Aswath Damodaran

LIVING  WITH  NOISE:  

INVESTING  IN  THE  FACE  OF  
UNCERTAINTY  
Aswath  Damodaran  
h?p://www.damodaran.com  
 Intrinsic  Value:  Three  Basic  ProposiJons  
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¨  The  value  of  an  asset  is  the  present  value  of  the  expected  cash  
flows  on  that  asset,  over  its  expected  life:  

¨  ProposiJon  1:  If  “it”  does  not  affect  the  cash  flows  or  alter  risk  
(thus  changing  discount  rates),  “it”  cannot  affect  value.    
¨  ProposiJon  2:  For  an  asset  to  have  value,  the  expected  cash  flows  
have  to  be  posiJve  some  Jme  over  the  life  of  the  asset.  
¨  ProposiJon  3:  Assets  that  generate  cash  flows  early  in  their  life  will  
be  worth  more  than  assets  that  generate  cash  flows  later;  the  
la?er  may  however  have  greater  growth  and  higher  cash  flows  to  
compensate.  

Aswath Damodaran

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 The  fundamental  determinants  of  value…  
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What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
What are the Firm: Growth in operating earnings/
cashflows from cashflows
existing assets? When will the firm
- Equity: Cashflows become a mature
after debt payments fiirm, and what are
- Firm: Cashflows How risky are the cash flows from both the potential
before debt payments existing assets and growth assets? roadblocks?
Equity: Risk in equity in the company
Firm: Risk in the firm’s operations

Aswath Damodaran

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 Current Cashflow to Firm
3M: A Pre-crisis valuation
Return on Capital
EBIT(1-t)= 5344 (1-.35)= 3474 Reinvestment Rate 25%
- Nt CpX= 350 30% Stable Growth
Expected Growth in g = 3%; Beta = 1.10;
- Chg WC 691
EBIT (1-t) Debt Ratio= 20%; Tax rate=35%
= FCFF 2433
.30*.25=.075 Cost of capital = 6.76%
Reinvestment Rate = 1041/3474
7.5% ROC= 6.76%;
=29.97%
Return on capital = 25.19% Reinvestment Rate=3/6.76=44%

Terminal Value5= 2645/(.0676-.03) = 70,409

First 5 years
Op. Assets 60607 Year 1 2 3 4 5 Term Yr
+ Cash: 3253 EBIT (1-t) $3,734 $4,014 $4,279 $4,485 $4,619 $4,758
- Debt 4920 - Reinvestment $1,120 $1,204 $1,312 $1,435 $1,540 , $2,113
=Equity 58400 = FCFF $2,614 $2,810 $2,967 $3,049 $3,079 $2,645

Value/Share $ 83.55
Cost of capital = 8.32% (0.92) + 2.91% (0.08) = 7.88%

On September 12,
Cost of Equity Cost of Debt 2008, 3M was
8.32% (3.72%+.75%)(1-.35) Weights trading at $70/share
= 2.91% E = 92% D = 8%

Riskfree Rate: Risk Premium

Riskfree rate = 3.72% Beta 4%
+ 1.15 X

Unlevered Beta for

Sectors: 1.09 D/E=8.8%

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Aswath Damodaran

 Average reinvestment rate
Tata Motors: April 2010 from 2005-09: 179.59%; Return on Capital
without acquisitions: 70% Stable Growth
17.16%
Current Cashflow to Firm g = 5%; Beta = 1.00
EBIT(1-t) : Rs 20,116 Reinvestment Rate
Expected Growth Country Premium= 3%
- Nt CpX Rs 31,590 70%
from new inv. Cost of capital = 10.39%
- Chg WC Rs 2,732 Tax rate = 33.99%
.70*.1716=0.1201
= FCFF - Rs 14,205 ROC= 10.39%;
Reinv Rate = (31590+2732)/20116 = Reinvestment Rate=g/ROC
170.61%; Tax rate = 21.00% =5/ 10.39= 48.11%
Return on capital = 17.16%

