valuations - damodaran
TRANSCRIPT
-
8/12/2019 Valuations - Damodaran
1/308
Valuation: Lecture Note Packet 1
Intrinsic Valuation
Aswath Damodaran
Updated: January 2013
Aswath Damodaran 1
-
8/12/2019 Valuations - Damodaran
2/308
2
The essence of intrinsic value
In intrinsic valuation, you value an asset based upon itsintrinsic characteristics.
For cash flow generating assets, the intrinsic value willbe a function of the magnitude of the expected cashflows on the asset over its lifetime and the uncertaintyabout receiving those cash flows.
Discounted cash flow valuation is a tool for estimatingintrinsic value, where the expected value of an asset is
written as the present value of the expected cash flowson the asset, with either the cash flows or the discountrate adjusted to reflect the risk.
Aswath Damodaran
2
-
8/12/2019 Valuations - Damodaran
3/308
3
The two faces of discounted cash flow valuation
The value of a risky asset can be estimated by discounting theexpected cash flows on the asset over its life at a risk-adjusteddiscount rate:
where the asset has a n-year life, E(CFt) is the expected cash flow in period tand r is a discount rate that reflects the risk of the cash flows.
Alternatively, we can replace the expected cash flows with theguaranteed 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.
Aswath Damodaran
3
-
8/12/2019 Valuations - Damodaran
4/308
4
Risk Adjusted Value: Two Basic Propositions
If 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 ofthe cash flows, IT cannot affect value.
The FOREVER LOSERproposition: For an asset to have value, the expected cashflows have to be positive some time over the life of the asset.
The ITS OKAYproposition: Assets that generate cash flows early in their life willbe worth more than assets that generate cash flows later; the latter may howeverhave greater growth and higher cash flows to compensate
Aswath Damodaran
4
-
8/12/2019 Valuations - Damodaran
5/308
5
DCF Choices: Equity Valuation versus Firm
Valuation
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flows
Little or No role in managementFixed MaturityTax Deductible
Residual Claim on cash flowsSignificant Role in management
Perpetual Lives
Growth Assets
Existing Investments
Generate cashflows todayIncludes long lived (fixed) and
short-lived(workingcapital) assets
Expected Value that will becreated by future investments
Equity valuation: Value just the
equity claim in the business
Firm Valuation: Value the entire business
Aswath Damodaran
5
-
8/12/2019 Valuations - Damodaran
6/308
6
Equity Valuation
Assets Liabilities
Assets in Place Debt
Equity
Discount rate reflects only thecost of raising equity financing
Growth Assets
Figure 5.5: Equity Valuation
Cash flows considered arecashflows from assets,after debt payments andafter making reinvestmentsneeded for future growth
Present value is value of just the equity claims on the firm
Aswath Damodaran
6
-
8/12/2019 Valuations - Damodaran
7/308
7
Firm Valuation
Assets Liabilities
Assets in Place Debt
Equity
Discount rate reflects the costof raising both debt and equityfinancing, in proportion to theiruse
Growth Assets
Figure 5.6: Firm Valuation
Cash flows considered arecashflows from assets,prior to any debt paymentsbut after firm hasreinvested to create growthassets
Present value is value of the entire firm, and reflects the value ofall claims on the firm.
Aswath Damodaran
7
-
8/12/2019 Valuations - Damodaran
8/308
8
Firm Value and Equity Value
To get from firm value to equity value, which of the followingwould 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 ofcapital 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 valuationc. equal to the value you would have got in an equity valuation
Aswath Damodaran
8
-
8/12/2019 Valuations - Damodaran
9/308
9
Cash Flows and Discount Rates
Assume that you are analyzing a company with the followingcashflows for the next five years.
Year CF to Equity Interest Exp (1-tax rate) CF to Firm
1 $ 50 $ 40 $ 90
2 $ 60 $ 40 $ 1003 $ 68 $ 40 $ 108
4 $ 76.2 $ 40 $ 116.2
5 $ 83.49 $ 40 $ 123.49
Terminal Value $ 1603.0 $ 2363.008
Assume also that the cost of equity is 13.625% and the firm canborrow 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 debtoutstanding is $800.
Aswath Damodaran
9
-
8/12/2019 Valuations - Damodaran
10/308
10
Equity versus Firm Valuation
Method 1: Discount CF to Equity at Cost of Equity to get valueof 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%
WACC = 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
Aswath Damodaran
10
-
8/12/2019 Valuations - Damodaran
11/308
11
First Principle of Valuation
Discounting Consistency Principle: Never mix and
match cash flows and discount rates.
Mismatching cash flows to discount rates is deadly.
Discounting cashflows after debt cash flows (equity cashflows) at the weighted average 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 ofthe value of the firm.
Aswath Damodaran
11
-
8/12/2019 Valuations - Damodaran
12/308
12
The Effects of Mismatching Cash Flows and
Discount Rates
Error 1: Discount CF to Equity at Cost of Capital to get equityvalue 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 tosubtract out debt, and get too high a value for equity Value of Equity = $ 1613
Value of Equity is overstated by $ 540
Aswath Damodaran
12
-
8/12/2019 Valuations - Damodaran
13/308
13
Discounted Cash Flow Valuation: The Steps
Estimate the discount rate or rates to use in the valuation Discount rate can be either a cost of equity (if doing equity valuation) or a cost of
capital (if valuing the firm)
Discount rate can be in nominal terms or real terms, depending upon whether thecash flows are nominal or real
Discount rate can vary across time.
Estimate the current earnings and cash flows on the asset, to eitherequity investors (CF to Equity) or to all claimholders (CF to Firm)
Estimate the future earnings and cash flows on the firm being valued,generally by estimating an expected growth rate in earnings.
Estimate when the firm will reach stable growthand what
characteristics (risk & cash flow) it will have when it does. Choose the right DCF model for this asset and value it.
Aswath Damodaran
13
-
8/12/2019 Valuations - Damodaran
14/308
14
Generic DCF Valuation Model
Aswath Damodaran
14
-
8/12/2019 Valuations - Damodaran
15/308
15
Same ingredients, different approaches
Input Dividend Discount
Model
FCFE (Potential
dividend) discount
model
FCFF (firm)
valuation model
Cash flow Dividend Potential dividends
= FCFE = Cash flows
after taxes,reinvestment needs
and debt cash
flows
FCFF = Cash flows
before debt
payments but afterreinvestment needs
and taxes.
Expected growth In equity income
and dividends
In equity income
and FCFE
In operating
income and FCFF
Discount rate Cost of equity Cost of equity Cost of capital
Steady state When dividends
grow at constant
rate forever
When FCFE grow at
constant rate
forever
When FCFF grow at
constant rate
forever
Aswath Damodaran
15
-
8/12/2019 Valuations - Damodaran
16/308
16
Start easy: The Dividend Discount Model
Aswath Damodaran
16
-
8/12/2019 Valuations - Damodaran
17/308
17
Moving on up: The potential dividendsor
FCFE model
Aswath Damodaran
17
-
8/12/2019 Valuations - Damodaran
18/308
18
To valuing the entire business: The FCFF model
Aswath Damodaran
18
-
8/12/2019 Valuations - Damodaran
19/308
DISCOUNTED CASH FLOWVALUATION: THE INPUTS
Aswath Damodaran
Aswath Damodaran 19
-
8/12/2019 Valuations - Damodaran
20/308
-
8/12/2019 Valuations - Damodaran
21/308
21
Estimating Inputs: Discount Rates
While discount rates obviously matter in DCF valuation, theydont matter as much as most analysts think they do.
At an intuitive level, the discount rate used should beconsistent with both the riskiness and the type of cashflowbeing 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 cashflows are cash flows to the firm, the appropriate discount rate is thecost of capital.
Currency: The currency in which the cash flows are estimated shouldalso be the currency in which the discount rate is estimated.
Nominal versus Real: If the cash flows being discounted are nominalcash flows (i.e., reflect expected inflation), the discount rate should benominal
Aswath Damodaran
21
-
8/12/2019 Valuations - Damodaran
22/308
22
Risk in the DCF Model
Aswath Damodaran
22
-
8/12/2019 Valuations - Damodaran
23/308
23
Not all risk is created equal
Estimation versus Economic uncertainty Estimation uncertainty reflects the possibility that you could have the wrong
modelor estimated inputs incorrectly within this model.
Economic uncertainty comes the fact that markets and economies can change overtime 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 firms
products, the competition it will face and the quality of its management team.
Macro uncertainty reflects the reality that your firms fortunes can be affected bychanges in the macro economic environment.
Discrete versus continuous uncertainty Discrete risk: Risks that 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 stageof the approval process or a company in Venezuela may be nationalized)
Continuous risk: Risks changes in interest rates or economic growth occurcontinuously and affect value as they happen.
Aswath Damodaran
23
-
8/12/2019 Valuations - Damodaran
24/308
24
Risk and Cost of Equity: The role of the marginal
investor
While the notion that the cost of equity should be higher for riskierinvestments and lower for safer investments is intuitive, what riskshould be built into the cost of equity is the question.
