Discounted Cashow Valuation: Equity and Firm Models

Aswath Damodaran

Aswath Damodaran

Summarizing the Inputs

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

the current cash ows on the investment, either to equity investors (dividends or free cash ows to equity) or to the rm (cash ow to the rm) the current cost of equity and/or capital on the investment the expected growth rate in earnings, based upon historical growth, analysts forecasts and/or fundamentals which cash ow to discount, which should indicate which discount rate needs to be estimated and what pattern we will assume growth to follow

The next step in the process is deciding

Aswath Damodaran

Which cash ow should I discount?

Use Equity Valuation

(a) for rms which have stable leverage, whether high or not, and (b) if equity (stock) is being valued

Use Firm Valuation

(a) for rms which have leverage which is too high or too low, and expect to change the leverage over time, because debt payments and issues do not have to be factored in the cash ows and the discount rate (cost of capital) does not change dramatically over time. (b) for rms for which you have partial information on leverage (eg: interest expenses are missing..) (c) in all other cases, where you are more interested in valuing the rm than the equity. (Value Consulting?)

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Given cash ows to equity, should I discount dividends or FCFE?

Use the Dividend Discount Model

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

Use the FCFE Model

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What discount rate should I use?

Cost of Equity versus Cost of Capital

If discounting cash ows to equity -> Cost of Equity If discounting cash ows to the rm -> Cost of Capital Match the currency in which you estimate the risk free rate to the currency of your cash ows If discounting real cash ows -> real cost of capital If nominal cash ows -> nominal cost of capital If ination is low (<10%), stick with nominal cash ows since taxes are based upon nominal income If ination is high (>10%) switch to real cash ows

What currency should the discount rate (risk free rate) be in?

Should I use real or nominal cash ows?

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Which Growth Pattern Should I use?

If your rm is
large and growing at a rate close to or less than growth rate of the economy, or constrained by regulation from growing at rate faster than the economy has the characteristics of a stable rm (average risk & reinvestment rates) Use a Stable Growth Model is large & growing at a moderate rate ( Overall growth rate + 10%) or has a single product & barriers to entry with a nite life (e.g. patents)

If your rm

Use a 2-Stage Growth Model

If your rm
is small and growing at a very high rate (> Overall growth rate + 10%) or has signicant barriers to entry into the business has rm characteristics that are very different from the norm

Use a 3-Stage or n-stage Model

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The Building Blocks of Valuation

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Classifying DCF Models

Figure 35.8: Discounted Cashflow Models
Can you estimate cash flows? Yes No Are the current earnings positive & normal? Yes Use current earnings as base Yes Stable leverage Unstable leverage Replace current earnings with normalized earnings No Is the cause temporary? No Is the firm likely to survive? Yes What rate is the firm growing at currently? < Growth rate of economy Stable growth model > Growth rate of economy Are the firms competitive advantges time limited?

Is leverage stable or likely to change over time?

Use dividend discount model

No 3-stage or n-stage model

FCFE

FCFF

2-stage model No Does the firm have a lot of debt?

Yes Adjust margins over time to nurse firm to financial health Yes

No Estimate liquidation value

Value Equity as an option to liquidate

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Companies Valued
Company Con Ed ABN Amro S&P 500 Nestle Tsingtao Model Used Stable DDM 2-Stage DDM 2-Stage DDM 2-Stage FCFE 3-Stage FCFE Remarks Dividends=FCFE, Stable D/E, Low g FCFE=?, Regulated D/E, g>Stable Collectively, market is an investment DividendsFCFE, Stable D/E, High g DividendsFCFE, Stable D/E,High g Normalized Earnings; Stable Sector The value of growth? Emerging Market company (not) Dealing with Distress Varying margins over time

DaimlerChrysler Stable FCFF Tube Investments 2-stage FCFF Embraer Global Crossing Amazon.com 2-stage FCFF 2-stage FCFF n-stage FCFF

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General Information

The risk premium that I will be using in the latest valuations for mature equity markets is 4%. This is the average implied equity risk premium from 1960 to 2003 as well as the average historical premium across the top 15 equity markets in the twentieth century. For the valuations from 1998 and earlier, I use a risk premium of 5.5%.

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Con Ed: Rationale for Model

The rm is in stable growth; based upon size and the area that it serves. Its rates are also regulated; It is unlikely that the regulators will allow prots to grow at extraordinary rates. Firm Characteristics are consistent with stable, DDM model rm
The beta is 0.80 and has been stable over time. The rm is in stable leverage. The rm pays out dividends that are roughly equal to FCFE.
Average Annual FCFE between 1999 and 2004 = $635 million Average Annual Dividends between 1999 and 2004 = $ 624 million Dividends as % of FCFE = 98%

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Con Ed: A Stable Growth DDM: December 31, 2004

Earnings per share for 2004 = $ 2.72 (Fourth quarter estimate used) Dividend Payout Ratio over 2004 = 83.06% Dividends per share for 2004 = $2.26 Expected Growth Rate in Earnings and Dividends =2% Con Ed Beta = 0.80 (Bottom-up beta estimate) Cost of Equity = 4.22% + 0.80*4% = 7.42% Value of Equity per Share = $2.26*1.02 / (.0742 -.02) = $ 42.53 The stock was trading at $ 43.42 on December 31, 2004

