect interest rate differences (For instances, if interest rates
in an emerging market are twice as high as rates in the US, halve
the interest coverage ratio).

Aswath Damodaran 103

104

Aswath Damodaran 104

 Corporate Bond Default Spreads on January 1, 2025
25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
Aaa/A Aa2/A Baa2/B Ba1/BB Caa/C Ca2/C
A1/A+ A2/A A3/A- Ba2/BB B1/B+ B2/B B3/B- C2/C D2/D
AA A BB + CC C
Spread 2025 0.45% 0.60% 0.77% 0.85% 0.95% 1.20% 1.55% 1.83% 2.61% 3.00% 4.42% 7.28% 10.10% 15.50% 19.00%
Spread 2024 0.59% 0.70% 0.92% 1.07% 1.21% 1.47% 1.74% 2.21% 3.14% 3.61% 5.24% 8.51% 11.78% 17.00% 20.00%
Spread 2023 0.69% 0.85% 1.23% 1.42% 1.62% 2.00% 2.42% 3.13% 4.55% 5.26% 7.37% 11.57% 15.78% 17.50% 20.00%
Spread 2022 0.67% 0.82% 1.03% 1.14% 1.29% 1.59% 1.93% 2.15% 3.15% 3.78% 4.62% 7.78% 8.80% 10.76% 14.34%
Spread 2021 0.69% 0.85% 1.07% 1.18% 1.33% 1.71% 2.31% 2.77% 4.05% 4.86% 5.94% 9.46% 9.97% 13.09% 17.44%

Spread 2025 Spread 2024 Spread 2023 Spread 2022 Spread 2021

Aswath Damodaran 105

106

§ Assume that the Brazilian government lends money to Embraer at

a subsidized interest rate (say 6% in dollar terms). In computing
the cost of capital to value Embraer, should be we use the cost of
debt based upon default risk or the subsidized cost of debt?
a. The subsidized cost of debt (6%). That is what the company is
paying.
b. The fair cost of debt (9.25%). That is what the company should
require its projects to cover.
c. A number in the middle.

Aswath Damodaran 106

107

§ In computing the cost of capital for a publicly traded firm, the

general rule for computing weights for debt and equity is that you
use market value weights (and not book value weights). Why?
a. Because the market is usually right
b. Because market values are easy to obtain
c. Because book values of debt and equity are meaningless
d. None of the above

§ If a company is not traded, and there is no market value available,

would it be reasonable to use book value?
a. Yes. There is no choice
b. No. There is a choice
If there is a choice, what is it?

Aswath Damodaran 107

108

§ Equity
§ Cost of Equity = 4.29% + 1.07 (4%) + 0.27 (7.89%) = 10.70%
§ Market Value of Equity =11,042 million BR ($ 3,781 million)

§ Debt
§ Cost of debt = 4.29% + 4.00% +1.00%= 9.29%
§ Market Value of Debt = 2,083 million BR ($713 million)

§ Cost of Capital = 10.70 % (.84) + 9.29% (1- .34) (0.16)) = 9.97%

§ The book value of equity at Embraer is 3,350 million BR.
§ The book value of debt at Embraer is 1,953 million BR; Interest
expense is 222 mil BR; Average maturity of debt = 4 years
§ Estimated market value of debt = 222 million (PV of annuity, 4 years,
9.29%) + $1,953 million/1.09294 = 2,083 million BR

Aswath Damodaran 108

109

§ Approach 1: Use a $R riskfree rate in all of the calculations

above. For instance, if the $R riskfree rate was 12%, the cost of
capital would be computed as follows:
§ Cost of Equity = 12% + 1.07(4%) + 0.27 (7. 89%) = 18.41%
§ Cost of Debt = 12% + 1% = 13%
§ (This assumes the riskfree rate has no country risk premium
embedded in it.)
§ Approach 2: Use the differential inflation rate to estimate the cost
of capital. For instance, if the inflation rate in $R is 8% and the
inflation rate in the U.S. is 2%
" 1+ Inflation %
BR
§ 1+ Cost of capital$R=(1+ Cost of Capital$ )$ '
# 1+ Inflation$ &
= 1.0997 (1.08/1.02)-1 = 0.1644 or 16.44%

€
Aswath Damodaran 109
110

§ When dealing with hybrids (convertible bonds, for instance),

break the security down into debt and equity and allocate the
amounts accordingly. Thus, if a firm has $ 125 million in
convertible debt outstanding, break the $125 million into straight
debt and conversion option components. The conversion option is
equity.
§ When dealing with preferred stock, it is better to keep it as a
separate component. The cost of preferred stock is the
preferred dividend yield. (As a rule of thumb, if the preferred stock
is less than 5% of the outstanding market value of the firm,
lumping it in with debt will make no significant impact on your
valuation).

Aswath Damodaran 110

111

§ Assume that the firm that you are analyzing has $125 million in
face value of convertible debt with a stated interest rate of 4%, a
10-year maturity and a market value of $140 million. If the firm
has a bond rating of A and the interest rate on A-rated straight
bond is 8%, you can break down the value of the convertible bond
into straight debt and equity portions.
§ Straight debt = (4% of $125 million) (PV of annuity, 10 years, 8%) +
125 million/1.0810 = $91.45 million
§ Equity portion = $140 million - $91.45 million = $48.55 million

§ The debt portion ($91.45 million) gets added to debt and the
option portion ($48.55 million) gets added to the market
capitalization to get to the debt and equity weights in the cost of
capital.

Aswath Damodaran 111

112

Cost of borrowing should be based upon

(1) synthetic or actual bond rating Marginal tax rate, reflecting
(2) default spread tax benefits of debt
Cost of Borrowing = Riskfree rate + Default spread

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

Cost of equity
based upon bottom-up Weights should be market value weights
beta

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Cash is king…

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115

§ Estimate the current earnings of the firm

§ If looking at cash flows to equity, look at earnings after interest
expenses - i.e. net income
§ If looking at cash flows to the firm, look at operating earnings after
taxes
§ Consider how much the firm invested to create future growth
§ If the investment is not expensed, it will be categorized as capital
expenditures. To the extent that depreciation provides a cash flow, it
will cover some of these expenditures.
§ Increasing working capital needs are also investments for future
growth
§ If looking at cash flows to equity, consider the cash flows from
net debt issues (debt issued - debt repaid)

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116

Where are the tax savings from interest expenses?

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Accounting Earnings, Flawed but Important

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120

Operating leases R&D Expenses

Firmʼs Comparable - Convert into debt - Convert into asset
history Firms - Adjust operating income - Adjust operating income

Normalize Cleanse operating items of

Earnings - Financial Expenses
- Capital Expenses
- Non-recurring expenses

Measuring Earnings

Update
- Trailing Earnings
- Unofficial numbers

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121

§ When valuing companies, we often depend upon financial

statements for inputs on earnings and assets. Annual reports are
often outdated and can be updated by using-
§ Trailing 12-month data, constructed from quarterly earnings reports.
§ Informal and unofficial news reports, if quarterly reports are
unavailable.
§ Updating makes the most difference for smaller and more
volatile firms, as well as for firms that have undergone significant
restructuring.
§ Time saver: To get a trailing 12-month number, all you need is
one 10K and one 10Q (example third quarter). For example, to
get trailing revenues from a third quarter 10Q:
§ Trailing 12-month Revenue = Revenues (in last 10K) - Revenues from
first 3 quarters of last year + Revenues from first 3 quarters of this
year.

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122

§ Make sure that there are no financial expenses mixed in with

operating expenses
§ Financial expense: Any commitment that is tax deductible that you
have to meet no matter what your operating results: Failure to meet it
leads to loss of control of the business.
§ Until 2019, accounting convention treated operating leases as
operating expenses, skewing income statements & balance sheets.
§ Make sure that there are no capital expenses mixed in with the
operating expenses
§ Capital expense: Any expense that is expected to generate benefits
over multiple periods.
§ There are a shole host of expenses (like R&D) that meet this
description that accountants treat as operating expenses.

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§ Since they give rise to contractual commitments, operating lease

expenses should be treated as financing expenses, with the
following adjustments to earnings and capital:
§ Debt Value of Operating Leases = Present value of Operating Lease
Commitments at the pre-tax cost of debt
§ Lease Asset: When you convert operating leases into debt, you also
create an asset to counter it of exactly the same value.
§ Adjusted Operating Earnings = Operating Earnings + Operating
Lease Expenses - Depreciation on Leased Asset
§ As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt *
PV of Operating Leases.

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§ The Gap has conventional debt of about $ 1.97 billion on its balance sheet
and its pre-tax cost of debt is about 6%. Its operating lease payments in the
2003 were $978 million and its commitments for the future are below:
Year Commitment (millions) Present Value (at 6%)
1 $899.00 $848.11
2 $846.00 $752.94
3 $738.00 $619.64
4 $598.00 $473.67
5 $477.00 $356.44
6&7 $982.50 each year $1,346.04
§ Debt Value of leases = $4,396.85 (Also value of leased asset)
§ Debt outstanding at The Gap = $1,970 m + $4,397 m = $6,367 m
§ Adjusted Operating Income = Stated OI + OL exp this year - Deprec’n
§ = $1,012 m + 978 m - 4397 m /7 = $1,362 million (7-year life for assets)

§ Approximate OI = $1,012 m + $ 4397 m (.06) = $1,276 m

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126

! Conventional!Accounting! Operating!Leases!Treated!as!Debt!
Income!Statement! !Income!Statement!
EBIT&&Leases&=&1,990& EBIT&&Leases&=&1,990&
0&Op&Leases&&&&&&=&&&&978& 0&Deprecn:&OL=&&&&&&628&
EBIT&&&&&&&&&&&&&&&&=&&1,012& EBIT&&&&&&&&&&&&&&&&=&&1,362&
Interest&expense&will&rise&to&reflect&the&
conversion&of&operating&leases&as&debt.&Net&
income&should&not&change.&
Balance!Sheet! Balance!Sheet!
Off&balance&sheet&(Not&shown&as&debt&or&as&an& Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&
asset).&Only&the&conventional&debt&of&$1,970& OL&Asset&&&&&&&4397&&&&&&&&&&&OL&Debt&&&&&4397&
million&shows&up&on&balance&sheet& Total&debt&=&4397&+&1970&=&$6,367&million&
&
Cost&of&capital&=&8.20%(7350/9320)&+&4%& Cost&of&capital&=&8.20%(7350/13717)&+&4%&
(1970/9320)&=&7.31%& (6367/13717)&=&6.25%&
Cost&of&equity&for&The&Gap&=&8.20%& &
After0tax&cost&of&debt&=&4%&
Market&value&of&equity&=&7350&
Return&on&capital&=&1012&(10.35)/(3130+1970)& Return&on&capital&=&1362&(10.35)/(3130+6367)&
&&&&&&&&&=&12.90%& &&&&&&&&&=&9.30%&
&

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128

§ In 2019, both IFRS and GAAP made a major shift on operating

leases, requiring companies to capitalize leases and show the
resulting debt (and counter asset) on the balance sheets.
§ That said, the accounting rules for capitalizing leases are far more
complex than the simple calculations that I have used, for two
reasons:
§ Accounting has to balance its desire to do the right thing with
maintaining some connection to its legacy rules.
§ Companies have lobbied to modify rules in their sectors to cushion the
impact.

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§ Accounting standards require us to consider R&D as an operating

expense even though it is designed to generate future growth. It
is more logical to treat it as capital expenditures.
§ To capitalize R&D,
§ Specify an amortizable life for R&D (2 - 10 years)
§ Collect past R&D expenses for as long as the amortizable life
§ Sum up the unamortized R&D over the period. (Thus, if the
amortizable life is 5 years, the research asset can be obtained by
adding up 1/5th of the R&D expense from five years ago, 2/5th of the
R&D expense from four years ago...:

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§ R & D was assumed to have a 5-year life.

