The Analyst Guide – 2018-Edition By Oscar Küntzel

Analyst Guide
The Stockholm Student Investment Fund’s essential guide to understanding
- Value creation, valuation pitfalls and misconceptions, narrative & numbers,
- Intrinsic valuation, pricing using multiples and real options, and
- Much more...
By Oscar Küntzel

2018-Edition

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The Analyst Guide – 2018-Edition By Oscar Küntzel

Table of Content

The Basics of Financial Statements, and the Role of Accounting in Valuation 3

Telling a Story and the Connection Between Narrative and Numbers 6

Facts About the Drivers of Value, the ROIC-WACC Spread and Revenue Growth 11

The Most Important Frameworks, Models and Equations for Understanding Businesses and its Finances 16

Biases, Uncertainty & Complexity 17

The Three Broad Approaches to Valuation 19

Intrinsic Valuation – a Search for True Values 20

Relative Valuation – a Process of Analytical Pricing! 34

Completing the Incomplete Aspects of Valuation 47

Real options – When a Static View of the World is Not Enough 52

Rules for the Road 73

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The Basics of Financial Statements, and the Role of Accounting in Valuation

Accounting in General
Accounting is a financial language used to understand the performance of a company based upon the inputs
and outputs into the company in question. The language is expressed in different statements, where the most
crucial for the understanding of the inner workings of a company is the balance sheet, the income statement
and the cash flow statement.
We will not go into details regarding accounting due to three reasons. First, many of you understand the
absolute basics of accounting already as you have probably taken at least one course within the subject. If you
are a first-year student and have no clue how accounting works, relax. Some of the more important aspects in
accounting used in valuation will be covered in the homework assignments and/or can be found exploring
external resources that we will help you find. Second, the writers of this guide happen to be finance masters, so
we are probably somewhat biased in the sense that we are more interested in subjects relating to finance than
accounting. We try to be transparent with our biases, just like we wish you to be open about yours when you
do your valuations in the future. Third - and perhaps most importantly, even though accounting can be
powerful in several aspects, especially in helping you grasp the specifics a company’s current and historical
reality - accounting is not valuation.

Accounting is Not Valuation…

We are not saying accounting does not have a role in valuation, because it most certainly does. Especially
coming from a school like SSE, where the accounting classes often are from a management and controlling
perspective, accounting has a place in valuation and value creating activities. We are just saying that accounting
does not equate valuation. Obviously, accounting rules must apply in the company’s future in the sense the asset
and financing side of a company must always balance, the bottom line of the income statements becomes
dividends or remains as equity on the balance sheet, and the cash flow statement provides information on
how cash has been generated within the company and how the cash balance has changed. Furthermore, we
can look at these statements to find measures of activity (e.g. how many days does it take for a company to get
rid of its inventory), profitability (i.e. how well does it generate earnings for any given level of capital put into
the business), solvency (e.g. how financially sound is the balance sheet) and liquidity (e.g. how does its short
term ability to pay its suppliers look like) and use the insight that they provide to gain understanding of what is
going on within the company.
Nevertheless, the value of a company is the present value of all the future cash flows that it generates. Under
“intrinsic valuation – A search for true values”, we will discuss what the present value and cash flows really
mean within a valuation framework, but for now, just understand that valuation is forward looking, whereas
accounting tries to help the investor understand the company today and historically, i.e. it is backward-looking. We
do not mean that in a bad way, we are just saying it like it is; accounting look at a company in a completely
other way than finance simply because it is the accountants job to record what has happened, and it is the
financial analysts job to make reasonable assumption about the future of a company.
Let us give you some examples why the accounting language can be separate from the ideas of true value.
Accountants break a company’s assets down in current assets like inventory and cash, tangible fixed assets like
machines, buildings and equipment, financial assets like investments in other companies and intangible assets
like Goodwill. We are going to discuss that last post – Goodwill, but before we do that, take a few seconds
and think about intangible assets in general. If I were to ask you to name a bunch of intangible assets, what

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would you think of? Most likely, you would name items like brand name, patents, customer lists, business
methodologies, and trademarks. These can be extremely valuable for companies, and often be their main
source of sustainable competitive advantages. Sure, you can’t touch them, but they are most certainly real. So,
lets go back to Goodwill. Sounds good, right? Ironically enough, it is the most useless asset on the balance
sheet, yet by far the most common intangible asset out there. Why? Simply because Goodwill is the plug-in
variable that is magically created when an acquiring company buys a target company for more than the equity
on the balance sheet of the target company. In other words, it is a plug-in variable to make the balance sheet
balance during an acquisition. You wouldn’t think about paying for a plug-in variable, right? So why should it
even matter in a valuation. There are many more examples of the drawbacks of accounting taken at face
value. For example, the fact that a company can have negative value of its equity, in a financially sound, low
risk company, is just mental. Take Swedish Match for example. A low WACC, High ROIC (see meaning of
these abbreviations under the next section) company with stable cash flows and growing revenues that has
been around for ages. Yet, it has negative equity due to a history of odd accounting rules that we won't go
into.
There are two key takeaways from this exercise. The first is that since the stock market systematically pays
more than the equity (or Assets – liabilities) when acquiring another company, it is quite obvious that the
balance sheet is a really poor measure of the value of a company. But that’s old news. The other takeaway is
that maybe we should not think of a company through the lens of the accounting language, but rather in a way
that captures assets that matters for a company and looks forward as the same time as it captures how the
company performs today. One framework where this is possible is when we think of a company in terms of a
financial balance sheet (see next section).
Before we go into the financial balance sheet, we would once again want to stress two things. First, it is still
highly useful to be an accounting mastermind. This is especially true when trying to find potential bombshells
hidden in dubious accounting choices. For example, there is something analysts sometime refer to as earnings
quality. In essence, it is using the knowledge of how the accounting statements fit together to examine whether
income statement earnings are also visible in the cash flow statement, as to make sure that earnings are really
connected to long-term value creation. If you take the elective course accounting problems in valuation, one of the
books you will read is financial shenanigans. If you want to read a witty, entertaining book of how to use
accounting to fool investors, we recommend that book.
The second thing we would like to stress is that accounting needs to stay being accounting. For us, “fair
value” accounting is an oxymoron. The best thing that could happen is that assets are not necessarily recorded
at “true value”, but rather recorded internally consistent across sectors, companies and “type” of asset or cost
(e.g. if something is expected to create value over multiple periods it is always seen as a CAPEX, not
sometimes as a cost simply because it is early in the process of development). Let’s go through an example to
clarify why that’s the case. One of the most important uses of accounting is the design and interpretation of
return measures. Under the section “Facts about the drivers of value, the ROIC-WACC spread and Revenue
Growth”, we will deep-dive more into the interpretation of return measures. But for now, it is crucial to
understand that accounting is normally what we base these measures like ROIC on. That’s extremely scary.
Why? It is one of the few measures used across sectors, companies and time when understanding the value of
a company that is solely based upon accounting. Both the numerator and denominator is purely in the hands
of accountants. Key accounting issues like the discussion of capitalizing expenditures like leasing expenditures,
R&D expenditures, brand-building marketing expenditures, and SG&A expenditures therefore have the
capacity to influence investment decisions as they can skew these measures one way or another depending on
company life-cycle, growth trajectory and true economic earnings. As stated before, accounting still needs to
remain as accounting, not gravitate towards fair value. As long as we can interpret the return measures in a
similar way, without having to capitalize certain measures ourselves, accounting works absolutely fine in its

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own way. We can then use these measures to draw conclusion for a cash flow generating profile that is correct
going forward. One brilliant (yet quite boring to be honest) discussion of this topic is Aswath Damodaran’s
paper “Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE):
Measurement and Implications”. He discusses how to think about where and why accounting fails and where
(and where not) to make adjustments and how to think about value creation given these adjustments. He also
discusses measure like cash ROIC, cash flow return on investment (CFROI) and in a very logical manner
discusses how return measures can become affected by the accounting treatment of stock buybacks and
dividends, acquisitions and cross holdings. Truly a recommended reading.

The Financial Balance Sheet

Thinking of a company in terms of a financial balance sheet is often a technique used by Aswath Damodaran,
a valuation professor, and in many people’s eyes also a valuation genius, whose ideas will be referred to many
times in this guide. The financial balance sheet is both much simpler and more complex than an accounting
balance sheet is the sense that it is more relevant for value and less controlled by certain accounting standards
and rules but simultaneously subject to more assumptions, forecasting and subjectivity.
On the asset side if the financial balance sheet, there are two items: Assets in place and growth assets. Assets in place
represent the long-lived and short lived assets from existing investments and are recorded at intrinsic value -
where the cash flows, growth and risk has been considered - and not at original cost or in line with some other
accounting logic. The assets in place for 3M or Coca-Cola are huge, and relate to all the manufacturing,
distribution, brand recognition, current cost structure etc. that create the stable cash flows the ancient
companies is known for generating. Quite straight forward, right? Growth assets, on the other hand, are

“When I am looking at an earnings report from Twitter, I am not looking at what they did last year. I am looking for
clues as to: is that growth potential increasing or not; are they doing the right things to create value from their growth assets.
Most of the tools we have in finance are developed for mature companies. P/E ratios. Return on Invested Capital. Things
you are taught in business school. But if you are a growth company and you are trying to assess them using those tools, it is
like using a hammer to do surgery. Think about it. That’s gonna be bloody and its gonna come to a bad end. “

- Aswath Damodaran, talks at Google

recorded at the expected value that will be created by future investments. Here, the analyst is giving credit to
the company for investments the have not made yet. This requires that assumptions must be made about how
the growth will look like in the future and how the great the return on these investments are in relation to the
risk associated with them (i.e. the excess returns). Comparing a company like Johnson & Johnson with
Snapchat, you are naturally going to assign a higher portion of the total value of Johnson & Johnson to assets
in place rather than growth assets and vice versa. Obviously, earnings in the latest quarterly report can’t be the
main focus for an investor in a young company, because that is not where the value of the company comes
from. A young company is not a bad company just because it is young and have not had a bunch of stuff to
record on its balance sheet. As you can see, it is very easy to find yourself limited by the accounting way of
thinking about value.

On the financing side of the financial balance sheet, you have debt and equity. Since debt is valued at the
market price of that debt, the equity is simply the residual, but is a fair value of the shareholder’s claim of the
company’s cash flows since all other items on the financial balance sheet are at intrinsic value.

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Telling a Story and the Connection Between Narrative and Numbers

The Most Important Aspect of Valuation?

If there is one single thing that you should bring with you from this guide, it is the importance of interlinking
narrative and numbers when doing valuation. There are so many things to say on this topic, but we will only
cover some of them. We furthermore strongly encourage you to read the book “Narrative and Numbers” by
Aswath Damodaran. It covers everything from the how to tell a story about a company and the elements of
storytelling to the power of numbers and number-crunching tools. He covers how to create and test-drive a
narrative with common sense and ultimately connect them to credible numbers and values and furthermore
what happens with values of companies when we alter a narrative of a company going forward. We will talk
about four aspects of the book that we believe every analyst of SSIF should understand: closing the gap with
valuation, the dangers of just sticking to one side, the three Ps, the story-assumptions-cash flow-value-
onepager.
Closing the Gap with Valuation
What did you like the most in high school: History and languages or Algebra and physics? If you belong to the
first group, you are probably one of the story-people, i.e. a right-brainer. If you belong to the second group on
the other hand, you might be one of the numbers-people, i.e. a left-brainer. Some people are born with an
ability to think effectively and in an integrated way with both sides of the brain, but most of us are less
fortunate, and are naturally more comfortable with one than the other. Consequently, most of us have a hard
time relating to arguments and insights coming from the opposite side of whatever side we are on.
Interestingly, valuation has to incorporate both an underlying story and numbers. Consequently, a great
valuation is as much about closing the gap between the number crunchers and the storyteller as it has to do
with coming to an investment decision.
So why do the detail oriented excel wizards that can construct meaningful models and analyze data have to
listen to the compelling narratives and ideas of the storytellers, and why should the convincing, charismatic
storytellers bother understanding the mathematical relationships that govern value creating activities of a
company and the market it operated in? The answer is that the valuations simply becomes more accurate. Just
thinking with one side of your brain is highly dangerous if you are trying to beat the market since you might
mislead yourself into making key assumptions that are way off. The dangers are to many not to bother
creating an integration between narrative and numbers.

The Dangers of Stories and Numbers on an Individual Basis

We can all understand the value of stories. They can be remembered for decades, they connect to listeners and
can change their emotion more than simple facts and they cause people to act. In business, they motivate
employees, they cause customers to pay premium prices and they make investors more patient and trusting in
the long-term vision of a company. We also see the value of numbers. They are precise and tangible, objective
when scientific in their use, and indicate control in the sense that they can measure and monitor aspects which
people can act upon. All these aspects of stories and numbers are true and important, but the dangers of
telling stories and crunching numbers are perhaps more valuable to understand for an analyst. Some of the
dangers are listed below.

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Stories Numbers
Accuracy is best measured by comparing how a model’s
result compare to reality, where as precision is a measure of
how close the outputs are from each other given the same
Stories invoke so much inputs. Number-crunching disciplines something think they
emotion that we lose track of reach accurate conclusion when they are really valuing
rational considerations. You precision over accuracy. Moreover, values in forecasting
can get away with much often seem precise when they are not due to ignoring
more dubious assumptions as statistics like the standard error.
a master storyteller. In
business and when it comes Numbers are less objective than we believe since collective,
down to money though, the analyzing and presenting data introduces biases, often hidden
truth often catches up. ones.

Dangers Analysts delude themselves into thinking they have control

over, or are mitigating a risk, just because they have
Human memories are fragile measured it. Sensitivity analysis is often done after a decision
and easily manipulated. has bene made, and risk measurement tools further often
Management might forget black (very unlikely but devastating) events.
repeatedly tell stories of
great, improbable Numbers can intimidate. Complex models prevent probing
achievements - like founders questions that can change the view of a company, especially
rising from poverty - to both with an audience uncomfortable with numbers.
investors and other
stakeholders, hiding or The pure number cruncher can 1) be replaced by a machine
manipulating some version of doing the job more cost-efficiently, or 2) be imitated by an
the truth. We ultimately start equally powerful computer
thinking we know things that
are not true. If everyone has the same quantitative way of reasoning using
the same data and tools, that might lead to herding, where
everything is bought and sold in the same way at the same
time. This might actually lead to more booms and busts.

Unchecked business stories Stories reminds us that changing the stories should change
lose focus, which is the numbers. They also question the ability to deliver
dangerous. Data brings the forecasted numbers as stories are simply changed by
storyteller back to a place tweaking your thought-process in one way or another. The
where the impossible or biases that going into your numbers previously only visible
The improbable is shined a light to yourself are furthermore exposed when you have to
Cure upon. Asking for a few explain the assumptions behind the model. It is also much
numbers in an overwhelming more difficult to copy the thought-process of a successful
story can very easily bring the storyteller with an understanding of valuation that just the
listeners into the realm on ideas of a number-cruncher.
logic and reason.

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The Three P’s

The three P’s - Probable, Plausible and Possible - refer to the conclusion that should be reached about the
viability of a story or several stories. It is an interesting framework to use for several reasons. First of all, if you
start thinking of the future of a company, you can create several storylines, and then make a judgement
regarding which storyline that fits in which category. If something is possible, but you have no idea how, or
even what this “thing” is that might happen, the valuation response is valuing it as an option. The value then
increases with potential market size and the exclusivity of the company’s access to that market. Having a
better idea of the market potential and having some indication that for example other companies have pulled
off a product launch or succeeded in another similar way, the story becomes plausible. Then value it in
expected growth but adjusted for the risk in expected return (or Cost of Capital). The value here also
obviously increases with the size of the market but are also connected to the company’s competitive
advantages. If the probability of occurrence of your story is increasing even more, for example after the
company having showcased a product success and delivered financial results, you can call the story probable.
There can still be uncertainty in the expectations, but here the valuation response is to show the story in the
base year numbers and expected cash flows, adjusting for the risk in the expected return.
Interestingly, we can often group different types of investors on where they choose to invest on the narrative
spectrum. Early stage Venture Capitalists on the possible side, and Ben Graham on the Probable side, with
late stage VCs and aggressive growth investors to conservative growth investors and aggressive value investors
in the middle. No type of strategy is necessarily always better than the other, but be sure to use the right
valuation tools for the right type of story in the underlying business. For example, there are high quality
pharmaceutical companies that has stable cash flows that we can include as probable in nature, but there are
also real options in that type of business, which would be preferable to include not to underestimate the value
of the enterprise.
We are going to list some potential pit-falls that some analysts might fall into when doing their valuations. We
will, like Damodaran, list them under the impossible stories, the implausible stories, and the improbable
stories.
The impossible

• As we will discuss under “intrinsic value – a search for true values”, you will estimate the intrinsic
value of a company in the future called the terminal value using either a liquidation value or a growing
perpetuity. Using a growing perpetuity, never set your growth rate above the growth rate of the economy. That
assumption would assume that the company in eternity becomes bigger than the economy since it is based
on an infinity formula.
• The eventual market share can not exceed 100%, which it often does in valuations where we look to the past
and forecast revenues to the future. Revenues will quickly approach the total market and go even
further.
• Companies that happen to have strong advantages in the marketplace today might have very high
profit margins and are increasing efficiency. In modeling, profit margins can by mistake exceed 100%
due to continued efficiencies. Obviously, a company cannot in real life generate profits higher than revenues.
• Just because equity holders do not charge interest on its capital, the money does not come without a
cost. The capital has an implicit cost. If the investors do not get dividends, they want price
appreciation, so measures like the dividend yield is not a measure of cost of capital. The idea of costless
capital is sometime thrown around, but no such thing exists. We cover this aspect more under “intrinsic value
– a search for true values”.

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The implausible

• Do not count on being able to get the best of several worlds, like being in a competitive sector,
capturing market share, but simultaneal raising prices. The market has certain dynamics that you most
likely can’t get around.
• Just because a market is big (think China), does not mean it is a good market to enter. The firm doing so most
likely have a lot of company, is a part of an overvalued group, will see a smaller market share of the
total and a low revenue growth, and has a high chance of ending up with nothing. Overpricing is big
when capital providers and entrepreneurs are overconfident, the size of the market is huge, there is
great uncertainty, and where one player gets to walk away with everything.
The improbable
Narratives that are improbable often have some type of inconsistency. Not inconsistencies with other
investors, but rather internally with itself, i.e. internal inconsistencies. These inconsistencies often show up
when one of the following three questions can’t be answered with a yes. Damodaran calls this device the iron
triangle of value.

• Risk & Growth: Is your risk reflective of how much, how, and where you are growing?
• Risk & Reinvestment: Is your risk consistent with your reinvestment strategy?
• Growth & Reinvestment: Are you reinvesting enough, given your growth?

The Story-Assumptions-Cashflow-Value One Pager

The main ideas behind a valuation should be able to fit on one page. Having looked at different types of
equity research reports, stock pitches in magazines, spread sheets valuation summaries and other similar tools
for giving the reader information about a valuation, we can one again reach the conclusion that Damodaran is
one of the few valuation experts that manage to connect narrative and numbers into one page. We do not
know what he calls them, but we have chosen to call them the “story-assumptions-cashflow-value” one pager,
simply because that is what the summary contains. Here is one example which we found in an excel sheet he
provided on his website doing a valuation of Tesla in August 2017.

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Tesla (August 2017)

The Story
Tesla is an auto/tech company looking towards the mass market. Its primary competitive advantages lies in superior battery technology and brand loyalty with a secondary
advantage in styling/design. In terms of investment needs and risk, it is as much tech as auto company. The combination of cash burn (negative cash flows for the next
seven years) and a large debt burden exposes the firm to distress risk, reflected in a 10% probability of failure.

