Aswath Damodaran

Topics: Generally Accepted Accounting Principles, Fundamental analysis, Stock market Pages: 28 (4160 words) Published: May 1, 2013
Valuation: Basics!
Aswath Damodaran

Aswath Damodaran!


Approaches to Valuation!



Intrinsic valuation, relates the value of an asset to the present value of expected future cashflows on that asset. In its most common form, this takes the form of a discounted cash flow valuation.

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.

Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics.

Aswath Damodaran!


I. 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!

Risk Adjusted Value: Three Basic Propositions

The value of an asset is the present value of the expected cash flows on that asset, over its expected life:

Proposition 1: If “it” does not affect the cash flows or alter risk (thus changing discount rates), “it” cannot affect value.

Proposition 2: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset.

Proposition 3: 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! 4!

Let’s start simple: Valuing a default-free bond !


The value of a default free bond can be computed as the present value of the coupons and the face value, discounted back to today at the risk free rate.

Thus, the value of five-year US treasury bond (assuming that the US treasury is default free) with a coupon rate of 5.50%, annual coupons and a market interest rate of 5.00% can be computed as follows:

Value of bond = PV of coupons of $55 each year for 5 years @ 5% + PV of $1000 at the end of year 5 @5% = $1021.64


The value of this bond will increase (decrease) as interest rates decrease (increase) and the sensitivity of the bond value to interest rate changes is measured with the duration of the bond.

Aswath Damodaran!


A little messier: Valuing a bond with default risk !


When valuing a bond with default risk, there are two ways in which you can approach the problem.

In the more conventional approach, you discount the promised coupons back at a “default-risk” adjusted discount rate. Thus, if you have a ten-year corporate bond, with an annual coupon of 4% and the interest rate (with default risk embedded in it) of 5%, the value of the bond can be written as follows:


Price of bond =


40 1,000 + = $922.78 (1.05)t (1.05)10

You can also value this bond, by adjusting the coupons for the likelihood of default (making them expected cash flows) and discounting back at a risk free rate.

Aswath Damodaran! 6!

Valuing Equity !
   

Equity represents a residual cashflow rather than a promised cashflow.

You can value equity in one of two ways:

•  By discounting cashflows to equity at the cost of equity to arrive at the value of equity directly.

•  By discounting cashflows to the firm at the cost of...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Damodaran Essay
  • Damodaran on Capital and Operating Leases Essay
  • Damodaran Book on Investment Valuation, 2nd Edition Essay

Become a StudyMode Member

Sign Up - It's Free