The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit (Little Books. Big Profits)

by Aswath Damodaran

Chapter 1 : Value—More Than a Number! Two Approaches to Valuation Why Should You Care? Some Truths about Valuation Start Your Engines!

Chapter 2 : Power Tools of the Trade Time Is Money Grappling with Risk Accounting 101 Making Sense of Data The Tool Box Is Full

Chapter 3 : Yes, Virginia, Every Asset Has an Intrinsic Value Value the Business or Just the Equity? Inputs to Intrinsic Valuation What Do These Models Tell Us? It’s All in the Intrinsic Value!

Chapter 4 : It’s All Relative! Standardized Values and Multiples Four Keys to Using Multiples Intrinsic versus Relative Value Einstein Was Right

How do accountants measure the value of assets? For most fixed and long-term assets, such as land, buildings, and equipment, they begin with what you originally paid for the asset (historical cost) and reduce that value for the aging of the asset (depreciation or amortization). For short-term assets (current assets), including inventory (raw materials, works in progress, and finished goods), receivables (summarizing moneys owed to the firm), and cash, accountants are more amenable to the use of an updated or market value. If a company invests in the securities or assets of another company, the investment is valued at an updated market value if the investment is held for trading and historical cost when it is not. In the special case where the holding comprises more than 50 percent of the value of another company (subsidiary), the firm has to record all of the subsidiary’s assets and liabilities on its balance sheet (this is called consolidation), with a minority interest item capturing the percentage of the subsidiary that does not belong to it. Finally, you have what are loosely categorized as intangible assets. While you would normally consider items such as brand names, customer loyalty, and a well-trained work force as intangible assets, the most commonly encountered intangible asset in accounting is goodwill. When a firm acquires another firm, the price it pays is first allocated to the existing assets of the acquired firm. Any excess paid becomes goodwill and is reco...

Just as with the measurement of asset value, the accounting categorization of liabilities and equity is governed by a set of fairly rigid principles. Current liabilities include obligations that the firm has coming due in the next accounting period, such as accounts payable and short-term borrowing, and these items are usually recorded at their current market value. Long-term debt, including bank loans and corporate bonds, are generally recorded at the face value at the time of issue and are generally not marked-to-market. Finally, the accounting measure of equity shown on the balance sheet reflects the original proceeds received by the firm when it issued the equity, augmented by any earnings made since then (or reduced by losses, if any) and reduced by any dividends paid out and stock buybacks.

Time value concepts

Risk and return models

Much of the earnings and cash flow data

statistical measures

There are four basic inputs that we need for a value estimate: cash flows from existing assets (net of reinvestment needs and taxes); expected growth in these cash flows for a forecast period; the cost of financing the assets; and an estimate of what the firm will be worth at the end of the forecast period.

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debt ratio

cost of capital

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When estimating market value, you have three choices: 1. Market value of equity: The price per share or market capitalization. 2. Market value of firm: The sum of the market values of both debt and equity. 3. Market value of operating assets or enterprise value: The sums of the market values of debt and equity, but with cash netted out of the value. When measuring

In contrast, the price to sales ratio and price to EBITDA are not consistently defined, since they divide the market value of equity by an operating measure. Using these multiples will lead you to finding any firm with a significant debt burden to be cheap.

To prevent outliers from skewing numbers, data reporting services that compute and report average values for multiples either throw out outliers when computing the averages or constrain the multiples to be less than or equal to a fixed number. The consequence is that averages reported by two services for the same sector or the market will almost never match up because they deal with outliers differently.

When looking at the average price/earnings ratio across a group of firms, the firms with negative earnings will all drop out of the sample because the price/earnings ratio cannot be computed. Why should this matter when the sample is large? The fact that the firms that are taken out of the sample are the firms losing money implies that the average PE ratio for the group will be biased because of the elimination of these firms. As a general rule, you should be skeptical about any multiple that results in a significant reduction in the number of firms being analyzed.