The Assumptions
Base year Years 1-5 Years 6-10 After year 10 Link to story
Revenues (a) $ 10 069 35,00% 35%->2.23% 2,23% Mass market focus = $100 billion in revenue
Operating margin (b) -1,02% -1,02% 12,00% 12,00% Tech superiority & brand = High margins
Tax rate 30,00% 30,00% 30,00% 30,00% Global marginal tax rate average
Reinvestment (c ) Sales to capital ratio = 2,24 RIR = 24,78% Invest like an auto/tech company
Return on capital -0,71% Marginal ROIC = 30,52% 9,00% In maturity,, has tech features
Cost of capital (d) 8,83% 7,50% 7,50% 50% auto, 50% technology
The Cash Flows
Revenues Operating Margin EBIT EBIT (1-t)* Reinvestment ** FCFF ***
1 $ 13 593 0,28% $ 39 $ 39 $ 1 573 $ (1 535)
2 $ 18 351 1,59% $ 291 $ 291 $ 2 124 $ (1 833)
3 $ 24 774 2,89% $ 715 $ 715 $ 2 867 $ (2 152)
4 $ 33 444 4,19% $ 1 401 $ 1 401 $ 3 871 $ (2 470)
5 $ 45 150 5,49% $ 2 479 $ 2 304 $ 5 226 $ (2 922)
6 $ 57 993 6,79% $ 3 940 $ 2 758 $ 5 734 $ (2 976)
7 $ 70 689 8,09% $ 5 722 $ 4 005 $ 5 668 $ (1 662)
8 $ 81 531 9,40% $ 7 661 $ 5 363 $ 4 840 $ 522
9 $ 88 693 10,70% $ 9 489 $ 6 642 $ 3 197 $ 3 445
10 $ 90 671 12,00% $ 10 880 $ 7 616 $ 883 $ 6 733
Terminal year $ 92 693 12,00% $ 11 123 $ 7 786 $ 1 929 $ 5 857
The Value
Terminal value $ 111 137
PV(Terminal value) $ 49 472
PV (CF over next 10 years) $ (6 108)
Value of operating assets = $ 43 364
Adjustment for distress $ 2 168 Probability of failure = 10,00%
- Debt & Minority Interests $ 10 328 Proceeds if firm fails = Value of operating assets * 50% = 21680
+ Cash & Other Non-operating assets $ 3 036
Value of equity $ 33 904
- Value of equity options $ -
Number of shares 157,90
Value per share $ 192,34 Stock was trading at = $365,00
* Ebit (1-t) = (Revenues * Operating Margin) * (1- Tax Rate) having considered operating losses brough forward for tax reasons
** Reinvestment = Change in Revenues / (Sales to Capital Ratio)
*** FCFF =Free Cash Flow to Firm

We welcome the analyst of SSIF to include multiples, peers, share price history, key developments regarding
risks and growth options, management change, insider transactions, triggers that might cause the market to
react, potential insights as to what the market has misunderstood and other information that might be of
interest. Just remember tough, that everything that has to do with the broad strokes of intrinsic valuation
should be able to be captured on one page.

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Facts about the drivers of value, the ROIC-WACC spread and Revenue Growth

What do the stock market really care about? What, really, drives value and thus price for stocks? It is actually
quite simple. A company’s return on invested capital (ROIC, but sometimes called ROC) and its revenue
growth together determine how revenues are converted into cash flows (and earnings). A company has to earn
above its cost of capital to create value though, so therefore, it is the difference between a company’s ROIC
and weighted average cost of capital, or WACC, that together with revenues that are the key drivers of value.

Return on Invested Capital

Cash Flow

Value
Revenue Growth

Cost of Capital (WACC)

We will cover what the WACC is more in detail under “Intrinsic Value – a Search for True Values”, but for
now you can think of it as what all the investors of debt and equity on average require the company to deliver
given its level of risk. The total amount of value a company can create over time is therefore determined by a
company’s ROIC-WACC spread (or above risk returns), its revenue growth, and its capacity to keep them
sustainably high over long periods of time. The figure below is similar to the previous picture, but it brings in
the time dimension, and emphasises that value cannot be generated if the ROIC is not actually above WACC.
As a matter of fact, a company investing to grow when its ROIC on new investments is below its WACC
actually destroys value (assuming the future ROIC won’t be much higher due to the size that the firm
reaches).

Spread
ROIC-WACC

Revenue
Value
Growth

Sustainability

The reason why we have to think about value-creation in the way described above is that is it the only way
consistent with financial theory. A company should take of projects where the net present value of those

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projects are positive, and they are only that when ROIC is above WACC. In corporate finance, we often talk
about EVA, or economic value added, which is simply a ROIC-WACC spread (where we have made sure that
ROIC is adjusted for any issues there might exist in financial reporting, like intangible assets not recognized
due to accounting rules) multiplied by invested capital. Thinking of these measures, it becomes very important
that we as analysts keep track of how management is incentivized within a company. Are their decision rules
for taking on investments based upon solely a profitability measure in percentage terms, or are they thinking
of risks and the time value of money, i.e. are they thinking of value-creation terms, which must include the
cost of capital and the amount of money being invested in value-creating projects? For internal control, we
should also add that Return on capital employed, ROCE, might be an equally valid measure as ROIC to use
when calculating EVA, if they have control over cash and other non-operative financial assets.
Since WACC is relatively stable among companies in the same sectors, and since it often also is more difficult
to change drastically for a company, we will just focus on ROIC and revenue growth in this section.
We should also add that ROIC and WACC are not applicable on financial companies, as we can’t define the
income statement nor the balance sheet in the standard way. There will be a separate information sheet on
that sector (banks, insurance companies, etc.) covering specific aspects to think about when analyzing those
companies. But put shortly, the primary drivers of value are then Return on Equity, growth and Cost of
Equity (the discounted cash flows are primarily dividends). In relative valuation, these aspects are related to
the price to book value, but more on that under relative valuation and the separate information sheet.
Return on Invested Capital
There are many measurements of profitability. Return on equity (ROE), return on assets (ROA) and return on
capital employed (ROCE) to mention a few. The theory behind value creation, the research done on stock
market performance, and the valuation professionals in the real world agree quite unanimously suggest that
ROIC – if calculated correctly – is the soundest measure of profitability. Now, it should be said that ROCE is
a great measure too. It depends on what you want to know, really. One book used as course literature in both
the Bachelors and Masters at the school – the profitability, financing and growth of the firm, by Johansson &
Runsten – covers the relationships between these measures in depth. Maybe most importantly though, is
understanding that we as much as possible want to separate the operative aspects from the non-operative
aspects, and we can confidently state that ROIC does just that. The inputs to the calculations are the
following:

• Net Operating profit less adjusted taxes (NOPLAT) represents the profits generated from the core
operations of a company, but after the income taxes that relate to those core operations.
• Invested Capital represent the cumulative amount the business has invested in its core operations,
primarily property, plant and equipment and working capital. Invested capital is often calculated from
the financing side of the balance sheet, where debt and equity are summed up, but the cash on the
asset side are also removed.
ROIC1 can therefore be calculated as follows:

1
ROIC is sometimes also expressed before tax, as the operating profit is sometimes simply divided by
invested capital. So whenever you are analyzing a company with the metric, make sure you know if you are
looking at a before or after tax measure of profitability.

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𝑁𝑂𝑃𝐿𝐴𝑇
𝑅𝑂𝐼𝐶 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Knowing that the free cash flow (a concept that is more explained under “Intrinsic Value – A search for True
Values) is what is left for the debt and equity holders after having done the investments in capital during a
year, and knowing that it is impossible to grow without doing investments, some simple algebra (which you
can find in the book Valuation by McKinsey, a strongly recommended read), we end up with the key value
driver formula – the formula that underpins valuation models.
𝑔
𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑁𝑂𝑃𝐿𝐴𝑇𝑡+1 (1 − 𝑅𝑂𝐼𝐶 )
𝑉𝑎𝑙𝑢𝑒 = =
𝑊𝐴𝐶𝐶 − 𝑔 𝑊𝐴𝐶𝐶 − 𝑔
In this equation you can see why ROIC matters so much. If you want to grow, it will cost you some part of
the free cash flow today. The higher your ROIC, the “cheaper” your growth is in the sense that you still can
generate high levels of cash flow today. This is obviously only a formula you can use in perpetuity when the
growth rate is low (otherwise the denominator becomes so small the value goes to infinity). Yet, it gives a
sense of the drivers of value, and is much more intuitive than for example the standard Gordon growth model
where you simply divide the dividend next year with the cost of capital minus the growth rate. In that equation
it might be difficult to see why that dividend is as high or low as it, and why the dividend can grow at the rate
the equation suggests.
Some short facts about ROIC

• ROIC is primarily driven by competitive advantages that drives price premiums or cost and capital
efficiencies. We will list them under “The Most important frameworks, models and equations for
understanding businesses and its finances”, where we also talk about what makes ROIC sustainable.
• The median ROIC in the U.S was around 10 percent from 1963 to 2000, but was up to 16 percent
2013. ROIC without Goodwill has increased over time, but including goodwill in invested capital will
show that ROIC is quite stable, meaning companies have not been able to extract much value from
their acquisitions.
• ROIC differ by industry. Software, pharmaceuticals, IT services, tech hardware, healthcare
equipment, electrical equipment, aerospace, defence and consumer staples have had high ROIC
historically, whereas utilities, paper and forest, airlines, roads, telecom, oil and gas, metals and mining
and household durables have delivered much worse profitability.
• ROIC is often quite widely dispersed among companies.
• Looking at individual companies, ROIC is often very stable over time. For example, among
companies in the U.S that had ROIC above 25% in 2003, 83% delivered above 25% ROIC 10 years
later in 2013.

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Revenue growth
Growth. It is one of those words that every analyst wants to hear, and every manager wants to deliver. As we
covered in the ROIC section though, increased revenues destroy value when investments are made that
delivered below cost of capital returns. Research by McKinsey emphasises this balance between ROIC and
Revenue growth. If ROIC is low, the company’s share price increases more when its ROIC increases than
when its revenue increases. On the other hand, the share price of a high-ROIC company increases more when
revenues are increased than when ROIC is improved even further. High ROIC projects in combination with
high revenue growth is consequently the sweet-spot for a company in terms of generating value.
Some short facts about revenue growth and value creation

• Growing by creating new markets through new products, convincing existing customers to buy more
of a product, or attracting new customers to the market deliver above average value for every dollar of
revenue, since there are either no established competitors, or all competitors benefit from the
development. Gaining share from rivals through incremental innovation or promotion and pricing, or
making large acquisitions create below average value since competitors can replicate, retaliate or you
simply have to pay more than you get. Average value is created using bolt-on, small, acquisitions and
gaining market shares in fast growing markets since you pay a reasonable price for what you get, and
competition can still grow.
• Sustaining growth is much harder than sustaining ROIC, simply due to the fact that it becomes
impossible to find investments with the type of nominal terms growth you need to continue with the
same growth rate in percentage. There are natural life-cycles to product markets, and the slow
growing products will ultimately become a part of a company’s portfolio.
• As an analyst, do not overestimate the growth phase of a company. Keep in mind this following fact:
the median growth period for companies classified as growth companies in the U.S. was according to
Damodaran just 3.5 years. McKinsey’s research suggests that companies growing faster than 20
percent typically grew only 8 percent within 5 years and 5 percent within 10 years.
• Real revenue growth is also fluctuating significantly, much more than ROIC.

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A few words about earnings

Some investors obsess themselves over how the earnings per share (EPS) develops in a company. Sure,
companies where there are great earnings trends are most likely also creating value, and furthermore, the value
of earnings and cash flows should be equal at as the company’s life goes to infinity. Nevertheless, here follows
some information on why ROIC and revenue growth matters more than EPS.

• Changes in accounting standards does not impact share prices, even thought they often in these changes
have impacted earnings. The effect on prices has been due to the cash flow effect of lower taxes, not
earnings. For example, when the accounting standards concerning employee stock options changed
making the implicit cost of the options expensed on the income statements and lowering earnings,
the stock market did not care. It was cash flows that mattered, not reported earnings.
• Mergers and acquisitions only affect share prices when the value creation changes, not as an effect of
EPS change, or due to the fact that the target was bought at a lower P/E ratio than the acquirer was
trading at. There was most likely a growth and profitability reason behind the multiple. If you want to
know more about the drivers of multiples, check out the “analytical tests” under “relative valuation”.
• Write-downs of Goodwill do not affect value creation, and thus not share prices. Rational investors look
at the underlying cash flows and business fundamentals rather than reported earnings and Goodwill
impairments. The stock market normally understands that an acquisition was not value creating from
the beginning, and already considered that goodwill probably would be impaired (even though this is
not always the case).
• Earnings volatility does not matter either. Ratios of market value to capital are decreasing with cash
flow volatility, but not earnings volatility when having already accounted for the volatility in cash
flows. Even the most stable companies have very volatile earnings, much more than you might think.
• Neither does meeting earnings estimates matter that much. Earnings surprises only account for 2 per cent
of the volatility in the four weeks surrounding the announcement.
• And what about earnings guidance, does it matter? Nope. It has no effect on volatility, higher valuations
or market liquidity. Most likely, it is just a cost for companies.

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The Most Important Frameworks, Models and Equations for Understanding

Businesses and its Finances
At SSE, and other business schools around the world, we are taught a bunch of models and frameworks to
understand businesses. We meet them in marketing, strategy, management, and in accounting and financial
management. As it turns out, many of them are quite useful in valuation. This part of the guide aims to do
two things. First, it will give the first-year students an introduction to some of the more famous models and
frameworks which can be employed in valuation. Second, it is used to show that – in our view – valuation is at
the center of all things we are taught during our bachelor years, as it can consider all these areas of study, find
the crucial aspects for a company’s future, and boil it down to a single number – the value of the company.
The Business and Its Environment
Models and frameworks are there to help you understand companies and the environment they operate in.
Below is a list of some of the more famous ones known to be applicable in real life. The list is not in any way
exhaustive and obviously also very subjective, so don’t get too mad if you disagree with it.

• Porter’s 5 forces
• Sustainable competitive advantages (not a model in the classical sense, but anyways…)
• PESTEL analysis
• BCG growth-share matrix
• SWOT analysis
We especially want to stress the importance of understanding competitive forces. There is a saying: Always do
a porter analysis, but never show you have done it. It is such a classic framework for understanding why
industries show above or below average returns, that is almost becomes ridiculous to practise in professional
life. You can read the original article on Harvard Business School if you have not already.
Industries can be set up for success, but companies can still fail, and vice versa. Therefore, it is crucial to
understand sustainable competitive advantages - the individual characteristics of a company’s business units
and product lines that create long-term value. Understanding an industry and identifying what company will
outperform its peers long-term is the key to understanding both why the ROIC-WACC spread and revenue
growth can be high, and furthermore stay high, for long periods of time. Remember, it is those aspects that
matter for the value of a company. According to McKinsey, there are really only 9 sources of competitive
advantages, 5 that create price premiums, and 4 that create cost and capital efficiencies. Price premiums are
created through innovative products, quality, brand, customer lock-in or rational price discipline. Cost and
capital efficiencies stem from an innovative business method, unique recourses, economies of scale or scalable
product/process. We once again recommend Valuation, by McKinsey for more information on these
competitive advantages.
We will not go into the other analysis tools on the list, but recommend you pay attention when they are
covered in school, or learn how to apply them yourselves.

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Metrics and Formulas

One of the major insights working with key ratios is that a company’s strategy will be reflected in its numbers.
Under “The basics of financial statements, and the role of accounting in valuation” we went pretty hard on
accounting, but here come some very positive aspects of the discipline: Analysts very comfortable with
accounting rules and principles often have a great feeling for details regarding why different key ratios change
in the way they do, differ across companies, and can consequently identify red flags in the metrics. When there
is a discrepancy between a firm’s strategy or the story the management is telling investors and what is actually
going on inside the company concerning for example its inventory, its receivables, unexpected increases or
decreases in certain asset classes, odd timing and size of reserves etcetera, an accountant with an eye for details
will be the first to notice. Disaster can be lure behind the corner.
Even though management can behave and everything goes according to plan for different companies in a
sector, metrics capturing a company’s current position can be very helpful to use as to understand how a
strategy is in reality reflected in numbers.
We recommend you to understand the meaning and practical application of the CFA (Chartered Financial
Analyst) key metrics, which are categorized under four broad categories, Activity, Liquidity, Solvency,
Profitability. A quick Google search will lead you to find them. These are also covered in accounting courses
at SSE, and even though some of them sometimes lack a very solid connection to valuation (e.g. in the
accounting world, you often hear “financially solid” - having a lot of equity and little debt on the balance sheet
- as a compliment regardless if taking on a calculated portion of more debt would decrease the WACC, and thus
increase the value of a company), they are always worth considering when understanding the companies and
their industry.
Furthermore, we would also like to recommend understanding Du-Pont analysis. The formula(s) are covered in
several courses at SSE, so for most analysts they probably are not foreign to you. The main idea is just that the
profitability is a function of margins and capital turnovers, but are often extended with the financial leverage
and other ratios to get to return on equity. A google search will do the trick here as well if you are unfamiliar
with the concept. We recommend you searching for the five-component Du-Pont formula and try to
understand all aspects of it. There are some similarities between the Du-Pont formulas and the Johansson
formulas, which are frameworks also covered at the school. We recommend, once again, the book “the
profitability, financing and growth of the firm, by Johansson & Runsten” on this area.

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How a few things stick together

• If the current balance sheet is a good proxy of the future balance sheet for any given size level for the
company, you will learn a lot from return measures like ROIC. The reason is simple. In valuation, you
forecast revenues, margins, reinvestment and risk. Since reinvestment (i.e. net CAPEX and change in
NWC) are changes between two balance sheets, and margins captures what happens between
revenues and NOPLAT, we can quickly understand the investment needs and the margins when
looking at ROIC.
• In other words, du-pont shows - on the y-axis (margins) - what happens between revenue and
NOPLAT in a DCF, while it - on the x-axis (capital turnover) – shows what happens between
NOPLAT and free cash flow.

Biases, Uncertainty & Complexity

This section about biases, uncertainty & complexity in valuation will be the shortest section in the guide. The
reason is not that these aspects – which can completely ruin the art of valuation - does not matter. But rather,
this section is short since we will refer to a short video of around 45 minutes on the subject instead. Please
search for The Dark Side of Valuation: India Business Forum on YouTube, or follow the following link
[Link]
Watch it, reflect upon it, then watch it again. Think about what he is saying, and think about the choices you
will do when valuing companies in SSIF.
We encourage every analyst to write a note on a piece of paper when they begin to analyze a company. It
should have the name of the company, and clearly state which preconceptions you have about it and why you
had those preconceptions. It should say why you chose to value it, whether you believed it was under of
overvalued, and have a rough estimate of its value. If you really do not know, just give us your gut feeling.
When you present your analysis at the pitching event, bring the note, and show it to everyone there. This will
not just will serve as a test to see who read the guide, but also help you understand your own biases, and invite
everyone to look upon your valuation with a better understanding of why the assumptions are what they are
and where to look for certain flaws in the narrative and numbers.

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The Three Broad Approaches to Valuation

Intrinsic Valuation, Relative Valuation (Pricing using Multiples), and Real options
There are only three broad approaches that can be used in valuation. The first is intrinsic valuation, where we
discount future cash flows to find the true value of an asset. In corporate finance, the cash flow is free cash
flow to firm or equity, and the discount factor is weighted average cost of capital or cost of equity. Intrinsic
valuation stands on a firm ground of the very fundamentals of finance; the value of an asset should always
equal the present value of its future cash flow. In effect, the value of a company is always a function of a
business capacity to generate cash flows, the growth in those cash flows, and the risk associated with the same
cash flows. In this guide, we will discuss the different components of the classical discounted cash flow
valuation (DCF) approach to valuation – Cash flows, growth, risk and terminal value. Even though the
concept terminal value is really an extension of the first three components in perpetuity, we have chosen to
discuss it separately as it comprises an important aspect of valuation. We will then end the Intrinsic valuation
part by discussing the loose ends to valuation, what we call valuation refinements which discusses the
unrealized power of the DCF, and valuation diagnostics, where we show how reflections of the output can be
of amazing value to the analyst.
The second technique is really a pricing technique, as it used to “Value” a company using multiples. In essence,
relative valuation boils down to 1) finding comparables, 2) scaling them to a common variable, i.e.
standardizing the prices, and 3) adjusting for differences across assets when comparing the values that were
just standardized. After that, you simply multiply your number with the variable you scaled it with in the first
place, and you and up with a value. Since multiples are one of the most misunderstood valuation techniques,
we introduce a four-step process with definitional, descriptive, analytical and application tests to both show
how easy the fair value of a company is to manipulate and further minimize potential pitfalls using the
technique. We also cover why relative valuation is used to much by professional analysts, what it says about our
view on efficient markets, and further we end with the five principles of relative valuation as explained by
McKinsey.
Much of what we do in valuation has been around for a long time, as is not very sophisticated by design. The
third valuation technique we will talk about is though, is an exception to that rule. Here, we will use option
pricing models as a valuation tool. Not to value options, but real businesses such as oil companies with
undeveloped reserves, young pharmaceutical companies, or perhaps equity in a deeply distressed firm. We will
look at the option to delay, the options to expand and abandon, and distressed equity as an option. We will
further discuss the key criterias when, and when not, to use real options is valuation.
What About Asset Based Valuation?
Some argue that there is one more valuation technique than the three above – asset based valuation. You
might for example be liquidating a business and thus selling its assets separately, or you might have an
accounting mission where you are moving towards a more “fair value” accounting and thus want to look at
the value of each assets separately, or perhaps you are a potential acquirer or investor interested in a sum of
the parts valuation of a company. The reason why we have not presented it as a fourth technique is quite
simple. Think about how you are going to value the individual assets. There is no other way than using
intrinsic valuation or relative valuation (or just grab the accounting value if you have zero ambitions), meaning
that even if you do an asset based valuation, you have to use one of the techniques already covered. Like we
explain under both intrinsic and relative valuation, though, we recommend valuing business by thinking about
the sum of its parts, when possible. This will be highly difficult in situations where cash flows from for
example business units or different types of products are linked together and dependent upon each other, but
easy when they are completely independent of each other.