Year R&D Expense Unamortized Amortization
Current € 1020.02 1.00 1020.02
-1 € 993.99 0.80 795.19 € 198.80
-2 € 909.39 0.60 545.63 € 181.88
-3 € 898.25 0.40 359.30 € 179.65
-4 € 969.38 0.20 193.88 € 193.88
-5 € 744.67 0.00 0.00 € 148.93
§ Value of research asset = € 2,914 million
§ Amortization of research asset in 2004 = € 903 million
§ Increase in Operating Income = 1020 - 903 = € 117 million

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! Conventional!Accounting! R&D!treated!as!capital!expenditure!
Income!Statement! !Income!Statement!
EBIT&&R&D&&&=&&3045& EBIT&&R&D&=&&&3045&
.&R&D&&&&&&&&&&&&&&=&&1020& .&Amort:&R&D&=&&&903&
EBIT&&&&&&&&&&&&&&&&=&&2025& EBIT&&&&&&&&&&&&&&&&=&2142&(Increase&of&117&m)&
EBIT&(1.t)&&&&&&&&=&&1285&m& EBIT&(1.t)&&&&&&&&=&1359&m&
Ignored&tax&benefit&=&(1020.903)(.3654)&=&43&
Adjusted&EBIT&(1.t)&=&1359+43&=&1402&m&
(Increase&of&117&million)&
Net&Income&will&also&increase&by&117&million&&
Balance!Sheet! Balance!Sheet!
Off&balance&sheet&asset.&Book&value&of&equity&at& Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&
3,768&million&Euros&is&understated&because& R&D&Asset&&&&2914&&&&&Book&Equity&&&+2914&
biggest&asset&is&off&the&books.& Total&Book&Equity&=&3768+2914=&6782&mil&&
Capital!Expenditures! Capital!Expenditures!
Conventional&net&cap&ex&of&2&million& Net&Cap&ex&=&2+&1020&–&903&=&119&mil&
Euros&
Cash!Flows! Cash!Flows!
EBIT&(1.t)&&&&&&&&&&=&&1285&& EBIT&(1.t)&&&&&&&&&&=&&&&&1402&&&
.&Net&Cap&Ex&&&&&&=&&&&&&&&2& .&Net&Cap&Ex&&&&&&=&&&&&&&119&
FCFF&&&&&&&&&&&&&&&&&&=&&1283&&&&&& FCFF&&&&&&&&&&&&&&&&&&=&&&&&1283&m&
Return&on&capital&=&1285/(3768+530)& Return&on&capital&=&1402/(6782+530)&

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135

§ Assume that you are valuing a firm that is reporting a loss of $

500 million, due to a one-time charge of $ 1 billion. What is the
earnings you would use in your valuation?
a. A loss of $ 500 million
b. A profit of $ 500 million

§ Would your answer be any different if the firm had reported one-
time losses like these once every five years?
a. Yes
b. No

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§ Though all firms may be governed by the same accounting

standards, the fidelity that they show to these standards can vary.
More aggressive firms will show higher earnings than more
conservative firms.
§ While you will not be able to catch outright fraud, you should look
for warning signals in financial statements and correct for them:
§ Income from unspecified sources - holdings in other businesses that
are not revealed or from special purpose entities.
§ Income from asset sales or financial transactions (for a non-financial
firm)
§ Sudden changes in standard expense items - a big drop in S,G &A or
R&D expenses as a percent of revenues, for instance.
§ Frequent accounting restatements
§ Accrual earnings that run ahead of cash earnings consistently
§ Big differences between tax income and reported income

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Reason for losses/low Valuation Response

earnings
Quick fixes

One-time or extraordinary Add back the one-time expense to get

charge corrected earnings
Macro factor (commodity Use earnings across the commodity or
price drop or recession) economic cycle as normalized earnings.
Young company working Estimate the profit margin that mature
Long term fixes

on business model companies in the business earn and

target that margin in the long term.
Structural problems at Use an industry average margin as a
company target and move towards that margin
over time, as structural problems are
fixed.

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Taxes and Reinvestment

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§ The tax rate that you should use in computing the after-tax
operating income should be
a. The effective tax rate in the financial statements (taxes paid/Taxable
income)
b. The tax rate based upon taxes paid and EBIT (taxes paid/EBIT)
c. The marginal tax rate for the country in which the company operates
d. The weighted average marginal tax rate across the countries in
which the company operates
e. None of the above
f. Any of the above, as long as you compute your after-tax cost of debt
using the same tax rate.

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§ The free cash flow to the firm starts with after-tax operating
income, where:
§ After-tax Operating Income = Operating Income (1- tax rate)

§ In computing free cash flow to the firm, the choice really is

between the effective and the marginal tax rate.
§ By using the marginal tax rate, we tend to understate the after-tax
operating income in the earlier years, but the after-tax tax operating
income is more accurate in later years.
§ By using the effective tax rate, we tend to overstate the after-tax
operating income in the later years, as effective tax rates move toward
the marginal tax rate.
§ You can have your cake and eat it too, by starting with the
effective tax rate, and adjusting towards the marginal tax rate
over time.

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§ Assume that you are trying to estimate the after-tax operating

income for a firm with $ 1 billion in net operating losses carried
forward.
§ This firm is expected to have operating income of $ 500 million
each year for the next 3 years, and the marginal tax rate on
income for all firms that make money is 40%. Estimate the after-
tax operating income each year for the next 3 years.
Year 1 Year 2 Year 3
EBIT 500 500 500
Taxes
EBIT (1-t)
Tax rate

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§ Net capital expenditures represent the difference between capital

expenditures and depreciation.
Net Cap Ex = Capital Expenditures - Depreciation
§ Depreciation is a cash inflow that pays for some or a lot (or sometimes
all of) the capital expenditures.
§ In general, the net capital expenditures will be a function of
how fast a firm is growing or expecting to grow.
§ High growth firms will usually have much higher net capital
expenditures than low growth firms.
§ Assumptions about net capital expenditures can therefore never be
made independently of assumptions about growth in the future.

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§ Research and development expenses, once they have been

re-categorized as capital expenses. The adjusted net cap ex will
be
§ Adjusted Net Capital Expenditures = Net Capital Expenditures +
Current year’s R&D expenses - Amortization of Research Asset
§ Acquisitions of other firms, since these are like capital
expenditures. The adjusted net cap ex will be
§ Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of
other firms - Amortization of such acquisitions
§ Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized
measure of acquisitions (looking at an average over time) should be
used
2. The best place to find acquisitions is in the statement of cash flows,
usually categorized under other investment activities

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Acquired Method of Acquisition Price Paid

GeoTel Pooling $1,344
Fibex Pooling $318
Sentient Pooling $103
American Internet Purchase $58
Summa Four Purchase $129
Clarity Wireless Purchase $153
Selsius Systems Purchase $134
PipeLinks Purchase $118
Amteva Tech Purchase $159
Total acquisitions $2,516

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Cap Expenditures (from statement of CF) = $ 584 mil

- Depreciation (from statement of CF) = $ 486 mil
Net Cap Ex (from statement of CF) = $ 98 mil
+ R & D expense = $ 1,594 mil
- Amortization of R&D = $ 485 mil
+ Acquisitions = $ 2,516 mil
Adjusted Net Capital Expenditures = $3,723 mil

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§ Accounting definition: Working capital is the difference between

current assets (inventory, cash and accounts receivable) and
current liabilities (accounts payables, short term debt and debt
due within the next year).
§ Valuation definition: A cleaner definition of working capital from
a cash flow perspective is the difference between non-cash
current assets (inventory and accounts receivable) and non-
debt current liabilities (accounts payable, supplier credit
etc.).

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§ Working Capital Detail: While some analysts break down

working capital into detail, it is a pointless exercise unless you
feel that you can bring some specific information that lets you
forecast the details.
§ Working Capital Volatility: Changes in non-cash working capital
from year to year tend to be volatile. It is better to either estimate
the change based on working capital as a percent of sales, while
keeping an eye on industry averages.
§ Negative Working Capital: Some firms have negative non-cash
working capital. Assuming that this will continue into the future will
generate positive cash flows for the firm and will get more positive
as growth increases.

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From the firm to equity

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§ In the strictest sense, the only cash flow from an equity

investment in a publicly traded firm is the dividend that will be
paid on the stock.
§ Actual dividends, however, are set by the managers of the firm
and may be much lower than the potential dividends (that could
have been paid out)
§ managers are conservative and try to smooth out dividends
§ managers like to hold on to cash to meet unforeseen future
contingencies and investment opportunities
§ When actual dividends are less (more) than potential dividends,
using a model that focuses only on dividends will under (over)
state the true value of the equity in a firm.

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§ Some analysts assume that the earnings of a firm represent its

potential dividends. This cannot be true for several reasons:
§ Earnings are not cash flows, since there are both non-cash
revenues and expenses in the earnings calculation
§ Even if earnings were cash flows, a firm that paid its earnings out as
dividends would not be investing in new assets and thus could not
grow
§ Valuation models, where earnings are discounted back to the present,
will overestimate the value of the equity in the firm
§ The potential dividends of a firm are the cash flows left over
after the firm has made any “investments” it needs to make to
create future growth and net debt repayments (debt repayments -
new debt issues)
§ The common categorization of capital expenditures into discretionary
and non-discretionary loses its basis when there is future growth built
into the valuation.

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§ Cash flows to Equity for a Levered Firm

Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
+ (New Debt Issues – Debt Repaid)
= Free Cash flow to Equity
§ Cash flows to equity represent residual cash flows for equity
investors, i.e., cash flows left over after every conceivable need
has been met.
§ That cash flow can be paid out without damaging the
operating business of the company and its growth potential.
It is thus a potential dividend.

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§ The statement of cash flows can be used to back into a FCFE, if

you are willing to navigate your way through it and not trust it fully.
§ FCFE
= Cashflow from Operations
+ Capital Expenditures (from the cash flow from investments)
+ Cash Acquisitions (from the cash flow from investments)
+(Debt Repaid – Debt Issued) (from financing cash flows)
= FCFE

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Net Income
- (1- DR) (Capital Expenditures - Depreciation)
- (1- DR) Working Capital Needs
= Free Cash flow to Equity
§ DR = Debt/Capital Ratio
§ For this firm,
§ Proceeds from new debt issues = Principal Repayments + (Capital
Expenditures - Depreciation + Working Capital Needs)
§ In computing FCFE, the book value debt to capital ratio should be
used when looking back in time but can be replaced with the
market value debt to capital ratio, looking forward.

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157

§ Net Income=$ 1533 Million

§ Capital spending = $ 1,746 Million
§ Depreciation per Share = $ 1,134 Million
§ Increase in non-cash working capital = $ 477 Million
§ Debt to Capital Ratio (DR) = 23.83%
§ Estimating FCFE (1997):
Net Income $1,533 Mil
- (Cap Exp - Depr)*(1-DR) $465.90 [(1746-1134)(1-.2383)]
Chg. Working Capital*(1-DR) $363.33 [477(1-.2383)]
= Free CF to Equity $ 704 Million

§ Dividends Paid $ 345 Million

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158

Debt Ratio and FCFE: Disney

1600

1400

1200

1000
FCFE

800

600

400

200

0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio

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Debt Ratio and Beta

8.00

7.00

6.00

5.00
Beta

4.00

3.00

2.00

1.00

0.00
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Debt Ratio

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§ In a discounted cash flow model, increasing the debt/equity ratio

will generally increase the expected free cash flows to equity
investors over future time periods and also the cost of equity
applied in discounting these cash flows. Which of the following
statements relating leverage to value would you subscribe to?
a. Increasing leverage will increase value because the cash flow effects
will dominate the discount rate effects
b. Increasing leverage will decrease value because the risk effect will
be greater than the cash flow effects
c. Increasing leverage will not affect value because the risk effect will
exactly offset the cash flow effect
d. Any of the above, depending upon what company you are looking at
and where it is in terms of current leverage

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Growth can be good, bad or neutral…

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§ When valuing a company, it is easy to get caught up in the details

of estimating growth and start viewing growth as a “good”, i.e.,
that higher growth translates into higher value.
§ Growth, though, is a double-edged sword.
§ The good side of growth is that it pushes up revenues and operating
income, perhaps at different rates (depending on how margins evolve
over time).
§ The bad side of growth is that you have to set aside money to reinvest
to create that growth.
§ The net effect of growth is whether the good outweighs the bad.

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§ Look at the past

§ The historical growth in earnings per share is usually a good starting
point for growth estimation
§ Look at what others are estimating
§ Analysts estimate growth in earnings per share for many firms. It is
useful to know what their estimates are.
§ Look at fundamentals
§ With stable margins, operating income growth can be tied to how
much a firm reinvests, and the returns it earns.
§ With changing margins, you have to start with revenue growth,
forecast margins and estimate reinvestment.

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Historical Growth

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§ Historical growth rates can be estimated in a number of different

ways
§ Arithmetic versus Geometric Averages
§ Simple versus Regression Models

§ Historical growth rates can be sensitive to

§ The period used in the estimation (starting and ending points)
§ The metric that the growth is estimated in..

§ In using historical growth rates, you have to wrestle with the

following:
§ How to deal with negative earnings
§ The effects of scaling up

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§ You are trying to estimate the growth rate in earnings per share at
Time Warner from 1996 to 1997. In 1996, the earnings per share
was a deficit of $0.05. In 1997, the expected earnings per share is
$ 0.25. What is the growth rate?
a. -600%
b. +600%
c. +120%
d. Cannot be estimated

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§ When the earnings in the starting period are negative, the growth
rate cannot be estimated. (0.30/-0.05 = -600%)
§ There are three solutions:
§ Use the higher of the two numbers as the denominator (0.30/0.25 =
120%)
§ Use the absolute value of earnings in the starting period as the
denominator (0.30/0.05=600%)
§ Use a linear regression model and divide the coefficient by the
average earnings.
§ When earnings are negative, the growth rate is meaningless.
Thus, while the growth rate can be estimated, it does not tell you
much about the future.

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Year Net Profit Growth Rate

1990 1.80
1991 6.40 255.56%
1992 19.30 201.56%
1993 41.20 113.47%
1994 78.00 89.32%
1995 97.70 25.26%
1996 122.30 25.18%
§ Geometric Average Growth Rate = 102%

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Year Net Profit

1996 $ 122.30
1997 $ 247.05
1998 $ 499.03
1999 $ 1,008.05
2000 $ 2,036.25
2001 $ 4,113.23
§ If net profit continues to grow at the same rate as it has in the
past 6 years, the expected net income in 5 years will be $ 4.113
billion.

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Analyst Estimates

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§ While the job of an analyst is to find under and overpriced stocks

in the sectors that they follow, a significant proportion of an
analyst’s time (outside of selling) is spent forecasting earnings
per share.
§ Most of this time, in turn, is spent forecasting earnings per share in
the next earnings report
§ While many analysts forecast expected growth in earnings per
share over the next 5 years, the analysis and information (generally)
that goes into this estimate is far more limited.
§ Analyst forecasts of earnings per share and expected growth are
widely disseminated by services such as Zacks and IBES, at
least for U.S companies.

