aswath damodaran1 alternative approaches to value enhancement maximize a variable that is correlated...

Aswath Damodaran 1

Alternative Approaches to Value Enhancement

Maximize a variable that is correlated with the value of the firm. There are several choices for such a variable. It could be an accounting variable, such as earnings or return on investment a marketing variable, such as market share a cash flow variable, such as cash flow return on investment (CFROI) a risk-adjusted cash flow variable, such as Economic Value Added (EVA)

The advantages of using these variables are that they Are often simpler and easier to use than DCF value.

The disadvantage is that the Simplicity comes at a cost; these variables are not perfectly correlated

with DCF value.

Aswath Damodaran 2

Economic Value Added (EVA) and CFROI

The Economic Value Added (EVA) is a measure of surplus value created on an investment.• Define the return on capital (ROC) to be the “true” cash flow return on

capital earned on an investment.

• Define the cost of capital as the weighted average of the costs of the different financing instruments used to finance the investment.

EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project) The CFROI is a measure of the cash flow return made on capital

CFROI = (Adjusted EBIT (1-t) + Depreciation & Other Non-cash Charges) / Capital Invested

Aswath Damodaran 3

Estimating EVA for Nestle

Capital Invested = 29500 Million Sfr Return on Capital = 12.77% Cost of Capital = 8.85% Economic Value Added in 1995 = (.1277 - .0885) (29,500 Million

Sfr) = 1154.50 Million Sfr

Aswath Damodaran 4

Estimating Tsingtao’s EVA in 1996

Tsingtao Brewery, a Chinese Beer manufacturer, has make significant capital investments in the last two years, and plans to increase its exports over time. Using 1996 numbers, Tsingtao had the following fundamentals:• Return on Capital = 1.28%

• Cost of Capital = 15.51%

• Capital Invested = 3,015 million CC Economic Value Added in 1996 = – 429 million CC

Aswath Damodaran 5

J.P. Morgan’s Equity EVA: 1996

Equity Invested at the end of 1995 = $ 10,451 Million Net Income Earned in 1996 = $ 1,574 Million Cost of Equity for 1996 = 7% + 0.94 (5.5%) = 12.17%

• I used the riskfree rate from the start of 1996 Equity EVA for J.P. Morgan = $ 1574 Million - ($10,451 Million)

(.1217) = $ 303 Million

Aswath Damodaran 6

Things to Note about EVA

EVA is a measure of dollar surplus value, not the percentage difference in returns.

It is closest in both theory and construct to the net present value of a project in capital budgeting, as opposed to the IRR.

The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the EVA of future projects.

Aswath Damodaran 7

A Simple Illustration

Assume that you have a firm with • IA = 100 In each year 1-5, assume that

• ROCA = 15% I = 10 (Investments are at beginning of each year)

• WACCA = 10% ROC New Projects = 15%

• WACCNew Projects = 10%

Assume that all of these projects will have infinite lives. After year 5, assume that

• Investments will grow at 5% a year forever

• ROC on projects will be equal to the cost of capital (10%)

Aswath Damodaran 8

Firm Value using EVA Approach

Capital Invested in Assets in Place =$ 100

EVA from Assets in Place = (.15 – .10) (100)/.10 =$ 50

+ PV of EVA from New Investments in Year 1 = [(.15 -– .10)(10)/.10] =$ 5

+ PV of EVA from New Investments in Year 2 = [(.15 -– .10)(10)/.10]/1.1 = $ 4.55

+ PV of EVA from New Investments in Year 3 = [(.15 -– .10)(10)/.10]/1.12 =$ 4.13



Value of Firm =$ 170.86

Aswath Damodaran 9

Firm Value using DCF Valuation: Estimating FCFF

Base

Y ear

1 2 3 4 5 Term.

