ASWATH DAMODARAN

VALUATION MBA 2021

https://www.youtube.com/watch?v=oi6M5KBWydg&list=PLUkh9m2Borqkl7FoAhhWY4piiZPFJs5_e&
ab_channel=AswathDamodaran

https://www.youtube.com/watch?v=gzmxH6aCkYE&list=PLUkh9m2BorqmRAGzJb5OIvTAKZZu9HWF
‐&ab_channel=AswathDamodaran

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/equity.html

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/eqdata.htm

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/covals.htm

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqspr21.htm

Following are notes, in short, just for a reference while doing actual valuations. See links for details.

SESSION NOTES
Session 1  All valuations are biased. Be true to yourself and know about your bias, and
in which direction your valuation could be biased.
Session 2  DCF can only be done on assets that generate cash flows
 Relative valuation can be done as a comparison between any two assets.
(types of  If all the market as a whole is over or undervalued, relative valuation will fail.
valuation)  Asset based Valuation: Liquidation, accounting, sum of the parts
 Contingent claim valuation is done when asset under consideration yields
option like cash flows. Like pharma’s licencing/R&D might pay off or fail for
some project.
Session 3  Choose what kind of DCF you want to do EQUITY or FIRM, and stay consistent
with the chosen one.
DCF BIG All terms like discount rates(discount to equity/ firm), cash flows (FCFF/FCFE)
PICTURE etc should stay consistent.
Dividend Discount Model:

Potential Dividends/FCFE Model:

 Entire firm/ FCFF:

……………………………………………………………………………………………………………………..

 You can either use expected cash flows with uncertainty or risk expected, or
just use a certainty equivalent cash flow figure that you know will be
achieved, and use risk free rate for calculation.

 RISK calculation can be done by CAPM, APM, Proxy models or Multi factor
models. We use CAPM for its simplicity.
Session 4  Risk free rate should not include any kind of default risk.
 Risk free rate depends on currency. Eg. Many countries use euros, use risk
Risk Free free rate of country which has least/no default risk.
Rates  If country has default risk attached to it, deduct the default risk from the local
currencies risk free rate.
COUNTRY  Methods of finding default risk spread
Risk
Premium

 Risk free rates can be negative

……………………………………………………………………………………………………………………………..
 RISK PREMIUMS. People use historical risk premium, but it is not very
forward looking. Your historical risk premium can be anything based on what
slice of history you use to get your historical risk premium. Instead using
Implied Equity risk premium gives us a much more forward‐looking number.
 How to estimate ERP of countries from us market ERP:
(you can add the ERP and country default risk if in hurry)
Session 5  Equity risk premium can be calculated as
(The country risk premium calculated in last chapter is scaled up or down
Company using Beta in this step) (for companies that either sell/produce in more than
Risk one countries sometimes are exposed to mixed country risks, use one of the
Premium three ways) (AD uses lambda approach)

 For finding country risk premiums, use DCF and reverse calculate the risk for
which people are actually paying today. This is known as IMPLIED EQUITY
RISK PREMIUM.
  An example of finding ERP of SENSEX

Session 6  The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns (Rm)
Betas Rj = a + b Rm
where a is the intercept and b is the slope of the regression.
Cost of  Regression betas have a few problems. High standard error, reflects a slice of
equity history, is backward looking. Instead of using regression betas we should use
Bottom‐up betas. This elemenates many issues, because law of large
numbers comes into play, as many firms beta is used to estimate this.
 How to estimate bottom up beta

 If you value bank do not unlever the beta


Session 7 COST OF DEBT
 The cost of debt is the rate at which you can borrow at currently, it will
Cost of reflect not only your default risk but also the level of interest rates in the
debt market.
 Use market number (market cost of debt), do not use book values, to
Cash determine cost of debt. If company doesn’t have bond or rating, give it a
flows synthetic rating yourself, it is still better than using book values.
 COST of DEBT = Rf + Country default spread + Company Default Spread
 If you are getting subsidised debt, do not use the subsidised debt in the DCF
all the way, because subsidy will go away after a few years. Instead do the
DCF with normal numbers, and capture the effect of subsidy after valuation.
Add the benefit in overall value.
 If you calculate cost of capital in USD or any other currency, this is how to
convert to local currency

 When dealing with preferred stock, it is better to keep it as a separate

component. The cost of preferred stock is the preferred dividend yield. (As a
rule of thumb, if the preferred stock is less than 5% of the outstanding
market value of the firm, lumping it in with debt will make no significant
impact on your valuation).


