Valuation

Aswath Damodaran

Aswath Damodaran 188

 First Principles

 Invest in projects that yield a return greater than the minimum

acceptable hurdle rate .
• The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners ’ funds (equity) or borrowed money (debt)
• Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.
 Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
 If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon
the stockholders ’ characteristics.
Objective: Maximize the Value of the Firm

Aswath Damodaran 189

 Discounted Cashflow Valuation: Basis for
Approach

t = n CF
Value = ∑ t
t
t = 1 (1 + r)

• where,
• n = Life of the asset
• CFt = Cashflow in period t
• r = Discount rate reflecting the riskiness of the estimated cashflows

Aswath Damodaran 190

 Equity Valuation

 The value of equity is obtained by discounting expected cashflows to equity,

i.e., the residual cashflows after meeting all expenses, tax obligations and
interest and principal payments, at the cost of equity, i.e., the rate of return
required by equity investors in the firm.
t=n CF
to Equity t
Value of Equity = ∑ (1+ k e )t
t=1

where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity
 The dividend discount model is a specialized case of equity valuation, and the
value of a stock is the present value of expected future dividends.

Aswath Damodaran 191

 Firm Valuation

 The value of the firm is obtained by discounting expected cashflows to

the firm, i.e., the residual cashflows after meeting all operating
expenses and taxes, but prior to debt payments, at the weighted
average cost of capital, which is the cost of the different components
of financing used by the firm, weighted by their market value
proportions.
t=n
CF to Firm t
Value of Firm = ∑ (1+ WACC)t
t=1

where,
CF to Firmt = Expected Cashflow to Firm in period t
WACC = Weighted Average Cost of Capital

Aswath Damodaran 192

 Generic DCF Valuation Model
DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Equity: After debt Net Income/EPS Firm is in stable growth:
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

Aswath Damodaran 193

 Estimating Inputs:
I. Discount Rates

 Critical ingredient in discounted cashflow valuation. Errors in

estimating the discount rate or mismatching cashflows and discount
rates can lead to serious errors in valuation.
 At an intutive level, the discount rate used should be consistent with
both the riskiness and the type of cashflow being discounted.
 The cost of equity is the rate at which we discount cash flows to equity
(dividends or free cash flows to equity). The cost of capital is the rate
at which we discount free cash flows to the firm.

Aswath Damodaran 194

 Estimating Aracruz ’s Cost of Equity

 Average Unlevered Beta for Paper and Pulp firms is 0.61

 Aracruz has a cash balance which was 20% of the market value in
1997, which is much higher than the typical cash balance at other
paper and pulp firms. The beta of cash is zero.
Unlevered Beta for Aracruz = (0.8) ( 0.61) + 0.2 (0) = 0.488
 Using Aracruz ’s gross debt equity ratio of 66.67% and a tax rate of
33%:
Levered Beta for Aracruz = 0.49 (1+ (1-.33) (.6667)) = 0.71
 Cost of Equity for Aracruz = Real Riskfree Rate + Beta(Premium)
= 5% + 0.71 (7.5%) = 10.33%
Real Riskfree Rate = 5% (Long term Growth rate in Brazilian economy)
Risk Premium = 7.5% (U.S. Premium + Brazil Risk (from rating))

Aswath Damodaran 195

 Estimating Cost of Equity: Deutsche Bank

 Deutsche Bank is in two different segments of business - commercial

banking and investment banking.
 To estimate its commercial banking beta, we will use the average beta
of commercial banks in Germany.
 To estimate the investment banking beta, we will use the average bet
of investment banks in the U.S and U.K.
Comparable Firms Average Beta Weight
Commercial Banks in Germany 0.90 90%
U.K. and U.S. investment banks 1.30 10%
 Beta for Deutsche Bank = 0.9 (.90) + 0.1 (1.30)= 0.94
 Cost of Equity for Deutsche Bank (in DM) = 7.5% + 0.94 (5.5%)
= 12.67%

