The Dark Side of Valuation
Valuing young, high growth companies

Aswath Damodaran

Aswath Damodaran
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 Risk Adjusted Value: Three Basic Propositions

The value of an asset is the present value of the expected cash flows on
that asset, over its expected life:

Proposition 1: If “it” does not affect the cash flows or alter risk (thus
changing discount rates), “it” cannot affect value.

Proposition 2: For an asset to have value, the expected cash flows
have to be positive some time over the life of the asset.

Proposition 3: Assets that generate cash flows early in their life will be
worth more than assets that generate cash flows later; the latter
may however have greater growth and higher cash flows to
compensate.

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 The fundamental determinants of value…

What is the value added by growth assets?

Equity: Growth in equity earnings/ cashflows
What are the Firm: Growth in operating earnings/
cashflows from cashflows
existing assets? When will the firm
- Equity: Cashflows become a mature
after debt payments fiirm, and what are
- Firm: Cashflows How risky are the cash flows from both the potential
before debt payments existing assets and growth assets? roadblocks?
Equity: Risk in equity in the company
Firm: Risk in the firm’s operations

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 The Dark Side of Valuation…

  Valuing stable, money making companies with consistent and clear

accounting statements, a long and stable history and lots of
comparable firms is easy to do.

  The true test of your valuation skills is when you have to value
“difficult” companies. In particular, the challenges are greatest when
valuing:

•  Young companies, early in the life cycle, in young businesses

•  Companies that don’t fit the accounting mold

•  Companies that face substantial truncation risk (default or nationalization risk)

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 The challenge with young companies…

Young and Start-up Companies

Making judgments on revenues/ profits difficult becaue
you cannot draw on history. If you have no product/
service, it is difficult to gauge market potential or
profitability. The company's entire value lies in future
growth but you have little to base your estimate on.
Cash flows from
existing assets non- What is the value added by growth
existent or negative. assets?
When will the firm
What are the cashflows become a mature
from existing assets? fiirm, and what are
How risky are the cash flows from both the potential
Different claims on existing assets and growth assets? roadblocks?
cash flows can
affect value of Limited historical data on earnings, Will the firm will make it
equity at each and no market prices for securities through the gauntlet of market
stage. makes it difficult to assess risk. demand and competition?
What is the value of Even if it does, assessing
equity in the firm? when it will become mature is
difficult because there is so
little to go on.

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 Upping the ante.. Young companies in young businesses…

  When valuing a business, we generally draw on three sources of information

•  The firm’s current financial statement

–  How much did the firm sell?

–  How much did it earn?

•  The firm’s financial history, usually summarized in its financial statements.

–  How fast have the firm’s revenues and earnings grown over time?

–  What can we learn about cost structure and profitability from these trends?

–  Susceptibility to macro-economic factors (recessions and cyclical firms)

•  The industry and comparable firm data

–  What happens to firms as they mature? (Margins.. Revenue growth…
Reinvestment needs… Risk)

  When valuing these companies, the ‘dark side’ beckons:

•  “Paradigm shifts” happen…

•  New metrics are invented …

•  The story dominates and the numbers lag…

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 9a. Amazon in January 2000 Sales to capital ratio and
expected margin are retail Stable Growth
Current Current
Revenue Margin: industry average numbers Stable Stable
Stable Operating ROC=20%
$ 1,117 -36.71% Revenue
Sales Turnover Competitive Margin: Reinvest 30%
Ratio: 3.00 Advantages Growth: 6% 10.00% of EBIT(1-t)
EBIT
From previous -410m Revenue Expected
years Growth: Margin: Terminal Value= 1881/(.0961-.06)
NOL: 42% -> 10.00% =52,148
500 m