………………………………………………………………………………………………………………………….
 Cash Flows
 Steps:
a. estimate current earnings of the firm
b. consider how much firm reinvests to create future growth
c. If looking at cash flows to equity, consider the cash flows from net debt
issues (debt issued ‐ debt repaid)
 Measuring CF
  Formula FCFF

 R&D expenses and any long‐term lease commitments should be taken into
account as capital expenses. Clean up for the same in cash flows.
 Normalise for cash flows for commodity companies or companies with
cyclical numbers.
 Get the most updated numbers. Get TTM numbers by adding up last 4
quarters, or use last 10k, and last 10q.
 Correct account earnings
a. Make sure that there are no financial expenses mixed in with operating
expenses Example: Operating Leases
b. Make sure that there are no capital expenses mixed in with the operating
expenses. Ex. R & D Adjustment
Session 8  R&D for tech and pharma etc., exploration costs for oil companies, human
resource and training for consultancy companies are done for growth in
From future, this needs to be considered as capital expense.
earnings  Any contractual commitment, like lease, contracts for movies and shows for
to cash Netflix etc, all should be treated like debt.
flows  For companies that have “truly” one time charge, we can ignore the charge.
If it occurs after every few years, then we have to factor that in.
 Framework for analysing companies with abnormally low earnings

 TAX RATE: In long term most companies go towards marginal tax rate, so in
valuation go towards marginal from effective tax rates.
 Net capital expenditures represent the difference between capital
expenditures and depreciation. In general, the net capital expenditures will
be a function of how fast a firm is growing or expecting to grow. High growth
firms will have much higher net capital expenditures than low growth firms
 Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s
R&D expenses ‐ Amortization of Research Asset

Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms ‐

Amortization of such acquisitions
 In accounting terms, the working capital is the difference between current
assets (inventory, cash and accounts receivable) and current liabilities
(accounts payables, short term debt and debt due within the next year).
 A cleaner definition of working capital from a cash flow perspective is the
difference between non‐cash current assets (inventory and accounts
receivable) and non‐debt current liabilities (accounts payable)
 ‐ve working capital is possible when companies use supplier credit to grow.
For volatile working capital, smooth it out.
…………………………………………………………………………………………………………………………
 FCFE

 If preferred stock exist, preferred dividends will also need to be netted out
Session 9  Growth is a double‐edged sword.
 Use either analyst growth rate, or compute growth using reinvestment rate.
Growth Analyst rates can be biased and most times are.
rates
 

Net income from non‐cash assets, expected growth rate:

Expected Growth in EBIT And Fundamentals:

Stable ROC and Reinvestment Rate

Session  Operating Income Growth when Return on Capital is Changing:

10

 Estimating Growth when Operating Income is Negative or Margins are

changing:
 When operating income is negative or margins are expected to change over
time, we use a three step process to estimate growth:

…………………………………………………………………………………………………………………….

 Closure in Valuation
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
Session  After DCF, you come up with the value of asset. After that we need to clean
11 up for the following

TYING UP
LOOSE
ENDS

 Cash:
1. The simplest and most direct way of dealing with cash and marketable
securities is to keep it out of the valuation ‐ the cash flows should be
before interest income from cash and securities, and the discount rate
should not be contaminated by the inclusion of cash. (Use betas of the
operating assets alone to estimate the cost of equity)
2. Once the operating assets have been valued, you should add back the
value of cash and marketable securities.
 3. In many equity valuations, the interest income from cash is included in
the cashflows. The discount rate has to be adjusted then for the presence
of cash. (The beta used will be weighed down by the cash holdings).
Unless cash remains a fixed percentage of overall value over time, these
valuations will tend to break down.

