Aswath Damodaran1 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 Damodaran2 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 Damodaran3 Estimating EVA for Nestle Capital Invested = Million Sfr Return on Capital = 12.77% Cost of Capital = 8.85% Economic Value Added in 1995 = ( ) (29,500 Million Sfr) = Million Sfr

Aswath Damodaran4 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 Damodaran5 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% (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 Damodaran6 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 Damodaran7 A Simple Illustration Assume that you have a firm with I A = 100In each year 1-5, assume that ROC A = 15%  I = 10 (Investments are at beginning of each year) WACC A = 10%ROC New Projects = 15% WACC New 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 Damodaran8 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= $ PV of EVA from New Investments in Year 3 = [(.15 -–.10)(10)/.10]/1.1 2 =$ PV of EVA from New Investments in Year 4 = [(.15 -–.10)(10)/.10]/1.1 3 =$ PV of EVA from New Investments in Year 5 = [(.15 -–.10)(10)/.10]/1.1 4 =$ 3.42 Value of Firm =$

Aswath Damodaran9 Firm Value using DCF Valuation: Estimating FCFF

Aswath Damodaran10 Firm Value: Cost of Capital and Capital Invested

Aswath Damodaran11 Firm Value: Present Value of FCFF

Aswath Damodaran12 EVA Valuation of Nestle

Aswath Damodaran13 DCF Valuation of Nestle

Aswath Damodaran14 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 Damodaran15 Year-to-Year EVA Changes: Nestle

Aswath Damodaran16 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 Damodaran17 Firm Value and EVA tradeoffs over time

Aswath Damodaran18 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 Damodaran19 Nestle’s Value at a 9.95 % Cost of Capital

Aswath Damodaran20 EVA: The Risk Effect

Aswath Damodaran21 EVA and Changes in Market Value 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 Damodaran22 High EVA companies do not earn excess returns

Aswath Damodaran23 Increases in EVA do not create excess returns

Aswath Damodaran24 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 Damodaran25 Valuation: Closing Thoughts Spring 2002 Aswath Damodaran

26 Do you have your life vests on?

Aswath Damodaran27 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 Damodaran28 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 Damodaran29 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 Damodaran30 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.

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Aswath Damodaran33 The Lego Blocks of Valuation

Aswath Damodaran34 The Models You Used in DCF Valuation

Aswath Damodaran35 What you found...

Aswath Damodaran36 The Most Undervalued stocks were..

Aswath Damodaran37 The most undervalued in May 2001 were

Aswath Damodaran38 The ultimate test… Did undervalued stocks make money?

Aswath Damodaran39 More on the winners... About 60% of all buy recommendations make money; about 45% of sell recommendations beat the market. There are two or three big winners in each period. Apple Computer in December 1996 Checkpoint Software in June 1999 Stocks on which there is disagreement among different people tend to do worse than stocks on which there is no disagreement Stocks that are under valued on both a DCF and relative valuation basis do better than stocks that are under valued on only one approach.

Aswath Damodaran40 The Most Overvalued stocks are...

Aswath Damodaran41 The Most Over Valued Firms in May 2001 were...

Aswath Damodaran42 Relative Valuation 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 Damodaran43 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 Damodaran44 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.

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Aswath Damodaran46 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

Aswath Damodaran47 The Multiples you used were...

Aswath Damodaran48 Valuation Results: DCF vs Relative Valuation

Aswath Damodaran49 Valuation Results: December

Aswath Damodaran50 Valuations: May 2000

Aswath Damodaran51 Valuations: December 2000

Aswath Damodaran52 DCF vs Relative Valuations

Aswath Damodaran53 Most undervalued on a Relative Basis

Aswath Damodaran54 The Most under valued firms in May 2001 were

Aswath Damodaran55 Most Over Valued Firms are..

Aswath Damodaran56 Most overvalued firms in May 2001 were..

Aswath Damodaran57 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 Damodaran58 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 Damodaran59 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 Damodaran60 Your recommendations were to..

Aswath Damodaran61 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 Damodaran62 Choices…Choices…Choices…

Aswath Damodaran63 Picking your approach Asset characteristics Marketability Cash flow generating capacity Uniqueness Your characteristics Time horizon Reasons for doing the valuation Beliefs about markets

Aswath Damodaran64 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 Damodaran65 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….

Aswath Damodaran66 Or maybe you can fly….