While risk is usually defined in terms of the variance of actualreturns around an expected return, risk and return models in
finance assume that the risk that should be rewarded (and thusbuilt into the discount rate) in valuation should be the riskperceived by the marginal investor in the investment
Most risk and return models in finance also assume that themarginal investor is well diversified, and that the only risk that heor she perceives in an investment is risk that cannot be diversified
away (i.e, market or non-diversifiable risk). In effect, it is primarilyeconomic, macro, continuous risk that should be incorporated intothe cost of equity.
Aswath Damodaran
24
-
8/12/2019 Valuations - Damodaran
25/308
25
The Cost of Equity: Competing Market Risk
Models
Model Expected Return Inputs Needed
CAPM E(R) = Rf + (Rm- Rf) Riskfree Rate
Beta relative to market portfolio
Market Risk Premium
APM E(R) = Rf + j (Rj- Rf) Riskfree Rate; # of Factors;Betas relative to each factor
Factor risk premiums
Multi E(R) = Rf + j (Rj- Rf) Riskfree Rate; Macro factors
factor Betas relative to macro factors
Macro economic risk premiums
Proxy E(R) = a + bj Yj Proxies
Regression coefficients
Aswath Damodaran
25
-
8/12/2019 Valuations - Damodaran
26/308
26
The CAPM: Cost of Equity
Consider the standard approach to estimating cost
of equity:
Cost of Equity = Riskfree Rate + Equity Beta * (Equity Risk
Premium) In practice,
Government security rates are used as risk free rates
Historical risk premiums are used for the risk premium
Betas are estimated by regressing stock returns againstmarket returns
Aswath Damodaran
26
-
8/12/2019 Valuations - Damodaran
27/308
27
I. A Riskfree Rate
On a riskfree asset, the actual return is equal to theexpected return. Therefore, there is no variance aroundthe expected return.
For an investment to be riskfree, then, it has to have
No default risk No reinvestment risk
1. Time horizon matters: Thus, the riskfree rates invaluation will depend upon when the cash flow isexpected to occur and will vary across time.
2. Not all government securities are riskfree: Somegovernments face default risk and the rates on bondsissued by them will not be riskfree.
Aswath Damodaran
27
-
8/12/2019 Valuations - Damodaran
28/308
28
Test 1: A riskfree rate in US dollars!
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
bea. A three-month Treasury bill rate (0.1%)
b. A ten-year Treasury bond rate (2%)
c. A thirty-year Treasury bond rate (3%)
d. A TIPs (inflation-indexed treasury) rate (1%)
e. None of the above
Aswath Damodaran
28
-
8/12/2019 Valuations - Damodaran
29/308
29
Test 2: A Riskfree Rate in Euros
Aswath Damodaran
29
-
8/12/2019 Valuations - Damodaran
30/308
30
Test 3: A Riskfree Rate in Indian Rupees
The Indian government had 10-year Rupee bondsoutstanding, with a yield to maturity of about 8.5% onJanuary 1, 2012.
In January 2012, the Indian government had a local currency
sovereign rating of Baa3. The typical default spread (over adefault free rate) for Baa3 rated country bonds in early 2012was 2%. The riskfree rate in Indian Rupees is
a. The yield to maturity on the 10-year bond (8.5%)
b. The yield to maturity on the 10-year bond + Default spread (10.5%)
c. The yield to maturity on the 10-year bondDefault spread (6.5%)
d. None of the above
Aswath Damodaran
30
-
8/12/2019 Valuations - Damodaran
31/308
31
Sovereign Default Spread: Three paths to the
same destination
Sovereign dollar or euro denominated bonds: Find sovereign bondsdenominated in US dollars, issued by emerging markets. Thedifference between the interest rate on the bond and the UStreasury bond rate should be the default spread. For instance, inJanuary 2012, the US dollar denominated 10-year bond issued bythe Brazilian government (with a Baa2 rating) had an interest rateof 3.5%, resulting in a default spread of 1.6% over the US treasuryrate of 1.9% at the same point in time. (On the same day, the ten-year Brazilian BR denominated bond had an interest rate of 12%)
CDS spreads: Obtain the default spreads for sovereigns in the CDSmarket. In January 2012, the CDS spread for Brazil in that market
was 1.43%. Average spread: For countries which dont issue dollar
denominated bonds or have a CDS spread, you have to use theaverage spread for other countries in the same rating class.
Aswath Damodaran
31
-
8/12/2019 Valuations - Damodaran
32/308
http://www.tradingeconomics.com/switzerland/government-bond-yieldhttp://www.tradingeconomics.com/israel/government-bond-yieldhttp://www.tradingeconomics.com/hong-kong/government-bond-yieldhttp://www.tradingeconomics.com/lithuania/government-bond-yieldhttp://www.tradingeconomics.com/japan/government-bond-yieldhttp://www.tradingeconomics.com/slovakia/government-bond-yieldhttp://www.tradingeconomics.com/taiwan/government-bond-yieldhttp://www.tradingeconomics.com/philippines/government-bond-yieldhttp://www.tradingeconomics.com/euro-area/government-bond-yieldhttp://www.tradingeconomics.com/italy/government-bond-yieldhttp://www.tradingeconomics.com/singapore/government-bond-yieldhttp://www.tradingeconomics.com/ireland/government-bond-yieldhttp://www.tradingeconomics.com/germany/government-bond-yieldhttp://www.tradingeconomics.com/croatia/government-bond-yieldhttp://www.tradingeconomics.com/denmark/government-bond-yieldhttp://www.tradingeconomics.com/slovenia/government-bond-yieldhttp://www.tradingeconomics.com/netherlands/government-bond-yieldhttp://www.tradingeconomics.com/indonesia/government-bond-yieldhttp://www.tradingeconomics.com/finland/government-bond-yieldhttp://www.tradingeconomics.com/spain/government-bond-yieldhttp://www.tradingeconomics.com/sweden/government-bond-yieldhttp://www.tradingeconomics.com/mexico/government-bond-yieldhttp://www.tradingeconomics.com/austria/government-bond-yieldhttp://www.tradingeconomics.com/chile/government-bond-yieldhttp://www.tradingeconomics.com/united-states/government-bond-yieldhttp://www.tradingeconomics.com/colombia/government-bond-yieldhttp://www.tradingeconomics.com/canada/government-bond-yieldhttp://www.tradingeconomics.com/hungary/government-bond-yieldhttp://www.tradingeconomics.com/united-kingdom/government-bond-yieldhttp://www.tradingeconomics.com/south-africa/government-bond-yieldhttp://www.tradingeconomics.com/czech-republic/government-bond-yieldhttp://www.tradingeconomics.com/turkey/government-bond-yieldhttp://www.tradingeconomics.com/france/government-bond-yieldhttp://www.tradingeconomics.com/peru/government-bond-yieldhttp://www.tradingeconomics.com/belgium/government-bond-yieldhttp://www.tradingeconomics.com/iceland/government-bond-yieldhttp://www.tradingeconomics.com/norway/government-bond-yieldhttp://www.tradingeconomics.com/russia/government-bond-yieldhttp://www.tradingeconomics.com/qatar/government-bond-yieldhttp://www.tradingeconomics.com/romania/government-bond-yieldhttp://www.tradingeconomics.com/south-korea/government-bond-yieldhttp://www.tradingeconomics.com/portugal/government-bond-yieldhttp://www.tradingeconomics.com/australia/government-bond-yieldhttp://www.tradingeconomics.com/india/government-bond-yieldhttp://www.tradingeconomics.com/latvia/government-bond-yieldhttp://www.tradingeconomics.com/brazil/government-bond-yieldhttp://www.tradingeconomics.com/bulgaria/government-bond-yieldhttp://www.tradingeconomics.com/vietnam/government-bond-yieldhttp://www.tradingeconomics.com/malaysia/government-bond-yieldhttp://www.tradingeconomics.com/venezuela/government-bond-yieldhttp://www.tradingeconomics.com/thailand/government-bond-yieldhttp://www.tradingeconomics.com/greece/government-bond-yieldhttp://www.tradingeconomics.com/new-zealand/government-bond-yieldhttp://www.tradingeconomics.com/pakistan/government-bond-yieldhttp://www.tradingeconomics.com/china/government-bond-yieldhttp://www.tradingeconomics.com/nigeria/government-bond-yieldhttp://www.tradingeconomics.com/poland/government-bond-yieldhttp://www.tradingeconomics.com/kenya/government-bond-yieldhttp://localhost/var/www/apps/conversion/tmp/scratch_3/ctl00$ContentPlaceHolder1$ctl00$ctl00$GridView1','Sort$Country -
8/12/2019 Valuations - Damodaran
33/308
33
Approach 1: Default spread from Government
BondsJanuary 2013
Aswath Damodaran
33
-
8/12/2019 Valuations - Damodaran
34/308
34
Approach 2: CDS Spreads
Aswath Damodaran
34
-
8/12/2019 Valuations - Damodaran
35/308
35
Approach 3: Typical Default Spreads: January
2013
Aswath Damodaran
35
-
8/12/2019 Valuations - Damodaran
36/308
36
Getting to a risk free rate in a currency: Example
The Brazilian government bond rate in nominal reais inJanuary 2013 was 9.18%. To get to a riskfree rate in nominalreais, we can use one of three approaches. Approach 1: Government Bond spread
The 2020 Brazil bond, denominated in US dollars, has a spread of
0.74% over the US treasury bond rate. Riskfree rate in $R = 9.18% - 0.74% = 8.44%
Approach 2: The CDS Spread
The CDS spread for Brazil on January 1, 2013 was 1.42%.