Aswath Damodaran 196

 Reviewing Disney ’s Costs of Equity & Debt

Business Unlevered D/E Ratio Levered Riskfree Risk Cost of

Beta Beta Rate Premium Equity
Creative Content 1.25 20.92% 1.42 7.00% 5.50% 14.80%
Retailing 1.50 20.92% 1.70 7.00% 5.50% 16.35%
Broadcasting 0.90 20.92% 1.02 7.00% 5.50% 12.61%
Theme Parks 1.10 20.92% 1.26 7.00% 5.50% 13.91%
Real Estate 0.70 59.27% 0.92 7.00% 5.50% 12.31%
Disney 1.09 21.97% 1.25 7.00% 5.50% 13.85%

 Disney’s Cost of Debt (based upon rating) = 7.50%

Aswath Damodaran 197

 Estimating Cost of Capital: Disney

 Equity
• Cost of Equity = 13.85%
• Market Value of Equity = $50.88 Billion
• Equity/(Debt+Equity ) = 82%
 Debt
• After-tax Cost of debt = 7.50% (1-.36) = 4.80%
• Market Value of Debt = $ 11.18 Billion
• Debt/(Debt +Equity) = 18%
 Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%

Aswath Damodaran 198

 II. Estimating Cash Flows

Cash Flows

To Equity To Firm

The Strict View The Broader View EBIT (1-t)

Dividends + Net Income - ( Cap Ex - Depreciation)
Stock Buybacks - Net Cap Ex (1-Debt Ratio) - Change in Working Capital
- Chg WC (1 - Debt Ratio) = Free Cashflow to Firm
= Free Cashflow to Equity

Aswath Damodaran 199

 Estimating FCFE next year: Aracruz

All inputs are per share numbers:

Earnings BR 0.222
- ( CapEx-Depreciation)*(1-DR) BR 0.042
-Chg. Working Capital*(1-DR) BR 0.018
Free Cashflow to Equity BR 0.170
 Earnings: Since Aracruz ’s 1996 earnings are “abnormally ” low, I used
the average earnings per share from 1992 to 1996.
 Capital Expenditures per share next year = 0.24 BR/share
 Depreciation per share next year = 0.18 BR/share
 Change in Working Capital = 0.03 BR/share
 Debt Ratio = 39%

Aswath Damodaran 200

 Estimating FCFF: Disney

 EBIT = $5,559 Million

 Capital spending = $ 1,746 Million
 Depreciation = $ 1,134 Million
 Increase in Non-cash Working capital = $ 617 Million
 Estimating FCFF
EBIT (1-t) $ 3,558
+ Depreciation $ 1,134
- Capital Expenditures $ 1,746
- Change in WC $ 617
= FCFF $ 2,329 Million

Aswath Damodaran 201

  Application Test: Estimating your firm ’s
FCFF

 Estimate the FCFF for your firm in its most recent financial year:
In general, If using statement of cash flows
EBIT (1-t) EBIT (1-t)
+ Depreciation + Depreciation
- Capital Expenditures + Capital Expenditures
- Change in Non-cash WC + Change in Non-cash WC
= FCFF = FCFF
Estimate the dollar reinvestment at your firm:
Reinvestment = EBIT (1-t) - FCFF

Aswath Damodaran 202

 Choosing a Cash Flow to Discount

 When you cannot estimate the free cash fllows to equity or the firm,
the only cash flow that you can discount is dividends. For financial
service firms, it is difficult to estimate free cash flows. For Deutsche
Bank, we will be discounting dividends.
 If a firm ’s debt ratio is not expected to change over time, the free cash
flows to equity can be discounted to yield the value of equity. For
Aracruz, we will discount free cash flows to equity.
 If a firm ’s debt ratio might change over time, free cash flows to equity
become cumbersome to estimate. Here, we would discount free cash
flows to the firm. For Disney, we will discount the free cash flow to
the firm.

Aswath Damodaran 203

 III. Expected Growth
Expected Growth

Net Income Operating Income

Retention Ratio= Return on Equity Reinvestment Return on Capital =

1 - Dividends/Net X Net Income/Book Value of Rate = (Net Cap X EBIT(1-t)/Book Value of
Income Equity Ex + Chg in Capital
WC/EBIT(1-t)

Aswath Damodaran 204

 Expected Growth in EPS

gE PS = Ret ained Earn ings t-1/ N It-1 * R OE

= R eten tionR at io* ROE
= b * RO E
• Pro position 1: The expected growth rate in e arnings for a company
can not exce ed i ts ret urn on eq uity i n th e lo n g t erm.

