Two Sides to Value!


Corporate Finance and Valuation

Aswath Damodaran
http://www.damodaran.com

Tata Group, May 2010

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A motive for valuation and corporate nance

" One hundred thousand lemmings cannot be wrong"

Grafti

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Lets start with an accounting balance sheet

The Balance Sheet

Assets
Long Lived Real Assets Short-lived Assets Investments in securities & assets of other firms Assets which are not physical, like patents & trademarks Fixed Assets Current Assets Financial Investments Intangible Assets Current Liabilties Debt Other Liabilities Equity

Liabilities
Short-term liabilities of the firm Debt obligations of firm Other long-term obligations Equity investment in firm

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And replace it with a nancial balance sheet

Assets
Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Expected Value that will be created by future investments Assets in Place Debt

Liabilities
Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible

Growth Assets

Equity

Residual Claim on cash flows Significant Role in management Perpetual Lives

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Corporate Finance: First Principles

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Connecting to Valuation

Growth from new investments Growth created by making new investments; function of amount and quality of investments Current Cashflows These are the cash flows from existing investment,s, net of any reinvestment needed to sustain future growth. They can be computed before debt cashflows (to the firm) or after debt cashflows (to equity investors).

Efficiency Growth Growth generated by using existing assets better Terminal Value of firm (equity)

Expected Growth during high growth period

Stable growth firm, with no or very limited excess returns

Length of the high growth period Since value creating growth requires excess returns, this is a function of - Magnitude of competitive advantages - Sustainability of competitive advantages

Cost of financing (debt or capital) to apply to discounting cashflows Determined by - Operating risk of the company - Default risk of the company - Mix of debt and equity used in financing

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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.

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Valuation: The Big Picture

If you get the big picture, the details will follow

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Discounted Cash Flow Valuation

What is it: In discounted cash ow valuation, the value of an asset is the present value of the expected cash ows on the asset.
Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash ows, growth and risk.
Information Needed: To use discounted cash ow valuation, you need

to estimate the life of the asset
to estimate the cash ows during the life of the asset
to estimate the discount rate to apply to these cash ows to get present value

Market Inefciency: 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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DCF Choices: Equity Valuation versus Firm Valuation

Firm Valuation: Value the entire business

Assets
Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Expected Value that will be created by future investments Assets in Place Debt

Liabilities
Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible

Growth Assets

Equity

Residual Claim on cash flows Significant Role in management Perpetual Lives

Equity valuation: Value just the equity claim in the business

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DISCOUNTED CASHFLOW VALUATION

Cashflow to Firm EBIT (1-t) - (Cap Ex - Depr) - Change in WC = FCFF Expected Growth Reinvestment Rate * Return on Capital

Firm is in stable growth: Grows at constant rate forever

Value of Operating Assets + Cash & Non-op Assets = Value of Firm - Value of Debt = Value of Equity

Terminal Value= FCFF n+1 /(r-g n) FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn ......... Forever Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Equity

Cost of Debt (Riskfree Rate + Default Spread) (1-t)

Weights Based on Market Value

Riskfree Rate : - No default risk - No reinvestment risk - In same currency and in same terms (real or nominal as cash flows

Beta - Measures market risk

Risk Premium - Premium for average risk investment

Type of Business

Operating Leverage

Financial Leverage

Base Equity Premium

Country Risk Premium

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Tata Chemicals: April 2010

Current Cashflow to Firm EBIT(1-t) : Rs 5,833 - Nt CpX Rs 5,832 - Chg WC Rs 4,229 = FCFF - Rs 4,228 Reinv Rate = (5832+4229)/5833 = 172.50% Tax rate = 31.5% Return on capital = 10.35% Op. Assets Rs 57,128 + Cash: 6,388 + Other NO 56,454 - Debt 32,374 =Equity 87,597 Value/Share Rs 372

Average reinvestment rate from 2007-09: 56.5% Reinvestment Rate 56.5% Expected Growth in EBIT (1-t) .565*.1035=0.0585 5.85%

Return on Capital 10.35%

Stable Growth g = 5%; Beta = 1.00 Country Premium= 3% Tax rate = 33.99% Cost of capital = 9.78% ROC= 9.78%; Reinvestment Rate=g/ROC =5/ 9.78= 51.14%

Rs Cashflows Year EBIT (1-t) - Reinvestment FCFF 1 INR 6,174 INR 3,488 INR 2,685 2 INR 6,535 INR 3,692 INR 2,842

Terminal Value5= 3831/(.0978-.05) = Rs 80,187 3 INR 6,917 INR 3,908 INR 3,008 4 INR 7,321 INR 4,137 INR 3,184 5 INR 7,749 INR 4,379 INR 3,370 7841 4010 3831

Discount at $ Cost of Capital (WACC) = 13.82% (.695) + 6.6% (0.305) = 11.62%

Cost of Equity 13.82%

Cost of Debt (5%+ 2%+3)(1-.3399) = 6.6%

Weights E = 69.5% D = 30.5%

On April 1, 2010 Tata Chemicals price = Rs 314

Riskfree Rate: Rs Riskfree Rate= 5%

Beta 1.21

Mature market premium 4.5% Firms D/E Ratio: 42%

Lambda 0.75

Country Equity Risk Premium 4.50% Rel Equity Mkt Vol 1.50

Unlevered Beta for Sectors: 0.95

Country Default Spread 3%

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Tata Steel: April 2010

Current Cashflow to Firm EBIT(1-t) : Rs 60,213 - Nt CpX Rs 61,620 - Chg WC - Rs 3,658 = FCFF Rs 2251 Reinv Rate = (61620-3658)/60213= 96.26% Tax rate = 28.90% Return on capital = 13.42% Op. Assets Rs501,661 + Cash: 15,906 + Other NO 467,315 - Debt 235,697 =Equity 749,184 Value/Share Rs 844

Average reinvestment rate from 2005-09: 38.1% Reinvestment Rate 38.1% Expected Growth in EBIT (1-t) .381*.1342=0.0511 5.11%

Return on Capital 13.42%

Stable Growth g = 5%; Beta = 1.20 Country Premium= 3% Tax rate = 33.99% Cost of capital = 11.16% ROC= 11.16%; Reinvestment Rate=g/ROC =5/ 11.16= 44.8%

Year EBIT (1-t) - Reinvestment FCFF

Rs Cashflows 1 2 INR 63,292 INR 66,529 INR 24,111 INR 25,344 INR 39,181 INR 41,185

Terminal Value5= 41572(.1116-.05) = Rs 701,444 3 INR 69,931 INR 26,640 INR 43,291 4 INR 73,507 INR 28,002 INR 45,504 5 INR 77,266 INR 29,434 INR 47,831 75,316 33,744 41,572