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Con Ed: Break Even Growth Rates

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Estimating Implied Growth Rate

To estimate the implied growth rate in Con Eds current stock price, we set the market price equal to the value, and solve for the growth rate:
Price per share = $ 43.42 = $2.26*(1+g) / (.0742 -g) Implied growth rate = 2.11%

Given its retention ratio of 16.94% and its return on equity in 2003 of 10%, the fundamental growth rate for Con Ed is: Fundamental growth rate = (.1694*.10) = 1.69% You could also frame the question in terms of a break-even return on equity.
Break even Return on equity = g/ Retention ratio = .0211/.1694 = 12.45%

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Implied Growth Rates and Valuation Judgments

When you do any valuation, there are three possibilities. The rst is that you are right and the market is wrong. The second is that the market is right and that you are wrong. The third is that you are both wrong. In an efcient market, which is the most likely scenario?

Assume that you invest in a misvalued rm, and that you are right and the market is wrong. Will you denitely prot from your investment? Yes No

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Con Ed: A Look Back

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ABN Amro: Rationale for 2-Stage DDM in December 2003

As a nancial service institution, estimating FCFE or FCFF is very difcult. The expected growth rate based upon the current return on equity of 16% and a retention ratio of 51% is 8.2%. This is higher than what would be a stable growth rate (roughly 4% in Euros)

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ABN Amro: Summarizing the Inputs

Market Inputs
Long Term Riskfree Rate (in Euros) = 4.35% Risk Premium = 4% (U.S. premium : Netherlands is AAA rated)

Current Earnings Per Share = 1.85 Eur; Current DPS = 0.90 Eur; Variable High Growth Phase Stable Growth Phase Length 5 years Forever after yr 5 Return on Equity 16.00% 8.35% (Set = Cost of equity) Payout Ratio 48.65% 52.10% (1 - 4/8.35) Retention Ratio 51.35% 47.90% (b=g/ROE=4/8.35) Expected growth .16*.5135=..0822 4% (Assumed) Beta 0.95 1.00 Cost of Equity 4.35%+0.95(4%) 4.35%+1.00(4%) =8.15% = 8.35%

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ABN Amro: Valuation

Year 1 2 3 4 5 EPS 2.00 2.17 2.34 2.54 2.75 DPS 0.97 1.05 1.14 1.23 1.34 PV of DPS (at 8.15%) 0.90 0.90 0.90 0.90 0.90

Expected EPS in year 6 = 2.75(1.04) = 2.86 Eur Expected DPS in year 6 = 2.86*0.5210=1.49 Eur Terminal Price (in year 5) = 1.49/(.0835-.04) = 34.20 Eur PV of Terminal Price = 34.20/(1.0815)5 = 23.11Eur Value Per Share = 0.90 + 0.90 + 0.90 + 0.90 + 0.90 + 23.11 = 27.62 Eur The stock was trading at 18.55 Euros on December 31, 2003
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The Value of Growth

In any valuation model, it is possible to extract the portion of the value that can be attributed to growth, and to break this down further into that portion attributable to high growth and the portion attributable to stable growth. In the case of the 2-stage DDM, this can be accomplished as follows:

Value of High Growth DPSt = Expected dividends per share in year t r = Cost of Equity Pn = Price at the end of year n gn = Growth rate forever after year n

Value of Stable Growth

Assets in Place

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ABN Amro: Decomposing Value

Value of Assets in Place = Current DPS/Cost of Equity = 0.90 Euros/.0835 = 10.78 Euros

Value of Stable Growth = 0.90 (1.04)/(.0835-.04) - 10.78 Euros

= 10.74 Euros (A more precise estimate would have required us to use the stable growth payout ratio to re-estimate dividends) Value of High Growth = Total Value - (10.78+10.74) = 27.62 - (10.78+ 10.74) = 6.10 Euros

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S & P 500: Rationale for Use of Model

While markets overall generally do not grow faster than the economies in which they operate, there is reason to believe that the earnings at U.S. companies (which have outpaced nominal GNP growth over the last 5 years) will continue to do so in the next 5 years. The consensus estimate of growth in earnings (from Zacks) is roughly 8% (with top-down estimates) Though it is possible to estimate FCFE for many of the rms in the S&P 500, it is not feasible for several (nancial service rms). The dividends during the year should provide a reasonable (albeit conservative) estimate of the cash ows to equity investors from buying the index.

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S &P 500: Inputs to the Model (12/31/04)

General Inputs
Long Term Government Bond Rate = 4.22% Risk Premium for U.S. Equities = 4% Current level of the Index = 1211.92

Inputs for the Valuation High Growth Phase 5 years 1.60% 8.5% 1.00 Stable Growth Phase Forever after year 5 1.60% 4.22% (Nominal g) 1.00

Length Dividend Yield Expected Growth Beta

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S & P 500: 2-Stage DDM Valuation

1 $21.06 $19.46 $609.98 2 $22.85 $19.51 3 $24.79 $19.56 4 $26.89 $19.61 5 $29.18 $760.28 $531.86

Expected Dividends = Expected Terminal Value = Present Value = Intrinsic Value of Index =

Cost of Equity = 4.22% + 1(4%) = 8.22% Terminal Value = 29.18*1.0422/(.0822 -.0422) = 760.28

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Explaining the Difference

The index is at 1212, while the model valuation comes in at 610. This indicates that one or more of the following has to be true.
The dividend discount model understates the value because dividends are less than FCFE. The expected growth in earnings over the next 5 years will be much higher than 8%. The risk premium used in the valuation (4%) is too high The market is overvalued.