Aswath Damodaran 205

 Estimating Expected Growth in EPS: Disney,
Aracruz and Deutsche Bank

Company ROE Retention Exp. Forecast Retention Exp

Ratio Growth ROE Ratio Growth
Disney 24.95% 77.68% 19.38% 25% 77.68% 19.42%
Aracruz 2.22% 65.00% 1.44% 13.91% 65.00% 9.04%
Deutsche Bank 7.25% 39.81% 2.89% 14.00% 45.00% 6.30%
ROE: Return on Equity for most recent year
Forecasted ROE = Expected ROE for the next 5 years
• For Disney, forecasted ROE is expected to be close to current ROE
• For Aracruz, the average ROE between 1994 and 1996 is used, since 1996
was a abnormally bad year
• For Deutsche Bank, the forecast ROE is set equal to the average ROE for
German banks

Aswath Damodaran 206

 ROE and Leverage

 ROE = ROC + D/E (ROC - i (1-t))

where,
ROC = (EBIT (1 - tax rate)) / Book Value of Capital
= EBIT (1- t) / Book Value of Capital
D/E = BV of Debt/ BV of Equity
i = Interest Expense on Debt / Book Value of Debt
t = Tax rate on ordinary income
 Note that BV of Capital = BV of Debt + BV of Equity.

Aswath Damodaran 207

 Decomposing ROE: Disney in 1996

 Return on Capital
= (EBIT(1-tax rate) / (BV: Debt + BV: Equity)
= 5559 (1-.36)/ (7663+11668) = 18.69%
 Debt Equity Ratio
= Book Value of Debt/ Book Value of Equity= 45%
 Interest Rate on Debt = 7.50%
 Expected Return on Equity = ROC + D/E (ROC - i(1-t))
= 18.69 % + .45 (18.69% - 7.50(1-.36)) = 24.95%

Aswath Damodaran 208

 Expected Growth in EBIT And Fundamentals

 Reinvestment Rate and Return on Capital

gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC
 Proposition 2: No firm can expect its operating income to grow over
time without reinvesting some of the operating income in net capital
expenditures and/or working capital.
 Proposition 3: The net capital expenditure needs of a firm, for a given
growth rate, should be inversely proportional to the quality of its
investments.

Aswath Damodaran 209

 Estimating Growth in EBIT: Disney

Actual reinvestment rate in 1996 = (Net Cap Ex+ Chg in WC)/ EBIT (1-t)
• Net Cap Ex in 1996 = (1745-1134)
• Change in Working Capital = 617
• EBIT (1- tax rate) = 5559(1-.36)
• Reinvestment Rate = (1745-1134+617)/(5559*.64)= 34.5%
 Forecasted Reinvestment Rate = 50%
 Return on Capital =20% (Higher than this year ’s 18.69%)
 Expected Growth in EBIT =.5(20%) = 10%
 The forecasted reinvestment rate is much higher than the actual
reinvestment rate in 1996, because it includes projected acquisition.
Between 1992 and 1996, adding in the Capital Cities acquisition to all
capital expenditures would have yielded a reinvestment rate of roughly
50%.

Aswath Damodaran 210

  Application Test: Estimating Expected
Growth

 Estimate the following:

• The reinvestment rate for your firm
• The after-tax return on capital
• The expected growth in operating income, based upon these inputs

Aswath Damodaran 211

 IV. Getting Closure in Valuation

 A publicly traded firm potentially has an infinite life. The value is

therefore the present value of cash flows forever.
t = ∞ CF
Value = ∑ t
t
t = 1 (1+ r)

 Since we cannot estimate cash flows forever, we estimate cash flows

for a “growth period ” and then estimate a terminal value, to capture the
value at the end of the period:
t = N CFt Terminal Value
Value = ∑ +
t (1 + r)N
t = 1 (1 + r)

Aswath Damodaran 212

 Stable Growth and Terminal Value

 When a firm ’s cash flows grow at a “constant ” rate forever, the present
value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate
 This “constant” growth rate is called a stable growth rate and cannot
be higher than the growth rate of the economy in which the firm
operates.
 While companies can maintain high growth rates for extended periods,
they will all approach “stable growth ” at some point in time.
 When they do approach stable growth, the valuation formula above
can be used to estimate the “terminal value ” of all cash flows beyond.

