Relative Valuation

AswathDamodaran

What is relative valuation?

Inrelativevaluation,thevalueofanassetiscomparedtothevalues
assessedbythemarketforsimilarorcomparableassets.
Todorelativevaluationthen,
weneedtoidentifycomparableassetsandobtainmarketvaluesforthese
assets
convertthesemarketvaluesintostandardizedvalues,sincetheabsolute
pricescannotbecomparedThisprocessofstandardizingcreatesprice
multiples.
comparethestandardizedvalueormultiplefortheassetbeinganalyzedto
thestandardizedvaluesforcomparableasset,controllingforany
differencesbetweenthefirmsthatmightaffectthemultiple,tojudge
whethertheassetisunderorovervalued

Relative valuation is pervasive

MostvaluationsonWallStreetarerelativevaluations.
Almost85%ofequityresearchreportsarebaseduponamultipleand
comparables.
Morethan50%ofallacquisitionvaluationsarebaseduponmultiples
Rulesofthumbbasedonmultiplesarenotonlycommonbutareoftenthe
basisforfinalvaluationjudgments.

Whiletherearemorediscountedcashflowvaluationsinconsultingand
corporatefinance,theyareoftenrelativevaluationsmasqueradingas
discountedcashflowvaluations.
Theobjectiveinmanydiscountedcashflowvaluationsistobackintoa
numberthathasbeenobtainedbyusingamultiple.
Theterminalvalueinasignificantnumberofdiscountedcashflow
valuationsisestimatedusingamultiple.

Why relative valuation?

IfyouthinkImcrazy,youshouldseetheguywholivesacrossthehall
JerrySeinfeldtalkingaboutKramerinaSeinfeldepisode

Alittleinaccuracysometimessavestonsofexplanation
H.H.Munro

Ifyouaregoingtoscrewup,makesurethatyouhavelotsofcompany
Exportfoliomanager

So, you believe only in intrinsic value? Here is

why you should still care about relative value

Evenifyouareatruebelieverindiscountedcashflowvaluation,
presentingyourfindingsonarelativevaluationbasiswillmakeit
morelikelythatyourfindings/recommendationswillreachareceptive
audience.
Insomecases,relativevaluationcanhelpfindweakspotsin
discountedcashflowvaluationsandfixthem.
Theproblemwithmultiplesisnotintheirusebutintheirabuse.Ifwe
canfindwaystoframemultiplesright,weshouldbeabletousethem
better.

Standardizing Value

Youcanstandardizeeithertheequityvalueofanassetorthevalueoftheassetitself,
whichgoesinthenumerator.
Youcanstandardizebydividingbythe
Earningsoftheasset
Price/EarningsRatio(PE)andvariants(PEGandRelativePE)
Value/EBIT
Value/EBITDA
Value/CashFlow
Bookvalueoftheasset
Price/BookValue(ofEquity)(PBV)
Value/BookValueofAssets
Value/ReplacementCost(TobinsQ)
Revenuesgeneratedbytheasset
Price/SalesperShare(PS)
Value/Sales
AssetorIndustrySpecificVariable(Price/kwh,Pricepertonofsteel....)

The Four Steps to Understanding Multiples

Definethemultiple
Inuse,thesamemultiplecanbedefinedindifferentwaysbydifferent
users.Whencomparingandusingmultiples,estimatedbysomeoneelse,it
iscriticalthatweunderstandhowthemultipleshavebeenestimated
Describethemultiple
Toomanypeoplewhouseamultiplehavenoideawhatitscrosssectional
distributionis.Ifyoudonotknowwhatthecrosssectionaldistributionof
amultipleis,itisdifficulttolookatanumberandpassjudgmenton
whetheritistoohighorlow.
Analyzethemultiple
Itiscriticalthatweunderstandthefundamentalsthatdriveeachmultiple,
andthenatureoftherelationshipbetweenthemultipleandeachvariable.
Applythemultiple
Definingthecomparableuniverseandcontrollingfordifferencesisfar
moredifficultinpracticethanitisintheory.

Definitional Tests

Isthemultipleconsistentlydefined?
Proposition1:Boththevalue(thenumerator)andthestandardizing
variable(thedenominator)shouldbetothesameclaimholdersinthe
firm.Inotherwords,thevalueofequityshouldbedividedbyequity
earningsorequitybookvalue,andfirmvalueshouldbedividedby
firmearningsorbookvalue.

Isthemultipleuniformlyestimated?
Thevariablesusedindefiningthemultipleshouldbeestimateduniformly
acrossassetsinthecomparablefirmlist.
Ifearningsbasedmultiplesareused,theaccountingrulestomeasure
earningsshouldbeappliedconsistentlyacrossassets.Thesamerule
applieswithbookvaluebasedmultiples.

Descriptive Tests

Whatistheaverageandstandarddeviationforthismultiple,acrossthe
universe(market)?
Whatisthemedianforthismultiple?
Themedianforthismultipleisoftenamorereliablecomparisonpoint.

Howlargearetheoutlierstothedistribution,andhowdowedealwith
theoutliers?
Throwingouttheoutliersmayseemlikeanobvioussolution,butifthe
outliersalllieononesideofthedistribution(theyusuallyarelarge
positivenumbers),thiscanleadtoabiasedestimate.

Aretherecaseswherethemultiplecannotbeestimated?Willignoring
thesecasesleadtoabiasedestimateofthemultiple?
Howhasthismultiplechangedovertime?

Analytical Tests

Whatarethefundamentalsthatdetermineanddrivethesemultiples?
Proposition2:Embeddedineverymultipleareallofthevariablesthat
driveeverydiscountedcashflowvaluationgrowth,riskandcashflow
patterns.
Infact,usingasimplediscountedcashflowmodelandbasicalgebra
shouldyieldthefundamentalsthatdriveamultiple

Howdochangesinthesefundamentalschangethemultiple?
Therelationshipbetweenafundamental(likegrowth)andamultiple
(suchasPE)isseldomlinear.Forexample,iffirmAhastwicethegrowth
rateoffirmB,itwillgenerallynottradeattwiceitsPEratio
Proposition3:Itisimpossibletoproperlycomparefirmsona
multiple,ifwedonotknowthenatureoftherelationshipbetween
fundamentalsandthemultiple.

10

Application Tests

Giventhefirmthatwearevaluing,whatisacomparablefirm?
Whiletraditionalanalysisisbuiltonthepremisethatfirmsinthesame
sectorarecomparablefirms,valuationtheorywouldsuggestthata
comparablefirmisonewhichissimilartotheonebeinganalyzedin
termsoffundamentals.
Proposition4:Thereisnoreasonwhyafirmcannotbecompared
withanotherfirminaverydifferentbusiness,ifthetwofirmshave
thesamerisk,growthandcashflowcharacteristics.

Giventhecomparablefirms,howdoweadjustfordifferencesacross
firmsonthefundamentals?
Proposition5:Itisimpossibletofindanexactlyidenticalfirmtothe
oneyouarevaluing.

11

Price Earnings Ratio: Definition

PE=MarketPriceperShare/EarningsperShare

ThereareanumberofvariantsonthebasicPEratioinuse.Theyare
baseduponhowthepriceandtheearningsaredefined.
Price:
isusuallythecurrentprice
issometimestheaveragepricefortheyear
EPS:
earningspershareinmostrecentfinancialyear
earningspershareintrailing12months(TrailingPE)
forecastedearningspersharenextyear(ForwardPE)
forecastedearningspershareinfutureyear

12

Looking at the distribution

PERatiosforUSStocksJanuary2006
800

700

600

Numberoffirms

500

400

CurrentPE
TrailingPE
ForwardPE

300

200

100

0
04

48

812

1216

1620

2024

2428 2832
PERatio

3236

3640

4050

5075

75100

>100

13

PE: Deciphering the Distribution

Mean
Standard Error
Median
Standard Deviation
Kurtosis
Skewness
Minimum
Maximum
Count
90th percentile
10th percentile
Confidence Level(95.0%)

Current PE Trailing PE Forward PE

43.58
40.52
29.93
3.74
7.38
1.81
20.67
19.04
18.18
241.96
463.62
88.57
1871.78
3611.60
474.76
38.68
58.97
19.35
0.75
3.12
4.38
12712.82 28518.28
2710.00
4179
3947
2397
54.21
44.31
28.14
11.22
10.17
13.75
7.34
14.47
3.55

14

Comparing PE Ratios: US, Europe, Japan and

Emerging Markets - January 2005
MedianPE
Japan=23.45
US=23.21
Europe=18.79
Em.Mkts=16.18

PEDistributions:Comparison
18.00%

16.00%

14.00%

%offirmsinmarket

12.00%

10.00%
US
EmergingMarkets

8.00%

Europe
Japan

6.00%

4.00%

2.00%

0.00%
04

48

812

1216 1620

2024

2428 2832 3236

PERatio

3640

4050

5075 75100

>100

15

PE Ratios in Brazil - January 2006

Brazilian companies: PE ratios in January 2006
30

25

20

15
HighestPEstocks
CBEE376.59
OHLB376.69
LAME392.17
MTBR3110.46
LIPR3118.66

LowestPEstocks
10
ACES33.65
USIM33.91
SAPR44.13
GOAU34.27
5
AVIL34.45

0
<4

4-8

8-12

12-16

16-20

20-24

24-28 28-32
PE Ratio

32-26

26-40

40-50

50-100

>100

16

PE Ratio: Understanding the Fundamentals

Tounderstandthefundamentals,startwithabasicequitydiscounted
cashflowmodel.
Withthedividenddiscountmodel,
P0

DPS1
r gn

Dividingbothsidesbytheearningspershare,
P0
PayoutRatio * (1 g n )
PE =
EPS 0
rg
n

IfthishadbeenaFCFEModel,
P0

FCFE1
r gn

P0
(FCFE/Earnings) * (1 g n )
PE =
EPS0
rg n

17

PE Ratio and Fundamentals

Proposition:Otherthingsheldequal,highergrowthfirmswill
havehigherPEratiosthanlowergrowthfirms.
Proposition:Otherthingsheldequal,higherriskfirmswillhave
lowerPEratiosthanlowerriskfirms
Proposition:Otherthingsheldequal,firmswithlower
reinvestmentneedswillhavehigherPEratiosthanfirmswith
higherreinvestmentrates.
Ofcourse,otherthingsaredifficulttoholdequalsincehighgrowth
firms,tendtohaveriskandhighreinvestmentrats.

