Investment Valuation, University Edition

ASWATH DAMODARAN is Professor of Finance at New York University’s Leonard N. Stern School of Business. He teaches corporate finance and valuation at leading investment banks. He has been the recipient of numerous awards for outstanding teaching, including the NYU Distinguished Teaching Award, and was named one of the nation’s top business school teachers by BusinessWeek. His publications include Damodaran on Valuation, Applied Corporate Finance, The Little Book of Valuation, Investment Philosophies, and The Dark Side of Valuation.

Preface xv

Chapter 1 Introduction to Valuation 1

A Philosophical Basis for Valuation 1

Pricing versus Valuation 2

The Bermuda Triangle of Valuation 2

Market Efficiency 6

The Role of Valuation 7

Conclusion 10

Questions and Short Problems 10

Chapter 2 Approaches to Valuation 13

Intrinsic Valuation 13

Pricing or Relative Valuation 21

Contingent Claim Valuation 25

Conclusion 27

Questions and Short Problems 27

Chapter 3 Understanding Financial Statements 29

The Basic Accounting Statements 29

Asset Measurement and Valuation 31

Measuring Financing mix 38

Measuring Earnings and Profitability 44

Measuring Risk 50

Other Issues in Analyzing Financial Statements 56

Conclusion 57

Questions and Short Problems 58

Chapter 4 The Basics of Risk 61

What Is Risk? 61

Equity Risk and Expected Return 62

Alternative Models for Equity Risk 74

A Comparative Analysis of Equity Risk Models 80

Models of Default Risk 81

Conclusion 85

Questions and Short Problems 85

Chapter 5 Option Pricing Theory and Models 91

Basics of Option Pricing 91

Option Pricing Models 94

Extensions of Option Pricing 109

Conclusion 110

Questions and Short Problems 111

Chapter 6 Market Efficiency—Definition, Tests, and Evidence 113

Market Efficiency and Investment Valuation 113

What Is an Efficient Market? 114

Testing Market Efficiency 118

Cardinal Sins in Testing Market Efficiency 123

Some Lesser Sins That Can Be a Problem 124

Evidence on Market Efficiency 125

Time Series Properties of Price Changes 125

Market Reaction to Information Events 133

Market Anomalies 137

Evidence on Insiders and Investment Professionals 146

Conclusion 152

Questions and Short Problems 153

Chapter 7 Riskless Rates and Risk Premiums 157

The Risk-Free Rate 157

Equity Risk Premium 162

Default Spreads on Bonds 182

Conclusion 185

Questions and Short Problems 186

Chapter 8 Estimating Risk Parameters and Costs of Financing 189

The Cost of Equity and Capital 189

Cost of Equity 190

From Cost of Equity to Cost of Capital 221

Best Practices at Firms 233

Conclusion 234

Questions and Short Problems 234

Chapter 9 Measuring Earnings 241

The Lead-in: From Accounting Data to Financial Information 241

Adjusting Earnings 243

Measuring Earnings Power: Clean Up and Time Differences 256

Conclusion 266

Questions and Short Problems 267

Chapter 10 From Earnings To Cash Flows 269

The Tax Effect 269

Reinvestment Needs 279

Conclusion 291

Questions and Short Problems 292

Chapter 11 Estimating Growth 295

The Importance of Growth 295

Historical Growth 296

Outsourcing Growth 307

Fundamental Determinants of Growth 311

Top-Down Growth: From Revenue Growth to Free Cash Flows 324

Qualitative Aspects of Growth 336

Conclusion 337

Questions and Short Problems 338

Chapter 12 Closure in Valuation: Estimating Terminal Value 341

Closure in Valuation 341

The Survival Issue 357

Closing Thoughts on Terminal Value 360

Conclusion 361

Questions and Short Problems 361

Chapter 13 Narrative and Numbers – Story to Value 363

Valuation as a Bridge 363

The Importance of Storytelling 364

The Dangers in Storytelling 366

From Story to Numbers: The Process 368

Narrative and Numbers Across the Life Cycle 380

Story Resets, Changes, and Breaks 382

Conclusion 384

Questions and Short Problems 385

Chapter 14 Equity Intrinsic Value Models 387

Equity Valuation 387

The Dividend Discount Model 388

The Augmented Dividend Discount Model 404

Potential Dividend or FCFE Models 408

FCFE Valuation Versus Dividend Discount Model Valuation 428

Conclusion 430

Questions and Short Problems 431

Chapter 15 Firm Valuation: Cost of Capital and Adjusted Present Value Approaches 437