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A More Realistic Valuation of the Index

We

estimated the free cashows to equity for each rm in the index and averaged the free cashow to equity as a percent of market cap. The average FCFE yield for the index was about 2.90% in 2004.
With

these inputs in the model:

1 $38.14 $35.24 $1,104.80 2 $41.38 $35.33 3 $44.89 $35.42 4 $48.71 $35.51 5 $52.85 $1,377.02 $963.29

Expected Dividends & Buybacks = Expected Terminal Value = Present Value = Intrinsic Value of Index =

At a level of 1112, the market is overvalued by about 10%.

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Nestle: Rationale for Using Model - January 2001

Earnings per share at the rm has grown about 5% a year for the last 5 years, but the fundamentals at the rm suggest growth in EPS of about 11%. (Analysts are also forecasting a growth rate of 12% a year for the next 5 years) Nestle has a debt to capital ratio of about 37.6% and is unlikely to change that leverage materially. (How do I know? I do not. I am just making an assumption.) Like many large European rms, Nestle has paid less in dividends than it has available in FCFE.

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Nestle: Summarizing the Inputs

General Inputs
Long Term Government Bond Rate (Sfr) = 4% Current EPS = 108.88 Sfr; Current Revenue/share =1,820 Sfr Capital Expenditures/Share=114.2 Sfr; Depreciation/Share=73.8 Sfr High Growth 5 years 0.85 23.63% 65.10% (Current) 23.63%*.651= 15.38% 9.30% (Existing) 37.60% Current Ratio Stable Growth Forever after yr 5 0.85 16% NA 4.00% 9.30% (Grow with earnings) 37.60% 150%

Length Beta Return on Equity Retention Ratio Expected Growth WC/Revenues Debt Ratio Cap Ex/Deprecn

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Estimating the Risk Premium for Nestle

Revenues 17.5 4.00% 4.3 12.00% 1.1 4.00% 18.4 4.00% 6.4 5.50% 5.8 9.00% 13 4.00% Weight 24.82% 6.10% 1.56% 26.10% 9.08% 8.23% 18.44%
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Risk Premium

North America South America Switzerland Germany/France/UK Italy/Spain Asia

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Rest of W. Europe

Nestle: Valuation
1 $125.63 $29.07 $16.25 $80.31 $74.04 2 $144.95 $33.54 $18.75 $92.67 $78.76 3 $167.25 $38.70 $21.63 $106.92 $83.78 4 $192.98 $44.65 $24.96 $123.37 $89.12 5 $222.66 $51.52 $28.79 $142.35 $94.7

Earnings - (Net CpEX)*(1-DR) - WC*(1-DR) Free Cashow to Equity Present Value

Earnings per Share in year 6 = 222.66(1.04) = 231.57 Net Capital Ex 6 = Deprecnn6 * 0.50 =73.8(1.1538)5(1.04)(.5)= 78.5 Sfr Chg in WC6 =( Rev6 - Rev5)(.093) = 1820(1.1538)5(.04)(.093)=13.85 Sfr FCFE6 = 231.57 - 78.5(1-.376) - 13.85(1-.376)= 173.93 Sfr Terminal Value per Share = 173.93/(.0847-.04) = 3890.16 Sfr Value=$74.04 +$78.76 +$83.78 +$89.12 +$94.7 +3890/(1.0847)5=3011Sf

The stock was trading 2906 Sfr on December 31, 1999

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Nestle: The Net Cap Ex Assumption

In our valuation of Nestle, we assumed that cap ex would be 150% of depreciation in steady state. If, instead, we had assumed that net cap ex was zero, as many analysts do, the terminal value would have been:

FCFE6 = 231.57 - 13.85(1-.376) = 222.93 Sfr Terminal Value per Share = 222.93/(.0847 -.04) = 4986 Sfr Value= $74.04 +$78.76 +$83.78 +$89.12 +$94.7 + 4986/(1.0847)5= 3740.91 Sfr

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The Effects of New Information on Value

No valuation is timeless. Each of the inputs to the model are susceptible to change as new information comes out about the rm, its competitors and the overall economy.
Market Wide Information
Interest Rates Risk Premiums Economic Growth

Industry Wide Information

Changes in laws and regulations Changes in technology

Firm Specic Information

New Earnings Reports Changes in the Fundamentals (Risk and Return characteristics)

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Nestle: Effects of an Earnings Announcement

Assume that Nestle makes an earnings announcement which includes two pieces of news:
The earnings per share come in lower than expected. The base year earnings per share will be 105.5 Sfr instead of 108.8 Sfr. Increased competition in its markets is putting downward pressure on the net prot margin. The after-tax margin, which was 5.98% in the previous analysis, is expected to shrink to 5.79%. The drop in earnings will make the projected earnings and cash ows lower, even if the growth rate remains the same The drop in net margin will make the return on equity lower (assuming turnover ratios remain unchanged). This will reduce expected growth.