18

Using the Fundamental Model to Estimate PE

For a High Growth Firm

Thepriceearningsratioforahighgrowthfirmcanalsoberelatedto
fundamentals.Inthespecialcaseofthetwostagedividenddiscount
model,thisrelationshipcanbemadeexplicitfairlysimply:
P0 =

(1+ g)n
EPS0 * PayoutRatio *(1+ g)* 1

(1+ r) n
rg

EPS 0 * PayoutRatio n *(1+ g)n *(1+ g n )

+
(r g n )(1+ r)n

Forafirmthatdoesnotpaywhatitcanaffordtoindividends,substitute
FCFE/Earningsforthepayoutratio.

Dividingbothsidesbytheearningspershare:

(1 + g)n
PayoutRatio * (1 + g) * 1

(1+ r) n
P0
PayoutRatio n *(1+ g) n * (1 + gn )
=
+
EPS 0
r g
(r g n )(1+ r) n

19

Expanding the Model

Inthismodel,thePEratioforahighgrowthfirmisafunctionof
growth,riskandpayout,exactlythesamevariablesthatitwasa
functionofforthestablegrowthfirm.
Theonlydifferenceisthattheseinputshavetobeestimatedfortwo
phasesthehighgrowthphaseandthestablegrowthphase.
Expandingtomorethantwophases,saythethreestagemodel,will
meanthatrisk,growthandcashflowpatternsineachstage.

20

A Simple Example
AssumethatyouhavebeenaskedtoestimatethePEratioforafirm
whichhasthefollowingcharacteristics:
Variable
HighGrowthPhase
StableGrowthPhase
ExpectedGrowthRate
25%
8%
PayoutRatio
20%
50%
Beta
1.00
1.00
Numberofyears
5years
Foreverafteryear5
Riskfreerate=T.BondRate=6%
Requiredrateofreturn=6%+1(5.5%)=11.5%

(1.25) 5
0.2 * (1.25) * 1
5
0.5 * (1.25) 5 * (1.08)
(1.115)
PE =
+
= 28.75
(.115 .25)
(.115 .08)(1.115) 5

21

PE and Growth: Firm grows at x% for 5 years,

8% thereafter
PE Ratios and Expected Growth: Interest Rate Scenarios
180

160

140

PE Ratio

120

r=4%
r=6%
r=8%
r=10%

100

80

60

40

20

0
5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Expected Growth Rate

22

PE Ratios and Length of High Growth: 25%

growth for n years; 8% thereafter

23

PE and Risk: Effects of Changing Betas on PE

Ratio:
Firm with x% growth for 5 years; 8% thereafter
PE Ratios and Beta: Growth Scenarios
50
45
40
35

PE Ratio

30
g=25%
g=20%
g=15%
g=8%

25
20
15
10
5
0
0.75

1.00

1.25

1.50

1.75

2.00

Beta

24

PE and Payout

25

I. Comparisons of PE across time: PE Ratio for

the S&P 500
PERatioforS&P500:19602005
35

30

25

PERatio

20
Averageoverperiod=16.82
15

10

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

26

Is low (high) PE cheap (expensive)?

AmarketstrategistarguesthatstocksareoverpricedbecausethePE
ratiotodayistoohighrelativetotheaveragePEratioacrosstime.Do
youagree?
Yes
No

Ifyoudonotagree,whatfactorsmightexplainthehigherPEratio
today?

27

E/P Ratios , T.Bond Rates and Term Structure

EPRatiosandInterestRates:S&P50019602005
16.00%

14.00%

12.00%

10.00%

8.00%

EarningsYield
T.BondRate
BondBill

6.00%

4.00%

2.00%

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

0.00%

2.00%
Year

28

Regression Results

ThereisastrongpositiverelationshipbetweenE/PratiosandT.Bond
rates,asevidencedbythecorrelationof0.70betweenthetwo
variables.,
Inaddition,thereisevidencethatthetermstructurealsoaffectsthePE
ratio.
Inthefollowingregression,using19602005data,weregressE/P
ratiosagainstthelevelofT.Bondratesandatermstructurevariable
(T.BondT.Billrate)
E/P=2.10%+0.744T.BondRate0.327(T.BondRateT.BillRate)
(2.44) (6.64)
(1.34)
Rsquared=51.35%

29

II. Comparing PE Ratios across a Sector

Company Name
PT Indosat ADR
Telebras ADR
Telecom Corporation of New Zealand ADR
Telecom Argentina Stet - France Telecom SA ADR B
Hellenic Telecommunication Organization SA ADR
Telecomunicaciones de Chile ADR
Swisscom AG ADR
Asia Satellite Telecom Holdings ADR
Portugal Telecom SA ADR
Telefonos de Mexico ADR L
Matav RT ADR
Telstra ADR
Gilat Communications
Deutsche Telekom AG ADR
British Telecommunications PLC ADR
Tele Danmark AS ADR
Telekomunikasi Indonesia ADR
Cable & Wireless PLC ADR
APT Satellite Holdings ADR
Telefonica SA ADR
Royal KPN NV ADR
Telecom Italia SPA ADR
Nippon Telegraph & Telephone ADR
France Telecom SA ADR
Korea Telecom ADR

PE
7.8
8.9
11.2
12.5
12.8
16.6
18.3
19.6
20.8
21.1
21.5
21.7
22.7
24.6
25.7
27
28.4
29.8
31
32.5
35.7
42.2
44.3
45.2
71.3

Growth
0.06
0.075
0.11
0.08
0.12
0.08
0.11
0.16
0.13
0.14
0.22
0.12
0.31
0.11
0.07
0.09
0.32
0.14
0.33
0.18
0.13
0.14
0.2
0.19
0.44

30

PE, Growth and Risk

Dependentvariableis:

PE

Rsquared=66.2%Rsquared(adjusted)=63.1%
Variable
Coefficient SE
tratio
Constant
13.1151
3.471
3.78
Growthrate
121.223
19.27
6.29
EmergingMarket
13.8531
3.606
3.84
EmergingMarketisadummy:1ifemergingmarket
0ifnot

prob
0.0010
0.0001
0.0009

31

Is Telebras under valued?

PredictedPE=13.12+121.22(.075)13.85(1)=8.35
Atanactualpricetoearningsratioof8.9,Telebrasisslightly
overvalued.
GiventheRsquaredontheregression,though,amoreprecise
statisticalstatementwouldbethatthepredicatedPEforTelebraswill
fallwithinarange.Inthiscase,therangewouldbeasfollows:
Upperendoftherange:10.06
Lowerendoftherange:6.64

Asageneralrule,thehighertheRsquaredthenarrowertherangefor
thepredictedvalues.Therangewillalsotendtobetighterforfirms
thatfallclosetotheaverageandbecomewiderforextremevalues.

32

Using the entire crosssection: A regression

approach

Incontrasttothe'comparablefirm'approach,theinformationinthe
entirecrosssectionoffirmscanbeusedtopredictPEratios.
Thesimplestwayofsummarizingthisinformationiswithamultiple
regression,withthePEratioasthedependentvariable,andproxiesfor
risk,growthandpayoutformingtheindependentvariables.

33

PE versus Growth
300

200

100

CurrentPE

100

Rsq=0.1500
20

20

40

60

80

100

ExpectedGrowthinEPS:next5years

34

PE Ratio: Standard Regression for US stocks January 2006

Model Summary
Model
1

R Sq uare
a

.554

Adjusted R
Squar e

.307

.306

Std. Error of the

Estimate
1411.5282671647

a. Predictors: (Constant), Expected Growth in EPS: next 5 years,

PAYOUT, Value Line Beta
Coeffici entsa,b
Unstandardiz ed
Coefficients
Model
1

B
(Constant)
Value Line Beta
PAYOUT

Standar dized
Coefficients

Std. Error

6.747

1.397

Beta

Sig.

4.830

.000

- .919

1.205

- .015

- .763

.446

7.325E- 02

.01 3

.105

5.644

.000

1.131

.03 8

.576

29. 657

.000

Expected Growth in
EPS: next 5 years
a. Dependent Variable: Current PE

b. Weighted Least Squares Regression - Weig hted by Mar ket Cap

35

Problems with the regression methodology

ThebasicregressionassumesalinearrelationshipbetweenPEratios
andthefinancialproxies,andthatmightnotbeappropriate.
ThebasicrelationshipbetweenPEratiosandfinancialvariablesitself
mightnotbestable,andifitshiftsfromyeartoyear,thepredictions
fromthemodelmaynotbereliable.
Theindependentvariablesarecorrelatedwitheachother.For
example,highgrowthfirmstendtohavehighrisk.Thismulti
collinearitymakesthecoefficientsoftheregressionsunreliableand
mayexplainthelargechangesinthesecoefficientsfromperiodto
period.