Y ear

EBIT (1-t) : Assets in Place $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00

EBIT(1-t) :Investments- Yr 1 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t) :Investments- Yr 2 $ 1.50 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t): Investments -Yr 3 $ 1.50 $ 1.50 $ 1.50

EBIT(1-t): Investments -Yr 4 $ 1.50 $ 1.50

EBIT(1-t): Investments- Yr 5 $ 1.50

Total EBIT(1-t) $ 16.50 $ 18.00 $ 19.50 $ 21.00 $ 22.50 $ 23.63

- Net Capital Expenditures $10.00 $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 11.25 $ 11.81

FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81

Aswath Damodaran 10

Firm Value: Cost of Capital and Capital Invested

Assets in Place $ 100.00

New Investment $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 11.25

Cumulative New Investment $ 10.00 $ 20.00 $ 30.00 $ 40.00 $ 50.00

Cumulative Total Investment $ 110.00 $ 120.00 $ 130.00 $ 140.00 $ 150.00

Return on Capital 15% 15% 15% 15% 15% 15% 10%

Cost of Capital 10% 10% 10% 10% 10% 10% 10%

Aswath Damodaran 11

Firm Value: Present Value of FCFF

Year 0 1 2 3 4 5 Term Year

FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81

PV of FCFF ($10) $ 5.91 $ 6.61 $ 7.14 $ 7.51 $ 6.99

Terminal Value $ 236.25

PV of Terminal Value $ 146.69

Value of Firm $170.85

Aswath Damodaran 12

EVA Valuation of Nestle

0 1 2 3 4 5 Term. Y ear

Return on Capital 12.77% 12.77% 12.77% 12.77% 12.77% 12.77% 12.77%

Cost of Capital 8.85% 8.85% 8.85% 8.85% 8.85% 8.85% 8.85%

EBIT(1-t) 3,766.66Fr 4,066.46Fr 4,390.06Fr 4,739.37Fr 5,116.40Fr 5,523.38Fr 5,689.08Fr

WACC(Capital) 2,612.06Fr 2,819.97Fr 3,044.38Fr 3,286.61Fr 3,548.07Fr 3,830.29Fr 3,945.20Fr

EVA 1,154.60Fr 1,246.49Fr 1,345.69Fr 1,452.76Fr 1,568.33Fr 1,693.08Fr 1,743.88Fr

PV of EVA 1,145.10Fr 1,135.67Fr 1,126.30Fr 1,117.00Fr 1,107.76Fr

29,787.18Fr

PV of EVA = 25,121.24Fr PV of 1693.08 Fr

growing at 3% a year

Value of Assets

in Place =

29,500.00Fr

Value of Firm = 54,621.24Fr

Value of Debt = 11,726.00Fr

Value of Equity = 42,895.24Fr

Value Per Share = 1,088.16Fr

Aswath Damodaran 13

DCF Valuation of Nestle

0 1 2 3 4 5 Terminal

Y ear

EBIT (1-t) 0.00Fr 4,066.46Fr 4,390.06Fr 4,739.37Fr 5,116.40Fr 5,523.38Fr 5,689.08Fr

+ Deprec’n 2,305.00Fr 2,488.02Fr 2,685.58Fr 2,898.83Fr 3,129.00Fr 1,273.99Fr 1,350.42Fr

- Cap Ex 3,898.00Fr 4,207.51Fr 4,541.60Fr 4,902.22Fr 5,291.48Fr 2,154.45Fr 2,283.71Fr

- Change in WC 755.00Fr 814.95Fr 879.66Fr 949.51Fr 1,024.90Fr 417.29Fr 442.33Fr

FCFF -2,348.00Fr 1,532.02Fr 1,654.38Fr 1,786.46Fr 1,929.03Fr 4,225.62Fr 4,313.46Fr

Terminal Value 151,113.54Fr

WACC 8.85% 8.85% 8.85% 8.85% 8.85% 8.85% 8.85%

PV of FCFF -2,348.00Fr 1,407.40Fr 1,396.19Fr 1,385.02Fr 1,373.90Fr 51,406.74Fr

Value of Firm= 54,621.24Fr




Aswath Damodaran 14

Year-by-year EVA Changes

Firms are often evaluated based upon year-to-year changes in EVA rather than the present value of EVA over time.

The advantage of this comparison is that it is simple and does not require the making of forecasts about future earnings potential.

Another advantage is that it can be broken down by any unit - person, division etc., as long as one is willing to assign capital and allocate earnings across these same units.