Term. Year
$41,346
Revenues $2,793 5,585 9,774 14,661 19,059 23,862 28,729 33,211 36,798 39,006 10.00%
Value of Op Assets $ 14,910 EBIT
-$373 -$94 $407 $1,038 $1,628 $2,212 $2,768 $3,261 $3,646 $3,883 35.00%
+ Cash $ 26 EBIT (1-t) -$373 -$94 $407 $871 $1,058 $1,438 $1,799 $2,119 $2,370 $2,524 $2,688
- Reinvestment $559 $931 $1,396 $1,629 $1,466 $1,601 $1,623 $1,494 $1,196 $736 $ 807
= Value of Firm $14,936 FCFF -$931 -$1,024 -$989 -$758 -$408 -$163 $177 $625 $1,174 $1,788
- Value of Debt $ 349 $1,881
= Value of Equity $14,587 1 2 3 4 5 6 7 8 9 10
- Equity Options $ 2,892 Forever
Value per share $ 34.32 Cost of Equity 12.90% 12.90% 12.90% 12.90% 12.90% 12.42% 12.30% 12.10% 11.70% 10.50%
Cost of Debt 8.00% 8.00% 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00%
All existing options valued AT cost of debt 8.00% 8.00% 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55%
as options, using current Cost of Capital 12.84% 12.84% 12.84% 12.83% 12.81% 12.13% 11.96% 11.69% 11.15% 9.61%
stock price of $84. Amazon was
trading at $84 in
Used average January 2000.
Cost of Equity interest coverage Cost of Debt Weights
12.90% ratio over next 5 6.5%+1.5%=8.0% Debt= 1.2% -> 15%
years to get BBB Tax rate = 0% -> 35%
rating. Pushed debt ratio
Dot.com retailers for firrst 5 years to retail industry
average of 15%.
Convetional retailers after year 5
Beta
Riskfree Rate: + 1.60 -> 1.00 X Risk Premium
T. Bond rate = 6.5% 4%

Internet/ Operating Current Base Equity Country Risk

Retail Leverage D/E: 1.21% Premium Premium

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 Lesson 1: Don’t trust regression betas….

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 Lesson 2: The cost of capital will change over time…

Year

1
2
3
4
5


EBIT

-$373
-$94
$407
$1,038
$1,628


Taxes

$0
$0
$0
$167
$570


EBIT(1-t)
-$373
-$94
$407
$871
$1,058


Tax rate

0%
0%
0%
16.13%
35%


NOL

$500
$873
$967
$560
$0 !

Yrs 1-3 4 5 6 7 8 9 10 Terminal year

Tax Rate 0.00% 16.13% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00% 35.00%
Debt Ratio 1.20% 1.20% 1.20% 3.96% 4.65% 5.80% 8.10% 15.00% 15.00%
Beta 1.60 1.60 1.60 1.48 1.36 1.24 1.12 1.00 1.00
Cost of Equity 12.90% 12.90% 12.90% 12.42% 11.94% 11.46% 10.98% 10.50% 10.50%
Cost of Debt 8.00% 8.00% 8.00% 7.80% 7.75% 7.67% 7.50% 7.00% 7.00%
After-tax cost of debt 8.00% 6.71% 5.20% 5.07% 5.04% 4.98% 4.88% 4.55% 4.55%
Cost of Capital 12.84% 12.83% 12.81% 12.13% 11.62% 11.08% 10.49% 9.61% 9.61%

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 Lesson 3: Use updated numbers and the free cash flows will
often be negative (even if the company is making money)

  When valuing Amazon in early 2000, the last annual report that was
available was the 1998 annual report. For a young company, that is
ancient data, since so much can change over the course of a short time
period. To value Amazon the trailing 12-month numbers were used.

  Trailing 12-month inputs

•  Amazon’s EBIT (Trailing 1999) = -$ 410 million

•  Tax rate used = 0%

•  Capital spending (Trailing 1999) = $ 243 million (includes acquisitions)

•  Depreciation (Trailing 1999) = $ 31 million

•  Non-cash Working capital Change (1999) = - 80 million

  Estimating FCFF (1999)

Current EBIT * (1 - tax rate) = - 410 (1-0)
= - $410 million

- (Capital Spending - Depreciation)
= $212 million

- Change in Working Capital

= -$ 80 million

Current FCFF



= - $542 million

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 Lesson 4: Many of the operating expenses may be capital
expenses….

  Since young companies are focused on generating future growth, it is

possible that some or a significant portion of what accountants
categorize as operating expenses represent expenditures designed to
generate future growth (and thus are capital expenditures).

  In the late 1990s, many dot-com companies argued that SG&A
expenses were really focused on getting new customers and should be
treated as capital expenditures. Amazon, for instance, would have
reported a profit if the SG&A expenses from 1999 were treated as
capital expenditures, rather than operating expenses.

  If we adopt this rationale, it will also mean that they are reinvesting far
more than we think they are. It will, however, make not their cash
flows less negative.