Terminal Value5= 23493/(.1039-.05) = Rs 435,686

Rs Cashflows
Op. Assets Rs210,813 Year 1 2 3 4 5 6 7 8 9 10
+ Cash: 11418 EBIT (1-t) 22533 25240 28272 31668 35472 39236 42848 46192 49150 51607 45278
+ Other NO 140576 - Reinvestment 15773 17668 19790 22168 24830 25242 25138 24482 23264 21503 21785
- Debt 109198 FCFF 6760 7572 8482 9500 10642 13994 17711 21710 25886 30104 23493
=Equity 253,628

Value/Share Rs 614
Discount at Cost of Capital (WACC) = 14.00% (.747) + 8.09% (0.253) = 12.50%
Growth declines to 5%
and cost of capital
moves to stable period
level.
Cost of Equity Cost of Debt
14.00% (5%+ 4.25%+3)(1-.3399) Weights
E = 74.7% D = 25.3% On April 1, 2010
= 8.09% Tata Motors price = Rs 781

Riskfree Rate:
Rs Riskfree Rate= 5% Beta Mature market Country Equity Risk
+ 1.20 X premium + Lambda X Premium
4.5% 0.80 4.50%

Unlevered Beta for Firmʼs D/E Rel Equity

Sectors: 1.04 Ratio: 33% Country Default Mkt Vol
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Aswath Damodaran
Spread X
1.50
3%
 9a. Amazon in January 2000 Sales to capital ratio and
expected margin are retail Stable Growth
Current Current
Revenue Margin: industry average numbers Stable Stable
Stable Operating ROC=20%
$ 1,117 -36.71% Revenue
Sales Turnover Competitive Margin: Reinvest 30%
Ratio: 3.00 Advantages Growth: 6% 10.00% of EBIT(1-t)
From previous
EBIT
years Revenue Expected
-410m
Growth: Margin: Terminal Value= 1881/(.0961-.06)
NOL:
42% -> 10.00% =52,148
500 m

Term. Year
Revenue&Growth 150.00% 100.00% 75.00% 50.00% 30.00% 25.20% 20.40% 15.60% 10.80% 6.00% 6%
Revenues $&&2,793 $&&5,585 $&9,774 $&14,661 $&19,059 $&23,862 $&28,729 $&33,211 $&36,798 $&39,006 $(((((41,346
Operating&Margin B13.35% B1.68% 4.16% 7.08% 8.54% 9.27% 9.64% 9.82% 9.91% 9.95% 10.00%
Value of Op Assets $ 15,170 EBIT B$373 B$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 $4,135
+ Cash $ 26 EBIT(1Bt) B$373 B$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 $2,688
= Value of Firm $14,936 &B&Reinvestment $600 $967 $1,420 $1,663 $1,543 $1,688 $1,721 $1,619 $1,363 $961 $155
FCFF B$931 B$1,024 B$989 B$758 B$408 B$163 $177 $625 $1,174 $1,788 $1,881
- Value of Debt $ 349 1 2 3 4 5 6 7 8 9 10
= Value of Equity $14,847
Forever
- Equity Options $ 2,892 Cost%of%Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 11.94% 11.46% 10.98% 10.50%
Value per share $ 35.08 Cost%of%Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00%
All existing options valued After<tax%cost%of%debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%
as options, using current Cost%of%Capital% 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.62% 11.08% 10.49% 9.61%
stock price of $84. Amazon was
Used average trading at $84 in
Cost of Equity interest coverage Cost of Debt Weights January 2000.
12.90% ratio over next 5 6.5%+1.5%=8.0% Debt= 1.2% -> 15%
years to get BBB Tax rate = 0% -> 35%
rating. Pushed debt ratio
Dot.com retailers for firrst 5 years to retail industry
Convetional retailers after year 5 average of 15%.
Beta
Riskfree Rate: + 1.60 -> 1.00 X Risk Premium
T. Bond rate = 6.5% 4%

Internet/ Operating Current D/ Base Equity Country Risk

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Aswath Damodaran
Retail Leverage E: 1.21% Premium Premium
 Starting numbers
Twitter Pre-IPO Valuation: October 5, 2013
2012 Trailing+2013
Revenues $316.9 $448.2 Revenue Pre-tax Sales to Stable Growth
Operating+Income ?$77.1 ?$92.9 growth of 55% a operating capital ratio of g = 2.7%; Beta = 1.00;
Adj+Op+Inc $4.3 year for 5 years, margin 1.50 for Cost of capital = 8%
Invested+Capital $549.1 tapering down increases to incremental ROC= 12%;
Operating+Margin 0.96% to 2.7% in year 25% over the sales Reinvestment Rate=2.7%/12% = 22.5%
Sales/Capital 0.82 10 next 10 years
Terminal Value10= 1433/(.08-.027) = $27.036

