Valuation Models

Aswath Damodaran

Aswath Damodaran

Misconceptions about Valuation

Myth 1: A valuation is an objective search for true value
Truth 1.1: All valuations are biased. The only questions are how much and in which direction. Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid.

Myth 2.: A good valuation provides a precise estimate of value

Truth 2.1: There are no precise valuations Truth 2.2: The payoff to valuation is greatest when valuation is least precise.

Myth 3: . The more quantitative a model, the better the valuation

Truth 3.1: Ones understanding of a valuation model is inversely proportional to the number of inputs required for the model. Truth 3.2: Simpler valuation models do much better than complex ones.

Aswath Damodaran

Approaches to Valuation
Valuation Models

Asset Based Valuation

Discounted Cashf low Models

Relative Valuation

Contingent Claim Models

Liquidation Value
Stable Current

Equity
Firm

Sec tor

Option to delay

Option to expand Young firms

Option to liquidate Equity in troubled firm

Market

Replac ement Cost

Tw o-s tage
Three-stage or n-stage

Normalized

Earnings Book Revenues Value

Sec tor specific

Undeveloped land

Equity Valuation Models

Dividends

Firm Valuation Models

Patent Undeveloped Res erves

Free Cashflow to Firm

Cost of capital approach

APV approach

Excess Return Models

Aswath Damodaran

Basis for all valuation approaches

The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon
a perception that markets are inefficient and make mistakes in assessing value an assumption about how and when these inefficiencies will get corrected

In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value.

Aswath Damodaran

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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Aswath Damodaran

Discounted Cashflow Valuation: Basis for Approach

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

where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.

Aswath Damodaran

Generic DCF Valuation Model

DISCOUNTED CASHFLOW VALUATION

Cash flows Firm: Pre-debt cash flow Equity: After debt cash flows

Expe cte d Growth Firm: Growth in Operating Earnings Equity: Growth in Net Income/EPS

Firm is in stable growth: Grows at con stant rate forever

Terminal Value

Value Firm: Value of Firm Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn ......... Fore ver

Le ngth of Pe riod of High Growth

Disc ount Rate Firm:Cost of Capital Equity: Cost of Equity

Aswath Damodaran

VALUING ABN AMRO

Divide nds EPS = 1.54 Eur * Payout Ratio 58.44% DPS = 0.90 Eur Retention Ratio = 41.56% Expe cte d Growth 41.56% * 16% = 6.65%

ROE = 16%

g =4%: ROE = 8.95%(=Cos t of equity) Beta = 1.00 Payout = (1- 4/8.95) = .553

Terminal Value= EPS *Payout/(r-g) 6 = (2.21*.553)/(.0895-.04) = 24.69 Value of Equity per share = 20.48 Eur EPS 1.64 Eur DPS 0.96 Eur 1.75 Eur 1.02 Eur 1.87 Eur 1.09 Eur 1.99 Eur 1.16 Eur 2.12 Eur 1.24 Eur ......... Forever
Discount at Cost of Equity

Cost of Equity 4.95% + 0.95 (4%) = 8.75%

Ris k fre e Rate : Long term bond rate in Euros 4.95%

Beta 0.95

Ris k Premium 4%

Average beta for European banks = 0.95

Mature Market 4%

Country Risk 0%

Aswath Damodaran

Aswath Damodaran

CONSTANT GROWTH MODEL

In this model the basic assumption is that dividends will grow at the same rate into an indefinite future. P0 = D(1+g)2 + D(1+g)2 + D(1+g)3 +..+D(1+g)N 1+r (1+r)2 (1+r )3 (1+r)n When the period approaches to infinity eq takes form: P0 = D 1 r-g

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Assumptions :
The firms dividend policy must be stable. The firm will earn a stable return over there. The analyst should predict 3 basic variables: Next years dividend. Firms long term growth rate. Required rate of return of the investor.

