valenh - Value Enhancement Back to Basics Aswath Damodaran...

Aswath Damodaran 146
Value Enhancement: Back to Basics

Aswath Damodaran 147
Price Enhancement versus Value
Enhancement

Aswath Damodaran 148
Discounted Cash Flow Valuation: The Steps
n
Estimate the discount rate or rates to use in the valuation
• Discount rate can be either a cost of equity (if doing equity valuation) or a
cost of capital (if valuing the firm)
• Discount rate can be in nominal terms or real terms, depending upon
whether the cash flows are nominal or real
• Discount rate can vary across time.
n
Estimate the current earnings and cash flows on the asset, to either
equity investors (CF to Equity) or to all claimholders (CF to Firm)
n
Estimate the future earnings and cash flows on the asset being
valued, generally by estimating an expected growth rate in earnings.
n
Estimate when the firm will reach “stable growth” and what
characteristics (risk & cash flow) it will have when it does.
n
Choose the right DCF model for this asset and value it.

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Cashflow to Firm
EBIT (1-t)
- (Cap Ex - Depr)
- Change in WC
= FCFF
Expected Growth
Reinvestment Rate
* Return on Capital
FCFF
1
FCFF
2
FCFF
3
FCFF
4
FCFF
5
Forever
Firm is in stable growth:
Grows at constant rate
forever
Terminal Value= FCFF
n+1
/(r-g
n
)
FCFF
n
........
Cost of Equity Cost of Debt
(Riskfree Rate
+ Default Spread) (1-t)
Weights
Based on Market Value
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity
Value of Operating Assets
+ Cash & Non-op Assets
= Value of Firm
- Value of Debt
= Value of Equity
Riskfree Rate :
- No default risk
- No reinvestment risk
- In same currency and
in same terms (real or
nominal as cash flows
+
Beta
- Measures market risk
X
Risk Premium
- Premium for average
risk investment
Type of
Business
Operating
Leverage
Financial
Leverage
Base Equity
Premium
Country Risk
Premium
DISCOUNTED CASHFLOW VALUATION

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Cashflow to Firm
EBIT(1-t) : 2196
- Nt CpX 1549
- Chg WC 253
= FCFF 394
Expected Growth
in EBIT (1-t)
.8206*.0996 = .0817
8.17 %
465 503 544 589 637
Forever
Stable Growth
g = 4%; Beta = 0.87
Country risk prem = 0%
Reinvest 40.2% of EBIT(1-t): 4%/9.96%
Terminal Value
5
= 2024/(.0686-.04) = 70,898
Cost of Equity
9.05%
Cost of Debt
(4.24%+ 0.20%)(1-.4908)
= 2.26%
Weights
E = 84.16% D = 15.84%
Discount at Cost of Capital (WACC) = 9.05% (0.8416) + 2.26% (0.1584) = 7.98%
50.457
- 9809= 40.647
Per Share: 7.73 E
Riskfree Rate :
Government Bond
Rate = 4.24%
+
Beta
0.87
X
Risk Premium
4.0% + 1.53%
Unlevered Beta for
Sector: 0.79
Firm’s D/E
Ratio: 18.8%
Mature Mkt
Premium
4%
Country Risk
Premium
1.53%
Telecom Italia: A Valuation (in Euro
Reinvestment Rate
82.06%
Return on Capital
9.96%
WC : 13% of
Revenues

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Current Cashflow to Firm
EBIT(1-t) : 1,395
- Nt CpX 1,012
- Chg WC 290
= FCFF 94
Reinvestment Rate =93.28%
Expected Growth
in EBIT (1-t)
.9328*.1162= .1084
10.84 %
Stable Growth
g = 5%; Beta = 1.00;
ROC=11.62%
Reinvestment Rate=43.03%
Terminal Value
5
= 1397/(.10-.05) = 27934
Cost of Equity
11.16%
Cost of Debt
(6%+ 1.00%)(1-.35)
= 4.55%
Weights
E = 100% D = 0%
Discount at Cost of Capital (WACC) = 11.16% (1.00) + 4.55% (0.00) = 11.16%
Asset Value: 16923
+ Cash: 4091
- Debt: 0
=Equity 21,014
-Options 538
Value/Share $12.11
Riskfree Rate :
Government Bond
Rate = 6%
+
Beta
1.29
X
Risk Premium
4%
Unlevered Beta for
Sectors: 1.29
Firm’s D/E
Ratio: 0%
Historical US
Premium
4%
Country Risk
Premium
0%
Compaq: Status Quo
Reinvestment Rate
93.28%
Return on Capital
11.62% (1998)
EBIT(1-t)
- Reinv
FCFF
$2,451
$ 1054
$1,397
$1,546.62 $1,714.30