Aswath Damodaran 211

TYING UP LOOSE ENDS

The trouble starts after you tell me you are done..
 But what comes next?
212

Since this is a discounted cashflow valuation, should there be a real option

Value of Operating Assets premium?

+ Cash and Marketable Operating versus Non-opeating cash

Securities Should cash be discounted for earning a low return?

+ Value of Cross Holdings How do you value cross holdings in other companies?
What if the cross holdings are in private businesses?

+ Value of Other Assets What about other valuable assets?

How do you consider under utlilized assets?
Should you discount this value for opacity or complexity?
Value of Firm How about a premium for synergy?
What about a premium for intangibles (brand name)?
What should be counted in debt?
- Value of Debt Should you subtract book or market value of debt?
What about other obligations (pension fund and health care?
What about contingent liabilities?
What about minority interests?

= Value of Equity Should there be a premium/discount for control?

Should there be a discount for distress

- Value of Equity Options What equity options should be valued here (vested versus non-vested)?
How do you value equity options?

= Value of Common Stock Should you divide by primary or diluted shares?

/ Number of shares

= Value per share Should there be a discount for illiquidity/ marketability?

Should there be a discount for minority interests?

Aswath Damodaran
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 1. The Value of Cash
213

¨ The simplest and most direct way of dealing with cash and
marketable securities is to keep it out of the valuation - the
cash flows should be before interest income from cash and
securities, and the discount rate should not be contaminated
by the inclusion of cash. (Use betas of the operating assets
alone to estimate the cost of equity).
¨ Once the operating assets have been valued, you should add
back the value of cash and marketable securities.
¨ In many equity valuations, the interest income from cash is
included in the cashflows. The discount rate has to be
adjusted then for the presence of cash. (The beta used will be
weighted down by the cash holdings). Unless cash remains a
fixed percentage of overall value over time, these valuations
will tend to break down.

Aswath Damodaran
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 An Exercise in Cash Valuation
214

Company A Company B Company C

Enterprise Value $1,000.0 $1,000.0 $1,000.0

Cash $100.0 $100.0 $100.0

Return on invested capital 10% 5% 22%

Cost of capital 10% 10% 12%

Trades in US US Argentina
In which of these companies is cash most likely to be
a) A Neutral Asset (worth $100 million)
b) A Wasting Asset (worth less than $100 million)
c) A Potential Value Creator (worth >$100 million)
Aswath Damodaran
214
 Should you ever discount cash for its low
returns?
215

¨ There are some analysts who argue that companies with a lot of
cash on their balance sheets should be penalized by having the
excess cash discounted to reflect the fact that it earns a low return.
¤ Excess cash is usually defined as holding cash that is greater than what the
firm needs for operations.
¤ A low return is defined as a return lower than what the firm earns on its
non-cash investments.
¨ This is the wrong reason for discounting cash. If the cash is invested
in riskless securities, it should earn a low rate of return. As long as
the return is high enough, given the riskless nature of the
investment, cash does not destroy value.
¨ There is a right reason, though, that may apply to some
companies… Managers can do stupid things with cash (overpriced
acquisitions, pie-in-the-sky projects….) and you have to discount for
this possibility.

Aswath Damodaran
215
 Cash: Discount or Premium?
216

Aswath Damodaran
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 A Detour: Closed End Mutual Funds
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¨ Assume that you have

a closed-end fund that
invests in ‘average
risk” stocks. Assume
also that you expect
the market (average
risk investments) to
make 11.5% annually
over the long term. If
the closed end fund
underperforms the
market by 0.50%,
estimate the discount
on the fund.