While it is simpler than DCF valuation, using year-by-year EVA changes comes at a cost. In particular, it is entirely possible that a firm which focuses on increasing EVA on a year-to-year basis may end up being less valuable.

Aswath Damodaran 15

Year-to-Year EVA Changes: Nestle

0 1 2 3 4 5 Term. Y ear


Cost of Capital 8.85% 8.85% 8.85% 8.85% 8.85% 8.85% 8.85%





29,787.18Fr

PV of EVA = 25,121.24Fr PV of 590.67 Fr growing

at 3% a year

Value of Assets

in Place =

29,500.00Fr



Value of Equity 42,895.24Fr

Value per Share = 1088.16Fr

Aswath Damodaran 16

When Increasing EVA on year-to-year basis may result in lower Firm Value

1. If the increase in EVA on a year-to-year basis has been accomplished at the expense of the EVA of future projects. In this case, the gain from the EVA in the current year may be more than offset by the present value of the loss of EVA from the future periods.• For example, in the Nestle example above assume that the return on

capital on year 1 projects increases to 13.27% (from the existing 12.77%), while the cost of capital on these projects stays at 8.85%. If this increase in value does not affect the EVA on future projects, the value of the firm will increase.

• If, however, this increase in EVA in year 1 is accomplished by reducing the return on capital on future projects to 12.27%, the firm value will actually decrease.

Aswath Damodaran 17

Firm Value and EVA tradeoffs over time

0 1 2 3 4 5 Term. Y ear


Cost of Capital 8.85% 8.85% 8.85% 8.85% 8.85% 8.85% 8.85%





28,930.98Fr


at 3% a year

Value of Assets

in Place =

29,500.00Fr





Aswath Damodaran 18

EVA and Risk

2. When the increase in EVA is accompanied by an increase in the cost of capital, either because of higher operational risk or changes in financial leverage, the firm value may decrease even as EVA increases.• For instance, in the example above, assume that the spread stays at 3.91%

on all future projects but the cost of capital increases to 9.85% for these projects (from 8.85%). The value of the firm will drop.

Aswath Damodaran 19

Nestle’s Value at a 9.95 % Cost of Capital

0 1 2 3 4 5 Term. Y ear


Cost of Capital 8.85% 9.85% 9.85% 9.85% 9.85% 9.85% 9.85%





21,101.04Fr


at 3% a year

Value of Assets

in Place =

29,500.00Fr




Value Per Share = 924.50Fr

Aswath Damodaran 20

EVA: The Risk Effect

Nestle: Value Per Share and Cost of Capital

0.00Fr

200.00Fr

400.00Fr

600.00Fr

800.00Fr

1,000.00Fr

1,200.00Fr

1,400.00Fr

7.85% 8.85% 9.85% 10.85% 11.85% 12.85% 13.85% 14.85%

Cost of Capital

Value Per Share

Aswath Damodaran 21

EVA and Changes in Market Value

The relationship between EVA and Market Value Changes is more complicated than the one between EVA and Firm Value.

The market value of a firm reflects not only the Expected EVA of Assets in Place but also the Expected EVA from Future Projects

To the extent that the actual economic value added is smaller than the expected EVA the market value can decrease even though the EVA is higher.

Aswath Damodaran 22

High EVA companies do not earn excess returns

Aswath Damodaran 23

Increases in EVA do not create excess returns

Aswath Damodaran 24

When focusing on year-to-year EVA changes has least side effects

1. Most or all of the assets of the firm are already in place; i.e, very little or none of the value of the firm is expected to come from future growth.• [This minimizes the risk that increases in current EVA come at the

expense of future EVA]

2. The leverage is stable and the cost of capital cannot be altered easily by the investment decisions made by the firm.• [This minimizes the risk that the higher EVA is accompanied by an

increase in the cost of capital]

3. The firm is in a sector where investors anticipate little or not surplus returns; i.e., firms in this sector are expected to earn their cost of capital.• [This minimizes the risk that the increase in EVA is less than what the

market expected it to be, leading to a drop in the market price.]

Aswath Damodaran 25

Valuation: Closing Thoughts

Spring 2002

Aswath Damodaran

Aswath Damodaran 26

Do you have your life vests on?

