• Bottom up betas
• Cost of debt
• Weights for cost of capital
• Dealing with hybrids

Before I get started, I wanted to mention that Professor Aswath Damodaran left a comment on a previous post. He has offered to respond to our questions if we get stuck on a topic.  I’ll gather up any questions we can’t resolve on our own and email them to the good professor.

Session 5 picks up on slide 55 of the Discounted Cashflow Valuation slide presentation. The discussion starts with how ideally betas should be for the business that a firm is in and then adjusted for operating leverage. To adjust for operating leverage, you need to know the breakdown of fixed and variable costs. However, it is not always easy to get information on fixed and variable costs. Therefore, the conventional approach is to adjusting betas for financial leverage using the debt to equity ratio, because it is much more straight forward. One think to keep in mind is that debt can have some market risk and impact beta.

Bottom-Up Betas

Slide 58 provides a schematic overview of how a bottom-up beta is calculated. The following steps are taken when calculating bottom-up betas:

1. Adjust for the business lines that the company as in.
2. Get unlevered beta for those businesses.
3. Estimate the proportion of value the firm derives from each of the businesses.
4. Develop weighted average for the betas.
5. Adjust for debt to equity ratio to get the levered beta for the firm.

The professor mentions that you probably should adjust for cash. You can assume the beta of cash is zero. Damodaran believes we should strive to use alternatives to regression betas. I can’t say I disagree.

Here are some of the benefits to using bottom-up betas: 

• Standard error is lower for bottom-up beta.
• Can be adjusted to business mix and financial leverage.
• You can do it even without historical stock prices.

Professor Damodaran applied the bottom-up beta to SAP (SAP) as an example. If you are interested in doing your own bottom-up betas, I recommend you study this portion of the lecture.  I found it interesting that since SAP’s software and consulting businesses have different margins, the weighting for the betas from each of these business lines should not be based solely on the proportion of revenues generated from each of the businesses.

On Damodaran’s website there is a table of unlevered betas by industry.  If you navigate to his main financial data webpage, you can also find unlevered betas by industry for various countries.

If you have a fairly unique company you are struggling to develop a bottom-up beta, try expanding your universe for comparables or even go up or down the supply chain.  When searching for comparables you should ask whether the company you are looking at goes down when the comparable goes down. Look at the correlation between revenues over time.

Cost of Debt 

Cost of Debt = rate at which you can borrow money today for the long term.

Professor Damodaran discusses a little debate his students are having between using the 30 year bond and 10 year bond for the risk free rate.  The difference is inconsequential. What you really want is to match the historical period selected to the equity risk premium for that time period. The 30 year bond usually has a higher interest rate but the equity risk premium should be lower. The equity risk premium is around 4.81 instead for 30 years.

You can be a risky company that can issue a safe bond by backing it with you best assets.  This is something you should watch out for according to Professor Damodaran. Instead you should look at the company’s debt rating for cost of debt. I usually get this from Moody’s or S&P. If a company’s debt is not rated, you can create a synthetic ratio using the following formula:

Interest Coverage Ratio = EBIT/Interest Expense

Then you can convert that ratio into a rating by looking up companies with ratings and looking at their interest coverage ratio. BondsOnline provides a snapshot of default spreads in any one point in time for a fee. The default spread changes over time, so you might need to look this up about once a year. Primarily, you want to adjust for country default spread. Being in an emerging market pushes up your cost of debt.

The next topic gets into adjusting for subsidies, primarily subsidized interest rates. Should cost of subsidized debt be used when subsidies are? It is safer to consider subsidies separately. You could instead value the subsidy separately. You need to consider what the cost of getting the subsidy is, such as higher operating costs for locating in areas with less skilled labor pools. You also need to consider how long the subsidy will potentially last.

Weights for Cost of Capital

According to Damodaran, weights should always be based on market value. Why do we use market value weights to get the cost of capital?

• To be consistent with what you have to pay at the prevailing market prices.
• It is a hypothetical acquisition valuation.
• That is what you have to pay today to buy the company.

One thing to keep in mind, the market value of equity cannot fall below zero. There is a  short cut for making currency adjustment on slide 72. You just take the difference between T-bills and TIPS rates to get the expected rate of inflation. Then you need the ratio of the inflation rate in the foreign currency to the inflation rate in dollars.

