Aswath Damodaran Alternative Approaches to Value Enhancement Maximize a variable that is correlated with the value of the firm. There are several choices for such a variable. It could be an accounting variable, such as earnings or return on investment a marketing variable, such as market share a cash flow variable, such as cash flow return on investment (CFROI) a risk-adjusted cash flow variable, such as Economic Value Added (EVA) The advantages of using these variables are that they Are often simpler and easier to use than DCF value. The disadvantage is that the Simplicity comes at a cost; these variables are not perfectly correlated with DCF value.
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Aswath Damodaran1 Alternative Approaches to Value Enhancement Maximize a variable that is correlated with the value of the firm. There are several choices.
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Aswath Damodaran 1
Alternative Approaches to Value Enhancement
Maximize a variable that is correlated with the value of the firm. There are several choices for such a variable. It could be an accounting variable, such as earnings or return on investment a marketing variable, such as market share a cash flow variable, such as cash flow return on investment (CFROI) a risk-adjusted cash flow variable, such as Economic Value Added (EVA)
The advantages of using these variables are that they Are often simpler and easier to use than DCF value.
The disadvantage is that the Simplicity comes at a cost; these variables are not perfectly correlated
with DCF value.
Aswath Damodaran 2
Economic Value Added (EVA) and CFROI
The Economic Value Added (EVA) is a measure of surplus value created on an investment.• Define the return on capital (ROC) to be the “true” cash flow return on
capital earned on an investment.
• Define the cost of capital as the weighted average of the costs of the different financing instruments used to finance the investment.
EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project) The CFROI is a measure of the cash flow return made on capital
CFROI = (Adjusted EBIT (1-t) + Depreciation & Other Non-cash Charges) / Capital Invested
Aswath Damodaran 3
Estimating EVA for Nestle
Capital Invested = 29500 Million Sfr Return on Capital = 12.77% Cost of Capital = 8.85% Economic Value Added in 1995 = (.1277 - .0885) (29,500 Million
Sfr) = 1154.50 Million Sfr
Aswath Damodaran 4
Estimating Tsingtao’s EVA in 1996
Tsingtao Brewery, a Chinese Beer manufacturer, has make significant capital investments in the last two years, and plans to increase its exports over time. Using 1996 numbers, Tsingtao had the following fundamentals:• Return on Capital = 1.28%
• Cost of Capital = 15.51%
• Capital Invested = 3,015 million CC Economic Value Added in 1996 = – 429 million CC
Aswath Damodaran 5
J.P. Morgan’s Equity EVA: 1996
Equity Invested at the end of 1995 = $ 10,451 Million Net Income Earned in 1996 = $ 1,574 Million Cost of Equity for 1996 = 7% + 0.94 (5.5%) = 12.17%
• I used the riskfree rate from the start of 1996 Equity EVA for J.P. Morgan = $ 1574 Million - ($10,451 Million)
(.1217) = $ 303 Million
Aswath Damodaran 6
Things to Note about EVA
EVA is a measure of dollar surplus value, not the percentage difference in returns.
It is closest in both theory and construct to the net present value of a project in capital budgeting, as opposed to the IRR.
The value of a firm, in DCF terms, can be written in terms of the EVA of projects in place and the present value of the EVA of future projects.