Riskfree rate in $R = 9.18% - 1.42% = 7.76%
Approach 3: The Rating based spread Brazil has a Baa2 local currency rating from Moodys. The default
spread for that rating is 1.75%
Riskfree rate in $R = 9.18% - 1.75% = 7.43%
Aswath Damodaran
36
-
8/12/2019 Valuations - Damodaran
37/308
-
8/12/2019 Valuations - Damodaran
38/308
38
No default free entity: Choices with riskfree
rates.
Estimate a range for the riskfree rate in local terms: Approach 1: Subtract default spread from local government bond rate:
Government bond rate in local currency terms - Default spread forGovernment in local currency
Approach 2: Use forward rates and the riskless rate in an index currency(say Euros or dollars) to estimate the riskless rate in the local currency.
Do the analysis in real terms (rather than nominal terms) using areal riskfree rate, which can be obtained in one of two ways from an inflation-indexed government bond, if one exists
set equal, approximately, to the long term real growth rate of the economyin which the valuation is being done.
Do the analysis in a currency where you can get a riskfree rate, sayUS dollars or Euros.
Aswath Damodaran
38
-
8/12/2019 Valuations - Damodaran
39/308
39
Why do risk free rates vary across currencies?
January 2013 Risk free rates
Aswath Damodaran
39
-
8/12/2019 Valuations - Damodaran
40/308
40
One more test on riskfree rates
In January 2013, the 10-year treasury bond rate in theUnited States was 1.76%, a historic low. Assume that youwere valuing a company in US dollars then, but werewary 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 overthe last 30 years has been about 4%)
b. Use the current 10-year bond rate as your riskfree rate but
make sure that your other assumptions (about growth andinflation) are consistent with the riskfree rate
c. Something else
Aswath Damodaran
40
-
8/12/2019 Valuations - Damodaran
41/308
41
II. Equity Risk Premiums
The ubiquitous historical risk premium
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:Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds1928-2012 7.65% 5.88% 5.74% 4.20%
2.20% 2.33%
1962-2012 5.93% 3.91% 4.60% 2.93%
2.38% 2.66%
2002-2012 7.06% 3.08% 5.38% 1.71%
5.82% 8.11%
Aswath Damodaran
41
-
8/12/2019 Valuations - Damodaran
42/308
42
The perils of trusting the past.
Noisy estimates: Even with long time periods of history,the risk premium that you derive will have substantialstandard error. For instance, if you go back to 1928(about 80 years of history) and you assume a standarddeviation of 20% in annual stock returns, you arrive at a
standard error of greater than 2%:Standard Error in Premium = 20%/80 = 2.26%
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 equitymarkets were among the most successful of the globaleconomies that you could have invested in early in thecentury.
Aswath Damodaran
42
k f k ? d
-
8/12/2019 Valuations - Damodaran
43/308
43
Risk Premium for a Mature Market? Broadening
the sample
Aswath Damodaran
43
Th i l t f ti ti dditi l
-
8/12/2019 Valuations - Damodaran
44/308
44
The simplest way of estimating an additional
country risk premium: The country default spread
Default spread for country: In this approach, the countryequity risk premium is set equal to the default spread for thecountry, estimated in one of three ways: The default spread on a dollar denominated bond issued by the
country. Brazils 10 year $ denominated bond at the start of 2013 was
trading at an interest rate of 2.60%, a default spread of 0.84% over theUS treasury bond rate of 1.76%.
The ten year CDS spread for Brazil of 1.42%
Brazils sovereign local currency rating is Baa2. The default spread for aBaa2 rated sovereign is about 1.75%.
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 5.80%. Country Risk Premium for Brazil = 1.75%
Total ERP for Brazil = 5.80% + 1.75% = 7.55%
Aswath Damodaran
44
-
8/12/2019 Valuations - Damodaran
45/308
A ld d h i i h ddi i l
-
8/12/2019 Valuations - Damodaran
46/308
46
A melded approach to estimating the additional
country risk premium
Country ratings measure default risk. While default risk premiumsand equity risk premiums are highly correlated, one would expectequity spreads to be higher than debt spreads.
Another is to multiply the bond default spread by the relativevolatility of stock and bond prices in that market. Using this
approach for Brazil in January 2013, you would get: Country Equity risk premium = Default spread on country bond* Country
Equity/ Country Bond Standard Deviation in Bovespa (Equity) = 21%
Standard Deviation in Brazil government bond = 14%
Default spread on C-Bond = 1.75%
Brazil Country Risk Premium = 1.75% (21%/14%) = 2.63% Brazil Total ERP = Mature Market Premium + CRP = 5.80% + 2.63% = 8.43%
Aswath Damodaran
46
Country Risk PremiumsAndorra 1.95% 7.70%Austria 0.00% 5.75%
Belgium 1 20% 6 95%
Albania 6.75% 12.50%
Armenia 4 73% 10 48%
-
8/12/2019 Valuations - Damodaran
47/308
Country Risk Premiums
July 2013
Black #: Total ERP
Red #: Country risk premium
AVG: GDP weighted average
Angola 5.40% 11.15%
Benin 8.25% 14.00%
Botswana 1.65% 7.40%
Burkina Faso 8.25% 14.00%
Cameroon 8.25% 14.00%
Cape Verde 6.75% 12.50%
Egypt 12.00% 17.75%Gabon 5.40% 11.15%
Ghana 6.75% 12.50%
Kenya 6.75% 12.50%
Morocco 4.13% 9.88%
Mozambique 6.75% 12.50%
Namibia 3.38% 9.13%
Nigeria 5.40% 11.15%
Rwanda 8.25% 14.00%
Senegal 6.75% 12.50%
South Africa 2.55% 8.30%
Tunisia 4.73% 10.48%Zambia 6.75% 12.50%
Africa 5.90% 11.65%
Belgium 1.20% 6.95%
Cyprus 16.50% 22.25%
Denmark 0.00% 5.75%
Finland 0.00% 5.75%
France 0.45% 6.20%
Germany 0.00% 5.75%
Greece 10.13% 15.88%
Iceland 3.38% 9.13%
Ireland 4.13% 9.88%
Isle of Man 0.00% 5.75%
Italy 3.00% 8.75%
Liechtenstein 0.00% 5.75%
Luxembourg 0.00% 5.75%
Malta 1.95% 7.70%
Netherlands 0.00% 5.75%
Norway 0.00% 5.75%
Portugal 5.40% 11.15%
Spain 3.38% 9.13%
Sweden 0.00% 5.75%
Switzerland 0.00% 5.75%Turkey 3.38% 9.13%
UK 0.45% 6.20%
W. Europe 1,.22% 6.97%
Argentina 10.13% 15.88%
Belize 14.25% 20.00%
Bolivia 5.40% 11.15%
Brazil 3.00% 8.75%
Chile 1.20% 6.95%
Colombia 3.38% 9.13%
Costa Rica 3.38% 9.13%
Ecuador 12.00% 17.75%
El Salvador 5.40% 11.15%
Guatemala 4.13% 9.88%Honduras 8.25% 14.00%
Mexico 2.55% 8.30%
Nicaragua 10.13% 15.88%
Panama 3.00% 8.75%
Paraguay 5.40% 11.15%
Peru 3.00% 8.75%
Suriname 5.40% 11.15%
Uruguay 3.38% 9.13%
Venezuela 6.75% 12.50%
Latin America 3.94% 9.69%
Canada 0.00% 5.75%
United States 0.00% 5.75%
North America 0.00% 5.75%
Armenia 4.73% 10.48%
Azerbaijan 3.38% 9.13%
Belarus 10.13% 15.88%
Bosnia 10.13% 15.88%
Bulgaria 3.00% 8.75%
Croatia 4.13% 9.88%
Czech Republic 1.43% 7.18%
Estonia 1.43% 7.18%
Georgia 5.40% 11.15%
Hungary 4.13% 9.88%
Kazakhstan 3.00% 8.75%
Latvia 3.00% 8.75%
Lithuania 2.55% 8.30%
Macedonia 5.40% 11.15%
Moldova 10.13% 15.88%
Montenegro 5.40% 11.15%
Poland 1.65% 7.40%
Romania 3.38% 9.13%
Russia 2.55% 8.30%
Serbia 5.40% 11.15%
Slovakia 1.65% 7.40%
Slovenia 4.13% 9.88%
Uganda 6.75% 12.50%
Ukraine 10.13% 15.88%
E. Europe/Russia 3.13% 8.88%
Bahrain 2.55% 8.30%
Israel 1.43% 7.18%
Jordan 6.75% 12.50%
Kuwait 0.90% 6.65%
Lebanon 6.75% 12.50%
Oman 1.43% 7.18%
Qatar 0.90% 6.65%
Saudi Arabia 1.20% 6.95%
UAE 0.90% 6.65%
Middle East 1.38% 7.13%
Australia 0.00% 5.75%
Cook Islands 6.75% 12.50%
New Zealand 0.00% 5.75%
Australia & NZ 0.00% 5.75%
Bangladesh 5.40% 11.15%
Cambodia 8.25% 14.00%
China 1.20% 6.95%
Fiji 6.75% 12.50%
Hong Kong 0.45% 6.20%
India 3.38% 9.13%
Indonesia 3.38% 9.13%
Japan 1.20% 6.95%
Korea 1.20% 6.95%
Macao 1.20% 6.95%
Malaysia 1.95% 7.70%
Mauritius 2.55% 8.30%
Mongolia 6.75% 12.50%
Pakistan 12.00% 17.75%
Papua NG 6.75% 12.50%
Philippines 4.13% 9.88%
Singapore 0.00% 5.75%
Sri Lanka 6.75% 12.50%
Taiwan 1.20% 6.95%
Thailand 2.55% 8.30%
Vietnam 8.25% 14.00%
Asia 1.77% 7.52%
F C t E it Ri k P i t
-
8/12/2019 Valuations - Damodaran
48/308
48
From Country Equity Risk Premiums to
Corporate Equity Risk premiums
Approach 1: Assume that every company in the country is equallyexposed to country risk. In this case, E(Return) = Riskfree Rate + CRP + Beta (Mature ERP)
Implicitly, this is what you are assuming when you use the local Governmentsdollar borrowing rate as your riskfree rate.