Aswath Damodaran 213

 Growth Patterns

 A key assumption in all discounted cash flow models is the period of

high growth, and the pattern of growth during that period. In general,
we can make one of three assumptions:
• there is no high growth, in which case the firm is already in stable growth
• there will be high growth for a period, at the end of which the growth rate
will drop to the stable growth rate (2-stage)
• there will be high growth for a period, at the end of which the growth rate
will decline gradually to a stable growth rate(3-stage)
 The assumption of how long high growth will continue will depend
upon several factors including:
• the size of the firm (larger firm -> shorter high growth periods)
• current growth rate (if high -> longer high growth period)
• barriers to entry and differential advantages (if high -> longer growth
period)

Aswath Damodaran 214

 Length of High Growth Period

 Assume that you are analyzing two firms, both of which are enjoying
high growth. The first firm is Earthlink Network, an internet service
provider, which operates in an environment with few barriers to entry
and extraordinary competition. The second firm is Biogen , a bio-
technology firm which is enjoying growth from two drugs to which it
owns patents for the next decade. Assuming that both firms are well
managed, which of the two firms would you expect to have a longer
high growth period?
 Earthlink Network
 Biogen
 Both are well managed and should have the same high growth period

Aswath Damodaran 215

 Choosing a Growth Pattern: Examples

Company Valuation in Growth Period Stable Growth

Disney Nominal U.S. $ 10 years 5%(long term
Firm (3-stage) nominal growth rate
in the U.S. economy
Aracruz Real BR 5 years 5%: based upon
Equity: FCFE (2-stage) expected long term
real growth rate for
Brazilian economy
Deutsche Bank Nominal DM 0 years 5%: set equal to
Equity: Dividends nominal growth rate
in the world
economy

Aswath Damodaran 216

 Firm Characteristics as Growth Changes

Variable High Growth Firms tend to Stable Growth Firms tend to

Risk be above-average risk be average risk
Dividend Payout pay little or no dividends pay high dividends
Net Cap Ex have high net cap ex have low net cap ex
Return on Capital earn high ROC (excess return) earn ROC closer to WACC
Leverage have little or no debt higher leverage

Aswath Damodaran 217

 Estimating Stable Growth Inputs

 Start with the fundamentals:

• Profitability measures such as return on equity and capital, in stable
growth, can be estimated by looking at
– industry averages for these measure, in which case we assume that this firm in
stable growth will look like the average firm in the industry
– cost of equity and capital, in which case we assume that the firm will stop
earning excess returns on its projects as a result of competition.
• Leverage is a tougher call. While industry averages can be used here as
well, it depends upon how entrenched current management is and whether
they are stubborn about their policy on leverage (If they are, use current
leverage; if they are not; use industry averages)
 Use the relationship between growth and fundamentals to estimate
payout and net capital expenditures.

Aswath Damodaran 218

 Estimating Stable Period Net Cap Ex

gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC

= Reinvestment Rate * ROC
 Moving terms around,
Reinvestment Rate = gEBIT / Return on Capital
 For instance, assume that Disney in stable growth will grow 5% and
that its return on capital in stable growth will be 16%. The
reinvestment rate will then be:
Reinvestment Rate for Disney in Stable Growth = 5/16 = 31.25%
 In other words,
• the net capital expenditures and working capital investment each year
during the stable growth period will be 31.25% of after-tax operating
income.

Aswath Damodaran 219

 Valuation: Deutsche Bank

 Sustainable growth at Deutsche Bank = ROE * Retention Ratio

= 14% (.45) = 6.30% { I used the normalized numbers for this]
 Cost of equity = 7.5% + 0.94 (5.5%) = 12.67%.
 Current Dividends per share = 2.61 DM
 Model Used:
• Stable Growth (Large firm; Growth is close to stable growth already)
• Dividend Discount Model (FCFE is tough to estimate)
 Valuation
• Expected Dividends per Share next year = 2.61 DM (1.063) = 2.73 DM
• Value per Share = 2.73 DM / (.1267 - .063) = 42.89 DM
 Deutsche Bank was trading for 119 DM on the day of this analysis.