36

The Multicollinearity Problem

Correlations

Current PE

Pearson Correlation

Current PE
1

Sig. (2- tailed)

N
Value Line Beta

.000

.00 0

4016

4016

216 4

.119**

Sig. (2- tailed)

.000

.00 0

4016

7096

254 6

Pearson Correlation

.414**

.154**

Sig. (2- tailed)

.000
2164

N
Payout Ratio

Pearson Correlation
N

Expected Growth in
EPS: next 5 years

Expected
Growth in
Valu e Line
EPS: next 5
Beta
years
Payout Ratio
.119**
.41 4**
.184**

.15 4**

.000
1619
- .204**
.000
1619

- .158**

.000

.000

2546

254 6

1131

Pearson Correlation

.184**

- .204**

- .158**

Sig. (2- tailed)

.000

.000

.00 0

1619

1619

113 1

1619

**. Correlation is significant at the 0.01 level (2- tailed).

37

Using the PE ratio regression

AssumethatyouweregiventhefollowinginformationforDell.The
firmhasanexpectedgrowthrateof10%,abetaof1.20andpaysno
dividends.Basedupontheregression,estimatethepredictedPEratio
forDell.
PredictedPE=

Dellisactuallytradingat22timesearnings.Whatdoesthepredicted
PEtellyou?

38

The value of growth

TimePeriod
January2006
January2005
January2004
July2003
January2003
July2002
January2002
July2001
January2001
July2000
January2000

Valueofextra1%ofgrowth
1.131
0.914
0.812
1.228
2.621
0.859
1.003
1.251
1.457
1.761
2.105

EquityRiskPremium
4.08%
3.65%
3.69%
3.88%
4.10%
4.35%
3.62%
3.05%
2.75%
2.20%
2.05%

39

Brazil: Cross Sectional Regression

January 2006
Model Summary
Model
1

R
.65 3a

R Square
.42 7

Adjusted R
Square
.34 9

Std. Error of the

Estimate
1438.20197584932

a. Predictor s: (Constant), Payout Ratio, BETA, Expected Earnings Growth

(if available)

Coef fici entsa,b

Unstandard ized
Coefficients
Model
1

B
(Constant)
Expected Earnings
Growth (if available)
BETA
Payout Ratio

Standardized
Coefficients

Std. Error

23.084

7.314

.245

.241

- 14.056
.216

Beta

Sig.
3.156

.00 5

.179

1.016

.32 1

5.389

- .423

- 2.608

.01 6

.093

.408

2.326

.03 0

a. Dependent Variable: PE
b. Weighted Least Squares Regression - Weig hted by Market Cap (local currency)

40

Value/Earnings and Value/Cashflow Ratios

WhilePriceearningsratioslookatthemarketvalueofequityrelativetoearningsto
equityinvestors,Valueearningsratioslookatthemarketvalueofthefirmrelativeto
operatingearnings.Valuetocashflowratiosmodifytheearningsnumbertomakeita
cashflownumber.
TheformofvaluetocashflowratiosthathastheclosestparallelsinDCFvaluationis
thevaluetoFreeCashFlowtotheFirm,whichisdefinedas:
Value/FCFF=
(MarketValueofEquity+MarketValueofDebtCash)
EBIT(1t)(CapExDeprecn)ChginWC
ConsistencyTests:

Ifthenumeratorisnetofcash(orifnetdebtisused,thentheinterestincomefromthecash
shouldnotbeindenominator
TheinterestexpensesaddedbacktogettoEBITshouldcorrespondtothedebtinthe
numerator.Ifonlylongtermdebtisconsidered,onlylongterminterestshouldbeaddedback.

41

Value of Firm/FCFF: Determinants

V0 =

RevertingbacktoatwostageFCFFDCFmodel,weget:

(1 + g)n
FCFF (1 + g) 1

0
n
(1+ WACC)
WACC g

FCFF0 (1+ g)n (1+ g n )

+
(WACC g )(1 + WACC)n
n

V0=Valueofthefirm(today)

FCFF0=FreeCashflowtothefirmincurrentyear

g=ExpectedgrowthrateinFCFFinextraordinarygrowthperiod(first
nyears)

WACC=Weightedaveragecostofcapital

gn=ExpectedgrowthrateinFCFFinstablegrowthperiod(aftern
years)

42

Value Multiples

DividingbothsidesbytheFCFFyields,
V0
=
FCFF0

(1 + g)n
(1 + g) 1
(1 + WACC)n
WACC g

(1+ g)n (1+ gn )

+
n
(WACC gn )(1 + WACC)

Thevalue/FCFFmultiplesisafunctionof
thecostofcapital
theexpectedgrowth

43

Value/FCFF Multiples and the Alternatives

Assumethatyouhavecomputedthevalueofafirm,usingdiscounted
cashflowmodels.Rankthefollowingmultiplesintheorderof
magnitudefromlowesttohighest?
Value/EBIT
Value/EBIT(1t)
Value/FCFF
Value/EBITDA
Whatassumption(s)wouldyouneedtomakefortheValue/EBIT(1t)
ratiotobeequaltotheValue/FCFFmultiple?

44

Illustration: Using Value/FCFF Approaches to

value a firm: MCI Communications

MCICommunicationshadearningsbeforeinterestandtaxesof$3356
millionin1994(Itsnetincomeaftertaxeswas$855million).
Ithadcapitalexpendituresof$2500millionin1994anddepreciation
of$1100million;Workingcapitalincreasedby$250million.
Itexpectsfreecashflowstothefirmtogrow15%ayearforthenext
fiveyearsand5%ayearafterthat.
Thecostofcapitalis10.50%forthenextfiveyearsand10%after
that.
Thecompanyfacesataxrateof36%.

V0
=
FCFF0

(1.15)5
(1.15) 1
(1.105)5
.105 .15

(1.15) (1.05)
=31.28
+
(.10 .05)(1.105)5

45

Multiple Magic

InthiscaseofMCIthereisabigdifferencebetweentheFCFFand
shortcutmeasures.Forinstancethefollowingtableillustratesthe
appropriatemultipleusingshortcutmeasures,andtheamountyou
wouldoverpaybyifyouusedtheFCFFmultiple.
FreeCashFlowtotheFirm
=EBIT(1t)NetCapExChangeinWorkingCapital
=3356(10.36)+11002500250=$498million
$Value
CorrectMultiple
FCFF
$498
31.28382355
EBIT(1t)
$2,148
7.251163362
EBIT
$3,356
4.640744552
EBITDA
$4,456
3.49513885

46

Reasons for Increased Use of Value/EBITDA

1.Themultiplecanbecomputedevenforfirmsthatarereportingnetlosses,sinceearnings
beforeinterest,taxesanddepreciationareusuallypositive.
2.Forfirmsincertainindustries,suchascellular,whichrequireasubstantialinvestmentin
infrastructureandlonggestationperiods,thismultipleseemstobemoreappropriatethan
theprice/earningsratio.
3.Inleveragedbuyouts,wherethekeyfactoriscashgeneratedbythefirmpriortoall
discretionaryexpenditures,theEBITDAisthemeasureofcashflowsfromoperations
thatcanbeusedtosupportdebtpaymentatleastintheshortterm.
4.Bylookingatcashflowspriortocapitalexpenditures,itmayprovideabetterestimateof
optimalvalue,especiallyifthecapitalexpendituresareunwiseorearnsubstandard
returns.
5.Bylookingatthevalueofthefirmandcashflowstothefirmitallowsforcomparisons
acrossfirmswithdifferentfinancialleverage.

47

Value/EBITDA Multiple

TheClassicDefinition
Value
MarketValueofEquity + MarketValueofDebt

EBITDA EarningsbeforeInterest, TaxesandDepreciation

TheNoCashVersion
EnterpriseValue MarketValueofEquity + MarketValueofDebt Cash

EBITDA
EarningsbeforeInterest,TaxesandDepreciation

Whencashandmarketablesecuritiesarenettedoutofvalue,noneof
theincomefromthecashandsecuritiesshouldbereflectedinthe
denominator.

48

Enterprise Value/EBITDA Distribution - US

EVtoOperatingIncomeMultiplesUSfirmsinJanuary2006
800

700

600

Numberoffirms

500

400
EV/EBIT
EV/EBITDA

300

200

100

0
<2

24

46

68

810 1012 1216 1620 2025 2530 3035 3540 4045 4550 5075 75
100
EVMultiple

>100

49

EV/EBITDA Multiple: Brazil in January 2006

EV/EBITDA: Brazil in January 2006
30

25

LowestEV/EBITDA
CEDO31.56
MTBR31.74
CRBM31.99
GOAU32.10
CEEB52.31

20

15

10

0
<2

2-4

4-6

6-8

8-10

10-12
12-14
EV/EBITDA

14-16

16-18

18-20

20-25

>25

50

The Determinants of Value/EBITDA Multiples:

Linkage to DCF Valuation

Firmvaluecanbewrittenas:

FCFF1
V0 =

WACC g

Thenumeratorcanbewrittenasfollows:
FCFF

=EBIT(1t)(CexDepr)WorkingCapital
=(EBITDADepr)(1t)(CexDepr)WorkingCapital
=EBITDA(1t)+Depr(t)CexWorkingCapital

51

From Firm Value to EBITDA Multiples

NowtheValueofthefirmcanberewrittenas,
Value =

EBITDA(1 t) + Depr(t) Cex WorkingCapital

WACC g

DividingbothsidesoftheequationbyEBITDA,

Value
(1 t)
Depr(t)/EBITDA
CEx/EBITDA
WorkingCapital/EBITDA
=
+

EBITDA
WACC g
WACC g
WACC g
WACC g

52

A Simple Example

Considerafirmwiththefollowingcharacteristics:

TaxRate=36%
CapitalExpenditures/EBITDA=30%
Depreciation/EBITDA=20%
CostofCapital=10%
Thefirmhasnoworkingcapitalrequirements
Thefirmisinstablegrowthandisexpectedtogrow5%ayearforever.