 Cross Holdings
1. Holdings in other firms can be categorized into:
a. Minority passive holdings, in which case only the dividend from the
holdings is shown in the balance sheet
b. Minority active holdings, in which case the share of equity income is
shown in the income statements
c. Majority active holdings, in which case the financial statements are
consolidated. (Since 100% of financials are included, minority intrest
shows up on the balance sheet)
2. If you want to value cross holdings right:

3. If you want a shortcut, check the book value of minority holdings and
multiply by P/BV ratio to get an estimate. To save time, and settle for an
approximation.
 Other Assets
1. If an asset is contributing to your cashflows, you cannot count the market
value of the asset in your value. Thus, you should not be counting the real
estate on which your offices stand, the PP&E representing your factories
and other productive assets, any values attached to brand names or
customer lists and definitely no non‐ assets (such as goodwill).
2. If you have assets or property that are not being utilized to generate cash
flows (vacant land, for example), you have not valued them yet. You can
assess a market value for these assets and add them on to the value of
the firm.
3. OVERFUNDED Pension Plan: If you have a defined benefit plan and your
assets exceed your expected liabilities, you could consider the over
funding.

Session  Some companies are easy and some are complex to value. Generally, a
12 ,13 company with less pages in its 10k is less complex.
 If company is too complex, or you cannot tell how the company is reporting
Last lose the cash flows that it is doing, do not believe that company will sustain it.
ends
story and  Do not try to add unnecessary items in debt, just to be conservative. It will
numbers actually lower the cost of capital and increase the value instead. Never
include account payables or supplier credit in debt.
 In DCF valuation we consider market value of debt to value firm. But if the
firm is distressed, its market value of debt might be much lower than book
debt. While we have to still take market value in the calculation, we should
take it with a grain of salt.
 If you have contingent liabilities ‐ for example, a potential liability from a
lawsuit that has not been decided ‐ you should consider the expected value
of these contingent liabilities. Ex. Cannabis stocks etc.

…………………………………………………………………………………………………………………………….
 Equity to Employees
 Restricted Stock Grants
Session 1. Relatively simple. Include Granted restricted stock in shares outstanding
12 ,13 today. This will lower the value per share.
2. To account for expected stock grants in the future, estimate the value of
Last lose these grants as a percent of revenue and forecast that as expense as part
ends of compensation expenses. That will reduce future income and cash
flows.
story and  Employee Options
numbers 1. Little more difficult to do. Two approaches, first Bludgeon approach: just
add the added equity shares issues thus decreasing the value per share.
This approach ignores that money will come into the company from
execution of options and thus overstate the effect of executing options.
2. Treasury Stock Approach. adds the proceeds from the exercise of options
to the value of the equity before dividing by the diluted number of shares
outstanding. But fails to consider the time premium on the options. Can
increase the value of equity per share.
3. Using option pricing model. Adjusted black Scholes model.
4. For future expected options grants, for companies like small tech
companies that regularly pay employees using cash.

………………………………………………………………………………………………………………….
 Good valuation is a bridge between stories and numbers. You have a story for
the company, that translates into numbers. So be very careful, and consider
checking out the sector as well.
 

Session
12 ,13

Last lose
ends

story and
numbers


  Be ready to modify narrative as events unfold

Session  Market and GDP have a ‐ve co‐relation. Which means that markets predict
14 the economy, and they do it pretty well, for about 2‐3 quarter hence to
come.
Valuing
markets
and
young
company

 Valuing index
 You can use analyst growth rates here because there are dozens of analysts
tracking the index.

 Index can be valued using the same framework used in finding EPR. Just
instead of solving for risk, we put in a value of risk we deem to be okay for
today.

 Following is an example of valuing index


 For factoring in the uncertainties, do a monte Carlo simulation

 DARK SIDE OF VALUATION

 Young company example amazon in 2000, see how numbers are either used
conventionally where they can be, and estimated where they have to. Like
full range of costs of capital is estimated, with assumption that 99%is equity
raised, because that is what should be done

 If you are worried about failure, incorporate into value

Session  Increasing growth is not always a value creating option. And it may destroy
15 value at times
 Financial leverage is a double‐edged sword. It magnifies both profits or
More on losses.
dark side
of
valuation

 Dealing with Decline


 If valuing a distressed company or highly in debt company use the above
formula, to take into account the probability of failure of the company. We
can reverse calculate probability that the market is attaching with the
company using bonds of the company.

