1

Relative Valuation
Aswath Damodaran
2
What is relative valuation?
In relative valuation, the value of an asset is compared to the values
assessed by the market for similar or comparable assets.
To do relative valuation then,
we need to identify comparable assets and obtain market values for these
assets
convert these market values into standardized values, since the absolute
prices cannot be compared This process of standardizing creates price
multiples.
compare the standardized value or multiple for the asset being analyzed to
the standardized values for comparable asset, controlling for any
differences between the firms that might affect the multiple, to judge
whether the asset is under or over valued
3
Relative valuation is pervasive
Most valuations on Wall Street are relative valuations.
Almost 85% of equity research reports are based upon a multiple and
comparables.
More than 50% of all acquisition valuations are based upon multiples
Rules of thumb based on multiples are not only common but are often the
basis for final valuation judgments.
While there are more discounted cashflow valuations in consulting and
corporate finance, they are often relative valuations masquerading as
discounted cash flow valuations.
The objective in many discounted cashflow valuations is to back into a
number that has been obtained by using a multiple.
The terminal value in a significant number of discounted cashflow
valuations is estimated using a multiple.
4
Why relative valuation?
If you think Im crazy, you should see the guy who lives across the hall
Jerry Seinfeld talking about Kramer in a Seinfeld episode

A little inaccuracy sometimes saves tons of explanation
H.H. Munro
If you are going to screw up, make sure that you have lots of company
Ex-portfolio manager
5
So, you believe only in intrinsic value? Here is
why you should still care about relative value
Even if you are a true believer in discounted cashflow valuation,
presenting your findings on a relative valuation basis will make it more
likely that your findings/recommendations will reach a receptive
audience.
In some cases, relative valuation can help find weak spots in
discounted cash flow valuations and fix them.
The problem with multiples is not in their use but in their abuse. If we
can find ways to frame multiples right, we should be able to use them
better.

6
Standardizing Value
You can standardize either the equity value of an asset or the value of the asset itself,
which goes in the numerator.
You can standardize by dividing by the
Earnings of the asset
Price/Earnings Ratio (PE) and variants (PEG and Relative PE)
Value/EBIT
Value/EBITDA
Value/Cash Flow
Book value of the asset
Price/Book Value(of Equity) (PBV)
Value/ Book Value of Assets
Value/Replacement Cost (Tobins Q)
Revenues generated by the asset
Price/Sales per Share (PS)
Value/Sales
Asset or Industry Specific Variable (Price/kwh, Price per ton of steel ....)
7
The Four Steps to Understanding Multiples
Define the multiple
In use, the same multiple can be defined in different ways by different
users. When comparing and using multiples, estimated by someone else, it
is critical that we understand how the multiples have been estimated
Describe the multiple
Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of
a multiple is, it is difficult to look at a number and pass judgment on
whether it is too high or low.
Analyze the multiple
It is critical that we understand the fundamentals that drive each multiple,
and the nature of the relationship between the multiple and each variable.
Apply the multiple
Defining the comparable universe and controlling for differences is far
more difficult in practice than it is in theory.
8
Definitional Tests
Is the multiple consistently defined?
Proposition 1: Both the value (the numerator) and the standardizing
variable ( the denominator) should be to the same claimholders in the
firm. In other words, the value of equity should be divided by equity
earnings or equity book value, and firm value should be divided by
firm earnings or book value.
Is the multiple uniformly estimated?
The variables used in defining the multiple should be estimated uniformly
across assets in the comparable firm list.
If earnings-based multiples are used, the accounting rules to measure
earnings should be applied consistently across assets. The same rule
applies with book-value based multiples.
9
Descriptive Tests
What is the average and standard deviation for this multiple, across the
universe (market)?
What is the median for this multiple?
The median for this multiple is often a more reliable comparison point.
How large are the outliers to the distribution, and how do we deal with
the outliers?
Throwing out the outliers may seem like an obvious solution, but if the
outliers all lie on one side of the distribution (they usually are large
positive numbers), this can lead to a biased estimate.
Are there cases where the multiple cannot be estimated? Will ignoring
these cases lead to a biased estimate of the multiple?
How has this multiple changed over time?
10
Analytical Tests
What are the fundamentals that determine and drive these multiples?
Proposition 2: Embedded in every multiple are all of the variables that
drive every discounted cash flow valuation - growth, risk and cash flow
patterns.
In fact, using a simple discounted cash flow model and basic algebra
should yield the fundamentals that drive a multiple
How do changes in these fundamentals change the multiple?
The relationship between a fundamental (like growth) and a multiple (such
as PE) is seldom linear. For example, if firm A has twice the growth rate
of firm B, it will generally not trade at twice its PE ratio
Proposition 3: It is impossible to properly compare firms on a
multiple, if we do not know the nature of the relationship between
fundamentals and the multiple.
11
Application Tests
Given the firm that we are valuing, what is a comparable firm?
While traditional analysis is built on the premise that firms in the same
sector are comparable firms, valuation theory would suggest that a
comparable firm is one which is similar to the one being analyzed in terms
of fundamentals.
Proposition 4: There is no reason why a firm cannot be compared
with another firm in a very different business, if the two firms have
the same risk, growth and cash flow characteristics.
Given the comparable firms, how do we adjust for differences across
firms on the fundamentals?
Proposition 5: It is impossible to find an exactly identical firm to the
one you are valuing.
12
Price Earnings Ratio: Definition
PE = Market Price per Share / Earnings per Share
There are a number of variants on the basic PE ratio in use. They are
based upon how the price and the earnings are defined.
Price: is usually the current price
is sometimes the average price for the year
EPS: earnings per share in most recent financial year
earnings per share in trailing 12 months (Trailing PE)
forecasted earnings per share next year (Forward PE)
forecasted earnings per share in future year
13
Looking at the distribution
0
100
200
300
400
500
600
700
800
N
u
m
b
e
r