There are two effects on value:

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Tsingtao Breweries: Rationale for Using Model: June 2001

Why three stage? Tsingtao is a small rm serving a huge and growing market China, in particular, and the rest of Asia, in general. The rms current return on equity is low, and we anticipate that it will improve over the next 5 years. As it increases, earnings growth will be pushed up. Why FCFE? Corporate governance in China tends to be weak and dividends are unlikely to reect free cash ow to equity. In addition, the rm consistently funds a portion of its reinvestment needs with new debt issues.

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Background Information

In 2000, Tsingtao Breweries earned 72.36 million CY(Chinese Yuan) in net income on a book value of equity of 2,588 million CY, giving it a return on equity of 2.80%. The rm had capital expenditures of 335 million CY and depreciation of 204 million CY during the year. The working capital changes over the last 4 years have been volatile, and we normalize the change using non-cash working capital as a percent of revenues in 2000:
Normalized change in non-cash working capital = (Non-cash working capital2000/ Revenues 2000) (Revenuess2000 Revenues1999) = (180/2253)*( 2253-1598) = 52.3 million CY Normalized Reinvestment = Capital expenditures Depreciation + Normalized Change in non-cash working capital = 335 - 204 + 52.3= 183.3 million CY

As with working capital, debt issues have been volatile. We estimate the rms book debt to capital ratio of 40.94% at the end of 1999 and use it to estimate the normalized equity reinvestment in 2000.

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Inputs for the 3 Stages

High Growth 5 years Moves to 0.80 4%+2.28% 2.8%->12% 149.97% 44.91%

Transition Phase 5 years 0.80 --> 12%->20% Moves to 50% Moves to 10%

Stable Growth Forever after yr 10 4+0.95% 20% 50% 10%

Length Beta 0.75 Risk Premium ROE Equity Reinv. Expected Growth

We wil asssume that

Equity Reinvestment Ratio= Reinvestment (1- Debt Ratio) / Net Income = = 183.3 (1-.4094) / 72.36 = 149.97% Expected growth rate- next 5 years = Equity reinvestment rate * ROENew+[1+(ROE5-ROEtoday)/ROEtoday]1/5-1 = 1.4997 *.12 + [(1+(.12-.028)/.028)1/5-1] = 44.91%

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Tsingtao: Projected Cash Flows

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Tsingtao: Terminal Value

Expected stable growth rate =10% Equity reinvestment rate in stable growth = 50% Cost of equity in stable growth = 13.96% Expected FCFE in year 11

= Net Income11*(1- Stable period equity reinvestment rate) = CY 1331.81 (1.10)(1-.5) = CY 732.50 million

Terminal Value of equity in Tsingtao Breweries = FCFE11/(Stable period cost of equity Stable growth rate) = 732.5/(.1396-.10) = CY 18,497 million

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Tsingtao: Valuation

Value of Equity

= PV of FCFE during the high growth period + PV of terminal value =-CY186.65+CY18,497/(1.14715*1.1456*1.1441*1.1426*1.1411*1.1396) = CY 4,596 million

Value of Equity per share = Value of Equity/ Number of Shares = CY 4,596/653.15 = CY 7.04 per share The stock was trading at 10.10 Yuan per share, which would make it overvalued, based upon this valuation.

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DaimlerChrysler: Rationale for Model June 2000

DaimlerChrysler is a mature rm in a mature industry. We will therefore assume that the rm is in stable growth. Since this is a relatively new organization, with two different cultures on the use of debt (Daimler has traditionally been more conservative and bankoriented in its use of debt than Chrysler), the debt ratio will probably change over time. Hence, we will use the FCFF model.

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Daimler Chrysler: Inputs to the Model

In 1999, Daimler Chrysler had earnings before interest and taxes of 9,324 million DM and had an effective tax rate of 46.94%. Based upon this operating income and the book values of debt and equity as of 1998, DaimlerChrysler had an after-tax return on capital of 7.15%. The market value of equity is 62.3 billion DM, while the estimated market value of debt is 64.5 billion The bottom-up unlevered beta for automobile rms is 0.61, and Daimler is AAA rated. The long term German bond rate is 4.87% (in DM) and the mature market premium of 4% is used. We will assume that the rm will maintain a long term growth rate of 3%.

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Daimler/Chrysler: Analyzing the Inputs

Expected Reinvestment Rate = g/ ROC = 3%/7.15% = 41.98% Cost of Capital

Bottom-up Levered Beta = 0.61 (1+(1-.4694)(64.5/62.3)) = 0.945 Cost of Equity = 4.87% + 0.945 (4%) = 8.65% After-tax Cost of Debt = (4.87% + 0.20%) (1-.4694)= 2.69% Cost of Capital = 8.65%(62.3/(62.3+64.5))+ 2.69% (64.5/(62.3+64.5)) = 5.62%

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Daimler Chrysler Valuation

Estimating FCFF
Expected EBIT (1-t) = 9324 (1.03) (1-.4694) = Expected Reinvestment needs = 5,096(.42) = Expected FCFF next year = 5,096 mil DM 2,139 mil DM 2,957 mil DM 112,847 mil DM 18,068 mil DM 130,915 mil DM 64,488 mil DM 66,427 mil DM

Valuation of Firm
Value of operating assets = 2957 / (.056-.03) = + Cash + Marketable Securities = Value of Firm = - Debt Outstanding = Value of Equity =

Value per Share = 72.7 DM per share Stock was trading at 62.2 DM per share on June 1, 2000

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Circular Reasoning in FCFF Valuation

In discounting FCFF, we use the cost of capital, which is calculated using the market values of equity and debt. We then use the present value of the FCFF as our value for the rm and derive an estimated value for equity. Is there circular reasoning here? Yes No If there is, can you think of a way around this problem?