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§ Analysts forecasts of EPS tend to be closer to the actual EPS than

simple time series models, but the differences tend to be small
Study Group tested Analyst Time Series
Error Model Error
Collins & Hopwood Value Line Forecasts 31.7% 34.1%
Brown & Rozeff Value Line Forecasts 28.4% 32.2%
Fried & Givoly Earnings Forecaster 16.4% 19.8%
§ The advantage that analysts have over time series models
§ tends to decrease with the forecast period (next quarter versus 5 years)
§ tends to be greater for larger firms than for smaller firms
§ tends to be greater at the industry level than at the company level

§ Forecasts of growth (and revisions thereof) tend to be highly

correlated across analysts.

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§ A study of All-America Analysts (chosen by Institutional Investor)

found that
§ There is no evidence that analysts who are chosen for the All-
America Analyst team were chosen because they were better
forecasters of earnings. (Their median forecast error in the quarter prior
to being chosen was 30%; the median forecast error of other analysts was
28%)
§ However, in the calendar year following being chosen as All-America
analysts, these analysts become slightly better forecasters than their
less fortunate brethren. (The median forecast error for All-America
analysts is 2% lower than the median forecast error for other analysts)
§ Earnings revisions made by All-America analysts tend to have a much
greater impact on the stock price than revisions from other analysts
§ The recommendations made by the All-America analysts have a greater
impact on stock prices (3% on buys; 4.7% on sells). For these
recommendations the price changes are sustained, and they continue to
rise in the following period (2.4% for buys; 13.8% for the sells).

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§ Tunnel Vision: Becoming so focused on the sector and

valuations within the sector that you lose sight of the bigger
picture.
§ Lemmingitis: Strong urge felt to change recommendations &
revise earnings estimates when other analysts do the same.
§ Stockholm Syndrome: Refers to analysts who start identifying
with the managers of the firms that they are supposed to follow.
§ Factophobia (generally is coupled with delusions of being a
famous story teller): Tendency to base a recommendation on a
“story” coupled with a refusal to face the facts.
§ Dr. Jekyll/Mr.Hyde: Analyst who thinks his primary job is to bring
in investment banking business to the firm.

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176

§ Proposition 1: There if far less private information and far more

public information in most analyst forecasts than is generally
claimed.
§ Proposition 2: The biggest source of private information for
analysts remains the company itself which might explain
§ why there are more buy recommendations than sell recommendations
(information bias and the need to preserve sources)
§ why there is such a high correlation across analysts forecasts and
revisions
§ why All-America analysts become better forecasters than other
analysts after they are chosen to be part of the team.
§ Proposition 3: There is value to knowing what analysts are
forecasting as earnings growth for a firm. There is, however,
danger when they agree too much (lemmingitis) and when they
agree to little (in which case the information that they have is so
noisy as to be useless).
Aswath Damodaran 176
177

Sustainable growth and Fundamentals

Aswath Damodaran
178

Investment Current Return on

in Existing Investment on Current
Projects
X Projects
= Earnings
$ 1000 12% $120

Investment Next Periodʼs Investment Return on

Next
+
in Existing Return on in New Investment on
Projects X Investment Projects X New Projects = Periodʼs
$1000 12% $100 12% Earnings
132

Investment Change in Investment Return on

+
in Existing ROI from in New Investment on
Projects X current to next Projects X New Projects Change in Earnings
$1000 period: 0% $100 12% = $ 12

Aswath Damodaran 178

179

In the special case where ROI on existing projects remains unchanged and is equal to the ROI on new projects

Investment in New Projects Change in Earnings

Current Earnings X Return on Investment = Current Earnings
100 $12
120 X 12% = $120

Reinvestment Rate X Return on Investment = Growth Rate in Earnings

83.33% X 12% = 10%

in the more general case where ROI can change from period to period, this can be expanded as follows:

Investment in Existing Projects*(Change in ROI) + New Projects (ROI) Change in Earnings

Investment in Existing Projects* Current ROI = Current Earnings

For instance, if the ROI increases from 12% to 13%, the expected growth rate can be written as follows:

$1,000 * (.13 - .12) + 100 (13%) $23

$ 1000 * .12 = $120
= 19.17%

Aswath Damodaran 179

180

Earnings Measure Reinvestment Measure Return Measure

Earnings per share Retention Ratio = % of Return on Equity = Net
net income retained by Income/ Book Value of
the company = 1 – Equity
Payout ratio
Net Income from non- Equity reinvestment Rate Non-cash ROE = Net
cash assets = (Net Cap Ex + Change in Income from non-cash
non-cash WC – Change in assets/ (Book value of
Debt)/ (Net Income) equity – Cash)

Operating Income Reinvestment Rate = (Net Return on Capital or ROIC

Cap Ex + Change in non- = After-tax Operating
cash WC)/ After-tax Income/ (Book value of
Operating Income equity + Book value of
debt – Cash)
Aswath Damodaran 180
181

§ When looking at growth in earnings per share, these inputs can be

cast as follows:
§ Reinvestment Rate = Retained Earnings/ Current Earnings = Retention
Ratio
§ Return on Investment = ROE = Net Income/Book Value of Equity

§ In the special case where the current ROE is expected to remain

unchanged
gEPS = Retained Earnings t-1/ NI t-1 * ROE
= Retention Ratio * ROE
= b * ROE
§ In 2008, using this approach on Wells Fargo:
§ Return on equity (based on 2008 earnings)= 17.56%
§ Retention Ratio (based on 2008 earnings and dividends) = 45.37%
§ Expected Growth Rate = 0.4537 (17.56%) = 7.97%

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182

ROE= Return on capital + D/E (ROC - i (1-tax rate))

where,
Return on capital = EBITt (1 - tax rate) / Book value of Capital t-1
D/E = BV of Debt/ BV of Equity
i = Interest Expense on Debt / BV of Debt
§ In 1998, Brahma (now Ambev) had an extremely high return on
equity, partly because it borrowed money at a rate well below its
return on capital
§ Return on Capital = 19.91%
§ Debt/Equity Ratio = 77%
§ After-tax Cost of Debt = 5.61%
§ Return on Equity = ROC + D/E (ROC - i(1-t))
§ = 19.91% + 0.77 (19.91% - 5.61%) = 30.92%

Aswath Damodaran 182

183

§ A more general version of expected growth in earnings can be

obtained by substituting in the equity reinvestment into real
investments (net capital expenditures and working capital) and
modifying the return on equity definition to exclude cash:
§ Net Income from non-cash assets = Net income – Interest income
from cash (1- t)
§ Equity Reinvestment Rate = (Net Capital Expenditures + Change in
Working Capital) (1 - Debt Ratio)/ Net Income from non-cash assets
§ Non-cash ROE = Net Income from non-cash assets/ (BV of Equity –
Cash)
§ Expected GrowthNet Income = Equity Reinvestment Rate * Non-cash
ROE
§ Th equity reinvestment rate, unlike the retention ratio, can be
higher than 100%, and if it is, the expected growth rate in net
income can exceed the return on equity.

Aswath Damodaran 183

184

§ In 2010, Coca Cola reported net income of $11,809 million. It had

a total book value of equity of $25,346 million at the end of 2009.
Coca Cola had a cash balance of $7,021 million at the end of
2009, on which it earned income of $105 million in 2010.
§ Non-cash Net Income = $11,809 - $105 = $ 11,704 million
§ Non-cash book equity = $25,346 - $7021 = $18,325 million
§ Non-cash ROE = $11,704 million/ $18,325 million = 63.87%

§ Coca Cola had capital expenditures of $2,215 million,

depreciation of $1,443 million and reported an increase in
working capital of $335 million. Coca Cola’s total debt increased
by $150 million during 2010.
§ Equity Reinvestment = 2215- 1443 + 335-150 = $957 million
§ Reinvestment Rate = $957 million/ $11,704 million= 8.18%

§ Expected growth rate in non-cash Net Income = 8.18% * 63.87%

= 5.22%

Aswath Damodaran 184

185

§ When looking at growth in operating income, the definitions are

§ Reinvestment Rate = (Net Capital Expenditures + Change in
WC)/EBIT(1-t)
§ Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity-
Cash)
§ Reinvestment Rate and Return on Capital
Expected Growth rate in Operating Income
= (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC
§ Proposition: The net capital expenditure needs of a firm, for a
given growth rate, should be inversely proportional to the quality
of its investments.

Aswath Damodaran 185

186

§ In 1999, Cisco’s fundamentals were as follows:

§ Reinvestment Rate = 106.81%
§ Return on Capital =34.07%
§ Expected Growth in EBIT =(1.0681)(.3407) = 36.39%

§ As a potential investor in Cisco, what would worry you the most

about this forecast?
a. That Cisco’s return on capital may be overstated (why?)
b. That Cisco’s reinvestment comes mostly from acquisitions (why?)
c. That Cisco is getting bigger as a firm (why?)
d. That Cisco is viewed as a star (why?)
e. All of the above

Aswath Damodaran 186

187

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188

§ When the return on capital is changing, there will be a second

component to growth, positive if the return on capital is increasing
and negative if the return on capital is decreasing.
§ If ROCt is the return on capital in period t and ROCt+1 is the return
on capital in period t+1, the expected growth rate in operating
income will be:
Expected Growth Rate = ROC t+1 * Reinvestment rate
+(ROC t+1 – ROCt) / ROCt
§ In general, if return on capital and margins are changing and/or
expected to change at a company, you are better off not using
any of the sustainable growth equations to estimate growth.

Aswath Damodaran 188

189

Expected growth = Growth from new investments + Efficiency growth

= Reinv Rate * ROC + (ROCt-ROCt-1)/ROCt-1
Assume that your cost of capital is 10%. As an investor, rank these
firms in the order of most value growth to least value growth.

Aswath Damodaran 189

190

Top Down Growth

Aswath Damodaran
191

§ All of the fundamental growth equations assume that the firm has a
return on equity or return on capital it can sustain in the long term.
§ When operating income is negative or margins are expected to
change over time, we use a three-step process to estimate growth:
§ Estimate growth rates in revenues over time
§ Determine the total market (given your business model) and estimate the
market share that you think your company will earn.
§ Decrease the growth rate as the firm becomes larger
§ Keep track of absolute revenues to make sure that the growth is feasible
§ Estimate expected operating margins each year
§ Set a target margin that the firm will move towards
§ Adjust the current margin towards the target margin
§ Estimate the capital that needs to be invested to generate revenue growth
and expected margins
§ Estimate a sales to capital ratio that you will use to generate reinvestment needs
each year.

Aswath Damodaran 191

192

Aswath Damodaran 192

193

In its prospectus, Airbnb has expanded its estimate of market potential to $3.4 trillion,
as evidenced in this excerpt from the prospectus:
We have a substantial market opportunity in the growing travel market and
experience economy. We estimate our serviceable addressable market (“SAM”)
today to be $1.5 trillion, including $1.2 trillion for short-term stays and $239 billion
for experiences. We estimate our total addressable market (“TAM”) to be $3.4
trillion, including $1.8 trillion for short-term stays, $210 billion for long-term stays,
and $1.4 trillion for experiences.
Aswath Damodaran 193
194

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195

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196

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197

Aswath Damodaran 197

198

Aswath Damodaran 198

199

§ While sustainable growth equations are stated in terms of returns

on capital (equity) or sales to capital the numbers that drive growth
are returns on new investments, i.e., marginal returns on capital
(equity) or marginal sales to capital ratios.
§ The marginal returns and sales to capital ratios can be computed by
looking at changes from year to year:
("#$%&'()* +),-.$! /"#$%&'()* +),-.$!"# )
§ 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑂𝐶 =
(+)1$2'$3 4&#('&5!"# /+)1$2'$3 4&#('&5!"$ )
(6&5$2! /6&5$2!"# )
§ 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑂𝐶 =
(+)1$2'$3 4&#('&5!"# /+)1$2'$3 4&#('&5!"$ )

§ As companies scale up, the marginal values for these variables

can diverge from the aggregate values.
§ For companies where there are investing economies to scale, the
marginal values can be significantly higher than the aggregate values.
§ For companies that are facing changing competitor or are entering new
businesses, the marginal values can be lower than the aggregate values.

Aswath Damodaran 199

200

The Big Enchilada

Aswath Damodaran
201

§ A publicly traded firm potentially has an infinite life. The value is

therefore the present value of cash flows forever.
t=∞ CF
Value = ∑ t
t
t=1 (1+r)

§ Since we cannot estimate cash flows forever, we estimate cash

flows for a “growth period” and then estimate a terminal value, to
capture the value at the end of the period:

t=N CF
Value = ∑ t + Terminal Value
t (1+r) N
t=1 (1+r)

Aswath Damodaran 201

202

Approach Inputs and Value Types of business

Liquidation Liquidation value of assets held Businesses built
Value by the firm in the terminal year. around a key person
or a time-limited
competitive advantage
(license or patent)
Going TV in year n = CFn+1/ (r – g), Going concerns with
Concern where g = growth rate forever long lives (>40 years)
(Perpetuity)
Going TV in year n = PV of CF in years Going concerns with
Concern n+1 to n+ k, where k is finite shorter lives
(Finite)
Pricing Terminal Year Operating Metric Never appropriate in
* Estimated Multiple of Metric an intrinsic
valuation.
Aswath Damodaran 202
203

§ When a firm’s cash flows grow at a “constant” rate forever, the

present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
§ The stable growth rate cannot exceed the growth rate of the
economy, but it can be lower.
§ If the economy is composed of high growth and stable growth firms,
the growth rate of the latter will be lower than the growth rate of
the economy.
§ The stable growth rate can be negative, for companies in declining
businesses.
§ If you use nominal cashflows and discount rates, the growth rate
should be nominal in the currency in which the valuation is
denominated.

