VIEWS: 4 PAGES: 47 POSTED ON: 10/24/2011
Valuation Models Aswath Damodaran Aswath Damodaran 1 Misconceptions about Valuation Myth 1: A valuation is an objective search for “true” value • Truth 1.1: All valuations are biased. The only questions are how much and in which direction. • Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid. Myth 2.: A good valuation provides a precise estimate of value • Truth 2.1: There are no precise valuations • Truth 2.2: The payoff to valuation is greatest when valuation is least precise. Myth 3: . The more quantitative a model, the better the valuation • Truth 3.1: One‟s understanding of a valuation model is inversely proportional to the number of inputs required for the model. • Truth 3.2: Simpler valuation models do much better than complex ones. Aswath Damodaran 2 Approaches to Valuation Valuation Models Asset Based Discounted Cashflow Relative Valuation Contingent Claim Valuation Models Models Liquidation Equity Sector Option to Option to Option to Value delay expand liquidate Stable Current Firm Market Young Equity in Replacement Two-stage firms troubled Cost Normalized firm Three-stage or n-stage Earnings Book Revenues Sector Undeveloped Value specific land Equity Valuation Firm Valuation Models Models Patent Undeveloped Dividends Reserves Cost of capital APV Excess Return Free Cashflow approach approach Models to Firm Aswath Damodaran 3 Basis for all valuation approaches The use of valuation models in investment decisions (i.e., in decisions on which assets are under valued and which are over valued) are based upon • a perception that markets are inefficient and make mistakes in assessing value • an assumption about how and when these inefficiencies will get corrected In an efficient market, the market price is the best estimate of value. The purpose of any valuation model is then the justification of this value. Aswath Damodaran 4 Discounted Cash Flow Valuation What is it: In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset. Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk. Information Needed: To use discounted cash flow valuation, you need • to estimate the life of the asset • to estimate the cash flows during the life of the asset • to estimate the discount rate to apply to these cash flows to get present value Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time, and are assumed to correct themselves over time, as new information comes out about assets. Aswath Damodaran 5 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 6 Equity Valuation versus Firm Valuation Value just the equity stake in the business Value the entire business, which includes, besides equity, the other claimholders in the firm Aswath Damodaran 7 I.Equity Valuation The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm. t=n CF to Equityt Value of Equity = (1+ k )t t=1 e where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity Forms: 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. In the more general version, you can consider the cashflows left over after debt payments and reinvestment needs as the free cashflow to equity. Aswath Damodaran 8 II. Firm Valuation Cost of capital approach: The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions. t= n CF to Firm t Value of Firm = (1+ WACC) t =1 t APV approach: The value of the firm can also be written as the sum of the value of the unlevered firm and the effects (good and bad) of debt. Firm Value = Unlevered Firm Value + PV of tax benefits of debt - Expected Bankruptcy Cost Aswath Damodaran 9 Generic DCF Valuation Model DISCOUNTED CASHFLOW VALUATION Expected Growth Cash flows Firm: Growth in Firm: Pre-debt cash Operating Earnings flow Equity: Growth in Net Income/EPS Firm is in stable growth: Equity: After debt Grows at constant rate cash flows forever Terminal Value CF1 CF2 CF3 CF4 CF5 CFn Value ......... Firm: Value of Firm Forever Equity: Value of Equity Le ngth of Pe riod of High Growth Discount Rate Firm:Cost of Capital Equity: Cost of Equity