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Intrinsic Valuation – A search for true values

Introduction to True Values
The value of an asset has always been, and will always be equal to the present value of its future cash flows.
The financial galaxy will see booms and busts, optimism and pessimism, high growth periods and low growth
periods, changing exchange rates, fluctuating interest rates, commodity price swings, and shifting correlations
between assets. It will be filled with the activities of traders in suits with heart problems, high frequency
algorithmic computers programmed by Russian math geniuses, prestigious investment companies, novice
young investors in pyjamas, enormous funds managing your parents pensions, insiders wanting to make some
extra cash, short-term speculators that just used up their cash balance on their poker account and are looking
for some more adrenaline, long-term dividend lovers what has never sold a share in their life, active alpha-
seekers using the latest financial research to outperform the market, passive index investors that has given up
on their own judgement, and everyone in between. Still, the main principle of value remains. The value of a
company is a function of its cash flows, the growth in those cash flows, and the risk associated with those
cash flows.
The next section will discuss the two major approaches to intrinsic valuation, which is valuing the entire
business or just the equity directly. The subsequent four sections will cover the different components of the
classical discounted cash flow valuation (DCF) approach to valuation – Cash flows, growth, risk and terminal
value. Even though the concept terminal value is really an extension of the first three components in
perpetuity, we have chosen to discuss it separately as it comprises an important aspect of valuation. We will
then end the Intrinsic valuation part by discussing the loose ends to valuation, what we call valuation
refinements which discusses the unrealized power of the DCF, and valuation diagnostics, where we show how
reflections of the output can be of amazing value to the analyst.
The Two Approaches
Normally in valuation, the analyst will end up with the estimated fair value of a share, which will then,
considering the current price of the share, lead to a financial decision. That number can either be reached by
valuing the entire business, i.e. both the assets in place and the growth assets (i.e. the asset side of the financial
balance sheet, as we covered under “The Basics of Financial Statements, and the Role of Accounting in
Valuation”), which is often referred to as the enterprise value, and adding cash and cash equivalents to that value,
and then subtracting out debt (or, put differently, we add up enterprise value and net debt). We will cover more
in detail why, and exactly what debt and cash equivalents refer to, under the loose end part later in this
chapter.
The other approach is to value equity directly. We then discount the dividends or the free cash flow to equity
at the cost of equity. But more on that under cash flows.

It is generally preferred to use the first method, where the focus is primarily on the business itself, and then
end the valuation with adjustments. We generally want to focus on operations as much as possible, which
means looking above the financial net in the income statement and stripping out excess cash from the balance
sheet when making profitability calculations. To be consistent, we therefore adjust for the financing and the
tax effect of interest in the discount rate (the WACC, covered under the risk section below). In theory, the
two approaches (i.e. valuing equity indirectly or directly) actually should yield the same results, but it can be
tricky to make that check in a more complicated model. Cash flow to equity models, though, is often
preferred for financial services companies like banks.

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Cash Flows
Direct equity valuation
As we are taught in the first finance courses, the value of equity is next year’s dividend divided by the cost of
equity minus the growth rate (if constant). Due to the fact that companies can buy back shares, which has the
same effect as a dividend, we can use the term augmented dividend, or dividends plus stock buybacks instead.
But as it turns out, we are implicitly in these models assuming that management are paying out exactly the
right amount from their excess cash so they can meet the operating and reinvestment needs of the company.
Since that is rarely the case, it is often better to measure potential dividends as the cash flow shareholders receive.
Potential dividends are what management could distribute after taxes, reinvestment needs and debt cash flows
requirements has been met. We call this the Free Cash Flow to Equity, and is equal to:

Which can be simplified to (setting Net income = NI, Depreciation - Capital expenditure = Net CAPEX,
change in working capital = ΔWC:

An intuitive way to think about this cash flow is basically: how much of the earnings and new capital raised
from debt are left for equity holders after having invested in the long-term fixed assets and more short term
assets (working capital). Since disproportionately issuing new debt (not growing in a financially balanced way)
and distributing cash to shareholders is not possible in the long term, the last part of the above equation
should be viewed with some caution. Financing decisions does not create value for equity holders just because
cash is distributed to them. There is always a trade off between positive aspects like higher growth rates in
earnings and earnings per share and the negative aspects of higher risk captured in the discount rate, but also
in bankruptcy costs, distress costs and agency costs. Financing decisions only creates value by finding the
optimal point in that trade off.
Forecasting said free cash flows to equity into the future and discounting them back at the cost of equity will
lead to your value of equity. The value of that equity divided by the number of shares outstanding will give
you your estimate of the stock price.
Enterprise Valuation to Equity (indirect)
The enterprise value approach (or operating assets approach) on the other hand, identifies the cash flows
available to both debt and equity holders. Instead of beginning with the net income, we then move up in the
income statement to operating income (EBIT). From that number we – after deducting the “fictional” tax, T,
that would be applicable to operating income - deduct the cash flows required to grow and invest to continue
to conduct the business. Setting the after tax operating income to EBIT*(1-T), Depreciation - Capital
expenditure = Net CAPEX and change in working capital = ΔWC, the e the free cash flow to the firm is:

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The key difference is simply that FCFF is before debt cash flows, whereas FCFE is after debt cash flows.
We can also think about the free cash flow to the firm in terms of operating income (EBIT) and reinvestment
rates. Going back to the key value driver formula in the section “Return on Invested Capital” under “Facts
about the drivers of value, the ROIC-WACC spread and Revenue Growth”, you will see the similarities to the
following functions:

Where reinvestment rate can be described as:

A simple way to think about the above equation is simply, how much of the after tax operating income is
being invested in term of both long and short term assets for the future. Since the numerator is the change in
invested capital in the business, and the denominator is a measure of income, we can just divide the both
numbers with invested capital to get the growth rate in the numerator and a profitability measure in the
denominator, like this:

Therefore:

It is this cash flow that is the equivalent of the potential dividend in the direct equity valuation model.

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Risk
Introductory words on extra resources
There is a powerpoint available as a resource on SSIF’s website called “Cost of capital” that specifically
discusses cost of capital further and in more detail. It can give the analyst deeper understanding of both the
estimation process and logic behind the cost of capital.
Cost of equity and cost of capital

When valuing equity, you look at the risk of the equity investments, whereas when valuing the business, you
look at the risk in a firm’s operations. Equity risk, in discount rate terms, will be captured in the cost of equity,
whereas business risk will be captured in the cost of capital – a weighted measure of the cost of equity and
cost of debt proportional to the choice of funding for the company, referred to as the WACC.
But what is this “cost” that we speak of? There are two ways of thinking about it, really. From the company’s
viewpoint, it is the implicit cost of the raised funds and thus a benchmark for how profitable a company must
be to create value. From an investor point of view, it is the required rate of return given the risk associated with
the company’s securities, or simply the rate of return that capital could be expected to earn in the best
alternative investment of equivalent risk. We want to stress one important issue here that is often forgotten.
When we are trying to find the cost of capital, we estimate it using the formula for WACC. It is not determined
by the formula. Risk is obviously a function of the reality that the company operates in and therefore
influenced by a huge number of factors. The market consequently prices the business relative to other assets
in the marketplace, giving rise to certain characteristics of volatility, risk premiums, expected returns, etc.
reflecting that risk more or less efficiently. We then try to use the information the market conveys to estimate
what the cost of capital is for a certain company. We use market values in these calculations, not because the
market is right (we wouldn’t be interested in doing valuation if that was always our view on the market
efficiency), but rather since we do the valuation today, and if we decide to buy a stake in the company, we have
no other choice than to buy it at today’s price levels and with that follows the logic that the return other
investors require on their investment in the company is a return on the market values, not the book values of
debt and equity.
The CAPM and practical applications

At this point, it should be said that finance is always in debate and continually evolving as a field of science.
What we are basically cover here is the CAPM view on risk augmented with some general practical tips to
make sure the analysts of SSIF does not make any huge flaws in assessing the discount rate and discrete
events. There is of course endless literature on the more theoretical aspects of asset pricing and investment
management that discusses what better captures the reality we see out there (like the fama-french 3, 4 and 5
factor models, CCAPM, and other generally flexible arbitrage pricing models) and to what level the market is
efficient and what models make the most sense, but we leave most of those aspects to be discussed in the
classroom. What can be said is that the CAPM is used in practice all the time, since its theoretical
underpinnings are very strong in the sense that investors should only be compensated for systematic risk
(undiversifiable risk) and not idiosyncratic risk (risk that can be diversified away by having many companies in
a portfolio).
The cost of equity formula is the following:

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Or, in words, the cost of equity is the sum of the risk-free rate 𝑅𝑓 and what the market requires for stocks to
return in general above the risk free rate (𝑅𝑚 − 𝑅𝑓 ), 𝑜𝑟 𝑡ℎ𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚, adjusted for the riskiness of this
particular stock in relation to the market, 𝛽. Beta is simply the stocks exposure to market risk in general. Here
are some facts about each component of the formula and practical tips for estimating each of them.

• The risk-free rate: The most commonly used proxy is the 10-year government bond yield, as
governments seldom default. 30-year bond yields are also sometimes used. This number is a google
search away.
• The equity risk premium (ERP): This number should reflect how investors perceive the risk in the stock
market relative to a risk-free asset. This number can be calculated in different ways, is volatile, depend
on one’s assumptions, and have different trends over time, which is why it is also a debated number.
Looking at U.S. history from 1928 to 2015, using an arithmetic average, stock has delivered 7.92%
above treasury bills. Using a geometric average, though, just looking at 2006 to 2015 and using treasure
bonds as the comparison, the value is 2.53%. You can find these exact numbers in the book Narrative
and Numbers by Aswath Damodaran. One way to calculate the ERP is looking forward using an
implied ERP by using fundamental performance (earnings, growth and ROIC expectations) and
backing out the risk premium. McKinsey argues for that the ERP for valuation purposes should
around 5 per cent in the U.S. and more developed economies by both taking lessons from the past
and looking forward, and taking into consideration aspects like survivorship bias in the sample and
basing the argument in a lot of financial theory. KPMG also releases informative reports available
online that estimates the ERP for several countries. It is normally in the range of 4 to 7 percent.
• Beta: Beta represents a stocks incremental risk to a diversified investor. It can be estimated using a
regression with the returns of the stock you are looking into as the dependent variable and the market
portfolio (often proxied with a weighted average of the returns of all the stocks in a country or the
biggest companies on an exchange, like the S&P 500 or OMX 30) as the independent variable. There
are several problems with this approach. The first is that it is backwards looking, when we are actually
interested in is the risk in the future. The second is that the measure is noisy, and can shift drastically
dependent on the sample you take. McKinsey gives 3 advise to make sure the results are relatively
reliable. 1) The measurement period should have at least 60 data points (e.g. five years of monthly
return data), and rolling betas should be graphed to see if there are any trends in the systematic risk
exposure. 2) Use monthly return, since daily returns are too noisy and lead to systematic biases. 3)
Regress company returns against a value-weighted, well diversified index. We also recommend that
use smooth the beta, which is a process where you make it closer to one if the standard error of the
regression beta is high in relation to the cross-sectional standard deviation of all betas. There is a
function in Bloomberg that does this automatically. Finally, we recommend using unlevered sector
betas as much as possible, and then lever that sector beta up towards the capital structure that the
company in question has. The reason is that looking at many companies will average out your
mistakes in the unlevered beta estimation process. Normally, a little common sense about the risk of a
company in relation to the market will get you far. As you might expect, unlevered betas are the
lowest for companies that has products and services that are demanded regardless of the state of the
economy. For example, electric utilities, health-care providers, education, tobacco, integrated oil &
gas and airlines have low betas (ranging from 0.5 to 0.9) whereas semiconductors, insurance and some
transportation sectors have betas above one.
Damodaran says that a company’s beta is a function of (i) the business it is in (degree of cyclicality),
(ii) its operating leverage (can be determined by looking at how changes in sales has historically
converted to changes in EBIT, and furthermore comparing this to peers), and (iii) its choice of
financing (remember, the equity beta increases with higher leverage).

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It is the cost of equity that you use to discount the estimated free cash flows to equity to end up with a value
for the equity in your company. If you wish to value the operations, you need a couple of more inputs.
Finding WACC
To estimate the cost of capital using the weighted average cost of capital requires that we know a few more
things. First, we have to find the after-tax cost of debt. This cost is perhaps more straightforward and intuitive
than the cost of equity, since the cost of debt is explicit. If the company’s debt is trading in the market, you
can simply use the yield to maturity (YTM) as the interest rate on the (straight) bond as the before tax cost of
debt. If the company’s debt is not trading, but is rated by a rating agency like Standard & Poor’s or Moody’s,
you can use the typical default spread (the extra return a bondholder should have on top of the completely
risk free debt) on debt of similar rating and add to the risk free rate. If the firm is not rated, and it has recently
borrowed long term from a bank, use the interest rate on the borrowing or estimate a synthetic rating for the
company, and use the synthetic rating to arrive at a default spread and a cost of debt.
There are two key things to take into consideration in the cost of debt:

• You want a long-term cost (preferably a 10-year cost) of debt even if your debt is short term. You do
not want to reward companies that “play the term structure” by giving them a lower cost of debt and
capital. In effect, you are assuming that the rolled over cost of short term debt becomes the cost of
long term debt.
• You want a current cost. Thus, you should not use debt and interest expenses on the books. The
book interest rate (interest expense/book debt) is not a good measure of the cost of debt because it
does not reflect the current cost of borrowing and may even be lower than the risk-free rate.
If you do not have default spreads, remember that the cost of debt should reflect the risk of the debt. One
very commonly used method in obtaining the default spread is therefore to use the interest coverage ratio of
the company, which is the earnings before interest expenses divided by interest expenses, as a proxy for
default risk. You can find these syntetic ratings on Damodarans website under useful datasets, or follow this
link: [Link]

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For example, for larger firms, you can use the below table to estimate the default spread.

For large manufacturing firms

If interest coverage ratio is
Rating is Spread is
> ≤ to
-100000 0,199999 D2/D 14,00%
0,2 0,649999 C2/C 10,50%
0,65 0,799999 Ca2/CC 8,00%
0,8 1,249999 Caa/CCC 6,50%
1,25 1,499999 B3/B- 5,50%
1,5 1,749999 B2/B 4,50%
1,75 1,999999 B1/B+ 3,75%
2 2,2499999 Ba2/BB 3,00%
2,25 2,49999 Ba1/BB+ 2,50%
2,5 2,999999 Baa2/BBB 1,60%
3 4,249999 A3/A- 1,25%
4,25 5,499999 A2/A 1,10%
5,5 6,499999 A1/A+ 1,00%
6,5 8,499999 Aa2/AA 0,80%
8,50 100000 Aaa/AAA 0,60%

The after-tax cost of debt is then simply:

Next, you need to know the market values of debt and equity as to be able to weigh the after tax cost of debt
and cost of equity. The market value of equity is just the market capitalization. If the debt is trading, then you
can just grab the market value from for example yahoo finance or any other finance data provider. The book
value of debt can differ from market values, but the company is small and its debt is not traded in the market,
the book value of debt will suffice.
The WACC equation thus becomes:

The reason we use the after-tax cost of debt is because interest is tax deductible, and since our free cash flow
to firm calculations is based on an operating income measure (before interest income and expenses), we need
to include the tax effect in our discount rate instead as to capture the positive effect of paying less tax when
having a higher interest (getting a lower taxable income). The WACC equation can be extended to include the
cost of preferred shares as well, but we will not go further into that matter in this guide.
There is nothing to stop you from changing the cost of capital as the firm you are valuing matures. As growth
tapers down, and the main value is created from assets in place, you should give it the risk characteristics of a

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mature company. That normally implied betas close to zero, and a capital structure more in line with the
mature companies in the sector (often more debt, making sure the tax benefits from debt are used to its
fullest).
Some argue that if your aim is to build in a drastic cost of capital change during the valuation period, especially
beginning when the cost of debt is very high, it is better to use a EVA (economic value added) valuation
model, where the value creation/destruction is calculated directly by looking at invested capital and the ROIC
WACC spread. You can read up more on EVA DCFs in the book Valuation by McKinsey.
We can also find WACC by first finding cost of assets (what we sometimes call the unlevered cost of equity)
and subtracting the effect of the cost of debt taking the interest tax shield into consideration, like this:

With some simple algebra you will see that the two ways of stating WACC is the same.
Discrete risks and country differences
Since SSIF looks at stocks all around the world, we thought it would be a good idea to zoom out a little bit
and provide some clarifications on how to think about country risks in valuation. In the process, we will also
discuss discrete risks, i.e. risks that occur due to certain events and are more binary in their nature. We need to
think of these risks separately, since the discount rate we use is for the DCF process has a going concern
assumption built into it. For example, if we are analyzing a company that is in financial distress, and believe it
will recover and become a stable company in 10 years, we will estimate cash flows for the future of the
company and discount them back with an appropriate discount rate, but we must also take into consideration
that it might fail on the way and simply stop existing. We have chosen to grab a graphical representation of
these ideas from Damodaran’s blog to showcase both how to think of country risk and discrete probabilities
of failure.

First off, choose a risk-free rate that is in the same currency as your cash flows. Second, one process of
finding the equity risk premium of a country is to add a country risk premium to a mature market risk
premium (think the U.S.) An excel sheet with estimates for specific countries equity risk premiums can be
found following this link. [Link]
Third, the relative risk measure has nothing to do with the market itself, as it is only a measure of relative risk.

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In the below picture, there are some clarification of the previous picture, but is zoomes out further to clarify
that micro and country specific risks should also be thought about in the expected cash flows going into the
DCF, as well as that discrete risks has value consequences, and these must be considered, especially in very
risky countries where for example nationalization is a real threat.

I we stated earlier, the probability of discrete events must be considered. The simple function for the adjusted
value thus becomes:

Risk associated with discrete events are not only specific to certain country aspects. Whole industries,
especially pharmaceuticals and oil and gas exploration, require valuation that is much more focused on
discrete events of failure or success. It is therefore that these industries should be analyzed with real options in
mind. We will discuss real options in a separate chapter, though.
Growth
The three approaches to estimating growth
We discussed growth under “Facts about the drivers of value, the ROIC-WACC spread and Revenue
Growth”. After having read and understood that past growth is not a guarantee for the future, you should
probably draw the conclusion that estimating future growth should not be solely based on past performance.
But looking at historical growth, analyzing how, and why, the company has grown or declined in the way it
has, is of course valuable as it in many cases gives indications and guidance in your analysis of a reasonable
future scenario. Luckily, looking back is just one of the tools in the toolbox for thinking of future growth.
The second is looking at what other analysts are projecting for the future. Especially in the short term, some
analysts are very well equipped in understanding the developments that might drive growth. But we remain
critical in relying to much on other analysts. One reason behind this is that you should keep your valuation
your valuation. Keeping the feedback loop open when developing your story for the company’s future and
listening to other is of course crucial, but you should never stop trying to make your own assessments of
growth, even though you might be uncertain. Complacency and forecast-herding is a dangerous but common
force in the financial world, so we understand that it might feel scary to deviate from other analysts on such a
crucial assessment like revenue growth, but the payoff to doing valuation is the highest when you trust
yourself, not others.

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The third approach is using fundamentals. Remember the key value driver formula and our discussions on the
iron triangle of value? One of the conclusions from our discussions so far should be that you cannot grow in
the long run without reinvesting, and reinvesting is cheaper when the return on capital is higher.
Consequently, we should realize that changing growth comes from either changing reinvestment, changing
return on capital, or a combination of both. Growth is both external and internal at the same time in the sense
that, most often, growth requires reinvestment by the company, but the market demand also has to be there
after the investment has been made. Growth, profitability and reinvestment in one way or another always
“happen” at the same time. It is equally true to say that growth is the basis for reinvestment as to say that
reinvestment is the basis for growth, but from a mathematical point of view, the simple relationship 𝑔𝑟𝑜𝑤𝑡ℎ =
𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 ∗ 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 has to hold. In the case where operating earnings are negative,
we usually benefit more from thinking about revenue growth potential first (e.g. thinking about where the
company might be in market share and how big the market can be in 10 years, and backing out the growth
rate from there), and then changing the operating margins in light of the specifics of the company (its long
term sustainable competitive advantages) and in relation to the market as a whole (what is the distribution of
margins, how will the competitiveness change over time, etc.) and as we get closer to a more mature company
apply a target operating margin. Think about its reinvestment needs (capital turnover) and derive what it must
reinvest into invested capital to create the estimated revenue growth. The ROIC should be reasonable at the
end of the forecast period. Look at the “story-assumptions, cash-flows-value-one-pager” for a clearer view on
this way of thinking.
The following picture summarizes the ways to estimating growth.