  Should Amazon.com’s selling expenses be treated as cap ex?

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 Lesson 5: Work backwards"

Year !Revenues !Operating Margin! !EBIT !!

Tr12m !$1,117 !-36.71% !-$410 !!
1! !$2,793 !-13.35% !-$373 !!
2! !$5,585 !-1.68% !-$94 !!
3! !$9,774 !4.16% !$407 !!
4! !$14,661 !7.08% !$1,038!!
5! !$19,059 !8.54% !$1,628!!
6! !$23,862 !9.27% !$2,212!!
7! !$28,729 !9.64% !$2,768!!
8! !$33,211 !9.82% !$3,261!!
9! !$36,798 !9.91% !$3,646!!
10! !$39,006 !9.95% !$3,883!!
TY(11) !$41,346 !10.00% !$4,135!Ind. Average!


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 Lesson 6: Scaling up is hard to do…

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 Lesson 7: Don’t forget to pay for growth…"

Yr
Rev Grwth
Rev
Reinv
Sales/Capital
ROC
!
1
150.00%
$1,676
$559
3.00
-76.62%


2
100.00%
$2,793
$931
3.00
-8.96%


3
75.00%
$4,189
$1,396
3.00
20.59%


4
50.00%
$4,887
$1,629
3.00
25.82%


5
30.00%
$4,398
$1,466
3.00
21.16%


6
25.20%
$4,803
$1,601
3.00
22.23%


7
20.40%
$4,868
$1,623
3.00
22.30%


8
15.60%
$4,482
$1,494
3.00
21.87%


9
10.80%
$3,587
$1,196
3.00
21.19%


10
6.00%
$2,208
$736
3.00
20.39%

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 Lesson 8: Survival and success are not guaranteed…

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 Lesson 9: There are always scenarios where the market price
can be justified…

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 Lesson 10: You will be wrong 100% of the time… and it
really is not (always) your fault…

  No matter how careful you are in getting your inputs and how well
structured your model is, your estimate of value will change both as
new information comes out about the company, the business and the
economy.

  As information comes out, you will have to adjust and adapt your
model to reflect the information. Rather than be defensive about the
resulting changes in value, recognize that this is the essence of risk.

  A test: If your valuations are unbiased, you should find yourself
increasing estimated values as often as you are decreasing values. In
other words, there should be equal doses of good and bad news
affecting valuations (at least over time).

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 Reinvestment:
9b. Amazon in January 2001 Cap ex includes acquisitions
Stable Growth
Current Current Working capital is 3% of revenues
Revenue Margin: Stable Stable
Stable Operating ROC=16.94%
$ 2,465 -34.60% Revenue Margin: Reinvest 29.5%
Sales Turnover Competitiv Growth: 5% 9.32% of EBIT(1-t)
Ratio: 3.02 e
EBIT Advantages
-853m Revenue Expected
Growth: Margin: Terminal Value= 1064/(.0876-.05)
NOL: 25.41% -> 9.32% =$ 28,310
1,289 m

Term. Year
1 2 3 4 5 6 7 8 9 10
Revenues $4,314 $6,471 $9,059 $11,777 $14,132 $16,534 $18,849 $20,922 $22,596 $23,726 $24,912
EBIT -$545 -$107 $347 $774 $1,123 $1,428 $1,692 $1,914 $2,087 $2,201 $2,302
EBIT(1-t) -$545 -$107 $347 $774 $1,017 $928 $1,100 $1,244 $1,356 $1,431 $1,509
- Reinvestment $612 $714 $857 $900 $780 $796 $766 $687 $554 $374 $ 445
FCFF -$1,157 -$822 -$510 -$126 $237 $132 $333 $558 $802 $1,057 $1,064
Value of Op Assets $ 8,789
+ Cash & Non-op $ 1,263 1 2 3 4 5 6 7 8 9 10
= Value of Firm $10,052 Forever
- Value of Debt $ 1,879 Debt Ratio 27.27% 27.27% 27.27% 27.27% 27.27% 24.81% 24.20% 23.18% 21.13% 15.00%
= Value of Equity $ 8,173 Beta 2.18 2.18 2.18 2.18 2.18 1.96 1.75 1.53 1.32 1.10
- Equity Options $ 845 Cost of Equity 13.81% 13.81% 13.81% 13.81% 13.81% 12.95% 12.09% 11.22% 10.36% 9.50%
Value per share $ 20.83 AT cost of debt 10.00% 10.00% 10.00% 10.00% 9.06% 6.11% 6.01% 5.85% 5.53% 4.55%
Cost of Capital 12.77% 12.77% 12.77% 12.77% 12.52% 11.25% 10.62% 9.98% 9.34% 8.76%