Aswath Damodaran 7
A Simple Illustration
Assume that you have a firm with • IA = 100 In each year 1-5, assume that
• ROCA = 15% I = 10 (Investments are at beginning of each year)
• WACCA = 10% ROC New Projects = 15%
• WACCNew Projects = 10%
Assume that all of these projects will have infinite lives. After year 5, assume that
• Investments will grow at 5% a year forever
• ROC on projects will be equal to the cost of capital (10%)
Aswath Damodaran 8
Firm Value using EVA Approach
Capital Invested in Assets in Place =$ 100
EVA from Assets in Place = (.15 – .10) (100)/.10 =$ 50
+ PV of EVA from New Investments in Year 1 = [(.15 -– .10)(10)/.10] =$ 5
+ PV of EVA from New Investments in Year 2 = [(.15 -– .10)(10)/.10]/1.1 = $ 4.55
+ PV of EVA from New Investments in Year 3 = [(.15 -– .10)(10)/.10]/1.12 =$ 4.13
+ PV of EVA from New Investments in Year 4 = [(.15 -– .10)(10)/.10]/1.13 =$ 3.76
+ PV of EVA from New Investments in Year 5 = [(.15 -– .10)(10)/.10]/1.14 =$ 3.42
Value of Firm =$ 170.86
Aswath Damodaran 9
Firm Value using DCF Valuation: Estimating FCFF
Base
Y ear
1 2 3 4 5 Term.
Y ear
EBIT (1-t) : Assets in Place $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00
PV of FCFF -2,348.00Fr 1,407.40Fr 1,396.19Fr 1,385.02Fr 1,373.90Fr 51,406.74Fr
Value of Firm= 54,621.24Fr
Value of Debt = 11,726.00Fr
Value of Equity = 42,895.24Fr
Value Per Share = 1,088.16Fr
Aswath Damodaran 14
Year-by-year EVA Changes
Firms are often evaluated based upon year-to-year changes in EVA rather than the present value of EVA over time.
The advantage of this comparison is that it is simple and does not require the making of forecasts about future earnings potential.
Another advantage is that it can be broken down by any unit - person, division etc., as long as one is willing to assign capital and allocate earnings across these same units.
While it is simpler than DCF valuation, using year-by-year EVA changes comes at a cost. In particular, it is entirely possible that a firm which focuses on increasing EVA on a year-to-year basis may end up being less valuable.
Aswath Damodaran 15
Year-to-Year EVA Changes: Nestle
0 1 2 3 4 5 Term. Y ear
Return on Capital 12.77% 12.77% 12.77% 12.77% 12.77% 12.77% 12.77%
Cost of Capital 8.85% 8.85% 8.85% 8.85% 8.85% 8.85% 8.85%
EVA 1,154.60Fr 1,246.49Fr 1,345.69Fr 1,452.76Fr 1,568.33Fr 1,693.08Fr 1,743.88Fr
PV of EVA 1,145.10Fr 1,135.67Fr 1,126.30Fr 1,117.00Fr 1,107.76Fr
29,787.18Fr
PV of EVA = 25,121.24Fr PV of 590.67 Fr growing
at 3% a year
Value of Assets
in Place =
29,500.00Fr
Value of Firm = 54,621.24Fr
Value of Debt = 11,726.00Fr
Value of Equity 42,895.24Fr
Value per Share = 1088.16Fr
Aswath Damodaran 16
When Increasing EVA on year-to-year basis may result in lower Firm Value
1. If the increase in EVA on a year-to-year basis has been accomplished at the expense of the EVA of future projects. In this case, the gain from the EVA in the current year may be more than offset by the present value of the loss of EVA from the future periods.• For example, in the Nestle example above assume that the return on
capital on year 1 projects increases to 13.27% (from the existing 12.77%), while the cost of capital on these projects stays at 8.85%. If this increase in value does not affect the EVA on future projects, the value of the firm will increase.
• If, however, this increase in EVA in year 1 is accomplished by reducing the return on capital on future projects to 12.27%, the firm value will actually decrease.