Estimating the Growth Rate

Equity Earnings Operating Income

Analysts Fundamentals Historical Analysts Fundamentals Historical

Stable ROE Changing ROE Stable Changing Negative

ROIC ROIC Earnings

𝑅𝑂𝐸 𝑅𝑂𝐸𝑡+1 ∗
∗ 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 𝑅𝑂𝐼𝐶 ∗ 𝑅𝑂𝐼𝐶𝑡+1 ∗
+ (𝑅𝑂𝐸𝑡+1 − 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒
𝑅𝑂𝐸𝑡 ) ∗ 𝑅𝑂𝐸𝑡 𝑟𝑎𝑡𝑒 + (𝑅𝑂𝐼𝐶𝑡+1 −
𝑅𝑂𝐼𝐶𝑡 ) ∗ 𝑅𝑂𝐼𝐶𝑡

1. Revenue growth
2. Operating Margin
3. Reinvestment needs

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Terminal value
What is the terminal value?
Publicly traded firms can, at least in theory, last forever. When we reach the end of our cashflow estimation
period, we want to compute a terminal value that reflects the value at that point, as it is truly impossible to
estimate cash flows forever. This is to put closure on the estimation, and make sure we capture all value in a
company when analyzing it. There are really only two ways of calculating this terminal value. The first is
liquidation value, and the second is going concern valuation.
Liquidation value
In some cases, there is reason to assume that a company won’t continue to operate and create cash flows at
the end of the estimation period. We then look at the assets the company holds at that time, and think about
what the liquidation value are for them. This number is often a mixture of market-based numbers such as real
estate that already have markets they are sold in, and estimates. Normally this is a quite conservative way of
estimating value, but it has its place. Companies that are project based, and might for example have to close
down a factory, restore the land it has built on, and then stop existing is a good example of where liquidation
value is a reasonable approach.
Going concern value
We can easily value a company in perpetuity by just using the following formula:

Once again, the definitions of cash flow and growth rate has to be consistent when with weather you are
valuing cash flows to equity or to firm, where the first requires the cost of equity and the latter requires the
cost of capital, WACC.
You can use the key value driver formula as the perpetuity formula, yielding:

RONIC just means return on new invested capital, and is just to just clarity that it is the new capital that is in
perpetuity being invested. Using this formula will guarantee you are not making unreasonable assumptions
about the FCFF for any given level of growth and ROIC.
There are three main constraints to consider when finding the terminal value.
1. The growth of the firm has to be less than or equal to the growth of the economy. The growth of the
economy can be proxied by the risk-free rate. Since the risk-free rate is also captures in the WACC, it
makes sense to use the same number in both numbers. It is completely fine to have a negative growth
rate, which just implied that the company will over time will be a smaller and smaller part of the
economy.

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2. In the terminal value, give the company the characteristics of a mature company. Beta should revert
to one, and the debt ratio to industry norms.
3. Reinvestment of earnings should be enough to maintain the chosen growth rate in perpetuity. Thus,
the free cash flow to the firm is not overstated.
Some misconceptions about terminal value

• It is uncertain to have a large portion of the company’s estimated value in the terminal value. This is a classic
misconception when doing valuation. You sum up the discounted value of the free cash flows during
your estimation process, and compare it to the terminal value discounted back to today. You become
scared because you feel as if your entire valuation is in that last number, which is sensitive to your
assumptions. There are a several aspects to remember here. First, if you are comfortable with the
length of your high growth period and you have applied the perpetuity formula at a place where you
actually believe the company will stop growing, you should be comfortable with whatever proportion
of value you see in your forecasted period and at terminal value. If you explicitly forecast FCFF or
FCFE 5 more years into the future when the growth is stable, and then apply the terminal value
formula into eternity, you will have a lower value in the terminal value and a higher value for the
explicit forecast years, but the total value remains the same. Second, if you feel uncertain, that
uncertainty should cut both ways: the results are just as likely to be higher than an unbiased estimate
as they are being lower. Third: instead of looking at the value in terms of the value of a certain
amount of years in relation to a continuing value, you can think of it either in terms of business
components (like base business and new product lines) and/or the economic profit approach, where
you sum up the invested capital, the present value of the economic profit (excess return multiplied by
the invested capital) the coming 10 years, and economic profit in the continuing value. You will then
see the value of the company from an operating performance view, rather than a mathematical one.
• The value is so extremely sensitive to the growth rate: Actually, the value is really sensitive to the spread
between ROIC and WACC. You can push up the terminal growth rate to 6 per cent, but if ROIC
equals WACC, there will be no effect on value. Further, if the growth rate is in line with the growth if
the economy or lower, there is really no cause for concern. In some DCFs, you will therefore see that
the continuing value is simply NOPLAT divided by WACC. The lack of a growth rate is not
necessarily because there is not any growth. Rather, it is because RONIC equals WACC. Whatever
you do, do not divide NOPLAT (i.e. leave out the growth and profitability part of the following
formula with WACC minus the growth rate. That implicitly assumed that the
RONIC goes to eternity for the equation to hold.
• The ROIC must equal WACC in the terminal value: Many argue that the company should not be assumed
to create excess returns in perpetuity. There is some logic behind this statement, but looking at the
data (think for example of how very lasting high ROIC is, that we discussed under “Facts about the
drivers of value, the ROIC-WACC spread and Revenue Growth”) firms with strong and sustainable
competitive advantages can maintain excess return, though at modest levels, for very long time
periods. One more aspect to consider here, though, is that if you lower RONIC to, say, WACC that
does not mean that all that the profitability generated by the company’s capital is immediately
lowered. Rather it is just the new capital that is less profitable. This point can be hard to see just
looking at the formula, but the logic behind the key value driver formula is that it is based upon
incremental returns on capital, not company-wide average returns. The original capital still earns the
returns projected in the last forecast period. Thus, if RONIC is set equal to WACC, the ROIC on
total capital will slowly come down towards RONIC and WACC.
Are there other techniques?

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Some argue that the book value of equity, and even multiples are techniques to estimate terminal value too,
but there is really no place in intrinsic valuation to discuss accounting measures of equity, nor use pricing
techniques in the future. Using a market multiple to estimate a terminal value, you are following a hybrid
approach to intrinsic value determination. This approach is not based solely on company fundamentals and
the mathematical properties of perpetuities, but rather a relative value. Sure, it is good to understand the
market sentiment, which we further discuss under relative valuation, but on top of all the issues and potential
pit-falls you normally have to consider in relative valuation, you now also have to make the assumption that
the market will price the company in a similar way that it does to other companies today, 5 or 10 years in the future
– a very risky and actually simply irresponsible way of doing “valuation”. Yet, we do see professionals apply
this technique, perhaps because they feel as if the perpetuity value is very sensitive to growth rates. But we
have already, in the previous section, discussed why that really is not an issue that should cause concern. In
our section on relative valuation, we further discuss that hiding your assumptions behind a multiple does not
make your valuation sounder, but rather less so. There is some logic in stating that we can look at the terminal
value calculation simply as a multiple, and that is true since 1/(WACC-g) is the multiple we use together with
the FCFF when in the perpetuity formula. And since WACC is one way or another derived from the market
(e.g. the equity risk premium might be derived from current valuations and analyst expectations on growth
and profitability), we are really just applying a multiple. It is fine to think of the value this way, but the
underlying idea is still to find an intrinsic argument for value though the present value of future cash flows,
not to take a multiple of a static truth like EV/EBITDA based upon todays transactions in the market.

Valuation Refinements and Diagnostics

You will sometimes hear that a DCF is not a versatile tool, and that its to rigid to be used to value most
companies. We disagree. We also agree with Damodaran on the following points that he brings up in his book
Narrative and Numbers that both showcases the flexibility of the DCF, and ways you can think about, and
reflect upon certain output that you might not normally do in a valuation setting.
Refinements of the DCF

• Currency Invariance: One of the strengths of a DCF is that it can be applied using any currency in any
interest environment, as long as you make sure to be consistent and use the same assumptions about
inflations in your cash flows and interest rates. Low inflation country → Low Growth rate, but also
low expected growth rate (as the growth is in nominal terms affected by that same inflation), and vice
versa in a high inflations country.
• Dynamic Discount Rates: A company that is expected to change with its business mix and growth over
time would also be expected to have a varying discount rate (does not have to be WACC) as the risk
profile and/or the debt mix might change. Therefore, it is completely logical and consistent to change
the discount rate as the narrative unfolds in the future of your forecast. This is a very flexible property
of the DCF. It should be said that you do not see this being done too often, though, as it is
demanding when trying to be very precise due to the fact that there is a feedback loop in value and
debt capacity due to how interest tax shields work. They might incorporate it in another way, do
scenario analysis, use the adjusted present value with a lot of simulation, or use some other technique.
Valuation Diagnostics

• Growth, Reinvestment Rate, and Investment Quality: Remember the iron triangle of value, i.e. the balance
between risk, reinvestment and growth? One check for consistency that you can do to reflect upon
this triangle is to divide the total change in operating income over the estimation period by the total

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reinvestment during the same period. You can refer to this as the Marginal return on invested capital,
a rough measure of how good, on average, you think the company’s investment will be in the future.
By comparing it to its history, industry averages, and the company’s cost of capital, you can reflect
upon if the marginal return on capital is too high or too low.
• Risk and Time Value of Money: Just to revisit and truly understand the basics of finance and discounting,
look into how much you are penalizing the company with the concept of time value of money and
risk. Do this by just adding up the un-discounted nominal cash flows, and compare it to your
discounted value. You will often be surprised with the sheer size of the difference, especially in a
high-inflation and risky setting.
• Cash Flow Value: Young growth firms and money losing firms often have negative cash flows. For
companies investing heavily for the future or turning their business around, you would expect
nothing else than seeing these negative cash flows today. Future high growth is contingent upon
negative cash flows today. Here is a consequence of those negative cash flows. They are capturing the
dilution effect – i.e. the concern that equity holders have that their current investments in the company
will be diluted as more equity holders has to put in money in future issues of stock. Therefore, you do
not need to adjust for future issues by increasing the numbers of shares outstanding. That would be
double counting the dilution effect. The negative value for shareholders due to the dilution effect is
simply the sum of the present value of the negative cash flows for those initial years.
• Negative Value of Equity: As covered, equity equals enterprise value minus net debt. What happens if
enterprise value is smaller than net debt though? In one sense, equity cannot be lower than zero, since
the market price cannot be lower than zero. In the other hand, equity can be less than zero in the
sense that a deceased company can continue to exist with the hope of an unlively turnaround that
pushes operating assets above net debt again. What happened during that period is that equity takes
on option characteristics, and the analyst should therefore use option valuation models to find a fair
value for the equity in that company.

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Relative Valuation – A Process of Analytical Pricing!

Introduction to Relative Valuation (pricing)

Let’s say you are looking to buy a house or an apartment (a challenging task for a student in Stockholm in this
day and age). The only problem is that you have no idea what its value is so, as the rational prospective
property buyer you are, you do not know what to bid. What you might do is look for clues in recent
transaction prices on property of similar characteristics of the one you are interested in. As a matter of fact,
this is to a large extent what property valuation experts are getting paid to do2. After having found a relatively
tight peer group of transactions – or comparables - e.g. within one or a few area codes or areas with the same
characteristics3, one reasonable way to continue is scaling the prices for these apartments or houses using a
common variable, preferably living area4. You end up with a price per square meter on historical transactions,
which might convey information of the value of the apartment you are looking to buy.
Even within a smaller area in a city, the price per square meter will most likely vary quite substantially. Does
this price inconsistency suggest market mispricing? No, it’s to early to call. Digging deeper, you will most likely
find that the apartments or houses that has recently been sold for higher price per square meters – or higher
multiples - also had some combination of smarter flor plan, a higher ceiling, greater view, extra storage space, a
terrace, free parking space, access to a gym etcetera (let’s continue this example assuming you are buying an
apartment in a larger building under a housing cooperative to which you pay a monthly fee even though you
technically owe the apartment, which is common in Sweden). Having considered said aspects5, you will most
likely find that less of the price difference remains unexplained. The remaining unexplained difference, if there
is one, might still not be market mispricing. Digging deeper you might see that the apartments selling at the
lowest price per square meter will be part of a housing cooperative with poor economy, and the building has
not gotten a renovation in 50 years – a bad combination. This should also be reflected in high and increasing
fees to the housing cooperative to prepare for coming capital expenditures and balance the equation, rightly
pushing down value.
Looking for a valuation mismatch, you want a low price per square meter coupled with several positive
aspects which you realize should be priced in the market, e.g. a strong economy of the housing economy, a
smart flor plan, an apartment with a large terrace with an unique view as well as a free parking space and a
spacious storage room. Having considered these aspects, you should also consider having a margin of safety,
i.e. be confident that the valuation mismatch is larger than say, 20%. This is especially true for real estate since
there are aspects which are hard to quantify like walkability to recreational areas, access to public
transportation and some specific features of the neighborhood, which can differ within your chosen peer
group. Many argue that differences in aspects like size, location, scale, age and quality of production should be
accounted for before comparisons are made, i.e. the comparables should be even more cautiously chosen, just
to only include almost identical apartments. Eliminating to many “comparables” though might just leave you
with a very few transactions which makes it difficult to draw any reliable conclusions at all.

2 Obviously, most skilled real estate analysts do some type of discounted cash flow valuation as well even though
estimating discount rates is difficult from both a theoretical and practical standpoint.
3 Alternatively use a wider group of transactions and adjust the valuation up or down for different area whether the

market prices these areas differently.

4 Sometimes though, scaling price to income (i.e. using the gross income multiplier) might be a better alternative

especially for real estate with commercial potential since it directly incorporated differences in scale, construction quality
and location (which then leads to higher rents/leases).
5 How they can be considered is discussed later in this chapter.

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After some thinking you will have reasoned your way towards a price per square meter price you would argue
the apartment should sell for given how similar apartments have been traded in the market. Now you simply
multiply the price per square meter with the number of square meters for the apartment you are looking at,
which with simple algebra equals your estimation for the true value of the apartment. Now you know what
your maximum bid is.
Relative valuation is, like you might be familiar with, not just used for real estate, but also for companies. The
coming sections will discuss why relative valuation is used, what is says about our view on efficient markets,
how to use and understand multiples in practice, some important principles from valuation experts, as well as
the way we feel that the analysts of SSIF should view and use relative valuation.

Why is Relative Valuation Used?

We can see four, quite pragmatic and perhaps somewhat cynical, reasons why most valuations you will
encounter are relative valuations. On each reason, we also comment on the implications for you as an analyst
of SSIF.
First, relative valuation can be done with less information and more quickly than intrinsic valuation. Especially when using
only forward multiples, ratios and key inputs based on analyst estimates, the only data you need is relating to
the companies’ fundamentals that are relevant in your sector. These comes down to a manageable amount of
financial ratios like ROIC, revenue growth and measures of risk (like CAPM based beta, balance sheet
strength and/or quantifiable aspects of the business strategy like % of revenues coming from recurring
customers, volatility in price of inputs into production, managements historical track record in controlling and
mitigating exposure of political events affecting the market etc.) which together evaluates the potential to
generate cash flow, the growth in those cash flows, and the uncertainty associated with said cash flows.
Luckily for the analysts of SSIF, you can work on an analysis for half a year if you would like, so there is no
stress into “just” relying on a relative valuation. We will help you to find information faster if you want to, but
there is nothing that says you must produce a valuation for every pitch. Therefore, you never solely have to rely
on a relative valuation.
Second, it is a lot easier to sell the idea of a stock being undervalued using relative valuation than intrinsic valuation. Why? You
simply have to find something that is even more overvalued than you are trying to sell to us. There were
stocks during the IT bubble trading at multiples that would require future growth and profitability to be
drastically higher from what they currently were to defend the valuation, but they still looked cheap compared
to other, more overvalued, companies. This second reason is probably one of the reasons that 85% of the
equity research reports from sell side equity researchers are based upon a multiple and comparables. One of
the beautiful things with SSIF though, is that we are simultaneously buy-side and sell-side, mitigating any bias
that might occur in relative valuation. We a place where people get their chance to conduct research and sell
their ideas, but also a money managing fund. We are grand storytellers yet careful listeners. We are stock
pitchers with optimism and we are the devils advocate with a detail-oriented mind. We must present
investment opportunities, yet live with the consequences of a holding.
Third, it is far easier to defend a relative valuation, than an intrinsic one. The reason is that in intrinsic valuation,
everyone can clearly see what you are assuming about cashflows, growth and risk. Anyone can pick apart your
story and do it quite credibly, specially when other listeners themselves are not familiar with the company and
its environment. That being said, the most long-term sustainable strategy for this fund is never to solely rely
on relative valuation, even though you might see some personal risk in exposing all your assumptions in an
intrinsic one. We respect transparency, assumptions based on reason, and thought-through analyses of
outcome way more than we are impressed by a base case 200% above current price, based on a loosely chosen
peer group. Remember (because we will), a base-case of an enterprise value of 4 times EBITA has a huge

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amount of assumptions built into it, and is not automatically cheap, just like 20 times EBITA is not necessarily
expensive. We truly believe that it is better to be transparently wrong than opaquely right6.
Fourth, if you are wrong with an intrinsic valuation, you are far more likely to be wrong alone. We do not care about that at
SSIF, because contrary to real life, we won’t fire you for making assumptions that happened to be off two
years into the future. On Wall Street, analysts have incentives not to be wrong alone. How do you make sure
you have lots of company and are not wrong along? You play the pricing game. It’s a survival mechanism, so
in some sense it is natural. We argue though that it is not rational. We rather encourage you to look in places
where there can be great contrarian investments, or perhaps step back from a surging stock where the pricing
game has taken over in place of valuation. Put simply: just think about doing your best effort possible, not the
job that minimizes your personal risk while consequentially being overconservative or complacent in your
investment picks.

Relative valuation vs intrinsic valuation – the view on efficient markets

Discounted cash flow valuation is used for a simple purpose: to value any company in any sector at any time,
with the idea that the market can be wrong, but will adjust itself over time. Relative valuation on the other
hand - still used to identity potentially undervalued companies – does so by assuming the market is right on
average. Think about it: the fact that we use multiples and fundamentals from comparable companies to justify
a certain value of a company in question relies on that those comparable companies are on average being
traded at fair prices, otherwise such a method would be useless. Just like when looking at houses, your
valuation very quickly becomes a pricing game, rather than a question of fundamentals. If you are interested in
an apartment, and a virtually identical apartment on the floor underneath sold for 150,000 per square meter,
you might argue the value of yours is the same. We urge you to remember though, that just because someone
just paid that price, the value is not necessarily 150,000 per square meter. The implication is that an analysis
using both intrinsic and relative valuation can end up with substantially different values7 since entire sectors or
groups of companies can be over or undervalued. For example, a DCF signaling a buy and a relative valuation
suggesting a sell might mean that the entire sector is undervalued, but there are still better stocks to buy in the
sector, whereas the opposite results might mean that within the sector, it is the best choice, but in its whole,
the sector is overvalued.
More often than not, there is no obvious investment decision to be made after a relative valuation having
considered profitability, growth opportunities and risk, but if the signal from your analysis using a relative
valuation is a strong buy, and an intrinsic valuation supports that view (without biasing your intrinsic valuation
from your findings comparing your company to its peers), you might be on to something. Just always, always,
remember that relative valuation and the use of multiples is closer to the realm of pricing than it is to the realm
of valuation – a distinction which is crucial to understand, but in practice often is blurred. One evidence of
this is the fact that corporate finance professionals, like investment bankers, use multiples at the end of their
DCF and call it the terminal value. That is disguising relative valuation – pricing - as valuation to put closure
on the analysis.

6 This exact wording comes from Aswath Damodaran talking about his assumptions going into a valuation on Apple,
which he releases every quarter and have done for many many years. You can find the lecture at
[Link]
7 Still, of course, assuming you have not made any technical flaws in your valuation.

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Relative Valuation – in Essence

In our opinion, effective use of multiples is more than anything about avoiding significant mistakes. Following
the steps, guidelines and way of thinking shown below will help you avoid some of the common pit-falls in
relative valuation.
In the most simplistic and practical sense, doing relative valuation comes down to 1) finding comparables, 2)
scaling them to a common variable, i.e. standardizing the prices, and 3) adjusting for differences across assets
when comparing the values that were just standardized. After that, you simply multiply your number with the
variable you scaled it with in the first place, and you and up with a value8. In our opinion, we believe a deep
understanding about the multiple itself is crucial to execute these steps effectively. More specifically, we
recommend following a four-step process as explained by Aswath Damodaran9 and displayed in the table
below.

1. Definitional Tests 2. Descriptive Tests

- Summary statistics!
- Current/trailing/forward?
- Median/average.
- Diluted/primary?
- Consistently defined - Multiple can’t be computed – dropped?
numerator/denominator? - Changes over time = dangerous!
- Accounting standards? - Today, statistics is easy!

3. Analytical Tests 4. Application Tests

- Drivers of multiples? - What is a comparable?

