Darmodaran approach to company valuation

RUSSIAN PLEKHANOV UNIVERSITY OF ECONOMICS

 

 

INTERNATIONAL BUSINESS SCHOOL

 

 

COURSEWORK IN CORPORATE FINANCE

DAMODARAN’s APPROACH TO VALUATION

 

 

 

 

 

 

Student: Dodonova Anastasia

Master Degree, 1^st year 

Supervisor: I.V.Sokolnikova 

 

 

 

 

 

Moscow

2011

Contents

 

 

 

 

Introduction 3

1. Basis of Valuation notions according to Damodaran 4

2. DCF model 6

2.1. DCF and notion of growth stages 6

2.2. Cost of equity 9

2.2.1 CAPM and risk premium for country risk 9

2.2.2 Implied risk premium 12

2.3 Value of equity 13

2.3.1. Dividend model 13

2.3.2. Calculation of growth rates 14

2.4. From FCFE to FCFF 17

2.4.1. Cost of capital 17

2.4.2. FCFE approach 17

2.4.3. FCFF approach 20

3. Relative Valuation 22

4. Equity as an Option 24

4.1. Definition and Application 24

4.2 Advantages and Drawbacks  of the Option approach 26

Conclusion 28

Endnotes 29

Bibliography 30

Appendix 31

 

 

 

 

 

 

Introduction

Valuation is an inseparable part of any investment activity, whether it concerns buying a whole company, just one particular kind of fixed or current asset, bonds or intellectual property.  Despite a tremendous crisis and post-recession period, demand on valuation services cannot be underappreciated. Therefore, valuation is a basis for fundamental decisions, operational development and strategic one, from behalf of investors and management.

In this coursework I will describe Damodoran’s approach to valuation. This person has contributed a lot to valuation’s technic. He is an author of two books on Corporate Finance, Investment Management, Valuation and The Dark Side of Valuation, and his works were published in such magazines as Journal of Financial and Quantitative Analysis, The Journal of Finance, The Journal of Financial Economics и The Review of Financial Studies. In addition, he is a professor in Stern School Business in New York on MBA. Such a remarkable specialist described and contributed a lot to valuation technics whose works are used both in theory in universities and in practice among businessmen and valuation specialist.

There are quite a few disputes which valuation methods should be implemented: revenue approach, expense approach or comparison of similar enterprises and which methods should be implemented for each of them. However, Damodaran used explanation for a lot of technics and his advices and new approaches are one of the most referred and frequently used.

This is why I have chosen the topic of Damodaran’s Approach to value management.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1. Basis of Valuation notions according to Damodaran

In one of his works Damodaran cites the words of Henry Blodget, Merrill Lynch Equity Research Analyst in January 2000, who said in a report on Internet Capital

Group, which was trading at $174 then: “Valuation is often not a helpful tool in determining when to sell hyper-growth stocks”. There were and still are many persons in financial market who have argued that market prices are determined by this factor, perceptions of buyers and sellers, but not by cashflows, earnings and different calculations. Certainly, Damodaran cannot but agree partially that perceptions are quite important. However, “bigger fool”, which says that an investor may buy questionable securities without any regard to their quality and quickly sell them off to another investor (or the greater fool), who might also to dispose of them quickly afterwards, does not the one thing to figure out asset pricing. Unfortunately, speculative bubbles always blast sooner or later that ends up with a rapid depreciation in share price due to constant selling. For example, the price of shares of the above mentioned Internet Capital Group fell down to $3 in one year.

Certainly, the valuation is not panacea for investment decisions. There are some misconceptions about valuation. First of all, a valuation is not an objective search for “true” value. There is not true and precise value. Furthermore, all valuations are biased. The only questions are how much and in which direction it is so. The direction itself and the magnitude of the bias in your is directly proportional to who pays you and how much you are paid. To expand on this myth, Damodaran gave an example of a recent company acquisition. According to him, the buyer hired a valuation firm to determine the value of the intended acquisition while the seller hired their own firm to do the same thing. When the two firms came back they presented significantly different results. In the end a third party was brought in and conveniently landed with a number right in the middle of the first firms numbers¹.

Value estimates are predicted with “everything is going to go as planned” in mind. There is no way to say whether some events will affect value in some specific time. There is always a lack of information and a level of uncertainty. So valuation professionals cannot ever be wrong even if their original forecasts are far from the final one.

In addition, there is another myth that if a model is more complicated and quantitative it is better. However, complex systems lead to more intricate results and confusion.