Aswath Damodaran 10 VALUING ABN AMRO ROE = 16% Retention Ratio = Dividends 41.56% Expected Growth EP S = 1.54 Eur 41.56% * g =4%: ROE = 8.95%(=Cost of equity) * Payout Ratio 58.44% 16% = 6.65% Beta = 1.00 DPS = 0.90 Eur Payout = (1- 4/8.95) = .553 Terminal Value= EPS6*Payout/(r-g) = (2.21*.553)/(.0895-.04) = 24.69 EPS 1.64 Eur 1.75 Eur 1.87 Eur 1.99 Eur 2.12 Eur Value of Equity per share = 20.48 Eur DPS 0.96 Eur 1.02 Eur 1.09 Eur 1.16 Eur 1.24 Eur ......... Forever Discount at Cost of Equity Cost of Equity 4.95% + 0.95 (4%) = 8.75% Riskfree Rate : Long term bond rate in Risk Premium Euros Beta 4% 4.95% + 0.95 X Average beta for European banks = 0.95 Mature Market Country Risk 4% 0% Aswath Damodaran 11 Aswath Damodaran 12 Avg Reinvestment Embraer: Status Quo ($) rate = 25.08% Return on Capital 21.85% Reinvestment Rate 25.08% Stable Growth Curre nt Cashflow to Firm Expected Growth g = 4.17%; Beta = 1.00; EBIT(1-t) : $ 404 in EBIT (1-t) Country Premium= 5% - Nt CpX 23 .2185*.2508=.0548 Cost of capital = 8.76% - Chg WC 9 5.48 % ROC= 8.76%; Tax rate=34% = FCFF $ 372 Reinvestment Rate=g/ROC Reinvestment Rate = 32/404= 7.9% =4.17/8.76= 47.62% Terminal Value = 288/(.0876-.0417) = 6272 5 $ Cashflows Op. Assets $ 5,272 Term Yr + Cash: 795 Year 1 2 3 4 5 549 - Debt 717 EBIT(1-t) 426 449 474 500 527 - 261 - Minor. Int. 12 - Reinvestment 107 113 119 126 132 = 288 =Equity 5,349 = FCFF 319 336 355 374 395 -Options 28 Value/Share $7.47 R$ 21.75 Discount at$ Cost of Capital (WACC) = 10.52% (.84) + 6.05% (0.16) = 9.81% On October 6, 2003 Embraer Price = R$15.51 Cost of Equity Cost of Debt 10.52 % (4.17%+1%+4%)(1-.34) We ights = 6.05% E = 84% D = 16% Riskfree Rate: $ Riskfree Rate= 4.17% Beta Mature marke t Country Equity Risk + 1.07 X prem ium + Lambda X Premium 4% 0.27 7.67% Unlevered Beta for Firm’s D/E Rel Equity Sectors: 0.95 Ratio: 19% Country Default Mkt Vol Spread X 6.01% 1.28 Aswath Damodaran 13 Current Current Revenue Margin: Stable Growth $ 3,804 -49.82% Cap ex growth slows Stable and net cap ex Stable Stable ROC=7.36% decreases Revenue EBITDA/ Reinvest EBIT Growth: 5% Sales 67.93% -1895m Revenue EBITDA/Sales 30% Growth: -> 30% NOL: 13.33% 2,076m Terminal Value= 677(.0736-.05) =$ 28,683 Term. Year Revenues $3,804 $5,326 $6,923 $8,308 $9,139 $10,053 $11,058 $11,942 $12,659 $13,292 $13,902 EBITDA ($95) $0 $346 $831 $1,371 $1,809 $2,322 $2,508 $3,038 $3,589 $ 4,187 EBIT ($1,675) ($1,738) ($1,565) ($1,272) $320 $1,074 $1,550 $1,697 $2,186 $2,694 $ 3,248 EBIT (1-t) ($1,675) ($1,738) ($1,565) ($1,272) $320 $1,074 $1,550 $1,697 $2,186 $2,276 $ 2,111 + Depreciation $1,580 $1,738 $1,911 $2,102 $1,051 $736 $773 $811 $852 $894 $ 939 - Cap Ex $3,431 $1,716 $1,201 $1,261 $1,324 $1,390 $1,460 $1,533 $1,609 $1,690 $ 2,353 - Chg WC $0 $46 $48 $42 $25 $27 $30 $27 $21 $19 $ 20 Value of Op Assets $ 5,530 FCFF ($3,526) ($1,761) ($903) ($472) $22 $392 $832 $949 $1,407 $1,461 $ 677 + Cash & Non-op $ 2,260 1 2 3 4 5 6 7 8 9 10 = Value of Firm $ 7,790 Forever - Value of Debt $ 4,923 Beta 3.00 3.00 3.00 3.00 3.00 2.60 2.20 1.80 1.40 1.00 = Value of Equity $ 2867 Cost of Equity 16.80% 16.80% 16.80% 16.80% 16.80% 15.20% 13.60% 12.00% 10.40% 8.80% - Equity Options $ 14 Cost of Debt 12.80% 12.80% 12.80% 12.80% 12.80% 11.84% 10.88% 9.92% 8.96% 6.76% Value per share $ 3.22 Debt Ratio 74.91% 74.91% 74.91% 74.91% 74.91% 67.93% 60.95% 53.96% 46.98% 40.00% Cost of Capital 13.80% 13.80% 13.80% 13.80% 13.80% 12.92% 11.94% 10.88% 9.72% 7.98% Cost of Equity Cost of Debt We ights 16.80% 4.8%+8.0%=12.8% Debt= 74.91% -> 40% Tax rate = 0% -> 35% Riskfree Rate: T. Bond rate = 4.8% Risk Prem ium Global Crossing Beta 4% November 2001 + 3.00> 1.10 X Stock price = $1.86 Internet/ Operating Current Base Equity Country Risk Retail Leverage D/E: 441% Premium Premium Aswath Damodaran 14 Valuing Global Crossing with Distress Probability of distress • Price of 8 year, 12% bond issued by Global Crossing = $ 653 120(1 Distress) t 1000(1 Distress) 8 t 8 653 t1 (1.05) t (1.05) 8 • Probability of distress = 