- Linear or not? - Identical firm impossible to find!
- Companion variables and valuation - How to use the knowledge of drivers
mismatches. of multiples?
- Eyeball approach and multiple
regressions

Definitional tests are, put simply, the assessments you do to make sure your multiple makes sense. What do we
mean by that? Well, a multiple does not make sense if you calculate it with different variations of earnings or
capital for different companies. Looking at P/E ratios for example, the earnings figure can be:

- Trailing (based on previous years’ numbers)

- Current (based on the past quarters in the current year, but mixed with analysts’ projections for the
coming quarters), or
- Forward (next years analysts projections).
Especially in volatile and high growth businesses, mixing these up will lead to major problems going forward.
Put simply: define the multiples uniformly within the group of companies you are looking at! Another aspect

8If your standardised price is P/E, you multiply it with your estimate for E (earnings), and you have the price for the
equity. If your standardized price is EV/IC, you multiple it with your estimate of IC (invested Capital), and you have the
Enterprise Value. This is used to then find the value of the equity, and thus your stock price.

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to consider is whether the companies you are looking at have a lot of convertible securities like convertible
preferred shared, convertible debentures or stock options. This might sound like a lot of fancy, nonsensical
words if you have never heard about them before, but in short what the do is they dilute the earnings that
shareholders have a claim on, i.e. decrease the earning per share. They often have a very limited effect, but
there are examples throughout history with such extravagant management stock options that shareholders
have taken a significant beating. That company might have looked cheap using primary earnings, but not using
diluted earnings.
The most important definitional test though, is making sure the numerator and denominator is consistently
defined. So, what is a consistently defined multiple? Since the numerator is what someone is paying for an
asset, and the denominator is what someone is getting in return, the questions you should ask yourself is
whether that someone is the same investor or group of investors. For example, a P/E ratio is a consistently
defined multiple since the numerator is the market value of equity (or price per share), and the denominator is
the net income to equity holders (or earnings per share). Similarly, P/B is consistently defined since the
denominator is the book value of equity.
Your denominator can also be firm value or enterprise value (EV), both being the market value of equity + market
value of debt, but the latter excluding excess cash and marketable securities10. EV multiples are most
commonly used. They are scaled using variations of revenues (or even members/subscribers/users), earnings,
cash flows and book values11. EV/EBITA (which often equals, and simplified to, EV/EBIT) is consistently
defined since enterprise value refers to the market value of the entire ongoing enterprise (debt and equity), and
EBITA is the before tax operating income, which includes earnings that are accessible to both debt holders
(receiving interest on the debt) and equity holders (the residual claim after interest has been paid). The same
applies to EV/EBITDA. EBIT, EBITA, and EBITDA are, like EV, measures related to operating assets: EV =
market value of operating assets, and EBITDA is the cash flow generated by those operating assets. Similarly,
EV/IC, or enterprise value to invested capital (a fancier version of P/B), is also consistently defined since the
invested capital is the book values of debt and equity less excess cash and marketable securities, i.e. the book
values of the operating assets. On the other hand, P/EBITDA, or even P/S (price to sales) or Price to
members/subscribers/users, are not consistently defined since the price of equity is put into relation to operating
measures. You would be surprised how often these multiples are used, even though they really do not make
sense. We have even seen them in lectures at SSE, unfortunately. If this “internal consistency thing” is not
intuitive to you, think about the housing market. If the P/E ratio is like dividing the price of the apartment
with the square meters of the apartment, P/S is like dividing the price of the apartment with the collective
square meters of all apartments in the same building, regardless of your share of the total living area in the
building.
Before going on too much about definitional tests, there is one more thing to remember. Accounting can be
deceiving. Accounting standards change, and they can differ across companies. It might be hard to fathom,
but in practise firms have some discretion in their accounting decisions, giving rise to differences in similar
companies within the same accounting governance. This is an argument for going further up in the income
statement in your multiple, and perhaps use a P/S multiple instead of a P/E multiple. But - as you will see
under analytical tests - then you better keep track and take into consideration how the net margin develops
over time.

10 Enterprise value can be defined with more precision. We refer to Valuation by McKinsey for brilliant explanations on
this topic.
11 Firm value, like EV, can also be used in multiples (but very rarely is). You then have to add income to cash and cross

holding to EBIT or EBITDA (since you want to be consistent with your inclusion of cash and cross holdings in your
calculations). Your book value divisor would be book value of equity + book value of preferred shares + book value of
book value of debt.

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Descriptive tests might be the most overlooked aspect of multiples, which is quite peculiar given how easy it is to
do basic statistics as long as you have a computer. You might have already repressed most of the stuff you
learned in your statistic classes, but you probably remember expressions like median, quartiles, standard
deviation, outliers and skewness. These are characteristics of a dataset, and believe it or not, quite useful
analytical tools when trying to understand companies using multiples. So let’s say you’ve got a dataset of 30
EV/EBIT multiples for a group of companies, and you have gone through the definitional test to make sure
they make sense. The first thing we recommend doing is creating a boxplot and/or a histogram. What’s the
median and the quartiles? Is the dataset skewed? Is there a wide dispersion of multiples? Are there any
extreme outliers? Are there certain groupings or patterns? What happens to the descriptive statistics of you
drop outliers? If you are using a downloaded dataset, there is almost a guarantee some outliers have been
dropped already. This way of handling data can differ between datasets. The same is true for screening tools.
Make sure you read up on how the dataset have been modified. Also make sure you have a reason for
dropping certain outliers if you choose to do so. If you are using P/E multiples, you might accidentally drop
very interesting, profitable and low risk companies like the Swedish tobacco producer Swedish Match due to
some accounting rules that pushes its book value of equity to negative territory. If you want an even deeper
understanding, analyze old data sets too, for example one from last year, one from 5 years ago and one from
10 years ago. How have the cross-sectional distribution changed, and to what degree?
What’s this statistical exercise good for you might ask? Think about the end game of a multiple analysis. You
aim to make an argument for why a certain company should be trading at a certain multiple. Not knowing
how that multiple stacks up against other companies’ multiples might cause you to reach unrealistic
conclusions. Further, not knowing whether multiples are cyclically high or low might lead to you
misinterpreting what is cheap or expensive.
Analytical tests are where theory meets practise in relative valuation. It is where the mathematical logic behind
value creation is analyzed, as to then be applied under application tests. It turns out that it is very simple to
find the drivers behind a multiple. No doubt, the environment of the companies, their strategies and
competitive advantages change and evolve over time, affecting these drivers on an individual company basis.
On a fundamental level though, a multiple is always a function of the same inputs. Moreover, even though
there is uncertainty and variability in individual companies’ fundamentals, that does not stop us from using
what we know about the company today as well as our best estimates for the near future. Let us give an
example. We know from the value driver formula that (setting EBIT=EBITA) the enterprise value of a
company is:
𝑔
𝐸𝐵𝐼𝑇 ∗ (1 − 𝑇) ∗ (1 − 𝑅𝑂𝐼𝐶 )
𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 =
𝑊𝐴𝐶𝐶 − 𝑔
In other words, the after tax operating income (EBIT*(1-T) or NOPLAT) is multiplied with one minus the
retention rate to determine the free cash flow to the firm. In perpetuity, the value of the company is this
number divided by the WACC minus the growth rate. Dividing the expression with EBIT leaves a simple
formula:
𝑔
𝐸𝑉 (1 − 𝑇) ∗ (1 − 𝑅𝑂𝐼𝐶 )
=
𝐸𝐵𝐼𝑇 𝑊𝐴𝐶𝐶 − 𝑔
Higher ROIC means a smaller need to reinvest earnings, creating “cheaper” growth, i.e. create lower
reinvestment needs, pushing value and the EV/EBIT multiple upwards. As the equation suggests, growth is
not necessarily good (sure, it decreases the denominator but increases the numerator). Nevertheless, if the
ROIC is high, the numerator can remain high even if the growth is high, still allowing the denominator to

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decrease, pushing up the multiple. Similarly, a less risky company, or a lower WACC, increases the EV/EBIT
multiple. A lower tax rate also increases value12 and the multiple. EV/EBITDA has the same drivers of value.
This simple procedure can in fact be done with every multiple. The results from analyzing multiples in this
way is summarized below.

When tax rates differ substantially within your peer group, use EV/NOPLAT instead of EV/EBIT or EV/EBITA.
12

Otherwise you might think companies with higher tax rates look cheaper.

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Valuation Mismatch Regression* Example US

Fundamentals Companion
Multiple Indicator for Comments Companies January 2017
Determinants Variable
Undervalued Company (R-squared)
Low PE ratio with high Often used, but mixes capital structure PE = -3.95 + 174.03 gEPS +
Expected Growth, Expected
P/E expected growth rate in and non-operating items with 20.58 Payout + 3.53 Beta
Payout, Risk Growth
EPS expectations of operating performance (42.6%)
Often used for companies where the PBV= 1.59 + 7.32 gEPS -
Expected Growth, Low P/BV ratio with
P/BV ROE book value of assets reflect market values. 0.64 Beta + 9.69
Payout, Risk, ROE high ROE
Effectively used for banks. ROE +0.24 Payout (43.6%)
Not consistently defined so recommend
not using. Companies with little cash and PS= 4.90+0.63 Payout
Expected Growth, Low P/S ratio with high
P/S Net Margin much debt will look decievingly cheap. +1.59 ln(gEPS) - 0.51 Beta +
Payout, Risk, Net Margin net profit margin
Very sensitive to the profit margin and 16.16 Net Margin (53.2%)
often wide, uniform cross-sectional
Good idea to incorporate growth, but
PEG has several deficiencies, e.g. 1) It
PEG = 0.50 + 0.51 Payout
P/E-to-Growth does not take ROIC into consideration,
--- --- --- – 1.09 ln(gEPS) -0.60 Beta
(PEG) 2) It will differ depending on used
(19.5%)
growth period and 3) It has no real
backup in theory. Not recommended.
Often volitile, and negative even though
Cost of Capital, Growth Free Cash ROIC is positive if growth is high.
EV/FCFF -- Not Obvious -- ---No Example---
Rate Flow Growth Dependent on company life cycle.
Prioritize multiples below.
EV/EBITDA= 35.83 +
Expected Growth, Low EV/EBITDA or Recommended multiples. Low
EV/EBITDA Reinvestment 7.60 g - 19.10 DFR - 24.40
Reinvestment Rate, Risk, EV/EBIT with low reeinvestment needs stems from high
& EV/EBIT Rate Tax Rate - 147.60 WACC
ROIC, Tax Rate reinvestment needs profitability, i.e. cheap growth.
(6%)
Highly Recommended. Only difference
Expected Growth,
Reinvestment Low EV/NOPLAT with from above is tax has been considered.
EV/NOPLAT Reinvestment Rate, Risk, ---No Example---
Rate low reinvestment needs Might not be available in
ROIC
screeners/datasets though.
Recommended. EV logically exceeds the
Expected Growth, Low EV/capital with EV/Invested Capital= 3.30
Return on invested capital when the company is
EV/Capital Reinvestment Rate, Risk, high return on invested + 0.23 g + 8.64 ROIC
Capital expected to deliver profitable growth
ROIC capital –4.20 DFR (63.5%)
(ROIC > WACC)
EV/Sales = 2.93 + 0.65 g+
Expected Growth, After-tax Low EV/Sales ratio with The operating margin primarily drives
4.48 Operating Margin +
EV/Sales Reinvestment Rate, Risk, Operating high after-tax operating this multiple, just like net margin drives
1.80 DFR- 1.80 Tax rate
Operating Margin Margin margin P/S.
(7.3%)
*gEPS = Expected growth rate in EPS for next 5 years (analyst estimates) All regressions are from:
g = Expected growth rate in revenues for next 5 years (if not available, use gEPS) [Link]
Payout = Dividends/Earnings ml
ROIC = Return on capital = EBIT (1- tax rate)/ Invested Capital
Operating Margin = Pre-tax Operating Income/ Sales
Invested Capital = Book value of equity + Book value of debt - Cash
ROE = Net Income/ Book value of Equity
Tax Rate = Effective tax rate = Taxes paid/ Taxable Income
DFR = Total Debt/(Total Debt + Market value of equity)
RIR = Reinvestment Rate = (Cap Ex – Depreciation + Chg in WC)/ EBIT (1-t)
WACC = Cost of capital in US dollars

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Read the above table from left to right. Choose a multiple, and examine what its drivers are, and what variable
is likely to drive the value of the multiple the most, i.e. its companion variable. The key takeaway from this
table should be that just looking at a multiple, like the P/E ratio, and thinking it is automatically cheap
because it is the lowest in its sector (or even country), is not an acceptable strategy.
Application tests are the ways you - with a mixture of qualitative reasoning and quantitative methods - use your
knowledge of the drivers of multiples in a practical implementation. On other words, what you do here is use
logic and reason and/or actual relationships between a set of fundamentals and multiples within a chosen
group to identify how certain company should be valued.
There are at least two ways to perform application tests. The first one is what we call an eyeball approach13. This
simply means examining the fundamentals of a group of companies and trying to eyeball what multiple a
company should be trading at given how its fundamentals stack up (for better of for worse) against other
companies. You might for example see that the median real estate company trades close to it book value of
equity, i.e. its P/BV is 1. Furthermore, you know that the median forward looking ROE is 8%, the median
expected growth rate in earnings per share is 5% for the coming 3 years and the median beta is 1,0. You are
trying to value a company which is expected to grow at 7% every year, has an expected ROE of 13% for the
coming years, but is riskier with a beta of 1,3. You might add a premium of, say, 0.3 times book value for the
higher profitability and 0.2 for the growth, but give them a discount for the higher risk of 0.2. You end up
with a multiple of 1 + 0.3 + 0.2 – 0.2 = 1.3. At this point, you are probably thinking something in the lines of
“but how am I actually supposed to know how much to add or subtract, or even what variables to include in
the first place”. Beginning with the second part of that question, I refer back to the analytical tests.
Remember, value comes down to a cash flow generating potential, the growth in those cash flows, and the
risk associated with those cash flows. In many cases, using fundamentals like the difference between the
ROIC and the WACC together with revenue growth will give great insight to most companies into those
aspects of value. Using market value of equity, like in the previous example, the substitute for ROIC is ROE
and WACC is the cost of equity (a function of beta). With regard to the magnitude of the premiums or
discounts, we would like to answer the question is several steps. As always in valuation, there is no true answer
in the sense that for example a higher revenue growth or EPS growth always increases a multiple with a
certain value. That is true both due to the fundamentals of value creation, e.g. high EPS growth can be
negative for the value of a company if revenue increases drastically but does so when ROIC is below the
WACC (or ROE is below Cost of Equity), but it is also accurate since the true value of a company is a
function of the sustainability of the profitability and growth. Understanding an industry, and the sustainable
competitive advantages that a company is what makes it possible for an analyst to gain insight into whether
profitable growth can be sustained (or perhaps improve). To refer back to our example, if the ROE of 13% is
expected to continue for 15 years, the premium should be higher than if it is expected to decline to industry
medians within 5 years. “Knowing” what premiums or discounts to add or subtract is therefore logically
something an analyst acquires over time. If you still feel uncomfortable with this approach, and is looking for
something a bit more quantifiable, we suggest using the other approach - regressions.
Multiple regression is the second approach, and a very powerful one indeed. In the rightmost column of the table
under analytical test, we have included regressions run by Aswath Damodoran (which can be found on his
website, link: [Link] ) on with
each relevant multiple as a dependent variable and the corresponding value drivers as independent variables.
This data is for US companies, but similar data exists for other parts of the world as well. As you can see, the

13 This expression is used by the professor William B. Cannon at Smith School of Business at Queen’s University

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idea is to quantify the effect that any given variable has on a multiple14. When you do your own analyses, we
recommend limiting yourself to the companies that has similar characteristics to your own. We further
recommend you to stick with the following simple rules:

• Check to see that the signs on the variables conform to you’re a priori expectations, i.e. positive
aspects for value should have a plus sign and vice versa.
• Do not include more than one risk variable in one regression.
• Do not include independent variables that themselves include your dependent variable. For example,
including the dividend yield when trying to find the drivers of P/E ratios means regressing P/E on
dividend/P, i.e. in some sense, price on 1/price. Your correlation will be spurious!
• Rule of thumb 1: drop variables that have a t-stat below approximately 1.2, be somewhat sceptical
with variables that have a t-stat between 1.2 and 1.6, and be confident in variables that have a t-stat
above 1.6.
• Rule of thumb 2: Do not even think about including more independent variables than the number of
companies divided by 5. One variable per 10 observation is preferable, and one per 15 is
recommended. Otherwise your regression might look good but is not really rooted in fundamentals
and causation but might rather be simple chance.
• Feel free to use several equations if you have many variations of profitability, growth and risk that
can matter for the valuations within your peer group, as to then average the results to average out
potential mistakes.
After you have an estimated relationship expressed as an equation, you can simply plug in the numbers in said
equation an end up with a multiple for your chosen company. Using the enterprise value to invested capital
regression for European companies for example, we might gain some insight whether SSIFs holding
Energiekontor is reasonably priced in the market (as of 2017).
𝐸𝑉
= 2.34 + 9,39𝑅𝑂𝐼𝐶 − 2.50𝐷𝐹𝑅 = 2.34 + 9,39 ∗ 0,1269 − 2.5 ∗ 0.511 = 2.25
𝐼𝐶
Multiplying this multiple with your estimate for the Invested Capital end 2017 will lead to an estimate of a fair
enterprise value. Assuming the Invested capital to be around 170000 kEUR, we get an enterprise value of
𝐸𝑉
𝐸𝑉 = ( ) ∗ 𝐼𝐶 = 2.25 ∗ 357𝑀𝐸𝑈𝑅 = 803.25 𝑀𝐸𝑈𝑅
𝐼𝐶
Adding cash and marketable securities to that number and subtracting out debt and debt equivalents will lead
to your estimate of the fair value for the equity of the company. In this case, the equity value ends up being in
the regions of around 780 MEUR, or around 45 EUR per share, suggesting the share is undervalued as it
trades around 18 EUR at the time of writing. Now, when you do your research and stock picks the coming
year, make sure to choose a more relevant peer group than all European companies. Further, looking at
EV/EBIT and perhaps P/E might yield quite different results. Doing an intrinsic valuation will prove it hard
to get as high as 45 EUR for Energiekontor, but this was only meant as an exercise.
The key takeaway from this section should be that relative valuation – or pricing using multiples of
comparable companies – is not some magical tool to use when you do not feel like doing a proper intrinsic
valuation. Relative valuation can be done quickly, and for many companies simultaneously, but that speed
requires that you consider the potential pit-falls that it brings. The stock market is probably smarter than you

14Damodoran includes variables even though their sign does not match logical a priory expectations. For example, the
beta for the P/E regression is positive, which would suggest that higher risk means higher value. This shows beta might
be a proxy for something else. We argue to then remove that variable and run the regression without beta.

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think, and therefore it will at least to some extent take into consideration the fundamental drivers of multiples.
The silver lining though, is that if you understand the business and its environment, how it stacks up against
other companies today and historically, understand if it has sustainable competitive advantages, create some
type of story for the future, and connect that story to numbers in a reasonable way, you still have a chance to
beat the market in the long term.

The Five Principles of Relative Valuation (McKinsey)

We would like to augment the previous section with some input from the book Valuation by Koller, Goedhart
and Wessels from McKinsey. They talk about five principles to think about when using relative valuation. The
truth is you can do a great valuation without grasping the details of the points below. It is just as true though,
that the risks of missing some crucial aspect of the valuation process is drastically decreased if taking the
following principles into consideration:

• Value multi-business companies as a sum of their parts: Companies often operate in several subindustries or
have different type of products that is vastly different from each other. More often than not, these
have different return on invested capital, have different growth and have different types of risk. When
possible, always split the company up into these businesses so you can find different, relevant peers
with similar characteristics for each business unit. You can also separate the corporate functions from
all individual businesses and add it to the estimated value for the business units to find the enterprise
value. Sum of the parts valuations are often drastically more accurate than when the entire company is
just lumped together.
• Use forward earnings estimates: Always (!) use a forecast of profits rather than historical profits in the
denominator of a multiple. This is consistent with the fact that the value of a company is the present
value of the future cash flows, not what has happened in the past. It should remove one-time effects
on earnings that has nothing to do with the company’s ability to generate cash flows to the investors.
Benjamin Graham and Warren Buffet calls this “earnings power” which is not nessesarily reported
earnings. In one sentence, the estimate should be cyclically normalized, real economic earnings. As an effect,
the analyst can see what the company can earn for its shareholder under normal conditions (an
average over the favourable and unfavourable cyclical environments) without diminishing its capacity
to continue to do so in the future (i.e. the connection between growth – reinvestment – profitability
must be sustainable). Looking at the cross-sectional distribution of multiples for volatile, fast growing
companies, you will see that backwards looking earnings are widely dispersed. On the other hand,
EV/EBITA multiples for three to five years into the future are actually very stable. Looking back in
time or just one year ahead into the future might fool you to believe some company is cheap or
expensive, but it is rather due to one-time items or short-term effects that has little to do with the
earning power of the company.
• Use the right multiple: In McKinsey’s view, use either Enterprise value divided by EBITA or NOPLAT.
We have already discussed some of the rationale behind this. For example, the P/E ratio mixes the
effect of operations and capital structure15. The reason why EBITA should (in most cases) be used
instead of EBITDA is due to the fact that the “D”, i.e. depreciation, is the accounting equivalent of
putting aside capital to replace the asset that is worn down. It represents future Capital expenditures.
Consequently, subtracting depreciation provides a better measure of the future cash flows that will be
available to investors. A company using in-house production might have a lower EV/EBITDA
margin than a company that outsources its production since its cost for raw materials is lower,
increasing EBITDA. On the other hand, the EV/EBITA multiple is the same for the companies

15
For examples on how this can distort the multiple, read the chapter on “using multiples” in Valuation.

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since depreciation of the machines that create the raw materials is higher for the in-house company,
causing EBITA to be the same.