There are three main approaches to valuation:

• Discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset.
• Relative valuation estimates the value of an asset by looking at the pricing of “comparable” assets relative to a common variable like earnings, cashflows, book value or sales.
• Contingent claim valuation uses option pricing models to measure the value of assets that share option characteristics

The basis for all them is to find assets which overvalued or undervalued. It is considered that markets are inefficient and may make errors and, therefore, it is necessary to find how to find and correct these mistakes. If there is an efficient market the price is supposed to be the best estimate of value. Hence, valuation has to prove that.

 

 

 

 

 

 

 

 

 

 

 

 

2. DCF model

2.1. DCF and notion of growth stages

Concerning DCF method it has such a philosophical Basis that every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. In order to perform this method it is necessary to calculate:

• the life of the asset

• the cash flows during the life of the asset

• the discount rate to apply to these cash flows to get present value

The most familiar and simple formula is Value =∑CFt/∑( 1 +r)t

where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. The discount rate can be taken as the rate of inflation, weighted average cost of capital rate, interest rate etc.

 

From this we can make some reasoning that for an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later due to time value of money; the latter may, however, have greater growth and, therefore, higher cash flows to make lower inputs in the beginning.

 

Applying this method I would like to show examples of just equity and the whole firm valuation.

For the former the value of equity is obtained by discounting expected cashflows to equity, that is the residual cashflows after meeting all expenses, tax obligations and interest and principal payments which connected with the cost of equity: ∑CF to Equityt/∑(1+ ke )t

Where, CF to Equity t = Expected Cashflow to Equity in period t

ke = Cost of Equity

Hence, the dividend discount model is a specialized case of equity valuation, and, vice versa, the value of a stock is the present value of expected future dividends.

 

For the latter 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, discounted 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:

∑CF to Firm t/ ∑(1+WACC)t

Logically it is possible to get equity value from firm value. For doing so it is necessary to subtract out the value of all debts and subtract the value of all non-equity claims in the firm that are included in the cost of capital calculation. Also it is often argued that equity valuation requires more assumptions than firm valuation, because cash flows to equity require explicit assumptions about changes in leverage whereas cash flows to the firm are pre-debt cash flows and do not require assumptions about leverage. Certainly it is very important not to mix cash flows and discount rates in valuation because if we use wacc for equity valuation we will have overestimated value (as wacc is based on leverage ration).

For a listed company, the life may be endless as we can always issue new stock. Therefore, cashflows are also infinite. Though, we know production life cycle and firm’s cycle. There is a growth period, maturity and decline. In addition, if a firm issues new stock, the value of the firm will decrease. This is why we estimate cash flows for a “growth period” and then estimate a terminal value, to get the value at the end of the period: ∑CFt/∑(1+r)t+Terminal Value/(1 + r)N

 

In order to calculate cash flows at a growth period we have to understand if it grows at a constant rate. If it is do we can calculate the value with the following formula: Value = Expected Cash Flow Next Period / (r - g)

where,

r = Discount rate (Cost of Equity or Cost of Capital)

g = Expected growth rate

A company can grow at high level but after some period of time it achieve stable growth rate and the terminal value can calculated by this formula. According to Damodaran the stable growth rate cannot be higher than growth of the economy of a country. However, in reality it can happen sometimes. For example, Gazprom have achieved several times higher growth than Russia itself. Though, it happens quite rarely at not for a long period.

 

DCF model implies that there are assumptions that the firm 1) can be in the stage of no high growth, 2) there will be high growth for a period, at the end of which the growth rate will drop fast to the stable growth rate, 3) and when there will be high growth for a period, at the end of which the growth rate will decline gradually to a stable growth rate.

 

The duration of high growth will vary depending on industry, economic situation, country etc but there are main factors that determine it:

• the size of the firm. The larger firm will have shorter high growth periods because it is more difficult to mobilize all the resources and keep up with the previous high growth stage.

• current growth rate . If it is high then there will be longer high growth period.

• barriers to entry and differential advantages. In case of high advantages there will be again longer growth period.

 

Graphically it can be represented by the following pictures:

 

1. Stable growth                     2-stage growth                              3-stage growth

 

Damodaran in his work demonstrate real-life examples of this growth patterns.

Resource: Aswath Damodaran-Valuation (http://pages.stern.nyu.edu)

Now I would like to switch to another component which determination is extremely important to find: discount rate. For equity it is based on risk and return model and a dividend-growth model. The former works on the principal of CAPM which gives estimation of cost of equity applying a beta of the firm.