Aswath Damodaran 17
Firm Value and EVA tradeoffs over time
0 1 2 3 4 5 Term. Y ear
Return on Capital 12.77% 13.27% 12.27% 12.27% 12.27% 12.27% 12.27%
Cost of Capital 8.85% 8.85% 8.85% 8.85% 8.85% 8.85% 8.85%
EVA 1,154.60Fr 1,258.27Fr 1,344.84Fr 1,438.28Fr 1,539.13Fr 1,648.00Fr 1,693.75Fr
PV of EVA 1,155.92Fr 1,134.95Fr 1,115.07Fr 1,096.20Fr 1,078.27Fr
28,930.98Fr
PV of EVA = 24,509.62Fr PV of 590.67 Fr growing
at 3% a year
Value of Assets
in Place =
29,500.00Fr
Value of Firm = 54,009.62Fr
Value of Debt = 11,726.00Fr
Value of Equity = 42,283.62Fr
Value Per Share = 1,072.64Fr
Aswath Damodaran 18
EVA and Risk
2. When the increase in EVA is accompanied by an increase in the cost of capital, either because of higher operational risk or changes in financial leverage, the firm value may decrease even as EVA increases.• For instance, in the example above, assume that the spread stays at 3.91%
on all future projects but the cost of capital increases to 9.85% for these projects (from 8.85%). The value of the firm will drop.
Aswath Damodaran 19
Nestle’s Value at a 9.95 % Cost of Capital
0 1 2 3 4 5 Term. Y ear
Return on Capital 12.77% 13.77% 13.77% 13.77% 13.77% 13.77% 13.77%
Cost of Capital 8.85% 9.85% 9.85% 9.85% 9.85% 9.85% 9.85%
The relationship between EVA and Market Value Changes is more complicated than the one between EVA and Firm Value.
The market value of a firm reflects not only the Expected EVA of Assets in Place but also the Expected EVA from Future Projects
To the extent that the actual economic value added is smaller than the expected EVA the market value can decrease even though the EVA is higher.
Aswath Damodaran 22
High EVA companies do not earn excess returns
Aswath Damodaran 23
Increases in EVA do not create excess returns
Aswath Damodaran 24
When focusing on year-to-year EVA changes has least side effects
1. Most or all of the assets of the firm are already in place; i.e, very little or none of the value of the firm is expected to come from future growth.• [This minimizes the risk that increases in current EVA come at the
expense of future EVA]
2. The leverage is stable and the cost of capital cannot be altered easily by the investment decisions made by the firm.• [This minimizes the risk that the higher EVA is accompanied by an
increase in the cost of capital]
3. The firm is in a sector where investors anticipate little or not surplus returns; i.e., firms in this sector are expected to earn their cost of capital.• [This minimizes the risk that the increase in EVA is less than what the
market expected it to be, leading to a drop in the market price.]
Aswath Damodaran 25
Valuation: Closing Thoughts
Spring 2002
Aswath Damodaran
Aswath Damodaran 26
Do you have your life vests on?
Aswath Damodaran 27
Truths about Valuation
Truth 1: Bias is endemic in valuation and can enter in subtle and not so subtle ways.
Truth 2.: A valuation is never precise and is never quite done. Truth 3: Complexity comes with a cost; More information is not
always better than less information.
Aswath Damodaran 28
Approaches to Valuation
Discounted cashflow valuation, where we try (sometimes desperately) to estimate the intrinsic value of an asset by using a mix of theory, guesswork and prayer.
Relative valuation, where we pick a group of assets, attach the name “comparable” to them and tell a story.
Contingent claim valuation, where we take the valuation that we did in the DCF valuation and divvy it up between the potential thieves of value (equity) and the potential victims of this crime (lenders)
Aswath Damodaran 29
Basis for all valuation approaches
We all believe market are inefficient, and that we can find under and over valued assets because of our superior intellect, models, information or some combination of all three.
Some Sobering facts:• 70-80% of portfolio managers under perform market indices.
• The Vanguard 500 Index fund is poised to overtake the Fidelity Magellan fund as the largest mutual fund in the United States. In the last 5 years, it has been the best performing large mutual fund in the United States.
• The more people trade, the more they seem to lose.– A study of mutual fund portfolios discovered that they would have made a
higher return, if they had frozen their portfolios on January 1.