13.53% a year • Cumulative probability of survival over 10 years = (1- .1353)10 = 23.37% Distress sale value of equity • Book value of capital = $14,531 million • Distress sale value = 15% of book value = .15*14531 = $2,180 million • Book value of debt = $7,647 million • Distress sale value of equity = $ 0 Distress adjusted value of equity • Value of Global Crossing = $3.22 (.2337) + $0.00 (.7663) = $0.75 Aswath Damodaran 15 Adjusted Present Value Model In the adjusted present value approach, the value of the firm is written as the sum of the value of the firm without debt (the unlevered firm) and the effect of debt on firm value Firm Value = Unlevered Firm Value + (Tax Benefits of Debt - Expected Bankruptcy Cost from the Debt) • The unlevered firm value can be estimated by discounting the free cashflows to the firm at the unlevered cost of equity • The tax benefit of debt reflects the present value of the expected tax benefits. In its simplest form, Tax Benefit = Tax rate * Debt • The expected bankruptcy cost is a function of the probability of bankruptcy and the cost of bankruptcy (direct as well as indirect) as a percent of firm value. Aswath Damodaran 16 Excess Return Models You can present any discounted cashflow model in terms of excess returns, with the value being written as: • Value = Capital Invested + Present value of excess returns on current investments + Present value of excess returns on future investments This model can be stated in terms of firm value (EVA) or equity value. Aswath Damodaran 17 EQUITY VALUATION W ITH EQUITY EVA Firm is in stable growth: Curre nt EVA Expected Growth Growth rate = 5% Net Income = $ 3104 .60 * 20% =12% Return on Equity = 15% - Equity cost = $ 1645 Cost of equity =9.40% Equity EVA = $ 1459 Terminal Value= $2220/(.094-.05)=50,459 Net Income $3,599 $4,031 $4,515 $5,057 $5,664 - Equity Cost (see below) $1,908 $2,137 $2,393 $2,680 $3,002 Excess Equity Return $1,692 $1,895 $2,122 $2,377 $2,662 Book Equity= 17997 + PV of EVA= 38334 = Equity EVA=56331 Forever Value/sh = $50.26 Discount atCost of Equity Cost of Equity 10.60% Risk Pre mium Beta 4.00% Riskfree Rate: + 1.40 X 5.00% Base Equity Country Risk Premium = 4% Premium=0% Aswath Damodaran 18 Choosing the right Discounted Cashflow Model Can you estimate cash flows? Are the current earnings What rate is the firm growing positive & normal? at currently? Yes No Yes No < Growth rate > Growth rate of of economy economy Use current Is the cause Is leverage stable or Use dividend earnings as temporary? Stable growth Are the firm’s likely to change over discount model base model competitive time? advantges time limited? Yes No Stable Unstable leverage leverage Replace current Is the firm Yes No earnings with likely to normalized survive? earnings 3-stage or FCFE FCFF 2-stage n-stage model model Yes No Adjust Does the firm margins over have a lot of time to nurse debt? firm to financial health No Yes Value Equity Estimate as an option liquidation to liquidate value Aswath Damodaran 19 Relative Valuation What is it?: The value of any asset can be estimated by looking at how the market prices “similar” or „comparable” assets. Philosophical Basis: The intrinsic value of an asset is impossible (or close to impossible) to estimate. The value of an asset is whatever the market is willing to pay for it (based upon its characteristics) Information Needed: To do a relative valuation, you need • an identical asset, or a group of comparable or similar assets • a standardized measure of value (in equity, this is obtained by dividing the price by a common variable, such as earnings or book value) • and if the assets are not perfectly comparable, variables to control for the differences Market Inefficiency: Pricing errors made across similar or comparable assets are easier to spot, easier to exploit and are much more quickly corrected. Aswath Damodaran 20 Variations on Multiples Equity versus Firm Value • Equity multiples (Price per share or Market value of equity) • Firm value