Alternative Approaches to Value Enhancement

Maximizeavariablethatiscorrelatedwiththevalueofthefirm.
Thereareseveralchoicesforsuchavariable.Itcouldbe

anaccountingvariable,suchasearningsorreturnoninvestment
amarketingvariable,suchasmarketshare
acashflowvariable,suchascashflowreturnoninvestment(CFROI)
ariskadjustedcashflowvariable,suchasEconomicValueAdded(EVA)

Theadvantagesofusingthesevariablesarethatthey
AreoftensimplerandeasiertousethanDCFvalue.

Thedisadvantageisthatthe
Simplicitycomesatacost;thesevariablesarenotperfectlycorrelated
withDCFvalue.

Aswath Damodaran

Economic Value Added (EVA) and CFROI

TheEconomicValueAdded(EVA)isameasureofsurplusvalue
createdonaninvestment.
Definethereturnoncapital(ROC)tobethetruecashflowreturnon
capitalearnedonaninvestment.
Definethecostofcapitalastheweightedaverageofthecostsofthe
differentfinancinginstrumentsusedtofinancetheinvestment.

EVA=(ReturnonCapitalCostofCapital)(CapitalInvestedinProject)
TheCFROIisameasureofthecashflowreturnmadeoncapital
CFROI=(AdjustedEBIT(1t)+Depreciation&OtherNoncash
Charges)/CapitalInvested

Aswath Damodaran

Estimating EVA for Nestle

CapitalInvested=29500MillionSfr
ReturnonCapital=12.77%
CostofCapital=8.85%
EconomicValueAddedin1995=(.1277.0885)(29,500Million
Sfr)=1154.50MillionSfr

Aswath Damodaran

Estimating Tsingtaos EVA in 1996

TsingtaoBrewery,aChineseBeermanufacturer,hasmakesignificant
capitalinvestmentsinthelasttwoyears,andplanstoincreaseits
exportsovertime.Using1996numbers,Tsingtaohadthefollowing
fundamentals:
ReturnonCapital=1.28%
CostofCapital=15.51%
CapitalInvested=3,015millionCC

EconomicValueAddedin1996=429millionCC

Aswath Damodaran

J.P. Morgans Equity EVA: 1996

EquityInvestedattheendof1995=$10,451Million
NetIncomeEarnedin1996=$1,574Million
CostofEquityfor1996=7%+0.94(5.5%)=12.17%
Iusedtheriskfreeratefromthestartof1996

EquityEVAforJ.P.Morgan=$1574Million($10,451Million)
(.1217)=$303Million

Aswath Damodaran

Things to Note about EVA

EVAisameasureofdollarsurplusvalue,notthepercentage
differenceinreturns.
Itisclosestinboththeoryandconstructtothenetpresentvalueofa
projectincapitalbudgeting,asopposedtotheIRR.
Thevalueofafirm,inDCFterms,canbewrittenintermsoftheEVA
ofprojectsinplaceandthepresentvalueoftheEVAoffuture
projects.

Aswath Damodaran

A Simple Illustration

Assumethatyouhaveafirmwith
IA=100
ROCA=15%
year)
WACCA=10%
WACCNewProjects=10%

Ineachyear15,assumethat
I=10(Investmentsareatbeginningofeach
ROCNewProjects=15%

Assumethatalloftheseprojectswillhaveinfinitelives.
Afteryear5,assumethat
Investmentswillgrowat5%ayearforever
ROConprojectswillbeequaltothecostofcapital(10%)

Aswath Damodaran

Firm Value using EVA Approach

CapitalInvestedinAssetsinPlace
EVAfromAssetsinPlace=(.15.10)(100)/.10
+PVofEVAfromNewInvestmentsinYear1=[(.15.10)(10)/.10]
+PVofEVAfromNewInvestmentsinYear2=[(.15.10)(10)/.10]/1.1
+PVofEVAfromNewInvestmentsinYear3=[(.15.10)(10)/.10]/1.12
+PVofEVAfromNewInvestmentsinYear4=[(.15.10)(10)/.10]/1.13
+PVofEVAfromNewInvestmentsinYear5=[(.15.10)(10)/.10]/1.14
ValueofFirm

Aswath Damodaran

=$100
=$50
=$5
=$4.55
=$4.13
=$3.76
=$3.42
=$170.86

Firm Value using DCF Valuation: Estimating

FCFF

Base

Y ear
EBIT(1t):AssetsinPlace

Y ear

$15.00 $15.00 $15.00 $15.00 $15.00 $15.00

EBIT(1t):InvestmentsYr 1

$1.50 $1.50 $1.50 $1.50 $1.50

EBIT(1t):InvestmentsYr 2

$1.50 $1.50 $1.50 $1.50

EBIT(1t):InvestmentsYr 3

$1.50 $1.50 $1.50

EBIT(1t):InvestmentsYr 4

$1.50 $1.50

EBIT(1t):InvestmentsYr 5

$1.50

TotalEBIT(1t)
NetCapitalExpenditures
FCFF

Aswath Damodaran

Term.