1 2 3 4 5 6 7 8 9 10
Operating assets $9,611 Revenues $33333333694.7 $33331,076.8 $33331,669.1 $33332,587.1 $33334,010.0 $33335,796.0 $33337,771.3 $33339,606.8 $3310,871.1 $3311,164.6 Terminal year (11)
+ Cash 375 Operating3Income $333333333323.3 $333333333362.0 $33333333136.3 $33333333273.5 $33333333520.3 $33333333891.5 $33331,382.2 $33331,939.7 $33332,456.3 $33332,791.2 EBIT (1-t) $1,849
+ IPO Proceeds 1000 Operating3Income3after3taxes $333333333323.3 $333333333362.0 $33333333136.3 $33333333265.3 $33333333364.2 $33333333614.2 $33333333937.1 $33331,293.8 $33331,611.4 $33331,800.3 - Reinvestment $ 416
- Debt 207 Reinvestment $33333333164.3 $33333333254.7 $33333333394.8 $33333333612.0 $33333333948.6 $33331,190.7 $33331,316.8 $33331,223.7 $33333333842.8 $33333333195.7 FCFF $1,433
Value of equity 10,779 FCFF $333333(141.0) $333333(192.7) $333333(258.5) $333333(346.6) $333333(584.4) $333333(576.5) $333333(379.7) $333333333370.0 $33333333768.5 $33331,604.6
- Options 805
Value in stock 9,974
/ # of shares 574.44 Cost of capital = 11.32% (.983) + 5.16% (.017) = 11.22% Cost of capital decreases to
Value/share $17.36 8% from years 6-10

Cost of Equity On October 5, 2013, Twitter

11.32% Cost of Debt Weights
(2.7%+5.3%)(1-.40) had not been priced yet, but
E = 98.31% D = 1.69%
= 5.16% the company's most recent
acquisition suggested a
price of about $20/share.

Risk Premium
Riskfree Rate:
Beta 6.15%
Riskfree rate = 2.7% X
+ 1.40
75% from US(5.75%) + 25%
from rest of world (7.23%)

90% advertising D/E=1.71%

(1.44) + 10% info
svcs (1.05)

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Aswath Damodaran

The  sources  of  uncertainty  

¨  Estimation versus Economic uncertainty

¤  Estimation uncertainty reflects the possibility that you could have the “wrong
model” or estimated inputs incorrectly within this model.

¤  Economic uncertainty comes the fact that markets and economies can change over
time and that even the best medals will fail to capture these unexpected changes.

¨  Micro uncertainty versus Macro uncertainty

¤  Micro uncertainty refers to uncertainty about the potential market for a firm’s
products, the competition it will face and the quality of its management team.

¤  Macro uncertainty reflects the reality that your firm’s fortunes can be affected by
changes 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 stage
of the approval process or a company in Venezuela may be nationalized)

¤  Continuous risk: Risks changes in interest rates or economic growth occur
continuously and affect value as they happen.

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Assessing uncertainty…

¨  Rank  the    four  firms  in  terms  of  uncertainty  (least  to  most)  in  your  
esJmate:  
q 3M  in  2007  
q Tata  Motors  in  2010  
q Amazon  in  2000  
q   Twi?er  in  2013  
•  With  each  company,  specify  the  type  of  uncertainty  that  you  face:  
  Company   Es+ma+on  or   Micro  or   Discrete  or  
Economic   Macro   Con+nuous  
3M  (2007)  
Tata  Motors  (2010)  
Amazon  (2000)  
Twi?er  (2013)  
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Unhealthy  ways  of  dealing  with  uncertainty  

¨  Paralysis & Denial: When faced with uncertainty, some of us

get paralyzed. Accompanying the paralysis is the hope that if
you close your eyes to it, the uncertainty will go away

¨  Mental short cuts (rules of thumb): Behavioral economists
note that investors faced with uncertainty adopt mental short
cuts that have no basis in reality. And here is the clincher.
More intelligent people are more likely to be prone to this.