Aswath Damodaran 27

Truths about Valuation

Truth 1: Bias is endemic in valuation and can enter in subtle and not so subtle ways.

Truth 2.: A valuation is never precise and is never quite done. Truth 3: Complexity comes with a cost; More information is not

always better than less information.

Aswath Damodaran 28

Approaches to Valuation

Discounted cashflow valuation, where we try (sometimes desperately) to estimate the intrinsic value of an asset by using a mix of theory, guesswork and prayer.

Relative valuation, where we pick a group of assets, attach the name “comparable” to them and tell a story.

Contingent claim valuation, where we take the valuation that we did in the DCF valuation and divvy it up between the potential thieves of value (equity) and the potential victims of this crime (lenders)

Aswath Damodaran 29

Basis for all valuation approaches

We all believe market are inefficient, and that we can find under and over valued assets because of our superior intellect, models, information or some combination of all three.

Some Sobering facts:• 70-80% of portfolio managers under perform market indices.

• The Vanguard 500 Index fund is poised to overtake the Fidelity Magellan fund as the largest mutual fund in the United States. In the last 5 years, it has been the best performing large mutual fund in the United States.

• The more people trade, the more they seem to lose.– A study of mutual fund portfolios discovered that they would have made a

higher return, if they had frozen their portfolios on January 1.

– A study of individual investors by Terrence O”Dean also noted a negative correlation between returns earned and transactions volume (and this is before trading costs)

Aswath Damodaran 30

Discounted Cash Flow Valuation

What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset.

Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk.

Information Needed: To use discounted cash flow valuation, you need• to estimate the life of the asset

• to estimate the cash flows during the life of the asset

• to estimate the discount rate to apply to these cash flows to get present value Market Inefficiency: Markets are assumed to make mistakes in pricing

assets across time, and are assumed to correct themselves over time, as new information comes out about assets.

Aswath Damodaran 31

Cash flowsFirm: Pre-debt cash flowEquity: After debt cash flows

Expected GrowthFirm: Growth in Operating EarningsEquity: Growth in Net Income/EPS

CF1CF2CF3CF4CF5ForeverFirm is in stable growth:Grows at constant rateforever

Terminal ValueCFn.........Discount RateFirm:Cost of Capital

Equity: Cost of Equity

ValueFirm: Value of Firm

Equity: Value of Equity

DISCOUNTED CASHFLOW VALUATIONLength of Period of High Growth

Aswath Damodaran 32

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

Expected Growth=ROC* Reinv RateFCFF1FCFF2FCFF3FCFF4FCFF5ForeverFirm is in stable growth:Grows at constant rateforever

Terminal Value= FCFF n+1/(r-gn)FCFFn.........Cost of EquityCost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market ValueDiscount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity- Equity Options= Value of Equity in Stock

Riskfree Rate :+Beta- Measures market riskXRisk Premium- Premium for averagerisk investment

Base EquityPremiumCountry RiskPremiumDISCOUNTED CASHFLOW VALUATIONDid younormalizeearnings?

Did you includeacquisitions andR&D?

Did you consideronly non-cash WCand smooth?

Is your ROClikely to changein the future?

Is your stable growth rate < growth rate in economy?

Is your growth rateconsistent with yourreinvestment rate?

Are you reinvesting enough to create stable growth?

Is your betaand leverageconsistent withstable growth?

Will these weights changeover time?Are you using a bottom-up beta that reflects yourbusiness risk and currentleverage?

Is your riskless rate in thesame currency and termsas the cash flows?

I s there sufficientdata for a historicalrisk premium?

Is the company exposed toadditional country risk?Is your risk premium a historicalor implied risk premium?Is the default spreadreflective of company’s risk?

I s length of growth period consistent withcompetitive advantages?

Aswath Damodaran 33

The Lego Blocks of Valuation

Choose aCash Flow Dividends

Expected Dividends to

Stockholders

Cashflows to Equity

Net Income

- (1- δ) (Capital Exp. - Deprec’n)

- (1- δ) Change in Work. Capital

= Free Cash flow to Equity (FCFE)

[δ = Debt Ratio]

Cashflows to Firm

EBIT (1- tax rate)- (Capital Exp. - Deprec’n)- Change in Work. Capital

= Free Cash flow to Firm (FCFF)

& A Discount Rate Cost of Equity

• Basis: The riskier the investment, the greater is the cost of equity.