$16.50 $18.00 $19.50 $21.00 $22.50 $23.63

$10.00 $10.00 $10.00 $10.00 $10.00 $11.25 $11.81
$6.50 $8.00 $9.50 $11.00 $11.25 $11.81

Firm Value: Cost of Capital and Capital

Invested
AssetsinPlace

$100.00

NewInvestment

$10.00 $10.00 $10.00 $10.00 $10.00 $11.25

CumulativeNewInvestment

$10.00 $20.00 $30.00 $40.00 $50.00

CumulativeTotalInvestment $110.00 $120.00 $130.00 $140.00 $150.00

ReturnonCapital

15%

15%

15%

15%

15%

15%

10%

CostofCapital

10%

10%

10%

10%

10%

10%

10%

Aswath Damodaran

10

Firm Value: Present Value of FCFF

Year

FCFF
PVofFCFF

$6.50 $8.00 $9.50 $11.00 $11.25 $11.81

($10)

$5.91 $6.61 $7.14 $7.51 $6.99

TerminalValue

$236.25

PVofTerminalValue

$146.69

ValueofFirm

Aswath Damodaran

TermYear

$170.85

11

EVA Valuation of Nestle

0

Term.Y ear

ReturnonCapital

12.77%

12.77%

12.77%

12.77%

12.77%

12.77%

12.77%

CostofCapital

8.85%

8.85%

8.85%

8.85%

8.85%

8.85%

8.85%

EBIT(1t)

3,766.66Fr 4,066.46Fr 4,390.06Fr 4,739.37Fr 5,116.40Fr

5,523.38Fr

5,689.08Fr

WACC(Capital)

2,612.06Fr 2,819.97Fr 3,044.38Fr 3,286.61Fr 3,548.07Fr

3,830.29Fr

3,945.20Fr

EVA

1,154.60Fr 1,246.49Fr 1,345.69Fr 1,452.76Fr 1,568.33Fr

1,693.08Fr

1,743.88Fr

1,145.10Fr 1,135.67Fr 1,126.30Fr 1,117.00Fr

1,107.76Fr

PVofEVA

29,787.18Fr
PVofEVA=

25,121.24Fr

PVof1693.08Fr
growingat3%ayear

ValueofAssets

29,500.00Fr

inPlace=
ValueofFirm=

54,621.24Fr

ValueofDebt=

11,726.00Fr

ValueofEquity=

42,895.24Fr

ValuePerShar e=

1,088.16Fr

Aswath Damodaran

12

DCF Valuation of Nestle

0

Terminal
Y ear

EBIT(1t)

4,066.46Fr 4,390.06Fr 4,739.37Fr 5,116.40Fr

5,523.38Fr

5,689.08Fr

+Deprecn

2,305.00Fr 2,488.02Fr 2,685.58Fr 2,898.83Fr 3,129.00Fr

1,273.99Fr

1,350.42Fr

CapEx

3,898.00Fr 4,207.51Fr 4,541.60Fr 4,902.22Fr 5,291.48Fr

2,154.45Fr

2,283.71Fr

417.29Fr

442.33Fr

4,225.62Fr

4,313.46Fr

ChangeinWC
FCFF

0.00Fr

755.00Fr

814.95Fr

879.66Fr

949.51Fr

1,024.90Fr

2,348.00Fr 1,532.02Fr 1,654.38Fr 1,786.46Fr 1,929.03Fr

TerminalValue
WACC

151,113.54Fr
8.85%

8.85%

8.85%

8.85%

8.85%

8.85%

PVofFCFF

2,348.00Fr 1,407.40Fr 1,396.19Fr 1,385.02Fr 1,373.90Fr 51,406.74Fr

ValueofFirm=

54,621.24Fr

ValueofDebt=

11,726.00Fr

ValueofEquity=

42,895.24Fr

ValuePerShar e=

1,088.16Fr

Aswath Damodaran

8.85%

13

Year-by-year EVA Changes

FirmsareoftenevaluatedbaseduponyeartoyearchangesinEVA
ratherthanthepresentvalueofEVAovertime.
Theadvantageofthiscomparisonisthatitissimpleanddoesnot
requirethemakingofforecastsaboutfutureearningspotential.
Anotheradvantageisthatitcanbebrokendownbyanyunitperson,
divisionetc.,aslongasoneiswillingtoassigncapitalandallocate
earningsacrossthesesameunits.
WhileitissimplerthanDCFvaluation,usingyearbyyearEVA
changescomesatacost.Inparticular,itisentirelypossiblethatafirm
whichfocusesonincreasingEVAonayeartoyearbasismayendup
beinglessvaluable.

