Investment Valuation

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FM p.i-xvi.qxd12/8/113:31 PMPage iiFounded in 1807, John Wiley & Sons is the oldest independent publishing company in theUnited States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services forour customers’ professional and personal knowledge and understanding.The Wiley Finance series contains books written specifically for finance and investmentprofessionals as well as sophisticated individual investors and their financial advisors.Book topics range from portfolio management to e-commerce, risk management, financialengineering, valuation and financial instrument analysis, as well as much more.For a list of available titles, please visit our Web site at www.WileyFinance.com.

FM p.i-xvi.qxd12/8/113:31 PMPage iiiInvestmentValuationTools and Techniques forDetermining the Value of Any AssetThird EditionASWATH DAMODARANwww.damodaran.comWILEYJohn Wiley & Sons, Inc.

FM p.i-xvi.qxd12/8/113:31 PMPage ivCopyright 2012 by Aswath Damodaran. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any formor by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except aspermitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the priorwritten permission of the Publisher, or authorization through payment of the appropriate per-copy feeto the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400,fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permissionshould be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken,NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best effortsin preparing this book, they make no representations or warranties with respect to the accuracy orcompleteness of the contents of this book and specifically disclaim any implied warranties ofmerchantability or fitness for a particular purpose. No warranty may be created or extended by salesrepresentatives or written sales materials. The advice and strategies contained herein may not besuitable for your situation. You should consult with a professional where appropriate. Neither thepublisher nor author shall be liable for any loss of profit or any other commercial damages, includingbut not limited to special, incidental, consequential, or other damages.For general information on our other products and services or for technical support, please contact ourCustomer Care Department within the United States at (800) 762-2974, outside the United States at(317) 572-3993 or fax (317) 572-4002.Wiley also publishes its books in a variety of electronic formats. Some content that appears in printmay not be available in electronic books. For more information about Wiley products, visit our website at www.wiley.com.Library of Congress Cataloging-in-Publication Data:ISBN 978-1-118-01152-2Printed in the United States of America10 9 8 7 6 5 4 3 2 1

FM p.i-xvi.qxd12/8/113:31 PMPage vI would like to dedicate this book to Michele, whose patienceand support made it possible, and to my four children—Ryan, Brendan, Kendra, and Kiran—who provided the inspiration.

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FM p.i-xvi.qxd12/8/113:31 PMPage viiPreface to the Third Editionhis is a book about valuation—the valuation of stocks, bonds, options, futuresand real assets. It is a fundamental precept of this book that any asset can be valued, albeit imprecisely in some cases. I have attempted to provide a sense of notonly the differences between the models used to value different types of assets, butalso the common elements in these models.The last decade has been an eventful one for those interested in valuation forseveral reasons. First, the growth of Asian and Latin American markets broughtemerging market companies into the forefront and you will see the increased focuson these companies in this edition. Second, we saw the havoc wreaked by macroeconomic factors on company valuations during the bank crisis of 2008, and a blurring of the lines between developed and emerging markets. The lessons I learnedabout financial fundamentals during the crisis about risk-free rates, risk premiumsand cash flow estimation are incorporated into the text. Third, the last year has seenthe influx of social media companies, with small revenues and outsized market capitalizations, in an eerie replay of the dot-com boom from the late 1990s. More thanever, it made clear that the more things change, the more they stay the same. Finally,the entry of new players into equity markets (hedge funds, private equity investorsand high-frequency traders) has changed markets and investing dramatically. Witheach shift, the perennial question arises, “Is valuation still relevant in “this” market?”, and my answer remains unchanged, “Absolutely and more than ever”.As technology increasingly makes the printed page an anachronism, I have triedto adapt in many ways. First, this book will be available in eBook format, andhopefully will be just as useful (if not more so) than the print editions. Second, everyvaluation in this book will be put on the web site that will accompany this book(www.damodaran.com) as will a significant number of datasets and spreadsheets. Infact, the valuations in the book will be constantly updated online, allowing thebook to have a much closer link to real time valuations.In the process of presenting and discussing the various aspects of valuation, Ihave tried to adhere to four basic principles. First, I have attempted to be as comprehensive as possible in covering the range of valuation models that are availableto an analyst doing a valuation, while presenting the common elements in thesemodels and providing a framework that can be used to pick the right model for anyvaluation scenario. Second, the models are presented with real world examples,warts and all, so as to capture some of the problems inherent in applying thesemodels. There is the obvious danger that some of these valuations will appear to behopelessly wrong in hindsight, but this cost is well worth the benefits. Third, inkeeping with my belief that valuation models are universal and not market-specific,illustrations from markets outside the United States are interspersed throughout thebook. Finally, I have tried to make the book as modular as possible, enabling areader to pick and choose sections of the book to read, without a significant loss ofcontinuity.Tvii