¨  Herding: When in doubt, it is safest to go with the crowd..
The herding instinct is deeply engrained and very difficult to
fight.

¨  Outsourcing: Assuming that there are experts out there who
have the answers does take a weight off your shoulders, even
if those experts have no idea of what they are talking about.

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 Ten  suggesJons  for  dealing  with  uncertainty…  
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1.  Less  is  more  (the  rule  on  detail….)  (Revenue  &  margin  forecasts)  
2.  Build  in  internal  checks  on  reasonableness…  (reinvestment  and  ROC)  
3.  Use  the  offsedng  principle  (risk  free  rates  &  inflaJon  at  Tata  Motors)  
4.  Draw  on  economic  first  principles  (Terminal  value  at  all  the  companies  )  
5.  Use  the  “market”  as  a  crutch  (equity  risk  premiums,  country  risk  
premiums)  
6.  Use  the  law  of  large  numbers  (Beta  for  all  companies  
7.  Don’t  let  the  discount  rate  become  the  receptacle  for  all  uncertainJes.  
8.  Confront  uncertainty,  if  you  can  
9.  Don’t  look  for  precision  
10.  You  can  live  with  mistakes,  but  bias  will  kill  you…  

Aswath Damodaran

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 1.  Less  is  more  
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Principle of parsimony: Estimate

Use “auto pilot” approaches to fewer inputs when faced with
estimate future years
uncertainty.
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 A  tougher  task  at  Twi?er  
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My estimate for 2023: Overall market will be close to

$200 billion and Twitter will about 5.7% ($11.5
billion)

Aswath Damodaran

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 2.  Build  in  “internal”  checks  for  
reasonableness…  
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Check total revenues, relative to the market that it serves… Are the margins
Your market share obviously cannot exceed 100% but there and imputed
may be tighter constraints.
returns on capital
‘reasonable’ in the
Aswath Damodaran
outer years?

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 Follow  up  proposiJons  on  growth…  
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¨  If  you  accept  the  proposiJon  that  growth  has  to  come  from  either  
increased  efficiency  (improving  return  on  capital  on  exisJng  assets)  and  
new  investments  (reinvestment  rate  &  return  on  capital):  
¤  High  growth  is  easy  to  deliver,  high  quality  growth  is  more  difficult.  

¤  Scaling  up  is  hard  to  do,  i.e.,  growth  is  more  difficult  to  sustain  as  
companies  get  larger.  

Aswath Damodaran

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 3.  Use  consistency  tests…  
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¨  While  you  can  not  grade  a  valuaJon  on  “correctness”  (since  
different  analysts    can  make  different  assumpJons  about  
growth  and  risk),  you  can  grade  it  on  consistency.  
¨  For  a  valuaJon  to  be  consistent,  your  esJmates  of  cash  flows  
have  to  be  consistent  with  your  discount  rate  definiJon.  
¤  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  cash  
flows  are  cash  flows  to  the  firm,  the  appropriate  discount  rate  is  the  
cost  of  capital.  
¤  Currency:  The  currency  in  which  the  cash  flows  are  esJmated  should  
also  be  the  currency  in  which  the  discount  rate  is  esJmated.  
¤  Nominal  versus  Real:  If  the  cash  flows  being  discounted  are  nominal  
cash  flows  (i.e.,  reflect  expected  inflaJon),  the  discount  rate  should  be  
nominal  

Aswath Damodaran

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 Tata  Motors:  In  Rupees  and  US  dollars  
17
(1.125)*(1.01/1.
04)-1 = .0925

Aswath Damodaran

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 4.  Draw  on  economic  first  principles  and  
mathemaJcal  limits…    
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¨  When  doing  valuaJon,  you  are  free  to  make  

assumpJons  about  how  your  company  will  evolve  
over  Jme  in  the  market  that  it  operates,  but  you  are  
not  free  to  violate  first  principles  in  economics  and  
mathemaJcs.  
¨  Put  differently,  there  are  assumpJons  in  valuaJon  
that  are  either  mathemaJcally  impossible  or  violate  
first  laws  of  economics  and  cannot  be  ever  jusJfied.  