53

Calculating Value/EBITDA Multiple

Inthiscase,theValue/EBITDAmultipleforthisfirmcanbeestimated
asfollows:

Value
(1 .36)
(0.2)(.36)
0.3
0
=
+


= 8.24
EBITDA
.10 .05
.10 .05
.10 .05
.10 .05

54

Value/EBITDA Multiples and Taxes

55

Value/EBITDA and Net Cap Ex

56

Value/EBITDA Multiples and Return on Capital

Value/EBITDA and Return on Capital
12

10

Value/EBITDA

0
6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

Return on Capital

57

Value/EBITDA Multiple: Trucking Companies

Company Name
KLLM Trans. Svcs.
Ryder System
Rollins Truck Leasing
Cannon Express Inc.
Hunt (J.B.)
Yellow Corp.
Roadway Express
Marten Transport Ltd.
Kenan Transport Co.
M.S. C arriers
Old Dominion Freight
Trimac Ltd
Matlack Systems
XTRA C orp.
Covenant Transport Inc
Builders Transport
Werner Enterprises
Landstar Sys.
AMERCO
USA Truck
Frozen Food Express
Arnold Inds.
Greyhound Lines Inc.
USFreightways
Golden Eagle Group Inc.
Arkansas Best
Airlease Ltd.
Celadon Group
Amer. Freightways
Transfinancial Holdings
Vitran Corp. 'A'
Interpool Inc.
Intrenet Inc.
Swift Transportation
Landair Services
CNF Transportation
Budget Group Inc
Caliber System
Knight Transportation Inc
Heartland Express
Greyhound CDA Transn C orp
Mark VII
Coach USA Inc
US 1 Inds Inc.
Average

Value
$ 114.32
$ 5,158.04
$ 1,368.35
$
83.57
$ 982.67
$ 931.47
$ 554.96
$ 116.93
$
67.66
$ 344.93
$ 170.42
$ 661.18
$ 112.42
$ 1,708.57
$ 259.16
$ 221.09
$ 844.39
$ 422.79
$ 1,632.30
$ 141.77
$ 164.17
$ 472.27
$ 437.71
$ 983.86
$
12.50
$ 578.78
$
73.64
$ 182.30
$ 716.15
$
56.92
$ 140.68
$ 1,002.20
$
70.23
$ 835.58
$ 212.95
$ 2,700.69
$ 1,247.30
$ 2,514.99
$ 269.01
$ 727.50
$
83.25
$ 160.45
$ 678.38
$
5.60

EBITDA
$
48.81
$ 1,838.26
$ 447.67
$
27.05
$ 310.22
$ 292.82
$ 169.38
$
35.62
$
19.44
$
97.85
$
45.13
$ 174.28
$
28.94
$ 427.30
$
64.35
$
51.44
$ 196.15
$
95.20
$ 345.78
$
29.93
$
34.10
$
96.88
$
89.61
$ 198.91
$
2.33
$ 107.15
$
13.48
$
32.72
$ 120.94
$
8.79
$
21.51
$ 151.18
$
10.38
$ 121.34
$
30.38
$ 366.99
$ 166.71
$ 333.13
$
28.20
$
64.62
$
6.99
$
12.96
$
51.76
$
(0.17)

Value/EBITDA
2.34
2.81
3.06
3.09
3.17
3.18
3.28
3.28
3.48
3.53
3.78
3.79
3.88
4.00
4.03
4.30
4.30
4.44
4.72
4.74
4.81
4.87
4.88
4.95
5.37
5.40
5.46
5.57
5.92
6.47
6.54
6.63
6.77
6.89
7.01
7.36
7.48
7.55
9.54
11.26
11.91
12.38
13.11
NA
5.61

58

A Test on EBITDA

RyderSystemlooksverycheaponaValue/EBITDAmultiplebasis,
relativetotherestofthesector.Whatexplanation(otherthan
misvaluation)mighttherebeforthisdifference?

59

US Market: Cross Sectional Regression

January 2006
Model Summary
Model
1

Adjusted R
Square

R Square
a

.71 4

.51 0

Std. Error of the

Estimate

.50 9

817.9946936935400 0

a. Predictor s: (Constant), Expected Growth in Revenues: next 5 years, Eff

Tax Rate, Reinvestment Rate, ROC

Coefficientsa,b
Unstandardiz ed
Coefficients
Model
1

B
(Constant)
Eff T ax Rate

Std. Error

3.3 27E- 02

.807

- 5.140E- 02

.022

1.2 01E- 02

Beta

Sig.
.041

.967

- .046

- 2.339

.019

.015

.016

.782

.434

- 1.684E- 02

.006

- .062

- 3.052

.002

1.2 96

.038

.726

34. 323

.000

ROC
Reinvestment Rate

Standar dized
Coefficients

Expected Growth in
Revenues: next 5 years
a. Dependent Variable: EV/ EBITDA

b. Weighted Least Squares Regression - Weighted by Market Cap

60

Price-Book Value Ratio: Definition

Theprice/bookvalueratioistheratioofthemarketvalueofequityto
thebookvalueofequity,i.e.,themeasureofshareholdersequityin
thebalancesheet.
Price/BookValue= MarketValueofEquity
BookValueofEquity
ConsistencyTests:
Ifthemarketvalueofequityreferstothemarketvalueofequityof
commonstockoutstanding,thebookvalueofcommonequityshouldbe
usedinthedenominator.
Ifthereismorethatoneclassofcommonstockoutstanding,themarket
valuesofallclasses(eventhenontradedclasses)needstobefactoredin.

61

Book Value Multiples: US stocks

BVMultiples:USinJanuary2006
700

600

500

400

300

200

100

0
<0.25 0.25
0.5

0.5
0.75

0.751 11.25 1.25

1.5

1.5
1.75

1.752 22.25 2.25

2.5

Price/BVofEquity

Value/BV

2.5
2.75

2.753 33.35 3.54

44.5

4.55

510

>10

EV/InvestedCapital

62

Book Value Multiples: Brazil

BV Ratios: Brazil in January 2006
25

HighestPBV
DASA310.27
GETI310.39
CYRE312.10
LREN315.41
ENMA317.52

20

15

10

LowestPBV
CESP30.22
ELET30.34
SAPR40.46

0
<0.25

0.250.5

0.50.75

0.75-1 1-1.25 1.251.5

P/BV of Equity

1.5- 1.75-2 2-2.5

1.75
BV Ratio

2.5-3

3-4

4-5

5-10

>10

Firm Value/ BV of Capital

63

Price Book Value Ratio: Stable Growth Firm

Goingbacktoasimpledividenddiscountmodel,
P0

DPS1
r gn

Definingthereturnonequity(ROE)=EPS0/BookValueofEquity,
thevalueofequitycanbewrittenas:
P0

BV0 * ROE * PayoutRatio * (1 gn )

rgn

P0
ROE * PayoutRatio * (1 g n )
PBV =
BV 0
rg
n

Ifthereturnonequityisbaseduponexpectedearningsinthenexttime
period,thiscanbesimplifiedto,
P0
ROE * PayoutRatio

PBV =
BV 0

rg n

64

PBV/ROE: European Banks

Bank
Banca di Roma SpA
Commerzbank AG
Bayerische Hypo und Vereinsbank AG
Intesa Bci SpA
Natexis Banques Populaires
Almanij NV Algemene Mij voor Nijver
Credit Industriel et Commercial
Credit Lyonnais SA
BNL Banca Nazionale del Lavoro SpA
Banca Monte dei Paschi di Siena SpA
Deutsche Bank AG
Skandinaviska Enskilda Banken
Nordea Bank AB
DNB Holding ASA
ForeningsSparbanken AB
Danske Bank AS
Credit Suisse Group
KBC Bankverzekeringsholding
Societe Generale
Santander Central Hispano SA
National Bank of Greece SA
San Paolo IMI SpA
BNP Paribas
Svenska Handelsbanken AB
UBS AG
Banco Bilbao Vizcaya Argentaria SA
ABN Amro Holding NV
UniCredito Italiano SpA
Rolo Banca 1473 SpA
Dexia
Average

Symbol
BAHQE
COHSO
BAXWW
BAEWF
NABQE
ALPK
CIECM
CREV
BAEXC
MOGG
DEMX
SKHS
NORDEA
DNHLD
FOLG
DANKAS
CRGAL
KBCBA
SODI
BAZAB
NAGT
SAOEL
BNPRB
SVKE
UBQH
BBFUG
ABTS
UNCZA
ROGMBA
DECCT

PBV
0.60
0.74
0.82
1.12
1.12
1.17
1.20
1.20
1.22
1.34
1.36
1.39
1.40
1.42
1.61
1.66
1.68
1.69
1.73
1.83
1.87
1.88
2.00
2.12
2.15
2.18
2.21
2.25
2.37
2.76
1.60

ROE
4.15%
5.49%
5.39%
7.81%
7.38%
8.78%
9.46%
6.86%
12.43%
10.86%
17.33%
16.33%
13.69%
16.78%
18.69%
19.09%
14.34%
30.85%
17.55%
11.01%
26.19%
16.57%
18.68%
21.82%
16.64%
22.94%
24.21%
15.90%
16.67%
14.99%
14.96%

65

PBV versus ROE regression

RegressingPBVratiosagainstROEforbanksyieldsthefollowing
regression:
PBV=0.81+5.32(ROE) R2=46%
Forevery1%increaseinROE,thePBVratioshouldincreaseby
0.0532.

66

Under and Over Valued Banks?