Dealing with Hybrids

Hybrids include convertible bonds and similarly preferred stock. Damodaran recommends trying to stay with the costs of debt and equity. You just break about the equity like portion from the debt like portion of the convertible bond.

In summary:

Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + Cost of Borrowing (1-t) (Debt/(Debt + Equity))

The next class will finally get into looking at cash flows from:

• Dividends
• Free Cash flows to equity
• Free cash flows to the firm

Be careful not to fall into accounting definitions of these numbers:

• Operating income = revenue – true operating expenses
• Capital expenses = investment in long term assets
• Working capital = investment in short term assets

I hope I haven’t lost all of you with all this talk about CAPM and betas. I’m looking forward to the next few lectures a lot more than I have to the past two. We will be moving into the more useful and practical topics regarding cash flows.

Country Equity Risk Premiums 

This week’s class started on the topic of country equity risk premiums on slide 32 of the Discounted Cashflow Valuation presentation (pdf). Professor Damodaran started out by noting that India just received an investment grade rating for the first time. One typically expects as country risk goes down that usually expect equity values go up. This wasn’t really clear for India’s stock prices after the rating increase earlier this year.

I had a few issues with the discussion of country equity risk premiums, so I’ll keep this short. Damodaran presents three way country equity risk premium can be estimated:

1. Assume that every company in the country is equally exposed to country risk.
2. Assume that a company’s exposure to country risk is similar to its exposure to other market risk (i.e., Beta).
3. Treat country risk as a separate risk factor and allow firms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales)

I think the third approach made the most sense. In this approach, Damodaran creates a term he labels λ. This lambda measures a company’s risk exposure to a country
based upon the proportion of its revenues that come from non-domestic sales, location of its production facilities, and use of risk management products. The thought here is that a company’s country risk exposure is determined by where it does business, not necesarily by where it is located. Really, the only practical component of country risk that can be easily measured is the proportion of revenues generated by a company in each country.

Damodaran looks at how sensitive a company is to country risk by regressing it its earnings to the country’s bond rate. There is also a cross market risk factor. If the Russian stock market collapse, it still causes impacts in far away Singapore. Damodaran believes there is a joint risk factor among emerging markets. I think this is a reasonable assumption given how global markets have become and also based on my experience at seeing how a market shock in China can ripple throughout all the world markets.

Damodaran notes that equity research analysts may be assigning too much risk to some emerging market companies that generate most of their revenues in developed stable countries such as the US. He then lays out a strategy for taking advantage of this potential miscalculation. He recommends identifying a few companies in each country that generate most of their revenues in stable countries. Then under this strategy we should wait for a crisis in an emerging market before investing. I like the concept of waiting for a crisis, but I think two other things need to be factored in. First, I think in addition to selecting emerging market companies that generate most of their revenues in stable countries, we should also give preference to those companies that have global competitive advantages. Second, we should be cautious in investing after a crisis in an emerging market if critical infrastructure utilized by a selected company has been severely damaged or if property rights are in danger of collapsing.

Lower and more stable interest rates are good for equity risk. Shifting equity risk premiums comes from investors’ stomachs. Each morning we wake up with a different gut sense of how risky the world is and this collective gut sense impacts the mood of Mr. Market. Most daily fluctuations in stock prices come from changes in our perceived risk.

I found it interesting that Damodaran notes that historical risk premiums (probably the most commonly used) are too high and will result in you finding stocks to be overvalued. Using the current implied equity risk premium is more market neutral. The average implied equity risk premium between 1960-2003 in the United States is about 4%. When using the historical implied equity risk premium, you are assuming that the market is correct on average but not necessarily at any given point in time.

Beta 

Beta is probably the least useful topic in this course, but it is still good to know what it is. The standard procedure for estimating betas is to regress stock returns against market returns. The slope of the regression is Beta. In reality, regression beta calculations are a waste of time because they depend highly on the index chosen.

There are a few non-regression based methods for estimating Beta. You could look at the standard deviation in stock prices instead of regressing against an index. You could also regress accounting earnings or revenues against those of an index. This seems somewhat more attractive but still probably not worth the effort.