Aswath Damodaran 203

 § Risk free Rate = Expected § Nominal GDP Growth = Expected
Inflation + Expected Real Inflation + Expected Real Growth
Interest Rate
§ The real growth rate in the economy
§ The real interest rate is what
borrowers agree to return to measures the expected growth in the
lenders in real goods/services. production of goods and services.

The argument for Risk free rate = Nominal GDP growth

1. In the long term, the real growth rate cannot be lower than the real interest rate,
since the growth in goods/services has to be enough to cover the promised rate.
2. In the long term, the real growth rate can be higher than the real interest rate, to
compensate risk taking. However, as economies mature, the difference should get
smaller and since there will be growth companies in the economy, it is prudent to
assume that the extra growth comes from these companies.

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205

§ You are implicitly making assumptions about nominal growth in

the economy, with your riskfree rate. Thus, with a low risk free
rate, you are assuming low nominal growth in the economy (with
low inflation and low real growth) and with a high risk free rate, a
high nominal growth rate in the economy.
§ If you make an explicit assumption about nominal growth in cash
flows that is at odds with your implicit growth assumption in the
denominator, you are being inconsistent and bias your valuations:
§ If you assume high nominal growth in the economy, with a low risk
free rate, you will over value businesses.
§ If you assume low nominal growth rate in the economy, with a high
risk free rate, you will under value businesses.

Aswath Damodaran 205

 Heineken: September 2019 (in Euros)
Maturty and Closure
Cash flows from existing assets The Payoff from growth
LTM 2013-2018
Revenues will
Revenues € 23,119 Growth rate = 3.22% grow 3.22% a Sales/Invested Stable Growth
Operatng margin
Operating Margin 14.86% 14.44% year for next 5
(per-tax) will drop
Capital will stay g = -0.5%;
Sales/Invested Capital 0.71 0.79 years, tapering
to 14.00%
at five-year Cost of capital = 5%
down to -0.5% average of 0.79. ROC= 5%;
ROIC 7.46% 8.32% growth in year 10 Reinvestment Rate=-.5%/5% = -10%
Effective Tax Rate 29.70% 27.00%

Euro Cashflows Terminal Value = 2972/(.05-..-(.005)) = 54,034

PV(Terminal value) € 36,390.85
PV (CF over next 10 years) € 15,300.34 1 2 3 4 5 6 7 8 9 10 Terminal year
Value of operating assets = € 51,691.19 Revenue growth rate 3.22% 3.22% 3.22% 3.22% 3.22% 2.48% 1.73% 0.99% 0.24% -0.50% -0.50%
- Debt € 19,709.52 Revenues € 23,863 € 24,632 € 25,425 € 26,244 € 27,089 € 27,759 € 28,240 € 28,519 € 28,589 € 28,446 € 28,304
EBIT (Operating) margin 14.38% 14.34% 14.30% 14.26% 14.21% 14.17% 14.13% 14.09% 14.04% 14.00% 14.00%
- Minority interests € 1,069.00
EBIT (Operating income) € 3,432 € 3,532 € 3,635 € 3,741 € 3,850 € 3,934 € 3,990 € 4,017 € 4,015 € 3,982 $ 3,963
+ Cash € 1,751.60 Tax rate 29.70% 29.70% 29.70% 29.70% 29.70% 28.76% 27.82% 26.88% 25.94% 25.00% $ 0
+ Non-operating assets € 1,401.00 EBIT(1-t) € 2,413 € 2,483 € 2,556 € 2,630 € 2,707 € 2,802 € 2,880 € 2,937 € 2,973 € 2,987 $ 2,972
Value of equity € 34,065.26 - Reinvestment € 942 € 973 € 1,004 € 1,036 € 1,070 € 849 € 609 € 353 € 88 € (181) $ (297)
Number of shares 571.10 FCFF € 1,471 € 1,511 € 1,552 € 1,594 € 1,637 € 1,953 € 2,271 € 2,584 € 2,885 € 3,168 $ 3,269
Estimated value /share € 59.65
Price € 93.25
Price as % of value 56.33% Discount at Euro Cost of Capital (WACC) = 7.66% (.599) + 1.13% (0.401) = 5.04% The Risk in the Cash flows

On September 1, 2019,
Cost of Equity
Heineken was trading at Weights
7.66% Cost of Debt
93.25 Euros/share E = 59.9% D = 40.1%
(-0.5%+2%)(1-.25) = 1.13%

Riskfree Rate: ERP = 6.83%

Euro Risk free rate = + X
-0.50% Beta = 1.20 Region Revenues Weight ERP
Europe 10348 50.24% 6.90%
North America 5920 28.74% 5.75%
Firm’s D/E Asia 2919 14.17% 7.22%
RaSo: 66.98%
Latin America & Caribbean 781 3.79% 10.53%
Unlevered beta of Africa & Mid East 631 3.06% 9.30%
alcoholic beverage Total 20599 100.00% 6.83%
business = 0.80

Aswath Damodaran 206

207

§ Most growth firms have difficulty sustaining their growth for long
periods, especially while earning excess returns. Assuming long
growth periods for all firms is ignoring this reality.
§ Proposition 1: The larger the potential market for a company’s
products and services, the greater the likelihood that you can maintain
growth for longer.
§ Proposition 2: The smaller a company, relative to the market it
aspires to reach, the longer the potential growth period can be.
§ It is not growth per se that creates value but growth with excess
returns. For growth firms to continue to generate value-creating
growth, they have to be able to keep the competition at bay.
§ Proposition 3: The stronger and more sustainable the competitive
advantages, the longer a growth company can sustain “value
creating” growth.
§ Proposition 4: Growth companies with strong and sustainable
competitive advantages are rare.

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208

§ The reinvestment rate in stable growth will be a function of the

stable growth rate and return on capital in perpetuity
§ Reinvestment Rate = Stable g/ Stable period ROC = g/ ROC
'
!"#$%&# %&' (%&()* )
§ Terminal Value in year n =
(*+,' +- *./0'.1&2)

Return on capital in perpetuity

6% 8% 10% 12% 14%
0.0% $1,000 $1,000 $1,000 $1,000 $1,000
Growth rate forever

0.5% $965 $987 $1,000 $1,009 $1,015

1.0% $926 $972 $1,000 $1,019 $1,032
1.5% $882 $956 $1,000 $1,029 $1,050
2.0% $833 $938 $1,000 $1,042 $1,071
2.5% $778 $917 $1,000 $1,056 $1,095
3.0% $714 $893 $1,000 $1,071 $1,122
Aswath Damodaran 208
209

§ There are some (McKinsey, for instance) who argue that the
return on capital should always be equal to cost of capital in
stable growth.
§ But excess returns seem to persist for very long time periods.

Aswath Damodaran 209

210

§ A typical assumption in many DCF valuations, when it comes to

stable growth, is that capital expenditures offset depreciation and
there are no working capital needs. Stable growth firms, we are
told, just have to make maintenance cap ex (replacing existing
assets ) to deliver growth.
a. If you make this assumption, what expected growth rate can
you use in your terminal value computation?

b. What if the stable growth rate = inflation rate? Is it okay to

make this assumption then?

Aswath Damodaran 210

211

§ Risk and costs of equity and capital: Stable growth firms tend to
§ Have betas closer to one
§ Have debt ratios closer to industry averages (or mature company
averages)
§ Country risk premiums (especially in emerging markets should evolve
over time)
§ The excess returns at stable growth firms should approach (or
become) zero. ROC -> Cost of capital and ROE -> Cost of equity
§ The reinvestment needs and dividend payout ratios should reflect
the lower growth and excess returns:
§ Stable period payout ratio = 1 - g/ ROE
§ Stable period reinvestment rate = g/ ROC

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212

Choosing the right model

Aswath Damodaran
213

§ In summary, at this stage in the process, we should have an

estimate of the
§ the current cash flows on the investment, either to equity investors
(dividends or free cash flows to equity) or to the firm (cash flow to the
firm)
§ the current cost of equity and/or capital on the investment
§ the expected growth rate in earnings, based upon historical growth,
analysts forecasts and/or fundamentals
§ The next step in the process is deciding
§ which cash flow to discount, which should indicate
§ which discount rate needs to be estimated and
§ what pattern we will assume growth to follow

Aswath Damodaran 213

214

§ Use Equity Valuation

(a) for firms which have stable leverage, whether high or not…
(b) For all financial service firms
§ Use Firm Valuation
(a) for firms which have leverage which is too high or too low, and
expect to change the leverage over time, because debt payments and
issues do not have to be factored in the cash flows and the discount
rate (cost of capital) does not change dramatically over time.
(b) for firms for which you have partial information on leverage (eg:
interest expenses are missing..)
(c) in all other cases, where you are more interested in valuing the firm
than the equity. (Value Consulting?)

Aswath Damodaran 214

215

§ Use the Dividend Discount Model

(a) For firms which pay dividends (and repurchase stock) which are
close to the Free Cash Flow to Equity (over a extended period)
(b)For firms where FCFE are difficult to estimate (Example: Banks and
Financial Service companies)
§ Use the FCFE Model
(a) For firms which pay dividends which are significantly higher or
lower than the Free Cash Flow to Equity. (What is significant? ... As a
rule of thumb, if dividends are less than 80% of FCFE or dividends are
greater than 110% of FCFE over a 5-year period, use the FCFE model)
(b) For firms where dividends are not available (Example: Private
Companies, IPOs)

Aswath Damodaran 215

216

§ Cost of Equity versus Cost of Capital

§ If discounting cash flows to equity -> Cost of Equity
§ If discounting cash flows to the firm -> Cost of Capital
§ What currency should the discount rate (risk free rate) be in?
§ Match the currency in which you estimate the risk free rate to the
currency of your cash flows
§ Should I use real or nominal cash flows?
§ If discounting real cash flows -> real cost of capital
§ If nominal cash flows -> nominal cost of capital
§ If inflation is low (<10%), stick with nominal cash flows since taxes are
based upon nominal income
§ If inflation is high (>10%) switch to real cash flows

Aswath Damodaran 216

217

Use a Stable Growth Model

§ If your firm is
§ large and growing at a rate close to or less than growth rate of the economy, or
§ constrained by regulation from growing at rate faster than the economy
§ has the characteristics of a stable firm (average risk & reinvestment rates)

Use a 2-Stage Growth Model

§ If your firm
§ is large & growing at a moderate rate (≤ Overall growth rate + 10%) or
§ has a single product & barriers to entry with a finite life (e.g. patents)

Use a 3-Stage or n-stage Model

§ If your firm
§ is small and growing at a very high rate (> Overall growth rate + 10%) or
§ has significant barriers to entry into the business
§ has firm characteristics that are very different from the nor

Aswath Damodaran 217

218

Choose a
Cash Flow Dividends Cashflows to Equity Cashflows to Firm
Expected Dividends to
Net Income EBIT (1- tax rate)
Stockholders
- (1- δ) (Capital Exp. - Deprec’n) - (Capital Exp. - Deprec’n)
- (1- δ) Change in Work. Capital - Change in Work. Capital
= Free Cash flow to Equity (FCFE) = Free Cash flow to Firm (FCFF)
[δ = Debt Ratio]
& A Discount Rate Cost of Equity Cost of Capital
• Basis: The riskier the investment, the greater is the cost of equity. WACC = ke ( E/ (D+E))
• Models: + kd ( D/(D+E))
CAPM: Riskfree Rate + Beta (Risk Premium) kd = Current Borrowing Rate (1-t)
APM: Riskfree Rate + Σ Betaj (Risk Premiumj): n factors E,D: Mkt Val of Equity and Debt
& a growth pattern Stable Growth Two-Stage Growth Three-Stage Growth
g g g

| |
t High Growth Stable High Growth Transition Stable

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219

The trouble starts after you tell me you are done..

Aswath Damodaran
220

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

Value of Operating Assets premium?

+ Cash and Marketable Operating versus Non-opeating cash

Securities 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 What about other valuable assets?

How do you consider under utlilized assets?
Should you discount this value for opacity or complexity?
Value of Firm How about a premium for synergy?
What about a premium for intangibles (brand name)?
What should be counted in debt?
- Value of 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 Should there be a discount for illiquidity/ marketability?

Should there be a discount for minority interests?

Aswath Damodaran 220

221

§ The simplest and most direct way of dealing with cash and
marketable securities is to keep it out of the valuation - the cash
flows should be before interest income from cash and securities,
and the discount rate should not be contaminated by the inclusion
of cash. (Use betas of the operating assets alone to estimate the
cost of equity).
§ Once the operating assets have been valued, you should add
back the value of cash and marketable securities.
§ In many equity valuations, the interest income from cash is
included in the cashflows. The discount rate has to be adjusted
then for the presence of cash. (The beta used will be weighted
down by the cash holdings). Unless cash remains a fixed
percentage of overall value over time, these valuations will tend
to break down.