Aswath Damodaran

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 And  the  “excess  return”  effect…  
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Stable  growth  rate   3M   Tata  Motors   Amazon   Twi6er  

0%   $70,409   435,686₹   $26,390   $23,111  
1%   $70,409   435,686₹   $28,263   $24,212  
2%   $70,409   435,686₹   $30,595   $25,679  
3%   $70,409   435,686₹   $33,594    
4%     435,686₹   $37,618    
5%     435,686₹   $43,334    
      $52,148    
Riskfree  rate   3.72%   5%   6.60%   2.70%  
ROIC   6.76%   10.39%   20%   12.00%  
Cost  of  capital   6.76%   10.39%   9.61%   8.00%  

Aswath Damodaran

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 5.  Use  the  market  as  a  crutch…  ERP  as  an  
illustraJon  
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 "        
Arithmetic Average" Geometric Average"
 " Stocks - T. Bills" Stocks - T. Bonds" Stocks - T. Bills" Stocks - T. Bonds"
Historical
1928-2012" 7.65%" 5.88%" 5.74%" 4.20%"
 " 2.20%" 2.33%"  "  " premium !
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%"  "  "
In 2012, the actual cash
returned to stockholders was After year 5, we will assume that
Analysts expect earnings to grow 7.67% in 2013, 7.28% in 2014,
72.25. Using the average total earnings on the index will grow at
scaling down to 1.76% in 2017, resulting in a compounded annual
yield for the last decade yields 1.76%, the same rate as the entire
growth rate of 5.27% over the next 5 years. We will assume that
69.46 economy (= riskfree rate).
dividends & buybacks will tgrow 5.27% a year for the next 5 years.

73.12 76.97 81.03 85.30 89.80 Data Sources:

Dividends and Buybacks
last year: S&P
73.12 76.97 81.03 85.30 89.80 89.80(1.0176) Expected growth rate:
January 1, 2013 1426.19 = + + + + +
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (r −.0176)(1+ r)5
2 3 4 5
S&P, Media reports,
S&P 500 is at 1426.19 Factset, Thomson-
Adjusted Dividends & Buybacks Expected Return on Stocks (1/1/13) = 7.54% Reuters
for base year = 69.46 T.Bond rate on 1/1/13 = 1.76%
Equity Risk Premium = 7.54% - 1.76% = 5.78%

