SESSION 2: INTRINSIC VALUATION LAYING THE FOUNDATION Aswath Damodaran ‹#› Aswath Damodaran 1

2 The Building Blocks for Value Aswath Damodaran 2

3 The essence of intrinsic value  In intrinsic valuation, you value an asset based upon its fundamentals.  Those fundamentals are cash flows, growth and risk.  Discounted cash flow valuation is a tool for estimating intrinsic value. Aswath Damodaran 3

4 The two faces of discounted cash flow valuation Discount expected cash flows at a risk adjusted discount rate: Discount certainty equivalent cash flows at a risk free rate. Aswath Damodaran 4

5 Risk Adjusted Value: Two Basic Propositions Proposition 1: If your asset is never expected to generate positive cash flows, it cannot have positive value. Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later. Proposition 3: Assets with negative cash flows up front can still be worth a lot if they have disproportionately large positive cash flows later. Aswath Damodaran 5

6 DCF Choices: Equity Valuation versus Firm Valuation Equity valuation: Value just the equity claim in the business Firm Valuation: Value the entire business Aswath Damodaran 6

7 Equity Valuation Aswath Damodaran 7

8 Firm Valuation Aswath Damodaran 8

9 Generic DCF Valuation Model Aswath Damodaran 9

10 First Principle of Valuation  Consistency principle: Your discount rate should match up to your cash flows.  The key error to avoid is mismatching cashflows and discount rates:  Discounting cash flows to equity at the weighted average cost of capital will lead to an upwardly biased estimate of the value of equity  Discounting cash flows to the firm at the cost of equity will yield a downward biased estimate of the value of the firm. Aswath Damodaran 10