Aswath Damodaran

14

Year-to-Year EVA Changes: Nestle

0

Term.Y ear

ReturnonCapital

12.77%

12.77%

12.77%

12.77%

12.77%

12.77%

12.77%

CostofCapital

8.85%

8.85%

8.85%

8.85%

8.85%

8.85%

8.85%

EBIT(1t)

3,766.66Fr 4,066.46Fr 4,390.06Fr 4,739.37Fr 5,116.40Fr

5,523.38Fr 5,689.08Fr

WACC(Capital)

2,612.06Fr 2,819.97Fr 3,044.38Fr 3,286.61Fr 3,548.07Fr

3,830.29Fr 3,945.20Fr

EVA

1,154.60Fr 1,246.49Fr 1,345.69Fr 1,452.76Fr 1,568.33Fr

1,693.08Fr 1,743.88Fr

PVofEVA

1,145.10Fr 1,135.67Fr 1,126.30Fr 1,117.00Fr

1,107.76Fr
29,787.18Fr

PVofEVA=

25,121.24Fr

PVof590.67Frgrowing
at3%ayear

ValueofAssets

29,500.00Fr

inPlace=
ValueofFirm=

54,621.24Fr

ValueofDebt=

11,726.00Fr

ValueofEquity

42,895.24Fr

Valueper Share=
Aswath Damodaran

1088.16Fr
15

When Increasing EVA on year-to-year basis

may result in lower Firm Value

1.IftheincreaseinEVAonayeartoyearbasishasbeen
accomplishedattheexpenseoftheEVAoffutureprojects.Inthis
case,thegainfromtheEVAinthecurrentyearmaybemorethan
offsetbythepresentvalueofthelossofEVAfromthefutureperiods.
Forexample,intheNestleexampleaboveassumethatthereturnon
capitalonyear1projectsincreasesto13.27%(fromtheexisting12.77%),
whilethecostofcapitalontheseprojectsstaysat8.85%.Ifthisincrease
invaluedoesnotaffecttheEVAonfutureprojects,thevalueofthefirm
willincrease.
If,however,thisincreaseinEVAinyear1isaccomplishedbyreducing
thereturnoncapitalonfutureprojectsto12.27%,thefirmvaluewill
actuallydecrease.

Aswath Damodaran

16

Firm Value and EVA tradeoffs over time

0

Term.Y ear

ReturnonCapital

12.77%

13.27%

12.27%

12.27%

12.27%

12.27%

12.27%

CostofCapital

8.85%

8.85%

8.85%

8.85%

8.85%

8.85%

8.85%

EBIT(1t)

3,766.66Fr 4,078.24Fr 4,389.21Fr 4,724.88Fr 5,087.20Fr

5,478.29Fr 5,642.64Fr

WACC(Capital)

2,612.06Fr 2,819.97Fr 3,044.38Fr 3,286.61Fr 3,548.07Fr

3,830.29Fr 3,948.89Fr

EVA

1,154.60Fr 1,258.27Fr 1,344.84Fr 1,438.28Fr 1,539.13Fr

1,648.00Fr 1,693.75Fr

PVofEVA

1,155.92Fr 1,134.95Fr 1,115.07Fr 1,096.20Fr

1,078.27Fr
28,930.98Fr

PVofEVA=

24,509.62Fr

PVof590.67Frgrowing
at3%ayear

ValueofAssets

29,500.00Fr

inPlace=
ValueofFirm=

54,009.62Fr

ValueofDebt=

11,726.00Fr

ValueofEquity=

42,283.62Fr

ValuePerShare=

1,072.64Fr

Aswath Damodaran

17

EVA and Risk

2.WhentheincreaseinEVAisaccompaniedbyanincreaseinthe
costofcapital,eitherbecauseofhigheroperationalriskorchangesin
financialleverage,thefirmvaluemaydecreaseevenasEVA
increases.
Forinstance,intheexampleabove,assumethatthespreadstaysat3.91%
onallfutureprojectsbutthecostofcapitalincreasesto9.85%forthese
projects(from8.85%).Thevalueofthefirmwilldrop.

Aswath Damodaran

18

Nestles Value at a 9.95 % Cost of Capital

0

Term.Y ear

ReturnonCapital

12.77%

13.77%

13.77%

13.77%

13.77%

13.77%

13.77%

CostofCapital

8.85%

9.85%

9.85%

9.85%

9.85%

9.85%

9.85%

EBIT(1t)

3,766.66Fr 4,089.94Fr 4,438.89Fr 4,815.55Fr 5,222.11Fr

5,660.96Fr 5,830.79Fr

WACC(Capital)

2,612.06Fr 2,843.45Fr 3,093.20Fr 3,362.79Fr 3,653.78Fr

3,967.88Fr 4,384.43Fr

EVA

1,154.60Fr 1,246.49Fr 1,345.69Fr 1,452.76Fr 1,568.33Fr

1,693.08Fr 1,446.36Fr

PVofEVA

1,134.68Fr 1,115.09Fr 1,095.82Fr 1,076.88Fr

1,058.25Fr
21,101.04Fr

PVofEVA=

18,669.84Fr

PVof590.67Frgrowing
at3%ayear

ValueofAssets

29,500.00Fr

inPlace=
ValueofFirm=

48,169.84Fr

ValueofDebt=

11,726.00Fr

ValueofEquity=

36,443.84Fr

ValuePerShar e=

924.50Fr

Aswath Damodaran

19

EVA: The Risk Effect

1,400.00Fr

1,200.00Fr

1,000.00Fr

800.00Fr

600.00Fr

400.00Fr

200.00Fr

0.00Fr
7.85%

Aswath Damodaran

8.85%

9.85%

10.85%

11.85%

12.85%

13.85%

14.85%

20

EVA and Changes in Market Value

TherelationshipbetweenEVAandMarketValueChangesismore
complicatedthantheonebetweenEVAandFirmValue.
ThemarketvalueofafirmreflectsnotonlytheExpectedEVAof
AssetsinPlacebutalsotheExpectedEVAfromFutureProjects
Totheextentthattheactualeconomicvalueaddedissmallerthanthe
expectedEVAthemarketvaluecandecreaseeventhoughtheEVAis
higher.