Discount at $ Cost of Capital (WACC) = 17.02% (.704) + 6.11% (0.296) = 13.79%

Cost of Equity 17.02%

Cost of Debt (5%+ 1.25%+3%)1-.3399) = 6.11%

Weights E = 70.4% D = 29.6%

On April 1, 2010 Tata Steel price = Rs 632

Riskfree Rate: Rs Riskfree Rate= 5%

Beta 1.57

Mature market premium 4.5% Firms D/E Ratio: 42%

Lambda 1.10

Country Equity Risk Premium 4.50% Rel Equity Mkt Vol 1.50

Unlevered Beta for Sectors: 1.23

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Country Default Spread 3%

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Tata Motors: April 2010

Current Cashflow to Firm Reinvestment Rate EBIT(1-t) : Rs 20,116 70% - Nt CpX Rs 31,590 - Chg WC Rs 2,732 = FCFF - Rs 14,205 Reinv Rate = (31590+2732)/20116 = 170.61%; Tax rate = 21.00% Return on capital = 17.16%

Average reinvestment rate from 2005-09: 179.59%; without acquisitions: 70% Expected Growth from new inv. .70*.1716=0.1201

Return on Capital 17.16%

Stable Growth g = 5%; Beta = 1.00 Country Premium= 3% Cost of capital = 10.39% Tax rate = 33.99% ROC= 12%; Reinvestment Rate=g/ROC =5/ 12= 41.67%

Rs Cashflows Op. Assets Rs231,914 + Cash: 11418 + Other NO 140576 - Debt 109198 =Equity 274,710 Value/Share Rs 665
Year EBIT (1-t) - Reinvestment FCFF 1 22533 15773 6760 2 25240 17668 7572 3 28272 19790 8482 4 31668 22168 9500 5 35472 24830 10642 6 39236 25242 13994 7 42848 25138 17711

Terminal Value5= 26412/(.1039-.05) = Rs 489,813

8 46192 24482 21710 9 49150 23264 25886 10 51607 21503 30104

45278 18866 26412

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 Weights 14.00% (5%+ 4.25%+3)(1-.3399) On April 1, 2010 E = 74.7% D = 25.3% = 8.09% Tata Motors price = Rs 781

Riskfree Rate: Rs Riskfree Rate= 5%

Beta 1.20

Mature market premium 4.5% Firms D/E Ratio: 33%

Lambda 0.80

Country Equity Risk Premium 4.50% Rel Equity Mkt Vol 1.50

Unlevered Beta for Sectors: 1.04

Country Default Spread 3%

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TCS: April 2010

Current Cashflow to Firm EBIT(1-t) : Rs 43,420 - Nt CpX Rs 5,611 - Chg WC Rs 6,130 = FCFF Rs 31,679 Reinv Rate = (56111+6130)/43420= 27.04%; Tax rate = 15.55% Return on capital = 40.63%

Average reinvestment rate from 2005--2009 =56.73%% Reinvestment Rate 56.73% Expected Growth from new inv. 5673*.4063=0.2305

Return on Capital 40.63%

Stable Growth g = 5%; Beta = 1.00 Country Premium= 3% Cost of capital = 9.52% Tax rate = 33.99% ROC= 15%; Reinvestment Rate=g/ROC =5/ 15= 33.33%

Rs Cashflows Op. Assets 1,355,361 + Cash: 3,188 + Other NO 66,140 - Debt 505 =Equity 1,424,185 Value/Share Rs 728
Year EBIT (1-t) - Reinvestment FCFF 1 53429 30308 23120 2 65744 37294 28450 3 80897 45890 35007 4 99544 56468 43076 5 122488 69483 53005 6 146299 76145 70154

Terminal Value5= 118655/(.0952-.05) = 2,625,649

7 169458 80271 89187 8 190165 81183 108983 9 206538 78509 128029 10 216865 72288 144577

177982 59327 118655

Discount at $ Cost of Capital (WACC) = 10.63% (.999) + 5.61% (0.001) = 10.62% Growth declines to 5% and cost of capital moves to stable period level. Weights E = 99.9% D = 0.1% On April 1, 2010 TCS price = Rs 841

Cost of Equity 10.63%

Cost of Debt (5%+ 0.5%+3)(1-.3399) = 5.61%

Riskfree Rate: Rs Riskfree Rate= 5%

Beta 1.05

Mature market premium 4.5% Firms D/E Ratio: 0.1%

Lambda 0.20

Country Equity Risk Premium 4.50% Rel Equity Mkt Vol 1.50

Unlevered Beta for Sectors: 1.05

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Country Default Spread 3%

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Valuation: The Details

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I. Estimating Discount Rates

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Cost of Equity

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A. The Riskfree Rate

On a riskfree asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return.
For an investment to be riskfree, then, it has to have

No default risk
No reinvestment risk

1.

2.

Time horizon matters: Thus, the riskfree rates in valuation will depend upon when the cash ow is expected to occur and will vary across time.
Not all government securities are riskfree: Some governments face default risk and the rates on bonds issued by them will not be riskfree.

For a rate to be riskfree in valuation, it has to be long term, default free and currency matched (to the cash ows)

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Estimating the Riskfree Rate in Rupees and US dollars..

a) b) c) d)

The Indian government had 10-year Rupee bonds outstanding, with a yield to maturity of about 8% on April 1, 2010. In January 2010, the Indian government had a local currency sovereign rating of Ba2. The typical default spread (over a default free rate) for Ba2 rated country bonds in early 2010 was 3%.
The riskfree rate in Indian Rupees is
The yield to maturity on the 10-year bond (8%)
The yield to maturity on the 10-year bond + Default spread (8%+3% =11%)
The yield to maturity on the 10-year bond Default spread (8%-3% = 5%)
None of the above
If you wanted to do you entire valuation in US dollars, what would you use as your riskfree rate?
How would your answer change if you were doing the analysis in Euros?

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A Euro Riskfree Rate

Figure 4: Goverment Bond Rates in Euros

6.00%

5.00%

4.00%

3.00%
2-year
2.00%
10-year

1.00%

0.00%

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Why do riskfree rates vary?

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b. Equity Risk Premiums

The historical premium is the premium that stocks have historically earned over riskless securities.
Practitioners never seem to agree on the premium; 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! Stocks ! Stocks ! T. Bills! T. Bonds! 7.53%! 6.03%! (2.28%)! (2.40%)! 5.48%! 3.78%! (2.42%)! (2.71%)! -1.59%! -5.47%! (6.73%)! (9.22%)! Geometric Average! Stocks ! Stocks ! T. Bills! T. Bonds! 5.56%! 4.29%! 4.09%! -3.68%! 2.74%! -7.22%!