2.2. Cost of equity

2.2.1 CAPM and risk premium for country risk

As it is highly known formula of Sharp САРМ = Rf + ß * (Rm-Rf) which also quite easy to use and very logical; as a holder of more risky assets should get risk premium. Damodaran introduced a new approach for calculation of risk premium for developing market. Damodaran used a new variable called relative equity market standard deviation which is calculated as Standard deviation of country X/ Standard deviation of US.

This model is easy to use because it starts with the U.S. risk-free rate and the U.S. equity premium. It is also useful if the local country has a viable equity market and the government debt is issued in U.S. dollars.

The model’s theory is to utilize the country default spread as adjusted for the standard deviation of the local equity market to the local bond market. This adjusted default spread is then added to the U.S. CAPM.

To estimate the long-term country default spread, the practitioner should start with the country credit rating and compare that to the country credit rating of a mature market, such as the U.S. The difference in the ratings can be measured in points, arriving at the default spread. The standard deviation of the local equity market and the local bond market can be calculated if both markets have adequate history. For situations where there is not enough history to develop standard deviations or if markets are in such turmoil that current calculations may not be deemed representative of the long term, a benchmark such as 1.5, may be appropriate. The model is applied to net cash flows expressed in U.S. dollars, and exchange risk must still be considered.

For illustration I have decided to introduce the table of countries with default spread of Latin America in 2012; risk premium calculations of countries will be explained later. Default Spread is the spread difference between dollar-denominated bonds issued by this country and the U.S. Treasury bond rate (resource: moodys.com).

Country	Local Currency Rating	Default Spread
Argentina	B3	600
Belize	B3	600
Bolivia	B1	400
Brazil	Baa2	175
Chile	Aa3	70
Colombia	Baa3	200
Costa Rica	Baa3	200
Ecuador	Caa2	850
El Salvador	Ba2	275
Guatemala	Ba1	240
Honduras	B2	500
Mexico	Baa1	150
Nicaragua	B3	600
Panama	Baa3	200
Paraguay	B1	400
Peru	Baa3	200
Uruguay	Ba1	240
Venezuela	B1	400

 

That is the 1^st step for risk premium calculation with a country risk.

So according to Damodaran country equity risk premiums can be calculated either by means of default spread on country bond, relative equity market approach or comparison of default of country’s bond and equity. This a following step.

For example,

• Brazil was rated B2 by Moody’s and the default spread on the Brazilian dollar denominated C.Bond at the end of August 2004 was 6.01%. (10.30%-4.29%)
• Brazil’s index Bovespa had standard deviation of 34.56, S&P 500’s one was 19.01 and the premium of the US was 4.82%. Therefore, Total risk premium for Brazil = 4.82% (34.56%/19.01%) = 8.76% and, subsequently, country equity risk premium for Brazil = 8.76% - 4.82% = 3.94%
• Country ratings measure default risk. While default risk premiums and equity risk premiums are highly correlated, one would expect equity spreads to be higher than debt spreads.

            Then, we get Brazil’s Equity risk premium = Default spread on country bond* σBovespa/σBrazil’s Bond=

=6.01% (34.56%/26.34%) = 7.89%

Applying this to our previous table we will get such results:

Country	Total Risk Premium	Country Risk Premium
Argentina	15.00%	9.00%
Belize	15.00%	9.00%
Bolivia	12.00%	6.00%
Brazil	8.63%	2.63%
Chile	7.05%	1.05%
Colombia	9.00%	3.00%
Costa Rica	9.00%	3.00%
Ecuador	18.75%	12.75%
El Salvador	10.13%	4.13%
Guatemala	9.60%	3.60%
Honduras	13.50%	7.50%
Mexico	8.25%	2.25%
Nicaragua	15.00%	9.00%
Panama	9.00%	3.00%
Paraguay	12.00%	6.00%
Peru	9.00%	3.00%
Uruguay	9.60%	3.60%
Venezuela	12.00%	6.00%

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

Calculating total risk premium, Damodaran added 6% rate for mature markets (obtained from the index S&P 500).

 

Calculation of the finite return will depend on the following approaches:

1. If it is assumed that every company in the country is equally exposed to country risk E(Return) = Rf  + Country risk premium+ ß(US premium). In comparison we can say this is assumed that the local

Government’s dollar borrowing rate is taken as a riskf rate. This formula implies that  specific firm also has its specific risk.

2. Assume that a company’s exposure to country risk is similar to its exposure to other market risk.