I recommend looking at slide 54, which has a diagram of beta of equity. I think this slide does a good job at breaking down the sources of potential risk faced by companies. The diagram breaks risk down into risks that come from the nature of the products and/or services provided by a company, the amount of fixed costs in proportion to total costs, and obviously financial leverage.  I would add a category for the risks associated with bad management and the risks associated with loosing any competitive advantages a company may have due to increasing competition or potential technological change.

This lecture ended on the topic of bottom up beta. This is Damodaran’s preferred method and what he will discuss in the next lecture.

Here is this week’s discussion question: 

How should value investors utilize the concepts of country equity risk premium and betas?

Professor Damodaran explains that cash flows to equity are cash flows after debt payments and that cash flows to firm are cash flows before debt payments. When valuing a company using cash flows to firm, one needs to use the cost of capital when discounting the cash flows and then you need to subtract out debt. 

The most important part of this discussion is Damodaran’s recommendation to pick an approach and stick with it. Don’t mix and match. I must admit that in the past I’ve gotten confused and probably mixed and match components of valuing stocks by discounting cash flows to equity and valuing stocks by discounting cash flows to firm. The professor point out three main mistakes that you need to watch out for, which include:

1. Discounting cash flows to equity at the cost of capital to get equity value
2. Discounting cash flows to firm at cost of equity to get firm value
3. Discounting cash flows to firm at cost of equity, forget to subtract out debt, and get too high a value for equity

Make sure that you don’t make any of these mistakes the next time you try to value a stock. When you see net income being used to value a company, you can tell that what is being discounted is the cash flows to equity and that the cost of equity should be used for the discounting. These distinctions are important because the cost of debt is cheaper than equity.

Professor Damodaran breaks down discounted cash flows (DCF) valuation into 5 steps on slide 11 of the course presentation. This a very important slide that I recommend you review it. DCF boils down to:

1. Getting the current cash flows.
2. Getting the growth rate for those cash flows in the near term.
3. Determining when the company will enter stable growth
4. Choose a discount rate to apply to the cash flows

The dividend discount model is the most basic DCF model. This model strictly looks at the flows of cash flows to equity in terms of dividends paid to shareholders. This method was detailed in 1938 by John Burr Williams in his classic book, The Theory of Investment Value.

There are several problems with this dividend discount technique. It is not a problem if a company is not able to pay a dividend right now, but if the company will be unable to pay a dividend in the future this method breaks down. Companies that payout dividends that are different than what they can afford to payout are a real problem under this method.

The dividend discount model often will result in too low a value since cash flows left over after paying dividends are considered burned up. One way around this drawback is to focus on what a company could have paid out in dividends. You just replace actual dividends with potential dividends. This then basically becomes the cash flows to equity model.

The other DCF approach looks at cash flow to the firms.  This is predebt cash flows. All you value is operating income.  Then you add back other assets like cash and subtract out the debt. This is basically the method I often use when I value stocks by discounting future free cash flows (operating cash flows minus capital expenditures).

After briefly reviewing the main valuation models, the course shifts gear into looking at DCF inputs.  The rest of this session focuses on the discount rate. Professor Damodaran admits that discount rates are not as critical as getting the cash flows right and the growth rates of those cash flows.  I tend to give very little attention to discount rates when I value a company. However, I am curious as to how the “professionals” determine discount rates.

The professor makes a few points about cash flows. First you pick the currency that will be used for both cash flows and for determining the discount rate. Also, if you do your cash flows in nominal terms, then your discount rate needs to be in nominal terms. Nominal simply means that the rates haven’t been adjusted for inflation.  For the most part, you will likely use nominal rates because they are the easiest to get directly.

Damodaran thinks its irrelevant to think in terms of how much risk we individually see in a company when valuing it. I don’t agree with that point.  If institutional investors do not see much risk in a particular company, but my own research of a company results in me seeing lots of risk and I’m right about that risk, then my individual view on risk is indeed important.

Professor Damodaran also briefly discussed the major ways the costs of equity is determined.  The models include CAPM, Arbitrage Pricing Model (APM), multi factor, and the proxy model. The CAPM method is made up of three factors:

1. Beta – Risk in the stock that cannot be diversified away
2. Risk free rate – The average rate on risk free securities
3. Risk premium

I personally do not think it is worth spending too much effort on determining the cost of equity for discounting future cash flows.  I’d rather assume a constant discount rate for all equities and then adjust my margin of safety to address company specific risk. Max left a comment in the previous lesson that also questions estimating cost of capital using betas and country risk premiums.