Aswath Damodaran 220

 What does the valuation tell us?

 Stock is tremendously overvalued: This valuation would suggest that

Deutsche Bank is significantly overvalued, given our estimates of
expected growth and risk.
 Dividends may not reflect the cash flows generated by Deutsche Bank.
TheFCFE could have been significantly higher than the dividends
paid.
 Estimates of growth and risk are wrong: It is also possible that we
have underestimated growth or overestimated risk in the model, thus
reducing our estimate of value.

Aswath Damodaran 221

 Valuation: Aracruz Cellulose

 The current earnings per share for Aracruz Cellulose is 0.044 BR.
 These earnings are abnormally low. To normalize earnings, we use the
average earnings per share between 1994 and 1996 of 0.204 BR per
share as a measure of the normalized earnings per share.
 Model Used:
• Real valuation (since inflation is still in double digits)
• 2-Stage Growth (Firm is still growing in a high growth economy)
• FCFE Discount Model (Dividends are lower than FCFE: See Dividend
section)

Aswath Damodaran 222

 Aracruz Cellulose: Inputs for Valuation

High Growth Phase Stable Growth Phase

Length 5 years Forever, after year 5
Expected Growth Retention Ratio * ROE 5% (Real Growth Rate in Brazil)
= 0.65 * 13.91%= 8.18%
Cost of Equity 5% + 0.71 (7.5%) = 10.33% 5% + 1(7.5%) = 12.5%
(Beta =0.71; R f=5%) (Assumes beta moves to 1)
Net Capital Expenditures Net capital ex grows at same Capital expenditures are assumed
rate as earnings. Next year, to be 120% of depreciation
capital ex will be 0.24 BR
and deprec’ n will be 0.18 BR.
Working Capital 32.15% of Revenues; 32.15% of Revenues;
Revenues grow at same rate as earnings in both periods.
Debt Ratio 39.01% of net capital ex and working capital investments come
from debt.

Aswath Damodaran 223

 Aracruz: Estimating FCFE for next 5 years

1 2 3 4 5 Terminal
Earnings BR 0.222 BR 0.243 BR 0.264 BR 0.288 BR 0.314 BR 0.330
- (CapEx -Depreciation)*(1-DR) BR 0.042 BR 0.046 BR 0.050 BR 0.055 BR 0.060 BR 0.052
-Chg. Working Capital*(1-DR) BR 0.010 BR 0.011 BR 0.012 BR 0.013 BR 0.014 BR 0.008
Free Cashflow to Equity BR 0.170 BR 0.186 BR 0.202 BR 0.221 BR 0.241 BR 0.269
Present Value BR 0.154 BR 0.152 BR 0.150 BR 0.149 BR 0.147

The present value is computed by discounting the FCFE at the current

cost of equity of 10.33%.

Aswath Damodaran 224

 Aracruz: Estimating Terminal Price and Value
per share

 The terminal value at the end of year 5 is estimated using the FCFE in
the terminal year.
• The FCFE in year 6 reflects the drop in net capital expenditures after year
5.
• Terminal Value = 0.269/(.125-.05) = 3.59 BR
• Value per Share = 0.154 + 0.152 + 0.150 + 0.149 + 0.147 + 3.59/1.1033 5
= 2.94 BR
 The stock was trading at 2.40 BR in September 1997.
 The value per share is based upon normalized earnings. To the extent
that it will take some time to get to normal earnings, discount this
value per share back to the present at the cost of equity of 10.33%.