Bank
Banca di Roma SpA
Commerzbank AG
Bayerische Hypo und Vereinsbank AG
Intesa Bci SpA
Natexis Banques Populaires
Almanij NV Algemene Mij voor Nijver
Credit Industriel et Commercial
Credit Lyonnais SA
BNL Banca Nazionale del Lavoro SpA
Banca Monte dei Paschi di Siena SpA
Deutsche Bank AG
Skandinaviska Enskilda Banken
Nordea Bank AB
DNB Holding ASA
ForeningsSparbanken AB
Danske Bank AS
Credit Suisse Group
KBC Bankverzekeringsholding
Societe Generale
Santander Central Hispano SA
National Bank of Greece SA
San Paolo IMI SpA
BNP Paribas
Svenska Handelsbanken AB
UBS AG
Banco Bilbao Vizcaya Argentaria SA
ABN Amro Holding NV
UniCredito Italiano SpA
Rolo Banca 1473 SpA
Dexia

Actual
0.60
0.74
0.82
1.12
1.12
1.17
1.20
1.20
1.22
1.34
1.36
1.39
1.40
1.42
1.61
1.66
1.68
1.69
1.73
1.83
1.87
1.88
2.00
2.12
2.15
2.18
2.21
2.25
2.37
2.76

Predicted
1.03
1.10
1.09
1.22
1.20
1.27
1.31
1.17
1.47
1.39
1.73
1.68
1.54
1.70
1.80
1.82
1.57
2.45
1.74
1.39
2.20
1.69
1.80
1.97
1.69
2.03
2.10
1.65
1.69
1.61

Under or Over
-41.33%
-32.86%
-24.92%
-8.51%
-6.30%
-7.82%
-8.30%
2.61%
-16.71%
-3.38%
-21.40%
-17.32%
-9.02%
-16.72%
-10.66%
-9.01%
7.20%
-30.89%
-0.42%
31.37%
-15.06%
11.15%
11.07%
7.70%
27.17%
7.66%
5.23%
36.23%
39.74%
72.04%

67

Looking for undervalued securities - PBV

Ratios and ROE : The Valuation Matrix
MV/BV

Overvalued
LowROE
HighMV/BV

HighROE
HighMV/BV

ROEr

LowROE
LowMV/BV

Undervalued
HighROE
LowMV/BV

68

Price to Book vs ROE: US companies in

January 2005
18
DELL
EBAY

16

BUD

EDP

14

YHOO

12

UNH
10

PG

8
6

ERICY

M DT
BA
DOW

KO
IBM WYE
M RK

AMGN

FNM

PBVRatio

NSANY

TWX
VIA/B

UL

GSK

FRE

RD

PBR

0
0

20

40

60

80

ReturnonEquity

69

PBV Matrix: Telecom Companies

12
TelAzteca

10

TelNZ

Vimple

Carlton

Cable&W

Teleglobe
FranceTel

DeutscheTel
BritTel
TelItalia
BCE

Portugal
Royal
Hellenic

AsiaSat
HongKong

Nippon
ChinaTel
Danmark
Espana
Telmex
TelArgFrance
PhilT
el
TelArgentina

2
APT
CallNet
Anonima

GrupoCentro

10

Televisas

Indast

TelIndo
TelPeru

0
20

30

40

50

60

ROE

70

PBV, ROE and Risk: Large Cap US firms

16
14

BUD G
PFE

12

ORCL
MMM

10

PBV Ratio

PG

8
UL

MRK

MDT
WMT

D
QCOM

FNMKMB

FRE

SC
70 60

EBAY

50 40

30 20

ROE

10 0

T SM
AMAT

AOL
VIA/ B

Regression Beta

71

PBV versus ROE: Brazilian companies in

January 2006
20
ENMA3
LREN3

PBV

CYRE3
GETI3

DASA3
10

IDNT3
CGOS3

IGBR3 AVPL3
0
- 200

SGAS3
LEVE3
- 100

1 00

2 00

ROE

72

IBM: The Rise and Fall and Rise Again

10.00

50.00%

9.00

40.00%

8.00

30.00%

7.00
20.00%

10.00%
5.00
0.00%

ReturnonEquity

PricetoBook

6.00

4.00
10.00%
3.00

20.00%

2.00

30.00%

1.00

0.00

40.00%
1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Year
PBV

ROE

73

PBV Ratio Regression: US

January 2006
Model Summary
Model
1

R
.74 6a

R Square
.55 6

Adjusted R
Square
.55 6

Std. Error of the

Estimate
164.92503173 8389500

a. Predictor s: (Constant), ROE, PAYOUT, Expected Growth in EPS: next 5

years, Value Line Beta
Coeffici entsa,b,c
Unstandardiz ed
Coefficients
Model
1

B
Value Line Beta
Expected Growth in
EPS: next 5 years
PAYOUT

Standar dized
Coefficients

Std. Error

Beta

Sig.

- .841

.08 7

- .185

- 9.626

.000

.11 7

.00 4

.409

26. 811

.000

1.406E- 03

.00 0

.033

3.858

.000

.17 0

.00 3

.767

57. 400

.000

ROE
a. Dependent Variable: PBV Ratio

b. Linear Regression through the Origin

c. Weighted Least Squares Regression - Weighted by Market Cap

74

PBV Regression: Brazil in January 2006

Model Summary
Model
1

R
.47 5a

R Square
.22 6

Adjusted R
Square
.22 0

Std. Error of the Estimate

260.157955056560300

a. Predictor s: (Constant), ROE

Coeffici entsa,b
Unstandardiz ed
Coefficients
Model
1

B
(Constant)
ROE

Standar dized
Coefficients

Std. Error

1.868

.445

9.247E- 02

.015

Beta
.475

Sig.

4.198

.000

6.037

.000

a. Dependent Variable: PBV

b. Weighted Least Squares Regression - Weighted by Market Cap (local currency)

75

Price Sales Ratio: Definition

Theprice/salesratioistheratioofthemarketvalueofequitytothe
sales.
Price/Sales= MarketValueofEquity
TotalRevenues
ConsistencyTests
Theprice/salesratioisinternallyinconsistent,sincethemarketvalueof
equityisdividedbythetotalrevenuesofthefirm.

76

Revenue Multiples: US stocks

RevenueMultiplesUSinJanuary2006
600

500

400

300

200

100

0
<0.1

0.1
0.2

0.2
0.3

0.3
0.4

0.4
0.5

0.5 0.751 11.25 1.25 1.5 1.752 22.5 2.53 33.5 3.54
0.75
1.5
1.75
RevenueMultiple
Price/Sales

EV/Sales

45

510

>10

EV/TrailingSales

77

Revenue Multiples: Brazil

Revenue Multiples: Brazil in January 2006
16

14
LowestEV/Sales
DPPI30.07
PTIP30.13
MTBR30.18
SGAS30.22
CEDO30.24

12

10

0
>10

5-10

4-5

3-4

2.5-3

2-2.5

1.75-2

1.5-1.75

1.25-1.5

1-1.25

0.9-1.0

0.8-0.9

0.7-0.8

0.6-0.7

0.5-0.6

0.4-0.5

0.3-0.4

0.3-0.3

0.1-0.2

<.1

Revenue Multiple
P/Sales

EV/Sales

78

Price/Sales Ratio: Determinants

Theprice/salesratioofastablegrowthfirmcanbeestimated
beginningwitha2stageequityvaluationmodel:
P0

DPS1
r gn

Dividingbothsidesbythesalespershare:
P0
NetProfitMargin * PayoutRatio *(1 g n )
PS =
Sales 0
rgn

79

PS/Margins: European Retailers - September

2003

80

Regression Results: PS Ratios and Margins

RegressingPSratiosagainstnetmargins,
PS=.39+0.6548(NetMargin) R2=43.5%
Thus,a1%increaseinthemarginresultsinanincreaseof0.6548in
thepricesalesratios.
TheregressionalsoallowsustogetpredictedPSratiosforthesefirms

81

Current versus Predicted Margins

Oneofthelimitationsoftheanalysiswedidintheselastfewpagesis
thefocusoncurrentmargins.Stocksarepricedbaseduponexpected
marginsratherthancurrentmargins.
Formostfirms,currentmarginsandpredictedmarginsarehighly
correlated,makingtheanalysisstillrelevant.
Forfirmswherecurrentmarginshavelittleornocorrelationwith
expectedmargins,regressionsofpricetosalesratiosagainstcurrent
margins(orpricetobookagainstcurrentreturnonequity)willnot
providemuchexplanatorypower.
Inthesecases,itmakesmoresensetoruntheregressionusingeither
predictedmarginsorsomeproxyforpredictedmargins.

82

A Case Study: The Internet Stocks

30

PKSI
LCOS

20

A
d
j
P
S

INTM

SPYG
MMXI

SCNT

FFIV

MQST
CNET
INTW

10
NETO

RAMP

CSGP

APNT
SPLN

PSIX
EDGR

BIDS

-0

ABTL

FATB
RMII

-0.8

ALOY

IIXL

TURF

-0.6

AMZN

ATHY

INFO
PPOD
GSVI

-0.4

NTPA
SONEPCLN

CLKS
BIZZ

ONEM

CBIS

ATHM
DCLK

ACOM EGRP
ITRA

ANET
TMNT GEEK
ELTX
BUYX
ROWE

-0.2

AdjMargin

83

PS Ratios and Margins are not highly

correlated

RegressingPSratiosagainstcurrentmarginsyieldsthefollowing
PS=81.36

7.54(NetMargin) R2=0.04
(0.49)

Thisisnotsurprising.Thesefirmsarepricedbaseduponexpected
margins,ratherthancurrentmargins.