– A study of individual investors by Terrence O”Dean also noted a negative correlation between returns earned and transactions volume (and this is before trading costs)
Aswath Damodaran 30
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• 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 31
Cash flowsFirm: Pre-debt cash flowEquity: After debt cash flows
Expected GrowthFirm: Growth in Operating EarningsEquity: Growth in Net Income/EPS
CF1CF2CF3CF4CF5ForeverFirm is in stable growth:Grows at constant rateforever
Terminal ValueCFn.........Discount RateFirm:Cost of Capital
Equity: Cost of Equity
ValueFirm: Value of Firm
Equity: Value of Equity
DISCOUNTED CASHFLOW VALUATIONLength of Period of High Growth
Aswath Damodaran 32
Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF
Expected Growth=ROC* Reinv RateFCFF1FCFF2FCFF3FCFF4FCFF5ForeverFirm is in stable growth:Grows at constant rateforever
Terminal Value= FCFF n+1/(r-gn)FCFFn.........Cost of EquityCost of Debt(Riskfree Rate+ Default Spread) (1-t)
WeightsBased on Market ValueDiscount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity- Equity Options= Value of Equity in Stock
Base EquityPremiumCountry RiskPremiumDISCOUNTED CASHFLOW VALUATIONDid younormalizeearnings?
Did you includeacquisitions andR&D?
Did you consideronly non-cash WCand smooth?
Is your ROClikely to changein the future?
Is your stable growth rate < growth rate in economy?
Is your growth rateconsistent with yourreinvestment rate?
Are you reinvesting enough to create stable growth?
Is your betaand leverageconsistent withstable growth?
Will these weights changeover time?Are you using a bottom-up beta that reflects yourbusiness risk and currentleverage?
Is your riskless rate in thesame currency and termsas the cash flows?
I s there sufficientdata for a historicalrisk premium?
Is the company exposed toadditional country risk?Is your risk premium a historicalor implied risk premium?Is the default spreadreflective of company’s risk?
I s length of growth period consistent withcompetitive advantages?
Aswath Damodaran 33
The Lego Blocks of Valuation
Choose aCash Flow Dividends
Expected Dividends to
Stockholders
Cashflows to Equity
Net Income
- (1- δ) (Capital Exp. - Deprec’n)
- (1- δ) Change in Work. Capital
= Free Cash flow to Equity (FCFE)
[δ = Debt Ratio]
Cashflows to Firm
EBIT (1- tax rate)- (Capital Exp. - Deprec’n)- Change in Work. Capital
= Free Cash flow to Firm (FCFF)
& A Discount Rate Cost of Equity
• Basis: The riskier the investment, the greater is the cost of equity.
What is it?: The value of any asset can be estimated by looking at how the market prices “similar” or ‘comparable” assets.
Philosophical Basis: The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics)
Information Needed: To do a relative valuation, you need • an identical asset, or a group of comparable or similar assets• a standardized measure of value (in equity, this is obtained by dividing the price
by a common variable, such as earnings or book value)• and if the assets are not perfectly comparable, variables to control for the
differences Market Inefficiency: Pricing errors made across similar or comparable
assets are easier to spot, easier to exploit and are much more quickly corrected.
Aswath Damodaran 43
Standardizing Value
Prices can be standardized using a common variable such as earnings, cashflows, book value or revenues. • Earnings Multiples
• Book Value Multiples
• Revenues
• Industry Specific Variable (Price/kwh, Price per ton of steel ....)
Aswath Damodaran 44
The Four Steps to Understanding Multiples
Anna Kournikova knows PE…. Or does she?• In use, the same multiple can be defined in different ways by different users. When
comparing and using multiples, estimated by someone else, it is critical that we understand how the multiples have been estimated
8 times EBITDA is not always cheap…• Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a multiple is, it is difficult to look at a number and pass judgment on whether it is too high or low.
You cannot get away without making assumptions• It is critical that we understand the fundamentals that drive each multiple, and the
nature of the relationship between the multiple and each variable. There are no perfect comparables
• Defining the comparable universe and controlling for differences is far more difficult in practice than it is in theory.