 In many emerging market companies, the real process of valuation begins

when you have finished your DCF valuation, since the cross holdings (which
can be numerous) have to be valued, often with minimal information
 Natural disasters: small companies in some economies are much exposed to
natural disasters (hurricanes, earthquakes), without the means to hedge
against that risk (with insurance or derivative products).
 Terrorism risk: Companies in some countries that are unstable or in the grips
of civil war are exposed to damage or destruction.
 Nationalization risk: While less common than it used to be, there are
countries where businesses may be nationalized, with owners receiving less
than fair value as compensation.
Session  Financial Firms valuation
16


 Financial service companies are opaque
a. With financial service firms, we enter into a Faustian bargain. They tell us
very little about the quality of their assets (loans, for a bank, for instance
are not broken down by default risk status) but we accept that in return
for assets being marked to market (by accountants who presumably have
access to the information that we don’t have).
b. estimating cash flows for a financial service firm is difficult to do. So, we
trust financial service firms to pay out their cash flows as dividends.
Hence, the use of the dividend discount model.
c. During times of crises or when you don’t trust banks to pay out what they
can afford to in dividends, using the dividend discount model may not
give you a “reliable” value.

 For financial service companies, book value matters

a. Since financial service firms mark to market, the book value is more likely
to reflect what the firms own right now (rather than a historical value)
b. The regulatory capital ratios are based on book equity. Thus, a bank with
negative or even low book equity will be shut down by the regulators
c. From a valuation perspective, it therefore makes sense to pay heed to
book value. In fact, you can argue that reinvestment for a bank is the
amount that it needs to add to book equity to sustain its growth
ambitions and safety requirements:

 Financial service is a broad category, and while banks may be its most
substantive component, there are a range of other companies, with very
different business models.
For instance, payment processing companies and credit card companies are
also financial service companies, but they derive their value from

………………………………………………………………………………………………………………………
 Valuing Companies with “intangible” assets


 capital expenditures are expenditures designed to create benefits over many
periods.
a. With pharmaceutical and technology firms, R&D is the ultimate cap ex
but is treated as an operating expense.
b. With consulting firms and other firms dependent on human capital,
recruiting and training expenses are your long‐term investments that are
treated as operating expenses.
c. With brand name consumer product companies, a portion of the
advertising expense is to build up brand name and is the real capital
expenditure. It is treated as an operating expense.
……………………………………………………………………………………………………………………

 Valuing cyclical and commodity companies


  With “macro” companies, it is easy to get lost in “macro” assumptions.

 Use probabilistic tools to assess value as a function of macro variables

Session  In relative valuation, the value of an asset is compared to the values assessed
17 by the market for similar or comparable assets. (Convert these market values
into standardized values, since the absolute prices cannot be compared)
Pricing  Relative valuation is much more likely to reflect market perceptions and
moods than discounted cash flow valuation. This can be an advantage in
momentum trading and timing for IPO.
 More effective for screening stocks, as much less information is needed.
 Definitional Tests that your relative valuation should go through:
 

Session  Companies manipulate these pricing numbers sometimes, for example, if a

18 company with 8% ROE write‐offs a huge amount, it can overnight change its
ROE to 16%. These changes need to be kept in mind.
Pricing …………………………………………………………………………………………………………………………….
analytics  PEG RATIO
1. PEG Ratio = PE ratio/ Expected Growth Rate in EPS

2.
3. Risk and payout, which affect PE ratios, continue to affect PEG ratios as
well.
4. Dividing PE by expected growth does not neutralize the effects of
expected growth, since the relationship between growth and value is not
linear and fairly complex (even in a 2‐stage model)
5. Due to these reasons, the very reason that peg ratio was created, doesn’t
really hold too well. So, use it with a big grain of salt for valuation.
6. Using this will make riskier companies to appear cheaper and better. If
comparing within multiple companies, use it only when companies are
equally risky.
…………………………………………………………………………………………………………………….
 Price to Book Ratio
1. All these equations are derived from simple equity/dividend discount
models.