Why do multiples change over time? Some of the change can be attributed to fundamentals. As interest rates and economic growth shift over time, the pricing of stocks will change to reflect these shifts; lower interest rates, for instance, played a key role in the rise of PE ratios through the 1990s. Some of the change, though, comes from changes in market perception of risk. As investors become more risk averse, which tends to happen during recessions, multiples paid for stocks will decrease. From a practical standpoint, what are the consequences? The first is that comparisons of multiples across time are fraught with danger. For instance, the common practice of branding a market to be under or overvalued based upon comparing the PE ratio today to past PE ratios will lead to misleading judgments when interest rates are higher or lower than historical norms. The second is that relative valuations have short shelf lives. A stock may look cheap relative to comparable companies today, but that assessment can shift dramatically over the next few months.

You make just as many assumptions when you do a relative valuation as you do in a discounted cash flow valuation. The difference is that the assumptions in a relative valuation are implicit and unstated, whereas those in discounted cash flow valuation are explicit and stated. In the intrinsic valuation chapter, we observed that the value of a firm is a function of three variables—its capacity to generate cash flows, its expected growth in these cash flows, and the uncertainty associated with these cash flows. Every multiple, whether it is of earnings, revenues, or book value, is a function of the same three variables—risk, growth, and cash flow generating potential. Intuitively, firms with higher growth rates, less risk, and greater cash flow generating potential should trade at higher multiples than firms with lower growth, higher risk, and less cash flow potential. To look under the hood, so to speak, of equity and firm value multiples, we can go back to simple discounted cash flow models for equity and firm value and use them to derive the multiples.

The key determinants of the PE ratio are the expected growth rate in earnings per share, the cost of equity, and the payout ratio. Other things remaining equal, we would expect higher growth, lower risk, and higher payout ratio firms to trade at higher multiples of earnings than firms without these characteristics. Dividing both sides by the book value of equity, we can estimate the price/book value ratio for a stable growth firm. where ROE is the return on equity (net income/book value of equity) and is the only variable in addition to the three that determine PE ratios (growth rate, cost of equity, and payout) that affects price-to-book equity.

While all of these computations are based upon a stable growth dividend discount model, the conclusions hold even when we look at companies with high growth potential and with other equity valuation models. We can do a similar analysis to derive the firm value multiples. The value of a firm in stable growth can be written as: Since the free cash flow of the firm is the after-tax operating income netted against the net capital expenditures and working capital needs of the firm, this can be rewritten as follows: Dividing both sides of this equation by sales, and defining the after-tax operating margin as after-tax operating income divided by sales, yields the following:

Table 4.3 summarizes the multiples and the key variables that determine each multiple, with the sign of the relationship in brackets next to each variable: indicates that an increase in this variable will increase the multiple, whereas indicates that an increase in this variable will decrease the multiple, holding all else constant. Table 4.3 Fundamentals Determining Multiples Multiple Fundamental Determinants PE ratio Expected growth(), payout(), risk() Price to book equity ratio Expected growth(), payout(), risk(), ROE() Price to sales ratio Expected growth(), payout(), risk(), net margin() EV to FCFF Cost of capital(), growth rate() EV to EBITDA Expected growth(), reinvestment rate(), risk(), ROIC(), Tax rate() EV to capital ratio Expected growth(), reinvestment rate(), risk(), ROIC() EV to sales Expected growth(), reinvestment rate(), risk(), operating margin()

Notwithstanding the fact that each multiple is determined by many variables, there is a single variable that dominates when it comes to explaining each multiple (and it is not the same variable for every multiple). This variable is called the companion variable and is key to finding undervalued stocks. In Table 4.4, the companion variables and mismatches are identified for six multiples. Table 4.4 Valuation Mismatches Multiple Companion Variable Mismatch Indicator for Undervalued Company PE ratio Expected growth Low PE ratio with high expected growth rate in earnings per share P/BV ratio ROE Low P/BV ratio with high ROE P/S ratio Net margin Low P/S ratio with high net profit margin EV/EBITDA Reinvestment rate Low EV/EBITDA ratio with low reinvestment needs EV/Capital Return on capital Low EV/Capital ratio with high return on capital EV/Sales After-tax operating margin Low EV/Sales ratio with high after-tax operating margin

Multiples tend to be used in conjunction with comparable firms to determine the value of a firm or its equity. A comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued. Nowhere in this definition is there a component that relates to the industry or sector to which a firm belongs. Thus, a telecommunications firm can be compared to a software firm, if the two are identical in terms of cash flows, growth, and risk.