1928-2009! 1960-2009! 2000-2009!

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The perils of trusting the past.

Noisy estimates: Even with long time periods of history, the risk premium that you derive will have substantial standard error. For instance, if you go back to 1928 (about 80 years of history) and you assume a standard deviation 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 equity markets were among the most successful of the global economies that you could have invested in early in the century.
These problems get exacerbated in markets like India, where there is far less historical data and survivor bias is worse.

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An Alternative: Watch what I pay, not what I say

In January 2010, the S&P 500 was trading at 1115.10. You can back out the return that investors can expect to pay from the index and expected cash ows

In 2010, the actual cash returned to stockholders was 40.38. That was down about 40% from 2008 levels.

Analysts expect earnings to grow 21% in 2010, resulting in a compounded annual growth rate of 7.2% over the next 5 years. We will assume that dividends & buybacks will keep pace. 46.40 49.74 53.32

After year 5, we will assume that earnings on the index will grow at 3.84%, the same rate as the entire economy (= riskfree rate). 57.16

43.29

January 1, 2010 S&P 500 is at 1115.10 Adjusted Dividends & Buybacks for 2008 = 40.38

Expected Return on Stocks (1/1/10) T.Bond rate on 1/1/10 Equity Risk Premium = 8.20% - 3.84%

= 8.20% = 3.84 % = 4.36%

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Implied Premiums in the US

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The Anatomy of a Crisis: Implied ERP from September 12, 2008 to January 1, 2009

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Implied Premium for Sensex: April 2010

Level of the Index = 17559

FCFE on the Index = 3.5% (Estimated FCFE for companies in index as % of market value of equity)
Other parameters

Riskfree Rate = 5% (Rupee)
Expected Growth (in Rupee)
Next 5 years = 20% (Used expected growth rate in Earnings)
After year 5 = 5%

Solving for the expected return:

Expected return on Equity = 11.72%
Implied Equity premium for India =11.72% - 5% = 6.72%

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A solution: Estimate a mature market premium with an added country risk premium

Assume that the equity risk premium for the US and other mature equity markets is 4.5%. You could then add on an additional premium for investing in an emerging markets.
Two ways of estimating the country risk premium:

Default spread on Country Bond: In this approach, the country equity risk premium is set equal to the default spread of the bond issued by the country.

Equity Risk Premium for India = 4.5% + 3% = 7.5%

Adjusted for equity risk: The country equity risk premium is based upon the volatility of the market in question relative to U.S market.

Total equity risk premium = Risk PremiumUS* Country Equity / Country Bond
Standard Deviation in Sensex = 30%
Standard Deviation in Indian government bond= 20%
Default spread on Indian Bond= 3%
Total equity risk premium for India = 4.5% + 3% (30/20) = 9%

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Aswath Damodaran!

Austria [1]
Belgium [1]
Cyprus [1]
Denmark
Finland [1]
France [1]
Germany [1]
Greece [1]
Iceland
Ireland [1]
Italy [1]
Canada
4.50%
Malta [1]
Mexico
6.90%
Netherlands [1]
United States of America
4.50%
Norway
Portugal [1]
Spain [1]
Sweden
Argentina
14.25%
Switzerland
Belize
14.25%
United Bolivia
12.75%
Kingdom
Brazil
7.50%
Chile
5.85%
Colombia
7.50%
Costa Rica
8.25%
Ecuador
19.50%
El Salvador
19.50%
Guatemala
8.25%
Honduras
12.75%
Nicaragua
14.25%
Panama
8.25%
Paraguay
14.25%
Peru
7.50%
Uruguay
9.75%
Venezuela
11.25%

Country Risk Premiums

January 2010

4.50%
4.95%
5.63%
4.50%
4.50%
4.50%
4.50%
6.08%
7.50%
4.95%
5.40%
5.85%
4.50%
4.50%
5.40%
4.50%
4.50%
4.50%
4.50%

Albania
Armenia
Azerbaijan
Belarus
Bosnia and Herzegovina
Bulgaria
Croatia
Czech Republic
Estonia
Hungary
Kazakhstan
Latvia
Lithuania
Moldova
Montenegro
Poland
Romania
Russia
Slovakia
Slovenia [1]
Turkmenistan
Ukraine

11.25%
9.00%
8.25%
11.25%
12.75%
7.50%
7.50%
5.85%
5.85%
6.90%
7.20%
7.50%
6.90%
15.75%
9.75%
6.08%
7.50%
6.90%
5.85%
5.40%
12.75%
12.75%

Bahrain
Israel
Jordan
Kuwait
Lebanon
Oman
Qatar
Saudi Arabia
United Arab Emirates

6.08%
Australia
5.85%
New Zealand
7.50%
5.40%
12.75%
6.08%
5.40%
5.85%
5.40%

4.50%
4.50%

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From Country Risk Premiums to Corporate Risk premiums

Approach 1: Assume that every company in the country is equally exposed to country risk. In this case,
E(Return) = Riskfree Rate + Country ERP + Beta (US premium)
Approach 2: Assume that a companys exposure to country risk is similar to its exposure to other market risk.
E(Return) = Riskfree Rate + Beta (US premium + Country ERP)
Approach 3: Treat country risk as a separate risk factor and allow rms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales)
E(Return)=Riskfree Rate+ (US premium) + (Country ERP)
Country ERP: Additional country equity risk premium

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Estimating Company Exposure to Country Risk

Different companies should be exposed to different degrees to country risk. For instance, a Korean rm that generates the bulk of its revenues in Western Europe and the US should be less exposed to country risk than one that generates all its business within Korea.
The factor measures the relative exposure of a rm to country risk. One simplistic solution would be to do the following:

= % of revenues domesticallyrm/ % of revenues domesticallyavg rm

Consider two rms HyundaI Heavy Industries and Megastudy, both Korean companies. The former gets about 20% of its revenues in Korea and the latter gets 100%. The average Korean rm gets about 80% of its revenues in Korea:

Hyundai = 20%/80% = 0.25

Megastudy = 100%/80% = 1.25
There are two implications

A companys risk exposure is determined by where it does business and not by where it is located
Firms might be able to actively manage their country risk exposures

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Estimating lambdas: Tata Group

Tata Chemicals % of production/ operations in India % of revenues in India Lambda

Tata Steel

Tata Motors

TCS

High

High

High

Low

75% 0.75 Gets 77% of its raw material from nondomestic sources,

88.83% 1.10

91.37%

7.62%

Other factors

0.80 0.20 Recently acquired While its operations are Jaguar/Land Rover, with spread all over, it significant non- uses primarily domestic sales Indian personnel

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Estimating Beta

The standard procedure for estimating betas is to regress stock 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 of the stock, and measures the riskiness of the stock.
This beta has three problems:

It has high standard error
It reects the rms business mix over the period of the regression, not the current mix
It reects the rms average nancial leverage over the period rather than the current leverage.