The reason EBITA is preferable to EBIT is since the “A”, i.e. Amortization, most often is
amortization of intangible assets. These assets are often acquired from buying other companies
(customer lists, brand names, etc.). When an acquisition happens, the company must put them on its
balance sheet, increasing invested capital and in effect also amortize them over the life of the asset.
Comparing to a company - with the same operating performance as the sum of the target and
acquirer - that grew organically where there is nothing to recognize on the balance sheet (marketing
costs etc. just show up on the income statement as a cost), EBITA is the same, but EBIT is lower
since “A” is negative. The enterprise value is the same, so the EV/EBIT multiple is higher for the
company that acquired the intangibles. Accounting has once again been deceiving for an analyst trying
to value a company. Now, all software development costs can be capitalized, so in that case it is better
to separate that amortization for the amortization of acquired intangibles. Another way to tackle the
problem with amortization, which many analysts do, is to go back in the history and actually capitalize
the costs of an organically growing company as the costs most likely in one way or another is an asset
for the company. In some DCF spreadsheets16 you can do that quite easily. In effect, you can use
EBIT both in your multiple and in your calculation of return on invested capital (EBIT(1-
T)/Invested Capital). EV/NOPLAT is preferable over EV/EBITA (or EV/EBIT with capitalized
costs) when there are different tax jurisdictions within your peer group.
• Adjust for non-operating assets: Your multiple (assumed EV/EBITA in this case) should not be affected
by non-operating assets. We know EBITA is only affected by operating assets (the number is not
affected by financing decisions since it is above the financial net in the income statement.) Then,
enterprise value should also only include operating assets. Let’s take H&M as an example to
understand why this matters. H&M is two things, a profitable retailer, and a quite substantial stack of
cash. That excess cash that just sits on the balance sheet (SEK 9.45bn last annual report) and generates
some interest income (SEK 0,22bn) that is not a part of the business itself, and thus it must be
excluded from the enterprise value just like it is excluded from EBITA. Similarly, nonconsolidated
subsidiaries should be excluded from your EV calculation, and valued separately. When other, outside
investors has a noncontrolling interest in a consolidated subsidiary of the company you are analyzing,
you need to value is as a debt equivalent, and include it in your EV. The reason is that the EBITA in
your income statement includes the income generating stream from that subsidiary, while you do not
technically have the right to all of it. Thus, it becomes a liability, so include it in the EV calculation.

Pensions and leases can be a bit trickier to adjust for. In essence, operating leases normally push
down enterprise value since there is a lease-based debt that is actually ignored, just as it pushes down
EBITA, since interest costs are “disguised” as rental expenses. You should preferably reverse this
effect, i.e. increase EV with the value of the operating leases and increase EBITA with the value of
the interest payments on the lease. Regarding pensions, the unfunded liabilities should be treated as
debt, and the excess assets as a nonoperating asset. Further, exclude the nonoperating parts of the
expenses related to pensions from EBITA. We will futher bring these aspects up under “Completing
the Incomplete Aspects of Valuation”, where you will see that it made sense that you excluded some
items from your multiple, as they will then be added or subtracted in a similar fashion when finding
the value of equity.
• Use the right peer group: The argument the authors propose is the following: getting a reasonable
valuation with multiples requires judgement about which companies and their multiples are truly

16
Like the helpful spreadsheet ”fcffsimpleginzu” that you can download on Aswath Damodarans website

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relevant for the valuation. Classification codes like GICS code can include over 50 companies in some
sector, but many do not necessarily compete with the company you are interested in. Using peers that
the company themselves provide can also be deceiving as they are often aspirational rather than
rational. Having found companies that compete head-to-head you have to – like we argued under
analytical and application tests – take into consideration growth, ROIC and WACC. Since WACC is
often pretty similar, the authors argue that multiples like one year forward looking EV/NOPLAT will
correspond to the forward estimate for ROIC and a compounded annual growth forecast for the
three years ahead. You can probably position your company between a couple of companies
EV/NOPLAT based on that their ROIC and growth is expected to correspond with yours. Just like
we argued under descriptive tests, the authors argue that you should investigate a series of questions:
why do the multiples differ and to what extent? You need to connect the numbers to the companies.
Do certain companies have a better product, better access to customers, recurring revenues, or
economies of scale? Strategic advantages should translate to better profitability, higher expected
growth rates and thus higher multiples.

Some Positive Words About Relative Valuation

We began by looking at relative valuation in quite a cynical way. We have also been very clear on the dangers
of using relative valuation. Now we want to stress some important aspects that we have not covered to an
enough large extent.

If you can’t understand relative valuation, you will have a very hard time analyzing market sentiment. If you
can’t analyze market sentiment, you will make a whole lot less good investment decisions, and have a much
harder time understanding the timing and pricing aspects of the stock market. Even if you are a true believer
in intrinsic valuation, it is very useful to understand the pricing that goes on in markets. Intrinsic values can
take years to correct themselves, whereas a company trading at the lower end of a multiples spectrum without
apparent reasons due to cash flow, growth and risk characteristics will tend to adjust quite quickly.
Another area where pricing matters more than intrinsic value is when a transaction has to take place today,
and the sentiment of the market dictates the price an investor can get from a certain position having to be
closed in a short amount of time. Say for example that a company will liquidate its assets, and the value of the
liquidations simply becomes the sum of the prices the company can get in the marketplace today. Here, the
market might simply trust how similar assets have been traded more than the value of the asset based upon
the future cash flows that can be attached to all those individual assets.
In a nutshell, it is risky and simply foolish not to bother with relative values, even though intrinsic valuation
should always remain a crucial part of an investment decision.

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Completing the Incomplete Aspects of Valuation

The Loose Ends – Going From Enterprise Value to Value Per Share
Having either used 1) intrinsic valuation to forecast the cash flows, growth, estimated the risk in the cash
flows, applied a terminal value to get a closure on the valuation, and taken into considerations discrete risks in
that process, or 2) used multiples to reach an estimate of how the market should price the company, you should
either have produced a value for equity directly, or estimated the value of the enterprise. We will in this
section assume that you did the latter, and talk about the loose ends to end up with the value of equity which
you then divide with the number of shares outstanding to reach the value of equity.

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General overview
It can be confusing sometimes to think about enterprise value and equity value, especially since firm value is

Firm Value
Cash & other non-operating assets
Equity

Value of operating assets = Fixed

assets + Intangible assets + Working
capital Debt

Enterprise Value

Equity

Value of operating assets = Fixed

assets + Intangible assets + Working
capital Debt

Cash & other non-operating assets

Market value of Equity Value

Value of operating assets = Fixed

assets + Intangible assets + Working
capital

Equity
Cash & other non-operating assets

Debt

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sometimes used too, and further since we sometimes see different definitions of enterprise value (but most
often it has the definition we will show here). But let’s make it as clear as possible using some pictures.

Since net debt is debt minus cash and marketable securities, we can also think of enterprise value as equity
plus net debt. It should be intuitive that equity can be more (less) valuable than the operating assets of the
company, if there is either a bunch of cash (debt) in excess of the operations. It should also make sense that
the equity value should not change just because the company issues new debt and just keeps the cash on the
balance sheet. Sure, it the cash is risk-less, but it does not earn its risk-free rate, then the company is effectively
destroying value. But if we assume that the cash we are talking about here is excess cash (surplus liquidity),
and that this cash is earning the risk-free rate, the market should not punish the company for not distributing
that cash to its shareholder. There are of course some counterarguments to this claim. For example, if the
company has historically underperformed, investors might actually literally value the cash to for example 80
cents on the dollar. The market value of equity thus increases if the company distributed cash. Similarly, there
are potentially some situations where investors will value cash on a balance sheet at a premium, because it has
such a strong track record of for example doing successful, value-creating acquisitions (not paying out the
synergies to the target) that the cash is more worth if the company has it than if it is distributed to investors.
But let’s talk about these, and a few more, loose ends on a more detailed level.
+ Excess cash and marketable securities
As a part of the net debt calculation, we want to make sure we are including the “right” cash. This amount
should correspond logically with our previous FCFF and ROIC calculations. Remember that we use a before-
financial-net number (NOPLAT) in the free cash flow and ROIC calculation? We are not including the
financial income that comes from cash in the bank. Since we have to the account for the value of cash that is
positive to shareholders in some way, we therefore choose to instead value it separately by normally just
adding this cash to our enterprise value in our process of finding the equity value. This cash should be the
excess cash not used in operations, i.e. we want to make sure that the cash we value separately (and not include
in the profitability and free cash slow calculations) is in fact only cash above a minimum level of cash that has
to be there for the company to function on a day to day basis. Normally, there is some minimum cash level
included in operating working capital. This will depend on company and industry, but using 2% of sales as a

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minimum level of cash is a quite common rule of thumb. Remember our discussion regarding different
profitability measures in the section about return on invested capital? We mentioned return on capital
employed as well. If we use this measure, where the denominator is book value equity and debt, not adjusted for
cash, and the numerator is earnings before interest expenses, i.e. earnings after interest income (on that same cash
that we include in the capital base), we instead end up valuing the firm value, not the enterprise value. This in
effect means that we should not add cash again, but rather just subtract debt to reach equity.
For U.S. companies, you also have to consider that there are certain tax laws that requires cash balances that
are in other countries (for tax purposes) must be taxed when they are repatriated (brought back) into the U.S.
Apple for example has over 100 billion U.S. dollars that will be taxed when brought back to be distributed to
shareholders.
Lastly, one should also consider that there are companies having cash balances that has been invested in more
or less risky assets. This can cause a discrepancy between the book value of the cash and the current, market
value. Obviously, this effect can be both positive and negative, and can be difficult to estimate the effect of if
the company is not clear on exactly what assets they have invested in (which they of course should be
transparent with).
There are a few more accounting problems you should consider which is like loans to other companies,
discontinued operations, excess real estate, tax-loss carry-forwards, and excess pension assets. But they are
normally not difficult to get your head around after reading up on them separately.

- Debt and debt equivalents

So, what debt should you take out from the enterprise value to reach your value of equity? Really everything.
It included short-term like commercial paper, notes payable and the current portion of long-term debt and
long-term interest bearing liabilities include fixed debt, floating debt and convertible debt with maturities more
than one year. Other contractual commitments should also be included. This includes off-balance sheet
obligations like operational leases. Leases is one of the biggest and most important adjustments an analyst must
do to understand the profitability of a company. All leases are a liability, and should be treated as one both in
profitability measures and in the bridge between enterprise value and equity. Unfunded pension and other retirement
liabilities should also be treated like debt equivalents and be deducted from enterprise value when finding the
equity value. With regards to provisions, it depends… Ongoing operating provisions should not be deducted,
long-term operation provisions should be deducted, non-operating provisions should be deducted, and
income-smoothing provisions should not be deducted. There are a few more potential liabilities, like
securitized receivables and contingent liabilities, but we encourage you to search online on more information
on those.

+- Cross holdings
You then want to add back the values of small (minority) holdings the company has in other companies, as
these cash flows were not included in your cash free cash flow. If you had majority stake in another company,
on the other hand, the accounting requires you to consolidate 100 percent of the subsidiaries operations as
your own. This creates minority interests, which is the accounting estimate of portion of the subsidiary that does
not really belong to the company you are valuing. What you should do, is subtract out the estimated market
value of the minority interest from you value that you get on a consolidated basis. There are several
accounting courses as SSE that covers these adjustments more in detail and discusses all the different
accounting methods and rules that exists. Minority holdings is most certainly one of the most mangled items
in valuation. The main takeaway that we would suggest you bring with you though, is that whenever you can,

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value the parent company based on just the parent company’s financials and then value each subsidiary
separately as its growth, risk and cash flow characteristics can differ. Then take your proportionate holding of
each of these subsidiaries and add them up. If you only have consolidated accounts, then you have no choice
but to simply use whatever information you have and make a judgement of what should be subtracted from
you consolidated valuation. If the company has a financial subsidiary, you must be extra careful as not to mix
earnings and book values from the financial subsidiary with the rest of the company. In those cases, the
company often accounts for the financial subsidiary’s characteristics in a clear way, though.

- Employee options (stock-based compensation)

Lastly, make sure to take employee/management options into consideration. In Sweden, paying employees
with stock options is not as common as, for example in Silicon Valley. But in general, make sure you do not
forget that it is a compensation method that can be deceiving for the analyst looking at the company. There
really is no conceivable argument not to treat them as an operating expense, as they are, in fact, operating expenses at the
time they are granted, even if that involves valuing the options using option pricing models. Some companies
argue that it is not a cash expense and thus should not be an expense at all, but they forget that if that these
companies had issued the options or restricted stock to the market and then used the cash flow from that
issuance to pay employees, it would in fact have been a cash flow. They often also occur more often than
what would be referred to as unusual events. The options have to be valued and subtracted from equity value
to reach the true before calculating the equity value per share. We know that there are analysts and teachers (at
SSE) that instead of decreasing the value of equity, decreases the number of shares outstanding, i.e. used a
diluted number of shares. There are two problems with this approach. First, out-of-the money options are
often treated as worthless in the adjustment, and second, you are ignoring the cash inflow from the option
exercise and the time value of the option when you do this.
To summarize
The process of going from Enterprise value to Equity is mostly common sense. You have to add net debt and
adjust for cross holdings and stock based compensation. Like in your FCFE and profitability calculations, you
also must make sure that you are consistent, and that you are truly separately summing up all non-operative
assets and further including all debt and debt equivalents. Finally, you just divide the value with the total
number of shares outstanding (since you have accounted for the dilution effect of options already) to end up
with your value per share.

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Real options – when a static view of the world is not enough

Introduction
In traditional valuation, we take a static view on the world. In what sense? The valuation takes place in a certain
point in time, where we make our best estimate of the expected cash flows based on what we know today, attach a
discount rate to those cash flows that reflect its risk based on what we know today, and we get a value. But is that
the best we can do? Sometimes, no. In certain situations, that approach miss segments of value. For example,
exclusive rights to a bad project today, might be worth something if the mechanisms and characteristics that
govern the value of that projects can change over time. That is called the value of an option to delay.

We will go through the option to delay, the option to expand and the option to abandon, as well as financial
flexibility and distressed equity after we have covered the three basic questions the analyst must understand to
incorporate real options into a valuation. The end-game is that this section of the analyst guide will make you
aware of when, and how to find premiums to your normal, discounted cash flow value. As you will see,
though, this is not a tool you can just apply whenever you feel like it to justify a predetermined value over
your base-analysis.
N.B: Option pricing will be useful in valuation when identifying the value of employee stock options too (see
“The loose ends to valuation” section of the analyst guide. In that case, the option is of a financial derivative
nature, whereas we are now talking about option that stems from the operations (and sometimes financing
when it comes to financial flexibility and distressed equity) of the business itself.
A few words about decision trees
It should be made clear that there are alternatives to the real option value method, that in theory could yield
the same results as the method outlined below. This includes the Copeland solution and a solution based on
risk-free rates. The Copeland method is when the analyst uses different discount rates for at each node (i.e.
possible scenarios which are either decision nodes or simply probability nodes in a binomial lattice) to reflect
where he/she is in the decision tree. The other method is using the risk-free rate to discount cash flows in
each branch, estimate the probabilities to estimate the expected value, and then adjust the expected value for
the market risk in the investment.
If you feel you can do a full decision tree, you don’t have to do real options. In certain scenarios, you can go a
long way with decision trees. When valuing pharmaceutical companies, for example, they can be helpful. If the
company has a lot of data on historical and estimated success and failure rates in different stages in the
development phase, you might use the tool with much greater accuracy and confidence than forcing expected
values and discount rates onto the valuation.
But let’s get into the process of finding the potential value of real options.
The three basic questions
There are three questions we need to understand as analysts to incorporate real option into a valuation in a
logical way.
1. When is there a real option embedded in a decision or an asset?
2. When does that real option have significant economic value?
3. Can that value be estimated using an option pricing model?
We will take you through the key issue and criteria that need to be understood to answer each of these
questions below. Underlying asset = UA.

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When is there a real option When does that real option Can that value be estimated
Question embedded in a decision or have significant economic using an option pricing
an asset? value? model?

An option is only an option if it An option is only valuable if is An option value depends on (i)
provides the holder with right to can be made clear that there is a the value of the UA, (ii) the
buy or sell a specified restriction on competition variance of the UA, (iii) expected
Key quantity an UA at a fixed in the event of the contingency. dividend if UA = stock, (iv) the
issue price at or before the Therefore, in a perfectly competitive strike price of the option, (v) the
expiration date of the option market, no contingency will life of the option, and (vi) the level
generate positive NPV of interest rates

There has to be a clearly There has to be exclusivity The identification of an

defined asset whose for an option to be valuable. option (to delay, expand, etc.)
value changes in an When the barriers to has to include the above key
unpredictable way competition become less components by creating a
steep, the option value replicating portfolio or
Criteria quickly disappears. using the black scholes
The payoffs on this asset (real
model, but with less
option) have to be
obvious inputs than with
contingent on a the valuation of derivative
specified event occurring instruments.
within a finite period.

In traditional valuation (DCF) Opportunities are not For the different real option
and pricing tools (multiples), options. Expanding into types, the components will
A little risk shows up as a negative. China is not an option. differ. You will see that the
Something For real options, since the Everyone can see it’s a big process requires a lot of
to think downside is limited, risk (or market, so the question truly estimation, but that is why it
about… variability in underlying value) boils down to exclusivity, not pays of to do it real option
increases value… “opportunities”. valuation correctly...

The Black-Scholes model use the following equation to value Call (c) and Put (p) options:

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If the stock is paying a (continuous) dividend, the equation is the following:

We won’t go through the logic behind the equations, but refer to videos like this one for more intuition:
[Link]

The real option types you might encounter in valuation

There might be arguments for more types of real options than covered in this guide, but it probably helps to
initially categorize them into (i) The option to delay, (ii) the option to expand, (iii) the option to abandon, (iv)
the option value of financial flexibility, and (v) distressed equity.
The option to delay
If you knew you had the rights to a project or product that has a negative NPV if taken/developed today, is it
worthless? Traditional investment analysis just answers the question if it is good today, so with that in mind,
the answer is yes. Yet, the option to delay inherent in the right can in fact be valuable since it can prove to
create value if taken in the future when the NPV is positive (or IRR>Hurdle rate). If the project never proves
valuable, all you lose is what you originally invested to access the investment opportunity (either through
R&D or cost of acquiring the patent if that is the case). Still, recognizing that a bad project and the right to

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that project are not the same thing is a large part of not messing up in a lot of businesses, and thus, a large
part of not messing up in the valuation of companies holding these potential projects.
Example 1, The value of a patent: If a product patent provides a firm with the right to develop a product and
market it, and it will do so only if the development is NPV positive and otherwise shelve it without further
costs, it most certainly sits with an asset that has the characteristics of an option to delay. In fact, a patent is an
option to delay. The underlying asset of the option, is as you can imagine, the product that comes out of the
patent. Let’s assume the cost of developing those products from the patent is K and the present value of the
estimated cash flows from the developed product is S. Then, the potential payoffs on a patent option can be
written as:

• = 𝑆 − 𝐾 𝑖𝑓 𝑆 > 𝐾
• =0 𝑖𝑓 𝑆 ≤ 𝐾
But this is only two of the inputs we need to understand the value of the option. So, lets think about how to
obtain all the inputs required for that task. Below, there is a table with the input and the estimation process,
which hopefully will guide you and give you a checklist if you ever need to find the value of a patent through
estimating the option to delay.
Input Estimation Process
1. Value of the • Present value of the cash inflows from taking the project now – i.e. an
underlying asset actual valuation of this specific patent
(i.e. the S) Comment: This will be a noisy estimation, but that is why there is value
in doing this process. Just make you best estimate!
2. Variance in value • Variance in cash flows of similar assets or firms, or
of the underlying • Variance in present value from capital budgeting simulation
asset (i.e. the σ) Comment: This is a project, you can’t go and check price variation on
Bloomberg like when estimating the value of a financial derivative.
3. Exercise price of • Option is exercised when investment is made
option (i.e. strike • Cost of making investment on the project; assumed to be constant
price, K) in present value dollars
Comment: You can easily develop some sense of the cost of converting the
patent into a commercial product. Do you have to build a plant, hire sales
people etc.?
4. Expiration of the • Life of the patent
option (i.e. t) Comment: If you have a patent life left of 12 years, that’s how long you
should play this game.
5. Dividend yield • Cost of delay
(i.e. q) • Each year of delay translates into one year less of value-creating
cash flows
1
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑙𝑎𝑦 =
𝑛
Comment: What do you lose by waiting to the very last day in real options,
that you don’t lose when you trade options in the market? You give up all
the competitive protection that the patent is designed to provide you. There
is a cost for not exercising early, and it increases as time passes and
expiration gets closer.