Aswath Damodaran

21

High EVA companies do not earn excess

returns

Aswath Damodaran

22

Increases in EVA do not create excess returns

Aswath Damodaran

23

When focusing on year-to-year EVA changes

has least side effects
1.Mostoralloftheassetsofthefirmarealreadyinplace;i.e,verylittle
ornoneofthevalueofthefirmisexpectedtocomefromfuture
growth.
[ThisminimizestheriskthatincreasesincurrentEVAcomeatthe
expenseoffutureEVA]

2.Theleverageisstableandthecostofcapitalcannotbealteredeasilyby
theinvestmentdecisionsmadebythefirm.
[ThisminimizestheriskthatthehigherEVAisaccompaniedbyan
increaseinthecostofcapital]

3.Thefirmisinasectorwhereinvestorsanticipatelittleornotsurplus
returns;i.e.,firmsinthissectorareexpectedtoearntheircostof
capital.
[ThisminimizestheriskthattheincreaseinEVAislessthanwhatthe
marketexpectedittobe,leadingtoadropinthemarketprice.]

Aswath Damodaran

24

Valuation: Closing Thoughts

Spring2002
AswathDamodaran

Aswath Damodaran

25

Do you have your life vests on?

Aswath Damodaran

26

Truths about Valuation

Truth1:Biasisendemicinvaluationandcanenterinsubtleandnot
sosubtleways.
Truth2.:Avaluationisneverpreciseandisneverquitedone.
Truth3:Complexitycomeswithacost;Moreinformationisnot
alwaysbetterthanlessinformation.

Aswath Damodaran

27

Approaches to Valuation

Discountedcashflowvaluation,wherewetry(sometimes
desperately)toestimatetheintrinsicvalueofanassetbyusingamix
oftheory,guessworkandprayer.
Relativevaluation,wherewepickagroupofassets,attachthename
comparabletothemandtellastory.
Contingentclaimvaluation,wherewetakethevaluationthatwedid
intheDCFvaluationanddivvyitupbetweenthepotentialthievesof
value(equity)andthepotentialvictimsofthiscrime(lenders)

Aswath Damodaran

28

Basis for all valuation approaches

Weallbelievemarketareinefficient,andthatwecanfindunderand
overvaluedassetsbecauseofoursuperiorintellect,models,
informationorsomecombinationofallthree.
SomeSoberingfacts:
7080%ofportfoliomanagersunderperformmarketindices.
TheVanguard500IndexfundispoisedtoovertaketheFidelityMagellan
fundasthelargestmutualfundintheUnitedStates.Inthelast5years,it
hasbeenthebestperforminglargemutualfundintheUnitedStates.
Themorepeopletrade,themoretheyseemtolose.
Astudyofmutualfundportfoliosdiscoveredthattheywouldhavemadea
higherreturn,iftheyhadfrozentheirportfoliosonJanuary1.
AstudyofindividualinvestorsbyTerrenceODeanalsonotedanegative
correlationbetweenreturnsearnedandtransactionsvolume(andthisisbefore
tradingcosts)

Aswath Damodaran

29

Discounted Cash Flow Valuation

Whatisit:Indiscountedcashflowvaluation,thevalueofanassetis
thepresentvalueoftheexpectedcashflowsontheasset.
PhilosophicalBasis:Everyassethasanintrinsicvaluethatcanbe
estimated,baseduponitscharacteristicsintermsofcashflows,growth
andrisk.
InformationNeeded:Tousediscountedcashflowvaluation,youneed
toestimatethelifeoftheasset
toestimatethecashflowsduringthelifeoftheasset
toestimatethediscountratetoapplytothesecashflowstogetpresentvalue

MarketInefficiency:Marketsareassumedtomakemistakesinpricing
assetsacrosstime,andareassumedtocorrectthemselvesovertime,as
newinformationcomesoutaboutassets.

