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
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
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
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Discounted Cash Flow Valuation
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
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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
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
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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
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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