84

Solution 1: Use proxies for survival and growth:

Amazon in early 2000

Hypothesizingthatfirmswithhigherrevenuegrowthandhighercash
balancesshouldhaveagreaterchanceofsurvivingandbecoming
profitable,weranthefollowingregression:(Thelevelofrevenueswas
usedtocontrolforsize)

PS=30.612.77ln(Rev)+6.42(RevGrowth)+5.11(Cash/Rev)
(0.66)
(2.63)
(3.49)

Rsquared=31.8%
PredictedPS=30.612.77(7.1039)+6.42(1.9946)+5.11(.3069)=
30.42
ActualPS=25.63
Stockisundervalued,relativetootherinternetstocks.

85

Solution 2: Use forward multiples

GlobalCrossinglost$1.9billionin2001andisexpectedtocontinuetolose
moneyforthenext3years.Inadiscountedcashflowvaluation(seenoteson
DCF valuation) of Global Crossing, we estimated an expected EBITDA for
GlobalCrossinginfiveyearsof$1,371million.
Theaverageenterprisevalue/EBITDAmultipleforhealthytelecommfirmsis
7.2currently.
ApplyingthismultipletoGlobalCrossingsEBITDAinyear5,yieldsavalue
inyear5of
EnterpriseValueinyear5=1371*7.2=$9,871million
EnterpriseValuetoday=$9,871million/1.1385=$5,172million
(ThecostofcapitalforGlobalCrossingis13.80%)
TheprobabilitythatGlobalCrossingwillnotmakeitasagoingconcernis77%.
ExpectedEnterprisevaluetoday=0.23(5172)=$1,190million

86

PS Regression: United States - January 2006

Model Summary
Model
1

R
.76 5a

R Square
.585

Adjusted R
Square
.58 4

Std. Error of the

Estimate
158.54523325 556650

a. Predictor s: (Constant), Net Margin, Expected Growth in EPS: next 5

years, PAYOUT, Value Line Beta
Coeffici entsa,b
Unstandardiz ed
Coefficients
Model
1

B
(Constant)

Std. Error

- 1.648

.15 6

.36 1

.14 6

8.800E- 02

Beta

Sig.

- 10.551

.000

.040

2.476

.013

.00 4

.316

19. 631

.000

1.174E- 03

.00 0

.052

3.488

.000

.23 6

.00 5

.704

46. 892

.000

Value Line Beta

Expected Growth in
EPS: next 5 years
PAYOUT

Standar dized
Coefficients

Net Margin
a. Dependent Variable: PS_RATIO

b. Weighted Least Squares Regression - Weig hted by Mar ket Cap

87

EV/Sales Regression: Brazil in January 2006

Model Summary
Model
1

R
.50 8a

R Square
.25 8

Adjusted R
Square
.24 6

Std. Error of the

Estimate
123.6103661033571 0

a. Predictor s: (Constant), Market Debt to Capital, After- tax Margin

Coefficientsa,b
Unstandardiz ed
Coefficients
Model
1

(Constant)
After- tax Mar gin
Market Debt to Capital

Standardized
Coefficients

B
2.272

Std. Error
.41 7

6.368E- 02

.01 6

- 2.290 E- 02

.00 8

Beta

t
5.450

Sig.
.000

.348

4.039

.000

- .245

- 2.849

.005

a. Dependent Variable: EV/ Sales

b. Weighted Least Squares Regression - Weighted by Mar ket Cap (local currency)

88

Choosing Between the Multiples

Aspresentedinthissection,therearedozensofmultiplesthatcanbe
potentiallyusedtovalueanindividualfirm.
Inaddition,relativevaluationcanberelativetoasector(or
comparablefirms)ortotheentiremarket(usingtheregressions,for
instance)
Sincetherecanbeonlyonefinalestimateofvalue,therearethree
choicesatthisstage:
Useasimpleaverageofthevaluationsobtainedusinganumberof
differentmultiples
Useaweightedaverageofthevaluationsobtainedusinganmberof
differentmultiples
Chooseoneofthemultiplesandbaseyourvaluationonthatmultiple

89

Picking one Multiple

Thisisusuallythebestwaytoapproachthisissue.Whilearangeof
valuescanbeobtainedfromanumberofmultiples,thebestestimate
valueisobtainedusingonemultiple.
Themultiplethatisusedcanbechoseninoneoftwoways:
Usethemultiplethatbestfitsyourobjective.Thus,ifyouwantthe
companytobeundervalued,youpickthemultiplethatyieldsthehighest
value.
UsethemultiplethathasthehighestRsquaredinthesectorwhen
regressedagainstfundamentals.Thus,ifyouhavetriedPE,PBV,PS,etc.
andrunregressionsofthesemultiplesagainstfundamentals,usethe
multiplethatworksbestatexplainingdifferencesacrossfirmsinthat
sector.
Usethemultiplethatseemstomakethemostsenseforthatsector,given
howvalueismeasuredandcreated.

90

A More Intuitive Approach

Managersineverysectortendtofocusonspecificvariableswhen
analyzingstrategyandperformance.Themultipleusedwillgenerally
reflectthisfocus.Considerthreeexamples.
Inretailing:Thefocusisusuallyonsamestoresales(turnover)andprofit
margins.Notsurprisingly,therevenuemultipleismostcommoninthis
sector.
Infinancialservices:Theemphasisisusuallyonreturnonequity.Book
Equityisoftenviewedasascarceresource,sincecapitalratiosarebased
uponit.Pricetobookratiosdominate.
Intechnology:Growthisusuallythedominanttheme.PEGratioswere
inventedinthissector.

91

In Practice

Asageneralruleofthumb,thefollowingtableprovidesawayofpickinga
multipleforasector

Sector
CyclicalManufacturing
HighTech,HighGrowth

MultipleUsed
PE,RelativePE
PEG

HighGrowth/NoEarnings
HeavyInfrastructure

PS,VS
VEBITDA

REITa

P/CF

FinancialServices
Retailing

PBV
PS
VS

Rationale
Oftenwithnormalizedearnings
Bigdifferencesingrowthacross
firms
Assumefuturemarginswillbegood
Firmsinsectorhavelossesinearly
yearsandreportedearningscanvary
dependingondepreciationmethod
Generallynocapexinvestments
fromequityearnings
Bookvalueoftenmarkedtomarket
Ifleverageissimilaracrossfirms
Ifleverageisdifferent

92

Reviewing: The Four Steps to Understanding

Multiples

Definethemultiple
Checkforconsistency
Makesurethattheyareestimateduniformly

Describethemultiple
Multipleshaveskeweddistributions:Theaveragesareseldomgood
indicatorsoftypicalmultiples
Checkforbias,ifthemultiplecannotbeestimated

Analyzethemultiple
Identifythecompanionvariablethatdrivesthemultiple
Examinethenatureoftherelationship

Applythemultiple

93

Real Options: Fact and Fantasy

AswathDamodaran

94

Underlying Theme: Searching for an Elusive

Premium

Traditionaldiscountedcashflowmodelsunderestimatethevalueof
investments,wherethereareoptionsembeddedintheinvestmentsto
Delayordefermakingtheinvestment(delay)
Adjustoralterproductionschedulesaspricechanges(flexibility)
Expandintonewmarketsorproductsatlaterstagesintheprocess,based
uponobservingfavorableoutcomesattheearlystages(expansion)
Stopproductionorabandoninvestmentsiftheoutcomesareunfavorable
atearlystages(abandonment)

Putanotherway,realoptionadvocatesbelievethatyoushouldbe
payingapremiumondiscountedcashflowvalueestimates.

95

A Real Option Premium

Inthelastfewyears,therearesomewhohavearguedthatdiscounted
cashflowvaluationsundervaluedsomecompaniesandthatareal
optionpremiumshouldbetackedontoDCFvaluations.To
understandingitsmoorings,comparethetwotreesbelow:
Abadinvestment..Becomesagoodone..
+100

2/3

Success
1/2

+80

+20
1/3

1/3

Today

Now

-100
2/3

1/2

-20

Failure
-120

STOP

1.Learnatrelativelylowcost
2.Makebetterdecisionsbasedonlearning

96

Three Basic Questions

Whenistherearealoptionembeddedinadecisionoranasset?
Whendoesthatrealoptionhavesignificanteconomicvalue?
Canthatvaluebeestimatedusinganoptionpricingmodel?

97

When is there an option embedded in an

action?

Anoptionprovidestheholderwiththerighttobuyorsellaspecified
quantityofanunderlyingassetatafixedprice(calledastrikepriceor
anexerciseprice)atorbeforetheexpirationdateoftheoption.
Therehastobeaclearlydefinedunderlyingassetwhosevalue
changesovertimeinunpredictableways.
Thepayoffsonthisasset(realoption)havetobecontingentonan
specifiedeventoccurringwithinafiniteperiod.

98

Payoff Diagram on a Call

NetPayoff
onCall

Strike
Price
Priceofunderlyingasset

99

Example 1: Product Patent as an Option

PVofCashFlows
fromProject

InitialInvestmentin
Project
PresentValueofExpected
CashFlowsonProduct
Projecthasnegative
NPVinthissection

Project'sNPVturns
positiveinthissection

100

Example 2: Undeveloped Oil Reserve as an

option

NetPayoffon
Extraction

CostofDeveloping
Reserve

Valueofestimatedreserve
ofnaturalresource

101

Example 3: Expansion of existing project as an

option
PVofCashFlows
fromExpansion

AdditionalInvestment
toExpand
PresentValueofExpected
CashFlowsonExpansion
Firmwillnotexpandin
thissection

Expansionbecomes
attractiveinthissection

102

When does the option have significant

economic value?

Foranoptiontohavesignificanteconomicvalue,therehastobea
restrictiononcompetitionintheeventofthecontingency.Ina
perfectlycompetitiveproductmarket,nocontingency,nomatterhow
positive,willgeneratepositivenetpresentvalue.
Atthelimit,realoptionsaremostvaluablewhenyouhaveexclusivity
youandonlyyoucantakeadvantageofthecontingency.They
becomelessvaluableasthebarrierstocompetitionbecomelesssteep.