Aswath Damodaran

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 Andorra   1.95%   7.70%  
Austria   0.00%   5.75%   Albania   6.75%   12.50%  
Country Risk Premiums! Belgium   1.20%   6.95%   Armenia   4.73%   10.48%  
Cyprus   16.50%   22.25%   Azerbaijan   3.38%   9.13%  
July 2013! Denmark   0.00%   5.75%   Belarus   10.13%   15.88%  
Finland   0.00%   5.75%   Bosnia   10.13%   15.88%  
Bulgaria   3.00%   8.75%   Bangladesh   5.40%   11.15%  
France   0.45%   6.20%  
CroaJa   4.13%   9.88%   Cambodia   8.25%   14.00%  
Germany   0.00%   5.75%  
Greece   10.13%   15.88%   Czech  Republic   1.43%   7.18%   China   1.20%   6.95%  
Iceland   3.38%   9.13%   Estonia   1.43%   7.18%   Fiji   6.75%   12.50%  
Ireland   4.13%   9.88%   Georgia   5.40%   11.15%   Hong  Kong   0.45%   6.20%  
Isle  of  Man   0.00%   5.75%   Hungary   4.13%   9.88%   India   3.38%   9.13%  
Italy   3.00%   8.75%   Kazakhstan   3.00%   8.75%   Indonesia   3.38%   9.13%  
Liechtenstein   0.00%   5.75%   Latvia   3.00%   8.75%   Japan   1.20%   6.95%  
Luxembourg   0.00%   5.75%   Lithuania   2.55%   8.30%  
Korea   1.20%   6.95%  
Malta   1.95%   7.70%   Macedonia   5.40%   11.15%  
Canada   0.00%   5.75%   Macao   1.20%   6.95%  
Moldova   10.13%   15.88%  
United  States     0.00%   5.75%   Netherlands   0.00%   5.75%   Malaysia   1.95%   7.70%  
Montenegro   5.40%   11.15%  
Norway   0.00%   5.75%   MauriJus   2.55%   8.30%  
North  America   0.00%   5.75%   Portugal   5.40%   11.15%  
Poland   1.65%   7.40%  
Romania   3.38%   9.13%   Mongolia   6.75%   12.50%  
Spain   3.38%   9.13%  
Russia   2.55%   8.30%   Pakistan   12.00%   17.75%  
Sweden   0.00%   5.75%  
Serbia   5.40%   11.15%   Papua  NG   6.75%   12.50%  
Switzerland   0.00%   5.75%  
Slovakia   1.65%   7.40%   Philippines   4.13%   9.88%  
ArgenJna   10.13%   15.88%   Turkey   3.38%   9.13%  
Slovenia   4.13%   9.88%   Singapore   0.00%   5.75%  
Belize   14.25%   20.00%   UK   0.45%   6.20%   Uganda   6.75%   12.50%  
W.  Europe   1,.22%   6.97%   Sri  Lanka   6.75%   12.50%  
Bolivia   5.40%   11.15%   Ukraine   10.13%   15.88%  
Taiwan   1.20%   6.95%  
Brazil   3.00%   8.75%  
Angola   5.40%   11.15%   Thailand   2.55%   8.30%  
Chile   1.20%   6.95%   E.  Europe/Russia   3.13%   8.88%  
Benin   8.25%   14.00%   Vietnam   8.25%   14.00%  
Colombia   3.38%   9.13%   Botswana   1.65%   7.40%  
Costa  Rica   3.38%   9.13%  
Asia   1.77%   7.52%  
Burkina  Faso   8.25%   14.00%   Bahrain   2.55%   8.30%  
Ecuador   12.00%   17.75%   Cameroon   8.25%   14.00%   Israel   1.43%   7.18%  
El  Salvador   5.40%   11.15%   Cape  Verde   6.75%   12.50%   Jordan   6.75%   12.50%  
Guatemala   4.13%   9.88%   Egypt   12.00%   17.75%   Kuwait   0.90%   6.65%  
Honduras   8.25%   14.00%   Gabon   5.40%   11.15%   Australia   0.00%   5.75%  
Lebanon   6.75%   12.50%  
Mexico   2.55%   8.30%   Ghana   6.75%   12.50%  
Oman   1.43%   7.18%   Cook  Islands   6.75%   12.50%  
Nicaragua   10.13%   15.88%   Kenya   6.75%   12.50%  
Qatar   0.90%   6.65%   New  Zealand   0.00%   5.75%  
Panama   3.00%   8.75%   Morocco   4.13%   9.88%  
Saudi  Arabia   1.20%   6.95%  
Mozambique   6.75%   12.50%   Australia  &  NZ   0.00%   5.75%  
Paraguay   5.40%   11.15%   UAE   0.90%   6.65%  
Namibia   3.38%   9.13%  
Peru   3.00%   8.75%   Middle  East   1.38%   7.13%  
Nigeria   5.40%   11.15%  
Suriname   5.40%   11.15%  
Rwanda   8.25%   14.00%  
Uruguay   3.38%   9.13%   Senegal   6.75%   12.50%   Black #: Total ERP

Venezuela   6.75%   12.50%   South  Africa   2.55%   8.30%   Red #: Country risk premium

La+n  America   3.94%   9.69%   Tunisia   4.73%   10.48%   AVG: GDP weighted average

Zambia   6.75%   12.50%  
Africa   5.90%   11.65%  
 6.  Draw  on  the  law  of  large  numbers…  
22

¨  To  esJmate  the  beta  

for  Tata  Motors  
¤  Unlevered  beta  for  
automobile  company  =  
0.98  
¤  D/E  raJo  for  Tata  
Motors  =  33.87%  
¤  Marginal  tax  rate  in  
India  =  33.99%  
¤  Levered  beta  =  0.98  (1+  
(1-­‐.3399)(.3387))  =  1.20  
Aswath Damodaran