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222

§
Company A Company B Company C

Enterprise Value $1,000.0 $1,000.0 $1,000.0

Cash $100.0 $100.0 $100.0

Return on invested capital 10% 5% 22%

Cost of capital 10% 10% 12%

Trades in US US Argentina
In which of these companies is cash most likely to be
a. A Neutral Asset (worth $100 million)
b. A Wasting Asset (worth less than $100 million)
c. A Potential Value Creator (worth >$100 million)

Aswath Damodaran 222

223

§ There are some analysts who argue that companies with a lot of
cash on their balance sheets should be penalized by having the
excess cash discounted to reflect the fact that it earns a low
return.
§ Excess cash is usually defined as holding cash that is greater than
what the firm needs for operations.
§ A low return is defined as a return lower than what the firm earns on
its non-cash investments.
§ This is the wrong reason for discounting cash. If the cash is
invested in riskless securities, it should earn a low rate of return.
As long as the return is high enough, given the riskless nature of
the investment, cash does not destroy value.
§ There is a right reason, though, that may apply to some
companies… Managers can do stupid things with cash
(overpriced acquisitions, pie-in-the-sky projects….) and you have
to discount for this possibility.
Aswath Damodaran 223
224

Aswath Damodaran 224

 § Assume that you have a
closed-end fund that invests
in ‘average risk” stocks.
Assume also that you expect
the market (average risk
investments) to make 11.5%
annually over the long term.
If the closed end fund
underperforms the market by
0.50%, estimate the discount
on the fund.

Aswath Damodaran 225

226

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227

§ Holdings in other firms can be categorized into

§ Minority passive holdings, in which case only the dividend from the
holdings is shown in the balance sheet
§ Minority active holdings, in which case the share of equity income is
shown in the income statements
§ Majority active holdings, in which case the financial statements are
consolidated.
§ In an intrinsic valuation, you would like to estimate the intrinsic
value of these holdings and including them in your overall intrinsic
valuation of the company.

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228

§ Step 1: Value the parent company without any cross holdings.

This will require using unconsolidated financial statements rather
than consolidated ones.
§ Step 2: Value each of the cross holdings individually. (If you use
the market values of the cross holdings, you will build in errors the
market makes in valuing them into your valuation).
§ Step 3: The final value of the equity in the parent company with N
cross holdings will be:
Value of parent company
– Debt of parent company
j= N
+
∑% owned of Company j * (Value of Company j - Debt of Company j)
j=1

€ Aswath Damodaran 228

229

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230

§ For majority holdings, with full consolidation, convert the

minority interest from book value to market value by applying a
price to book ratio (based upon the sector average for the
subsidiary) to the minority interest.
§ Estimated market value of minority interest = Minority interest on
balance sheet * Price to Book ratio for sector (of subsidiary)
§ Subtract this from the estimated value of the consolidated firm to get
to value of the equity in the parent company.
§ For minority holdings in other companies, convert the book value
of these holdings (which are reported on the balance sheet)
into market value by multiplying by the price to book ratio of
the sector(s). Add this value on to the value of the operating
assets to arrive at total firm value.

Aswath Damodaran 230

231

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232

§ Assets that you should not be counting (or adding on to DCF

values)
§ If an asset is contributing to your cashflows, you cannot count
the market value of the asset in your value.
§ Assets that you can count (or add on to your DCF valuation)
§ Overfunded pension plans: If you have a defined benefit plan and
your assets exceed your expected liabilities, you could consider the
over funding with two caveats:
§ Collective bargaining agreements may prevent you from laying claim to
these excess assets.
§ There are tax consequences. Often, withdrawals from pension plans get
taxed at much higher rates.
§ Unutilized assets: If you have assets or property that are not being
utilized to generate cash flows (vacant land, for example), you have
not valued them yet. You can assess a market value for these assets
and add them on to the value of the firm.

Aswath Damodaran 232

233

Price tag: $200 million

Aswath Damodaran 233

234

Company A Company B
Operating Income $ 1 billion $ 1 billion
Tax rate 40% 40%
ROIC 10% 10%
Expected Growth 5% 5%
Cost of capital 8% 8%
Business Mix Single Multiple
Holdings Simple Complex
Accounting Transparent Opaque
§ Which firm would you value more highly?

Aswath Damodaran 234

235

Company Number of pages in last 10Q Number of pages in last 10K

General Electric 65 410
Microsoft 63 218
Wal-mart 38 244
Exxon Mobil 86 332
Pfizer 171 460
Citigroup 252 1026
Intel 69 215
AIG 164 720
Johnson & Johnson 63 218
IBM 85 353

Aswath Damodaran 235

236

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237

§ In Discounted Cashflow Valuation

§ The Aggressive Analyst: Trust the firm to tell the truth and value the
firm based upon the firm’s statements about their value.
§ The Conservative Analyst: Don’t value what you cannot see.
§ The Compromise: Adjust the value for complexity
§ Adjust cash flows for complexity
§ Adjust the discount rate for complexity
§ Adjust the expected growth rate/ length of growth period
§ Value the firm and then discount value for complexity (a complexity
discount)

§ In relative valuation
§ In a relative valuation, you may be able to assess the price that the
market is charging for complexity:
§ With the hundred largest market cap firms, for instance:
PBV = 0.65 + 15.31 ROE – 0.55 Beta + 3.04 Expected growth rate – 0.003 #
Pages in 10K

Aswath Damodaran 237

238

§ General Rule: Debt generally has the following characteristics:

§ Contractual commitment to make fixed payments in the future
§ The fixed payments are tax deductible
§ Failure to make the payments can lead to either default or loss of
control of the firm to the party to whom payments are due.
§ Defined as such, debt should include
§ All interest bearing liabilities, short term as well as long term
§ All leases, operating as well as capital

§ Debt should not include

§ Accounts payable or supplier credit

§ Be wary of your conservative impulses which will tell you to count

everything as debt. That will push up the debt ratio and lead you
to understate your cost of capital.
Aswath Damodaran 238
239

§ You are valuing a distressed telecom company and have

arrived at an estimate of $ 1 billion for the enterprise value
(using a discounted cash flow valuation). The company has $ 1
billion in face value of debt outstanding but the debt is trading
at 50% of face value (because of the distress). What is the
value of the equity to you as an investor?
§ The equity is worth nothing (EV minus Face Value of Debt)
§ The equity is worth $ 500 million (EV minus Market Value of Debt)

§ Would your answer be different if you were told that the

liquidation value of the assets of the firm today is $1.2 billion and
that you were planning to liquidate the firm today?

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240

§ If you have under funded pension fund or health care plans,

you should consider the under funding at this stage in getting to
the value of equity.
§ If you do so, you should not double count by also including a cash flow
line item reflecting cash you would need to set aside to meet the
unfunded obligation.
§ You should not be counting these items as debt in your cost of capital
calculations….
§ If you have contingent liabilities - for example, a potential
liability from a lawsuit that has not been decided - you should
consider the expected value of these contingent liabilities
§ Value of contingent liability = Probability that the liability will occur *
Expected value of liability

Aswath Damodaran 240

§ In recent years, firms have turned to giving employees (and
especially top managers) equity option or restricted stock
packages as part of compensation. If they are options, they
usually are long term and on volatile stocks. If restricted stock, the
restrictions are usually on trading.
§ These equity compensation packages are clearly valuable and
the question becomes how best to deal with them in valuation.
§ Two key issues with employee options:
1. How do options or restricted stock granted in the past affect equity
value per share today?
2. How do expected grants of either, in the future, affect equity value
today?

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242

§ When employee compensation takes the form of

restricted stock grants, the solution is relatively simple.
§ To account for restricted stock grants in the past, make sure
that you count the restricted stock that have already been
granted in shares outstanding today. That will reduce your
value per share.
§ To account for expected stock grants in the future, estimate the
value of these grants as a percent of revenue and forecast that
as expense as part of compensation expenses. That will
reduce future income and cash flows.
§ This process has been made easier by accounting rules
that have changed to require that stock based
compensation be expensed in the year that they are
granted. Thus, extrapolating past margins already
incorporates stock based compensation.

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243

§ It is true that options can increase the number of shares

outstanding but dilution per se is not the problem.
§ Options affect equity value at exercise because
§ Shares are issued at below the prevailing market price. Options
get exercised only when they are in the money.
§ Alternatively, the company can use cashflows that would have been
available to equity investors to buy back shares which are then
used to meet option exercise. The lower cashflows reduce equity
value.
§ Options affect equity value before exercise because we have to
build in the expectation that there is a probability of and a cost to
exercise.

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244

§ XYZ company has $ 100 million in free cashflows to the firm,

growing 3% a year in perpetuity and a cost of capital of 8%. It has
100 million shares outstanding and $ 1 billion in debt. Its value
can be written as follows:
Value of firm = 100 / (.08-.03) = 2000
Debt = 1000
= Equity = 1000
Value per share = 1000/100 = $10

§ XYZ decides to give 10 million options at the money (with a strike

price of $10) to its CEO. What effect will this have on the value of
equity per share?
a. None. The options are not in-the-money.
b. Decrease by 10%, since the number of shares could increase by 10
million
c. Decrease by less than 10%. The options will bring in cash into the
firm but they have time value.

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245

§ The simplest way of dealing with options is to try to adjust the

denominator for shares that will become outstanding if the options
get exercised. In the example cited, this would imply the
following:
Value of firm = 100 / (.08-.03) = 2000
Debt = 1000
= Equity = 1000
Number of diluted shares = 110
Value per share = 1000/110 = $9.09
§ The diluted approach fails to consider that exercising options
will bring in cash into the firm. Consequently, they will
overestimate the impact of options and understate the value of
equity per share.

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246

§ The treasury stock approach adds the proceeds from the exercise
of options to the value of the equity before dividing by the diluted
number of shares outstanding.
§ In the example cited, this would imply the following:
Value of firm = 100 / (.08-.03) = 2000
Debt = 1000
= Equity = 1000
Number of diluted shares = 110
Proceeds from option exercise = 10 * 10 = 100
Value per share = (1000+ 100)/110 = $ 10
§ The treasury stock approach fails to consider the time
premium on the options. The treasury stock approach also has
problems with out-of-the-money options. If considered, they can
increase the value of equity per share. If ignored, they are treated
as non-existent.
Aswath Damodaran 246
247

§ Step 1: Value the firm, using discounted cash flow or other

valuation models.
§ Step 2: Subtract out the value of the outstanding debt to arrive
at the value of equity. Alternatively, skip step 1 and estimate the of
equity directly.
§ Step 3:Subtract out the market value (or estimated market
value) of other equity claims:
§ Value of Warrants = Market Price per Warrant * Number of Warrants
: Alternatively estimate the value using option pricing model
§ Value of Conversion Option = Market Value of Convertible Bonds -
Value of Straight Debt Portion of Convertible Bonds
§ Value of employee Options: Value using the average exercise price
and maturity.
§ Step 4: Divide the remaining value of equity by the number of
shares outstanding to get value per share.

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248

§ Option pricing models can be used to value employee options

with four caveats –
§ Employee options are long term, making the assumptions about
constant variance and constant dividend yields much shakier,
§ Employee options result in stock dilution, and
§ Employee options are often exercised before expiration, making it
dangerous to use European option pricing models.
§ Employee options cannot be exercised until the employee is vested.

§ These problems can be partially alleviated by using an option

pricing model, allowing for shifts in variance and early exercise,
and factoring in the dilution effect. The resulting value can be
adjusted for the probability that the employee will not be
vested.

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249

§ To value employee options, you need the following inputs into the
option valuation model:
§ Stock Price = $ 10, Adjusted for dilution = $9.58
§ Strike Price = $ 10
§ Maturity = 10 years (Can reduce to reflect early exercise)
§ Standard deviation in stock price = 40%
§ Riskless Rate = 4%

§ Using a dilution-adjusted Black Scholes model, we arrive at the

following inputs:
§ N (d1) = 0.8199
§ N (d2) = 0.3624
§ Value per call = $ 9.58 (0.8199) - $10 e -(0.04) (10)(0.3624) = $5.42

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250

§ Using the value per call of $5.42, we can now estimate the value
of equity per share after the option grant:
§ Value of firm = 100 / (.08-.03) = 2000
§ Debt = 1000
§ = Equity = 1000
§ Value of options granted = $ 54.2
§ = Value of Equity in stock = $945.8
§ / Number of shares outstanding / 100
§ = Value per share = $ 9.46
§ Note that this approach yields a higher value than the diluted
share count approach (which ignores exercise proceeds)
and a lower value than the treasury stock approach (which
ignores the time premium on the options)

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251

§ Assume now that this firm intends to continue granting options

each year to its top management as part of compensation. These
expected option grants will also affect value.
§ The simplest mechanism for bringing in future option grants into
the analysis is to do the following:
§ Estimate the value of options granted each year over the last few
years as a percent of revenues.
§ Forecast out the value of option grants as a percent of revenues into
future years, allowing for the fact that as revenues get larger, option
grants as a percent of revenues will become smaller.
§ Consider this line item as part of operating expenses each year. This
will reduce the operating margin and cashflow each year.
§ To the extent that accountants have been treating option grants
as expenses in the year that they are granted already, you are
effectively forecasting their continuance, when you keep those
margins.
Aswath Damodaran 251
§ Over the last decade, just as accountants have come to their
senses and treated stock-based compensation as an operating
expense, companies and analysts have tried to reverse this move
by adding back these expenses to arrive at “adjusted” EBITDA
and earnings numbers.
§ The rationale that they provide is that options are non-cash
expenses, and that they should be added back, just as we do
depreciation.
§ The truth is that options are not non-cash expenses, but in-kind
expenses, where equity in the firm is being paid out to
employees. Consequently, you should not be adding them back.