I did find the discussion of the risk free rate to be of interest. The risk free rate should have no default risk. This excludes corporate bonds, so we are really looking at government bonds.  However, not all government bonds are risk free.

In addition, the risk free rate should have no reinvestment risk associated. This reinvestment risk comes from the potential that when for example a six month T-bill needs to be reinvested, there is the real risk that interest rates on T-bills could drop. Professor Damodaran recommends that we should match up cash flow lengths to the length of bonds used to determine the risk free rate. I tend to use the 10 year U.S. Treasury Note for my risk free rate. Basically for equity valuation, the risk free rate should be derived from long term securities that are default free and match the currency of cash flows. The U.S. geometric average risk free rate from 1994-2004 is 4.51%. Professor Damodaran mentions that using the U.S. rate for risk premium could be biased since the U.S. equity market was the most successful in the twentieth century. A lower risk premium of 4% over a range of countries may be more appropriate (see slide 28).

The final part of this class looked at estimating the risk free rate using various techniques for other countries, especially emerging markets. I’m not sure why using the average global rate would not be more appropriate since using a country specific rate for an emerging country might be downwardly biased.

Please share your comments and questions on this class session in the comments section below.

We are now on session two of Equity Instruments. The lecture starts off by following the Introduction to Valuation presentation slides. This session start with slide 4 on “Misconceptions about Valuation”.

Bias in equity valuation is the first topic covered. Professor Damodaran lays out two scenarios. First, an investment banker in a friendly merger will be tempted to raise their valuation to justify the price being offered in a merger. They might change the growth rate higher, lower the discount rate, improve margins, increase cash flows, reduce reinvestment, and add an arbitrary control premium. As a user of equity valuations, you need to ask the right questions.

The second scenario is a private business owner asking for a valuation for estate tax purposes. The bias will be to lower the price for appraisal valuations.  They apply discounts for liquidity, etc.

Key questions to ask about a valuation:

• Who is doing the valuation?
• What are the potential biases?

Remember: Don’t lie to yourself in your valuations!

Professor Damodaran makes a good point about the main misconception about valuation. That is if I do valuation right, I will get the right answer. However, we just don’t know what the right answer is. If you cannot handle this kind of uncertainty, don’t get into stocks.

Damodaran also notes that the payoff is often best for equities you are most uncomfortable valuing. I don’t agree that we should always try to value the incredibly uncertain situations with some businesses. I remember a Buffett quote, “If I was teaching a course in business school, I’d ask the students to value an Internet company for the final. Anyone who turns in any number for valuation, will fail the class.” I share Buffett’s feelings on valuing highly uncertain businesses. I think Damodaran pushes a techniques a bit too far in their ability to value highly uncertain situations.

I laughed when I heard, “If I make my model bigger, it will get better.” This is another misconception about valuation that Damodaran points out. I think we should be all leary of complex valuation models.  Two things result from overly complex models:

1. Input fatigue – You end up inputting a random number after input number twelve according to Damodaran. (Hehe.) With more details, your assumptions end up hiding in all the information.
2. The model becomes a black box – You have no idea what makes the model work. If you ever read, “The model valued the company at $x,” watch out. This likely means the analyst doesn’t know how it works and/or doesn’t believe in the results of the model. The professor doesn’t ever want to hear us say the Damodaran spreadsheet came up with it.

Don’t try to value cash! Don’t estimate items you can simply measure the value.

Only new concept in valuation in recent time is real option model valuation.  The rest, discounted cash flows and relative valuation, have always been around.

Discounted Cash Flow Valuation 

I think the professor made a good point in reminding us that every valuation approach assumes markets make mistakes. What are we trying to do with discounted cash flow valuation? We are trying to estimate the intrinsic value or “true” value of an asset.

DCF Assumptions:

1. We need to assume that markets make mistakes.
2. We need to assume you can find the mistakes using your discounted cash flow model.

Here’s the unfair part of investing based on valuation; you can do everything right and go bankrupt. The market can be wrong longer than you can wait. This is why long term investing is so important.