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CONDITIONS FOR PURCHASE/SALE OF STOCK

If Theoretical value > Actual price = buy Theoretical value < Actual price = sell

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EXAMPLE

ABC Companys: Expected dividend per share = Rs 3.50 Growth rate of dividend=10% Required rate of return= 15% Market price = Rs 75 P0 = ?

D1 rg D1 = 3.50 r = 0.15 g = 0.10 = 3.50 .05 = Rs 70 Thr< M.P, investor is advised not to buy.

P0

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TWO STAGE GROWTH MODEL

The growth stages are divided into two: Period of extraordinary growth. constant growth period of infinite nature. The extra ordinary growth period will continue for some period followed by the constant growth rate. Example: Information technology

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Present value of the stock or price= present value of the dividend during the above normal growth period present value of stock price at the end of the above normal growth period

P0 =

N D (1+g )
0 s

+ DN+1

DO gs gn rs N

= = = = =

(1+rs)t (rs - gn) (1+rs)N Dividend of the previous period Above normal growth rate Normal growth rate Required rate of return Period of above normal-growth

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THE THREE-PHASE MODEL

Dividends are assumed to grow at a constant rate ga for a period of A years. After the phase A the growth rate of the dividend declines for A+1 yrs through out the phase B & the decline in the dividend rate would be linear. Afterwards there would be perpetual growth rate gn. Some times the ga would be less than gn & in the second phase there would be linear growth rate.

P0=

A D

t 0 (1+ga) +

B D

t-1(1+gb)

+ DB(1+gn)

D0 gs gn rs N

(1+r)t (1+r)t r-gn(1+r)B = Dividend of the previous period. = Above normal growth rate. = Normal growth rate = Required rate of return = Period of above normal growth

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Choosing the right Discounted Cashflow Model

Can you estimate cash flows? Yes No Are the curre nt earnings positive & normal? Yes Use current earning s as base Yes Stable levera ge Unstable levera ge No Is the cause tempo rary? What rate is th e firm growing at curren tly? < Growth ra te of eco nomy Stable growth model No Yes > Growth ra te of econo my Are the firms competitive advan tges time limited?

Is leverage sta ble or likely to cha nge over time?

Use divid end discount mode l

FCFE

FCFF

Replace current Is the firm earning s with likely to normalized survive? earning s

No 3-stage or n-stage model

2-stage model No

Yes Adjust margins over time to nurse firm to finan cia l health Yes

Does the firm have a lot o f debt?

No Estimate liquidation value

Value Eq uity as an option to liq uida te

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An Example: Price Earnings Ratio: Definition

PE = Market Price per Share / Earnings per Share

There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined. Price: is usually the current price is sometimes the average price for the year EPS: earnings per share in most recent financial year earnings per share in trailing 12 months (Trailing PE) forecasted earnings per share next year (Forward PE) forecasted earnings per share in future year

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Which approach should you use? Depends upon the asset being valued..
Asset Marketab ility and Valua tion App roache s
Mature businesses Separable & marketable assets Growth bu sin esses Linked and non-marketable assets

Liquidation & Replacement cost valuation

Other valua tion models

Cash Flows and Valuation Approa ches

Cashflo ws cu rren tly o r expe cted in nea r future Cashflo ws if a contingen cy occu rs Assets that will never generate cashflows

Discounted cashflow or re lative valuation models

Option pricing models

Relative valuation mo dels

Uniqueness of Asset and Va luation Approaches Large number of simila r asse ts tha t are priced

Unique asset or business

Discounted cashflow or optio n pricing models

Relative valuation mo dels

Aswath Damodaran

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And the analyst doing the valuation.

Investor Time Horizo n and Valuation Approaches

Very sho rt time horizon

Long Time Horizon

Liquidation value

Relative valuation Option pricing models

Discounted Cashflow value

Views on marke t and Valuatio n Approaches

Marke ts are correct o n average but make mistakes on ind ividual a ssets Asset markets and finan cial marke ts may diverge Marke ts make mistakes but correct them o ver time

Relative valuation

Liquidation value

Discounted Cashflow value

Option pricing models

Aswath Damodaran

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