Aswath Damodaran 252

Tell me a story.. 253

Aswath Damodaran
Number Crunchers Story Tellers

Aswath Damodaran 254

§ Every valuation starts with a narrative, a story that you see
unfolding for your company in the future.
§ In developing this narrative, you will be making assessments of
§ Your company (its products, its management and its history.
§ The market or markets that you see it growing in.
§ The competition it faces and will face.
§ The macro environment in which it operates.

§ If understanding the products and services that a business sells

makes it easier to construct a story, it follows that B2C (sell to
final consumer) businesses will be easier to value than B2B
businesses.

Aswath Damodaran 255

Aswath Damodaran 256
§ Every valuation starts with a narrative, a story that you see
unfolding for your company in the future.
§ In developing this narrative, you will be making assessments of
your company (its products, its management), the market or
markets that you see it growing in, the competition it faces and
will face and the macro environment in which it operates.
§ Rule 1: Keep it simple.
§ Rule 2: Keep it focused.
§ Rule 3: Stay grounded in reality.

Aswath Damodaran 257

§ In June 2014, my initial narrative for Uber was that it would be
§ An urban car service business: I saw Uber primarily as a force in
urban areas and only in the car service business.
§ Which would expand the business moderately (about 40% over
ten years) by bringing in new users.
§ With local networking benefits: If Uber becomes large enough in
any city, it will quickly become larger, but that will be of little help
when it enters a new city.
§ Maintain its revenue sharing (20%) system due to strong
competitive advantages (from being a first mover).
§ And its existing low-capital business model, with drivers as
contractors and very little investment in infrastructure.

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260

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§ With a runaway business story, you usually have three
ingredients:
§ Charismatic, likeable Narrator: The narrator of the business story is
someone that you want to see succeed, either because you like the
narrator or because he/she will be a good role model.
§ Telling a story about disrupting a much business, where you dislike the
status quo: The status quo in the business that the story is disrupting
is dissatisfying (to everyone involved)>
§ With a societal benefit as bonus: And if the story holds, society and
humanity will benefit.
§ Since you want this story to work out, you stop asking questions,
because the answers may put the story at risk.

Aswath Damodaran 262

 The Impossible: The Runaway Story
The Story The Checks (?)

+ +
+ Money

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264

The Meltdown Story

Bad Business Model

Story at war with numbers The business model has a
Untrustworthy Storyteller Meltdown Story
The company's narrative fundamental flaw that can Investors, lenders
A narrator, who through
conflicts with its own affect either future and observers
his/her words or actions
+ actions and/or with the + profitability or survival, but = question story,
has become unwilling to accept
actual results/numbers the management is either in
untrustworthy. the company's spin
reported by the company. denial about the flaw or on number, pushing
opaque in how it plans to pricing down.
deal with it.

Aswath Damodaran 264

 The Implausible: The Big Market Delusion

Aswath Damodaran 265

 The Improbable: Willy Wonkitis

Aswath Damodaran 266

 The Uber narrative (June 2014)

Uber is an urban car service company,

competing against taxis & limos in urban areas,
but it may expand demand for car service.
Total Market The global taxi/limo business is $100 billion in
2013, growing at 6% a year.
X

Market Share Uber will have competitive advantages against

traditional car companies & against newcomers in
=
this business, but no global networking benefits.
Target market share is 10%
Revenues (Sales)

-
Uber will maintain its current model of keeping 20%
Operating Expenses of car service payments, even in the face of
competition, because of its first mover advantages. It
= will maintain its current low-infrastructure cost model,
allowing it to earn high margins.
Operating Income Target pre-tax operating margin is 40%.
-

Taxes

After-tax Operating Income Uber has a low capital intensity model, since it
does not own cars or other infrastructure,
- allowing it to maintain a high sales to capital
ratio for the sector (5.00)
Reinvestment

After-tax Cash Flow The company is young and still trying to establish
a business model, leading to a high cost of
Adjust for time value & risk capital (12%) up front. As it grows, it will become
safer and its cost of capital will drop to 8%.
Adjusted for operating risk
with a discount rate and
VALUE OF
for failure with a
OPERATING
probability of failure.
ASSETS

Uber has cash & capital, but

Cash there is a chance of failure.
10% probability of failure.

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268

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269

§ Not just car service company.: Uber is a car company, not just a
car service company, and there may be a day when consumers
will subscribe to a Uber service, rather than own their own cars. It
could also expand into logistics, i.e., moving and transportation
businesses.
§ Not just urban: Uber can create new demands for car service in
parts of the country where taxis are not used (suburbia, small
towns).
§ Global networking benefits: By linking with technology and credit
card companies, Uber can have global networking benefits.

Aswath Damodaran 269

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272

Narrative Break/End Narrative Shift Narrative Change

(Expansion or
Contraction)
Events, external (legal, Improvement or Unexpected entry/success
political or economic) or deterioration in initial in a new market or
internal (management, business model, changing unexpected exit/failure in
competitive, default), that market size, market share an existing market.
can cause the narrative to and/or profitability.
break or end.

Your valuation estimates Your valuation estimates Valuation estimates have to

(cash flows, risk, growth & will have to be modified to be redone with new overall
value) are no longer reflect the new data about market potential and
operative the company. characteristics.

Estimate a probability that Monte Carlo simulations or Real Options

it will occur & scenario analysis
consequences
Aswath Damodaran 272
Let’s have some fun! 273

Aswath Damodaran
274

§ The equity risk premiums that I have used in the valuations that
follow reflect my thinking (and how it has evolved) on the issue.
§ Pre-1998 valuations: In the valuations prior to 1998, I use a risk
premium of 5.5% for mature markets (close to both the historical
and the implied premiums then)
§ Between 1998 and Sept 2008: In the valuations between 1998 and
September 2008, I used a risk premium of 4% for mature markets,
reflecting my belief that risk premiums in mature markets do not
change much and revert back to historical norms (at least for implied
premiums).
§ Valuations done in 2009: After the 2008 crisis and the jump in equity
risk premiums to 6.43% in January 2008, I have used a higher equity
risk premium (5-6%) for the next 5 years and will assume a reversion
back to historical norms (4%) only after year 5.
§ After 2009: I have used updated implied equity risk premiums, as
of the time that I did the valuations.

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275

§ With each company that I value in this next section, I will try to
start with a story about the company and use that story to
construct a valuation.
§ With each valuation, rather than focus on all of the details (which
will follow the blueprint already laid out), I will focus on a specific
component of the valuation that is unique or different.
§ Finally, while the valuations are scattered over time, they all
represent valuations done in real time, with decisions that
followed, and without the benefit of hindsight.

Aswath Damodaran 275

276

Stocks that look like Bonds, Things Change and Market

Valuations

Aswath Damodaran
 Test 1: Is the firm paying Training Wheels valuation: Test 2: Is the stable growth rate
dividends like a stable growth Con Ed in August 2008 consistent with fundamentals?
firm? Retention Ratio = 27%
Dividend payout ratio is 73% ROE =Cost of equity = 7.7%
In trailing 12 months, through June Expected growth = 2.1%
2008
Earnings per share = $3.17 Growth rate forever = 2.1%
Dividends per share = $2.32

Value per share today= Expected Dividends per share next year / (Cost of equity - Growth rate)
= 2.32 (1.021)/ (.077 - ,021) = $42.30

Cost of Equity = 4.1% + 0.8 (4.5%) = 7.70% On August 12, 2008

Con Ed was trading at $
40.76.
Riskfree rate Beta Equity Risk
4.10% 0.80 Premium
10-year T.Bond rate Beta for regulated 4.5%
power utilities Implied Equity Risk
Premium - US
market in 8/2008
Test 3: Is the firm’s risk and cost of equity consistent with a stable growith firm?
Beta of 0.80 is at lower end of the range of stable company betas: 0.8 -1.2

Why a stable growth dividend discount model?

1. Why stable growth: Company is a regulated utility, restricted from investing in new
growth markets. Growth is constrained by the fact that the population (and power
needs) of its customers in New York are growing at very low rates.
Growth rate forever = 2%
2. Why equity: Company’s debt ratio has been stable at about 70% equity, 30% debt
for decades.
3. Why dividends: Company has paid out about 97% of its FCFE as dividends over
the last five years.

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278

§ Assume that you believe that your valuation of Con Ed ($42.30) is

a fair estimate of the value, 7.70% is a reasonable estimate of
Con Ed’s cost of equity and that your expected dividends for next
year (2.32*1.021) is a fair estimate, what is the expected stock
price a year from now (assuming that the market corrects its
mistake)?

§ If you bought the stock today at $40.76, what return can you
expect to make over the next year (assuming again that the
market corrects its mistake)?

Aswath Damodaran 278

 Current Cashflow to Firm
3M: A Pre-crisis valuation
Return on Capital
EBIT(1-t)= 5344 (1-.35)= 3474 Reinvestment Rate 25%
- Nt CpX= 350 30% Stable Growth
Expected Growth in g = 3%; Beta = 1.10;
- Chg WC 691
EBIT (1-t) Debt Ratio= 20%; Tax rate=35%
= FCFF 2433
Reinvestment Rate = 1041/3474 .30*.25=.075 Cost of capital = 6.76%
7.5% ROC= 6.76%;
=29.97%
Return on capital = 25.19% Reinvestment Rate=3/6.76=44%

Terminal Value5= 2645/(.0676-.03) = 70,409

First 5 years
Op. Assets 60607 Year 1 2 3 4 5 Term Yr
+ Cash: 3253 EBIT (1-t) $3,734 $4,014 $4,279 $4,485 $4,619 $4,758
- Debt 4920 - Reinvestment $1,120 $1,204 $1,312 $1,435 $1,540 , $2,113
=Equity 58400 = FCFF $2,614 $2,810 $2,967 $3,049 $3,079 $2,645

Value/Share $ 83.55
Cost of capital = 8.32% (0.92) + 2.91% (0.08) = 7.88%

On September 12,
Cost of Equity Cost of Debt 2008, 3M was
8.32% (3.72%+.75%)(1-.35) Weights trading at $70/share
= 2.91% E = 92% D = 8%

Riskfree Rate: Risk Premium

Riskfree rate = 3.72% Beta 4%
+ 1.15 X

Unlevered Beta for

Sectors: 1.09 D/E=8.8%

Aswath Damodaran 279

 Did not increase debt
Lowered base operating income by 10% 3M: Post-crisis valuation ratio in stable growth
Current Cashflow to Firm Reduced growth Return on Capital to 20%
Reinvestment Rate rate to 5% 20%
EBIT(1-t)= 4810 (1-.35)= 3,180 Stable Growth
25% Expected Growth in
- Nt CpX= 350 g = 3%; Beta = 1.00;; ERP =4%
- Chg WC 691 EBIT (1-t)
Debt Ratio= 8%; Tax rate=35%
= FCFF 2139 .25*.20=.05
Cost of capital = 7.55%
Reinvestment Rate = 1041/3180 5%
ROC= 7.55%;
=33% Reinvestment Rate=3/7.55=40%
Return on capital = 23.06%
Terminal Value5= 2434/(.0755-.03) = 53,481
First 5 years
Op. Assets 43,975 Year 1 2 3 4 5 Term Yr
+ Cash: 3253 EBIT (1-t) $3,339 $3,506 $3,667 $3,807 $3,921 $4,038
- Debt 4920 - Reinvestment $835 $877 $1,025 $1,288 $1,558 $1,604
=Equity 42308 = FCFF $2,504 $2,630 $2,642 $2,519 $2,363 $2,434

Value/Share $ 60.53
Cost of capital = 10.86% (0.92) + 3.55% (0.08) = 10.27%

Higher default spread for next 5 years On October 16, 2008,

Cost of Equity Cost of Debt MMM was trading at
10.86% (3.96%+.1.5%)(1-.35) Weights $57/share.
= 3.55% E = 92% D = 8%

Increased risk premium to 6% for next 5 years

Riskfree Rate: Risk Premium
Riskfree rate = 3.96% Beta 6%
+ 1.15 X

Unlevered Beta for

Sectors: 1.09 D/E=8.8%

Aswath Damodaran 280

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286

Anyone can value a company that is stable, makes money and

has an established business model!

Aswath Damodaran
287

What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
What are the Firm: Growth in operating earnings/
cashflows from cashflows
existing assets? When will the firm
- Equity: Cashflows become a mature
after debt payments fiirm, and what are
- Firm: Cashflows How risky are the cash flows from both the potential
before debt payments existing assets and growth assets? roadblocks?
Equity: Risk in equity in the company
Firm: Risk in the firm’s operations

Aswath Damodaran 287

288

§ Valuing stable, money making companies with consistent and

clear accounting statements, a long and stable history and lots of
comparable firms is easy to do.
§ The true test of your valuation skills is when you have to value
“difficult” companies. In particular, the challenges are greatest
when valuing:
§ Young companies, early in the life cycle, in young businesses
§ Companies that don’t fit the accounting mold
§ Companies that face substantial truncation risk (default or
nationalization risk)

Aswath Damodaran 288

289

§ Across the life cycle:

§ Young, growth firms: Limited history, small revenues in conjunction with big
operating losses and a propensity for failure make these companies tough to value.
§ Mature companies in transition: When mature companies change or are forced to
change, history may have to be abandoned and parameters have to be reestimated.
§ Declining and Distressed firms: A long but irrelevant history, declining markets, high
debt loads and the likelihood of distress make them troublesome.
§ Across markets
§ Emerging market companies are often difficult to value because of the way they
are structured, their exposure to country risk and poor corporate governance.
§ Across sectors
§ Financial service firms: Opacity of financial statements and difficulties in
estimating basic inputs leave us trusting managers to tell us what’s going on.
§ Commodity and cyclical firms: Dependence of the underlying commodity prices or
overall economic growth make these valuations susceptible to macro factors.
§ Firms with intangible assets: Accounting principles are left to the wayside on
these firms.