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Tube Investment: Rationale for Using 2-Stage FCFF Model June 2000

Tube Investments is a diversied manufacturing rm in India. While its growth rate has been anemic, there is potential for high growth over the next 5 years. The rms nancing policy is also in a state of ux as the family running the rm reassesses its policy of funding the rm.

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Stable Growth Rate and Value

In estimating terminal value for Tube Investments, I used a stable growth rate of 5%. If I used a 7% stable growth rate instead, what would my terminal value be? (Assume that the cost of capital and return on capital remain unchanged.)

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The Effects of Return Improvements on Value

The rm is considering changes in the way in which it invests, which management believes will increase the return on capital to 12.20% on just new investments (and not on existing investments) over the next 5 years. The value of the rm will be higher, because of higher expected growth.

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Return Improvements on Existing Assets

If Tube Investments is also able to increase the return on capital on existing assets to 12.20% from 9.20%, its value will increase even more. The expected growth rate over the next 5 years will then have a second component arising from improving returns on existing assets: Expected Growth Rate = .122*.60 +{ (1+(.122-.092)/.092)1/5-1} =.1313 or 13.13%

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Tube Investments and Tsingtao: Should there be a corporate governance discount?

Stockholders in Asian, Latin American and many European companies have little or no power over the managers of the rm. In many cases, insiders own voting shares and control the rm and the potential for conict of interests is huge. Would you discount the value that you estimated to allow for this absence of stockholder power? Yes No.

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Embraer: An Emerging Market Company? A Valuation in October 2003

We will use a 2-stage FCFF model to value Embraer to allow for maximum exibility. High Growth
Beta 1.07 Lambda 0.27 Counry risk premium 7.67% Debt Ratio 15.93% Return on Capital 21.85% Cost of Capital 9.81% Expected Growth Rate 5.48% Reinvestment Rate 25.04%

Stable Growth
1.00 0.27 5.00% 15.93% 8.76% 8.76% 4.17% 4.17%/8.76% = 47.62%

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Embraers Cash and Cross Holdings

Embraer has a 60% interest in an equipment company and the nancial statements of that company are consolidated with those of Embraer. The minority interests (representing the equity in the subsidiary that does not belong to Embraer) are shown on the balance sheet at 23 million BR. Estimated market value of minority interests = Book value of minority interest * P/BV of sector that subsidiary belongs to = 23.12 *1.5 = 34.68 million BR or $11.88 million dollars. Present Value of FCFF in high growth phase = $1,342.97 Present Value of Terminal Value of Firm = $3,928.67 Value of operating assets of the rm = $5,271.64 + Value of Cash, Marketable Securities = $794.52 Value of Firm = $6,066.16 Market Value of outstanding debt = $716.74 - Minority Interest in consolidated holdings =34.68/2.92 = $11.88 Market Value of Equity = $5,349.42 - Value of Equity in Options = $27.98 Value of Equity in Common Stock = $5,321.44 Market Value of Equity/share = $7.47 Market Value of Equity/share in BR = 7.47 *2.92 BR/$ = R$ 21.75 Aswath Damodaran 58

Dealing with Distress

A DCF valuation values a rm as a going concern. If there is a signicant likelihood of the rm failing before it reaches stable growth and if the assets will then be sold for a value less than the present value of the expected cashows (a distress sale value), DCF valuations will understate the value of the rm. Value of Equity= DCF value of equity (1 - Probability of distress) + Distress sale value of equity (Probability of distress) There are three ways in which we can estimate the probability of distress:
Use the bond rating to estimate the cumulative probability of distress over 10 years Estimate the probability of distress with a probit Estimate the probability of distress by looking at market value of bonds..

The distress sale value of equity is usually best estimated as a percent of book value (and this value will be lower if the economy is doing badly and there are other rms in the same business also in distress).

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Current Revenue $ 3,804

Current Margin: -49.82% EBIT -1895m

Stable Growth
Cap ex growth slows and net cap ex decreases Revenue Growth: 13.33% EBITDA/Sales -> 30% Stable Stable Revenue EBITDA/ Growth: 5% Sales 30% Stable ROC=7.36% Reinvest 67.93%

NOL: 2,076m
Revenues EBITDA EBIT EBIT (1-t) + Depreciation - Cap Ex - Chg WC FCFF Beta Cost of Equity Cost of Debt Debt Ratio Cost of Capital

