1. Valuation in 60 minutes, give or take a few…
Aswath Damodaran

2. Valuation Basics The best way to value cash is to count it.
Time has value and so does certainty.
Buzz words don’t deserve premiums. Cash does.
Relative value and intrinsic value don’t always match.

3. DCF Choices: Equity Valuation versus Firm Valuation
Firm Valuation: Value the entire business
A business and the equity in the business can be very different numbers…
A firm like GE in 2005 had a value of $ 500 billion for its business but its equity is worth only $ 300 billion - the difference is due to the substantial debt that GE has used to fund its expansion.
You can have valuable businesses, where the equity is worth nothing because the firm has borrowed too much….
Equity valuation: Value just the equity claim in the business

4. More generally… The value of any business is a function of..
With an asset with an infinite life, you need to stop estimating cash flows at some point and estimate a terminal value. In a discounted cash flow framework, this can be done when the growth rate in cash flows becomes perpetual (less than or equal to the growth rate of the economy)
Sets up the basic inputs:
1. Discount rates
2. Cash flows
3. Expected Growth
4. Length of the period that they can sustain a growth rate higher than the growth rate of the economy.

5. Estimating cash flows to a business

6. And discount rates…

7. Let’s do some valuation…
You have been asked to value a business. The business expects to $ 120 million in after-tax earnings (and cash flow) next year and to continue generating these earnings in perpetuity. The firm is all equity funded and the cost of equity is 10%.
What is the value of the business?
What is the value of equity in this business?
If there were 100 shares outstanding, what is the value of equity per share?
What would happen to the value of equity per share if the firm has granted options to its managers over time? (Assume that there are 20 million options outstanding)

8. Now, let’s try some growth
Assume now that you were told that the firm can grow earnings at 2% a year forever. Estimate the value of the business.
Now what if you were told that the firm can grow its earnings at 4% a year forever?
What if the growth rate were 6% a year forever?

9. Where does growth come from?
To grow, a company has to reinvest. How much it will have to reinvest depends in large part on how fast it wants to grow and what type of return it expects to earn on the reinvestment.
Reinvestment rate = Growth Rate/ Return on Capital
Assume in the previous example that you were told that the return on capital was 10%. Estimate the reinvestment rate and the value of the business (with a 2% growth rate).
What about with a 4% growth rate?

10. The Determinants of Growth: How investment decisions affect value
Quality growth is rare requires that a firm be able to reinvest a lot and reinvest well (earnings more than your cost of capital) at the same time.
The larger you get, the more difficult it becomes to maintain quality growth.
You can grow while destroying value at the same time.

11. Now you run the firm…
Now assume that you think you can run this firm better than the existing managers with the following changes:
Status Quo You as manager
After-tax Operating Earnings $120 million $150 million
Return on capital 10% 12%
Expected growth rate 4% 4%
Debt ratio 0% 30%
Cost of capital 10% 9%
What is the value of the business?
What should we call the difference (between this value and the earlier one)?

15. 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.
Most valuations on Wall Street are relative valuations, involving three components - a multiple, a set of comparable firms and a story. (In an informal survey of equity research reports that I did in 1998 and 1999, 92% of equity research reports could be categorized as relative valuations (though some had appendices with expected cash flows).
Implicitly, you assume that markets are correct on average. (A logical follow-up is that equity research analysts must be much stronger believers in market efficiency than they claim to be, if their primary tools are multiples.

16. Let’s do some relative valuation..

17. The first missing component…

18. And the second… Dependent variable is: PE
R squared = 66.2% R squared (adjusted) = 63.1%
Variable Coefficient SE t-ratio prob
Constant
Growth rate ≤
Emerging Market
Emerging Market is a dummy: 1 if emerging market
0 if not
Predicted PE = (7.5) (1) = 8.35
At an actual price to earnings ratio of 8.9, Telebras is slightly overvalued.
Higher growth telecomm companies have higher PE ratios..
One way to read this regression: If you have two companies - one with a growth rate of 10% and one with a growth rate of 20%, the latter should have a PE that is 12.1 higher..
If the firm happens to be an emerging market firm, though, you would expect its PE ratio to be lower than a firm with similar growth in a developed market.

19. The fundamentals behind multiples
Every multiple has embedded in it all of the assumptions that underlie discounted cashflow valuation. In particular, your assumptions about growth, risk and cashflow determine your multiple.
Firms that look cheap because they trade at low PE, Price to Book or EV to EBITDA multiples are often not cheap. The key to doing relative valuation is to look for firms that look cheap on a multiple but don’t deserve to trade at that multiple based upon their fundamentals.
So, what would your perfect under valued stock look like on a PE ratio basis?

20. Relative Valuation: Some closing propositions
Proposition 1: In a relative valuation, all that you are concluding is that a stock is under or over valued, relative to your comparable group.
Your relative valuation judgment can be right and your stock can be hopelessly over valued at the same time.
Proposition 2: In asset valuation, there are no similar assets. Every asset is unique.
If you don’t control for fundamental differences in risk, cashflows and growth across firms when comparing how they are priced, your valuation conclusions will reflect your flawed judgments rather than market misvaluations.

21. Closing Thoughts on Valuation
Valuation is simple. We choose to make it complex.
The biggest enemies of good valuations are biases and preconceptions that you bring into the valuations.
You cannot value equity precisely. Be ready to be wrong and do not take it personally.
Making a model bigger will not necessarily make it better.