Aswath Damodaran 289

290

Aswath Damodaran 290

291

§ When valuing a business, we generally draw on three sources of

information
§ The firm’s current financial statements
§ How much did the firm sell?
§ How much did it earn?
§ The firm’s financial history, usually summarized in its financial
statements.
§ How fast have the firm’s revenues and earnings grown over time?
§ What can we learn about cost structure and profitability from these trends?
§ Susceptibility to macro-economic factors (recessions and cyclical firms)
§ The industry and peer group firms
§ What happens to firms as they mature?

§ It is when valuing these companies that you find yourself tempted by

the dark side, where
§ “Paradigm shifts” happen…
§ New metrics are invented …
§ The story dominates and the numbers lag…

Aswath Damodaran 291

Aswath Damodaran
29
2
 § Spotlight the business the
company is in & use the beta
of that business.
§ Don’t try to incorporate failure
risk into the discount rate.
§ Let the cost of capital change
over time, as the company
changes.
§ If you are desperate, use the
cross section of costs of
capital to get your estimation
going (use the 90th or 95th
percentile across all
companies).

Aswath Damodaran 293

Aswath Damodaran 294
 § Lower revenue growth rates,
as revenues scale up.
§ Keep track of dollar
revenues, as you go through
time, measuring against
market size.
§ If you set your growth period
to be much longer than ten
years, you are already
building in the expectation
that your firm is an
exceptional firm.

Aswath Damodaran 295

Aswath Damodaran 296
§ With young growth companies, it is almost a given that the number
of shares outstanding will increase over time for two reasons:
§ To grow, the company will have to issue new shares either to raise cash
to take projects or to offer to target company stockholders in acquisitions
§ Many young, growth companies also offer options to managers as
compensation and these options will get exercised, if the company is
successful.
§ Both effects are already incorporated into the value per share,
even though we use the current number of shares in estimating
value per share
§ The need for new equity issues is captured in negative cash flows in
the earlier years. The present value of these negative cash flows will
drag down the current value of equity and this is the effect of future
dilution. In the Amazon valuation, the value of equity is reduced by $3.09
billion (the present value of negative FCFF in the first 6 years), about a
16% reduction. That takes care of new issues in the future.
§ The existing options are valued and netted out against the current
value, taking care of the option overhang. The future earnings are after
stock based compensation expenses (don’t fall for the “its not a cash
expense” ploy) to take care of future option grants.

Aswath Damodaran 297

Aswath Damodaran 298
 6% 8% 10% 12% 14%
30% $ (1.94) $ 2.95 $ 7.84 $ 12.71 $ 17.57
35% $ 1.41 $ 8.37 $ 15.33 $ 22.27 $ 29.21
40% $ 6.10 $ 15.93 $ 25.74 $ 35.54 $ 45.34
45% $ 12.59 $ 26.34 $ 40.05 $ 53.77 $ 67.48
50% $ 21.47 $ 40.50 $ 59.52 $ 78.53 $ 97.54
55% $ 33.47 $ 59.60 $ 85.72 $ 111.84 $ 137.95
60% $ 49.53 $ 85.10 $ 120.66 $ 156.22 $ 191.77

Aswath Damodaran 299

§ No matter how careful you are in getting your inputs and how well
structured your model is, your estimate of value will change
both as new information comes out about the company, the
business and the economy.
§ As information comes out, you will have to adjust and adapt
your model to reflect the information. Rather than be defensive
about the resulting changes in value, recognize that this is the
essence of risk.
§ A test: If your valuations are unbiased, you should find
yourself increasing estimated values as often as you are
decreasing values. In other words, there should be equal
doses of good and bad news affecting valuations (at least
over time).

Aswath Damodaran 300

 Amazon: Value and Price

$90.00

$80.00

$70.00

$60.00

$50.00

Value per share

$40.00 Price per share

$30.00

$20.00

$10.00

$0.00
2000 2001 2002 2003
Time of analysis

Aswath Damodaran 301

302

Aswath Damodaran 302

Aswath Damodaran 303
304

§ Mature companies are generally the easiest group to value.

They have long, established histories that can be mined for
inputs. They have investment policies that are set and capital
structures that are stable, thus making valuation more grounded
in past data.
§ However, this stability in the numbers can mask real
problems at the company. The company may be set in a
process, where it invests more or less than it should and does not
have the right financing mix. In effect, the policies are consistent,
stable and bad.
§ If you expect these companies to change or as is more often
the case to have change thrust upon them, you will have to
revalue the firm, with the changes built in.

Aswath Damodaran 304

305

Aswath Damodaran 305

 Hormel Foods: The Value of Control Changing
Hormel Foods sells packaged meat and other food products and has been in existence as a publicly traded company for almost 80 years.
In 2008, the firm reported after-tax operating income of $315 million, reflecting a compounded growth of 5% over the previous 5 years.
The Status Quo
Run by existing management, with conservative reinvestment policies (reinvestment rate = 14.34% and debt ratio = 10.4%.
Anemic growth rate and short growth period, due to reinvestment policy Low debt ratio affects cost of capital

Expected value =$31.91 (.90) + $37.80 (.10) = $32.50

Probability of management change = 10%
New and better management
More aggressive reinvestment which increases the reinvestment rate (to 40%) and tlength of growth (to 5 years), and higher debt ratio (20%).
Operating Restructuring 1
Financial restructuring 2
Expected growth rate = ROC * Reinvestment Rate
Cost of capital = Cost of equity (1-Debt ratio) + Cost of debt (Debt ratio)
Expected growth rae (status quo) = 14.34% * 19.14% = 2.75%
Status quo = 7.33% (1-.104) + 3.60% (1-.40) (.104) = 6.79%
Expected growth rate (optimal) = 14.00% * 40% = 5.60%
Optimal = 7.75% (1-.20) + 3.60% (1-.40) (.20) = 6.63%
ROC drops, reinvestment rises and growth goes up.
Cost of equity rises but cost of capital drops.

Aswath Damodaran
30
6
307

Exhibit 7.1: Optimal Financing Mix: Hormel Foods in January 2009

As debt ratio increases, equity

As firm borrows more money,
becomes riskier.(higher beta)
its ratings drop and cost of
and cost of equity goes up. 2
1 debt rises

Current Cost
of Capital Optimal: Cost of
capital lowest
between 20 and
30%.

As cost of capital drops,

Debt ratio is percent of overall At debt ratios > 80%, firm does not have enough firm value rises (as
market value of firm that comes operating income to cover interest expenses. Tax operating cash flows
from debt financing. rate goes down to reflect lost tax benefits. 3 remain unchanged)

Aswath Damodaran 307

308

Historial data often Growth can be negative, as firm sheds assets and
reflects flat or declining shrinks. As less profitable assets are shed, the firm’s
revenues and falling remaining assets may improve in quality.
margins. Investments
often earn less than the What is the value added by growth
cost of capital. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Underfunded pension existing assets and growth assets? roadblocks?
obligations and
litigation claims can
lower value of equity. Depending upon the risk of the There is a real chance,
Liquidation assets being divested and the use of especially with high financial
preferences can affect the proceeds from the divestuture (to leverage, that the firm will not
value of equity pay dividends or retire debt), the risk make it. If it is expected to
in both the firm and its equity can survive as a going concern, it
What is the value of change. will be as a much smaller
equity in the firm? entity.

Aswath Damodaran 308

309

§ In decline, firms often see declining revenues and lower

margins, translating in negative expected growth over time.
§ If these firms are run by good managers, they will not fight decline.
Instead, they will adapt to it and shut down or sell investments that do
not generate the cost of capital. This can translate into negative net
capital expenditures (depreciation exceeds cap ex), declining working
capital and an overall negative reinvestment rate. The best case
scenario is that the firm can shed its bad assets, make itself a much
smaller and healthier firm and then settle into long-term stable growth.
§ As an investor, your worst case scenario is that these firms are run by
managers in denial who continue to expand the firm by making bad
investments (that generate lower returns than the cost of capital).
These firms may be able to grow revenues and operating income but
will destroy value along the way.

Aswath Damodaran 309

Aswath Damodaran
310
311

§ A DCF valuation values a firm as a going concern. If there is a

significant likelihood of the firm failing before it reaches stable growth
and if the assets will then be sold for a value less than the present
value of the expected cashflows (a distress sale value), DCF
valuations will overstate the value of the firm.
Value of Equity= DCF value of equity (1 - Probability of distress) +
Distress sale value of equity (Probability of distress)
§ There are three ways in which we can estimate the probability of
distress:
§ Use the bond rating to estimate the cumulative probability of distress
Estimate the probability of distress with a probit
§ Estimate the probability of distress by looking at market value of
bonds..
§ The distress sale value of equity is usually best estimated as a
percent of book value (and this value will be lower if the economy is
doing badly and there are other firms in the same business also in
distress).

Aswath Damodaran 311

 Reinvestment:
Capital expenditures include cost of Stable Growth
Current Current
new casinos and working capital Stable Stable
Revenue Margin: Stable
$ 4,390 4.76% Operating ROC=10%
Extended Industry Revenue Margin: Reinvest 30%
reinvestment average Growth: 3% 17% of EBIT(1-t)
EBIT break, due ot
$ 209m investment in Expected
past Margin: Terminal Value= 758(.0743-.03)
-> 17% =$ 17,129

Term. Year
Revenues $4,434 $4,523 $5,427 $6,513 $7,815 $8,206 $8,616 $9,047 $9,499 $9,974 $10,273
Oper margin 5.81% 6.86% 7.90% 8.95% 10% 11.40% 12.80% 14.20% 15.60% 17% 17%
EBIT $258 $310 $429 $583 $782 $935 $1,103 $1,285 $1,482 $1,696 $ 1,746
Tax rate 26.0% 26.0% 26.0% 26.0% 26.0% 28.4% 30.8% 33.2% 35.6% 38.00% 38%
EBIT * (1 - t) $191 $229 $317 $431 $578 $670 $763 $858 $954 $1,051 $1,083
- Reinvestment -$19 -$11 $0 $22 $58 $67 $153 $215 $286 $350 $ 325
Value of Op Assets $ 9,793 FCFF $210 $241 $317 $410 $520 $603 $611 $644 $668 $701 $758
+ Cash & Non-op $ 3,040 1 2 3 4 5 6 7 8 9 10
= Value of Firm $12,833 Forever
- Value of Debt $ 7,565 Beta 3.14 3.14 3.14 3.14 3.14 2.75 2.36 1.97 1.59 1.20
= Value of Equity $ 5,268 Cost of equity 21.82% 21.82% 21.82% 21.82% 21.82% 19.50% 17.17% 14.85% 12.52% 10.20%
Cost of debt 9% 9% 9% 9% 9% 8.70% 8.40% 8.10% 7.80% 7.50%
Value per share $ 8.12 Debtl ratio 73.50% 73.50% 73.50% 73.50% 73.50% 68.80% 64.10% 59.40% 54.70% 50.00%
Cost of capital 9.88% 9.88% 9.88% 9.88% 9.88% 9.79% 9.50% 9.01% 8.32% 7.43%

Cost of Equity Cost of Debt Weights

21.82% 3%+6%= 9% Debt= 73.5% ->50%
9% (1-.38)=5.58%

Riskfree Rate:
T. Bond rate = 3% Risk Premium
Las Vegas Sands
Beta 6% Feburary 2009
+ 3.14-> 1.20 X Trading @ $4.25

Aswath Damodaran Casino Current Base Equity Country Risk

31
1.15 D/E: 277% Premium Premium
2
§ Ratings based approach: In February 2009, Las Vegas Sands was rated B+, and
based upon history (previous ten years), the likelihood of default is 28.25%.
§ Bond Price based: In February 2009, LVS was rated B+ by S&P. Historically,
28.25% of B+ rated bonds default within 10 years. LVS has a 6.375% bond,
maturing in February 2015 (7 years), trading at $529. If we discount the expected
cash flows on the bond at the riskfree rate, we can back out the probability of
distress from the bond price:
t =7
63.75(1− ΠDistress )t 1000(1− ΠDistress )7
529 = ∑ t +
t =1 (1.03) (1.03)7

pDistress = Annual probability of default = 13.54%

Cumulative probability of surviving 10 years = (1 - .1354)10 = 23.34%
Cumulative€ probability of distress over 10 years = 1 - .2334 = .7666 or 76.66%
§ If LVS is becomes distressed:
§ Expected distress sale proceeds = $2,769 million < Face value of debt
§ Expected equity value/share = $0.00

§ Expected value per share

§ With ratings-based approach: $8.12 (.7175) + $ 0 (.2825) = $5.83
§ With bond-based approach: $8.12 (1 - .7666) + $0.00 (.7666) = $1.92

Aswath Damodaran 313

314

Estimation Issues - Emerging Market Companies

Big shifts in economic
environment (inflation,
itnerest rates) can affect
operating earnings history. Growth rates for a company will be affected heavily be
Poor corporate growth rate and political developments in the country
governance and weak in which it operates.
accounting standards can What is the value added by growth
lead to lack of
assets?
transparency on earnings.
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
roadblocks?
Cross holdings can existing assets and growth assets?
affect value of
equity Even if the company’s risk is stable, Economic crises can put
there can be significant changes in many companies at risk.
country risk over time. Government actions
What is the value of
(nationalization) can affect
equity in the firm?
long term value.