multiplies (Firm value or Enterprise value) Scaling variable • Earnings (EPS, Net Income, EBIT, EBITDA) • Book value (Book value of equity, Book value of assets, Book value of capital) • Revenues • Sector specific variables Base year • Most recent financial year (Current) • Last four quarters (Trailing) • Average over last few years (Normalized) • Expected future year (Forward) Comparables • Sector • Market Aswath Damodaran 21 Definitional Tests Is the multiple consistently defined? • Proposition 1: Both the value (the numerator) and the standardizing variable ( the denominator) should be to the same claimholders in the firm. In other words, the value of equity should be divided by equity earnings or equity book value, and firm value should be divided by firm earnings or book value. Is the multiple uniformally estimated? • The variables used in defining the multiple should be estimated uniformly across assets in the “comparable firm” list. • If earnings-based multiples are used, the accounting rules to measure earnings should be applied consistently across assets. The same rule applies with book-value based multiples. Aswath Damodaran 22 An Example: Price Earnings Ratio: Definition PE = Market Price per Share / Earnings per Share There are a number of variants on the basic PE ratio in use. They are based upon how the price and the earnings are defined. Price: is usually the current price is sometimes the average price for the year EPS: earnings per share in most recent financial year earnings per share in trailing 12 months (Trailing PE) forecasted earnings per share next year (Forward PE) forecasted earnings per share in future year Aswath Damodaran 23 Descriptive Tests What is the average and standard deviation for this multiple, across the universe (market)? What is the median for this multiple? • The median for this multiple is often a more reliable comparison point. How large are the outliers to the distribution, and how do we deal with the outliers? • Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on one side of the distribution (they usually are large positive numbers), this can lead to a biased estimate. Are there cases where the multiple cannot be estimated? Will ignoring these cases lead to a biased estimate of the multiple? How has this multiple changed over time? Aswath Damodaran 24 PE Ratio: Descriptive Statistics Aswath Damodaran 25 PE: Deciphering the Distribution Current PE Trailing PE Forward PE Mean 36.04 34.14 30.79 Standard Error 1.94 2.93 1.15 Median 18.25 17.25 18.52 Standard Deviation 123.36 176.34 57.56 Skewness 23.13 28.40 13.66 Minimum 0.65 1.35 3.30 Maximum 5103.50 6914.50 1414.00 Count 4024 3627 2491 Largest(500) 48.00 39.60 34.49 Smallest(500) 9.38 9.62 12.94 Aswath Damodaran 26 8 Times EBITDA is not cheap… Aswath Damodaran 27 Analytical Tests What are the fundamentals that determine and drive these multiples? • Proposition 2: Embedded in every multiple are all of the variables that drive every discounted cash flow valuation - growth, risk and cash flow patterns. • In fact, using a simple discounted cash flow model and basic algebra should yield the fundamentals that drive a multiple How do changes in these fundamentals change the multiple? • The relationship between a fundamental (like growth) and a multiple (such as PE) is seldom linear. For example, if firm A has twice the growth rate of firm B, it will generally not trade at twice its PE ratio • Proposition 3: It is impossible to properly compare firms on a multiple, if we do not know the nature of the relationship between fundamentals and the multiple. Aswath Damodaran 28 Relative Value and Fundamentals Value of Stock = DPS 1/(ke - g) PE=Payout Ratio PEG=Payout ratio PBV=ROE (Payout ratio) PS= Net Margin (Payout ratio) (1+g)/(r-g) (1+g)/g(r-g) (1+g)/(r-g) (1+g)/(r-g) PE=f(g, payout, risk) PEG=f(g, payout, risk) PBV=f(ROE,payout, g, risk) PS=f(Net Mgn, payout, g, risk) Equity Multiples Firm Multiple s V/FCFF=f(g, WACC) V/EBIT(1-t)=f(g, RIR, WACC) V/EBIT=f(g, RIR, WACC, t) VS=f(Oper