Aswath Damodaran

30

Value
Length
Cash
Expected
Firm
Forever
Terminal
CF
Discount
.........
inofValue
stable
Rate
Growth
Period
growth:
of High
Growth
1 isflows
2
3
4
5
n
DISCOUNTED
CASHFLOW
GrowsValue
Firm:Cost
Firm:
Pre-debt
Growth
at constant
ofofCapital
inFirm
cashrate
flow
Operating
forever
Earnings
Equity: Value
After of
Growth
Cost
debt
ofEquity
inEquity
cashIncome/EPS
Net
flows

Aswath Damodaran

VALUATION

31

Cashflow
Expected
Firm
Forever
Terminal
FCFF
.........
Cost
Weights
Discount
Value
Riskfree
Beta
R
X
Base
Country
Did
Will
IAre
Is
your
the
there
length
you
these
is
Premium
of
company
default
ofrisk
ROC
stable
growth
beta
riskless
inconsider
include
reinvesting
using
Equity
Debt
Risk
sufficient
Operating
Value=
at
Rate
of
stable
Growth=
weights
to
premium
growth
WACC=
Firm
spread
growth
arate
rate
exposed
:bottomgrowth:
FCFF
change
Assets
period
inaCost
the
historical
toconsistent
of
/(r-g
Equity
with VALUATION
+ Equity)) + Cost of Debt (Debt/(Debt+ Equity))
1Equity
2
3
4
5
n
n+1
n) (Equity/(Debt
+sisk
DISCOUNTED
CASHFLOW
EBIT
ROC*
Grows
(Riskfree
Based
-+
Premium
normalize
acquisitions
only
likely
rate
consistent
enough
and
over
up
same
data
additional
or
reflective
competitive
Measures
Premium
Cash
implied
beta
leverage
<non-cash
time?
for
to
(1-t)
currency
growth
Reinv
on
at&
change
that
to
a of
constant
Rate
Non-op
historical
Market
country
risk
create
with
for
market
advantages?
and
reflects
Rate
rate
average
premium?
WC
your
and
Value
Assets
in
risk?
rate
risk
terms
your
- (Cap
forever
+
=
earnings?
R&D?
and
in
economy?
reinvestment
stable
consistent
business
as
risk
companys
Default
Value
the
the
investment
premium?
smooth?
future?
growth?
cash
Ex
ofrisk
Spread)
-Firm
with
risk?
Depr)
flows?
rate?
and current
(1-t)
- Value
stable
leverage?
Change
growth?
of in
Debt
WC
= Value
FCFF of Equity
- Equity Options
= Value of Equity in Stock

Aswath Damodaran

32

The Lego Blocks of Valuation

Choose a
CashFlow

Dividends
ExpectedDividendsto
Stockholders

CashflowstoEquity

NetIncome

(1

Aswath Damodaran

Three-Stage Growth
g

|
High Growth Stable

|
Transition Stable
High Growth

33

The Models You Used in DCF Valuation

50

45

40

35

30

25

20

15

10

0
DDMSt

Aswath Damodaran

DDM2

DDM3

FCFEst

FCFE2

FCFE3

FCFFSt

FCFF2

FCFF3

FCFFGen

34

What you found ...

30

25

20

15

10

0
Undervalued Undervalued 33- Undervalued 10- Undervalued 0more than 50%
50%
33%
10%

Aswath Damodaran

Overvalued 010%

Overvalued 10- Overvalued 50- Overvalued more

50%
100%
than 100%

35

The Most Undervalued stocks were..

Company
BarnesandNoble.com
Conexant Systems
Tyco International
JPMorganChase*
Peacock PLC
Creditrisk Monitor.com
FEMSA (FMX)
Royal Ahold
Chalco
Vital Images

Aswath Damodaran

Price
$1.29
$10.03
$21.25
$35.50
$1.31
$0.30
$47.89
$26.70
$0.18
$8.40

Model Used
FCFF2
FCFF2
FCFFSt
DDMSt
Fcff2
FCFFGen
FCFF2
FCFFGen
FCFF3
FCFESt

Value Per Share

$6.80
$26.91
$47.45
$77.10
$2.81
$0.62
$89.25
$49.70
$0.33
$15.29

Recommendation
Buy
Buy
Buy
Buy
BUY
Sell
BUY
Buy
Buy
Buy

36

The most undervalued in May 2001 were

Company
Netcentives Inc.
Oracle
SiriusSatelliteRadio
Salon.com

Price/Share
0.8
17.15
$9.50

Infosys Technologies (USD)

$
Aether
Good Guys
i2
Priceline
Aether Systems (AETH)
$
Metromedia Fiber Network, Inc

Aswath Damodaran

DCF Value
% Undervalued
4.64
-82.76%
$78.82
78.24%
$43.10
77.96%
0.59 $
2.30
-74.35%

69.86
13.89
$4.10
16.22
$4.20
13.47
$4.83

202.66
38.47
$10.04
$37.70
$9.36
29.01
$9.96

-65.53%
-63.89%
-59.16%
-56.98%
-55.13%
-53.57%
-51.51%

37

The ultimate test Did undervalued stocks

make money?

180.00%

160.00%

140.00%

120.00%

100.00%
Top 10 Buy Recommendations
S&P 500
80.00%

60.00%

40.00%

20.00%

0.00%
Fall 1996 (Dec 96)

Aswath Damodaran

Spr 97 (May 97)

Fall 1998 (Dec 98)

Spr 98 (May 98)

38

More on the winners...