No historical performance data: Most young companies have only one or two years of data available on operations and financing and some have financials for only a portion of a year. Small or no revenues, operating losses: Many young companies have small or nonexistent revenues. Expenses often are associated with getting the business established, rather than generating revenues. In combination, the result is significant operating losses. Many don’t survive: One study concluded that only 44 percent of all businesses that were founded in 1998 survived at least four years and only 31 percent made it through seven years. Investments are illiquid: Even those firms that are publicly traded tend to have small market capitalizations and relatively few shares traded (low float). A significant portion of the equity is usually held by the founders, venture capitalists, and other private equity investors. Multiple claims on equity: It is not uncommon for some equity investors to have first claims on cash flows (dividends) and others to have additional voting right shares.

What do you scale value to? Young companies often lose money (both net income and EBITDA are negative), have little to show in terms of book value, and have miniscule revenues. Scaling market value to any of these variables is going to be difficult. What are your comparable companies? Even if a young company operates in a sector where there are many other young companies, there can be significant variations across companies. For young companies in mature sectors, the task will be even more challenging. How do you control for survival? Intuitively, we would expect the relative value of a young company (the multiple of revenues or earnings that we assign it) to increase with its likelihood of survival. However, putting this intuitive principle into practice is not easy to do.

The basic principles that govern terminal value remain unchanged: the growth rate used has to be less than the growth rate of the economy, the cost of capital has to converge on that of a mature firm, and there has to be enough reinvestment to sustain the stable growth. Evergreen

Relative valuation is more challenging with young firms that have little to show in terms of operations and face substantial risks in operations and threats to their existence, for the following reasons: Life cycle affects fundamentals: To the extent that we are comparing a young firm to more mature firms in the business, there are likely to be significant differences in risk, cash flows, and growth across the firms. Survival: A related point is that there is a high probability of failure in young firms. Firms that are mature and have a lower probability of failure should therefore trade at higher market values, for any given variable such as revenues, earnings, or book value, holding all else (growth and risk) constant. Scaling variable: Young firms often have very little revenues to show in the current year and many will be losing money; the book value is usually meaningless. Applying a multiple to any one of these measures will result in outlandish numbers. Liquidity: Since equity in publicly traded companies is often more liquid than equity in young growth companies, the value obtained by using these multiples may be too high if applied to a young company.

There are simple practices that can not only prevent egregious valuation errors but also lead to better valuations: Use forward revenues/earnings: Since young firms often have small revenues and negative earnings, one solution is to forecast the operating results of the firm further down the life cycle and use these forward revenues and earnings as the basis for valuation. In effect, we will estimate the value of the business in five years, using revenues or earnings from that point in time. While Evergreen Solar has revenues of only $90 million in the current year, it is projected to have $483 million in revenues in year 5. Adjust the multiple for the firm’s characteristics at the forward period: Consider a simple illustration. Assume that you have a company that is expected to have revenue growth of 50 percent for the next five years and 10 percent thereafter. The multiple that you apply to revenues or earnings in year five should reflect an expected growth rate of 10 percent (and not 50 percent). To estimate a value for Evergreen Solar in year five, we use 1.55, the multiple of revenues at which larger, mature firms in the sector trade at today. Adjust for time value and survival risk: When forward multiples are used to derive value, we need to adjust for the time value of money and the likelihood that the firm will not survive to get to the forward value. Incorporating the expected revenues for Evergreen Solar, applying the sector average multiple, and adjusting for th...