103

Exclusivity: Putting Real Options to the Test

ProductOptions:Patentonadrug
Patentsrestrictcompetitorsfromdevelopingsimilarproducts
Patentsdonotrestrictcompetitorsfromdevelopingotherproductstotreat
thesamedisease.

NaturalResourceoptions:Anundevelopedoilreserveorgoldmine.
Naturalresourcereservesarelimited.
Ittakestimeandresourcestodevelopnewreserves

GrowthOptions:Expansionintoanewproductormarket
Barriersmayrangefromstrong(exclusivelicensesgrantedbythe
governmentasintelecombusinesses)toweaker(brandname,
knowledgeofthemarket)toweakest(firstmover).

104

Determinants of option value

VariablesRelatingtoUnderlyingAsset
ValueofUnderlyingAsset;asthisvalueincreases,therighttobuyatafixedprice
(calls)willbecomemorevaluableandtherighttosellatafixedprice(puts)will
becomelessvaluable.
Varianceinthatvalue;asthevarianceincreases,bothcallsandputswillbecome
morevaluablebecausealloptionshavelimiteddownsideanddependuponprice
volatilityforupside.
Expecteddividendsontheasset,whicharelikelytoreducethepriceappreciation
componentoftheasset,reducingthevalueofcallsandincreasingthevalueofputs.

VariablesRelatingtoOption
StrikePriceofOptions;therighttobuy(sell)atafixedpricebecomesmore(less)
valuableatalowerprice.
LifeoftheOption;bothcallsandputsbenefitfromalongerlife.

LevelofInterestRates;asratesincrease,therighttobuy(sell)atafixedprice
inthefuturebecomesmore(less)valuable.

105

The Building Blocks for Option Pricing Models:

Arbitrage and Replication

Theobjectiveincreatingareplicatingportfolioistouseacombination
ofriskfreeborrowing/lendingandtheunderlyingassettocreatethe
samecashflowsastheoptionbeingvalued.
Call=Borrowing+BuyingoftheUnderlyingStock
Put=SellingShortonUnderlyingAsset+Lending
Thenumberofsharesboughtorsoldiscalledtheoptiondelta.

Theprinciplesofarbitragethenapply,andthevalueoftheoptionhas
tobeequaltothevalueofthereplicatingportfolio.

106

The Binomial Option Pricing Model

OptionDetails
K=$40
t=2
r=11%

100D1.11B=60
50D1.11B=10
D=1,B=36.04
Call=1*7036.04=33.96

Stock
Price

Call

100

60

50

10

25

Call=33.96
70D1.11B=33.96
35D1.11B=4.99
70
D=0.8278,B=21.61
Call=0.8278*5021.61=19.42

50
Call=19.42

35
Call=4.99
50D1.11B=10
25D1.11B=0
D=0.4,B=9.01
Call=0.4*359.01=4.99

107

The Limiting Distributions.

Asthetimeintervalisshortened,thelimitingdistribution,ast>0,
cantakeoneoftwoforms.
Ifast>0,pricechangesbecomesmaller,thelimitingdistributionisthe
normaldistributionandthepriceprocessisacontinuousone.
Ifast>0,pricechangesremainlarge,thelimitingdistributionisthe
poissondistribution,i.e.,adistributionthatallowsforpricejumps.

TheBlackScholesmodelapplieswhenthelimitingdistributionis
thenormaldistribution,andexplicitlyassumesthattheprice
processiscontinuousandthattherearenojumpsinassetprices.

108

The Black Scholes Model

Valueofcall=SN(d1)KertN(d2)
where,
2
S
ln
+ (r +
)t
K
2
d1 =
t
d2=d1t

ThereplicatingportfolioisembeddedintheBlackScholesmodel.To
replicatethiscall,youwouldneedto
BuyN(d1)sharesofstock;N(d1)iscalledtheoptiondelta
BorrowKertN(d2)

109

The Normal Distribution

d

N(d 1)

d1

-3.00
-2.95
-2.90
-2.85
-2.80
-2.75
-2.70
-2.65
-2.60
-2.55
-2.50
-2.45
-2.40
-2.35
-2.30
-2.25
-2.20
-2.15
-2.10
-2.05
-2.00
-1.95
-1.90
-1.85
-1.80
-1.75
-1.70
-1.65
-1.60
-1.55
-1.50
-1.45
-1.40
-1.35
-1.30
-1.25
-1.20
-1.15
-1.10
-1.05
-1.00

N(d)
0.0013
0.0016
0.0019
0.0022
0.0026
0.0030
0.0035
0.0040
0.0047
0.0054
0.0062
0.0071
0.0082
0.0094
0.0107
0.0122
0.0139
0.0158
0.0179
0.0202
0.0228
0.0256
0.0287
0.0322
0.0359
0.0401
0.0446
0.0495
0.0548
0.0606
0.0668
0.0735
0.0808
0.0885
0.0968
0.1056
0.1151
0.1251
0.1357
0.1469
0.1587

d
-1.00
-0.95
-0.90
-0.85
-0.80
-0.75
-0.70
-0.65
-0.60
-0.55
-0.50
-0.45
-0.40
-0.35
-0.30
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
0.55
0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95
1.00

N(d)
0.1587
0.1711
0.1841
0.1977
0.2119
0.2266
0.2420
0.2578
0.2743
0.2912
0.3085
0.3264
0.3446
0.3632
0.3821
0.4013
0.4207
0.4404
0.4602
0.4801
0.5000
0.5199
0.5398
0.5596
0.5793
0.5987
0.6179
0.6368
0.6554
0.6736
0.6915
0.7088
0.7257
0.7422
0.7580
0.7734
0.7881
0.8023
0.8159
0.8289
0.8413

d
1.05
1.10
1.15
1.20
1.25
1.30
1.35
1.40
1.45
1.50
1.55
1.60
1.65
1.70
1.75
1.80
1.85
1.90
1.95
2.00
2.05
2.10
2.15
2.20
2.25
2.30
2.35
2.40
2.45
2.50
2.55
2.60
2.65
2.70
2.75
2.80
2.85
2.90
2.95
3.00

N(d)
0.8531
0.8643
0.8749
0.8849
0.8944
0.9032
0.9115
0.9192
0.9265
0.9332
0.9394
0.9452
0.9505
0.9554
0.9599
0.9641
0.9678
0.9713
0.9744
0.9772
0.9798
0.9821
0.9842
0.9861
0.9878
0.9893
0.9906
0.9918
0.9929
0.9938
0.9946
0.9953
0.9960
0.9965
0.9970
0.9974
0.9978
0.9981
0.9984
0.9987

110

When can you use option pricing models to

value real options?

Thenotionofareplicatingportfoliothatdrivesoptionpricingmodels
makesthemmostsuitedforvaluingrealoptionswhere
Theunderlyingassetistradedthisyieldnotonlyobservablepricesand
volatilityasinputstooptionpricingmodelsbutallowsforthepossibility
ofcreatingreplicatingportfolios
Anactivemarketplaceexistsfortheoptionitself.
Thecostofexercisingtheoptionisknownwithsomedegreeofcertainty.

Whenoptionpricingmodelsareusedtovaluerealassets,wehaveto
acceptthefactthat
Thevalueestimatesthatemergewillbefarmoreimprecise.
Thevaluecandeviatemuchmoredramaticallyfrommarketpricebecause
ofthedifficultyofarbitrage.

111

Valuing a Product Patent as an option: Avonex

Biogen,abiotechnologyfirm,hasapatentonAvonex,adrugtotreat
multiplesclerosis,forthenext17years,anditplanstoproduceand
sellthedrugbyitself.Thekeyinputsonthedrugareasfollows:
PVofCashFlowsfromIntroducingtheDrugNow=S=$3.422billion
PVofCostofDevelopingDrugforCommercialUse=K=$2.875billion
PatentLife=t=17yearsRisklessRate=r=6.7%(17yearT.Bondrate)
VarianceinExpectedPresentValues=2=0.224(Industryaveragefirm
varianceforbiotechfirms)
ExpectedCostofDelay=y=1/17=5.89%
d1=1.1362 N(d1)=0.8720
d2=0.8512 N(d2)=0.2076

CallValue=3,422exp(0.0589)(17)(0.8720)2,875(exp(0.067)(17)(0.2076)=$
907million

112

Valuing an Oil Reserve

Consideranoffshoreoilpropertywithanestimatedoilreserveof50
millionbarrelsofoil,wherethecostofdevelopingthereserveis$600
milliontoday.
Thefirmhastherightstoexploitthisreserveforthenexttwentyyears
andthemarginalvalueperbarrelofoilis$12perbarrelcurrently
(Priceperbarrelmarginalcostperbarrel).Thereisa2yearlag
betweenthedecisiontoexploitthereserveandoilextraction.
Oncedeveloped,thenetproductionrevenueeachyearwillbe5%of
thevalueofthereserves.
Therisklessrateis8%andthevarianceinln(oilprices)is0.03.