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A standard regression.. A beta for Tata Motors

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And another one..

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Determinants of Betas

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Bottom-up Betas

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Bottom Up Beta Estimates for Tata Companies

Tata Steel

Tata Chemicals Tata Motors TCS Business Chemicals & Software & Steel Automobiles Information Processing breakdown Fertilizers Unlevered beta 0.94 1.23 0.98 1.05 D/E Ratio 43.85% 42.03% 33.87% 0.03% Levered Beta 1.21 1.57 1.20 1.05

A closer look at Tata Chemicals

% of revenues Chemicals Fertilizers Company 42% 58% Unlevered Beta 1.05 0.86 0.94

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TCS: Geographical breakdown

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From Cost of Equity to Cost of Capital

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What is debt?

General Rule: Debt generally has the following characteristics:

Commitment to make xed payments in the future
The xed payments are tax deductible
Failure to make the payments can lead to either default or loss of control of the rm to the party to whom payments are due.

As a consequence, debt should include

Any interest-bearing liability, whether short term or long term.
Any lease obligation, whether operating or capital.

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Debt and Equity at the Tata Group

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Estimating the Cost of Debt

If the rm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate.
If the rm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt.
If the rm is not rated,

and it has recently borrowed long term from a bank, use the interest rate on the borrowing or
estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt

The cost of debt has to be estimated in the same currency as the cost of equity and the cash ows in the valuation.

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Estimating Synthetic Ratings

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
The interest coverage ratio can be linked to a debt rating, which in turn can provide an estimate of default spread and the cost of debt for a company.

Cost of debt = Riskfree Rate + Default spread for the company
In emerging markets, where governments themselves have default risk, the cost of debt for a company will include some or all of the default spread for the country.

Cost of debt = Riskfree Rate + Default spread for the country + Default spread for the company

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Interest Coverage Ratios, Ratings and Default Spreads

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Estimating the cost of debt for Tata companies

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Estimating Cost of Capital: Tata Group

Beta Lambda Cost of equity Synthetic rating Cost of debt Debt Ratio Cost of Capital Tata Chemicals 1.21 0.75 13.82% BBB 6.60% 30.48% 11.62% Tata Steel 1.57 1.10 17.02% A 6.11% 29.59% 13.79% Tata Motors 1.20 0.80 14.00% B+ 8.09% 25.30% 12.50% TCS 1.05 0.20 10.63% AAA 5.61% 0.03% 10.62%

Tata Chemicals: Divisional Costs of Capital

Chemicals Fertilizers Beta 1.35 1.11 Cost of equity 14.47% 13.37% Cost of debt 6.60% 6.60% Debt Ratio 30.48% 30.48% Cost of capital 12.07% 11.30%

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II. Estimating Cashows and Growth

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Dening Cashow

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From Reported to Actual Earnings

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Dealing with Operating Lease Expenses

Operating Lease Expenses are treated as operating expenses in computing operating income. In reality, operating lease expenses should be treated as nancing expenses, with the following 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 Asset
As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of Operating Leases.

Aswath Damodaran!

52!

R&D Expenses: Operating or Capital Expenses

Accounting standards require us to consider R&D as an operating 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 by adding up 1/5th of the R&D expense from ve years ago, 2/5th of the R&D expense from four years ago...:

Aswath Damodaran!

53!

What tax rate?

The tax rate that you should use in computing the after-tax operating income should be
The effective tax rate in the nancial statements (taxes paid/Taxable income)
The tax rate based upon taxes paid and EBIT (taxes paid/EBIT)
The marginal tax rate for the country in which the company operates
The weighted average marginal tax rate across the countries in which the company operates
None of the above
Any of the above, as long as you compute your after-tax cost of debt using the same tax rate

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54!

Tata Group: Tax Rates

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55!

Capital expenditures should include

Research and development expenses, once they have been re-categorized as capital expenses. The adjusted net cap ex will be

Adjusted Net Capital Expenditures = Net Capital Expenditures + Current years R&D expenses - Amortization of Research Asset

Acquisitions of other rms, since these are like capital expenditures. The adjusted net cap ex will be

Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other rms Amortization of such acquisitions
Two caveats:
1. Most rms do not do acquisitions every year. Hence, a normalized measure of acquisitions (looking at an average over time) should be used
2. The best place to nd acquisitions is in the statement of cash ows, usually categorized under other investment activities

Aswath Damodaran!

56!

Working Capital Investments

In accounting terms, the working capital is the difference between current assets (inventory, cash and accounts receivable) and current liabilities (accounts payables, short term debt and debt due within the next year)
A cleaner denition of working capital from a cash ow perspective is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable)
Any investment in this measure of working capital ties up cash. Therefore, any increases (decreases) in working capital will reduce (increase) cash ows in that period.
When forecasting future growth, it is important to forecast the effects of such growth on working capital needs, and building these effects into the cash ows.

Aswath Damodaran!

57!

Breaking down aggregate reinvestment over last 5 years: Tata Group

Aswath Damodaran!

58!

Estimating FCFF: Tata Group

Tax rate =21%

Normalized EBIT = Normalized EBT + Interest Expense in 2009

= Rs 18,727 + Rs 6,737 m= Rs 25,464 m
Normalized EBT = Revenues in 2009 * Average Margin


= Rs 265,868 m* 7.04% = Rs 18,727 m

2004
Revenues
EBT
EBT Margin
Aswath Damodaran! 2005
2006
2007
2008
Total

INR 206,487
INR 242,905
INR 320,648
INR 335,771
INR 295,252
INR 1,401,063
INR 16,519
INR 20,534
INR 25,732
INR 25,765
INR 10,138
INR 98,688
8.00%
8.45%
8.02%
7.67%
3.43%
7.04%
59!

Growth in Earnings

Look at the past

The historical growth in earnings per share is usually a good starting point for growth estimation

Look at what others are estimating

Analysts estimate growth in earnings per share for many rms. It is useful to know what their estimates are.

Look at fundamentals

Ultimately, all growth in earnings can be traced to two fundamentals - how much the rm is investing in new projects, and what returns these projects are making for the rm.

Aswath Damodaran!

60!

The Determinants of Growth

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61!

Measuring Return on Capital (Equity)

Aswath Damodaran!

62!