Cost of Equity Cost of Debt Weights

13.81% 6.5%+3.5%=10.0% Debt= 27.3% -> 15%
Tax rate = 0% -> 35%

Riskfree Rate:
T. Bond rate = 5.1% Amazon.com
Risk Premium
Beta 4% January 2001
+ 2.18-> 1.10 X Stock price = $14

Internet/ Operating Current Base Equity Country Risk

Aswath Damodaran
Retail Leverage D/E: 37.5% Premium Premium 18

 Here is your consolation prize… the market makes even
bigger mistakes…

Amazon: Value and Price

$90.00

$80.00

$70.00

$60.00

$50.00

Value per share

$40.00 Price per share

$30.00

$20.00

$10.00

$0.00
2000 2001 2002 2003
Time of analysis

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 Lesson 11: Pricing ≠ Valuation

  Faced with uncertainty, most investors price young, growth

companies, rather than value them. You price an asset by looking at
what others will pay rather than what an asset is worth.

  Pricing usually manifests itself in the form of multiples (sometimes
creative) and comparisons across firms and transactions.

  Those who price assets argue that they are doing so, because they do
not want to make the assumptions that underlie full-fledged valuation
but those assumptions are made implicitly rather than explicitly.

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 Starting numbers
Valuing Facebook Pre-IPO: May 17, 2012
This year Last year
Revenues $3,711.00 $ 1,974.00
Operating income or EBIT $1,695.00 $ 1,032.00 Revenue Pre-tax Sales to Stable Growth
Invested Capital $4,216.11 $ 694.00 growth of 40% a operating capital ratio of g = 2%; Beta = 1.00;
Tax rate 40.00% year for 5 years, margin declines 1.50 for Cost of capital = 8%
tapering down to 35% in year incremental ROC= 20%;
Operating margin 45.68%
to 2% in year 10 10 sales Reinvestment Rate=2%/20% = 10%
Return on capital 146.54%
Sales/Capital 0.88
Revenue growth rate 87.99% Terminal Value10= 8,330/(.08-.02) = 138,830

Year 1 2 3 4 5 6 7 8 9 10
Revenues $ 5,195 $ 7,274 $ 10,183 $ 14,256 $ 19,959 $ 26,425 $ 32,979 $ 38,651 $ 42,362 $ 43,209 Term yr
Operating margin 44.61% 43.54% 42.47% 41.41% 40.34% 39.27% 38.20% 37.14% 36.07% 35.00% EBIT (1-t) 9255
EBIT $ 2,318 $ 3,167 $ 4,325 $ 5,903 $ 8,051 $ 10,377 $ 12,599 $ 14,353 $ 15,279 $ 15,123
Operating assets 65,967 - Reinv 926
EBIT (1-t) $ 1,391 $ 1,900 $ 2,595 $ 3,542 $ 4,830 $ 6,226 $ 7,559 $ 8,612 $ 9,167 $ 9,074
+ Cash 1,512 - Reinvestment $ 990 $ 1,385 $ 1,940 $ 2,715 $ 3,802 $ 4,311 $ 4,369 $ 3,782 $ 2,474 $ 565 FCFF 8330
- Debt 1,219 FCFF $ 401 $ 515 $ 655 $ 826 $ 1,029 $ 1,915 $ 3,190 $ 4,830 $ 6,694 $ 8,509
Value of equity 66,264
- Options 3,088
Value in stock 63,175 Cost of capital = 11.19% (.988) + 1.59% (.012) = 11.07% Cost of capital decreases to
Value/share $27.07 8% from years 6-10

Cost of Equity Cost of Debt At 4.00 pm, May 17,

11.19% (2%+0.65%)(1-.40) Weights
the offering was
= 1.59% E = 98.8% D = 1.2%
priced at $38/share

Riskfree Rate: Risk Premium

Riskfree rate = 2% Beta 6%
+ 1.53 X

Unlevered Beta for

Sectors: 1.52 D/E=1.21%

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 Lesson 12: Uncertainty is not a bug, but a feature with young
companies

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