Terminal Value= 677(.0736-.05) =$ 28,683

$3,804 $5,326 $6,923 $8,308 $9,139 ($95) $ 0 $346 $831 $1,371 ($1,675) ($1,738) ($1,565) ($1,272) $320 ($1,675) ($1,738) ($1,565) ($1,272) $320 $1,580 $1,738 $1,911 $2,102 $1,051 $3,431 $1,716 $1,201 $1,261 $1,324 $0 $46 $48 $42 $25 ($3,526) ($1,761) ($903) ($472) $22 1 2 3 4 5 3.00 16.80% 12.80% 74.91% 13.80% 3.00 16.80% 12.80% 74.91% 13.80% 3.00 16.80% 12.80% 74.91% 13.80% 3.00 16.80% 12.80% 74.91% 13.80% 3.00 16.80% 12.80% 74.91% 13.80% $10,053 $11,058 $11,942 $12,659 $13,292 $1,809 $2,322 $2,508 $3,038 $3,589 $1,074 $1,550 $1,697 $2,186 $2,694 $1,074 $1,550 $1,697 $2,186 $2,276 $736 $773 $811 $852 $894 $1,390 $1,460 $1,533 $1,609 $1,690 $27 $30 $27 $21 $19 $392 $832 $949 $1,407 $1,461 6 7 8 9 10 2.60 15.20% 11.84% 67.93% 12.92% 2.20 13.60% 10.88% 60.95% 11.94% 1.80 12.00% 9.92% 53.96% 10.88% 1.40 10.40% 8.96% 46.98% 9.72% 1.00 8.80% 6.76% 40.00% 7.98% Term. Year $13,902 $ 4,187 $ 3,248 $ 2,111 $ 939 $ 2,353 $ 20 $ 677

Value of Op Assets $ + Cash & Non-op $ = Value of Firm $ - Value of Debt $ = Value of Equity $ - Equity Options $ Value per share $

5,530 2,260 7,790 4,923 2867 14 3.22

Forever

Cost of Equity 16.80%

Cost of Debt 4.8%+8.0%=12.8% Tax rate = 0% -> 35%

Weights Debt= 74.91% -> 40%

Riskfree Rate: T. Bond rate = 4.8%

Beta 3.00> 1.10

Risk Premium 4%

Global Crossing November 2001 Stock price = $1.86

Internet/ Retail

Operating Leverage

Current D/E: 441%

Base Equity Premium

Country Risk Premium

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Valuing Global Crossing with Distress

Probability of distress

t= 8 Price of 8 year, 12% bond issued by Global Crossing = $ 653 t 8

653 =

120(1 Distress ) 1000(1 Distress ) + t (1.05) (1.05) 8 t=1

Probability of distress = 13.53% a year Cumulative probability of survival over 10 years = (1- .1353)10 = 23.37% Book value of capital = $14,531 million Distress sale value = 15% of book value = .15*14531 = $2,180 million Book value of debt = $7,647 million Distress sale value of equity = $ 0 Value of Global Crossing = $3.22 (.2337) + $0.00 (.7663) = $0.75

Distress sale value of equity

Distress adjusted value of equity

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More than one way to skin a cat

In the conventional approach to rm valuation, we discount the cash ows back at a risk adjusted discount rate to arrive at value. There are frequent claims from both academics and practitioners of better ways of doing discounted cash ow valuation. In particular, there are two alternatives offered to the classic discounted cash ow model
The adjusted present value model, where we value the rm as if it were all equity funded and then add on the effects of debt (good and bad) to this value The excess return model, where we compute the present value of expected excess returns that the rm will earn and add it to the capital invested in the rm

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Avg Reinvestment rate = 28.54%

Titan Cements: Status Quo

Reinvestment Rate 28.54% Expected Growth in EBIT (1-t) .2854*.1925=.0549 5.49%

Current Cashflow to Firm EBIT(1-t) : 173 - Nt CpX 49 - Chg WC 52 = FCFF 72 Reinvestment Rate = 101/173 =58.5%

Return on Capital 19.25% Stable Growth g = 3.41%; Beta = 1.00; Country Premium= 0% Cost of capital = 6.57% ROC= 6.57%; Tax rate=33% Reinvestment Rate=51.93% Terminal Value5= 100.9/(.0657-.0341) = 3195

Op. Assets 2,897 + Cash: 77 - Debt 414 - Minor. Int. 46 =Equity 2,514 -Options 0 Value/Share 32.84

Year EBIT EBIT(1-t) - Reinvestment = FCFF

1 244.53 182.25 52.01 130.24

2 257.96 192.26 45.87 137.39

3 272.13 202.82 57.88 144.94

4 287.08 213.96 61.06 152.90

5 302.85 225.7 64.42 161.30

Term Yr 313.2 209.8 108.9 100.9

Discount at Cost of Capital (WACC) = 7.56% (.824) + 3.11% (0.176) = 6.78%

Cost of Equity 7.56%

Cost of Debt (3.41%+.5%+.26%)(1-.2547) = 3.11%

Weights E = 82.4% D = 17.6%

On April 27, 2005 Titan Cement stock was trading at 25 a share

Riskfree Rate: Euro riskfree rate = 3.41%

Beta 0.93

Risk Premium 4.46%

Unlevered Beta for Sectors: 0.80

Firms D/E Ratio: 21.35%

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Mature risk premium 4%

Country Equity Prem 0.46%

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Adjusted Present Value Model

In the adjusted present value approach, the value of the rm is written as the sum of the value of the rm without debt (the unlevered rm) and the effect of debt on rm value Firm Value = Unlevered Firm Value + (Tax Benets of Debt - Expected Bankruptcy Cost from the Debt)
The unlevered rm value can be estimated by discounting the free cashows to the rm at the unlevered cost of equity The tax benet of debt reects the present value of the expected tax benets. In its simplest form, Tax Benet = Tax rate * Debt The expected bankruptcy cost is a function of the probability of bankruptcy and the cost of bankruptcy (direct as well as indirect) as a percent of rm value.