About60%ofallbuyrecommendationsmakemoney;about45%of
sellrecommendationsbeatthemarket.
Therearetwoorthreebigwinnersineachperiod.
AppleComputerinDecember1996
CheckpointSoftwareinJune1999

Stocksonwhichthereisdisagreementamongdifferentpeopletendto
doworsethanstocksonwhichthereisnodisagreement
StocksthatareundervaluedonbothaDCFandrelativevaluation
basisdobetterthanstocksthatareundervaluedononlyoneapproach.

Aswath Damodaran

39

The Most Overvalued stocks are...

Company
EchoStarComm
Waverider(WAVC)
Revlon
WholeFoodsMarketInc.
MetroOneTelecommunications
FuelCellTech.(FLCEF)
KrispyKreme
AustrianAirlines(AAIRAV)
Yahoo
AmericanSkiingCompany
Level3Communications

Aswath Damodaran

Price
$24.84

0.14
$5.03
$47.75
$19.44
$15.87
$38.05
$9.50
$14.77
$0.18
$3.90

ModelUsed
FCFFGen
FCFF2
FCFF2
FCFE3
FCFF3
FCFFGen
FCFE3
FCFFGen
FCFFGen
FCFF2
FCFFGen

Valuepershare
$12.95

0.07
$2.30
$18.73
$6.75
$4.35
$10.28
1.67
$2.59
$0.01
$0.19

Recommendation
Sell
Sell
Sell
Sell
Sell
Sell
Sell
Sell
Sell
Sell
Buy

40

The Most Over Valued Firms in May 2001

were...
Company
Juniper Networks
Bulgari SPA
Exodus Communications
NTT DoCoMo
Yahoo!
MGM (Metro-Goldwyn-Mayer)
Fox Entertainment
Geron Corporation
Checkpoint Software CHKP
Xerox
Nvidia
Siebel Systems
BAE Systems Plc

Aswath Damodaran

Price
55.02
$11.36
$9.97

DCF Value % Overvalued

32.22
70.76%
$6.46
75.85%
$5.41
84.29%
2,540,0001,356,000
87.32%
18.55
$ 20.04
$22.62
$11.54
$75.10
8.18
$73.75
$45.70
3.38

9.89
$ 10.39
$10.78
$5.41
$31.37
3.23
$27.29
$13.90
0.83

87.56%
92.88%
109.83%
113.31%
139.40%
153.25%
170.25%
228.78%
307.23%
41

Relative Valuation

Whatisit?:Thevalueofanyassetcanbeestimatedbylookingathowthe
marketpricessimilarorcomparableassets.
PhilosophicalBasis:Theintrinsicvalueofanassetisimpossible(orcloseto
impossible)toestimate.Thevalueofanassetiswhateverthemarketis
willingtopayforit(baseduponitscharacteristics)
InformationNeeded:Todoarelativevaluation,youneed
anidenticalasset,oragroupofcomparableorsimilarassets
astandardizedmeasureofvalue(inequity,thisisobtainedbydividingtheprice
byacommonvariable,suchasearningsorbookvalue)
andiftheassetsarenotperfectlycomparable,variablestocontrolforthe
differences

MarketInefficiency:Pricingerrorsmadeacrosssimilarorcomparable
assetsareeasiertospot,easiertoexploitandaremuchmorequickly
corrected.

Aswath Damodaran

42

Standardizing Value

Pricescanbestandardizedusingacommonvariablesuchasearnings,
cashflows,bookvalueorrevenues.

Aswath Damodaran

EarningsMultiples
BookValueMultiples
Revenues
IndustrySpecificVariable(Price/kwh,Pricepertonofsteel....)

43

The Four Steps to Understanding Multiples

AnnaKournikovaknowsPE.Ordoesshe?

8timesEBITDAisnotalwayscheap

Toomanypeoplewhouseamultiplehavenoideawhatitscrosssectional
distributionis.Ifyoudonotknowwhatthecrosssectionaldistributionofa
multipleis,itisdifficulttolookatanumberandpassjudgmentonwhetheritistoo
highorlow.

Youcannotgetawaywithoutmakingassumptions

Inuse,thesamemultiplecanbedefinedindifferentwaysbydifferentusers.When
comparingandusingmultiples,estimatedbysomeoneelse,itiscriticalthatwe
understandhowthemultipleshavebeenestimated

Itiscriticalthatweunderstandthefundamentalsthatdriveeachmultiple,andthe
natureoftherelationshipbetweenthemultipleandeachvariable.

Therearenoperfectcomparables

Aswath Damodaran

Definingthecomparableuniverseandcontrollingfordifferencesisfarmore
difficultinpracticethanitisintheory.