Free Cash Flow to the Firm 437

Firm Valuation: The Cost of Capital Approach 440

Firm Valuation: The Adjusted Present Value Approach 453

Firm Valuation: Sum of the Parts 458

Effect of Leverage on Firm Value 468

Conclusion 477

Questions and Short Problems 477

Chapter 16 Estimating Equity Value per Share 481

Value of Nonoperating Assets 481

Firm Value and Equity Value 500

Stock-based Compensation 501

Value Per Share When Voting Rights Vary 510

Conclusion 512

Questions and Short Problems 512

Chapter 17 Fundamental Principles of Relative Valuation 515

Use of Relative Valuation 515

Standardized Values and Multiples 516

Four Basic Steps to Using Multiples 518

Reconciling Relative and Discounted Cash Flow Valuations 530

Conclusion 530

Questions and Short Problems 531

Chapter 18 Earnings Multiples 533

Price-Earnings Ratio 533

The PEG Ratio 555

Other Variants on the PE Ratio 565

Enterprise Value to EBITDA Multiple 569

Conclusion 577

Questions and Short Problems 578

Chapter 19 Book Value Multiples 581

Price-to-Book Equity 581

Value-to-Book Ratios 603

Tobin’S Q: Market Value/Replacement Cost 608

Conclusion 610

Questions and Short Problems 610

Chapter 20 Revenue Multiples and Sector-Specific Multiples 613

Revenue Multiples 613

Sector-Specific Multiples 644

Conclusion 653

Questions and Short Problems 653

Chapter 21 Valuing Financial Service Firms 657

Categories of Financial Service Firms 657

What Is Unique About Financial Service Firms? 658

General Framework for Valuation 659

Discounted Cash Flow Valuation 660

Relative Valuation 675

The Crisis Effect 680

Nonbank Financial Service Firms 688

Conclusion 691

Questions and Short Problems 692

Chapter 22 Valuing Money-Losing Firms 695

Negative Earnings: Consequences and Causes 695

Valuing Money-Losing Firms 700

Conclusion 728

Questions and Short Problems 728

Chapter 23 Valuing Young or Start-Up Firms 733

Information Constraints 733

General Framework for Analysis 738

Value Drivers 750

Estimation Noise 751

The Expectations Game 753

Conclusion 755

Questions and Short Problems 756

Chapter 24 Valuing Private Firms 757

What Makes Private Firms Different? 757

Estimating Valuation Inputs at Private Firms 758

Valuation Motives and Value Estimates 781

Valuing Venture Capital and Private Equity Stakes 786

Pricing Private Businesses 789

Conclusion 793

Questions and Short Problems 793

Chapter 25 Acquisitions and Takeovers 795

Background on Acquisitions 795

Steps in an Acquisition 799

Takeover Valuation: Biases and Common Errors 818

Structuring the Acquisition 820

Improving the Odds 825

Analyzing Management and Leveraged Buyouts 828

Conclusion 832

Questions and Short Problems 833

Chapter 26 Valuing Real Estate 837

Real Versus Financial Assets 837

Real Estate: The Underfollowed Investment Class 838

Intrinsic Valuation of Real Estate 843

Comparable/Relative Valuation 860

Valuing Real Estate Businesses 862

Conclusion 864

Questions and Short Problems 865

Chapter 27 Valuing Other Assets 867

Investment classification 867

Cash-Flow–Producing Assets 869

Collectibles 883

Trophy Assets 897

Conclusion 904

Questions and Short Problems 904

Chapter 28 The Option to Delay and Valuation Implications 907

Real Options: Promise and Pitfalls 907

The Option to Delay a Project 910

Valuing a Patent 918

Natural Resource Options 925

Other Applications 931

Conclusion 932

Questions and Short Problems 932

Chapter 29 The Options to Expand and to Abandon: Valuation Implications 935

The Option to Expand 935

When Are Expansion Options Valuable? 942

Valuing a Firm with the Option to Expand 945

Valuing the Optionality in Users and Data 947

Value of Financial Flexibility 950

The Option to Abandon 953

Reconciling Net Present Value and Real Option Valuations 956

Conclusion 956

Questions and Short Problems 957

Chapter 30 Valuing Equity in Distressed Firms 959

Equity in Highly Levered Distressed Firms 959

Optionality in Valuation: A Corporate Life Cycle Perspective 961

Implications of Viewing Equity as an Option 963

Estimating the Value of Equity as an Option 966

Distressed Equity as an Option: Consequences for Decision-Making 972

Conclusion 975

Questions and Short Problems 975

Chapter 31 Value Enhancement: A Discounted Cash Flow Valuation Framework 977

Value-Creating and Value-Neutral Actions 977

Ways of Increasing Value 978

Value Enhancement Chain 996

Closing Thoughts on Value Enhancement 1001

Conclusion 1002

Questions and Short Problems 1003

Chapter 32 Value Enhancement: Economic Value Added, Cash Flow Return on Investment, and Other Tools 1007

Economic Value Added 1008

Cash Flow Return on Investment 1023

A Postscript on Value Enhancement 1028

Conclusion 1029

Questions and Short Problems 1030

Chapter 33 Probabilistic Approaches in Valuation: Scenario Analysis, Decision Trees, and Simulations 1033

Scenario Analysis 1033

Decision Trees 1038

Simulations 1047

An Overall Assessment of Probabilistic Risk-Assessment Approaches 1058

Conclusion 1060

Questions and Short Problems 1061

Chapter 34 Overview and Conclusion 1065

Choices in Valuation Models 1065

Which Approach Should You Use? 1066

Choosing the Right Intrinsic Valuation Model 1069

Choosing the Right Pricing Model 1074

When Should You Use the Option Pricing Models? 1076

Conclusion 1078

References 1079

Index 1091