There is an obvious issue with valuing a patent this way; most of the inputs will be missing for anyone outside
the company. For biotech companies, they might sometime provide their own estimation process and present

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value of developing a drug today based upon a patent, which might simplify the analyst’s life a little. If not,
previously developed drugs or other research might be of help in the estimation process.

Let’s go through an example that might help solidify how, and why, it matters to think about these types of
assets through real options.
A biotech company has a patent on BuffetLife, a drug to treat spontaneous urges to take short-term bets on
market movements. The life of the patent is 15 years, and it plans to produce and sell the drug itself.
The inputs are the following:

• PV of cash flows from developing the product Now = S = 9000

• PV of cost of developing cost for commercial use = K = 800
• Patent life = t = 15 years. Riskless rate = r = 3% = 15-year T-bond rate.
• Variance in expected present values = 𝜎 2 = 0.224 = industry average firm variance for biotech
firms.
1
• Expected cost of delay = y = 15 = 6.67%

The output from the Black-Scholes option pricing model is the following:

r 0,03
S 900
K 800
q 0,067
T 15
Sigma^2 0,224

d1 0,681 =(LN(C3/C4)+(C2-C5+C7/2)*C6)/(SQRT(C7)*SQRT(C6))
d2 -1,152 =C9-SQRT(C7)*SQRT(C6)
N(d1) 0,752 =[Link](C9;0;1;TRUE)
N(d2) 0,125 =[Link](C10;0;1;TRUE)

Call value 185,42 =C3*EXP(-C5*C6)*C11-C4*EXP(-C2*C6)*C12

If the company was to take this project today, it would be worth the present value of the cash inflows less the
present value of the costs of developing the project today, which is 900-800=100. Notice that the value of the
option is 185, significantly higher. Due to the fact that the project can be delayed, and the variance in the
underlying value of the project, the difference can be huge. Consider, for example, the effect of the optionality
when the value of the cash inflows if the project is taken today is 700, and the variance is 30%.

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r 0,03
S 700
K 800
q 0,067
T 15
Sigma^2 0,3

d1 0,738
d2 -1,383
N(d1) 0,770
N(d2) 0,083

Call value 155,74

PV inflows today 700
PV outflows today 800
Project today -100
Option - Project 255,74

In this case, the value of taking the project today is minus 100, but the value of the option is still high, 156.
The difference an analyst might get in the estimation process by shifting from a static to a time-varying view is
therefore 256, quite a substantial change.
One thing to keep in mind is that a company has a patent on one solution to a technical problem, not a
solution that keeps other solutions from being developed to treat the same problem. If another company is 4
years away from developing a product called MungerLife, which essentially treats the same problem in
investors, the cost of delay will probably drop from 15 to 4 years. This will drastically decrease the value of the
option of delay on BuffetLife. You can easily see how the analyst has to be careful in assessing the market
situation when using real options, since it is a powerful tool in drastically increasing value when the
uncertainty is high and potential market size is huge. The proof that competition is more present than one
might think in for bio-tech companies and drug-developers is that the average time between patent acquisition
and drug development is very low. This shows that most companies look at the competitors and see that there
is a huge risk that there will be alternative solutions to the problem of treating the patients.
Going from one patent to valuing a firm with patents
Here is how you can approach valuing a company that has several patents and/or is in the business of
continually developing patented products. For simplicity, let continue to assume it is a pharmaceutical
company that is being valued.
Take the company’s developed drugs (which are already out there and have cash flows), and simply do a DCF
of these developed drugs. Then you can take their patents (like the BuffetLife Patent), value each patent like
an option, come up with a value, and add it on to the value of the DCF from the existing drugs. There is a
third layer left though. The company has an R&D department continually working on developing new drugs.
You have no idea what these drugs can be, but like always in valuation, you have to make your best judgement
as to whether the value added by that R&D will be positive, zero or negative. Now you might understand why
valuing pharmaceutical companies with this approach can be a road you don’t want to take if there is large
number of patents. But for younger of more focused companies, this approach is definitely a viable one.

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Reflecting back on previous sections in the analyst guide, like when we discussed the financial balance sheet
and the drivers of value, we can see the similarities with the approach above. Just like we separated assets in
place from the value of growth assets, and made very clear that value is only created of a company invests to
earn excess value, the discussion on how to value the future of a pharmaceutical company must depend on its
capacity to create value from its R&D. If a research driven company expects to create 1.25 dollar in value for
every dollar invested, then we should obviously attach a greater value to its future operations (growth assets)
than if it would create 1 dollar, or even 0.8 dollars (i.e. destroy value) when it invests 1 dollar in R&D.
To clarify how 1 dollar invested can create 1.25 dollars, we just took the average ROIC for pharmaceutical
companies (of 14%), and compared it with the average cost of capital (10%), and calculated the ratio of the
present value to the invested capital using a EVA framework, assuming the excess value will decrease to 0%
after year 10. See below:

1 2 3 4 5 6 7 8 9 10 After 10
ROIC 14% 14% 14% 14% 14% 14% 14% 14% 14% 14% 10%
WACC 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
ROIC-WACC 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 0%
Invested Capital 1,00 1,00 1,00 1,00 1,00 1,00 1,00 1,00 1,00 1,00 1,00
EVA 0,04 0,04 0,04 0,04 0,04 0,04 0,04 0,04 0,04 0,04 0
PV (EVA) 0,036 0,033 0,030 0,027 0,025 0,023 0,021 0,019 0,017 0,015 0,000
Sum 0,246
Invested Capital 1,000
PV Investment 1,246
Value/dollar invested 1,246

You can then, if you have estimated the R&D expenditures going forward, find the value of the company’s
future capacity of R&D. In this example, we have used a 20% growth rate and a 15% cost of capital to reflect
the risk in a young growth company’s future (highly uncertain) cash flows. In the picture below the value of
the patents are simply the R&D costs times 1.25.

N.B. It is completely reasonable to use a cost of capital for these cash flows that is different from the cash
flows of the existing cash flows. It is not unreasonable that the already developed drugs is very stable and
known, for example due to fixed licences to other pharmaceutical companies. In that case, a pre-tax cost of
debt of the guarantors is more reasonable than the company’s own cost of capital in a normal setting. On the
other hand, the future cash flows are much riskier.

1 2 3 4 5 6 7 8 9 10
R&D costs 120,0 144,0 172,8 207,4 248,8 298,6 358,3 430,0 516,0 619,2
Value of patents 149,5 179,4 215,3 258,3 310,0 372,0 446,4 535,7 642,8 771,4
Excess value 29,5 35,4 42,5 51,0 61,2 73,4 88,1 105,7 126,8 152,2
PV (at 15%) 25,6 26,8 27,9 29,1 30,4 31,7 33,1 34,5 36,0 37,6
Sum (PV) 312,9

Adding the 312.9 to whatever your estimate of the firm’s cash flow from existing drugs is plus the option
value of current patents will lead to your estimate of the enterprise value.
Example 2: The value of natural resource options:

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An oil mining, gold mining, coal mining or any other type of natural resource company, the business can be
divided into 2 slices. First, there are the developed reserves, from which they extract their resource, which they
then sell and generate cash flows from. Then they have undeveloped reserves. Let’s assume the cost of
developing those undeveloped reserves is K and the present value of the estimated value (given whatever prise
assumption you have) is of the resource is S. Then, the potential payoffs on a natural resource option can be
written as:

• = 𝑆 − 𝐾 𝑖𝑓 𝑆 > 𝐾
• =0 𝑖𝑓 𝑆 ≤ 𝐾
Like in the patent example, we estimate the value of this option by trying our best to understand the individual
estimates of the inputs required in the Black-Scholes model (see below).

Input Estimation Process

1. Value of the available • Expert estimates (geologists for oil); the present value of the
reserves of the resource after-tax cash flows from the resource are then estimated.
(i.e. the S) Comment: You can estimate this based on current prices or
perhaps futures prices

2. Cost of developing • Past costs and specifics of the investment

reserve (i.e. strike price, Comment: This is going to be different in different parts of the
K) world.
3. Time to expiration (i.e. • Relinquishment period if an asset has to be relinquished at a
t) point in time
• Time to exhaust inventory
4. Variance in value of the • Based on the variability of the price of the resources and
underlying asset (i.e. the variability of available reserves.
σ) Comment 1: Valuing a natural resource company has an advantage
over valuing a patent from an estimation perspective – you can go
and look up the historical variance on for example oil prices and
know that the underlying asset is directly connected to the variance
you are putting into your model.
Comment 2: Since there is uncertainty in quantity, not only prices
add to the variance, so does available reserves. This wouldn’t be a
factor if we trusted the estimates of geologists 100%, but we
normally don’t.

5. Net production revenue • Net production revenue each year as a percentage of market
(i.e. dividend yield, or q) value, which is going to act like a dividend yield. T
Comment: There is a cost of delay stemming from the fact that
the company has to give up some cash flows when deciding not
to developing the reserves. This cost increases as the option
becomes more “in-the-money”, i.e. the natural resource price is a
lot higher than the development cost

6. Development lag • Calculate present value of reserve based on lag

Comment: If the CEO of Exxon mobile picks up his phone and says
“develop all reserves right away”, the oil does not start coming out of
the ground the next day. Its more like two years into the future. This

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matters since is creates a lag that carries risk (prices can shift during
this period).

Let’s once again try an example that can help combine these different inputs with each other to come up with
a value.
Gulf Oil was the target of a takeover in early 1984 at $70 share, with 165.3 million shares outstanding and
total debt of $9.9billion.

• Estimated reserves: 3038 million barrels of oil. Average cost of developing these reserves was
estimated at $10 per barrel in present value dollars. The development lag is approximately 2 years.
• The average relinquishment life of the reserves is 12 years.
• The price of oil was $22.38 per barrel, and the production cost, taxes and royalties were estimated at
$7 per barrel.
• The bond rate at the time was 9%.
• Gulf was expected to have net production revenues each year of approximately 5% of the value of
the developed reserves. The variance in oil prices is 0.03 (which might look small but it’s a standard
deviation squared)
Let’s think about what the value of the underlying asset is. You can develop 3038 million barrels and make
$22.38-$7 dollars per barrel. But remember, the development lag is 2 years, so the value is:
3 038 ∗ (22.38 − 7)
= $42 380.44 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1.05^2
The cost of developing the reserves are simply 3 038 ∗ 10 = $30 380 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
If this was a DCF, the value would be 12 million. Valuing the option yields the following results:

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r 0,09
S 42380,33
K 30380
q 0,050
T 12
Sigma^2 0,03

d1 1,655
d2 1,055
N(d1) 0,951
N(d2) 0,854

Call value 13306,41

PV inflows today 42380,33
PV outflows today 30380
Project today 12000,33
Option - Project 1306,08

The option is worth 13.3 billion, which is higher than the 12 billion coming from the DCF value. The extra
1.3 billion is coming from the fact that oil prices are volatile, the company can observe them, and adapt their
behaviour from that observation.
Adding this 13.3 billion to the value of the already developed reserves, that is expected to create cash flows on
the production in place, you can get to the total value of the firm. In this case, there was a 915 million annual
cash flow from the developed reserves expected to continue for another 10 years, that, discounted back at a
12,5% cost of capital equals $5063.83 million dollars. The total value for the firm added up to $18 372 million,
that after subtracting debt lead to a value of equity of $8 472 million, or 51.25 dollars per share.
One issue when valuing oil companies is that they (except for their developed reserves, of course) only have
to report viable reserves, which from a option standpoint only is the in-the-money options. This will
underestimate the value of the company. Moreover, information like the average development costs by
reserves are not normally given in detail.
Generally, though, real option pricing models work well with natural resource options, because the pass the
tests, or “questions” outlined earlier. That is,

• The Option Test:

o Underlying Asset: Oil or gold in reserve
o Contingency:
▪ If value > Cost of development: Value - Dev Cost
▪ If value < Cost of development: 0
• The Exclusivity Test:
o Natural resource reserves are limited (at least for the short term)
o It takes time and resources to develop new reserves
• The Option Pricing Test

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o Underlying Asset: While the reserve or mine may not be traded, the commodity is. If we
assume that we know the quantity with a fair degree of certainty, you can trade the underlying
asset
o Option: Oil companies buy and sell reserves from each other regularly
o Cost of Exercising the Option: This is the cost of developing a reserve. Given the experience
that commodity companies have with this, they can estimate this cost with a fair degree of
precision
Another reflection that might be worth bringing up is the following: A natural resource company with a lot of
undeveloped reserves will actually increase more in terms of market cap than a natural resource company with
a lot of developed reserves when oil price becomes more volatile (and when the market in general sees more
uncertainty in the oil supply/demand). Why? If the undeveloped reserve part of the market value of these
companies are driven by real option pricing theory (which we just concluded that they should), a company
with a higher proportion of undeveloped reserves should be perceived as more valuable when the volatility in
the underlying asset increases.
The option to expand
Imagine thinking about opening up a chain of restaurants in an exotic, emerging market country. You have a
feeling that the NPV of the first 5 chains will be negative, i.e. the project of opening these up in itself is not a
good one. Still though, there is a possibility that the project will end up being profitable. And if it is, you have
the alternative to expand the project, opening up 100 more restaurants as you now have access to the market.
Just like the value of a patent of the value of a resource company, this can be thought of as an option. In this
case, the option is out-of-the money when the NPV for expanding still is negative, and in-the-money then the
NPV for expanding is positive. The strike price is the additional investment required to expand. Already at
this stage, you can see how this rationale for investing – sometimes referred to the value of a “strategic
option” – can be used my management to defend making certain NPV negative projects that absolutely
should not be taken.
Let’s take another example that might be more reasonable when trying to quantify a real option to expand.
This example, which is on a young, start-up company can be found in the lectures from Damodaran too.
You have completed a DCF valuation of a small anti-virus software company, Secure Mail, and estimated its
value to be $115 million.

• Assume that there is the possibility that the company could use the customer base that it develops for
the anti-virus software and the technology on which the software is based to create a database
software program sometime in the next 5 years.
o It will cost Secure Mail about $500 million to develop a new database program, if they
decided to do it today
o Based upon the information you have now on the potential for a database program, the
company can expect to generate about $ 40 million a year in after-tax cashflows for ten years
o The cost of capital for private companies that provide database software is 12%
o The annualized standard deviation in firm value at publicly traded database companies is 50%
o The five-year treasury bond rate is 3%
• Therefore,
o S = Exercise price = Value of entering the database software market = PV of $40 million for 10
years @12% = $226 million
o K = Strike Price = Cost of entering the database software market = $ 500 million
o t = Period over which you have the right to enter the market = 5 years

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o σ = Standard deviation of stock prices of database firms = 50%

o r = Riskless rate = 3%
• Using the same Black-Scholes model as outlines before, the value is $ 56 million
• Value of company with the value to expand to database market = $ 115 million + $ 56 million = $
171 million
A quick reflection: What have we actually valued here? It is the value of a company that has an option to
expand, based on a proprietary database. On the face of it, the potential to develop this new database simply
looks like a bad project and would only decrease the value from the DCF of 115 million, but its high risk in
terms of volatility gives it an upside. Does it sound far-fetched and artificial that the value can increase so
much from a DCF taking options into consideration? Think of a social media company like Facebook.
I imagine if you were asked to value Facebook, you would tell a story of a successful online advertising
company and come up with a value from that narrative. But what’s Facebook’s biggest competitive advantage?
It’s the billions of users who are on Facebook hours a day, all year around. Currently Facebook is making
money though advertising, but regardless of what view you have on the future, they still have those billions of
users glued to their platform. Is it possible that Facebook can come up with new ways of making money from
these users? Of course! It’s not that you, or even Facebook, has to know how they are going to make money
from these users. Therefore, you don’t necessarily build a specific narrative into your forecasts that takes a
specific view of how they are going to make money from the users into consideration. Still, the option exists
that they might. If the stars are aligned, those billions of users can be used in a way that they add value to the
company. Many analysts won’t model these scenarios, and accountants most definitely won’t put the users on
the balance sheet, but it would be insane to claim that the user base does not add value just because they are
not, at this moment, generating any cash flows.
Now, here comes the important part in this section: The constraints that will stop you from valuing every
company as holders of real options, and the framework that can make you realize that options are not binary,
but rather should be thought of as being positioned on a scale.

1. What is the value of the second investment?

Second Investment Second Investment has

If… has zero excess large, sustainable,
returns excess returns

Option has Option has

Then… no value high value
no be to be
captured captured

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2. How much of that value, if any, can the company capture?

2. a) Is the first investment necessary for the second investment?

If… No, not necessary Yes, pre-requisite

2 b) Is the company’s access to the second investment exclusive?

No, there is zero competitive advantage Yes, there is an exclusive right

And If…
in access of second investment to the second investment

0% of option 100% of option

Then… valued can be Weighted
value can be
consideration of level
captured of pre-requisite and captured
exclusivity rights…

The weighted consideration of question 1 and 2 (which in itself is a weighted consideration of level of pre-
requisite and exclusivity rights) determines the value of the option!
If the value of the second investment is high and the company can capture a large proportion of that value, then the option is
valuable. The option does not exist if the company has zero exclusivity to the second investment, and it is not
really an option to expand at all if there is no initial reinvestment. It might help to go back and think about the
initial restaurant example at this stage. Let’s say the restaurant chain claims its entrance to the emerging market
should be thought about as an option to expand, as its NPV is negative and the project can’t be justified from
a DCF standpoint. What’s the immediate weakness in that claim based on what you just learned? If you need a
clue, think about it this way. Who else is watching if the company is creating value except for the company
itself? An argument can probably be made that the entire market with all its intense food-related competition
is watching. These are large companies, with capital, access to the market, marketing capacities and diversity in
offerings. What, then, is missing to be able to call it an option? Exclusivity! No exclusivity = no option.
Simple as that. Opportunities are not options.
Let’s go through the real option test for expansion options, just like we did for the other real options.

• The Options Test

o Underlying Asset: Expansion Project
o Contingency
▪ If PV of CF from expansion > Cost of expansion: PV – expansion cost: Value - Dev
Cost

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▪ If PV of CF from expansion < Cost of Expansion: 0

• The Exclusivity Test
o Barriers may range from strong (exclusive licenses granted by the government) to weaker
(brand name, knowledge of the market) to weakest (first mover)
• The Pricing Test
o Underlying Asset: As with patents, there is no trading in the underlying asset and you must
estimate value and volatility
o Option: Licenses are sometimes bought and sold, but more diffuse expansion options are not
o Cost of Exercising the Option: Not known with any precision and may itself evolve over
time as the market evolves
• Using option pricing models to value expansion options will not only yield extremely noisy estimates,
but may attach inappropriate premiums to discounted cashflow estimates.
The option to abandon
A firm may sometimes have the option to abandon a project, if the cash flows do not measure up to
expectations. If abandoning the project allows the firm to save itself from further losses, this option can make
a project more valuable. This option is actually the only put option in the real option world. All other real
options, whether it’s the value of a drug for a pharmaceutical or the value of expanding for a social media
company, have a potential for upside as the value of the underlying asset increases. The option to abandon on
the other hand, is valuable as the NPV for a project moves into negative territory, as the company can back
off from destroying value.
Here is an example of an option to abandon.

• Airbus is considering a joint venture with Lear Aircraft to produce a small commercial airplane
(capable of carrying 40- 50 passengers on short haul flights)
o Airbus will have to invest $ 500 million for a 50% share of the venture
o Its share of the present value of expected cash flows is $ 480 million.
• Lear Aircraft, which is eager to enter into the deal, offers to buy Airbus’s 50% share of the
investment anytime over the next five years for $ 400 million, if Airbus decides to get out of the
venture.
• A simulation of the cash flows on this time share investment yields a variance in the present value of
the cash flows from being in the partnership is 0.16.
• The project has a life of 30 years.
• Value of the Underlying Asset = S = PV of Cash Flows from Project = $ 480 million
• Strike Price = K = Salvage Value from Abandonment = $ 400 million
• Variance in Underlying Asset’s Value = σ = 0.16
• Time to expiration = Life of the Project = t = 5 years
• Dividend Yield = q = 1/Life of the Project = 1/30 = 0.033 (We are assuming that the project’s
present value will drop by roughly 1/n each year into the project)
• Assume that the five-year riskless rate = r = 6%. The value of the put option can be estimated.
• Value of Put = 𝑷 = 𝐾 ∙ 𝑒 −𝑟𝑡 (1 − 𝑁(𝑑2)) − 𝑆 ∙ 𝑒 −𝑦𝑡 (1 − 𝑁(𝑑1)) = 400 ∙ 𝑒 −0.06∙5 (1 −
0.4624) − 480 ∙ 𝑒 −0.033∙5 (1 − 0.7882) = $ 𝟕𝟑. 𝟐𝟑 𝑴𝒊𝒍𝒍𝒊𝒐𝒏
• The value of this abandonment option has to be added on to the net present value of the project of -
$ 20 million, yielding a total net present value with the abandonment option of $ 53.23 million.

