fairvalue - Fair Value: Fact or Opinion A s w a th D a m o...

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Aswath Damodaran 1 Fair Value: Fact or Opinion Aswath Damodaran
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Aswath Damodaran 2 Fair value is in the eyes of the beholder… Don t measure fair value by precision : As uncertainty about an asset’s cash flows increase, the estimates of fair value made by different analysts will also diverge. Some assets will therefore always have more precise estimates of fair value than others. Bias will always permeate fair value estimates : Much as we pay lip service to the notion that we can estimate fair value objectively, bias will find its way into fair value estimates. Honesty about the bias is all that we can demand of analysts. A good estimate of fair value is one where you will be willing to be either buyer or seller with real money. Simple models will trump more complex models : More rules and complexity will not always yield better estimates of fair value.
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Aswath Damodaran 3 Approaches to estimating fair value Discounted cashflow valuation , relates the value of an asset to the present value of expected future cashflows on that asset. Relative valuation , estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales.
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Aswath Damodaran 4 I. Discounted Cashflow Valuation: The fair value of an asset is… where CF t is the expected cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and n is the life of the asset. Proposition 1: The ease of valuing an asset is not a function of how tangible or intangible it is but whether it generates cash flows and how easy it is to estimate those cash flows. Proposition 2: Assets that are independent and generate cashflows on their own are easier to value than assets that generate intermingled cash flows. Proposition 3: Assets with finite and specified lives are easier to value than assets with unspecfiied or infinite lives. Value of asset = CF 1 (1+r) 1 + CF 2 2 + CF 3 3 + CF 4 4 ..... + CF n n
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Aswath Damodaran 5 Two Measures of Cash Flows Cash flows to Equity : Thesea are the cash flows generated by the asset after all expenses and taxes, and also after payments due on the debt. This cash flow, which is after debt payments, operating expenses and taxes, is called the cash flow to equity investors . Cash flow to Firm : There is also a broader definition of cash flow that we can use, where we look at not just the equity investor in the asset, but at the total cash flows generated by the asset for both the equity investor and the lender. This cash flow, which is before debt payments but after operating expenses and taxes, is called the cash flow to the firm
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Aswath Damodaran 6 Two Measures of Discount Rates Cost of Equity : This is the rate of return required by equity investors on an investment. It will incorporate a premium for equity risk -the greater the risk, the greater the premium.
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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fairvalue - Fair Value: Fact or Opinion A s w a th D a m o...

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