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An APV Valuation of Titan Cement Step 1: Unlevered rm value

In the conventional approach, we valued Titan using the levered beta for the company of 0.93 and the debt to capital ratio of 17.6% to estimate a cost of capital for discounting the free cash flows to the firm. the APV approach, we use the unlevered beta of 0.80 to estimate the unlevered cost of equity, For the first 5 years, with a riskfree rate of 3.41% and a risk premium of 4.46%, this yields a cost of equity of 6.98%.
Unlevered cost of equity = 3.41% + 0.80(4.46%) = 6.98%

Beyond year 5, we will use an unlevered beta of 0.875 to correspond with the levered beta of 1 used in illustration 6.2. With the market risk premium reduced to 4%, this yields a cost of equity of 6.91%.
The levered beta used in illustration 6.2 was 1, the debt to equity ratio assumed for the stable growth period was 21.36% and the tax rate was 33%.Unlevered beta = 1.00/ (1+(1-.33)(.2136)) = 0.875 Unlevered stable period cost of equity = 3.41%+0.875 (4%) = 6.91%

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The Unlevered Firm Value

Year EBIT * (1 - tax rate) - (CapExDepreciation) -Chg. Working Capital Free Cashflow to Firm Terminal value Present Value @6.98% Value of firm =

Curre n t 172.76 49.20 51.80 71.76

1 182.25 40.54 11.47 130.24

2 192.26 42.77 12.11 137.39

3 202.82 45.11 12.77 144.94

4 213.96 47.59 13.47 152.90

5 225.72 50.21 14.21 161.30 3,036.62 $2,282

$122 $2,759

$120

$118

$117

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The Tax Benets of Debt

The tax benefits from debt are computed based upon Titans existing dollar debt of 414 million Euros and a tax rate of 25.47%:
Expected tax benefits in perpetuity = Tax rate (Debt) = 0.2547 (414 million) = 105.45 million Euros

This captures the tax benefit on the dollar debt outstanding today and does not factor in future debt issues (or increases in the debt ratio) and the tax benefits that will accrue from that additional debt.

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The Expected Bankruptcy Costs

To estimate this, we made two assumptions.

First, based upon its existing synthetic rating of AA, the probability of default at the existing debt level is very small (0.28%). Second, we estimate the cost of bankruptcy is 30% of unlevered firm value.

Expected bankruptcy cost =Probability of bankruptcy * Cost of bankruptcy * (Unlevered firm value + Tax benefits from debt) = 0.0028*0.30*(2,759+105) = 2.41 million Euros

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The APV Value of Titan Cements

The value of the operating assets can now be computed

Value of the operating assets = Unlevered firm value + PV of tax benefits Expected Bankruptcy Costs = 2,759 + 105.45 2.41 = 2,862 million Euros

In contrast, we valued the operating assets at 2,897 million Euros with the cost of capital approach. The difference between the two approaches can be attributed to the tax benefits built into each one. The APV model considers the tax benefits only on existing debt whereas the cost of capital approach adds in the tax benefits from future debt issues.

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Excess Return Models

You can present any discounted cashow model in terms of excess returns, with the value being written as:
Value = Capital Invested + Present value of excess returns on current investments + Present value of excess returns on future investments

This model can be stated in terms of rm value (EVA) or equity value.

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An EVA Valuation of Titan Cement

Year EBIT (1-t) Cost of capital Capital Invested at beginning of year Reinvestment during year Cost of capital*Capital Invested EVA Present Value @ WACC PV of EVA Capital invested today PV of EVA in perpetuity on assets in pace Value of operating assets 1 182.25 6.78% 946.90 52.01 64.17 118.08 110.59 539.81 946.90 PV of EVA from existing investments in perpetuity. 2 192.26 6.78% 998.92 54.87 67.69 124.57 109.26 3 202.82 6.78% 1,053.79 57.88 71.41 131.41 107.95 4 213.96 6.78% 1,111.67 61.06 75.33 138.63 106.65 5 225.72 6.78% 1,172.74 64.42 79.47 146.25 105.37 1,237.16 Terminal year 209.83

1,410.71 2,897.42

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The Dark Side of Valuation

Aswath Damodaran http://www.stern.nyu.edu/~adamodar

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To make our estimates, we draw our information from..

The rms current nancial statement

How much did the rm sell? How much did it earn? How fast have the rms revenues and earnings grown over time? What can we learn about cost structure and protability from these trends? Susceptibility to macro-economic factors (recessions and cyclical rms) What happens to rms as they mature? (Margins.. Revenue growth Reinvestment needs Risk)

The rms nancial history, usually summarized in its nancial statements.

The industry and comparable rm data

We often substitute one type of information for another; for instance, in valuing Ford, we have 70 years+ of historical data, but not too many comparable rms; in valuing a software rm, we might not have too much historical data but we have lots of comparable rms.
73

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The Dark Side...

Valuation is most difcult when a company

Has negative earnings and low revenues in its current nancial statements No history No comparables ( or even if they exist, they are all at the same stage of the life cycle as the rm being valued)

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Amazons Bottom-up Beta

Unlevered beta for rms in internet retailing = Unlevered beta for rms in specialty retailing =

1.60 1.00

Amazon is a specialty retailer, but its risk currently seems to be determined by the fact that it is an online retailer. Hence we will use the beta of internet companies to begin the valuation but move the beta, after the rst ve years, towards the beta of the retailing business.