• Models:CAPM: Riskfree Rate + Beta (Risk Premium)

APM: Riskfree Rate + Σ Betaj (Risk Premiumj): n factors

Cost of CapitalWACC = ke ( E/ (D+E))

+ kd ( D/(D+E))

kd = Current Borrowing Rate (1-t)E,D: Mkt Val of Equity and Debt

& a growth pattern

t

g Stable Growth

g- Two Stage Growth

|High GrowthStable

gThree-Stage Growth

|High Growth StableTransition

Aswath Damodaran 34

The Models You Used in DCF Valuation

DCF Model Used

0

5

10

15

20

25

30

35

40

45

50

DDMSt DDM2 DDM3 FCFEst FCFE2 FCFE3 FCFFSt FCFF2 FCFF3 FCFFGen

Model

Number of Valuations

Aswath Damodaran 35

What you found ...

DCF Value vs Market Price

0

5

10

15

20

25

30

Undervaluedmore than 50%

Undervalued 33-50%

Undervalued 10-33%

Undervalued 0-10%

Overvalued 0-10%

Overvalued 10-50%

Overvalued 50-100%

Overvalued morethan 100%

Under or Over Valuation

Number of Firms

Aswath Damodaran 36

The Most Undervalued stocks were..

Company Price Model Used Value Per Share RecommendationBarnesandNoble.com $1.29 FCFF2 $6.80 BuyConexant Systems $10.03 FCFF2 $26.91 BuyTyco International $21.25 FCFFSt $47.45 BuyJPMorganChase* $35.50 DDMSt $77.10 BuyPeacock PLC $1.31 Fcff2 $2.81 BUYCreditrisk Monitor.com $0.30 FCFFGen $0.62 SellFEMSA (FMX) $47.89 FCFF2 $89.25 BUYRoyal Ahold $26.70 FCFFGen $49.70 BuyChalco $0.18 FCFF3 $0.33 BuyVital Images $8.40 FCFESt $15.29 Buy

Aswath Damodaran 37

The most undervalued in May 2001 were

Company Price/Share DCF Value % UndervaluedNetcentives Inc. 0.8 4.64 -82.76%Oracle 17.15 $78.82 -78.24%

Sirius Satellite Radio $9.50 $43.10 -77.96%

Salon.com 0.59$ 2.30$ -74.35%

Infosys Technologies (USD) 69.86$ 202.66$ -65.53%Aether 13.89 38.47 -63.89%Good Guys $4.10 $10.04 -59.16%i2 16.22 $37.70 -56.98%Priceline $4.20 $9.36 -55.13%Aether Systems (AETH) 13.47$ 29.01$ -53.57%Metromedia Fiber Network, Inc $4.83 $9.96 -51.51%

Aswath Damodaran 38

The ultimate test… Did undervalued stocks make money?

Buy Recommendations: Equity Classes

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

140.00%

160.00%

180.00%

Fall 1996 (Dec 96) Spr 97 (May 97) Fall 1998 (Dec 98) Spr 98 (May 98)

Class

Top 10 Buy Recommendations

S&P 500

Aswath Damodaran 39

More on the winners...

About 60% of all buy recommendations make money; about 45% of sell recommendations beat the market.

There are two or three big winners in each period. • Apple Computer in December 1996

• Checkpoint Software in June 1999 Stocks on which there is disagreement among different people tend to

do worse than stocks on which there is no disagreement Stocks that are under valued on both a DCF and relative valuation

basis do better than stocks that are under valued on only one approach.

Aswath Damodaran 40

The Most Overvalued stocks are...