Aswath Damodaran 225

 Disney Valuation

 Model Used:
• Cash Flow: FCFF (since I think leverage will change over time)
• Growth Pattern: 3-stage Model (even though growth in operating income
is only 10%, there are substantial barriers to entry)

Aswath Damodaran 226

 Disney: Inputs to Valuation

High Growth Phase Transition Phase Stable Growth Phase

Length of Period 5 years 5 years Forever after 10 years
Revenues Current Revenues: $ 18,739; Continues to grow at same rate Grows at stable growth rate
Expected to grow at same rate a as operating earnings
operating earnings
Pre-tax Operating Margin 29.67% of revenues, based upon Increases gradually to 32% of Stable margin is assumed to be
1996 EBIT of $ 5,559 million. revenues, due to economies of 32%.
scale.
Tax Rate 36% 36% 36%
Return on Capital 20% (approximately 1996 level) Declines linearly to 16% Stable ROC of 16%
Working Capital 5% of Revenues 5% of Revenues 5% of Revenues
Reinvestment Rate 50% of after-tax operating Declines to 31.25% as ROC and 31.25% of after-tax operating
(Net Cap Ex + Working Capital income; Depreciation in 1996 is growth rates drop: income; this is estimated from
Investments/EBIT) $ 1,134 million, and is assumed Reinvestment Rate = g/ROC the growth rate of 5%
to grow at same rate as earnings Reinvestment rate = g/ROC
Expected Growth Rate in EBIT ROC * Reinvestment Rate = Linear decline to Stable Growth 5%, based upon overall nominal
20% * .5 = 10% Rate economic growth
Debt/Capital Ratio 18% Increases linearly to 30% Stable debt ratio of 30%
Risk Parameters Beta = 1.25, ke = 13.88% Beta decreases linearly to 1.00; Stable beta is 1.00.
Cost of Debt = 7.5% Cost of debt stays at 7.5% Cost of debt stays at 7.5%
(Long Term Bond Rate = 7%)
Aswath Damodaran 227
 Disney: FCFF Estimates

Base 1 2 3 4 5 6 7 8 9 10

Expected Growth 10% 10% 10% 10% 10% 9% 8% 7% 6% 5%

Revenues $ 18,739 $ 20,613 $ 22,674 $ 24,942 $ 27,436 $ 30,179 $ 32,895 $ 35,527 $ 38,014 $ 40,295 $ 42,310

Oper. Margin 29.67% 29.67% 29.67% 29.67% 29.67% 29.67% 30.13% 30.60% 31.07% 31.53% 32.00%

EBIT $ 5,559 $ 6,115 $ 6,726 $ 7,399 $ 8,139 $ 8,953 $ 9,912 $ 10,871 $ 11,809 $ 12,706 $ 13,539

EBIT (1-t) $ 3,558 $ 3,914 $ 4,305 $ 4,735 $ 5,209 $ 5,730 $ 6,344 $ 6,957 $ 7,558 $ 8,132 $ 8,665

+ Depreciation $ 1,134 $ 1,247 $ 1,372 $ 1,509 $ 1,660 $ 1,826 $ 2,009 $ 2,210 $ 2,431 $ 2,674 $ 2,941

- Capital Exp. $ 1,754 $ 3,101 $ 3,411 $ 3,752 $ 4,128 $ 4,540 $ 4,847 $ 5,103 $ 5,313 $ 5,464 $ 5,548

- Change in WC $ 94 $ 94 $ 103 $ 113 $ 125 $ 137 $ 136 $ 132 $ 124 $ 114 $ 101

= FCFF $ 1,779 $ 1,966 $ 2,163 $ 2,379 $ 2,617 $ 2,879 $ 3,370 $ 3,932 $ 4,552 $ 5,228 $ 5,957

ROC 20% 20% 20% 20% 20% 20% 19.2% 18.4% 17.6% 16.8% 16%

Reinv. Rate 50% 50% 50% 50% 50% 46.875% 43.48% 39.77% 35.71% 31.25%

Aswath Damodaran 228

 Disney: Costs of Capital

Year 1 2 3 4 5 6 7 8 9 10

Cost of Equity 13.88% 13.88% 13.88% 13.88% 13.88% 13.60% 13.33% 13.05% 12.78% 12.50%

Cost of Debt 4.80% 4.80% 4.80% 4.80% 4.80% 4.80% 4.80% 4.80% 4.80% 4.80%

Debt Ratio 18.00% 18.00% 18.00% 18.00% 18.00% 20.40% 22.80% 25.20% 27.60% 30.00%

Cost of Capital 12.24% 12.24% 12.24% 12.24% 12.24% 11.80% 11.38% 10.97% 10.57% 10.19%