The biggest advantage of discounted cash flow (DCF) valuation is that the valuation is disconnected from the market. If you are valuing businesses like Buffett according to Damodaran, then discounted cash flow valuation is tailor made for you. You are forced to understand how businesses work. However, those advantages are also the disadvantages of DCF valuation. Yikes!

An important point is that the whole market could end up looking overvalued with DCF. We need to remember that investing is like a no strikes called baseball game. We don’t have to invest in stocks when the market is overvalued. I actually try to wait for the fat pitches before I take any big swings at a stock.

Another disadvantage is that it takes a lot more time and resources to do discounted cash flows valuations versus relative valuation. However, I believe the advantages of DCF outweigh the additional costs of time and resources if you truly want to outperform the market.

Relative Valuation

With relative valuation, you value an asset based on how similar assets are priced. Most valuations are relative valuations. There are three main information needs for relative valuation:

1. Set of comperable assets
2. Standardized prices – multiples
3. Variables to control for differences

With relative valuation, you think on average markets are efficient, but on occassion prices are mispriced and stick out. It assumes mispricing assets are relatively rare.

It is not surprising that relative valuation is used if you as an analyst are judged on your relative performance versus absolute performance. You see this with all the mutual and even hedge fund managers. However, since I work for myself, I am only concerned about absolute performance. I try to avoid using relative valuation.

What if all of the stocks are expensive? With relative valuations, you’ll end up just buying the cheaper of overvalued assets. You can’t expect to make money in these type of situations. You just hope to loose less than the market.

Another danager the professor indicates is that you  tend to make implicit assumptions with relative valuations that you might not realize. I didn’t quite follow this point, so I’d be interested to hear your take on what this actually means. 

Relative valuation works best when the comparable assets are similar. It is very challenging with stocks, since they are never really that similar to each other.

What approach would work for you?

• Discounted cash flow valuation or
• Relative valuation

List your choice in the comments section now and then we will revisit this question in the last session again to see if your position has changed at all.

Option Valuation

Also know as contingent valuation. You can use option price model for stocks when these three following features line up:

1. There is an underlying asset which has value.
2. The payoff on the option occurs only if the value of the underlying asset is greater than the excercise price.
3. There is a fixed life

Examples include a patent held by a biotech company, unexploited reserves held by a natural resource company and Delta Airlines stock. With Delta Airlines stock, there is the hope that something good will happen. 95% of the time, nothing good happens.

Options valuation is the fall back position for convential valuation. Things get flipped around in option valuation.  As risk increases, options become more valuable. Weird!

Option valuation can get you into trouble if you are not careful. The inputs are difficult to get for real options.

Discounted Cashflow Valuation 

After this introduction to valuation, Professor Damodaran moves to the Discounted Cashflows Valuation presentation. He discusses the equation that drives discounted cash flows valuation.

Cash flows have to be positive in some point in time for DCF.  Valuation can be for the whole business or just the equity of the business. Dividend discount model is the most strict cash flows to equity valuation model.

What debt to subtract out to get from the value of the firm to the value of the equity? That’s a great question that I have often had. The debt you use in your cost of capital is a starting point.

The professor uses the example of Merck (MRK).  For a discounted cashflows to firm valuation you should really subtract out cost of the contingent liability for the Vioxx litigation. The liability makes equity less valuable.

The weekly challenge is to value the same company twice; once a discounted cashflow to the firm and then to equity? We should be able to value of equity the same with both methods. The professor asks, “What are the asumptions that make the valuations converge?” You should try to figure this out and discuss it in the comments section below.

Full Disclosure: I own shares of Merck.

First, I recommend that you start by watching the introduction to Equity Instruments. You will need to install the free Real Player to watch this class video. There will be a webcast for each of the 26 class sessions. For this first class, you will also want to pick up the three handouts, the syllabus, the project description, and the intro class presentation slides. 

There are also 3 books on valuation by Damodaran that are recommended:

1. Damodaran on Valuation - newest
2. Investment Valuation – most comprehensive
3. The Dark Side of Valuation

I’ll be using the online manuscript for my text for this class since I’m already familiar with it. There are also additional valuation readings that go along with the course.