Company Price Model Used Value per share RecommendationEchoStar Comm 24.84$ FCFFGen 12.95$ SellWaverider (WAVC) 0.14 FCFF2 0.07 SellRevlon 5.03$ FCFF2 2.30$ SellWhole Foods Market Inc. 47.75$ FCFE3 18.73$ SellMetro One Telecommunications 19.44$ FCFF3 6.75$ SellFuel Cell Tech. (FLCEF) $15.87 FCFFGen $4.35 SellKrispy Kreme 38.05$ FCFE3 10.28$ SellAustrian Airlines (AAIR AV) $9.50 FCFFGen 1.67 SellYahoo $14.77 FCFFGen $2.59 SellAmerican Skiing Company $0.18 FCFF2 $0.01 SellLevel 3 Communications 3.90$ FCFFGen 0.19$ Buy

Aswath Damodaran 41

The Most Over Valued Firms in May 2001 were...

Company Price DCF Value % OvervaluedJuniper Networks 55.02 32.22 70.76%Bulgari SPA $11.36 $6.46 75.85%Exodus Communications $9.97 $5.41 84.29%NTT DoCoMo 2,540,0001,356,000 87.32%

Yahoo! 18.55 9.89 87.56%MGM (Metro-Goldwyn-Mayer) 20.04$ 10.39$ 92.88%Fox Entertainment $22.62 $10.78 109.83%Geron Corporation $11.54 $5.41 113.31%Checkpoint Software CHKP $75.10 $31.37 139.40%Xerox 8.18 3.23 153.25%Nvidia $73.75 $27.29 170.25%Siebel Systems $45.70 $13.90 228.78%BAE Systems Plc 3.38 0.83 307.23%

Aswath Damodaran 42

Relative Valuation

What is it?: The value of any asset can be estimated by looking at how the market prices “similar” or ‘comparable” assets.

Philosophical Basis: The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics)

Information Needed: To do a relative valuation, you need • an identical asset, or a group of comparable or similar assets• a standardized measure of value (in equity, this is obtained by dividing the price

by a common variable, such as earnings or book value)• and if the assets are not perfectly comparable, variables to control for the

differences Market Inefficiency: Pricing errors made across similar or comparable

assets are easier to spot, easier to exploit and are much more quickly corrected.

Aswath Damodaran 43

Standardizing Value

Prices can be standardized using a common variable such as earnings, cashflows, book value or revenues. • Earnings Multiples

• Book Value Multiples

• Revenues

• Industry Specific Variable (Price/kwh, Price per ton of steel ....)

Aswath Damodaran 44

The Four Steps to Understanding Multiples

Anna Kournikova knows PE…. Or does she?• In use, the same multiple can be defined in different ways by different users. When

comparing and using multiples, estimated by someone else, it is critical that we understand how the multiples have been estimated

8 times EBITDA is not always cheap…• Too many people who use a multiple have no idea what its cross sectional

distribution is. If you do not know what the cross sectional distribution of a multiple is, it is difficult to look at a number and pass judgment on whether it is too high or low.

You cannot get away without making assumptions• It is critical that we understand the fundamentals that drive each multiple, and the

nature of the relationship between the multiple and each variable. There are no perfect comparables

• Defining the comparable universe and controlling for differences is far more difficult in practice than it is in theory.

Aswath Damodaran 45

Value of Stock = DPS 1/(ke - g)PE=Payout Ratio (1+g)/(r-g)PEG=Payout ratio (1+g)/g(r-g)PBV=ROE (Payout ratio) (1+g)/(r-g)PS= Net Margin (Payout ratio)(1+g)/(r-g)Value of Firm = FCFF1/(WACC -g)Value/FCFF=(1+g)/(WACC-g)Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g)Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)VS= Oper Margin (1-RIR) (1+g)/(WACC-g)Equity MultiplesFirm MultiplesPE=f(g, payout, risk)PEG=f(g, payout, risk)PBV=f(ROE,payout, g, risk)PS=f(Net Mgn, payout, g, risk)V/FCFF=f(g, WACC)V/EBIT(1-t)=f(g, RIR, WACC)V/EBIT=f(g, RIR, WACC, t)VS=f(Oper Mgn, RIR, g, WACC)

Aswath Damodaran 46

Estimating a Multiple

Use comparable firms, compute the average multiple and adjust subjectively for differences

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

Use market, run a regression of multiple against fundamentals and estimate a predicted multiple for firm

Aswath Damodaran 47

The Multiples you used were ...