Here, ((ROE) = EPS0 / Book Value of Equity)

2. Enterprise value multiple EV/ Book Capital

Deriving these equations from DCF equations gives us much more insight
about the multiple, what the number will depend upon etc.
……………………………………………………………………………………………………………..
 EV/Sales Ratio

1.
…………………………………………………………………………………………………………………..
 The value of a brand name
1. One of the critiques of traditional valuation is that is fails to consider the
value of brand names and other intangibles
2. The approaches used by analysts to value brand names are often ad‐hoc
and may significantly overstate or understate their value
3. One of the benefits of having a well‐known and respected brand name is
that firms can charge higher prices for the same products, leading to
higher profit margins and hence to higher price‐sales ratios and firm
value. The larger the price premium that a firm can charge, the greater is
the value of the brand name.

4.
5. Since brand name gives the company higher margins or better sales, in a
way the brand name is already incorporated in the valuation. Since the
cash flows already factor it in.
…………………………………………………………………………………………………………………..
 
 Using multiples alone, will not give you a very accurate result (company
over/under valued) even within the same sectors. Because companies can be
in different businesses, different life cycles, different growth ratios etc.
 A much better way is to use a regression and check an expected PE/ any
other ratio against growth rate, revenues, EBITDA, reinvestment or any other
multiple. This is called Predicted PE / any other ratio.

Session  When Nothing is Working

19 1. In late 2000s, internet stocks could make sense using basic multiples.
2. Use proxies for survival and growth. (Eg. Using price to sales ratio against
Pricing market price. Regressing and comparing firms, for internet stocks in
Closure 2000)
and Asset 3. Solution 2: Use forward multiples Watch out for bumps in the road
Based (Tesla).
Valuation 4. Solution 3: Let the market tell you what matters. Social media in October
2013.
Read the tea leaves: See what the market cares about

 Problems with the regression methodology

1. Non‐linearity: The basic regression assumes a linear relationship
between PE ratios and the financial proxies, and that might not be
appropriate.
2. Non‐stationarity: The basic relationship between PE ratios and financial
variables itself might not be stable, and if it shifts from year to year, the
predictions from the model may not be reliable. For instance, the 2022
 regression has a markedly lower R‐squared than the regressions in prior
years, as the COVID effect on earnings plays out.
3. Multi‐collinearity: The independent variables are correlated with each
other. For example, high growth firms tend to have high risk. This multi‐
collinearity makes the coefficients of the regressions unreliable and may
explain the large changes in these coefficients from period to period.
Session
19  If a coefficient in a regression is statistically insignificant, all it is doing is
adding noise to the regression prediction.
Pricing 1. There are simple statistical tests of significance, such as the t statistics (>2
Closure is very good, 1‐2 is marginal, <1 is noise)
and Asset 2. With small samples, don’t overload the regression with independent
Based variables.
Valuation 3. Take the variable out of the regression, even if the fundamentals say it
should matter. In pricing, it is the market that determines what matters.

 With financial firms, use equity multiples, using firm multiples is pointless.
 If you have non‐financial firms, with wide differences in debt, use enterprise
value multiples, using equity multiples can be dangerous here.
 If only some companies in the sector are making money, use revenue
multiples instead of earnings multiple.

 In relative valuation all you are concluding is that over/under priced relative
to your comparable group.
 The entire sector can be over/under valued, in such cases also relative
valuation will tell you that some elements are under‐priced, even if they
intrinsically are over‐valued.
 Relative valuation is pricing, not valuation.


…………………………………………………………………………………………………………………………
 Asset‐based valuation
1. In asset‐based valuation, you value a business by valuing its individual
Session
assets. These individual assets can be tangible or intangible.
19
2. Liquidation: If you are liquidating a business by selling its assets piece
meal, rather than as a composite business, you would like to estimate
Pricing
what you will get from each asset or asset class individually.
Closure
and Asset 3. Fair value Accounting: As both US and international accounting
Based standards have turned to “fair value” accounting, accountants have been
Valuation called upon to redo balance sheet to reflect the assets at their fair rather
than book value.
4. Sum of the parts: If a business is made up of individual divisions or
assets, you may want to value these parts individually for one of two
groups. Potential acquirers may want to do this, as a precursor to
restructuring the business, or Investors may be interested because a
business that is selling for less than the sum of its parts may be “cheap”.