In both discounted cash flow and relative valuation, we build in our expectations of what success will look like in terms of revenues and earnings. Sometimes, success in one business or market can be a stepping-stone to success in other businesses or markets. Success with an existing product can sometimes provide an opening for a firm to introduce a new product. The success of the iPod laid the foundations for the introduction of the iPhone and the iPad for Apple. Companies that succeed with a product in one market may be able to expand into other markets with similar success. The most obvious example of this is expanding into foreign markets to build on domestic market success, a pathway adopted by companies like Coca Cola, McDonald’s, and many retail companies. The more subtle examples are products that are directed at one market that serendipitously find new markets: An ulcer drug that reduces cholesterol would be a good example. Why cannot we build expectations about new products and new markets into our cash flows and value? We can try, but there are two problems. First, our forecasts about these potential product and market extensions will be very hazy at the time of the initial valuation and the cash flows will reflect this uncertainty. Apple would not have been able to visualize the potential market for the iPhone at the time that they were introducing the iPod. Second, it is the information gleaned and the lessons learned during the initial product launch and subs...

Value Plays There are many reasons why young growth companies fail: Revenue growth may lag, target margins may be lower than expected, capital markets may shut down, or key people may leave. Investors can improve their odds of success by focusing on the following: Big potential market: The potential market for the company’s products and services has to be large enough to absorb high revenue growth for an extended period, without being overwhelmed. Expense tracking and controls: Young companies can become undisciplined in tracking and controlling expenses, while chasing growth. Set targets for margin improvement and view failure to meet these targets as reasons to sell. Access to capital: Capital access is critical to both growth and success. Look for firms with larger cash balances and institutional investor bases because they are better positioned. Dependence on key individuals: Young firms are often dependent upon key individuals or founders. Focus on firms that have built up a solid bench to back up key personnel. Exclusivity: Success will attract competition, often from larger companies with deep pockets. You want young firms that have products that are difficult for others to imitate, whether this exclusivity comes from patents, technology, or brand name. As a bonus, with exclusivity, success is also more likely to feed on itself, allowing a firm to enter new markets and introduce new products. In summary, you want to invest in young companies with tough-to-imitate pr...

Here is an alternative definition: Growth firms get more of their value from investments that they expect to make in the future and less from investments already made.

Growth companies are diverse in size and growth prospects, but they share some common characteristics: Dynamic financials: Not only can the earnings and book value numbers for the latest year be very different from numbers in the prior year, but they can change dramatically even over shorter time periods. Size disconnect: The market values of growth companies, if they are publicly traded, are often much higher than the book values, since markets incorporate the value of growth assets and accountants do not. In addition, the market values can seem discordant with the operating numbers for the firm—revenues and earnings. Many growth firms have market values in the billions, while reporting small revenues and negative earnings. Use of debt: Growth firms in any business will tend to carry less debt, relative to their value (intrinsic or market), than more stable firms in the same business, simply because they do not have the cash flows from existing assets to support more debt. Market history is short and unstable: Even if growth companies are publicly traded, they generally have stock price data going back for only short periods, and even that data is unstable. While the degree to which these factors affect growth firms can vary across firms, they are prevalent in almost every growth firm.

The issues that make discounted cash flow valuation difficult also crop up, not surprisingly, when we do relative valuation and listed next are a few of them. Comparable firms: Even if all of the companies in a sector are growth firms, they can vary widely in terms of risk and growth characteristics, thus making it difficult to generalize from industry averages. Base year values and choice of multiples: If a firm is a growth firm, the current values for scaling variables such as earnings, book value, or revenues may provide limited or unreliable clues to the future potential for the firm. Controlling for growth differences: Not only does the level of growth make a difference to value, but so does the length of the growth period and the excess returns that accompany that growth rate. Put another way, two companies with the same expected growth rate in earnings can trade at very different multiples of these earnings. Controlling for risk differences: Determining how the trade-off between growth and risk will affect value is difficult to do in any valuation but becomes doubly so in relative valuation, where many companies have both high growth and high risk. Analysts who use multiples to value growth firms may feel a false sense of security about their valuations, since their assumptions are often implicit rather than explicit. The reality, though, is that relative valuations yield valuations that are just as subject to error as discounted cash flow valuations. Valuation Solu...

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Insurance companies

investment bank

Investment firms

For instance, until a decade ago, the Glass-Steagall Act in the United States restricted commercial banks from investment banking activities as well as from taking active equity positions in nonfinancial service firms.

The first is that drawing a distinction between debt and equity is difficult for financial service firms.

Defining cash flow for a bank is also difficult,

The same issues rear their head in relative valuation.