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FM p.i-xvi.qxd12/8/113:31 PMPage ixContentsCHAPTER 1Introduction to ValuationA Philosophical Basis for ValuationGeneralities about ValuationThe Role of ValuationConclusionQuestions and Short Problems112699CHAPTER 2Approaches to ValuationDiscounted Cash Flow ValuationRelative ValuationContingent Claim ValuationConclusionQuestions and Short Problems111119232525CHAPTER 3Understanding Financial StatementsThe Basic Accounting StatementsAsset Measurement and ValuationMeasuring Financing MixMeasuring Earnings and ProfitabilityMeasuring RiskOther Issues in Analyzing Financial StatementsConclusionQuestions and Short Problems272729364247535555CHAPTER 4The Basics of RiskWhat is Risk?Equity Risk and Expected ReturnAlternative Models for Equity RiskA Comparative Analysis of Equity Risk ModelsModels of Default RiskConclusionQuestions and Short Problems5858597176778182CHAPTER 5Option Pricing Theory and ModelsBasics of Option PricingDeterminants of Option Value878789ix

FM p.i-xvi.qxd12/8/113:31 PMPage xxCONTENTSOption Pricing ModelsExtensions of Option PricingConclusionQuestions and Short Problems90107109109CHAPTER 6Market Efficiency—Definition, Tests, and EvidenceMarket Efficiency and Investment ValuationWhat Is an Efficient Market?Implications of Market EfficiencyNecessary Conditions for Market EfficiencyPropositions about Market EfficiencyTesting Market EfficiencyCardinal Sins in Testing Market EfficiencySome Lesser Sins That Can Be a ProblemEvidence on Market EfficiencyTime Series Properties of Price ChangesMarket Reaction to Information EventsMarket AnomaliesEvidence on Insiders and Investment ProfessionalsConclusionQuestions and Short 149150CHAPTER 7Riskless Rates and Risk PremiumsThe Risk-Free RateEquity Risk PremiumDefault Spreads on BondsConclusionQuestions and Short Problems154154159177180180CHAPTER 8Estimating Risk Parameters and Costs of FinancingThe Cost of Equity and CapitalCost of EquityFrom Cost of Equity to Cost of CapitalBest Practices at FirmsConclusionQuestions and Short Problems182182183209221221222CHAPTER 9Measuring EarningsAccounting versus Financial Balance SheetsAdjusting EarningsConclusionQuestions and Short Problems228228229246248

FM p.i-xvi.qxd12/8/113:31 PMPage xiContentsxiCHAPTER 10From Earnings to Cash FlowsThe Tax EffectReinvestment NeedsConclusionQuestions and Short Problems249249257267268CHAPTER 11Estimating GrowthThe Importance of GrowthHistorical GrowthAnalyst Estimates of GrowthFundamental Determinants of GrowthQualitative Aspects of GrowthConclusionQuestions and Short Problems270270271281284301302302CHAPTER 12Closure in Valuation: Estimating Terminal Value304Closure in ValuationThe Survival IssueClosing Thoughts on Terminal ValueConclusionQuestions and Short Problems304318320321321CHAPTER 13Dividend Discount ModelsThe General ModelVersions of the ModelIssues in Using the Dividend Discount ModelTests of the Dividend Discount ModelConclusionQuestions and Short Problems323323324344345348349CHAPTER 14Free Cash Flow to Equity Discount ModelsMeasuring What Firms Can Return to Their StockholdersFCFE Valuation ModelsFCFE Valuation versus Dividend Discount Model ValuationConclusionQuestions and Short Problems351351357372376376CHAPTER 15Firm Valuation: Cost of Capital and Adjusted Present Value ApproachesFree Cash flow to the FirmFirm Valuation: The Cost of Capital Approach380380383

FM p.i-xvi.qxd12/8/113:31 PMPage xiixiiCONTENTSFirm Valuation: The Adjusted Present Value ApproachEffect of Leverage on Firm ValueAdjusted Present Value and Financial LeverageConclusionQuestions and Short Problems398402415419419CHAPTER 16Estimating Equity Value per ShareValue of Nonoperating AssetsFirm Value and Equity ValueManagement and Employee OptionsValue per Share When Voting Rights VaryConclusionQuestions and Short Problems423423440442448450451CHAPTER 17Fundamental Principles of Relative ValuationUse of Relative ValuationStandardized Values and MultiplesFour Basic Steps to Using MultiplesReconciling Relative and Discounted Cash Flow ValuationsConclusionQuestions and Short Problems453453454456466467467CHAPTER 18Earnings MultiplesPrice-Earnings RatioThe PEG RatioOther Variants on the PE RatioConclusionQuestions and Short Problems468468487497508508CHAPTER 19Book Value MultiplesPrice-to-Book EquityApplications of Price–Book Value RatiosUse in Investment StrategiesValue-to-Book RatiosTobin’s Q: Market Value/Replacement CostConclusionQuestions and Short Problems511511521530532537539539CHAPTER 20Revenue Multiples and Sector-Specific MultiplesRevenue MultiplesSector-Specific Multiples542542571