Measuring Return on Capital at Tata Group

Tata Chemicals Tata Steel INR INR 8,515 84,683 31.50% 28.90% INR INR 5,833 60,213 INR 180,217 INR 273,007 INR 4,650 INR 448,574 13.42% Tata Motors (actual) INR 17,527 21.00% INR 13,846 Tata Motors (normalized) INR 25,464 21.00% INR 20,117

EBIT Tax rate EBIT (1-t)

TCS INR 51,414 15.55% INR 43,420

BV of Debt

INR 23,438

INR 62,805 INR 78,395 INR 23,973 INR 117,227 11.81%

INR 62,805 INR 78,395 INR 23,973 INR 117,227 17.16%

BV of Equity INR 35,717 Cash INR 2,776 Invested INR 56,379 Capital ROC 10.35%

INR 183 INR 110,048 INR 3,370 INR 106,861 40.63%

Aswath Damodaran!

63!

Measuring Reinvestment Rate and Expected Growth at Tata Group

Tata Chemicals ROC 10.35% Tata Motors TCS 17.16% 40.63%

Tata Steel 13.42%

Reinvestment Rate (last year) Reinvestment Rate (last 5 years) Reinvestment Rate (last 5 years - w/ o acquisitions)

172.50% 283.28% 56.50%

96.26% 170.61% 27.04% 166.10% 190.74% 56.73% 38.09% 179.59% 30.87%

ROC used Reinvestment rate Sustainable growth

10.35% 56.50% 5.85%

13.42% 38.09% 5.11%

17.16% 40.63% 70% 56.73% 12.01% 23.05%

Aswath Damodaran!

64!

III. The Tail that wags the dog Terminal Value

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65!

Getting Closure in Valuation

A publicly traded rm potentially has an innite life. The value is therefore the present value of cash ows forever.

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

Since we cannot estimate cash ows forever, we estimate cash ows for a growth period and then estimate a terminal value, to capture the value at the end of the period:

t = N CFt Terminal Value Value = + t (1 + r)N t = 1 (1 + r)

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66!

Ways of Estimating Terminal Value

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67!

Stable Growth and Terminal Value

When a rms cash ows grow at a constant rate forever, the present value of those cash ows can be written as:

Value = Expected Cash Flow Next Period / (r - g)
where,

r = Discount rate (Cost of Equity or Cost of Capital)

g = Expected growth rate

While companies can maintain high growth rates for extended periods, they will all approach stable growth at some point in time. When they will do so will depend upon:

How large they are relative to the market in which they operate
Their competitive advantages

Aswath Damodaran!

68!

Four Rules for Terminal value

Respect the cap: The stable growth rate cannot exceed the growth rate of the economy but it can be set lower. One simple proxy for the nominal growth rate of the economy is the riskfree rate.

Riskfree rate = Expected ination + Expected Real Interest Rate
Nominal growth rate in economy = Expected Ination + Expected Real Growth

Stable period excess returns: Firms that generate returns on capital that vastly exceed their costs of capital should see these excess returns shrink in stable growth as competition enters and size works against them.
Reinvest to grow: Growth is never free and this is especially true in stable growth. To grow at a perpetual rate, rms have to reinvest and how much they reinvest will be a function of the return on capital:

Reinvestment Rate = Stable growth rate/ Stable ROC
Adjust risk and cost of capital: The cost of equity and capital in stable growth should be reective of a mature rm in stable growth. In particular,

Betas should move towards one
Debt ratios should converge on long-term sustainable averages

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69!

1. How high can the stable growth rate be?

The stable growth rate cannot exceed the growth rate of the economy but it can be set lower.

If you assume that the economy is composed of high growth and stable growth rms, the growth rate of the latter will probably be lower than the growth rate of the economy.
The stable growth rate can be negative. The terminal value will be lower and you are assuming that your rm will disappear over time.
If you use nominal cashows and discount rates, the growth rate should be nominal in the currency in which the valuation is denominated.

One simple proxy for the nominal growth rate of the economy is the riskfree rate.

Riskfree rate = Expected ination + Expected Real Interest Rate
Nominal growth rate in economy = Expected Ination + Expected Real Growth

Aswath Damodaran!

70!

2. When will the rm reach stable growth?

Size of the rm

Success usually makes a rm larger. As rms become larger, it becomes much more difcult for them to maintain high growth rates

Current growth rate

While past growth is not always a reliable indicator of future growth, there is a correlation between current growth and future growth. Thus, a rm growing at 30% currently probably has higher growth and a longer expected growth period than one growing 10% a year now.

Barriers to entry and differential advantages

Ultimately, high growth comes from high project returns, which, in turn, comes from barriers to entry and differential advantages.
The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are, how long they will stay up and how strong they will remain.

Aswath Damodaran!

71!

3. What else should change in stable growth?

In stable growth, rms should have the characteristics of other stable growth rms. In particular,

The risk of the rm, as measured by beta and ratings, should reect that of a stable growth rm.

Beta should move towards one
The cost of debt should reect the safety of stable rms (BBB or higher)

The debt ratio of the rm might increase to reect the larger and more stable earnings of these rms.

The debt ratio of the rm might moved to the optimal or an industry average
If the managers of the rm are deeply averse to debt, this may never happen

The return on capital generated on investments should move to sustainable levels, relative to both the sector and the companys own cost of capital.

Aswath Damodaran!

72!

4. What excess returns will you generate in stable growth and why does it matter?

Strange though this may seem, the terminal value is not as much a function of stable growth as it is a function of what you assume about excess returns in stable growth.
The key connecting link is the reinvestment rate that you have in stable growth, which is a function of your return on capital:
Reinvestment Rate = Stable growth rate/ Stable ROC

The terminal value can be written in terms of ROC as follows:
Terminal Value = EBITn+1 (1-t) (1 g/ ROC)/ (Cost of capital g)
In the scenario where you assume that a rm earns a return on capital equal to its cost of capital in stable growth, the terminal value will not change as the growth rate changes.
If you assume that your rm will earn positive (negative) excess returns in perpetuity, the terminal value will increase (decrease) as the stable growth rate increases.

73!

Aswath Damodaran!

Stable Growth Assumptions: Tata Group

Beta

High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth High Growth Stable Growth

Tata Chemicals 1.21 1.00 0.75 0.75 4.50% 3.00% 13.82% 11.75% 30.48% 30.48% 10.00% 8.00% 11.62% 9.78% 13.42% 9.78% 56.50% 51.14% 5.85% 5%

Tata Steel 1.57 1.20 1.10 1.10 4.50% 3.00% 17.02% 13.70% 29.59% 29.59% 9.25% 7.75% 13.79% 11.16% 11.81% 11.16% 38.09% 44.80% 5.11% 5%

Tata Motors 1.20 1.00 0.80 0.80 4.50% 3.00% 14.00% 11.90% 25.30% 25.30% 12.25% 9.00% 12.50% 10.39% 17.16% 12.00% 70.00% 41.67% 12.01% 5%

TCS 1.05 1.00 0.20 0.20 4.50% 3.00% 10.63% 10.10% 0.03% 10% 8.50% 6.50% 10.62% 9.52% 40.63% 15% 56.73% 33.33% 23.05% 5%

Lambda Country Risk Premium Cost of equity Debt Ratio Cost of debt Cost of capital Reurn on capital Reinvestment Rate Expected growth rate

Aswath Damodaran!