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Estimating Synthetic Ratings and cost of debt

The rating for a rm can be estimated using the nancial characteristics of the rm. In its simplest form, the rating can be estimated from the interest coverage ratio Interest Coverage Ratio = EBIT / Interest Expenses Amazon.com has negative operating income; this yields a negative interest coverage ratio, which should suggest a low rating. We computed an average interest coverage ratio of 2.82 over the next 5 years. This yields an average rating of BBB for Amazon.com for the rst 5 years. (In effect, the rating will be lower in the earlier years and higher in the later years than BBB)

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Estimating the cost of debt

The synthetic rating for Amazon.com is BBB. The default spread for BBB rated bonds is 1.50% Pre-tax cost of debt = Riskfree Rate + Default spread = 6.50% + 1.50% = 8.00% After-tax cost of debt right now = 8.00% (1- 0) = 8.00%: The rm is paying no taxes currently. As the rms tax rate changes and its cost of debt changes, the after tax cost of debt will change as well.
1 2 0% 3 0% 4 5 6 35% 7 35% 8 35% 9 35% 10 35% 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00% 16.1% 35%

Pre-tax

Tax rate 0%

After-tax 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%

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Estimating Cost of Capital: Amazon.com

Equity
Cost of Equity = 6.50% + 1.60 (4.00%) = 12.90% Market Value of Equity = $ 84/share* 340.79 mil shs = $ 28,626 mil (98.8%) Cost of debt = 6.50% + 1.50% (default spread) = 8.00% Market Value of Debt = $ 349 mil (1.2%)

Debt

Cost of Capital

Cost of Capital = 12.9 % (.988) + 8.00% (1- 0) (.012)) = 12.84%

Amazon.com has a book value of equity of $ 138 million and a book value of debt of $ 349 million. Shows you how irrelevant book value is in this process.

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Calendar Years, Financial Years and Updated Information

The operating income and revenue that we use in valuation should be updated numbers. One of the problems with using nancial statements is that they are dated. As a general rule, it is better to use 12-month trailing estimates for earnings and revenues than numbers for the most recent nancial year. This rule becomes even more critical when valuing companies that are evolving and growing rapidly. Last 10-K $ 610 million - $125 million Trailing 12-month $1,117 million - $ 410 million

Revenues EBIT

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Are S, G & A expenses capital expenditures?

Many internet companies are arguing that selling and G&A expenses are the equivalent of R&D expenses for a high-technology rms and should be treated as capital expenditures. If we adopt this rationale, we should be computing earnings before these expenses, which will make many of these rms protable. It will also mean that they are reinvesting far more than we think they are. It will, however, make not their cash ows less negative. Should Amazon.coms selling expenses be treated as cap ex?

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Amazon.coms Tax Rate

Year 1 2 3 4 5

EBIT Taxes EBIT(1-t) Tax rate NOL

-$373 $0 -$373 0% $500

-$94 $0 -$94 0% $873

$407 $0 $407 0% $967

$1,038 $1,628 $167 $871 $570 $1,058

16.13% 35% $560 $0

After year 5, the tax rate becomes 35%.

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Estimating FCFF: Amazon.com

EBIT (Trailing 1999) = -$ 410 million Tax rate used = 0% (Assumed Effective = Marginal) Capital spending (Trailing 1999) = $ 243 million (includes acquisitions) Depreciation (Trailing 1999) = $ 31 million Non-cash Working capital Change (1999) = - 80 million Estimating FCFF (1999)
Current EBIT * (1 - tax rate) = - 410 (1-0) = - $410 million - (Capital Spending - Depreciation) = $212 million - Change in Working Capital = -$ 80 million Current FCFF = - $542 million

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Growth in Revenues, Earnings and Reinvestment: Amazon

Year Revenue Growth Investment 1 150.00% 3.00 2 100.00% 3.00 3 75.00% 20.59% 4 50.00% 25.82% 5 30.00% 21.16% 6 25.20% 22.23% 7 20.40% 22.30% 8 15.60% 21.87% Chg in New Revenue $1,676 $559 -76.62% $2,793 $931 -8.96% $4,189 $1,396 $4,887 $1,629 $4,398 $1,466 $4,803 $1,601 $4,868 $1,623 $4,482 $1,494 Sales/Capital ROC

3.00 3.00 3.00 3.00 3.00 3.00

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Amazon.com: Stable Growth Inputs

Beta Debt Ratio Return on Capital Expected Growth Rate Reinvestment Rate

High Growth
1.60 1.20% Negative NMF >100%

Stable Growth

1.00 15% 20% 6% 6%/20% = 30%

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Estimating the Value of Equity Options

Details of options outstanding

Average strike price of options outstanding = Average maturity of options outstanding = Standard deviation in ln(stock price) = Annualized dividend yield on stock = Treasury bond rate = Number of options outstanding = Number of shares outstanding = Value of equity options = $ 2,892 million $ 13.375 8.4 years 50.00% 0.00% 6.50% 38 million 340.79 million

Value of options outstanding (using dilution-adjusted Black-Scholes model)

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What do you need to break-even at $ 84?

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Amazon over time

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