 7.  Don’t  let  the  discount  rate  become  the  
receptacle  for  all  your  uncertainty…  
23

Aswath Damodaran

23

 ContrasJng  ways  of  dealing  with  survival  risk…  
24

¨  The  Venture  Capital  approach:    In  the  venture  capital  

approach,  you  hike  the  “discount  rate”  well  above  what  
would  be  appropriate  for  a  going  concern  and  then  use  this  
“target”  rate  to  discount  your  “exit  value”  (which  is  
esJmated  using  a  mulJple  and  forward  earnings).  
¤  Value    =  (Forward  Earnings  in  year  n  *  Exit  mulJple)/  (1+  target  rate)n  
¨  The  decision  tree  approach:    
¤  Value  the  business  as  a  “going  concern”,  with  a  rate  of  return  
appropriate  for  a  “going  concern”.    
¤  EsJmate  the  probability  of  survival  (and  failure)  and  the  value  of  the  
business  in  the  event  of  failure.  
¤  Value  =    Going  concern  value  (Probability  of  survival)  +  LiquidaJon  
value  (Probability  of  failure)  

Aswath Damodaran

24

25
Aswath Damodaran

 8.  Confront  uncertainty,  if  you  can…    
26

Aswath Damodaran

26

 With  the  consequences  for  equity  value…  
27

Aswath Damodaran

27

 9.  Don’t  look  for  precision..    
28

¨  No  ma?er  how  careful  you  are  in  gedng  your  inputs  
and  how  well  structured  your  model  is,  your  
esJmate  of  value  will  change  both  as  new  
informaJon  comes  out  about  the  company,  the  
business  and  the  economy.  
¨  As  informaJon  comes  out,  you  will  have  to  adjust  
and  adapt  your  model  to  reflect  the  informaJon.  
Rather  than  be  defensive  about  the  resulJng  
changes  in  value,  recognize  that  this  is  the  essence  
of  risk.    
Aswath Damodaran

28

 Reinvestment:
9b. Amazon in January 2001 Cap ex includes acquisitions
Stable Growth
Current Current Working capital is 3% of revenues
Revenue Margin: Stable Stable
Stable Operating ROC=16.94%
$ 2,465 -34.60% Revenue Margin: Reinvest 29.5%
Sales Turnover Competitiv Growth: 5% 9.32% of EBIT(1-t)
Ratio: 3.02 e
EBIT Advantages
-853m Revenue Expected
Growth: Margin: Terminal Value= 1064/(.0876-.05)
NOL: 25.41% -> 9.32% =$ 28,310
1,289 m

Term. Year
1 2 3 4 5 6 7 8 9 10
Revenues $4,314 $6,471 $9,059 $11,777 $14,132 $16,534 $18,849 $20,922 $22,596 $23,726 $24,912
EBIT -$545 -$107 $347 $774 $1,123 $1,428 $1,692 $1,914 $2,087 $2,201 $2,302
EBIT(1-t) -$545 -$107 $347 $774 $1,017 $928 $1,100 $1,244 $1,356 $1,431 $1,509
- Reinvestment $612 $714 $857 $900 $780 $796 $766 $687 $554 $374 $ 445
FCFF -$1,157 -$822 -$510 -$126 $237 $132 $333 $558 $802 $1,057 $1,064
Value of Op Assets $ 8,789
+ Cash & Non-op $ 1,263 1 2 3 4 5 6 7 8 9 10
= Value of Firm $10,052 Forever
- Value of Debt $ 1,879 Debt Ratio 27.27% 27.27% 27.27% 27.27% 27.27% 24.81% 24.20% 23.18% 21.13% 15.00%
= Value of Equity $ 8,173 Beta 2.18 2.18 2.18 2.18 2.18 1.96 1.75 1.53 1.32 1.10
- Equity Options $ 845 Cost of Equity 13.81% 13.81% 13.81% 13.81% 13.81% 12.95% 12.09% 11.22% 10.36% 9.50%
Value per share $ 20.83 AT cost of debt 10.00% 10.00% 10.00% 10.00% 9.06% 6.11% 6.01% 5.85% 5.53% 4.55%
Cost of Capital 12.77% 12.77% 12.77% 12.77% 12.52% 11.25% 10.62% 9.98% 9.34% 8.76%

Cost of Equity Cost of Debt Weights

13.81% 6.5%+3.5%=10.0% Debt= 27.3% -> 15%
Tax rate = 0% -> 35%

Riskfree Rate:
T. Bond rate = 5.1% Amazon.com
Risk Premium
Beta 4% January 2001
+ 2.18-> 1.10 X Stock price = $14

