Investment Valuation

Valuation is at the heart of any investment decision, whether that decision is buy, sell or hold. But the pricing of many assets has become a more complex task in modern markets, especially after the recent financial crisis. In order to be successful at this endeavor, you must have a firm understanding of the proper valuation techniques. One valuation book stands out as withstanding the test of time among investors and students of financial markets, Aswath Damodaran’sInvestment Valuation.

Now completely revised and updated to reflect changing market conditions, this third edition comprehensively introduces investment professionals and students to the range of valuation models available and how to chose the right model for any given asset valuation scenario. This edition includes valuation techniques for a whole host of real options, start-up firms, unconventional assets, distressed companies and private equity, and real estate. All examples have been updated and new material has been added.

• Fully revised to incorporate valuation lessons learned from the last five years, from the market crisis and emerging markets to new types of equity investments
• Includes valuation practices across the life cycle of companies and emphasizes value enhancement measures, such as EVA and CFROI
• Contains a new chapter on probabilistic valuation techniques such as decision trees and Monte Carlo Simulation
• Author Aswath Damodaran is regarded as one of the best educators and thinkers on the topic of investment valuation

This indispensable guide is a must read for anyone wishing to gain a better understanding of investment valuation and its methods. With it, you can take the insights and advice of a recognized authority on the valuation process and immediately put them to work for you.

Table of Contents

CHAPTER 1 Introduction to Valuation 1

A Philosophical Basis for Valuation 1

Generalities about Valuation 2

The Role of Valuation 6

Conclusion 9

Questions and Short Problems 9

CHAPTER 2 Approaches to Valuation 11

Discounted Cash Flow Valuation 11

Relative Valuation 19

Contingent Claim Valuation 23

Conclusion 25

Questions and Short Problems 25

CHAPTER 3 Understanding Financial Statements 27

The Basic Accounting Statements 27

Asset Measurement and Valuation 29

Measuring Financing Mix 36

Measuring Earnings and Profitability 42

Measuring Risk 47

Other Issues in Analyzing Financial Statements 53

Conclusion 55

Questions and Short Problems 55

CHAPTER 4 The Basics of Risk 58

What is Risk? 58

Equity Risk and Expected Return 59

Alternative Models for Equity Risk 71

A Comparative Analysis of Equity Risk Models 76

Models of Default Risk 77

Conclusion 81

Questions and Short Problems 82

CHAPTER 5 Option Pricing Theory and Models 87

Basics of Option Pricing 87

Determinants of Option Value 89

Option Pricing Models 90

Extensions of Option Pricing 107

Conclusion 109

Questions and Short Problems 109

CHAPTER 6 Market Efficiency—Definition, Tests, and Evidence 111

Market Efficiency and Investment Valuation 111

What Is an Efficient Market? 112

Implications of Market Efficiency 112

Necessary Conditions for Market Efficiency 114

Propositions about Market Efficiency 114

Testing Market Efficiency 116

Cardinal Sins in Testing Market Efficiency 120

Some Lesser Sins That Can Be a Problem 121

Evidence on Market Efficiency 122

Time Series Properties of Price Changes 122

Market Reaction to Information Events 130

Market Anomalies 134

Evidence on Insiders and Investment Professionals 142

Conclusion 149

Questions and Short Problems 150

CHAPTER 7 Riskless Rates and Risk Premiums 154

The Risk-Free Rate 154

Equity Risk Premium 159

Default Spreads on Bonds 177

Conclusion 180

Questions and Short Problems 180

CHAPTER 8 Estimating Risk Parameters and Costs of Financing 182

The Cost of Equity and Capital 182

Cost of Equity 183

From Cost of Equity to Cost of Capital 210

Best Practices at Firms 221

Conclusion 222

Questions and Short Problems 223

CHAPTER 9 Measuring Earnings 229

Accounting versus Financial Balance Sheets 229

Adjusting Earnings 230

Conclusion 247

Questions and Short Problems 249

CHAPTER 10 From Earnings to Cash Flows 250

The Tax Effect 250

Reinvestment Needs 258

Conclusion 268

Questions and Short Problems 269

CHAPTER 11 Estimating Growth 271

The Importance of Growth 272

Historical Growth 272

Analyst Estimates of Growth 282

Fundamental Determinants of Growth 285

Qualitative Aspects of Growth 301

Conclusion 302

Questions and Short Problems 302

CHAPTER 12 Closure in Valuation: Estimating Terminal Value 304

Closure in Valuation 304

The Survival Issue 318

Closing Thoughts on Terminal Value 320

Conclusion 321

Questions and Short Problems 321

CHAPTER 13 Dividend Discount Models 323

The General Model 323

Versions of the Model 324

Issues in Using the Dividend Discount Model 344

Tests of the Dividend Discount Model 345

Conclusion 348

Questions and Short Problems 349

CHAPTER 14 Free Cash Flow to Equity Discount Models 351

Measuring What Firms Can Return to Their Stockholders 351

FCFE Valuation Models 357

FCFE Valuation versus Dividend Discount Model Valuation 372

Conclusion 376

Questions and Short Problems 376

CHAPTER 15 Firm Valuation: Cost of Capital and Adjusted Present Value Approaches 380

