Valuation
Aswath Damodaran www.damodaran.com Aswath Damodaran

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Some Initial Thoughts

" One hundred thousand lemmings cannot be wrong"
Graffiti

Aswath Damodaran

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Misconceptions about Valuation

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Myth 1: A valuation is an objective search for “true” value
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Myth 2.: A good valuation provides a precise estimate of value
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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.
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
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Aswath Damodaran

Truth 3.1: One’s 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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Approaches to Valuation

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Discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset.
Relative valuation, estimates the value of an asset by looking at the pricing of
'comparable' assets relative to a common variable like earnings, cashflows, book value or sales.
Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics.

Aswath Damodaran

4

Discounted Cash Flow Valuation

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What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset.
Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk.
Information Needed: To use discounted cash flow valuation, you need
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to estimate the life of the asset to estimate the cash flows during the life of the asset to estimate the discount rate to apply to these cash flows to get present value

Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets.

Aswath Damodaran

5

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

Liabilities

Assets in Place

Debt

Growth Assets

Equity

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

Residual Claim on cash flows
Significant Role in management
Perpetual Lives

Equity valuation: Value just the equity claim in the business

Aswath Damodaran

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Valuation with Infinite Life
DISCOUNTED CASHFLOW VALUATION

Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS

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

Firm is in stable growth:
Grows at constant rate forever Terminal Value
Value
Firm: Value of Firm
Equity: Value of Equity

CF1

CF2

CF3

CF4

CF5

CFn
.........
Forever

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity

Aswath Damodaran

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DISCOUNTED CASHFLOW VALUATION
Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF

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

FCFF1

FCFF3

FCFF4

Terminal Value= FCFF n+1 /(r-g n)
FCFF5
FCFFn
.........

+

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

Beta
- Measures market risk

Type of
Business

Aswath Damodaran

FCFF2

Firm is in stable growth:
Grows at constant rate forever Forever
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Cost of Equity

Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and in same