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So, what are the implications for investment analysis and valuation given what we now know about these
options? Its threefold, really.
1. Having a option to abandon a project can make otherwise unacceptable projects acceptable.
2. Other things remaining equal, you would attach more value to companies with
a. More cost flexibility, that is, making more of the costs of the projects into variable costs as
opposed to fixed costs.
b. Fewer long-term contracts/obligations with employees and customers, since these add to the
cost of abandoning a project.
3. These actions will undoubtedly cost the firm some value, but this has to be weighed off against the
increase in the value of the abandonment option.
Capital structure related real options – specifically the value of financial flexibility
The most direct applications of option pricing in capital structure decisions is in the design of securities. In
fact, most complex financial instruments can be broken down into some combination of a simple
bond/common stock and a variety of options. If these securities are to be issued to the public, and traded, the
options must be priced. If these are non-traded instruments (bank loans, for instance), they still should be
priced into the interest rate on the instrument.
The other application of option pricing with regards to capital structure is in valuing flexibility. Often, firms
preserve debt capacity or hold back on issuing debt because they want to maintain flexibility. Understanding
this aspect of capital structure can truly be an eye opener to why certain analysts talk about balance sheet
qualities in a way that differs from what we normally learn in the corporate finance classroom (i.e. that it is
only about decreasing the cost of capital to the smallest possible value).
Financial flexibility is really about one thing and one thing only, preserving excess debt capacity and/or excess
cash (which today is not warranted) for the future. It is preserved, as to be able to take that once in a lifetime
investment and great NPV positive project when they appear. The company has, knowingly, remained below
the optimal debt ratio (that minimized the cost of capital), as to be able to thrive in for example an economic
downturn.
You can think about it this way: If we would live in a world where market always found its way to companies
with great ideas, there were no other external constraints to raising capital, and furthermore there were no
internal constraints to raising capital, then financial flexibility would not have any value. That’s not the world
we live in though. The company might find this huge, amazing company to acquire, and all that’s required is
capital. Capacity-wise, the funding is not accessible, not internally nor externally. It is simply above the
expected, normal reinvestment needs of the company. If you were the CFO of this company, how would you
start thinking of the value that can be gained by positioning the company’s capital structure as to have more
flexibility in the undertakings of these type of projects? Let’s say you lower the debt ratio from 50% (peer
average and reasonable given the cyclicality, operating leverage and credit environment) to 15% (can easily be
argued to be inefficient from a cost of capital perspective) and retain more cash as to be prepared for these
types of opportunities. This is a strategy that is intended to create shareholder value as you are confident in
the investments that can be made when the opportunity presents itself. To your great surprise, the CEO starts
questioning your tactic. He claims that he receives several phone calls from analysts and investors that you are
not efficiently managing the balance sheet. You start arguing back and forth. He claims that you can easily
decrease the cost of capital with some 1% by increasing the debt ratio. You claim that the market is not
efficient enough to reward you company with capital as soon as you identify excess-value projects, so you
should keep excess debt capacity. After a few hours, you realize that both have a valid point. But how do you
weigh one aspect against the other? How do you reach a logical solution?

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The answer is, and you guessed it, to think about the financial flexibility as an option. You have excess debt
capacity to draw on to make that once in a lifetime investment. What’s the payoff? To the extent that the
investment has positive NPV, you are able to take advantage of the financial flexibility by creating value on
investments that have actual reinvestment needs higher than expected normal reinvestment needs that can be financed
without flexibility. This value has to be compared to the 100 basis points you are leaving on the table by being
under levered.
Damodaran did this exercise for Disney. In his example, Disney had a cost of capital of 12.22% at a lower
than optimal debt ratio of 18%, when its optimal debt ratio was 40%, corresponding to a cost of capital of
11.64%. They are some 58 basis points above what they can be. He used the following structure to explain
the inputs:
Input Estimation In General, For Disney
Process
1. Value of the Expected annual Measures Average of
underlying reinvestment needs magnitude of Reinvestment/ Value
asset (i.e. the (i.e. net CAPEX reinvestment over last 5 years = 5.3%
S) and change in needs
NWC) (as % of
firm value)
2. Variance in Variance in annual Measures how Variance over last 5 years
value of the reinvestment needs much volatility in
underlying there is in ln(Reinvestment/Value)
asset (i.e. the reinvestment =0.375
σ) needs
3. Exercise (Internal (I.e. Measures the Average over last 5 years
price of FCFE) + Normal capital = 4.8%
option (i.e. access to external constraints
strike price, funds (i.e. what they
K) normally borrow))/
Value
4. Expiration 1 year Measures and T =1
of the option annual value for
(i.e. t) flexibility

These inputs implied a value of the option of 1.61%. Remember, this is on an annual basis. This can be seen
as the value of the option to take a project, but the overall value of flexibility will still depend on what projects
you take - specifically, the quality of them. If the value of the project that will be taken has a zero NPV, then
the option to take that project will also be worthless. In the Disney example, the company earn a 18.69% on
its capital and has a cost of capital of 12.22%. The excess return (annually) is 6.47%. Assuming that they can
continue to generate these excess returns in perpetuity: Value of Flexibility (annual)= 1.61%(.0647/.1222) =
0.85 % of value.
As previously mentioned, Disney’s cost of capital at its optimal debt ratio is 11.64%. The cost it incurs to
maintain flexibility is therefore 0.58% annually (12.22%- 11.64%). It therefore pays 0.27% annually to
maintain flexibility since 0.85% is larger than 0.58% (and the two measures are both on an annual basis and in
effect are applicable on the entire value of the company).
Just like we took some time to understand that there are certain drivers of the option to abandon (like More
cost flexibility and fewer long-term contracts/obligations with employees and customers) there are drivers of
the option of financial flexibility. There are three main drivers:

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• Capital Constraints (External and Internal): The greater the capacity to raise funds, either internally or
externally, the less the value of flexibility.
o 1.1: Firms with significant internal operating cash flows should value flexibility less than firms
with small or negative operating cash flows.
o 1.2: Firms with easy access to financial markets should have a lower value for flexibility than
firms without that access.
• Unpredictability of reinvestment needs: The more unpredictable the reinvestment needs of a firm,
the greater the value of flexibility.
• Capacity to earn excess returns: The greater the capacity to earn excess returns, the greater the value
of flexibility.
o 1.3: Firms that do not have the capacity to earn or sustain excess returns get no value from
flexibility

Some reflections: We would expect small companies to be more under levered than large companies. Why?
Because they normally face more capital constraints. We would expect emerging companies to value financial
flexibility more than companies in developed markets and thus more under levered Why? Well functioning
financial markets means ease in raising funds whenever one wants to, increasing the value of financial
flexibility. We would expect a company in a crisis to value financial flexibility more than the same company in
good times. Why? Markets collapses in a crisis, liquidity dries up, and even the most long-term promising
projects on an NPV perspective sometimes remain unfunded.
If you are a company that knows exactly what you will need to reinvest the next ten years, there is no value of
flexibility. Unpredictable business will on the other hand see great value in financial flexibility. We would
therefore expect tech companies to value financial flexibility a lot more than steel companies. Thus, tech
companies can reasonably be expected to be for more under levered than steel companies.
Yet, even if you are a young, tech-related company, active in an emerging market during a time of crises, the
value of the financial flexibility will still be zero if it can’t create excess returns on its projects. Therefore, if
you hear an analyst talk about the value of financial flexibility of the company in a sector that struggles to earn
its cost of capital, please tell them to stop filling your head with non-sense. Why would anyone pay more for a
company that flexes some financial muscles in terms of excess debt capacity and a large cash balance if they
can only employ that capital on projects that will destroy value?
Let’s move on to the last type of real option - which for the sake of SSIF hopefully won’t be something that
will be used to too large of an extent – the value of equity as an option.
Valuing equity as an option
Basing accounting and the principle of limited liability teaches us that equity in a firm is a residual claim, i.e.,
equity holders lay claim to all cashflows left over after other financial claim-holders (debt, preferred stock etc.)
have been satisfied. If a firm is liquidated, the same principle applies, with equity investors receiving whatever
is left over in the firm after all outstanding debts and other financial claims are paid off. The principle of
limited liability, however, protects equity investors in publicly traded firms if the value of the firm is less than
the value of the outstanding debt, and they cannot lose more than their investment in the firm. This means
that equity is really an option on the value of the underlying business.
Let’s kick off with a simple example.

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• Assume that you have a firm whose assets are currently valued at $100 million and that the standard
deviation in this asset value is 40%.
• Further, assume that the face value of debt is $80 million (It is zero coupon debt with 10 years left to
maturity).
• If the ten-year treasury bond rate is 10%,
o how much is the equity worth?
o What should the interest rate on debt be?
• Value of the underlying asset = S
o Value of the firm = $ 100 million
• Exercise price = K
o Face Value of outstanding debt = $ 80 million
• Life of the option = t
o Life of zero-coupon debt = 10 years
• Variance in the value of the underlying asset = σ2
o Variance in firm value = 0.16
• Riskless rate = r
o Treasury bond rate corresponding to option life = 10%
• Based upon these inputs, the Black-Scholes model provides the following value for the call:
o d1 = 1.5994
o N(d1) = 0.9451
o d2 = 0.3345
o N(d2) = 0.6310
• Value of the call = 100 ∙ (0.9451) − 80 e(−0.10)(10) ∙ (0.6310) = $𝟕𝟓. 𝟗𝟒 𝐦𝐢𝐥𝐥𝐢𝐨𝐧
• Value of the outstanding debt = $100 - $75.94 = $24.06 million
• We can also back out what the Interest rate on debt should be = ($ 80 / $24.06) ^ (1/10) -1 =
12.77%
Interestingly, we can experiment with the value for the equity part (currently 76 million) and the debt part (24
million) when catastrophic events occur to better understand the dynamics of valuing equity as an option.
o For example, assume that a catastrophe wipes out half the value of this firm (the value drops to $ 50
million), while the face value of the debt remains at $ 80 million. What will happen to the equity value
of this firm?
o a. It will drop in value to $ 25.94 million [ $ 50 million - market value of debt from previous
calculation = 24.06 million]
o b. It will be worth nothing since debt outstanding > Firm Value
o c. It will be worth more than $ 25.94 million
Before we check, think about it. B) can’t be the alternative, right? We are not accountants that will argue the
equity claim is zero just because equity from a purely mathematical standpoint moves into negative territory…
It has to be something else. What can we logically conclude about the value for the debt? Shouldn’t they share
some of the loss? Its not like the bank, or whoever the lender is, can back out or be in denial about the event.
They should logically not be unscathed when the value of the firm is lower than the face value of the debt.
Let’s check out what the answer is:
o Value of the underlying asset = S
o Value of the firm = $ 50 million
o Exercise price = K

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o Face Value of outstanding debt = $ 80 million

o Life of the option = t
o Life of zero-coupon debt = 10 years
o Variance in the value of the underlying asset = σ2
o Variance in firm value = 0.16
o Riskless rate = r
o Treasury bond rate corresponding to option life = 10%
o Based upon these inputs, the Black-Scholes model provides the following value for the call:
o d1 = 1.0515
o N(d1) = 0.8534
o d2 = -0.2135
o N(d2) = 0.4155
o Value of the call = 50 ∙ (0.8534) − 80 e(−0.10)(10) ∙ (0.4155) = $30.44 million
o Value of the bond= $50 - $30.44 = $19.56 million
o The equity in this firm drops by $45.50 million, less than the overall drop in value of $50 million,
because of the option characteristics of equity.
o This might explain why stock in firms, which are in Chapter 11 and essentially bankrupt, still has
value.
We think that further discussions about the conflict between stockholders and bondholders should be held in
the classroom. A key conclusion from that discussion should be that the value of the equity can rise from a
negative NPV project if it contributes greatly to the volatility of the firm.
One key further aspect to discuss with regards to equity as an option is the difficulty in obtaining option
pricing inputs in the real world. Here is a little list you can use to understand the estimation process of the key
inputs.

Input Estimation Process

1. Value of the • Cumulate market values of equity and debt (or)
firm • Value the assets in place using FCFF and WACC (or)
• Use cumulated market value of assets, if traded
2. Variance of the • If stocks and bonds are traded,
firm value 2
σ𝑓𝑖𝑟𝑚 = w𝑒2 ∙ σ2𝑒 + w𝑑2 ∙ σ2𝑑 + 2 ∙ 𝑤𝑒 ∙ 𝑤𝑑 ∙ ρ𝑒𝑑 ∙ 𝜎𝑒 ∙ 𝜎𝑑 where ∙ σ2𝑒 =
variance in the stock price

𝑤𝑒 = MV weight of Equity
σ2𝑑 = the variance in the bond price
𝑤𝑑 = MV weight of debt

• If not traded, use variances of similarly rated bonds.

• Use average firm value variance from the industry in which company
operates.
3. Value of the • If the debt is short term, you can use only the face or book value of
debt the debt.
• If the debt is long term and coupon bearing, add the cumulated
nominal value of these coupons to the face value of the debt.
4. Maturity of the • Face value weighted duration of bonds outstanding (or)
debt • If not available, use weighted maturity

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Let’s go through another example with distressed equity as an option.

• Eurotunnel has been a financial disaster since its opening

o In 1997, Eurotunnel had earnings before interest and taxes of - £56 million and net income
of -£685 million
o At the end of 1997, its book value of equity was -£117 million ¨
• It had £8,865 million in face value of debt outstanding
o The weighted average duration of this debt was 10.93 years

Debt type Face Value Duration

Short term 935 0.5
10 Year 2435 6.7
20 Year 3555 12.6
Longer 1940 18.2
Total 8865 10.93

The DCF valuation produces the following:

• The value of the firm estimated using projected cashflows to the firm, discounted at the weighted
average cost of capital was £2,312 million.
• This was based upon the following assumptions
o Revenues will grow 5% a year in perpetuity.
o The COGS which is currently 85% of revenues will drop to 65% of revenues in yr. 5 and stay
at that level.
o Capital spending and depreciation will grow 5% a year in perpetuity.
o There are no working capital requirements.
o The debt ratio, which is currently 95.35%, will drop to 70% after year 5. The cost of debt is
10% in high growth period and 8% after that.
o The beta for the stock will be 1.10 for the next five years, and drop to 0.8 after the next 5
years.
o The long-term bond rate is 6%.
• The stock has been traded on the London Exchange, and the annualized standard deviation based
upon ln(prices) is 41%.
• There are Eurotunnel bonds, that have been traded; the annualized standard deviation in ln(price) for
the bonds is 17%.
o The correlation between stock price and bond price changes has been 0.5. The proportion of
debt in the capital structure during the period (1992-1996) was 85%.
o Annualized variance in firm value =(0.15)2 ∙ (0.41)2 + (0.85)2 ∙ (0.17)2 + 2 ∙ (0.15) ∙
(0.85) ∙ (0.5) ∙ (0.41) ∙ (0.17) = 0.0335
o The 15-year bond rate is 6%. (using a bond with a duration of roughly 11 years to match the
life of the option)
Valuing Eurotunnel’s equity and debt:

• Inputs to Model
o Value of the underlying asset = S = Value of the firm = £2,312 million

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o Exercise price = K = Face Value of outstanding debt = £8,865 million

o Life of the option = t = Weighted average duration of debt = 10.93 years
o Variance in the value of the underlying asset = σ2 = Variance in firm value = 0.0335
o Riskless rate = r = Treasury bond rate corresponding to option life = 6%
• Based upon these inputs, the Black-Scholes model provides the following value for the call:
o d1 = -0.8337
o N(d1) = 0.2023
o d2 = -1.4392
o N(d2) = 0.0751
• Value of the call = 2312 ∙ (0.2023) − 8,865 ∙ e(−0.06)(10.93) ∙ (0.0751) = £122 million
• Appropriate interest rate on debt = (8865/2190)(1/10.93) − 1 = 13.65%

Closing reflections on real options

Reading this section of the analyst guide might be overwhelming, especially is you have never done option
pricing calculations, and even more so if the concepts discussed earlier in the analyst guide (like competitive
advantages, excess returns, cash flows, growth risk, contingency etc.) are not understood completely.
You might feel that it seems like real options are everywhere. There is some truth to that. From an analytical
standpoint, though, we rarely have to consider them since most of them have no significant economic value.
Why? there is no exclusivity associated with using them.
We can also conclude that when options have significant economic value, the inputs needed to value them in a
binomial model can be used in more traditional approaches (decision trees) to yield equivalent value.
Generally, though, the real value from real options lies in (i) Recognizing that building in flexibility and escape
hatches into large decisions has value (ii) Insights we get on understanding how and why companies behave
the way they do in investment analysis and capital structure choices.
A final reflection is that the process of acquiring the inputs for real option valuation can seem like a guessing
game. Like often in valuation, its about coming up with best estimates and internal consistency. Best estimates
require knowing the business, knowing the sector, and understanding how management operates the business.
Without a deep understanding of those factors, everything is a guessing game, and you will have no
confidence in your own estimation process. Internal consistency means you apply the same broad story for
the company for all value drivers. A risky company can see great value in real options, but you better apply the
same logic consistently for your continuous cash flows, growth and risk in the DCF and multiples.

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Rules for The Road

• Before you start to analyze a company in depth that you have already decide to value, write
down what your initial expectations are regarding its value. In our opinion, all valuations are
biased, it is just a question of how much and in which direction. You might as well be honest to
yourself and the rest of the fund with why you have chosen the company you have, and what the
implications are for the valuation you are going to do. You have probably read some article,
heard someone talk about the company, or perhaps you are a customer to the company. Write it
all down, and reflect back on it after your valuation is done. Transparency is crucial for the long-
term success of this fund, and this is a step every analyst should take to make sure they eliminate
as bias as possible, but maybe more importantly, are open with their bias.
• Do not fall into the trap of believing that the more numbers are stacked into a model, the better
it is. The level of quantitative analysis is not necessarily correlated to a great valuation. We
would argue that the actual understanding of the model is, for most people in most cases,
negatively correlated to the number of inputs. This is perhaps due to the fact that the underlying
story you are trying to tell, and the reasonableness of that story gets lost somewhere in some of
the unnecessary nitty-gritty details.
• Sometimes you see a valuation with a ridiculously precise estimate of value, down to the penny
of a company trading as several hundreds of dollars. No range, scenarios, or rounding of
numbers, just a precise estimate. Do not be fooled that there is some genius valuation method
behind those estimates of value that is better than a valuation with some simplified assumptions
and rounded numbers. As a matter of fact, when there are substantial uncertainty and lack of
precision, the payoff of an investment can be the largest due to the fact that many investors shy
away from even trying to value the company, or are to afraid to give some best estimate
scenarios of outcome using simple valuation models.
• It is better to face up to uncertainty than to simply claim a margin of safety exists. Often, it is
the percentage difference between the base-case scenario and the current price that interest
investors. At SSIF, we think it is absolutely crucial to understand that different sectors, different
companies, different parts of a valuation and different inputs have different distribution of
outcomes around the median. A 10% difference between the target price and current price can
have a very tight distribution of outcomes around it and therefore be a great investment,
whereas a 25% difference between the target price and current price can have a very wide
distribution around it, and therefore have lower conviction. Whenever possible, face up to the
uncertainty by using either simulations of attach probabilities to scenarios that combine
different input outcomes.
• You have, or are in the coming years going to have studied not just finance, accounting,
economics and econometrics, but also marketing, management and strategy. Do not waste the
knowledge that those courses bring. Value creating companies - which often are the ones where
great stockholder value is created over time - employ great business strategies, position
themselves cleverly in the marketplace, are often filled with talented people, and reach
corporations and/or people in creative and interesting ways. Pursuing a bachelor at SSE, or
having finished a bachelor at another top university should give you the tools to analyze
companies in depth. Remember that the drivers of value: the cash flows of existing assets, the
value of growth assets, the capacity to continue to grow for a long time and the risk associated
with the future cash flows can all in one way or another be related to these areas of studies. You
must tie your growth and profitability assumptions to aspects like strong brand names, patents,
lock-in strategies, unique resources, difficult to copy business models etcetera.

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• Never stop reading. There are endless of great books on topics relating to investing and
valuation. Check out our recommended readings on our website for an updated list of great
reads!

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