74!

Terminal Value and Growth: Contrasts

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75!

V. Tying up Loose Ends

For rm value to equity value per share

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76!

1. Value cash and other non-operating assets

When you discount operating cash ows at the cost of capital, you have valued only the operating assets (that contribute to the operating income) of the rm. Any assets whose earnings are not counted as part of operating income have not been valued yet. In particular, these would include:

Cash and marketable securities: The income from these are not part of operating income. Hence, the current value of these assets has to be added to the value of the operating assets.
Non-operating assets: If the rm own other assets that have value but do not contribute to operations, the value of these assets should also be included in the rm value.

The key, though, is to not double count an asset. Thus, an asset (say your ofce headquarters building) that has value but is used for operations should not be added on to the value of operating assets.

Aswath Damodaran!

77!

2. Dealing with Holdings in Other rms

Cross holdings in other rms can create problems because the accounting for these holdings can vary widely across countries, across companies and even within the same company, across different holdings. In particular, we care about

How the income from these holdings is accounted for in the income statement

What is counted as income? (Operating income, Net income or just dividends)
Where is it shown? (Above or below the operating income line)
How much of the income is shown? (The share of the holding, 100%?)

How is the value of the asset recorded on the balance sheet?

Is it recorded at original cost, updated book value or market value?
Is just the net value of the holding shown or are all of the assets and liabilities recorded?

Aswath Damodaran!

78!

How to value holdings in other rms.. In a perfect world..

In a perfect world, we would strip the parent company from its subsidiaries and value each one separately. The value of the combined rm will be

Value of parent company + Proportion of value of each subsidiary

To do this right, you will need

to be provided detailed information on each subsidiary to estimated cash ows and discount rates.
To have a manageable number of subsidiaries

Aswath Damodaran!

79!

Three compromise solutions

The market value solution: When the subsidiaries are publicly traded, you could use their traded market capitalizations to estimate the values of the cross holdings. You do risk carrying into your valuation any mistakes that the market may be making in valuation.
The relative value solution: When there are too many cross holdings to value separately or when there is insufcient information provided on cross holdings, you can convert the book values of holdings that you have on the balance sheet (for both minority holdings and minority interests in majority holdings) by using the average price to book value ratio of the sector in which the subsidiaries operate.
The take what I can get solution: Estimate the market value of those holdings that are publicly traded, the relative value of those holdings where there are publicly traded investments to obtain multiples from and book value for the rest.

Aswath Damodaran!

80!

3. Subtract out debt

If you have under funded pension fund or health care plans, you should consider the under funding at this stage in getting to the value of equity.

If you do so, you should not double count by also including a cash ow line item reecting cash you would need to set aside to meet the unfunded obligation.
You should not be counting these items as debt in your cost of capital calculations.

If you have contingent liabilities - for example, a potential liability from a lawsuit that has not been decided - you should consider the expected value of these contingent liabilities

Value of contingent liability = Probability that the liability will occur * Expected value of liability

Aswath Damodaran!

81!

4. Value other claims on equity

In recent years, rms have turned to giving employees (and especially top managers) equity option packages as part of compensation. These options are usually

Long term
At-the-money when issued
On volatile stocks

Options outstanding

Step 1: List all options outstanding, with maturity, exercise price and vesting status.
Step 2: Value the options, taking into accoutning dilution, vesting and early exercise considerations
Step 3: Subtract from the value of equity and divide by the actual number of shares outstanding (not diluted or partially diluted).

Aswath Damodaran!

82!

Getting to per share value: Tata Companies

Value of Operating Assets + Cash + Value of Holdings Value of Firm - Debt - Options Value of Equity Value per share Tata Chemicals Tata Steel INR 57,129 INR 501,661 INR 6,388 INR 15,906 INR 56,454 INR 467,315 INR 119,971 INR 984,882 INR 32,374 INR 235,697 INR 0 INR 0 INR 87,597 INR 749,185 INR 372.34 INR 844.43 Tata Motors TCS INR 231,914 INR 1,355,361 INR 11,418 INR 3,188 INR 140,576 INR 66,141 INR 383,908 INR 1,424,690 INR 109,198 INR 505 INR 0 INR 0 INR 274,710 INR 1,424,184 INR 665.07 INR 727.66

Aswath Damodaran!

83!

Corporate Finance meets Value: The secret to value enhancement

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84!

Price Enhancement versus Value Enhancement

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85!

Value-Neutral Actions

Stock splits and stock dividends change the number of units of equity in a rm, but cannot affect rm value since they do not affect cash ows, growth or risk.
Accounting decisions that affect reported earnings but not cash ows should have no effect on value.

Changing inventory valuation methods from FIFO to LIFO or vice versa in nancial reports but not for tax purposes
Changing the depreciation method used in nancial reports (but not the tax books) from accelerated to straight line depreciation
Major non-cash restructuring charges that reduce reported earnings but are not tax deductible
Using pooling instead of purchase in acquisitions cannot change the value of a target rm.

Decisions that create new securities on the existing assets of the rm (without altering the nancial mix) such as tracking stock.

Aswath Damodaran!

86!

The Paths to Value Creation.. Back to the determinants of value..

Are you investing optimally for future growth? How well do you manage your existing investments/assets? Growth from new investments Growth created by making new investments; function of amount and quality of investments Efficiency Growth Growth generated by using existing assets better

Is there scope for more efficient utilization of exsting assets?

Cashflows from existing assets Cashflows before debt payments, but after taxes and reinvestment to maintain exising assets

Expected Growth during high growth period

Stable growth firm, with no or very limited excess returns

Are you building on your competitive advantages?

Length of the high growth period Since value creating growth requires excess returns, this is a function of - Magnitude of competitive advantages - Sustainability of competitive advantages

Are you using the right amount and kind of debt for your firm?

Cost of capital to apply to discounting cashflows Determined by - Operating risk of the company - Default risk of the company - Mix of debt and equity used in financing

Aswath Damodaran!

87!

Value Creation 1: Increase Cash Flows from Assets in Place

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88!

1.1.: Poor Investments: Should you divest?

Every rm has at least a few investments in place that are poor investments, earning less than the cost of capital or even losing money.
In deciding whether to divest, there are three values that we need to consider:

Continuing Value: This is the present value of the expected cash ows from continuing the investment through the end of its life.
Salvage or Liquidation Value: This is the net cash ow that the rm will receive if it terminated the project today.
Divestiture Value: This is the price that will be paid by the highest bidder for this investment.