Approach 2: Assume that a companys 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 tohave different exposures to country risk (perhaps based upon theproportion of their revenues come from non-domestic sales) E(Return)=Riskfree Rate+ (Mature ERP) + (CRP)
Mature ERP = Mature market Equity Risk Premium
CRP = Additional country risk premium
Aswath Damodaran
48
A h 1 & 2 E ti ti t i k
-
8/12/2019 Valuations - Damodaran
49/308
49
Approaches 1 & 2: Estimating country risk
premium exposure
Location based CRP: The standard approach in valuation is toattach a country risk premium to a company based upon itscountry of incorporation. Thus, if you are an Indian company,you are assumed to be exposed to the Indian country riskpremium. A developed market company is assumed to beunexposed to emerging market risk.
Operation-based CRP: There is a more reasonable modifiedversion. The country risk premium for a company can becomputed as a weighted average of the country risk
premiums of the countries that it does business in, with theweights based upon revenues or operating income. If acompany is exposed to risk in dozens of countries, you cantake a weighted average of the risk premiums by region.
Aswath Damodaran
49
O ti b d CRP Si l M lti l
-
8/12/2019 Valuations - Damodaran
50/308
50
Operation based CRP: Single versus Multiple
Emerging Markets
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 Brazils CRP was 7.89%.
Multiple emerging markets: Ambev, the Brazilian-based beverage
company, reported revenues from the following countries during 2011.
Aswath Damodaran
50
Extending to a multinational: Regional breakdown
-
8/12/2019 Valuations - Damodaran
51/308
51
Extending to a multinational: Regional breakdown
Coca Colas revenue breakdown and ERP in 2012
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
51
-
8/12/2019 Valuations - Damodaran
52/308
52
Two problems with these approaches..
Focus just on revenues: To the extent that revenues arethe only variable that you consider, when weighting riskexposure across markets, you may be missing otherexposures to country risk. For instance, an emergingmarket company that gets the bulk of its revenues
outside the country (in a developed market) may stillhave all of its production facilities in the emergingmarket.
Exposure not adjusted or based upon beta: To the extentthat the country risk premium is multiplied by a beta, weare assuming that beta in addition to measuringexposure to all other macro economic risk also measuresexposure to country risk.
Aswath Damodaran
52
-
8/12/2019 Valuations - Damodaran
53/308
53
Approach 3: Estimate a lambda for country risk
Source of revenues: Other things remaining equal, acompany should be more exposed to risk in a country ifit generates more of its revenues from that country.
Manufacturing facilities: Other things remaining equal, afirm that has all of its production facilities in a riskycountryshould be more exposed to country risk thanone which has production facilities spread over multiplecountries. The problem will be accented for companiesthat cannot move their production facilities (mining andpetroleum companies, for instance).
Use of risk management products: Companies can useboth options/futures markets and insurance to hedgesome or a significant portion of country risk.
Aswath Damodaran
53
-
8/12/2019 Valuations - Damodaran
54/308
54
Estimating Lambdas: The Revenue Approach
The easiest and most accessible data is on revenues. Most companies break theirrevenues down by region.
= % of revenues domesticallyfirm/ % of revenues domestically average firm Consider, for instance, Embraer and Embratel, both of which are incorporated and
traded in Brazil. Embraer gets 3% of its revenues from Brazil whereas Embratelgets almost all of its revenues in Brazil. The average Brazilian company gets about
77% of its revenues in Brazil: LambdaEmbraer = 3%/ 77% = .04
LambdaEmbratel = 100%/77% = 1.30
Note that if the proportion of revenues of the average company gets in themarket is assumed to be 100%, this approach collapses into the first one.,
There are two implications
A company
s risk exposure is determined by where it does business and not by where it islocated
Firms might be able to actively manage their country risk exposure
Aswath Damodaran
54
A richer lambda estimate: Use stock returns and country
-
8/12/2019 Valuations - Damodaran
55/308
55
A richer lambda estimate: Use stock returns and country
bond returns: Estimating a lambdafor Embraer in 2004
Embraer versus C Bond: 2000-2003
Return on C-Bond
20100-10-20-30
ReturnonEmbraer
40
20
0
-20
-40
-60
Embratel versus C Bond: 2000-2003
Return on C-Bond
20100-10-20-30
ReturnonEmbratel
100
80
60
40
20
0
-20
-40
-60
-80
ReturnEmbraer= 0.0195 + 0.2681ReturnC BondReturnEmbratel= -0.0308 + 2.0030ReturnC Bond
Aswath Damodaran
55
Estimating a US Dollar Cost of Equity for
-
8/12/2019 Valuations - Damodaran
56/308
56
Estimating a US Dollar Cost of Equity for
Embraer - September 2004
Assume that the beta for Embraer is 1.07, and that the US $ riskfree rateused is 4%. Also assume that the risk premium for the US is 5% and thecountry risk premium for Brazil is 7.89%. Finally, assume that Embraergets 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
56
Valuing Emerging Market Companies with
-
8/12/2019 Valuations - Damodaran
57/308
57
Valuing Emerging Market Companies with
significant exposure in developed markets
The conventional practice in investment banking is to add the countryequity risk premium on to the cost of equity for every emerging marketcompany, notwithstanding its exposure to emerging market risk. Thus, in2004, 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, whichof the following consequences do you see from this approach?
a. Emerging market companies with substantial exposure in developedmarkets will be significantly over valued by equity research analysts.
b. Emerging market companies with substantial exposure in developedmarkets will be significantly under valued by equity research analysts.
Can you construct an investment strategy to take advantage of themisvaluation? What would need to happen for you to make money of this
strategy?
Aswath Damodaran
57
-
8/12/2019 Valuations - Damodaran
58/308
58
Implied Equity Premiums
Lets start with a general proposition. If you know the pricepaid for an asset and have estimates of the expected cashflows on the asset, you can estimate the IRR of these cashflows. If you paid the price, this is what you have priced theasset to earn (as an expected return).
If you assume that stocks are correctly priced in the aggregateand you can estimate the expected cashflows from buyingstocks, you can estimate the expected rate of return on stocksby finding that discount rate that makes the present valueequal to the price paid. 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 everyday, if you are so inclined).
Aswath Damodaran
58
-
8/12/2019 Valuations - Damodaran
59/308
59
Implied Equity Premiums: January 2008
We can use the information in stock prices to back out how risk averse the market is and how much of a riskpremium it is demanding.
If you pay the current level of the index, you can expect to make a return of 8.39% on stocks (which is obtained bysolving for r in the following equation)
Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 8.39% - 4.02% = 4.37%
1468.36 =61.98
(1+ r)+
65.08
(1+ r)2+
68.33
(1+ r)3+
71.75
(1+ r)4+
75.34
(1+ r)5+
75.35(1.0402)
(r .0402)(1+ r)5
January 1, 2008S&P 500 is at 1468.364.02% of 1468.36 = 59.03
Between 2001 and 2007dividends and stock
buybacks averaged 4.02%of the index each year.
Analysts expect earnings to grow 5% a year for the next 5 years. Wewill assume that dividends & buybacks will keep pace..Last years cashflow (59.03) growing at 5% a year
After year 5, we will assume thatearnings on the index will grow at4.02%, the same rate as the entireeconomy (= riskfree rate).