Free Cash flow to the Firm 380

Firm Valuation: The Cost of Capital Approach 383

Firm Valuation: The Adjusted Present Value Approach 398

Effect of Leverage on Firm Value 402

Adjusted Present Value and Financial Leverage 415

Conclusion 419

Questions and Short Problems 419

CHAPTER 16 Estimating Equity Value per Share 423

Value of Nonoperating Assets 423

Firm Value and Equity Value 440

Management and Employee Options 442

Value per Share When Voting Rights Vary 448

Conclusion 450

Questions and Short Problems 451

CHAPTER 17 Fundamental Principles of Relative Valuation 453

Use of Relative Valuation 453

Standardized Values and Multiples 454

Four Basic Steps to Using Multiples 456

Reconciling Relative and Discounted Cash Flow Valuations 466

Conclusion 467

Questions and Short Problems 467

CHAPTER 18 Earnings Multiples 468

Price-Earnings Ratio 468

The PEG Ratio 487

Other Variants on the PE Ratio 497

Enterprise Value to EBITDA Multiple 500

Conclusion 508

Questions and Short Problems 508

CHAPTER 19 Book Value Multiples 511

Price-to-Book Equity 511

Applications of Price–Book Value Ratios 521

Use in Investment Strategies 530

Value-to-Book Ratios 532

Tobin’s Q: Market Value/Replacement Cost 537

Conclusion 539

Questions and Short Problems 539

CHAPTER 20 Revenue Multiples and Sector-Specific Multiples 542

Revenue Multiples 542

Sector-Specific Multiples 571

Conclusion 577

Questions and Short Problems 577

CHAPTER 21 Valuing Financial Service Firms 581

Categories of Financial Service Firms 581

What is Unique about Financial Service Firms? 582

General Framework for Valuation 583

Discounted Cash Flow Valuation 584

Asset-Based Valuation 599

Relative Valuation 599

Issues in Valuing Financial Service Firms 605

Conclusion 607

Questions and Short Problems 608

CHAPTER 22 Valuing Firms with Negative or Abnormal Earnings 611

Negative Earnings: Consequences and Causes 611

Valuing Negative Earnings Firms 615

Conclusion 639

Questions and Short Problems 639

CHAPTER 23 Valuing Young or Start-Up Firms 643

Information Constraints 643

New Paradigms or Old Principles: A Life Cycle Perspective 644

Venture Capital Valuation 646

General Framework for Analysis 648

Value Drivers 659

Estimation Noise 661

Implications for Investors 662

Implications for Managers 663

The Expectations Game 663

Conclusion 665

Questions and Short Problems 666

CHAPTER 24 Valuing Private Firms 667

What Makes Private Firms Different? 667

Estimating Valuation Inputs at Private Firms 668

Valuation Motives and Value Estimates 688

Valuing Venture Capital and Private Equity Stakes 693

Relative Valuation of Private Businesses 695

Conclusion 699

Questions and Short Problems 699

CHAPTER 25 Aquisitions and Takeovers 702

Background on Acquisitions 702

Empirical Evidence on the Value Effects of Takeovers 705

Steps in an Acquisition 705

Takeover Valuation: Biases and Common Errors 724

Structuring the Acquisition 725

Analyzing Management and Leveraged Buyouts 730

Conclusion 734

Questions and Short Problems 735

CHAPTER 26 Valuing Real Estate 739

Real versus Financial Assets 739

Discounted Cash Flow Valuation 740

Comparable/Relative Valuation 759

Valuing Real Estate Businesses 761

Conclusion 763

Questions and Short Problems 763

CHAPTER 27 Valuing Other Assets 766

Cash-Flow-Producing Assets 766

Non-Cash-Flow-Producing Assets 775

Assets with Option Characteristics 777

Conclusion 778

Questions and Short Problems 779

CHAPTER 28 The Option to Delay and Valuation Implications 781

The Option to Delay a Project 781

Valuing a Patent 789

Natural Resource Options 796

Other Applications 802

Conclusion 802

Questions and Short Problems 803

CHAPTER 29 The Options to Expand and to Abandon: Valuation Implications 805

The Option to Expand 805

When Are Expansion Options Valuable? 812

Valuing a Firm with the Option to Expand 815

Value of Financial Flexibility 817

The Option to Abandon 820

Reconciling Net Present Value and Real Option Valuations 823

Conclusion 823

Questions and Short Problems 824

CHAPTER 30 Valuing Equity in Distressed Firms 826

Equity in Highly Levered Distressed Firms 826

Implications of Viewing Equity as an Option 828

Estimating the Value of Equity as an Option 831

Consequences for Decision Making 836

Conclusion 839

Questions and Short Problems 839

CHAPTER 31 Value Enhancement: A Discounted Cash Flow Valuation Framework 841

Value-Creating and Value-Neutral Actions 841

Ways of Increasing Value 842

Value Enhancement Chain 859

Closing Thoughts on Value Enhancement 864

Conclusion 865

Questions and Short Problems 865

CHAPTER 32 Value Enhancement: Economic Value Added, Cash Flow Return on Investment, and Other Tools 869

Economic Value Added 870

Cash Flow Return on Investment 884

A Postscript on Value Enhancement 890

Conclusion 891

Questions and Short Problems 891

CHAPTER 33 Probabilistic Approaches in Valuation: Scenario Analysis, Decision Trees, and Simulations 894

Scenario Analysis 894

Decision Trees 899

Simulations 908

An Overall Assessment of Probabilistic Risk-Assessment Approaches 919

Conclusion 921

Questions and Short Problems 921

CHAPTER 34 Overview and Conclusion 925

Choices in Valuation Models 925

Which Approach Should You Use? 926

Choosing the Right Discounted Cash Flow Model 929

Choosing the Right Relative Valuation Model 933

When Should You Use the Option Pricing Models? 937

Conclusion 938

References 939

Index 954