If the continuing value is the greatest, there can be no value created by terminating or liquidating this investment, even if it is a bad investment.
If the liquidation or divestiture value is greater than the continuing value, the rm value will increase by the difference between the two values:

If liquidation is optimal: Liquidation Value - Continuing Value
If divestiture is optimal: Divestiture Value - Continuing Value

Aswath Damodaran!

89!

1.2: Manage working capital

If non-cash working capital is dened to be the difference between non-cash current assets (accounts receivable & inventory) and non-debt current liabilities (accounts payable & supplier credit), there are three ways in which you can reduce working capital (and increase cash ows):

Reduce inventory at every stage in the process (work in process, nished goods)
Offer less or tighter credit and/or demand a fair market interest rate when offering credit.
Use supplier credit or accounts payable, but only if the nancing cost (explicit or implicit) is lower than the companys pre-tax cost of debt.

Reducing working capital is not a free good. The cash ow gain from reducing inventory and tightening credit has to be weighed off against the cost of lost sales and prots.

Aswath Damodaran!

90!

Potential for increasing cash ows from existing assets: Tata Group

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91!

Value Creation 2: Increase Expected Growth

Keeping all else constant, increasing the expected growth in earnings will increase the value of a rm.
The expected growth in earnings of any rm is a function of two variables:

The amount that the rm reinvests in assets and projects
The quality of these investments

Price Leader versus Volume Leader Strategies! Return on Capital = Operating Margin * Capital Turnover Ratio!

Aswath Damodaran!

92!

2.1: Increase the Reinvestment Rate

Holding all else constant, increasing the reinvestment rate will increase the expected growth in earnings of a rm. Increasing the reinvestment rate will, however, reduce the cash ows of the rms. The net effect will determine whether value increases or decreases.
As a general rule,

Increasing the reinvestment rate when the ROC is less than the cost of capital will reduce the value of the rm
Increasing the reinvestment rate when the ROC is greater than the cost of capital will increase the value of the rm

Aswath Damodaran!

93!

2.2: Improve Quality of Investments

If a rm can increase its return on capital on new projects, while holding the reinvestment rate constant, it will increase its rm value.

The rms cost of capital still acts as a oor on the return on capital. If the return on capital is lower than the cost of capital, increasing the return on capital will reduce the amount of value destroyed but will not create value. The rm would be better off under those circumstances returning the cash to the owners of the business.
It is only when the return on capital exceeds the cost of capital, that the increase in value generated by the higher growth will more than offset the decrease in cash ows caused by reinvesting.

This proposition might not hold, however, if the investments are in riskier projects, because the cost of capital will then increase.

Aswath Damodaran!

94!

Assessing the Tata Companies Growth Potential

Aswath Damodaran!

95!

A postscript on creating growth: The Role of Acquisitions and Divestitures

An acquisition is just a large-scale project. All of the rules that apply to individual investments apply to acquisitions, as well. For an acquisition to create value, it has to

Generate a higher return on capital, after allowing for synergy and control factors, than the cost of capital.
Put another way, an acquisition will create value only if the present value of the cash ows on the acquired rm, inclusive of synergy and control benets, exceeds the cost of the acquisitons

A divestiture is the reverse of an acquisition, with a cash inow now (from divesting the assets) followed by cash outows (i.e., cash ows foregone on the divested asset) in the future. If the present value of the future cash outows is less than the cash inow today, the divestiture will increase value.
A fair-price acquisition or divestiture is value neutral.

Aswath Damodaran!

96!

Value Creating Growth Evaluating the Alternatives..

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97!

Indian companies are becoming acquirers

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98!

This trend makes us feel good, but does it create value? Returns to Indian rms acquiring US rms..

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99!

A more general problem Growing through acquisitions has never been easy

Firms that grow through acquisitions have generally had far more trouble creating value than rms that grow through internal investments.
In general, acquiring rms tend to

Pay too much for target rms
Over estimate the value of synergy and control
Have a difcult time delivering the promised benets

Worse still, there seems to be very little learning built into the process. The same mistakes are made over and over again, often by the same rms with the same advisors.
Conclusion: There is something structurally wrong with the process for acquisitions which is feeding into the mistakes.

Aswath Damodaran!

100!

Seven reasons why acquisitions fail

1.

2. 3.

4.

5. 6.

7.

Aswath Damodaran!

Risk Transference: Attributing acquiring company risk characteristics to the target rm. Just because you are a safe rm and operate in a secure market, does not mean that you can transfer these characteristics to a target rm.
Debt subsidies: Subsiding target rm stockholders for the strengths of the acquiring rm is providing them with a benet they did not earn.
Auto-pilot Control: Adding 20% or some arbitrary number to the market price just because other people do it is a recipe for overpayment. Using silly rules such as EPS accretion just makes the problem worse.
Elusive Synergy: While there is much talk about synergy in mergers, it is seldom valued realistically or appropriately.
Its all relative: The use of transaction multiples (multiples paid by other acquirers in acquisitions) perpetuates over payment.
Verdict rst, trial afterwards: Deciding you want to do an acquisition rst and then looking for justication for the price paid does not make sense.
Its not my fault: Holding no one responsible for delivering results is a surere way not to get results

101!

Testing Tatas acquisition strategy?

Do you use your companys cost of equity to value the target company?
Do you use your companys cost of debt and debt capacity to estimate the cost of capital for the target company?
Do you add arbitrary premiums for control and other components or justify acquisitions based upon EPS accretion?
Do you value synergy realistically? Do you try to bargain for a share of that value?
Do you use transaction multiples to justify acquisitions?
Do you decide on whether to do the acquisition before you look at the value?
Do you hold those who are the strongest advocates for the acquisitions (managers, investment bankers) accountable for their performance?

Aswath Damodaran!

102!

III. Building Competitive Advantages: Increase length of the growth period

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103!

Gauging Barriers to Entry

Tata Chemicals ROC Cost of capital Length of growth period Competitive Advantages

Tata Steel 13.42% 13.79% 5 Breaking even?

10.35% 11.62% 5 Is there one?

Tata Motors 11.81% (17.16%) 12.50%

TCS 40.63% 10.62%

10 10 What is the The jewel in edge? the crown?

For the two companies where there is little evidence of a competitive edge, which barrier to entry offers the most promise? What if you cannot nd one?
For the one company (Tata Motors) which may or may not have excess returns, what is the competitive edge? How can you make it stronger?
For the one company (TCS) which seems to have the most signicant excess returns, what is the most signicant competitive advantage? What are the biggest threats you see to this competitive advantage?

Aswath Damodaran!

104!