61.98 65.08 68.33 71.75 75.34
Aswath Damodaran
59
-
8/12/2019 Valuations - Damodaran
60/308
60
Implied Risk Premium Dynamics
Assume that the index jumps 10% on January 2 and that nothing elsechanges. What will happen to the implied equity risk premium?
a. Implied equity risk premium will increase
b. Implied equity risk premium will decrease
Assume that the earnings jump 10% on January 2 and that nothing else
changes. What will happen to the implied equity risk premium?a. Implied equity risk premium will increase
b. Implied equity risk premium will decrease
Assume that the riskfree rate increases to 5% on January 2 and thatnothing else changes. What will happen to the implied equity riskpremium?
a. Implied equity risk premium will increase
b. Implied equity risk premium will decrease
Aswath Damodaran
60
A year that made a difference The implied
-
8/12/2019 Valuations - Damodaran
61/308
61
A year that made a difference.. The implied
premium in January 2009
Year Market value of index Dividends Buybacks Cash to equity Dividend yield Buyback yield Total yield2001 1148.09 15.74 14.34 30.08 1.37% 1.25% 2.62%
2002 879.82 15.96 13.87 29.83 1.81% 1.58% 3.39%
2003 1111.91 17.88 13.70 31.58 1.61% 1.23% 2.84%
2004 1211.92 19.01 21.59 40.60 1.57% 1.78% 3.35%
2005 1248.29 22.34 38.82 61.17 1.79% 3.11% 4.90%
2006 1418.30 25.04 48.12 73.16 1.77% 3.39% 5.16%2007 1468.36 28.14 67.22 95.36 1.92% 4.58% 6.49%
2008 903.25 28.47 40.25 68.72 3.15% 4.61% 7.77%
Normalized 903.25 28.47 24.11 52.584 3.15% 2.67% 5.82%
Aswath Damodaran
61
The Anatomy of a Crisis: Implied ERP from
-
8/12/2019 Valuations - Damodaran
62/308
62
The Anatomy of a Crisis: Implied ERP from
September 12, 2008 to January 1, 2009
Aswath Damodaran
62
-
8/12/2019 Valuations - Damodaran
63/308
63
An Updated Equity Risk Premium:
On January 1, 2013, the S&P 500 was at 1426.19, essentially unchangedfor the year. And it was a year of macro shockspolitical upheaval in the
Middle East and sovereign debt problems in Europe. The treasury bond
rate dropped below 2% and buybacks/dividends surged.
Aswath Damodaran
63
-
8/12/2019 Valuations - Damodaran
64/308
64
Implied Premiums in the US: 1960-2012
Aswath Damodaran
64
-
8/12/2019 Valuations - Damodaran
65/308
65
Implied Premium versus Risk Free Rate
Aswath Damodaran
65
-
8/12/2019 Valuations - Damodaran
66/308
66
Equity Risk Premiums and Bond Default Spreads
Aswath Damodaran
66
Equity Risk Premiums and Cap Rates (Real
-
8/12/2019 Valuations - Damodaran
67/308
67
Equity Risk Premiums and Cap Rates (Real
Estate)
Aswath Damodaran
67
-
8/12/2019 Valuations - Damodaran
68/308
68
Why implied premiums matter?
In many investment banks, it is common practice (especiallyin corporate finance departments) to use historical riskpremiums (and arithmetic averages at that) as risk premiumsto compute cost of equity. If all analysts in the departmentused the geometric average premium for 1928-2012 of 4.2%
to value stocks in January 2013, given the implied premium of5.78%, what were they likely to find?
a. The values they obtain will be too low (most stocks will lookovervalued)
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
68
-
8/12/2019 Valuations - Damodaran
69/308
69
Which equity risk premium should you use?
If you assume this Premium to use
Premiums revert back to historical norms
and your time period yields these norms
Historical risk premium
Market is correct in the aggregate or that
your valuation should be market neutral
Current implied equity risk premium
Marker makes mistakes even in the
aggregate but is correct over time
Average implied equity risk premium over
time.
Aswath Damodaran
69
And the approach can be extended to emerging markets
-
8/12/2019 Valuations - Damodaran
70/308
70
pp g g
Implied premium for the Sensex (September 2007)
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:
Expected return on stocks = 11.18% Implied equity risk premium for India = 11.18% - 6.76% =
4.42%
15446 =537.06
(1+ r)+
612.25
(1+ r)2+
697.86
(1+ r)3+
795.67
(1+ r)4+
907.07
(1+ r)5+
907.07(1.0676)
(r .0676)(1+ r)5
Aswath Damodaran
70
Can country risk premiums change? Brazil CRP
-
8/12/2019 Valuations - Damodaran
71/308
71
Can country risk premiums change? Brazil CRP
& Total ERP from 2000 to 2012
Aswath Damodaran
71
Implied Equity Risk Premium comparison:
-
8/12/2019 Valuations - Damodaran
72/308
72
Implied Equity Risk Premium comparison:
January 2008 versus January 2009
Aswath Damodaran
72
Country ERP (1/1/08) ERP (1/1/09)
United States 4.37% 6.43%
UK 4.20% 6.51%
Germany 4.22% 6.49%Japan 3.91% 6.25%
India 4.88% 9.21%
China 3.98% 7.86%Brazil 5.45% 9.06%
-
8/12/2019 Valuations - Damodaran
73/308
Aswath Damodaran73
Th CAPM B t
-
8/12/2019 Valuations - Damodaran
74/308
74
The CAPM Beta
The standard procedure for estimating betas is to regressstock 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 ofthe stock, and measures the riskiness of the stock.
This beta has three problems:It has high standard error
It reflects the firms business mix over the period of the
regression, not the current mixIt reflects the firms average financial leverage over the periodrather than the current leverage.
Aswath Damodaran
74
B t E ti ti Th N i P bl
-
8/12/2019 Valuations - Damodaran
75/308
75
Beta Estimation: The Noise Problem
Aswath Damodaran
75
B t E ti ti Th I d Eff t
-
8/12/2019 Valuations - Damodaran
76/308
76
Beta Estimation: The Index Effect
Aswath Damodaran
76
Stock-priced based solutions to the Regression
-
8/12/2019 Valuations - Damodaran
77/308
77
p g
Beta Problem
Modify the regression beta by changing the index used to estimate the beta
adjusting the regression beta estimate, by bringing in informationabout the fundamentals of the company
Estimate the beta for the firm using
the standard deviation in stock prices instead of a regression againstan index
Relative risk = Standard deviation in stock prices for investment/Average standard deviation across all stocks
Estimate the beta for the firm from the bottom up without
employing the regression technique. This will require understanding the business mix of the firm
estimating the financial leverage of the firm
Imputed or implied beta (cost of equity) for the sector.
Aswath Damodaran
77
Alt ti f l ti i k f it
-
8/12/2019 Valuations - Damodaran
78/308
78
Alternative measures of relative risk for equity
Accounting risk measures: To the extent that you dont trust market-priced based measures of risk, you could compute relative risk measuresbased on Accounting earnings volatility: Compute an accounting beta or relative volatility
Balance sheet ratios: You could compute a risk score based upon accounting ratioslike debt ratios or cash holdings (akin to default risk scores like the Z score)
Proxies: In a simpler version of proxy models, you can categorize firmsinto risk classes based upon size, sectors or other characteristics.
Qualitative Risk Models: In these models, risk assessments are based atleast partially on qualitative factors (quality of management).
Debt based measures: You can estimate a cost of equity, based upon anobservable costs of debt for the company. Cost of equity = Cost of debt * Scaling factor
Aswath Damodaran
78
D t i t f B t & R l ti Ri k
-
8/12/2019 Valuations - Damodaran
79/308
79
Determinants of Betas & Relative Risk
Aswath Damodaran
79
In a perfect world we would estimate the beta
-
8/12/2019 Valuations - Damodaran
80/308
80
p
of a firm by doing the following
Aswath Damodaran
80
Adjusting for operating leverage
-
8/12/2019 Valuations - Damodaran
81/308
81
Adjusting for operating leverage
Within any business, firms with lower fixed costs (as apercentage of total costs) should have lower unleveredbetas. If you can compute fixed and variable costs foreach firm in a sector, you can break down the unleveredbeta 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 isdifficult to get information on fixed and variable costs forindividual firms.
In practice, we tend to assume that the operatingleverage of firms within a business are similar and usethe same unlevered beta for every firm.
Aswath Damodaran
81
Adjusting for financial leverage
-
8/12/2019 Valuations - Damodaran
82/308
82
Adjusting for financial leverage
Conventional approach: If we assume that debt carriesno market risk (has a beta of zero), the beta of equityalone can be written as a function of the unlevered betaand the debt-equity ratio
L= u(1+ ((1-t)D/E))
In some versions, the tax effect is ignored and there is no (1-t) inthe equation.
Debt Adjusted Approach: If beta carries market risk andyou can estimate the beta of debt, you can estimate thelevered beta as follows:
L= u(1+ ((1-t)D/E)) - debt(1-t) (D/E)
While the latter is more realistic, estimating betas for debt can bedifficult to do.
Aswath Damodaran
82
Bottom up Betas
-
8/12/2019 Valuations - Damodaran
83/308
83
Bottom-up Betas
Aswath Damodaran
83
Why bottom up betas?