Aswath Damodaran 45
Value of Stock = DPS 1/(ke - g)PE=Payout Ratio (1+g)/(r-g)PEG=Payout ratio (1+g)/g(r-g)PBV=ROE (Payout ratio) (1+g)/(r-g)PS= Net Margin (Payout ratio)(1+g)/(r-g)Value of Firm = FCFF1/(WACC -g)Value/FCFF=(1+g)/(WACC-g)Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g)Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)VS= Oper Margin (1-RIR) (1+g)/(WACC-g)Equity MultiplesFirm MultiplesPE=f(g, payout, risk)PEG=f(g, payout, risk)PBV=f(ROE,payout, g, risk)PS=f(Net Mgn, payout, g, risk)V/FCFF=f(g, WACC)V/EBIT(1-t)=f(g, RIR, WACC)V/EBIT=f(g, RIR, WACC, t)VS=f(Oper Mgn, RIR, g, WACC)
Aswath Damodaran 46
Estimating a Multiple
Use comparable firms, compute the average multiple and adjust subjectively for differences
Use comparable firms, run a regression of multiple against fundamentals and estimate predicted multiple for firm
Use market, run a regression of multiple against fundamentals and estimate a predicted multiple for firm
Company Price per share Multiple Relative Value RecommendationWaverider (WAVC) 0.14 Value Sales 1.47 SellBarnesandNoble.com 1.29$ PS 12.55$ BuyVA Software $1.18 PS 10.18$ SellXOMA $2.12 PS $14.11 SellLevel 3 Communications 3.90$ VS 14.97$ BuyPowergen £7.74 PBV £29.16 BUYTyco International $21.25 PB $79.13 BuyFEMSA (FMX) 47.89 PBV 143.8 BUYAustrian Airlines (AAIR AV) $9.50 V/EBITDA 20.17 SellVital Images 8.40$ VS 17.30$ BuyA&P 25.88$ EV/Sales 51.08$ Sell
Aswath Damodaran 54
The Most under valued firms in May 2001 were
Company Price Multiple Relative Value % Under Valued
Williams Controls $1.50 PE $40.15 -96.26%Netcentives Inc. 0.8 PS 12.8 -93.75%Salon.com 0.59$ PS 7.45$ -92.08%Mediaset Group S.p.A. (Euros) 11.90€ PE 32.00€ -62.81%Terayon (4/25/01) $5.30 PS $13.75 -61.45%Netradio 0.35$ VS 0.89$ -60.67%Priceline $4.20 PS $10.30 -59.22%Oracle $16.90 PE $37.78 -55.27%Infosys Technologies (USD) 69.86$ PEG 150.16$ -53.48%Internet Securities Systems 46.28$ PEG 99.09$ -53.29%Charles Schwab $20.06 PBV $41.79 -52.00%Matav Cable Systems 39.37 FV/Subscriber 80.84 -51.30%
Aswath Damodaran 55
Most Over Valued Firms are..
Company Price per share Multiple Relative Value RecommendationProcter & Gamble 89.80$ PE 40.49$ SellYahoo $14.77 PS $6.52 SellCablevision 25.80$ PBV 8.42$ SellSprint PCS 11.30$ Value/BV 2.96$ SellKrispy Kreme $38.30 PE $9.89 SellWhole Foods Market Inc. 47.75$ V/S 12.17$ SellMGM $16.27 Value/Sales 2.91 BUYHollywood Entertainment Corp. $19.05 VBV $3.11 BuyTivo 3.799$ PS 0.42$ HoldMorton's Restaurant Group $13.03 V/BV $1.16 SellKrispy Kreme 38.05$ PEG 1.88$ SellCreditrisk Monitor.com 0.30$ VS 0.00$ Sell
Aswath Damodaran 56
Most overvalued firms in May 2001 were..