Session  The process of valuing private companies is not different from the process of
20 valuing public companies. You estimate cash flows, attach a discount rate
based upon the riskiness of the cash flows and compute a present value. As
Private with public companies, you can either value.
Company 1. The entire business, by discounting cash flows to the firm at the cost of
Valuation capital.
2. The equity in the business, by discounting cashflows to equity at the cost
of equity.
 When valuing private companies, you face two standard problems:
1. There is not market value for either debt or equity
2. The financial statements for private firms are likely to go back fewer
years, have less detail and have more holes in them
 Conventional risk and return models in finance are built on the presumption
that the marginal investors in the company are diversified and that they
therefore care only about the risk that cannot be diversified. That risk is
measured with a beta or betas, usually estimated by looking at past prices or
returns.
 STEP 1
 To get from the market beta to the total beta, we need a measure of how
much of the risk in the firm comes from the market and how much is firm‐
specific.

 Assume that the debt‐to‐equity ratio for the firm is similar to the average
market debt to equity ratio for publicly traded firms in the sector.
 To compute the cost of capital, we will use the same industry average debt
ratio that we used to lever the betas. (Give the company an artificial rating
using Coverage Ratio, to get a default spread and estimate cost of debt)
 Step 2: Clean up the financial statements
 In private companies, wages might be skipped or not taken by the owner.
Add them in.
 Check every item and see what will change when you run this company, and
the original owners are gone.

 Step 3: Assess the impact of the “key” person

 Sometimes the key person has a reputation in the market or is the one man
running the show, we need to consider how much cash flows will be affected
if this key person is gone.
 Step 4: Don’t forget valuation fundamentals
  To complete the valuation, you need to assume an expected growth rate. As
Private with any business, assumptions about growth have to be consistent with
Company reinvestment assumptions. Do not forget to take in reinvestment rate.
Valuation  Step 5: Complete the valuation
 Using the same principles as a publicly traded company
 Step 6: Consider the effect of illiquidity
 In private company valuation, illiquidity is a constant theme. All the talk,
though, seems to lead to a rule of thumb. The illiquidity discount for a private
firm is between 20‐30% and does not vary across private firms
 We can also use the following equation, or any other latest market study on
valuing illiquidity

Session  1. An option provides the holder with the right to buy or sell a specified
21 quantity of an underlying asset at a fixed price (called a strike price or an
exercise price) at or before the expiration date of the option.
first steps 2. There has to be a clearly defined underlying asset whose value changes
on Real over time in unpredictable ways.
Options 3. The payoffs on this asset (real option) have to be contingent on a specified
event occurring within a finite period.

 For an option to have significant economic value, there has to be a restriction

on competition in the event of the contingency. In a perfectly competitive
product market, no contingency, no matter how positive, will generate
positive net present value. At the limit, real options are most valuable when
you have exclusivity ‐ you and only you can take advantage of the
contingency. They become less valuable as the barriers to competition
become less steep.
 The Black Scholes Model

Session  Most practitioners who use option pricing models to value real options argue
22 for the binomial model over the Black‐Scholes
 A decision tree valuation of a pharmaceutical company with one drug in the
Valuing FDA pipeline:
options
to delay
and
expand

 Key Tests for Real Options:

1. Is there an option embedded in this asset/ decision?
2. Is there exclusivity?
3. Can you use an option pricing model to value the real option? (Is the cost
of exercising the option known and clear?)
 Option to delay taking an investment, when a firm has exclusive rights to it,
until a later date.
 The second of these options is taking one investment may allow us to take
advantage of other opportunities (investments) in the future. Option to
Expand.
 The last option that is embedded in projects is the option to abandon a
investment, if the cash flows do not measure up.
 Obtaining inputs for patent option valuation

 Valuing a firm with patents

.
 Estimating Inputs for Natural Resource Options
Session  Real World Approaches to Valuing Equity in Troubled Firms: Getting Inputs
23

Option to
Abandon,
Flexibility
and
Distresse
d Equity
(as
option)

 There are real options everywhere.