Aswath Damodaran
 The Most Famous Closed End Fund in History?
218

Berkshire Hathaway: The Fading Buffett Premium

$400,000 3.00

2.62
$350,000
2.42 2.50
2.27
$300,000

1.90 1.91 1.87 2.00

1.84 1.82 1.80
$250,000
1.62 1.57 1.61
1.52 1.52 1.54 1.51
$200,000 1.33 1.37 1.34 1.29 1.50
1.30
1.21
1.07
$150,000
1.00

$100,000

0.50
$50,000

$0 0.00
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

P/BV Ratio Market Cap BV of Equity

Aswath Damodaran
218
 2. Dealing with Holdings in Other firms
219

¨ Holdings in other firms can be categorized into

¤ Minority passive holdings, in which case only the dividend
from the holdings is shown in the balance sheet
¤ Minority active holdings, in which case the share of equity
income is shown in the income statements
¤ Majority active holdings, in which case the financial
statements are consolidated.

Aswath Damodaran
219
 An Exercise in Valuing Cross Holdings
220

¨ Assume that you have valued Company A using consolidated

financials for $ 1 billion (using FCFF and cost of capital) and that the
firm has $ 200 million in debt. How much is the equity in Company
A worth?

¨ Now assume that you are told that Company A owns 10% of
Company B and that the holdings are accounted for as passive
holdings. If the market cap of company B is $ 500 million, how
much is the equity in Company A worth?

¨ Now add on the assumption that Company A owns 60% of

Company C and that the holdings are fully consolidated. The
minority interest in company C is recorded at $ 40 million in
Company A’s balance sheet. How much is the equity in Company A
worth?
Aswath Damodaran
220
 More on Cross Holding Valuation
221

¨ Building on the previous example, assume that

¤ You have valued equity in company B at $ 250 million
(which is half the market’s estimate of value currently)
¤ Company A is a steel company and that company C is a
chemical company. Furthermore, assume that you have
valued the equity in company C at $250 million.
¤ Estimate the value of equity in company A.

Aswath Damodaran
221
 If you really want to value cross holdings right….
222

¨ Step 1: Value the parent company without any cross

holdings. This will require using unconsolidated financial
statements rather than consolidated ones.
¨ Step 2: Value each of the cross holdings individually. (If
you use the market values of the cross holdings, you will
build in errors the market makes in valuing them into
your valuation.
¨ Step 3: The final value of the equity in the parent
company with N cross holdings will be:
¤ Value of un-consolidated parent company
¤ – Debt of un-consolidated parent company
¤ + j= N% owned of Company j * (Value of Company j - Debt of Company j)
∑
j=1

Aswath Damodaran
222
€
 Valuing Yahoo as the sum of its intrinsic
pieces
223

Aswath Damodaran
223
 If you have to settle for an approximation, try this…
224

¨ For majority holdings, with full consolidation, convert the

minority interest from book value to market value by applying
a price to book ratio (based upon the sector average for the
subsidiary) to the minority interest.
¤ Estimated market value of minority interest = Minority interest on
balance sheet * Price to Book ratio for sector (of subsidiary)
¤ Subtract this from the estimated value of the consolidated firm to get
to value of the equity in the parent company.
¨ For minority holdings in other companies, convert the book
value of these holdings (which are reported on the balance
sheet) into market value by multiplying by the price to book
ratio of the sector(s). Add this value on to the value of the
operating assets to arrive at total firm value.
Aswath Damodaran
224
 Yahoo: A pricing game?
225

Aswath Damodaran
225
 3. Other Assets that have not been counted
yet..
226

¨ Assets that you should not be counting (or adding on to DCF values)
¤ If an asset is contributing to your cashflows, you cannot count the market value of
the asset in your value. Thus, you should not be counting the real estate on which
your offices stand, the PP&E representing your factories and other productive
assets, any values attached to brand names or customer lists and definitely no non-
assets (such as goodwill).
¨ Assets that you can count (or add on to your DCF valuation)
¤ Overfunded pension plans: If you have a defined benefit plan and your assets
exceed your expected liabilities, you could consider the over funding with two
caveats:
n Collective bargaining agreements may prevent you from laying claim to these
excess assets.
n There are tax consequences. Often, withdrawals from pension plans get taxed at
much higher rates.
¤ Unutilized assets: If you have assets or property that are not being utilized to
generate cash flows (vacant land, for example), you have not valued them yet. You
can assess a market value for these assets and add them on to the value of the
firm.

