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Valuation: Closing ThoughtsAswath Damodaran

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Do you have your life vests on?

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Truths about Valuation

Truth 1: All valuations are biased. Truth 2.: There are no precise valuations. Truth 3: Complexity comes with a cost; More information is not

always better than less information.

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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)

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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)

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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.

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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

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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?

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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.

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The Four Steps to Understanding Multiples

Define the multiple• In use, the same multiple can be defined in different ways by different users. When

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

Describe the multiple• Too many people who use a multiple have no idea what its cross sectional

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

Analyze the multiple• It is critical that we understand the fundamentals that drive each multiple, and the

nature of the relationship between the multiple and each variable. Apply the multiple

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

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Value of Stock = DPS 1/(ke - g)PE=Payout Ratio (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)

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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

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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.

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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.

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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.

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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.

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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.

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Or maybe you can fly….