-
8/12/2019 Valuations - Damodaran
84/308
84
Why bottom-up betas?
The standard error in a bottom-up beta will be significantlylower than the standard error in a single regression beta.Roughly speaking, the standard error of a bottom-up betaestimate can be written as follows:
Std error of bottom-up beta =
The bottom-up beta can be adjusted to reflect changes in thefirms business mix and financial leverage. Regression betasreflect the past.
You can estimate bottom-up betas even when you do nothave historical stock prices. This is the case with initial publicofferings, private businesses or divisions of companies.
Average Std Error across Betas
Number of firms in sample
Aswath Damodaran
84
Bottom-up Beta: Firm in Multiple Businesses
-
8/12/2019 Valuations - Damodaran
85/308
85
SAP in 2004
Approach 1: Based on business mix
SAP is in three business: software, consulting and training. We will
aggregate the consulting and training businesses
Business Revenues EV/Sales Value Weights Beta
Software $ 5.3 3.25 17.23 80% 1.30
Consulting $ 2.2 2.00 4.40 20% 1.05
SAP $ 7.5 21.63 1.25
Approach 2: Customer Base
Aswath Damodaran
85
Embraers Bottom up Beta
-
8/12/2019 Valuations - Damodaran
86/308
86
Embraer s Bottom-up Beta
Business Unlevered Beta D/E Ratio Levered betaAerospace 0.95 18.95% 1.07
Levered Beta = 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 Europeanaerospace companies be used to estimate the beta for a Brazilianaerospace company?
a. Yes
b. NoWhat concerns would you have in making this assumption?
Aswath Damodaran
86
Gross Debt versus Net Debt Approaches
-
8/12/2019 Valuations - Damodaran
87/308
87
Gross Debt versus Net Debt Approaches
Analysts in Europe and Latin America often take the difference betweendebt and cash (net debt) when computing debt ratios and arrive at verydifferent 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 Embraerwill even out since the debt ratio used in the cost of capital equation willnow be a net debt ratio rather than a gross debt ratio.
Aswath Damodaran
87
The Cost of Equity: A Recap
-
8/12/2019 Valuations - Damodaran
88/308
88
The Cost of Equity: A Recap
Aswath Damodaran
88
Estimating the Cost of Debt
-
8/12/2019 Valuations - Damodaran
89/308
89
Estimating the Cost of Debt
The cost of debt is the rate at which you can borrow atcurrently, It will reflect not only your default risk but also thelevel of interest rates in the market.
The two most widely used approaches to estimating cost ofdebt are:
Looking up the yield to maturity on a straight bond outstanding fromthe firm. The limitation of this approach is that very few firms havelong term straight bonds that are liquid and widely traded
Looking up the rating for the firm and estimating a default spreadbased upon the rating. While this approach is more robust, differentbonds 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 foryour firm and the cost of debt based upon that rating.
Aswath Damodaran
89
Estimating Synthetic Ratings
-
8/12/2019 Valuations - Damodaran
90/308
90
Estimating Synthetic Ratings
The rating for a firm can be estimated using the financialcharacteristics of the firm. In its simplest form, the rating
can be estimated from the interest coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
For Embraers 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
90
Interest Coverage Ratios, Ratings and Default
-
8/12/2019 Valuations - Damodaran
91/308
91
Spreads: 2003 & 2004
If Interest Coverage Ratio is Estimated Bond Rating Default Spread(2003) Default Spread(2004)> 8.50 (>12.50) AAA 0.75% 0.35%
6.50 - 8.50 (9.5-12.5) AA 1.00% 0.50%
5.50 - 6.50 (7.5-9.5) A+ 1.50% 0.70%
4.25 - 5.50 (6-7.5) A 1.80% 0.85%
3.00 - 4.25 (4.5-6) A 2.00% 1.00%
2.50 - 3.00 (4-4.5) BBB 2.25% 1.50%
2.25- 2.50 (3.5-4) BB+ 2.75% 2.00%
2.00 - 2.25 ((3-3.5) BB 3.50% 2.50%
1.75 - 2.00 (2.5-3) B+ 4.75% 3.25%
1.50 - 1.75 (2-2.5) B 6.50% 4.00%
1.25 - 1.50 (1.5-2) B 8.00% 6.00%
0.80 - 1.25 (1.25-1.5) CCC 10.00% 8.00%
0.65 - 0.80 (0.8-1.25) CC 11.50% 10.00%
0.20 - 0.65 (0.5-0.8) C 12.70% 12.00%
< 0.20 (
-
8/12/2019 Valuations - Damodaran
92/308
92
Cost of Debt computations
Companies in countries with low bond ratings and high default riskmight bear the burden of country default risk, especially if they aresmaller or have all of their revenues within the country.
Larger companies that derive a significant portion of their revenuesin global markets may be less exposed to country default risk. Inother words, they may be able to borrow at a rate lower than the
government. The synthetic rating for Embraer is A-. Using the 2004 default
spread of 1.00%, we estimate a cost of debt of 9.29% (using ariskfree rate of 4.29% and adding in two thirds of the countrydefault spread of 6.01%):
Cost of debt= Riskfree rate + 2/3(Brazil country default spread) + Company defaultspread =4.29% + 4.00%+ 1.00% = 9.29%
Aswath Damodaran
92
Synthetic Ratings: Some Caveats
-
8/12/2019 Valuations - Damodaran
93/308
93
Synthetic Ratings: Some Caveats
The relationship between interest coverage ratios andratings, developed using US companies, tends to travelwell, as long as we are analyzing large manufacturingfirms 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 theUS. One way to adjust for this difference is modify theinterest coverage ratio table to reflect interest rate
differences (For instances, if interest rates in anemerging market are twice as high as rates in the US,halve the interest coverage ratio.
Aswath Damodaran
93
Default Spreads: The effect of the crisis of
-
8/12/2019 Valuations - Damodaran
94/308
94
2008.. And the aftermath
Default spread over treasury
Rating 1-Jan-08 12-Sep-08 12-Nov-08 1-Jan-09 1-Jan-10 1-Jan-11
Aaa/AAA 0.99% 1.40% 2.15% 2.00% 0.50% 0.55%
Aa1/AA+ 1.15% 1.45% 2.30% 2.25% 0.55% 0.60%
Aa2/AA 1.25% 1.50% 2.55% 2.50% 0.65% 0.65%
Aa3/AA- 1.30% 1.65% 2.80% 2.75% 0.70% 0.75%
A1/A+ 1.35% 1.85% 3.25% 3.25% 0.85% 0.85%
A2/A 1.42% 1.95% 3.50% 3.50% 0.90% 0.90%A3/A- 1.48% 2.15% 3.75% 3.75% 1.05% 1.00%
Baa1/BBB+ 1.73% 2.65% 4.50% 5.25% 1.65% 1.40%
Baa2/BBB 2.02% 2.90% 5.00% 5.75% 1.80% 1.60%
Baa3/BBB- 2.60% 3.20% 5.75% 7.25% 2.25% 2.05%
Ba1/BB+ 3.20% 4.45% 7.00% 9.50% 3.50% 2.90%
Ba2/BB 3.65% 5.15% 8.00% 10.50% 3.85% 3.25%
Ba3/BB- 4.00% 5.30% 9.00% 11.00% 4.00% 3.50%
B1/B+ 4.55% 5.85% 9.50% 11.50% 4.25% 3.75%
B2/B 5.65% 6.10% 10.50% 12.50% 5.25% 5.00%
B3/B- 6.45% 9.40% 13.50% 15.50% 5.50% 6.00%
Caa/CCC+ 7.15% 9.80% 14.00% 16.50% 7.75% 7.75%
ERP 4.37% 4.52% 6.30% 6.43% 4.36% 5.20%
94
Updated Default Spreads - January 2013
-
8/12/2019 Valuations - Damodaran
95/308
95
Updated Default Spreads January 2013
Aswath Damodaran
95
Rating 1 year 5 year 10 year 30 yearAaa/AAA 0.04% 0.16% 0.41% 0.65%
Aa1/AA+ 0.07% 0.35% 0.57% 0.84%
Aa2/AA 0.09% 0.53% 0.73% 1.03%
Aa3/AA- 0.12% 0.58% 0.78% 1.09%
A1/A+ 0.15% 0.62% 0.82% 1.15%
A2/A 0.36% 0.77% 0.95% 1.23%
A3/A- 0.41% 1.04% 1.31% 1.74%
Baa1/BBB+ 0.63% 1.28% 1.55% 1.99%
Baa2/BBB 0.81% 1.53% 1.84% 2.33%
Baa3/BBB- 1.29% 1.98% 2.28% 2.74%
Ba1/BB+ 2.07% 2.78% 3.12% 3.56%
Ba2/BB 2.85% 3.58% 3.97% 4.39%
Ba3/BB- 3.63% 4.38% 4.81% 5.21%
B1/B+ 4.41% 5.18% 5.65% 6.03%
B2/B 5.19% 5.98% 6.49% 6.85%
B3/B- 5.97% 6.78% 7.34% 7.68%
Caa/CCC+ 6.75% 7.57% 8.18% 8.50%
Subsidized Debt: What should we do?