Aswath Damodaran 229

 Disney: Terminal Value

 The terminal value at the end of year 10 is estimated based upon the
free cash flows to the firm in year 11 and the cost of capital in year 11.
 FCFF 11 = EBIT (1-t) - EBIT (1-t) Reinvestment Rate
= $ 13,539 (1.05) (1-.36) - $ 13,539 (1.05) (1-.36) (.3125)
= $ 6,255 million
 Note that the reinvestment rate is estimated from the cost of capital of
16% and the expected growth rate of 5%.
 Cost of Capital in terminal year = 10.19%
 Terminal Value = $ 6,255/(.1019 - .05) = $ 120,521 million

Aswath Damodaran 230

 Disney: Present Value

Year 1 2 3 4 5 6 7 8 9 10

FCFF $ 1,966 $ 2,163 $ 2,379 $ 2,617 $ 2,879 $ 3,370 $ 3,932 $ 4,552 $ 5,228 $ 5,957

Term Value 120,521

Present Value $ 1,752 $ 1,717 $ 1,682 $1,649 $1,616 $ 1,692 $1,773 $ 1,849 $ 1,920 42,167

Cost of Capital 12.24% 12.24% 12.24% 12.24% 12.24% 11.80% 11.38% 10.97% 10.57% 10.19%

Aswath Damodaran 231

 Present Value Check

 The FCFF and costs of capital are provided for all 10 years. Confirm
the present value of the FCFF in year 7.

Aswath Damodaran 232

 Disney: Value Per Share

Value of the Firm = $ 57,817 million

+ Value of Cash = $ 0 (almost no non-operating cash)
- Value of Debt = $ 11,180 million
= Value of Equity = $ 46,637 million
/ Number of Shares 675.13
Value Per Share = $ 69.08

Aswath Damodaran 233

 Disney: A Valuation
Reinvestment Rate Return on Capital
50.00% Expected Growth 20%
Cashflow to Firm in EBIT (1-t)
EBIT(1-t) : 3,558 Stable Growth
.50*.20 = .10 g = 5%; Beta = 1.00;
- Nt CpX 612 10.00 %
- Chg WC 617 D/(D+E) = 30%; ROC=16%
= FCFF 2,329 Reinvestment Rate=31.25%

Terminal Value 10 = 6255/(.1019-.05) = 120,521

ROC drops to 16%
57,817 Reinv. rate drops to 31.25%
- 11,180= 46,637 1,966 2,163 2,379 2,617 2,879 3,370 3,932 4,552 5,228 5,957
Per Share: 69.08
Forever
Discount at Cost of Capital (WACC) = 13.85% (0.82) + 4.8% (0.18) = 12.22%
Transition
Beta drops to 1.00
Debt ratio rises to 30%

Cost of Equity Cost of Debt

13.85% (7%+ 0.50%)(1-.36) Weights
= 4.80% E = 82% D = 18%

Riskfree Rate :
Government Bond Risk Premium
Rate = 7% Beta 5.5%
+ 1.25 X

Unlevered Beta for Firm’s D/E Historical US Country Risk

Sectors: 1.09 Ratio: 21.95% Premium Premium
5.5% 0%
Aswath Damodaran 234
 Determine the business risk of the firm (Beta, Default Risk)

The Investment Decision The Dividend Decision The Financing Decision

Invest in projects that yield a return If there are not enough Choose a financing mix that
greater than the minimum acceptable investments that earn the maximizes the value of the projects
hurdle rate hurdle rate, return the cash to taken, and matches the assets being
the owners financed.

