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Valuation: ClosingThoughts

Fall 2007Aswath Damodaran

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Approaches to Valuation

Discounted cashflow valuation, where we try (sometimesdesperately) to estimate the intrinsic value of an asset by using a mixof theory, guesswork and prayer.

Relative valuation, where we pick a group of assets, attach the name“comparable” to them and tell a story.

Contingent claim valuation, where we take the valuation that we didin the DCF valuation and divvy it up between the potential thieves ofvalue (equity) and the potential victims of this crime (lenders)

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Cash flowsFirm: Pre-debt cash flowEquity: After debt cash flows

Expected GrowthFirm: Growth in Operating EarningsEquity: Growth in Net Income/EPS

CF1 CF2 CF3 CF4 CF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value

CFn.........

Discount RateFirm:Cost of Capital

Equity: Cost of Equity

ValueFirm: Value of Firm

Equity: Value of Equity

DISCOUNTED CASHFLOW VALUATION

Length of Period of High Growth

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The nine circles of DCF valuation hell.. With aspecial bonus circle…

Base Year & Accounting Fixation

Death and taxes

Grow baby, grow...

It!s all in the discount rate...

Growth isn!t free

Terminal value as an ATM

Debt ratios change..

Valuation garnishes...

Per share value

?

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The Models You Used in D�CF Valuation

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What you found ...

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The Most Undervalued stocks are..

Company Name Price DCf Value Recommendation % Under or overVonage 2.09$ 9.93$ Buy -78.95%Orbital Sciences $2.06 7.06$ Buy -70.82%Trump 4.72$ 11.67$ BUY -59.55%Bon Ton Stores 13.92$ 33.15$ Buy -58.01%Napster 2.36$ 5.25$ Sell -55.05%Majesco $1.50 $3.12 BUY -51.92%Lululemon Athletica LTD 47.00 96.25 Buy -51.17%Metal Management 50.75$ 89.09$ Buy -43.04%SMSI 7.80$ 13.17$ Buy -40.77%LeapFrog Enterprises 6.99$ 11.75$ Buy -40.51%LeapFrog Enterprises (LF) $6.99 $11.75 Buy -40.51%BASF 97.20$ 156.70$ Buy -37.97%TXT $73.38 $115.51 Buy -36.47%

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The Most Overvalued stocks are...

Company Name Price DCf Value Recommendation % Under or overVWS 67.47$ 42.86$ Sell 57.42%China Southern Airline 62.83$ $39.71 Sell 58.22%Servcorp ($Aus) 5.15$ 3.15$ Sell 63.49%ProLogis 68.97 $41.34 BUY 66.84%Sharper Image Corporation 3.33$ 1.61$ Sell 106.83%Under Armour $48.44 $22.75 Sell 112.92%eDiets.com 5.37$ 2.11$ Sell 154.50%Harrahs 87.72$ 29.52$ Hold 197.15%Sharper Image 3.51$ 0.50$ Sell 602.00%

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The ultimate test… Did undervalued stocksmake money?

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More on the winners...

About 60% of all buy recommendations make money; about 45% ofsell recommendations beat the market.

There are two or three big winners in each period.• Apple Computer in December 1996• Checkpoint Software in June 1999

Stocks on which there is disagreement among different people tend todo worse than stocks on which there is no disagreement

Stocks that are under valued on both a DCF and relative valuationbasis do better than stocks that are under valued on only one approach.

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Relative Valuation: The Four Steps toUnderstanding Multiples

Anna Kournikova knows PE…. Or does she?• In use, the same multiple can be defined in different ways by different users. When

comparing and using multiples, estimated by someone else, it is critical that weunderstand how the multiples have been estimated

8 times EBITDA is not always cheap…• Too many people who use a multiple have no idea what its cross sectional

distribution is. If you do not know what the cross sectional distribution of amultiple is, it is difficult to look at a number and pass judgment on whether it is toohigh or low.

You cannot get away without making assumptions• It is critical that we understand the fundamentals that drive each multiple, and the

nature of the relationship between the multiple and each variable. There are no perfect comparables

• Defining the comparable universe and controlling for differences is far moredifficult in practice than it is in theory.