113

Valuing an oil reserve as a real option

CurrentValueoftheasset=S=Valueofthedevelopedreserve
discountedbackthelengthofthedevelopmentlagatthedividend
yield=$12*50/(1.05)2=$544.22
(Ifdevelopmentisstartedtoday,theoilwillnotbeavailableforsale
untiltwoyearsfromnow.Theestimatedopportunitycostofthisdelay
isthelostproductionrevenueoverthedelayperiod.Hence,the
discountingofthereservebackatthedividendyield)
ExercisePrice=PresentValueofdevelopmentcost=$12*50=$600
million
Timetoexpirationontheoption=20years
Varianceinthevalueoftheunderlyingasset=0.03
Risklessrate=8%
DividendYield=Netproductionrevenue/Valueofreserve=5%

114

Valuing the Option

Basedupontheseinputs,theBlackScholesmodelprovidesthe
followingvalueforthecall:
d1=1.0359
d2=0.2613

N(d1)=0.8498
N(d2)=0.6030

CallValue=544.22exp(0.05)(20)(0.8498)600(exp(0.08)(20)(0.6030)=$
97.08million
Thisoilreserve,thoughnotviableatcurrentprices,stillisavaluable
propertybecauseofitspotentialtocreatevalueifoilpricesgoup.
Extendingthisconcept,thevalueofanoilcompanycanbewrittenas
thesumofthreevalues:
Valueofoilcompany=Valueofdevelopedreserves(DCFvaluation)
+Valueofundevelopedreserves(Valuedasoption)

115

An Example of an Expansion Option

AmbevisconsideringintroducingasoftdrinktotheU.S.market.The
drinkwillinitiallybeintroducedonlyinthemetropolitanareasofthe
U.S.andthecostofthislimitedintroductionis$500million.
Afinancialanalysisofthecashflowsfromthisinvestmentsuggests
thatthepresentvalueofthecashflowsfromthisinvestmenttoAmbev
willbeonly$400million.Thus,byitself,thenewinvestmenthasa
negativeNPVof$100million.
Iftheinitialintroductionworksoutwell,Ambevcouldgoaheadwith
afullscaleintroductiontotheentiremarketwithanadditional
investmentof$1billionanytimeoverthenext5years.Whilethe
currentexpectationisthatthecashflowsfromhavingthisinvestment
isonly$750million,thereisconsiderableuncertaintyaboutboththe
potentialforthedrink,leadingtosignificantvarianceinthisestimate.

116

Valuing the Expansion Option

ValueoftheUnderlyingAsset(S)=PVofCashFlowsfrom
ExpansiontoentireU.S.market,ifdonenow=$750Million
StrikePrice(K)=CostofExpansionintoentireU.Smarket=$1000
Million
Weestimatethestandarddeviationintheestimateoftheprojectvalue
byusingtheannualizedstandarddeviationinfirmvalueofpublicly
tradedfirmsinthebeveragemarkets,whichisapproximately34.25%.
StandardDeviationinUnderlyingAssetsValue=34.25%

Timetoexpiration=Periodforwhichexpansionoptionapplies=5
years
CallValue=$234Million

117

One final example: Equity as a Liquidatiion

Option
NetPayoff
onEquity

FaceValue
ofDebt
Valueoffirm

118

Application to valuation: A simple example

Assumethatyouhaveafirmwhoseassetsarecurrentlyvaluedat$100
millionandthatthestandarddeviationinthisassetvalueis40%.
Further,assumethatthefacevalueofdebtis$80million(Itiszero
coupondebtwith10yearslefttomaturity).
Ifthetenyeartreasurybondrateis10%,
howmuchistheequityworth?
Whatshouldtheinterestrateondebtbe?

119

Valuing Equity as a Call Option

Inputstooptionpricingmodel

Valueoftheunderlyingasset=S=Valueofthefirm=$100million
Exerciseprice=K=FaceValueofoutstandingdebt=$80million
Lifeoftheoption=t=Lifeofzerocoupondebt=10years
Varianceinthevalueoftheunderlyingasset=2=Varianceinfirmvalue=0.16
Risklessrate=r=Treasurybondratecorrespondingtooptionlife=10%

Basedupontheseinputs,theBlackScholesmodelprovidesthefollowing
valueforthecall:
d1=1.5994
d2=0.3345

N(d1)=0.9451
N(d2)=0.6310

Valueofthecall=100(0.9451)80exp(0.10)(10)(0.6310)=$75.94million
Valueoftheoutstandingdebt=$100$75.94=$24.06million
Interestrateondebt=($80/$24.06)1/101=12.77%

120

The Effect of Catastrophic Drops in Value

Assumenowthatacatastrophewipesouthalfthevalueofthisfirm
(thevaluedropsto$50million),whilethefacevalueofthedebt
remainsat$80million.Whatwillhappentotheequityvalueofthis
firm?
Itwilldropinvalueto$25.94million[$50millionmarketvalueof
debtfrompreviouspage]
Itwillbeworthnothingsincedebtoutstanding>FirmValue
Itwillbeworthmorethan$25.94million

121

Valuing Equity in the Troubled Firm

Valueoftheunderlyingasset=S=Valueofthefirm=$50million
Exerciseprice=K=FaceValueofoutstandingdebt=$80million
Lifeoftheoption=t=Lifeofzerocoupondebt=10years
Varianceinthevalueoftheunderlyingasset=2=Varianceinfirm
value=0.16
Risklessrate=r=Treasurybondratecorrespondingtooptionlife=
10%

122

The Value of Equity as an Option

Basedupontheseinputs,theBlackScholesmodelprovidesthe
followingvalueforthecall:
d1=1.0515
d2=0.2135

N(d1)=0.8534
N(d2)=0.4155

Valueofthecall=50(0.8534)80exp (0.10)(10)(0.4155)=$30.44
million
Valueofthebond=$50$30.44=$19.56million
Theequityinthisfirmdropsby,becauseoftheoptioncharacteristics
ofequity.
Thismightexplainwhystockinfirms,whichareinChapter11and
essentiallybankrupt,stillhasvalue.

123

Equity value persists ..

Value of Equity as Firm Value Changes
80

70

60

Value of Equity

50

40

30

20

10

0
100

90

80

70

60

50

40

30

20

10

Value of Firm ($ 80 Face Value of Debt)

124

Obtaining option pricing inputs in the real

worlds
Input
ValueoftheFirm

EstimationProcess
Cumulatemarketvaluesofequityanddebt(or)
Valuethe
assetsinplace usingFCFFandWACC(or)
Usecumulatedmarketvalueofassets,iftraded.

VarianceinFirmValue

Ifstocksandbondsaretraded,
2firm =we2e2 +wd2d2+2we wd ed ed
wheree2 =varianceinthestockprice
we=MVweightofEquity
d2 =thevarianceinthebondpricew d=MVweightofdebt
Ifnottraded,usevariancesofsimilarlyratedbonds.
Useaveragefirmvaluevariancefromtheindustryinwhich
companyoperates.

ValueoftheDebt

Ifthedebtisshortterm,youcanuseonlythefaceorbookvalue
ofthedebt.
Ifthedebtislongtermandcouponbearing,addthecumulated
nominalvalueofthesecouponstothefacevalueofthedebt.

MaturityoftheDebt

Facevalueweighteddurationofbondsoutstanding(or)
Ifnotavailable,useweightedmaturity

125

Valuing Equity as an option - Eurotunnel in

early 1998

Eurotunnelhasbeenafinancialdisastersinceitsopening
In1997,Eurotunnelhadearningsbeforeinterestandtaxesof56million
andnetincomeof685million
Attheendof1997,itsbookvalueofequitywas117million

Ithad8,865millioninfacevalueofdebtoutstanding
Theweightedaveragedurationofthisdebtwas10.93years
DebtType
FaceValue
Duration

Shortterm
10year
20year
Longer
Total

935
2435
3555
1940

0.50
6.7
12.6
18.2

8,865mil

10.93years

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The Basic DCF Valuation

Thevalueofthefirmestimatedusingprojectedcashflowstothefirm,
discountedattheweightedaveragecostofcapitalwas2,312million.
Thiswasbaseduponthefollowingassumptions
Revenueswillgrow5%ayearinperpetuity.
TheCOGSwhichiscurrently85%ofrevenueswilldropto65%of
revenuesinyr5andstayatthatlevel.
Capitalspendinganddepreciationwillgrow5%ayearinperpetuity.
Therearenoworkingcapitalrequirements.
Thedebtratio,whichiscurrently95.35%,willdropto70%afteryear5.
Thecostofdebtis10%inhighgrowthperiodand8%afterthat.
Thebetaforthestockwillbe1.10forthenextfiveyears,anddropto0.8
afterthenext5years.
Thelongtermbondrateis6%.

127

Other Inputs

ThestockhasbeentradedontheLondonExchange,andthe
annualizedstddeviationbaseduponln(prices)is41%.
ThereareEurotunnelbonds,thathavebeentraded;theannualizedstd
deviationinln(price)forthebondsis17%.
Thecorrelationbetweenstockpriceandbondpricechangeshasbeen0.5.
Theproportionofdebtinthecapitalstructureduringtheperiod(1992
1996)was85%.
Annualizedvarianceinfirmvalue
=(0.15)2(0.41)2+(0.85)2(0.17)2+2(0.15)(0.85)(0.5)(0.41)(0.17)=0.0335

The15yearbondrateis6%.(Iusedabondwithadurationofroughly
11yearstomatchthelifeofmyoption)

128

Valuing Eurotunnel Equity and Debt

InputstoModel

Valueoftheunderlyingasset=S=Valueofthefirm=2,312million
Exerciseprice=K=FaceValueofoutstandingdebt=8,865million
Lifeoftheoption=t=Weightedaveragedurationofdebt=10.93years
Varianceinthevalueoftheunderlyingasset=2=Varianceinfirm
value=0.0335
Risklessrate=r=Treasurybondratecorrespondingtooptionlife=6%

Basedupontheseinputs,theBlackScholesmodelprovidesthe
followingvalueforthecall:
d1=0.8337
d2=1.4392

N(d1)=0.2023
N(d2)=0.0751

Valueofthecall=2312(0.2023)8,865exp (0.06)(10.93)(0.0751)=122
million
Appropriateinterestrateondebt=(8865/2190) (1/10.93)1=13.65%

129

Back to Lemmings...

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