Aswath Damodaran
226
 An Uncounted Asset?
227

Price tag: $200 million

Aswath Damodaran
227
 4. A Discount for Complexity:
An Experiment
228

Company A Company B
Operating Income $ 1 billion $ 1 billion
Tax rate 40% 40%
ROIC 10% 10%
Expected Growth 5% 5%
Cost of capital 8% 8%
Business Mix Single Multiple
Holdings Simple Complex
Accounting Transparent Opaque
Which firm would you value more highly?
Aswath Damodaran
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 Measuring Complexity: Volume of Data in
Financial Statements
229

Company Number of pages in last 10Q Number of pages in last 10K

General Electric 65 410
Microsoft 63 218
Wal-mart 38 244
Exxon Mobil 86 332
Pfizer 171 460
Citigroup 252 1026
Intel 69 215
AIG 164 720
Johnson & Johnson 63 218
IBM 85 353

Aswath Damodaran
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 Measuring Complexity: A Complexity Score
230

Aswath Damodaran
230
 Dealing with Complexity
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¨ In Discounted Cashflow Valuation

¤ The Aggressive Analyst: Trust the firm to tell the truth and value the firm
based upon the firm’s statements about their value.
¤ The Conservative Analyst: Don’t value what you cannot see.
¤ The Compromise: Adjust the value for complexity
n Adjust cash flows for complexity
n Adjust the discount rate for complexity
n Adjust the expected growth rate/ length of growth period
n Value the firm and then discount value for complexity
¨ In relative valuation
¤ In a relative valuation, you may be able to assess the price that the market
is charging for complexity:
¤ With the hundred largest market cap firms, for instance:
PBV = 0.65 + 15.31 ROE – 0.55 Beta + 3.04 Expected growth rate – 0.003 #
Pages in 10K

Aswath Damodaran
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 5. Be circumspect about defining debt for cost of
capital purposes…
232

¨ General Rule: Debt generally has the following characteristics:

¤ Commitment to make fixed payments in the future
¤ The fixed payments are tax deductible
¤ Failure to make the payments can lead to either default or loss of
control of the firm to the party to whom payments are due.
¨ Defined as such, debt should include
¤ All interest bearing liabilities, short term as well as long term
¤ All leases, operating as well as capital
¨ Debt should not include
¤ Accounts payable or supplier credit
¨ Be wary of your conservative impulses which will tell you to
count everything as debt. That will push up the debt ratio and
lead you to understate your cost of capital.

Aswath Damodaran
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 Book Value or Market Value
233

¨ You are valuing a distressed telecom company and have

arrived at an estimate of $ 1 billion for the enterprise value
(using a discounted cash flow valuation). The company has $
1 billion in face value of debt outstanding but the debt is
trading at 50% of face value (because of the distress). What is
the value of the equity to you as an investor?
a. The equity is worth nothing (EV minus Face Value of Debt)
b. The equity is worth $ 500 million (EV minus Market Value of Debt)

¨ Would your answer be different if you were told that the

liquidation value of the assets of the firm today is $1.2 billion
and that you were planning to liquidate the firm today?

Aswath Damodaran
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 But you should consider other potential
liabilities when getting to equity value
234

¨ If you have under funded pension fund or health care

plans, you should consider the under funding at this
stage in getting to the value of equity.
¤ If you do so, you should not double count by also including a
cash flow line item reflecting cash you would need to set aside
to meet the unfunded obligation.
¤ You should not be counting these items as debt in your cost of
capital calculations….
¨ If you have contingent liabilities - for example, a
potential liability from a lawsuit that has not been
decided - you should consider the expected value of
these contingent liabilities
¤ Value of contingent liability = Probability that the liability will
occur * Expected value of liability

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