Mgn, RIR, g, WACC) Value/FCFF=(1+g)/ Value/EBIT(1-t) = (1+g) Value/EBIT=(1+g)(1- VS= Oper Margin (1- (WACC-g) (1- RIR)/(WACC-g) RiR)/(1-t)(WACC-g) RIR) (1+g)/(WACC-g) Value of Firm = FCFF 1/(WACC -g) Aswath Damodaran 29 What to control for... Multiple Variables that determine it… PE Ratio Expected Growth, Risk, Payout Ratio PBV Ratio Return on Equity, Expected Growth, Risk, Payout PS Ratio Net Margin, Expected Growth, Risk, Payout Ratio EVV/EBITDA Expected Growth, Reinvestment rate, Cost of capital EV/ Sales Operating Margin, Expected Growth, Risk, Reinvestment Aswath Damodaran 30 Application Tests Given the firm that we are valuing, what is a “comparable” firm? • While traditional analysis is built on the premise that firms in the same sector are comparable firms, valuation theory would suggest that a comparable firm is one which is similar to the one being analyzed in terms of fundamentals. • Proposition 4: There is no reason why a firm cannot be compared with another firm in a very different business, if the two firms have the same risk, growth and cash flow characteristics. Given the comparable firms, how do we adjust for differences across firms on the fundamentals? • Proposition 5: It is impossible to find an exactly identical firm to the one you are valuing. Aswath Damodaran 31 Comparing PE Ratios across a Sector Comp any Name PE Gr owth PT In dosat ADR 7.8 0.06 Tele bra s ADR 8.9 0.07 5 Tele co m Cor por ation of Ne w Ze aland ADR 11 .2 0.11 Tele co m Argen tin a Ste t - Fra nce Te lecom SA ADR B 12 .5 0.08 Hellen ic Telecommun ica tio n Org anization SA ADR 12 .8 0.12 Tele co municacion es d e Ch ile ADR 16 .6 0.08 Swisscom AG ADR 18 .3 0.11 Asia Satellite Te lecom Holdin gs ADR 19 .6 0.16 Por tu gal Telecom SA ADR 20 .8 0.13 Tele fo nos de Mexico ADR L 21 .1 0.14 Matav RT ADR 21 .5 0.22 Telstra ADR 21 .7 0.12 Gila t Commu nications 22 .7 0.31 Deutsch e Te leko m AG ADR 24 .6 0.11 British Telecommunication s PLC ADR 25 .7 0.07 Tele Dan mark AS ADR 27 0.09 Tele komunika si Indo nesia ADR 28 .4 0.32 Cable & Wire less PLC ADR 29 .8 0.14 APT Satellite Hold ings ADR 31 0.33 Tele fo nica SA ADR 32 .5 0.18 Royal KPN NV ADR 35 .7 0.13 Tele co m Italia SPA ADR 42 .2 0.14 Nippo n Telegr aph & Tele pho ne ADR 44 .3 0.2 Fra nce Telecom SA ADR 45 .2 0.19 Kor ea Telecom ADR 71 .3 0.44 Aswath Damodaran 32 PE, Growth and Risk Dependent variable is: PE R squared = 66.2% R squared (adjusted) = 63.1% Variable Coefficient SE t-ratio prob Constant 13.1151 3.471 3.78 0.0010 Growth rate 121.223 19.27 6.29 ≤ 0.0001 Emerging Market -13.8531 3.606 -3.84 0.0009 Emerging Market is a dummy: 1 if emerging market 0 if not Aswath Damodaran 33 Is Telebras under valued? Predicted PE = 13.12 + 121.22 (.075) - 13.85 (1) = 8.35 At an actual price to earnings ratio of 8.9, Telebras is slightly overvalued. Aswath Damodaran 34 PE Ratio without a constant - US Stocks Mo d e l Su mm a ry Adjus t e d R St d. Er ro r o f th e a Mo de l R R Sq ua r e Sq ua r e Es tim a te 1 .8 5 6 b .73 3 .73 2 13 5 0.6 77 6 1 93 1 3 a . Fo r r e g re ss io n t hr ou gh th e or igin (th e n o - int e rc e pt m od e l), R Squ a r e m e a su r e s t he pr o po rt ion of t he va r ia b ility in th e de p e n de n t va ria ble a b ou t th e o rig in ex pla ine d b y r e gr e s sion . T his CANNOT b e c o m p ar ed to R Sq ua r e fo r m od e ls whic h inc lu d e a n int er c e p t. b . Pr e d ic tor s: Valu e Line Bet a , P a you t Ra tio , Ex pe c te d Gr owt h in EPS: ne x t 5 ye a rs Co e f fici e n ts a,b ,c Uns t an d ar d iz ed St a nd a r diz e d 9 5% Co nf ide n ce Int e rva l f or Coe f fic ie nt s C oe ffic ie n ts B Mo de l B Std . Er r or Be t a t Sig . Lo wer Bo un d Up pe r Bo un d 1 Exp e ct e d Gro wth in 1 .2 28 .05 5 .51 4 22 .1 87 .0 0 0 1 .1 19 1.3 3 6 EPS: n e xt 5 ye ar s Pa yo ut Ra tio - 1 .1 E- 0 2 .01 4 - .01 3 - .7 68 .4 4 3 - .03 9 .0 1 7 e Va lu e Lin e B ta 1 1. 70 5 .82 5 .38 4 14 .1 84 .0 0 0 1 0. 