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Value of Stock = DPS 1/(ke - g)

PE=Payout Ratio (1+g)/(r-g)

PEG=Payout ratio (1+g)/g(r-g)

PBV=ROE (Payout ratio) (1+g)/(r-g)

PS= Net Margin (Payout ratio)(1+g)/(r-g)

Value of Firm = FCFF 1/(WACC -g)

Value/FCFF=(1+g)/(WACC-g)

Value/EBIT(1-t) = (1+g) (1- RIR)/(WACC-g)

Value/EBIT=(1+g)(1-RiR)/(1-t)(WACC-g)

VS= Oper Margin (1-RIR) (1+g)/(WACC-g)

Equity Multiples

Firm Multiples

PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk)

V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC)

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The Multiples you used were ...

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DCF vs Relative Valuations

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Most undervalued on a Relative Basis

Company Name Price Relative Value Recommendation % Under or Over: RelativeBon Ton Stores 13.92$ 269.00$ Buy -94.83%Trump Entertainment Resorts, Inc. 5.54 29.5 Buy -81.22%Vonage 2.09$ 7.80$ Buy -73.21%Cognizant Tech (CTSH) $30.28 $110.53 Buy -72.60%Dendreon $5.50 $15.25 Buy -63.93%Hansen Natural (HANS) $47.26 $118.49 Buy -60.11%Vale Inco (RIO) 34.86$ 84.69$ Buy -58.84%Metal Management 50.75$ 119.89 Buy -57.67%RealNetworks Inc. 6.34$ 14.71$ Buy -56.90%Hansen Natural Corp 44.28$ 101.55$ Buy -56.40%Harmony Gold Co. 10.59$ 24.00$ Buy -55.88%

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Most Over Valued Firms are..

Company Name Price Relative Value Recommendation % Under or Over: RelativeProLogis 68.97 21.72 Buy 217.54%China Southern Airline 62.83$ 19.16$ Sell 227.92%Blockbuster 3.34 1.00 Buy 234.00%Elan Corp., PLC 24.27$ 6.24$ Sell 288.94%RIMM $103.65 $23.21 Sell 346.57%LeapFrog Enterprises 6.99$ 1.39$ Buy 402.88%Lululemon Athletica LTD 47.00 6.60 Buy 612.12%Lan 15.02$ 1.00$ Buy 1402.00%Sharper Image 3.51$ 0.16$ Sell 2093.75%

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Contingent Claim (Option) Valuation

Options have several features• They derive their value from an underlying asset, which has value• The payoff on a call (put) option occurs only if the value of the underlying

asset is greater (lesser) than an exercise price that is specified at the timethe option is created. If this contingency does not occur, the option isworthless.

• They have a fixed life Any security that shares these features can be valued as an option.

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Results of Option Valuations

Number of firms valued using option models = 12 Number of firms where equity was worth nothing before DCF model

used = 4 Percent increase in value for remaining firms = 65.05%

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Your recommendations were to ..

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Choices…Choices…Choices…

Valuation Models

Asset BasedValuation

Discounted CashflowModels

Relative Valuation Contingent Claim Models

LiquidationValue

ReplacementCost

Equity ValuationModels

Firm ValuationModels

Cost of capitalapproach

APVapproach

Excess ReturnModels

Stable

Two-stage

Three-stageor n-stage

Current

Normalized

Equity

Firm

Earnings BookValue

Revenues Sectorspecific

Sector

Market

Option todelay

Option toexpand

Option toliquidate

Patent UndevelopedReserves

Youngfirms

Undevelopedland

Equity introubledfirm

Dividends

Free Cashflowto Equity

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Picking your approach

Asset characteristics• Marketability• Cash flow generating capacity• Uniqueness

Your characteristics• Time horizon• Reasons for doing the valuation• Beliefs about markets

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What approach would work for you?

As an investor, given your investment philosophy, time horizon andbeliefs about markets (that you will be investing in), which of the theapproaches to valuation would you choose?

Discounted Cash Flow Valuation Relative Valuation Neither. I believe that markets are efficient.

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Some Not Very Profound Advice

Its all in the fundamentals. The more things change, the more they staythe same.

Focus on the big picture; don’t let the details trip you up. Experience does not equal knowledge.

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Or maybe you can fly….