29
Aswath Damodaran
Internet/ Operating Current Base Equity Country Risk
Retail Leverage D/E: 37.5% Premium Premium
 To  illustrate:  Your  mistakes  versus  market  
mistakes..  
30
Amazon: Value and Price

$90.00

$80.00

$70.00

$60.00

$50.00

Value per share

$40.00 Price per share

$30.00

$20.00

$10.00

$0.00
2000 2001 2002 2003
Time of analysis
Aswath Damodaran

30

 10.  You  can  make  mistakes,  but  try  to  keep  bias  
out..    
31

¨  When  you  are  wrong  on  individual  company  valuaJons,  as  
you  inevitably  will  be,  recognize  that  while  those  mistakes  
may  cause  the  value  to  be  very  different  from  the  price  for  an  
individual  company,  the  mistakes  should  average  out  across  
companies.  
¤  Put  differently,  if  you  are  an  investor,  you  have  can  make  the  “law  of  
large  numbers”  work  for  you  by  diversifying  across  companies,  with  
the  degree  of  diversificaJon  increasing  as  uncertainty  increases.  
¨  If  you  are  “biased”  on  individual  company  valuaJons,  your  
mistakes  will  not  average  out,  no  ma?er  how  diversified  you  
get.  
¨  Bo?om  line:  You  are  be?er  off  making  large  mistakes  and  
being  unbiased  than  making  smaller  mistakes,  with  bias.  
Aswath Damodaran

31

 And  don’t  forget:  It  is  not  just  the  value  that  you  
are  uncertain  about…  
32

Tools for pricing

Tools for intrinsic analysis Tools for "the gap" - Multiples and comparables
- Discounted Cashflow Valuation (DCF) - Behavioral finance - Charting and technical indicators
- Intrinsic multiples - Price catalysts - Pseudo DCF
- Book value based approaches
- Excess Return Models

Value of cashflows, INTRINSIC THE GAP

adjusted for time PRICE
VALUE Value Is there one? Price
and risk Will it close?

Drivers of intrinsic value

Drivers of "the gap" Drivers of price
- Cashflows from existing assets
- Information - Market moods & momentum
- Growth in cash flows
- Liquidity - Surface stories about fundamentals
- Quality of Growth
- Corporate governance

Aswath Damodaran

32

 And  here  is  how  it  plays  out…  
33

The value process

The  Pricing  Process:  Apple  
My valuation of Apple in January 2013
90.0%  

80.0%  

70.0%  

60.0%  

50.0%  

40.0%  

30.0%  

20.0%  

My valuation of Apple with revenue growth of 6% 10.0%  

(Normal, σ=3%), target pre-tax margin of 30% 0.0%  

(Uniform,25%-35%) and cost of capital of 12.5% 1  month   6  months   1  year   5  years   10  years  

(Triangle, 11-14%). There is a 90% chance that Gap  widens   Gap  stays  same   Gap  narrows  
Apple is undervalued at $440/share.

Aswath Damodaran

 Strategies  for  managing  the  risk  in  the  “closing”  
of  the  gap  
34

¨  The  “karmic”  approach:  In  this  one,  you  buy  (sell  short)  under  
(over)  valued  companies  and  sit  back  and  wait  for  the  gap  to  
close.  You  are  implicitly  assuming  that  given  Jme,  the  market  
will  see  the  error  of  its  ways  and  fix  that  error.  
¨  The  catalyst  approach:  For  the  gap  to  close,  the  price  has  to  
converge  on  value.  For  that  convergence  to  occur,  there  
usually  has  to  be  a  catalyst.    
¤  If  you  are  an  acJvist  investor,  you  may  be  the  catalyst  yourself.  In  fact,  
your  act  of  buying  the  stock  may  be  a  sufficient  signal  for  the  market  
to  reassess  the  price.  
¤  If  you  are  not,  you  have  to  look  for  other  catalysts.  Here  are  some  to  
watch  for:  a  new  CEO  or  management  team,  a  “blockbuster”  new  
product  or  an  acquisiJon  bid  where  the  firm  is  targeted.  

Aswath Damodaran

34