Aswath Damodaran 314

315

§ Emerging market companies are undoubtedly exposed to

additional country risk because they are incorporated in countries
that are more exposed to political and economic risk.
§ Not all emerging market companies are equally exposed to
country risk and many developed markets have emerging market
risk exposure because of their operations.
§ You can use either the “weighted country risk premium”, with the
weights reflecting the countries you get your revenues from or the
lambda approach (which may incorporate more than revenues) to
capture country risk exposure.

Aswath Damodaran 315

316

§ You can value any company in any currency. Thus, you can value
a Brazilian company in nominal reais, US dollars or Swiss Francs.
§ For your valuation to stay invariant and consistent, your cash
flows and discount rates have to be in the same currency. Thus, if
you are using a high inflation currency, both your growth rates
and discount rates will be much higher.
§ For your cash flows to be consistent, you have to use expected
exchange rates that reflect purchasing power parity (the higher
inflation currency has to depreciate by the inflation differential
each year).

Aswath Damodaran 316

Aswath Damodaran 317
318

§ Stockholders in Asian, Latin American and many European

companies have little or no power over the managers of the firm.
In many cases, insiders own voting shares and control the firm
and the potential for conflict of interests is huge.
§ This weak corporate governance is often a reason for given for
using higher discount rates or discounting the estimated value for
these companies.
§ Would you discount the value that you estimate for an emerging
market company to allow for this absence of stockholder power?
§ Yes
§ No.

Aswath Damodaran 318

 Where is the
corporate
governance
discount in this
valuation?

Aswath Damodaran
31
9
320

§ Emerging market companies are more prone to having cross

holdings that companies in developed markets.
§ This is partially the result of history (since many of the larger public
companies used to be family owned businesses until a few decades
ago)
§ And partly because those who run these companies value control (and
use cross holdings to preserve this control).
§ In many emerging market companies, the real process of
valuation begins when you have finished your DCF valuation,
since the cross holdings (which can be numerous) have to be
valued, often with minimal information.

Aswath Damodaran 320

321

1.62% 2.97% 0.22%

100.00% 5.32% 4.64%

80.00% 36.62%
47.45%
47.06%

60.00% % of value from cash

% of value from holdings
95.13%
% of value from operating assets
40.00%

60.41%
47.62% 50.94%

20.00%

0.00%
Tata Chemicals Tata Steel Tata Motors TCS

Aswath Damodaran 321

322

§ Natural disasters: Small companies in some economies are much

exposed to natural disasters (hurricanes, earthquakes), without
the means to hedge against that risk (with insurance or derivative
products).
§ Terrorism risk: Companies in some countries that are unstable or
in the grips of civil war are exposed to damage or destruction.
§ Nationalization risk: While less common than it used to be, there
are countries where businesses may be nationalized, with owners
receiving less than fair value as compensation.

Aswath Damodaran 322

Aswath Damodaran 323
§ If you believe that there is no chance of regime change, your
expected value will remain $1.65 trillion.
§ If you believe that regime change is imminent, and that your
equity will be fully expropriated, your expected value will be zero.
§ If you believe that there remains a non-trivial chance (perhaps as
high as 20%) that there will be a regime change and that if there
is one, there will be changes that reduce, but not extinguish, your
equity claim:

Aswath Damodaran 324

325

Defining capital expenditures and working capital is a

Existing assets are challenge.Growth can be strongly influenced by
usually financial regulatory limits and constraints. Both the amount of
assets or loans, often new investments and the returns on these investments
marked to market. can change with regulatory changes.
Earnings do not
provide much What is the value added by growth
information on assets?
underlying risk.
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
existing assets and growth assets? roadblocks?
Preferred stock is a
significant source of
capital. For financial service firms, debt is In addition to all the normal
raw material rather than a source of constraints, financial service
capital. It is not only tough to define firms also have to worry about
What is the value of but if defined broadly can result in maintaining capital ratios that
equity in the firm? high financial leverage, magnifying are acceptable ot regulators. If
the impact of small operating risk they do not, they can be taken
changes on equity risk. over and shut down.

Aswath Damodaran 325

Aswath Damodaran
32
6
327

§ With financial service firms, we enter into a Faustian bargain.

They tell us very little about the quality of their assets (loans, for a
bank, for instance are not broken down by default risk status) but
we accept that in return for assets being marked to market (by
accountants who presumably have access to the information that
we don’t have).
§ In addition, estimating cash flows for a financial service firm is
difficult to do. So, we trust financial service firms to pay out their
cash flows as dividends. Hence, the use of the dividend discount
model.
§ During times of crises or when you don’t trust banks to pay out
what they can afford to in dividends, using the dividend discount
model may not give you a “reliable” value.

Aswath Damodaran 327

328

§ The book value of assets and equity is mostly irrelevant when

valuing non-financial service companies. After all, the book value of
equity is a historical figure and can be nonsensical. (The book value
of equity can be negative and is so for more than a 1000 publicly
traded US companies)
§ With financial service firms, book value of equity is relevant for two
reasons:
§ Since financial service firms mark to market, the book value is more likely
to reflect what the firms own right now (rather than a historical value)
§ The regulatory capital ratios are based on book equity. Thus, a bank with
negative or even low book equity will be shut down by the regulators.
§ From a valuation perspective, it therefore makes sense to pay heed
to book value. In fact, you can argue that reinvestment for a bank is
the amount that it needs to add to book equity to sustain its growth
ambitions and safety requirements:
§ FCFE = Net Income – Reinvestment in regulatory capital (book equity)

Aswath Damodaran 328

Aswath Damodaran 329
330

§ Financial service is a broad category, and while banks may be its

most substantive component, there are a range of other
companies, with very different business models.
§ For instance, payment processing companies and credit card
companies are also financial service companies, but they derive
their value from
§ Getting consumers to use their platforms to make payments to
businesses or to each other, resulting in transactions on the platform
(called Gross Merchandising Value or GMV)
§ Keeping a slice, called a take rate, of the GMV for themselves.

Aswath Damodaran 330

Aswath Damodaran 331
332

If capital expenditures are miscategorized as

operating expenses, it becomes very difficult to
assess how much a firm is reinvesting for future
growth and how well its investments are doing.

What is the value added by growth

assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
The capital existing assets and growth assets? roadblocks?
expenditures
associated with
acquiring intangible It ican be more difficult to borrow Intangbile assets such as
assets (technology, against intangible assets than it is brand name and customer
against tangible assets. The risk in loyalty can last for very long
himan capital) are
operations can change depending periods or dissipate
mis-categorized as
operating expenses, upon how stable the intangbiel asset overnight.
leading to inccorect is.
accounting earnings
and measures of
capital invested.

Aswath Damodaran 332

333

§ If we start with accounting first principles, capital expenditures are

expenditures designed to create benefits over many periods.
They should not be used to reduce operating income in the period
that they are made, but should be depreciated/amortized over
their life. They should show up as assets on the balance sheet.
§ Accounting is consistent in its treatment of cap ex with
manufacturing firms, but is inconsistent with firms that do not fit
the mold.
§ With pharmaceutical and technology firms, R&D is the ultimate cap ex
but is treated as an operating expense.
§ With consulting firms and other firms dependent on human capital,
recruiting and training expenses are your long term investments that
are treated as operating expenses.
§ With brand name consumer product companies, a portion of the
advertising expense is to build up brand name and is the real capital
expenditure. It is treated as an operating expense.

Aswath Damodaran 333

334

Aswath Damodaran 334

Aswath Damodaran 335
1. Brand Name: It is undeniable that Birkenstock not only has a brand name, in
terms of recognition and visibility, but has the pricing power and operating
margins to back up that brand name.
2. Celebrity Customer Base: Birkenstock attracts celebrities in different age
groups, from Gwyneth Paltrow & Heidi Klum to Paris Jackson & Kendall Jenner,
and more impressively, it does so without paying them sponsorship fees. If the
best advertising is unsolicited, Birkenstock clearly has mastered the game.
3. Good Management: Birkenstock seems to have struck gold with Oliver Reichert.
Not only has he steered the company towards high growth, but he has done so
without upsetting the balance that lies behind its brand name.
4. The Barbie Buzz: Margot Robbie's pink Birkenstock sandals in that movie, which
has been the blockbuster hit of the year, hyper charged the demand for the
company's footwear. It is true that buzzes fade, but not before they create a
revenue bump and perhaps even increase the customer base for the long term.

336
338
339

Company growth often comes from movements in the

economic cycle, for cyclical firms, or commodity prices,
for commodity companies.

What is the value added by growth

assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Historial revenue and existing assets and growth assets? roadblocks?
earnings data are
volatile, as the
Primary risk is from the economy for For commodity companies, the
economic cycle and
cyclical firms and from commodity fact that there are only finite
commodity prices
price movements for commodity amounts of the commodity may
change.
companies. These risks can stay put a limit on growth forever.
dormant for long periods of apparent For cyclical firms, there is the
prosperity. peril that the next recession
may put an end to the firm.

Aswath Damodaran 339

340

§ With cyclical and commodity companies, it is undeniable that the

value you arrive at will be affected by your views on the economy
or the price of the commodity.
§ Consequently, you will feel the urge to take a stand on these
macro variables and build them into your valuation. Doing so,
though, will create valuations that are jointly impacted by your
views on macro variables and your views on the company, and it
is difficult to separate the two.
§ The best (though not easiest) thing to do is to separate your
macro views from your micro views. Use current market based
numbers for your valuation, but then provide a separate
assessment of what you think about those market numbers.

Aswath Damodaran 340

341

§ If there is a key macro variable affecting the value of your

company that you are uncertain about (and who is not), why not
quantify the uncertainty in a distribution (rather than a single
price) and use that distribution in your valuation.
§ That is exactly what you do in a Monte Carlo simulation, where
you allow one or more variables to be distributions and compute a
distribution of values for the company.
§ With a simulation, you get not only everything you would get in a
standard valuation (an estimated value for your company) but you
will get additional output (on the variation in that value and the
likelihood that your firm is under or over valued)

Aswath Damodaran 341

Aswath Damodaran
34
2
 Shell: Revenues vs Oil Price
500,000.0 $120.00

450,000.0
$100.00
400,000.0 Revenues = 39,992.77 + 4,039.39 * Average Oil
Price R squared = 96.44%

Average Oil Price during year

Revenues (in millions of $)

350,000.0
$80.00
300,000.0

250,000.0 $60.00

200,000.0
$40.00
150,000.0

100,000.0
$20.00
50,000.0

0 $-
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
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Revenue Oil price

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4
Value versus Price 345

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Tools for pricing

Tools for intrinsic analysis Tools for "the gap" - Multiples and comparables
- Discounted Cashflow Valuation (DCF) - Behavioral finance - Charting and technical indicators
- Intrinsic multiples - Price catalysts - Pseudo DCF
- Book value based approaches
- Excess Return Models

Value of cashflows, INTRINSIC THE GAP

adjusted for time PRICE
VALUE Value Is there one? Price
and risk Will it close?

Drivers of intrinsic value

Drivers of "the gap" Drivers of price
- Cashflows from existing assets
- Information - Market moods & momentum
- Growth in cash flows
- Liquidity - Surface stories about fundamentals
- Quality of Growth
- Corporate governance

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 View of the gap Investment Strategies
The Efficient The gaps between price and value, if Index funds
Marketer they do occur, are random.
The “value” You view pricers as dilettantes who Buy and hold stocks
extremist will move on to fad and fad. where value < price
Eventually, the price will converge on
value.
The pricing Value is only in the heads of the (1) Look for mispriced
extremist “eggheads”. Even if it exists (and it is securities.
questionable), price may never (2) Get ahead of shifts in
converge on value. demand/momentum.

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§ Uncertainty about the magnitude of the gap:
§ Margin of safety: Many value investors swear by the notion of the
“margin of safety” as protection against risk/uncertainty.
§ Collect more information: Collecting more information about the
company is viewed as one way to make your investment less risky.
§ Ask what if questions: Doing scenario analysis or what if analysis
gives you a sense of whether you should invest.
§ Confront uncertainty: Face up to the uncertainty, bring it into the
analysis and deal with the consequences.
§ Uncertainty about gap closing: This is tougher and you can
reduce your exposure to it by
§ Lengthening your time horizon
§ Providing or looking for a catalyst that will cause the gap to close.

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 § The “karmic” approach: In this one, you buy (sell short) under
(over) valued companies and sit back and wait for the gap to
close. You are implicitly assuming that given time, the market will
see the error of its ways and fix that error.
§ The catalyst approach: For the gap to close, the price has to
converge on value. For that convergence to occur, there usually
has to be a catalyst.
§ If you are an activist investor, you may be the catalyst yourself. In fact,
your act of buying the stock may be a sufficient signal for the market
to reassess the price.
§ If you are not, you have to look for other catalysts. Here are some to
watch for: a new CEO or management team, a “blockbuster” new
product or an acquisition bid where the firm is targeted.

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