44

V/EBIT=f(g,
VS=f(Oper
PE=Payout
PEG=Payout
PBV=ROE
PS=
Value
Value/FCFF=(1+g)/
Value/EBIT(1-t)
Value/EBIT=(1+g)(1VS=
Equity
Firm
PE=f(g,
PEG=f(g,
PBV=f(ROE,payout,
PS=f(Net
V/FCFF=f(g,
V/EBIT(1-t)=f(g,
Oper
Net
Multiples
ofMultiples
payout,
Stock
Firm
Margin
Mgn,
payout,
Margin
(Payout
Mgn,
Ratio
RIR,
WACC)
ratio
==payout,
FCFF
=
risk)
RIR,
(Payout
RIR,
DPS
WACC,
risk)
(1+g)
(1ratio)
g,WACC)
risk)
g,
/(k
WACC)
ratio)
t)risk)
1g,
1/(WACC
e - g) -g)
(1+g)/g(r-g)
(1+g)/(r-g)
(WACC-g)
(1RiR)/(1-t)(WACC-g)
RIR)
(1+g)/(r-g)
RIR)/(WACC-g)
(1+g)/(WACC-g)

Aswath Damodaran

45

Estimating a Multiple

Usecomparablefirms,computetheaveragemultipleandadjust
subjectivelyfordifferences
Usecomparablefirms,runaregressionofmultipleagainst
fundamentalsandestimatepredictedmultipleforfirm
Usemarket,runaregressionofmultipleagainstfundamentalsand
estimateapredictedmultipleforfirm

Aswath Damodaran

46

The Multiples you used were ...

40

35

30

25

20

15

10

0
PBV

Aswath Damodaran

VBV

PE

VEBITDA

Sector Specific

PEG

PS

VS

47

Valuation Results: DCF vs Relative Valuation

35

30

25

20

15

10

0
Undervalued Undervalued 33- Undervalued 10- Undervalued 0more than 50%
50%
33%
10%
DCF Valuaton (S2002)

Aswath Damodaran

Overvalued 010%

Overvalued 10- Overvalued 50- Overvalued more

50%
100%
than 100%

Relative Valuation (S2002)

48

Valuation Results: December 1999 ...

35

30

25

20
DCF Valuation
Relative Valuation
15

10

0
Undervalued Undervalued 33- Undervalued 10- Undervalued 0more than 50%
50%
33%
10%

Aswath Damodaran

Overvalued 010%

Overvalued 10- Overvalued 5050%

100%

Overvalued
more than
100%

49

Valuations: May 2000

40

35

30

25

DCF Valuation

20

Relative Valuation

15

10

Undervalued

50-100%

Aswath Damodaran

Undervalued

10-50%

Undervalued 0-

Overvalued 0-

10%

Overvalued 10-

10%

Overvalued 50-

50%

Overvalued

100%

>100%

50

Valuations: December 2000

35

30

25

20

DCF Valuation

Relative Valuation

15

10

Undervalued

Undervalued

more than

33-50%

50%

Aswath Damodaran

Undervalued

10-33%

Undervalued

Overvalued

0-10%

Overvalued

0-10%

10-50%

Overvalued

50-100%

Overvalued

more than

100%

51

DCF vs Relative Valuations

40

35

30

25

20

15

10

0
<50%

50-67%

67-90%

90%-100%

100-110%

110%-150%

150-200%

>200%

DCF as fraction of Relative Value

Aswath Damodaran

52

Most undervalued on a Relative Basis

Company
Waverider(WAVC)
BarnesandNoble.com
VASoftware
XOMA
Level3Communications
Powergen
TycoInternational
FEMSA(FMX)
AustrianAirlines(AAIRAV)
VitalImages
A&P

Aswath Damodaran

Pricepershare
Multiple
0.14
ValueSales
$1.29
PS
$1.18
PS
$2.12
PS
$3.90
VS
7.74
PBV
$21.25
PB
47.89
PBV
$9.50
V/EBITDA
$8.40
VS
$25.88
EV/Sales

RelativeValue
Recommendation
1.47
Sell
$12.55
Buy
$10.18
Sell
$14.11
Sell
$14.97
Buy
29.16
BUY
$79.13
Buy
143.8
BUY
20.17
Sell
$17.30
Buy
$51.08
Sell

53

The Most under valued firms in May 2001 were

Company
WilliamsControls
NetcentivesInc.
Salon.com
MediasetGroupS.p.A.(Euros)
Terayon(4/25/01)
Netradio
Priceline
Oracle
InfosysTechnologies(USD)
InternetSecuritiesSystems
CharlesSchwab
MatavCableSystems

Aswath Damodaran

Price
Multiple
RelativeValue
%UnderValued
$1.50
PE
$40.15
96.26%
0.8
PS
12.8
93.75%
$ 0.59
PS
$ 7.45
92.08%
11.90
PE
32.00
62.81%
$5.30
PS
$13.75
61.45%
$ 0.35
VS
$ 0.89
60.67%
$4.20
PS
$10.30
59.22%
$16.90
PE
$37.78
55.27%
$ 69.86
PEG
$ 150.16
53.48%
$ 46.28
PEG
$ 99.09
53.29%
$20.06
PBV
$41.79
52.00%
39.37
FV/Subscriber
80.84
51.30%

54

Most Over Valued Firms are..

Company
Procter & Gamble
Yahoo
Cablevision
Sprint PCS
Krispy Kreme
Whole Foods Market Inc.
MGM
Hollywood Entertainment Corp.