In this first lecture, Professor Damodaran gives the background history about this class, misleadingly called Equity Instruments and Markets.  Even though the class is called Equity Instruments and Markets, it is really a valuation class. This is the old Ben Graham Security Analysis class, except Professor Damodaran has lopped off most of the material on bonds.

I recommend you skip to minute 14 in this first webcast to get past the housekeeping stuff for this course.  You could even consider skipping the whole first hour if you are tight on time.

Course inspiration: “Everything is a valuation problem ultimately.”

“Every asset has a value; we just don’t know what it is,” states Professor Damodaran as the basic theme of this course.  I’m excited about this class because, we are really going to get into the details of valuing businesses and then the common stock of those businesses.

Damodaran is going to cover 3 approaches to valuation over the semester:

1. Intrinsic value – discounted cash flow models and beyond
2. Relative valuation models – compared to other companies. What people are “willing to pay”
3. Contingent claim valution – option valuation for valuing businesses

The classes will start by looking at the differences in valuation approaches, the advantage and disadvantages of the different approaches, and why you might use the different approaches depending on the situation. After briefly covering those issues, there will be 6 sessions grinding through the details of valution. These session will cover the basics of corporate finance. After getting the mechanics down, there will be 3 sessions on actually valuing companies. After we make it to this point, Damodaran states that we should then be able to value a company every ten minutes. That sounds pretty impressive to me.

The course then moves to relative valution after the 11th session. Most valuations we read about are relative valuations. I’m not a big fan of relative valuations but I’m curious to hear what the professor has to say about how to use relative valuation the right way. The relative valuation sessions will start with PE and move all the way to enterprise value ratios, such as the enterprise value to revenue ratio. I’m most interested in learning how to avoid the obvious traps Professor Damodaran knows about.

The course then covers valuing private businesses. The key issue with private company valuation appears to hinge on estimating cash flows when financials might be full of holes.

Then the class will cover the topic of using the option pricing model to value businesses. Damodaran will provide specific cases when the options model is useful and when it is not. As a value investor, I’m not sure I’ll be using the options pricing model very often but it might serve as a useful mental model.

Finally, the course will cover acquisition valuation and valuation enhancement. The professor made some interesting comments on the 20% control premium rule of thumb in M&A. It is apparently based on the averge premium paid over the market price over all transactions. The data comes from MergerStat. Damodaran speculates, however, that this premium could just be stupidity, ego, etc.

There is a project associated with this class that I would like us to also do.  The project involves valuing companies as a group and applying all the valuation techniques on a real company. We should have each member of the study group take a company.  The professor suggests that we include at least one money loosing company, one high revenue growth company, one non-US company, and one service company.

“There is no such thing as certainty,” states Professor Damodaran when it comes to valuations. Most people don’t believe in valuation according to Damodaran. He explains that he does valuation to fight the lemming effect. “They must know something I don’t know” are the seven deadliest words in valuation according to Damodaran. There is a lemming inside of each of us trying to get out and they can be lumped into three groups:

1. Proud lemmings – Momentum investor
2. Yogi bear lemmings – They think they are smarter than the average bear. They go to the edge and then think they can pull away.
3. Lemmings with a life vest – valuation slows the process down, so we have something else holding us besides hope.

Perception effects price, but fundamentals determine value. I totally agree with that.

There are some misconceptions about valuations. Valuations are not objective or scientific. Valutions are more of an art.  We should realize that they are biased. Valuations will also be effected by who is paying you for the valuation.

I got a kick out of Damodaran’s comment on the illusion of extra decimal points. I try to avoid looking at pennies and cents with all the uncertainty involved in valuing companies. But as Damodaran points out, adding those stray decimal points can make you look smart at work.

The other word of wisdom shared by Professor Damodaran is that meeting the management of a company will introduce bias that will really effect your valuation. He thinks it’s best to know nothing about a company to avoid biases. However, I’m not sure this is true for individuals that are really good at reading people. Regardless, I’m not one of those individuals gifted with the ability to judge people accurately based on a face to face meeting.

That’s it for the first lecture. I’ll be sending out an email to everyone who showed interest in joining a study group to let them know that we have started.  We can use the comments section below this post to discuss this class session. Let us know what company you might want to research for the class valuation project.

I plan on completing another class session this week.  After that, we can meet every Tuesday night here to discuss the next class. Time to hit the books.