-
8/12/2019 Valuations - Damodaran
96/308
96
Subsidized Debt: What should we do?
Assume that the Brazilian government lends money toEmbraer 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 subisidized 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
96
Weights for the Cost of Capital Computation
-
8/12/2019 Valuations - Damodaran
97/308
97
Weights for the Cost of Capital Computation
In computing the cost of capital for a publicly tradedfirm, 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
Aswath Damodaran
97
Estimating Cost of Capital: Embraer in 2004
-
8/12/2019 Valuations - Damodaran
98/308
98
Estimating Cost of Capital: Embraer in 2004
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
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; Interestexpense is 222 mil BR; Average maturity of debt = 4 years
Estimated market value of debt = 222 million (PV of annuity, 4 years,9.29%) + $1,953 million/1.09294= 2,083 million BR
Aswath Damodaran
98
If you had to do it.Converting a Dollar Cost of
l l l f l
-
8/12/2019 Valuations - Damodaran
99/308
99
Capital to a Nominal Real Cost of Capital
Approach 1: Use a BR riskfree rate in all of the calculationsabove. For instance, if the BR riskfree rate was 12%, the costof capital would be computed as follows: Cost of Equity = 12% + 1.07(4%) + 27 (7. %) = 18.41%
Cost of Debt = 12% + 1% = 13%
(This assumes the riskfree rate has no country risk premiumembedded in it.)
Approach 2: Use the differential inflation rate to estimate thecost of capital. For instance, if the inflation rate in BR is 8%and the inflation rate in the U.S. is 2%
Cost of capital=
= 1.0997 (1.08/1.02)-1 = 0.1644 or 16.44%
(1+Cost of Capital$) 1+ InflationBR
1+ Inflation$
Aswath Damodaran
99
Dealing with Hybrids and Preferred Stock
-
8/12/2019 Valuations - Damodaran
100/308
100
Dealing with Hybrids and Preferred Stock
When dealing with hybrids (convertible bonds, forinstance), break the security down into debt and equityand allocate the amounts accordingly. Thus, if a firm has$ 125 million in convertible debt outstanding, break the$125 million into straight debt and conversion optioncomponents. The conversion option is equity.
When dealing with preferred stock, it is better to keep itas a separate component. The cost of preferred stock isthe preferred dividend yield. (As a rule of thumb, if the
preferred stock is less than 5% of the outstanding marketvalue of the firm, lumping it in with debt will make nosignificant impact on your valuation).
Aswath Damodaran
100
Decomposing a convertible bond
-
8/12/2019 Valuations - Damodaran
101/308
101
Decomposing a convertible bond
Assume that the firm that you are analyzing has $125million 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%, youcan 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
Aswath Damodaran
101
Recapping the Cost of Capital
-
8/12/2019 Valuations - Damodaran
102/308
102
Recapping the Cost of Capital
Aswath Damodaran
102
Aswath Damodaran 103
-
8/12/2019 Valuations - Damodaran
103/308
II. ESTIMATING CASH FLOWS
Cash is king
Steps in Cash Flow Estimation
-
8/12/2019 Valuations - Damodaran
104/308
104
Steps in Cash Flow Estimation
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 aftertaxes
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, itwill 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 fromnet debt issues (debt issued - debt repaid)
Aswath Damodaran
104
Measuring Cash Flows
-
8/12/2019 Valuations - Damodaran
105/308
105
g
Cash flows can be measured to
All claimholders in the firm
EBIT (1- tax rate)- ( Capital Expenditures - Depreciation)- Change in non-cash working capital= Free Cash Flow to Firm (FCFF)
Just Equity Investors
Net Income- (Capital Expenditures - Depreciation)- Change in non-cash Working Capital- (Principal Repaid - New Debt Issues)- Preferred Dividend
Dividends+ Stock Buybacks
Aswath Damodaran
105
Measuring Cash Flow to the Firm
-
8/12/2019 Valuations - Damodaran
106/308
106
g
EBIT ( 1 - tax rate)
- (Capital Expenditures - Depreciation)
- Change in Working Capital
= Cash flow to the firm Where are the tax savings from interest payments in
this cash flow?
Aswath Damodaran
106
From Reported to Actual Earnings
-
8/12/2019 Valuations - Damodaran
107/308
107
p g
Aswath Damodaran
107
I. Update Earnings
-
8/12/2019 Valuations - Damodaran
108/308
108
p g
When valuing companies, we often depend upon financialstatements for inputs on earnings and assets. Annual reports areoften 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 volatilefirms, as well as for firms that have undergone significantrestructuring.
Time saver: To get a trailing 12-month number, all you need is one10K and one 10Q (example third quarter). Use the Year to datenumbers from the 10Q:
Trailing 12-month Revenue = Revenues (in last 10K) - Revenues from first 3quarters of last year + Revenues from first 3 quarters of this year.
Aswath Damodaran
108
II. Correcting Accounting Earnings
-
8/12/2019 Valuations - Damodaran
109/308
109
g g g
Make sure that there are no financial expenses mixed in withoperating 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 toloss of control of the business.
Example: Operating Leases: While accounting convention treats operating
leases as operating expenses, they are really financial expenses and needto be reclassified as such. This has no effect on equity earnings but doeschange the operating earnings
Make sure that there are no capital expenses mixed in with theoperating expenses Capital expense: Any expense that is expected to generate benefits over
multiple periods. R & D Adjustment: Since R&D is a capital expenditure (rather than an
operating expense), the operating income has to be adjusted to reflect itstreatment.
Aswath Damodaran
109
The Magnitude of Operating Leases
-
8/12/2019 Valuations - Damodaran
110/308
110
g p g
Aswath Damodaran
110
Dealing with Operating Lease Expenses
-
8/12/2019 Valuations - Damodaran
111/308
111
g p g p
Operating Lease Expenses are treated as operating expensesin computing operating income. In reality, operating leaseexpenses should be treated as financing expenses, with thefollowing adjustments to earnings and capital:
Debt Value of Operating Leases = Present value of Operating
Lease Commitments at the pre-tax cost of debt When you convert operating leases into debt, you also create
an asset to counter it of exactly the same value.
Adjusted Operating Earnings Adjusted Operating Earnings = Operating Earnings + Operating Lease
Expenses - Depreciation on Leased AssetAs an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost ofDebt * PV of Operating Leases.
Aswath Damodaran
111
-
8/12/2019 Valuations - Damodaran
112/308
The Collateral Effects of Treating Operating
Leases as Debt
-
8/12/2019 Valuations - Damodaran
113/308
113
Leases as Debt
C o n v en t i o na l Ac c o u n ti n g O p e r at i n g L e a s es Tr e a t ed a s D e b t
Income Statement
E B IT & L e as e s = 1 , 9 90
- Op L ea ses = 9 78
E BI T = 1 ,0 12
I n c o m e S t a t e me n t
E BI T& L ea se s = 1 ,9 9 0
- D e pr ec n : O L = 6 2 8
EBIT = 1,362
I n te r es t e x p en s e w i ll r i s e t o r e fl e ct t h e
c o n ve r s i on o f o p e ra t i n g l ea s e s a s d e b t . Ne t
i n c o me s h o u l d n o t c h an g e .
B a l an c e S h ee t O ff b al an ce s he et ( No t s ho wn a s d eb t o r a s a n
a s s e t ). On l y t h e c o n v en t i o na l d e b t o f $1, 970
m i l l i on s h o w s u p o n b a l a n c e s h ee t
Balance SheetAsset Liability
O L A s se t 4 3 9 7 O L D eb t 4 3 97
T o ta l d eb t = 4 3 9 7 + 1 9 70 = $ 6 ,3 6 7 mi l l io n
C o st o f c a pi t al = 8 . 20 % (7 3 5 0/ 9 32 0 ) + 4 %
( 1970/9320) = 7. 31%
C o s t o f eq u i t y f o r Th e G ap = 8. 20%A f t e r- t a x c o s t o f d eb t = 4%
M a r k et va l u e o f e q u i ty = 7350
C o st o f c a pi t al = 8 . 20 % (7 3 50 / 13 7 1 7) + 4 %
( 6 36 7 /1 3 7 17 ) = 6 . 25 %
Return on capital = 1012 (1-.35)/(3130+1970)
= 1 2. 90 %
R e t ur n o n c a p i t al = 1362 ( 1- . 35) / ( 3130+ 6367)
= 9 .3 0%
Aswath Damodaran
113
The Magnitude of R&D Expenses
-
8/12/2019 Valuations - Damodaran
114/308
114
Aswath Damodaran
114
R&D Expenses: Operating or Capital Expenses
-
8/12/2019 Valuations - Damodaran
115/308
115
Accounting standards require us to consider R&D as anoperating 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 byadding up 1/5th of the R&D expense from five years ago, 2/5th
of the R&D expense from four years ago...:
Aswath Damodaran
115
-
8/12/2019 Valuations - Damodaran
116/308
The Effect of Capitalizing R&D at SAP
-
8/12/2019 Valuations - Damodaran
117/308
117
Convent ional Account ing R&D treated as capital expenditureIncome Statement
E BI T& R &D = 3 04 5- R & D = 1 0 20
E B IT = 2 0 25
EBIT (1-t) = 1285 m
Income Statement
E B I T & R & D = 3 0 4 5- A mo rt : R &D = 9 03
E BI T = 2 14 2 ( In cr ea se o f 1 17 m )
E BI T ( 1- t) = 1 35 9 m
I gn or ed t ax b en ef it = ( 10 20 -9 03 )( . 36 54 ) = 4 3A d ju s te d E BI T ( 1 -t ) = 1 3 59 + 43 = 1 4 02 m
( I n c r e as e o f 1 1 7 m i l li o n )N e t I n c om e w i ll a l so i n cr e as e b y 1 1 7 m i ll i on
Balance Sheet
O f f b a la n ce s h ee t a s se t . B o ok v a lu e o f e q ui ty at
3 , 7 6 8 m i l li o n E u ro s i s u n d e r st a t e d b e c a u seb i g g es t a ss e t i s of f t h e b o o ks .