Return on Capital Reinvestment Rate

20.00% 50% Equity: Debt::
Beta=1.25 Default Risk

Cost of Capital
Current Expected Growth = ROC * RR 12.22%
EBIT(1-t) = = .50 * 20%= 10%
$3,558 million

Year EBIT(1-t) Reinvestment FCFF Terminal Value PV

1 $ 3,914 $ 1,947 $ 1,966 $ 1,752
2 $ 4,305 $ 2,142 $ 2,163 $ 1,717
3 $ 4,735 $ 2,356 $ 2,379 $ 1,682
4 $ 5,209 $ 2,343 $ 2,866 $ 1,649
5 $ 5,730 $ 2,851 $ 2,879 $ 1,616
6 $ 6,344 $ 2,974 $ 3,370 $ 1,692
7 $ 6,957 $ 2,762 $ 4,196 $ 1,773
Transition to 8 $ 7,558 $ 3,006 $ 4,552 $ 1,849 In stable growth:
stable growth 9 $ 8,132 $ 2,904 $ 5,228 $ 1,920 Reinvestment Rate=31.67%
inputs 10 $ 8,665 $ 2,708 $ 5,957 $ 120,521 $ 42,167 Return on Capital = 16%
Value of Disney = $ 57,817 Beta = 1.00
- Value of Debt = $11,180 Debt Ratio = 30.00%
= Value of Equity $ 46,637 Cost of Capital = 10.19% 235
Aswath Damodaran
Value of Disney/share = $ 69.08
 Relative Valuation

 In relative valuation, the value of an asset is derived from the pricing

of 'comparable' assets, standardized using a common variable such as
earnings, cashflows, book value or revenues. Examples include --
• Price/Earnings (P/E) ratios
– and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples)
• Price/Book (P/BV) ratios
– and variants (Tobin's Q)
• Price/Sales ratios

Aswath Damodaran 236

 Multiples and Fundamenals

DPS1
P0 =
 Gordon Growth Model: r − gn

 Dividing both sides by the earnings,

P0 Payout Ratio * (1 + g n )
= PE =
EPS0 r-g n

 Dividing both sides by the book value of equity,

P0 ROE * Payout Ratio * (1 + g n )
= PBV =
BV 0 r-g
 If the return on equity is written inn terms of the retention ratio and the
expected growth rate
P0 ROE - gn
= PBV =
BV 0
 Dividing by the Sales per share, r-gn

P0 Profit Margin * Payout Ratio * (1 + g n )

= PS =
Sales 0 r-g n

Aswath Damodaran 237

 Disney: Relative Valuation

Company PE Expected Growth PEG

King World Productions 10.4 7.00% 1.49
Aztar 11.9 12.00% 0.99
Viacom 12.1 18.00% 0.67
All American Communications 15.8 20.00% 0.79
GC Companies 20.2 15.00% 1.35
Circus Circus Enterprises 20.8 17.00% 1.22
Polygram NV ADR 22.6 13.00% 1.74
Regal Cinemas 25.8 23.00% 1.12
Walt Disney 27.9 18.00% 1.55
AMC Entertainment 29.5 20.00% 1.48
Premier Parks 32.9 28.00% 1.18
Family Golf Centers 33.1 36.00% 0.92
CINAR Films 48.4 25.00% 1.94
Average 22.19 18.56% 1.20

Aswath Damodaran 238

 Is Disney fairly valued?

 Based upon the PE ratio, is Disney under, over or correctly valued?

 Under Valued
 Over Valued
 Correctly Valued
 Based upon the PEG ratio, is Disney under valued?
 Under Valued
 Over Valued
 Correctly Valued
 Will this valuation give you a higher or lower valuation than the
discounted CF valutaion ?
 Higher
 Lower

Aswath Damodaran 239

 Relative Valuation Assumptions

 Assume that you are reading an equity research report where a buy
recommendation for a company is being based upon the fact that its PE
ratio is lower than the average for the industry. Implicitly, what is the
underlying assumption or assumptions being made by this analyst?
 The sector itself is, on average, fairly priced
 The earnings of the firms in the group are being measured consistently
 The firms in the group are all of equivalent risk
 The firms in the group are all at the same stage in the growth cycle
 The firms in the group are of equivalent risk and have similar cash
flow patterns
 All of the above

Aswath Damodaran 240

 First Principles

 Invest in projects that yield a return greater than the minimum

acceptable hurdle rate .
• The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners ’ funds (equity) or borrowed money (debt)
• Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.
 Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
 If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon
the stockholders ’ characteristics.
Objective: Maximize the Value of the Firm

Aswath Damodaran 241