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Basics
Aswath Damodaran
Aswath Damodaran 1
Discounted Cashflow Valuation: Basis for
Approach
t = n CF
Value = ∑ t
t
t = 1( 1 +r)
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.
Proposition 1: For an asset to have value, the expected cash flows
have to be positive some time over the life of the asset.
Proposition 2: Assets that generate cash flows early in their life will
be worth more than assets that generate cash flows later; the latter
may however have greater growth and higher cash flows to
compensate.
Aswath Damodaran 2
Equity Valuation versus Firm Valuation
Aswath Damodaran 3
I.Equity Valuation
where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity
n The dividend discount model is a specialized case of equity valuation, and the
value of a stock is the present value of expected future dividends.
Aswath Damodaran 4
II. Firm Valuation
where,
CF to Firmt = Expected Cashflow to Firm in period t
WACC = Weighted Average Cost of Capital
Aswath Damodaran 5
Firm Value and Equity Value
n To get from firm value to equity value, which of the following would
you need to do?
o Subtract out the value of long term debt
o Subtract out the value of all debt
o Subtract the value of all non-equity claims in the firm, that are
included in the cost of capital calculation
o Subtract out the value of all non-equity claims in the firm
n Doing so, will give you a value for the equity which is
o greater than the value you would have got in an equity valuation
o lesser than the value you would have got in an equity valuation
o equal to the value you would have got in an equity valuation
Aswath Damodaran 6
Cash Flows and Discount Rates
n Assume that you are analyzing a company with the following cashflows for
the next five years.
Year CF to Equity Int Exp (1-t) CF to Firm
1 $ 50 $ 40 $ 90
2 $ 60 $ 40 $ 100
3 $ 68 $ 40 $ 108
4 $ 76.2 $ 40 $ 116.2
5 $ 83.49 $ 40 $ 123.49
Terminal Value $ 1603.0 $ 2363.008
n Assume also that the cost of equity is 13.625% and the firm can borrow long
term at 10%. (The tax rate for the firm is 50%.)
n The current market value of equity is $1,073 and the value of debt outstanding
is $800.
Aswath Damodaran 7
Equity versus Firm Valuation
Aswath Damodaran 8
First Principle of Valuation
Aswath Damodaran 9
The Effects of Mismatching Cash Flows and
Discount Rates
Aswath Damodaran 10
Discounted Cash Flow Valuation: The Steps
Aswath Damodaran 11
Generic DCF Valuation Model
Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Equity: After debt Net Income/EPS Firm is in stable growth:
cash flows Grows at constant rate
forever
Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever
Equity: Value of Equity
Length of Period of High Growth
Discount Rate
Firm:Cost of Capital
Aswath Damodaran 12
EQUITY VALUATION WITH DIVIDENDS
Cost of Equity
Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
- In same currency and + - Measures market risk X
risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium Premium
Aswath Damodaran 13
Financing Weights EQUITY VALUATION WITH FCFE
Debt Ratio = DR
Cost of Equity
Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
- In same currency and + - Measures market risk X
risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium Premium
Aswath Damodaran 14
VALUING A FIRM
Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
+ - Measures market risk X
- In same currency and risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium Premium
Aswath Damodaran 15