Multiples Used

0

5

10

15

20

25

30

35

40

PBV VBV PE VEBITDA Sector Specific PEG PS VS

Multiple

Number of Firms

Aswath Damodaran 48

Valuation Results: DCF vs Relative Valuation

Aswath Damodaran 49

Valuation Results: December 1999 ...

Aswath Damodaran 50

Valuations: May 2000

0

5

10

15

20

25

30

35

40

Undervalued

50-100%

Undervalued

10-50%

Undervalued 0-

10%

Overvalued 0-

10%

Overvalued 10-

50%

Overvalued 50-

100%

Overvalued

>100%

DCF Valuation

Relative Valuation

Aswath Damodaran 51

Valuations: December 2000

DCF and Relative Valuations

0

5

10

15

20

25

30

35

Undervalued

more than

50%

Undervalued

33-50%

Undervalued

10-33%

Undervalued

0-10%

Overvalued

0-10%

Overvalued

10-50%

Overvalued

50-100%

Overvalued

more than

100%

% Under or Over Valued

DCF Valuation

Relative Valuation

Aswath Damodaran 52

DCF vs Relative Valuations

DCF as % of Relative Value

0

5

10

15

20

25

30

35

40

<50% 50-67% 67-90% 90%-100% 100-110% 110%-150% 150-200% >200%

DCF as fraction of Relative Value

Aswath Damodaran 53

Most undervalued on a Relative Basis

Company Price per share Multiple Relative Value RecommendationWaverider (WAVC) 0.14 Value Sales 1.47 SellBarnesandNoble.com 1.29$ PS 12.55$ BuyVA Software $1.18 PS 10.18$ SellXOMA $2.12 PS $14.11 SellLevel 3 Communications 3.90$ VS 14.97$ BuyPowergen £7.74 PBV £29.16 BUYTyco International $21.25 PB $79.13 BuyFEMSA (FMX) 47.89 PBV 143.8 BUYAustrian Airlines (AAIR AV) $9.50 V/EBITDA 20.17 SellVital Images 8.40$ VS 17.30$ BuyA&P 25.88$ EV/Sales 51.08$ Sell

Aswath Damodaran 54

The Most under valued firms in May 2001 were

Company Price Multiple Relative Value % Under Valued

Williams Controls $1.50 PE $40.15 -96.26%Netcentives Inc. 0.8 PS 12.8 -93.75%Salon.com 0.59$ PS 7.45$ -92.08%Mediaset Group S.p.A. (Euros) 11.90€ PE 32.00€ -62.81%Terayon (4/25/01) $5.30 PS $13.75 -61.45%Netradio 0.35$ VS 0.89$ -60.67%Priceline $4.20 PS $10.30 -59.22%Oracle $16.90 PE $37.78 -55.27%Infosys Technologies (USD) 69.86$ PEG 150.16$ -53.48%Internet Securities Systems 46.28$ PEG 99.09$ -53.29%Charles Schwab $20.06 PBV $41.79 -52.00%Matav Cable Systems 39.37 FV/Subscriber 80.84 -51.30%

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Most Over Valued Firms are..

Company Price per share Multiple Relative Value RecommendationProcter & Gamble 89.80$ PE 40.49$ SellYahoo $14.77 PS $6.52 SellCablevision 25.80$ PBV 8.42$ SellSprint PCS 11.30$ Value/BV 2.96$ SellKrispy Kreme $38.30 PE $9.89 SellWhole Foods Market Inc. 47.75$ V/S 12.17$ SellMGM $16.27 Value/Sales 2.91 BUYHollywood Entertainment Corp. $19.05 VBV $3.11 BuyTivo 3.799$ PS 0.42$ HoldMorton's Restaurant Group $13.03 V/BV $1.16 SellKrispy Kreme 38.05$ PEG 1.88$ SellCreditrisk Monitor.com 0.30$ VS 0.00$ Sell

Aswath Damodaran 56

Most overvalued firms in May 2001 were..