08 7 13 .3 24 a . De p e nd e n t Va r ia b le : Cu r re nt PE b . Line a r Re g r e ss ion t hr ou gh th e Orig in c . We igh te d Le a st Sq u ar e s Re g re ss ion - We ig h te d by Ma r ke t Ca p Aswath Damodaran 35 Relative Valuation: Choosing the Right Model Aswath Damodaran 36 Contingent Claim (Option) Valuation Options have several features • They derive their value from an underlying asset, which has value • The payoff on a call (put) option occurs only if the value of the underlying asset is greater (lesser) than an exercise price that is specified at the time the option is created. If this contingency does not occur, the option is worthless. • They have a fixed life Any security that shares these features can be valued as an option. Aswath Damodaran 37 Option Payoff Diagrams Strike P rice Value of Asset Put Option Call Option Aswath Damodaran 38 Underlying Theme: Searching for an Elusive Premium Traditional discounted cashflow models under estimate the value of investments, where there are options embedded in the investments to • Delay or defer making the investment (delay) • Adjust or alter production schedules as price changes (flexibility) • Expand into new markets or products at later stages in the process, based upon observing favorable outcomes at the early stages (expansion) • Stop production or abandon investments if the outcomes are unfavorable at early stages (abandonment) Put another way, real option advocates believe that you should be paying a premium on discounted cashflow value estimates. Aswath Damodaran 39 Three Basic Questions When is there a real option embedded in a decision or an asset? • There has to be a clearly defined underlying asset whose value changes over time in unpredictable ways. • The payoffs on this asset (real option) have to be contingent on an specified event occurring within a finite period. When does that real option have significant economic value? • For an option to have significant economic value, there has to be a restriction on competition in the event of the contingency. • At the limit, real options are most valuable when you have exclusivity - you and only you can take advantage of the contingency. They become less valuable as the barriers to competition become less steep. Can that value be estimated using an option pricing model? • The underlying asset is traded - this yield not only observable prices and volatility as inputs to option pricing models but allows for the possibility of creating replicating portfolios • An active marketplace exists for the option itself. • The cost of exercising the option is known with some degree of certaint Aswath Damodaran 40 Putting Natural Resource Options to the Test The Option Test: • Underlying Asset: Oil or gold in reserve • Contingency: If value > Cost of development: Value - Dev Cost If value < Cost of development: 0 The Exclusivity Test: • Natural resource reserves are limited (at least for the short term) • It takes time and resources to develop new reserves The Option Pricing Test • Underlying Asset: While the reserve or mine may not be traded, the commodity is. If we assume that we know the quantity with a fair degree of certainty, you can trade the underlying asset • Option: Oil companies buy and sell reserves from each other regularly. • Cost of Exercising the Option: This is the cost of developing a reserve. Given the experience that commodity companies have with this, they can estimate this cost with a fair degree of precision. Bottom Line: Real option pricing models work well with natural resource options. Aswath Damodaran 41 The Real Options Test: Patents and Technology The Option Test: • Underlying Asset: Product that would be generated by the patent • Contingency: If PV of CFs from development > Cost of development: PV - Cost If PV of CFs from development < Cost of development: 0 The Exclusivity Test: • Patents restrict competitors from developing similar products • Patents do not restrict competitors from developing other products to treat the same disease. The Pricing Test • Underlying Asset: Patents are not traded. Not only do you therefore have to estimate the present values and volatilities yourself, you cannot construct replicating positions or do arbitrage. • Option: Patents are bought and sold, though not as frequently as oil reserves or mines. • Cost of Exercising the Option: This is the cost of converting the patent for commercial production. Here, experience does help and drug firms can make fairly precise estimates of the cost. Bottom Line: Use real option pricing arguments with caution. Aswath Damodaran 42 The Real Options Test for Growth (Expansion) Options The Options Test • Underlying Asset: Expansion Project • Contingency If PV of CF from expansion > Expansion Cost: PV - Expansion Cost If PV of CF from expansion < Expansion Cost: 0 The Exclusivity Test • Barriers may range from strong (exclusive licenses granted by the government) to weaker (brand name, knowledge of the market) to weakest (first mover). The Pricing Test • Underlying Asset: As with patents, there is no trading in the underlying asset and you have to estimate value and volatility. • Option: Licenses are sometimes bought and sold, but more diffuse expansion options are not. • Cost of Exercising the Option: Not known with any precision and may itself evolve over time as the market evolves. Bottom Line: Using option pricing models to value expansion options will not only yield extremely noisy estimates, but may attach inappropriate premiums to discounted cashflow estimates. Aswath Damodaran 43 Summarizing the Real Options Argument There are real options everywhere. Most of them have no significant economic value because there is no exclusivity associated with using them. When options have significant economic value, the inputs needed to value them in a binomial model can be used in more traditional approaches (decision trees) to yield equivalent value. The real value from real options lies in • Recognizing that building in flexibility and escape hatches into large decisions has value • Insights we get on understanding how and why companies behave the way they do in investment analysis and capital structure choices. Aswath Damodaran 44 Valuation Models Asset Based Discounted Cashflow Relative Valuation Contingent Claim Valuation Models Models Liquidation Equity Sector Option to Option to Option to Value delay expand liquidate Stable Current Firm Market Young Equity in Replacement Two-stage firms troubled Cost Normalized firm Three-stage or n-stage Earnings Book Revenues Sector Undeveloped Value specific land Equity Valuation Firm Valuation Models Models Patent Undeveloped Dividends Reserves Cost of capital APV Excess Return Free Cashflow approach approach Models to Firm Aswath Damodaran 45 Which approach should you use? Depends upon the asset being valued.. Asset Marketabili ty and Val uation Approaches Mature businesses Growth businesses Separable & marketable assets Linked and non-marketable assets Liquidation & Other valuation models Replacement cost valuation Cash Flows and Val uati on Approaches Cashflows currently or Cashflows if a contingency Assets that will never expected in near future occurs generate cashflows Discounted cashflow Option pricing models Relative valuation models or relative valuation models Uni queness of Asset and Valuati on Approaches Large number of similar Unique asset or business assets that are priced Discounted cashflow Relative valuation models or option pricing models Aswath Damodaran 46 And the analyst doing the valuation…. Investor Time Hori zon and Val uati on Approaches Very short time horizon Long Time Horizon Liquidation value Relative valuation Option pricing Discounted Cashflow value models Views on market and Val uati on Approaches Markets are correct on Asset markets and financial Markets make mistakes but average but make mistakes markets may diverge correct them over time on individual assets Relative valuation Liquidation value Discounted Cashflow value Option pricing models Aswath Damodaran 47