Tivo
Morton's Restaurant Group
Krispy Kreme
Creditrisk Monitor.com

Aswath Damodaran

Pricepershare
Multiple
RelativeValue
Recommendation
$
89.80
PE
$
40.49
Sell
$14.77
PS
$6.52
Sell
$
25.80
PBV
$
8.42
Sell
$
11.30
Value/BV
$
2.96
Sell
$38.30
PE
$9.89
Sell
$
47.75
V/S
$
12.17
Sell
$16.27
Value/Sales
2.91
BUY
$19.05
VBV
$3.11
Buy
$
3.799
PS
$
0.42
Hold
$13.03
V/BV
$1.16
Sell
$
38.05
PEG
$
1.88
Sell
$
0.30
VS
$
0.00
Sell

55

Most overvalued firms in May 2001 were..

Company
Starbucks

Electronic Data System

DoubleClick(as of 4/27)
Staples
Lucent Technologies
Staples
Yahoo!
NTT DoCoMo
Geron Corporation
Pixar (4.24.01)
MGM (Metro-Goldwyn-Mayer)
Juniper Networks

Aswath Damodaran

Price

Multiple

RelativeValue

%OverValued
$37.16
PS
$16.83
120.80%
$
62.50
PE $
25.74
142.81%
$12.86
PS
$4.99
157.72%
16.72
VS
$5.48
205.11%
$ 10.20
PEG
$
3.15
223.81%
16.02
P/S
4.48
257.59%
18.55
PEG
4.98
272.49%
2,540,000
PBV
543,000
367.77%
$11.54
VS
$2.17
431.80%
$30.20
PE
$5.05
498.02%
$ 20.04
EV/EBITDA
$
2.81
613.17%
55.02
V/S
5.47
905.85%

56

Contingent Claim (Option) Valuation

Optionshaveseveralfeatures
Theyderivetheirvaluefromanunderlyingasset,whichhasvalue
Thepayoffonacall(put)optionoccursonlyifthevalueofthe
underlyingassetisgreater(lesser)thananexercisepricethatisspecified
atthetimetheoptioniscreated.Ifthiscontingencydoesnotoccur,the
optionisworthless.
Theyhaveafixedlife

Anysecuritythatsharesthesefeaturescanbevaluedasanoption.

Aswath Damodaran

57

Indirect Examples of Options

Equityinadeeplytroubledfirmafirmwithnegativeearningsand
highleveragecanbeviewedasanoptiontoliquidatethatisheldby
thestockholdersofthefirm.Viewedassuch,itisacalloptiononthe
assetsofthefirm.
Thereservesownedbynaturalresourcefirmscanbeviewedascall
optionsontheunderlyingresource,sincethefirmcandecidewhether
andhowmuchoftheresourcetoextractfromthereserve,
Thepatentownedbyafirmoranexclusivelicenseissuedtoafirm
canbeviewedasanoptionontheunderlyingproduct(project).The
firmownsthisoptionforthedurationofthepatent.

Aswath Damodaran

58

Results of Option Valuations

Numberoffirmsvaluedusingoptionmodels=23
Medianincreaseinvaluefromtheoptionmodel=87%
Whattypesoffirmsdoyouthinkhadthebiggestincreaseinvalue?

Aswath Damodaran

59

Your recommendations were to ..

100
90
80
70
60
Buy
Sell
Hold

50
40
30
20
10
0
Spring 2002

Aswath Damodaran

Spring 2001

Fall 00

Spring '00

Fall 99 (Dec)

Spr 99 (May)

Fall 98 (Dec)

60

Value Enhancement

Foranactiontocreatevalue,ithasto

Increasecashflowsfromassetsinplace
Increasetheexpectedgrowthrate
Increasethelengthofthegrowthperiod
Reducethecostofcapital

Thevalueenhancementmeasuresthathavebeenwidelypromotedas
newanddifferentareneither.
EVAandCFROIhavetheirrootsintraditionaldiscountedcashflow
models
Measures(likeEVAandCFROI)donotcreatevalue;managersdo.

Aswath Damodaran

61

ChoicesChoicesChoices

Free Cashflow
to Firm

Aswath Damodaran

62

Picking your approach

Assetcharacteristics
Marketability
Cashflowgeneratingcapacity
Uniqueness

Yourcharacteristics
Timehorizon
Reasonsfordoingthevaluation
Beliefsaboutmarkets

Aswath Damodaran

63

What approach would work for you?

Asaninvestor,givenyourinvestmentphilosophy,timehorizonand
beliefsaboutmarkets(thatyouwillbeinvestingin),whichofthethe
approachestovaluationwouldyouchoose?
DiscountedCashFlowValuation
RelativeValuation
Neither.Ibelievethatmarketsareefficient.

Aswath Damodaran

64

Some Not Very Profound Advice

Itsallinthefundamentals.
Focusonthebigpicture;dontletthedetailstripyouup.
Keepyourperspective;itisonlyavaluation.
Ifyouhavetochoosebetweenvaluationskillsandluck.

Aswath Damodaran

65

Or maybe you can fly.

Aswath Damodaran

66