 Most of them have no significant economic value because there is no
exclusivity associated with using them.
 When options have significant economic value, the inputs needed to value
them in a binomial model can be used in more traditional approaches
(decision trees) to yield equivalent value.
 The real value from real options lies in:
1. Recognizing that building in flexibility and escape hatches into large
decisions has value
2. Insights we get on understanding how and why companies behave the
way they do in investment analysis and capital structure choices.
Session  The seven sins in acquisitions…
24

Acquirers
anonms
Seven
steps to
sobriety

 The Value of Synergy

1. the firms involved in the merger are valued independently, by

discounting expected cash flows to each firm at the weighted average
cost of capital for that firm.
2. the value of the combined firm, with no synergy, is obtained by adding
the values obtained for each firm in the first step.
3. The effects of synergy are built into expected growth rates and
cashflows, and the combined firm is re‐valued with synergy.
4. Value of Synergy = Value of the combined firm, with synergy ‐ Value of
the combined firm, without synergy

Session  Using the DCF framework, there are four basic ways in which the value of a
25 firm can be enhanced:
1. The cash flows from existing assets to the firm can be increased
Value (increasing after‐tax earnings/ reducing reinvestment needs)
Enhance‐ 2. The expected growth rate in these cash flows can be increased
‐ment (Increasing the rate of reinvestment in the firm/ Improving the return on
capital on those reinvestments)
Sometimes, growing less is the answer (for firms that are losing money or
not making their cost of capital)
 3. The length of the high growth period can be extended to allow for more
years of high growth.
4. The cost of capital can be reduced by
a. Reducing the operating risk in investments/assets
b. Changing the financial mix
c. Changing the financing composition

 Optimising capital ratio

 ¨ Growth, by itself, does not create value. It is growth, with investment in
excess return projects, that creates value.

Session  Dante meets DCF: Nine layers of valuation hell. And a bonus layer
26

Closing

 Layer 1: Base Year fixation

1. We need to check for consistency in numbers, example oil prices change
dramatically, and revenues can jump up and down. Normalise numbers if
numbers look all over the place. And for commodities this is always the
case.
 Layer 2: Taxes and Value
1. Always calculate the effective tax rate yourself.
2. Be careful not to double count tax benefits. Be cautious choosing
numbers between FCFF and FCFE.
 Layer 3: High Growth for how long
1. You can grow for a certain period only; growth diminishes as you grow
bigger.
2. You cannot grow more than the economy forever. Terminal growth
should never exceed the growth of market.
 Layer 4: The Cost of Capital
1. Check all numbers, don’t make basic mistakes.
 Layer 5: The price of growth
1. Check if the growth rate is plausible. If the firm is making reinvestments
to deliver the growth or not.
 2. Check how much revenues the company grows to in terminal year and if
it is plausible.
 Layer 6: The “fixed debt ratio” assumption
1. Never use target debt ratio. Use the company’s current debt ratio.
2. This is because using the future debt ratio right now, will change the
current debt and equity mix, and change cost of capital, and cost of
equity as well (because if a company takes more debt people see it as
riskier, its cost of equity will rise). This can never be calculated correctly.
 Layer 7: The Terminal Value
1. Never use multiples to estimate terminal value, because it makes your
DCF a pricing in actual. As terminal value is the biggest number in your
valuation.
2. Either use liquidation or stable growth model to assess terminal value
 Layer 8. From firm value to equity value: The Garnishing Effect
1. Add cash balance for equity value
2. Subtract the debt outstanding always for EQUITY value
3. Add % of holdings in other companies’ equity
4. Subtract minority interests.
 Layer 9. From equity value to equity value per share
1. Subtract value of options
 Layer 10. The final circle of hell
1. Never mix and match equity valuation and firm valuation. Be consistent
with cash flows and discount rates.