Company Price Multiple Relative Value % Over Valued

Starbucks $37.16 PS $16.83 120.80%Electronic Data System 62.50$ PE 25.74$ 142.81%DoubleClick(as of 4/27) $12.86 PS $4.99 157.72%Staples 16.72 VS $5.48 205.11%Lucent Technologies 10.20$ PEG 3.15$ 223.81%Staples 16.02 P/S 4.48 257.59%Yahoo! 18.55 PEG 4.98 272.49%NTT DoCoMo 2,540,000 PBV 543,000 367.77%Geron Corporation $11.54 VS $2.17 431.80%Pixar (4.24.01) $30.20 PE $5.05 498.02%MGM (Metro-Goldwyn-Mayer) 20.04$ EV/EBITDA 2.81$ 613.17%Juniper Networks 55.02 V/S 5.47 905.85%

Aswath Damodaran 57

Contingent Claim (Option) Valuation

Options have several features• They derive their value from an underlying asset, which has value

• The payoff on a call (put) option occurs only if the value of the underlying asset is greater (lesser) than an exercise price that is specified at the time the option is created. If this contingency does not occur, the option is worthless.

• They have a fixed life Any security that shares these features can be valued as an option.

Aswath Damodaran 58

Indirect Examples of Options

Equity in a deeply troubled firm - a firm with negative earnings and high leverage - can be viewed as an option to liquidate that is held by the stockholders of the firm. Viewed as such, it is a call option on the assets of the firm.

The reserves owned by natural resource firms can be viewed as call options on the underlying resource, since the firm can decide whether and how much of the resource to extract from the reserve,

The patent owned by a firm or an exclusive license issued to a firm can be viewed as an option on the underlying product (project). The firm owns this option for the duration of the patent.

Aswath Damodaran 59

Results of Option Valuations

Number of firms valued using option models = 23 Median increase in value from the option model = 87% What types of firms do you think had the biggest increase in value?

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Your recommendations were to ..

Recommendations

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Spring 2002 Spring 2001 Fall 00 Spring '00 Fall 99 (Dec) Spr 99 (May) Fall 98 (Dec)

Buy

Sell

Hold

Aswath Damodaran 61

Value Enhancement

For an action to create value, it has to• Increase cash flows from assets in place

• Increase the expected growth rate

• Increase the length of the growth period

• Reduce the cost of capital The value enhancement measures that have been widely promoted as

new and different are neither. • EVA and CFROI have their roots in traditional discounted cash flow

models

• Measures (like EVA and CFROI) do not create value; managers do.

Aswath Damodaran 62

Choices…Choices…Choices…

Valuation Models

Asset Based

Valuation

Discounted Cashflow

Models

Relative Valuation Contingent Claim

Models

Liquidation

Value

Replacement

Cost

Equity Valuation

Models

Firm Valuation

Models

Cost of capital

approach

APV

approach

Excess Return

Models

Stable

Two-stage

Three-stage

or n-stage

Current

Normalized

Equity

Frim

Earnings Book

Value

Revenues Sector

specific

Sector

Market

Option to

delay

Option to

expand

Option to

liquidate

Patent Undeveloped

Reserves

Young

firms

Undeveloped

land

Equity in

troubled

firm

Dividends

Free Cashflow

to Firm

Aswath Damodaran 63

Picking your approach

Asset characteristics• Marketability

• Cash flow generating capacity

• Uniqueness Your characteristics

• Time horizon

• Reasons for doing the valuation

• Beliefs about markets

Aswath Damodaran 64

What approach would work for you?

As an investor, given your investment philosophy, time horizon and beliefs about markets (that you will be investing in), which of the the approaches to valuation would you choose?

Discounted Cash Flow Valuation Relative Valuation Neither. I believe that markets are efficient.

Aswath Damodaran 65

Some Not Very Profound Advice

Its all in the fundamentals. Focus on the big picture; don’t let the details trip you up. Keep your perspective; it is only a valuation. If you have to choose between valuation skills and luck….

Aswath Damodaran 66

Or maybe you can fly….

aswath damodaran1 alternative approaches to value enhancement maximize a variable that is correlated...

Documents

capital capital

eva eva

cost of capital

capital cost

capital cfroi

eva approach capital

capital roc

eva of projects