Company Price Multiple Relative Value % Over Valued
Starbucks $37.16 PS $16.83 120.80%Electronic Data System 62.50$ PE 25.74$ 142.81%DoubleClick(as of 4/27) $12.86 PS $4.99 157.72%Staples 16.72 VS $5.48 205.11%Lucent Technologies 10.20$ PEG 3.15$ 223.81%Staples 16.02 P/S 4.48 257.59%Yahoo! 18.55 PEG 4.98 272.49%NTT DoCoMo 2,540,000 PBV 543,000 367.77%Geron Corporation $11.54 VS $2.17 431.80%Pixar (4.24.01) $30.20 PE $5.05 498.02%MGM (Metro-Goldwyn-Mayer) 20.04$ EV/EBITDA 2.81$ 613.17%Juniper Networks 55.02 V/S 5.47 905.85%
Aswath Damodaran 57
Contingent Claim (Option) Valuation
Options have several features• They derive their value from an underlying asset, which has value
• The payoff on a call (put) option occurs only if the value of the underlying asset is greater (lesser) than an exercise price that is specified at the time the option is created. If this contingency does not occur, the option is worthless.
• They have a fixed life Any security that shares these features can be valued as an option.
Aswath Damodaran 58
Indirect Examples of Options
Equity in a deeply troubled firm - a firm with negative earnings and high leverage - can be viewed as an option to liquidate that is held by the stockholders of the firm. Viewed as such, it is a call option on the assets of the firm.
The reserves owned by natural resource firms can be viewed as call options on the underlying resource, since the firm can decide whether and how much of the resource to extract from the reserve,
The patent owned by a firm or an exclusive license issued to a firm can be viewed as an option on the underlying product (project). The firm owns this option for the duration of the patent.
Aswath Damodaran 59
Results of Option Valuations
Number of firms valued using option models = 23 Median increase in value from the option model = 87% What types of firms do you think had the biggest increase in value?
Aswath Damodaran 60
Your recommendations were to ..
Recommendations
0
10
20
30
40
50
60
70
80
90
100
Spring 2002 Spring 2001 Fall 00 Spring '00 Fall 99 (Dec) Spr 99 (May) Fall 98 (Dec)
Buy
Sell
Hold
Aswath Damodaran 61
Value Enhancement
For an action to create value, it has to• Increase cash flows from assets in place
• Increase the expected growth rate
• Increase the length of the growth period
• Reduce the cost of capital The value enhancement measures that have been widely promoted as
new and different are neither. • EVA and CFROI have their roots in traditional discounted cash flow
models
• Measures (like EVA and CFROI) do not create value; managers do.
Aswath Damodaran 62
Choices…Choices…Choices…
Valuation Models
Asset Based
Valuation
Discounted Cashflow
Models
Relative Valuation Contingent Claim
Models
Liquidation
Value
Replacement
Cost
Equity Valuation
Models
Firm Valuation
Models
Cost of capital
approach
APV
approach
Excess Return
Models
Stable
Two-stage
Three-stage
or n-stage
Current
Normalized
Equity
Frim
Earnings Book
Value
Revenues Sector
specific
Sector
Market
Option to
delay
Option to
expand
Option to
liquidate
Patent Undeveloped
Reserves
Young
firms
Undeveloped
land
Equity in
troubled
firm
Dividends
Free Cashflow
to Firm
Aswath Damodaran 63
Picking your approach
Asset characteristics• Marketability
• Cash flow generating capacity
• Uniqueness Your characteristics
• Time horizon
• Reasons for doing the valuation
• Beliefs about markets
Aswath Damodaran 64
What approach would work for you?
As an investor, given your investment philosophy, time horizon and beliefs about markets (that you will be investing in), which of the the approaches to valuation would you choose?
Discounted Cash Flow Valuation Relative Valuation Neither. I believe that markets are efficient.
Aswath Damodaran 65
Some Not Very Profound Advice
Its all in the fundamentals. Focus on the big picture; don’t let the details trip you up. Keep your perspective; it is only a valuation. If you have to choose between valuation skills and luck….