Value Creation 4: Reduce Cost of Capital

Aswath Damodaran!

105!

Optimal Financing Mix: Tata Chemicals

Debt Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
Beta
0.94
1.01
1.09
1.20
1.35
1.56
1.87
2.46
3.82
7.70
Cost of Equity
11.84%
12.34%
12.97%
13.78%
14.85%
16.36%
18.61%
22.92%
32.83%
61.16%
Bond Rating
Interest rate on debt
AAA
8.50%
AAA
8.50%
A+
9.00%
A-
9.50%
B+
12.25%
B-
13.50%
CC
18.00%
CC
18.00%
C
20.00%
C
20.00%
Tax Rate
33.99%
33.99%
33.99%
33.99%
33.99%
33.99%
33.99%
30.58%
23.29%
19.89%
Cost of Debt (after-tax)
5.61%
5.61%
5.94%
6.27%
8.09%
8.91%
11.88%
12.50%
15.34%
16.02%
WACC
11.84%
11.67%
11.56%
11.52%
12.14%
12.63%
14.57%
15.62%
18.84%
20.54%
Firm Value (G)
INR 102,601
INR 105,375
INR 107,152
INR 107,831
INR 98,001
INR 91,387
INR 71,784
INR 64,170
INR 48,022
INR 42,200

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106!

Optimal Financing: Tata Companies

Is the debt matched to assets at these companies?

Can you reduce your xed costs? If so, how?
Are there ways you can make your product/service less discretionary?

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V. From fair value to fair price..

There is many a slip between the cup and the lip

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108!

Are markets fair?

In an efcient market, the market price converges instantaneously on value. Thus, a rm that takes value increasing actions will see its stock price go up and a rm that is value destructive will be punished by the market.
In practice, there are three potential impediments to this process working smoothly:

Investors may be irrational and/or short term.
Markets may not trust the managers of the rm.
Information about the actions may not get to markets or the message may be muddled.

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109!

I. The right investors

Optimally, a rm that is focused on long term value would like to get investors who

Have long time horizons
Care about fundamentals
Do their research/homework

While rms do not get to pick their investors, they can inuence the composition by

Having a core of long term investors who may also be insiders in the rm
Choosing a dividend policy that attracts the right type of investors
What they focus on when they make decisions

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110!

II. Management Trust

Management trust is earned through a history of being focused on delivering value to investors. In other words, rms that have delivered solid returns to stockholders over time and taken good investments earn the trust of their stockholders, whereas rms that have delivered poor returns or over promised lose that trust.
When a rm loses the trust of its stockholders, it will not only nd every action that it takes subjected to scrutiny and scrutiny but will come under intense pressure to return more of its cash to stockholders.

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111!

A Symbol of Distrust How much cash is too much cash?

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112!

III. Information Gaps

For markets to react appropriately to actions taken by a rm, information about those actions has to be conveyed clearly and credibly to markets. In practice, information disclosure is hindered by

An unwillingness to provide key details of actions, for fear of letting competitors in on secrets.
A belief that investors are not intelligent or informed enough to use information appropriately.
An inability to communicate effectively and directly.
Complexity and confusion in the disclosure,

Managers will be better served trusting their investors to make the right judgments about actions and providing them with the information (positive and negative) to make these judgments.

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113!

Information Overload A Discount for Complexity

Company A
Company B
Operating Income
$ 1 billion
$ 1 billion
Tax rate
40%
40%
ROIC
10%
10%
Expected Growth
5%
5%
Cost of capital
8%
8%
Business Mix
Single Business
Multiple Businesses
Holdings
Simple
Complex
Accounting
Transparent
Opaque
Which rm would you value more highly?

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114!

Measuring Complexity: Volume of Data in Financial Statements

Company General Electric Microsoft Wal-mart Exxon Mobil Pfizer Citigroup Intel AIG Johnson & Johnson IBM

Number of pages in last 10Q 65 63 38 86 171 252 69 164 63 85

Number of pages in last 10K 410 218 244 332 460 1026 215 720 218 353

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115!

Measuring Complexity: A Complexity Score

Item
Operating Income
Follow-up Question
Answer
Weighting factor
Gerdau Score
Number of businesses (with more than 10% of 1
2.00
2
revenues) =
2. One-time income and expenses
Percent of operating income =
10%
10.00
1
3. Income from unspecied sources
Percent of operating income =
0%
10.00
0
4. Items in income statement that are volatile
Percent of operating income =
15%
5.00
0.75
Tax Rate
1. Income from multiple locales
Percent of revenues from non-domestic locales =
70%
3.00
2.1
2. Different tax and reporting books
Yes or No
No
Yes=3
0
3. Headquarters in tax havens
Yes or No
No
Yes=3
0
4. Volatile effective tax rate
Yes or No
Yes
Yes=2
2
Capital Expenditures
1. Volatile capital expenditures
Yes or No
Yes
Yes=2
2
2. Frequent and large acquisitions
Yes or No
Yes
Yes=4
4
3. Stock payment for acquisitions and investments
Yes or No
No
Yes=4
0
Working capital
1. Unspecied current assets and current liabilities
Yes or No
No
Yes=3
0
2. Volatile working capital items
Yes or No
Yes
Yes=2
2
Expected Growth rate
1. Off-balance sheet assets and liabilities (operating leases and R&D)
Yes or No
No
Yes=3
0
2. Substantial stock buybacks
Yes or No
No
Yes=3
0
3. Changing return on capital over time
Is your return on capital volatile?
Yes
Yes=5
5
4. Unsustainably high return
Is your rm's ROC much higher than industry average?
No
Yes=5
0
Cost of capital
1. Multiple businesses
Number of businesses (more than 10% of revenues) =
1
1.00
1
2. Operations in emerging markets
Percent of revenues=
50%
5.00
2.5
3. Is the debt market traded?
Yes or No
No
No=2
2
4. Does the company have a rating?
Yes or No
Yes
No=2
0
5. Does the company have off-balance sheet debt?
Yes or No
No
Yes=5
0
No-operating assets
Minority holdings as percent of book assets
Minority holdings as percent of book assets
0%
20.00
0
Firm to Equity value
Consolidation of subsidiaries
Minority interest as percent of book value of equity
63%
20.00
12.6
Per share value
Shares with different voting rights
Does the rm have shares with different voting rights?
Yes
Yes = 10
10
Equity options outstanding
Options outstanding as percent of shares
0%
10.00
0
Complexity Score =
48.95
Factors
1. Multiple Businesses
GE Score
30
0.8
1.2
1
1.8
3
0
0
2
4
4
0
2
3
3
5
0
20
2.5
0
0
5
0.8
1.2
0
0.25
90.55

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116!

Back to Lemmings...

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117!