B a l an c e S h e et
A s s e t L i a b il i t y
R & D A s se t 2 9 14 B o ok E q ui t y + 29 1 4T o t a l B o o k E q u i ty = 3 76 8 + 2 91 4 = 6 7 8 2 m i l
Capital ExpendituresC o n ve n t i on a l n e t c a p e x of 2 m i l li o n
Euros
Capital ExpendituresN et Ca p e x = 2+ 1 020 90 3 = 1 19 mil
C a sh F lo w s
E B IT ( 1 -t ) = 1 2 85
- N et Ca p Ex = 2
FCFF = 1283
Cash Flows
E BI T ( 1- t) = 14 02
- N et C ap E x = 1 19
F CF F = 1 28 3 m
Return on ca pital = 1285/(3768+530) Return on capital = 1402/( 6782+530)
Aswath Damodaran
117
III. One-Time and Non-recurring Charges
-
8/12/2019 Valuations - Damodaran
118/308
118
Assume that you are valuing a firm that is reporting aloss of $ 500 million, due to a one-time charge of $ 1billion. What is the earnings you would use in yourvaluation?
a. A loss of $ 500 million
b. A profit of $ 500 million
Would your answer be any different if the firm hadreported one-time losses like these once every fiveyears?
a. Yes
b. No
Aswath Damodaran
118
IV. Accounting Malfeasance.
-
8/12/2019 Valuations - Damodaran
119/308
119
Though all firms may be governed by the same accountingstandards, the fidelity that they show to these standards can vary.More aggressive firms will show higher earnings than moreconservative firms.
While you will not be able to catch outright fraud, you should lookfor 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&Dexpenses 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
Aswath Damodaran
119
V. Dealing with Negative or Abnormally Low
Earnings
-
8/12/2019 Valuations - Damodaran
120/308
120
Earnings
Aswath Damodaran
120
What tax rate?
-
8/12/2019 Valuations - Damodaran
121/308
121
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 (taxespaid/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 companyoperates
d. The weighted average marginal tax rate across the countries inwhich the company operates
e. None of the abovef. Any of the above, as long as you compute your after-tax cost of
debt using the same tax rate
Aswath Damodaran
121
The Right Tax Rate to Use
-
8/12/2019 Valuations - Damodaran
122/308
122
The choice really is between the effective and the marginaltax rate. In doing projections, it is far safer to use themarginal tax rate since the effective tax rate is really areflection of the difference between the accounting and thetax books.
By using the marginal tax rate, we tend to understate theafter-tax operating income in the earlier years, but the after-tax tax operating income is more accurate in later years
If you choose to use the effective tax rate, adjust the tax rate
towards the marginal tax rate over time. While an argument can be made for using a weighted average
marginal tax rate, it is safest to use the marginal tax rate of the country
Aswath Damodaran
122
A Tax Rate for a Money Losing Firm
-
8/12/2019 Valuations - Damodaran
123/308
123
Assume that you are trying to estimate the after-taxoperating income for a firm with $ 1 billion in netoperating losses carried forward. This firm is expected tohave operating income of $ 500 million each year for thenext 3 years, and the marginal tax rate on income for all
firms that make money is 40%. Estimate the after-taxoperating income each year for the next 3 years.
Year 1 Year 2 Year 3
EBIT 500 500 500
TaxesEBIT (1-t)
Tax rate
Aswath Damodaran
123
Net Capital Expenditures
-
8/12/2019 Valuations - Damodaran
124/308
124
Net capital expenditures represent the differencebetween capital expenditures and depreciation.Depreciation is a cash inflow that pays for some or alot (or sometimes all of) the capital expenditures.
In general, the net capital expenditures will be afunction of how fast a firm is growing or expecting togrow. High growth firms will have much higher netcapital expenditures than low growth firms.
Assumptions about net capital expenditures cantherefore never be made independently ofassumptions about growth in the future.
Aswath Damodaran
124
Capital expenditures should include
-
8/12/2019 Valuations - Damodaran
125/308
125
Research and development expenses, once they have beenre-categorized as capital expenses. The adjusted net cap exwill be Adjusted Net Capital Expenditures = Net Capital Expenditures +
Current years R&D expenses - Amortization of Research Asset
Acquisitions of other firms, since these are like capitalexpenditures. 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 beused
2. The best place to find acquisitions is in the statement of cash flows,usually categorized under other investment activities
Aswath Damodaran
125
Ciscos Acquisitions: 1999
-
8/12/2019 Valuations - Damodaran
126/308
126
Acquired Method of Acquisition Price PaidGeoTel 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
$2,516
Aswath Damodaran
126
Ciscos Net Capital Expenditures in 1999
-
8/12/2019 Valuations - Damodaran
127/308
127
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
(Amortization was included in the depreciation number)
Aswath Damodaran
127
Working Capital Investments
-
8/12/2019 Valuations - Damodaran
128/308
128
In accounting terms, the working capital is the differencebetween current assets (inventory, cash and accountsreceivable) and current liabilities (accounts payables, shortterm debt and debt due within the next year)
A cleaner definition of working capital from a cash flow
perspective is the difference between non-cash currentassets (inventory and accounts receivable) and non-debtcurrent liabilities (accounts payable)
Any investment in this measure of working capital ties upcash. Therefore, any increases (decreases) in working capitalwill reduce (increase) cash flows in that period.
When forecasting future growth, it is important to forecastthe effects of such growth on working capital needs, andbuilding these effects into the cash flows.
Aswath Damodaran
128
Working Capital: General Propositions
-
8/12/2019 Valuations - Damodaran
129/308
129
Changes in non-cash working capital from year toyear tend to be volatile. A far better estimate of non-cash working capital needs, looking forward, can beestimated by looking at non-cash working capital as
a proportion of revenues Some firms have negative non-cash working capital.
Assuming that this will continue into the future willgenerate positive cash flows for the firm. While this
is indeed feasible for a period of time, it is notforever. Thus, it is better that non-cash workingcapital needs be set to zero, when it is negative.
Aswath Damodaran
129
Volatile Working Capital?
-
8/12/2019 Valuations - Damodaran
130/308
130
Amazon Cisco MotorolaRevenues $ 1,640 $12,154 $30,931
Non-cash WC -$419 -$404 $2547
% of Revenues -25.53% -3.32% 8.23%
Change from last year $ (309) ($700) ($829)
Average: last 3 years -15.16% -3.16% 8.91%Average: industry 8.71% -2.71% 7.04%
WC as % of Revenue 3.00% 0.00% 8.23%
Aswath Damodaran
130
Dividends and Cash Flows to Equity
-
8/12/2019 Valuations - Damodaran
131/308
131
In the strictest sense, the only cash flow that an investorwill receive from an equity investment in a publiclytraded firm is the dividend that will be paid on the stock.
Actual dividends, however, are set by the managers ofthe 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 futurecontingencies and investment opportunities
When actual dividends are less than potential dividends,
using a model that focuses only on dividends will understate the true value of the equity in a firm.
Aswath Damodaran
131
Measuring Potential Dividends
-
8/12/2019 Valuations - Damodaran
132/308
132
Some analysts assume that the earnings of a firm represent itspotential 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 asdividends would not be investing in new assets and thus could not grow
Valuation models, where earnings are discounted back to the present, willover estimate the value of the equity in the firm
The potential dividends of a firm are the cash flows left over afterthe firm has made any investmentsit needs to make to createfuture growth and net debt repayments (debt repayments - newdebt issues) The common categorization of capital expenditures into discretionary and
non-discretionary loses its basis when there is future growth built into thevaluation.
Aswath Damodaran
132
Estimating Cash Flows: FCFE
-
8/12/2019 Valuations - Damodaran
133/308
133
Cash flows to Equity for a Levered FirmNet Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)
= Free Cash flow to Equity
I have ignored preferred dividends. If preferred stock
exist, preferred dividends will also need to be nettedout
Aswath Damodaran
133
Estimating FCFE when Leverage is Stable
-
8/12/2019 Valuations - Damodaran
134/308
134
Net Income- (1- ) (Capital Expenditures - Deprec