o
f

f
i
r
m
s
0-4 4-8 8-12 12-16 16-20 20-24 24-28 28 - 32 32-36 36-40 40-50 50-75 75-100 >100
PE Ratio
PE Ratios for US Stocks - January 2006
Current PE
Trailing PE
Forward PE
14
PE: Deciphering the Distribution
Current PE Trailing PE Forward PE
Mean 43.58 40.52 29.93
Standard Error 3.74 7.38 1.81
Median 20.67 19.04 18.18
Standard Deviation 241.96 463.62 88.57
Kurtosis 1871.78 3611.60 474.76
Skewness 38.68 58.97 19.35
Minimum 0.75 3.12 4.38
Maximum 12712.82 28518.28 2710.00
Count 4179 3947 2397
90th percentile 54.21 44.31 28.14
10th percentile 11.22 10.17 13.75
Confidence Level(95.0%) 7.34 14.47 3.55
15
Comparing PE Ratios: US, Europe, Japan and
Emerging Markets - January 2005
Median PE
Japan = 23.45
US = 23.21
Europe = 18.79
Em. Mkts = 16.18
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
%

o
f

f
i
r
m
s

i
n

m
a
r
k
e
t
0-4 4-8 8-12 12-16 16-20 20-24 24-28 28 - 32 32-36 36-40 40-50 50-75 75-100 >100
PE Ratio
PE Distributions: Comparison
US
Emerging Markets
Europe
Japan
16
PE Ratios in Brazil - January 2006
0
5
10
15
20
25
30
<4 4-8 8-12 12-16 16-20 20-24 24-28 28-32 32-26 26-40 40-50 50-100 >100
PE Ratio
Brazilian companies: PE ratios in January 2006
Lowest PE stocks
ACES3 3.65
USIM3 3.91
SAPR4 4.13
GOAU3 4.27
AVIL3 4.45
Highest PE stocks
CBEE3 76.59
OHLB3 76.69
LAME3 92.17
MTBR3 110.46
LIPR3 118.66
17
PE Ratio: Understanding the Fundamentals
To understand the fundamentals, start with a basic equity discounted
cash flow model.
With the dividend discount model,


Dividing both sides by the earnings per share,


If this had been a FCFE Model,

P
0
=
DPS
1
r g
n
P
0
EPS
0
= PE=
Payout Ratio*(1+ g
n
)
r-g
n
P
0
=
FCFE
1
r g
n
P
0
EPS
0
= PE =
(FCFE/Earnings)*(1+ g
n
)
r-g
n
18
PE Ratio and Fundamentals
Proposition: Other things held equal, higher growth firms will
have higher PE ratios than lower growth firms.
Proposition: Other things held equal, higher risk firms will have
lower PE ratios than lower risk firms
Proposition: Other things held equal, firms with lower
reinvestment needs will have higher PE ratios than firms with
higher reinvestment rates.
Of course, other things are difficult to hold equal since high growth
firms, tend to have risk and high reinvestment rats.
19
Using the Fundamental Model to Estimate PE
For a High Growth Firm
The price-earnings ratio for a high growth firm can also be related to
fundamentals. In the special case of the two-stage dividend discount
model, this relationship can be made explicit fairly simply:



For a firm that does not pay what it can afford to in dividends, substitute
FCFE/Earnings for the payout ratio.
Dividing both sides by the earnings per share:

P
0
=
EPS
0
* Payout Ratio*(1+ g)* 1
(1+ g)
n
(1+ r)
n
|
\

|
.
r - g
+
EPS
0
* Payout Ratio
n
*(1+ g)
n
*(1+ g
n
)
(r -g
n
)(1+ r)
n
P
0
EPS
0
=
Payout Ratio* (1 + g) * 1
(1 + g)
n
(1+ r)
n
|
\

|
.
|
r - g
+
Payout Ratio
n
*(1+ g)
n
* (1 + g
n
)
(r - g
n
)(1+ r)
n
20
Expanding the Model
In this model, the PE ratio for a high growth firm is a function of
growth, risk and payout, exactly the same variables that it was a
function of for the stable growth firm.
The only difference is that these inputs have to be estimated for two
phases - the high growth phase and the stable growth phase.
Expanding to more than two phases, say the three stage model, will
mean that risk, growth and cash flow patterns in each stage.
21
A Simple Example
Assume that you have been asked to estimate the PE ratio for a firm
which has the following characteristics:
Variable High Growth Phase Stable Growth Phase
Expected Growth Rate 25% 8%
Payout Ratio 20% 50%
Beta 1.00 1.00
Number of years 5 years Forever after year 5
Riskfree rate = T.Bond Rate = 6%
Required rate of return = 6% + 1(5.5%)= 11.5%


PE =
0.2 * (1.25) * 1
(1.25)
5
(1.115)
5
|
\

|
.
|
(.115 - .25)
+
0.5 * (1.25)
5
*(1.08)
(.115- .08) (1.115)
5
= 28.75
22
PE and Growth: Firm grows at x% for 5 years,
8% thereafter
PE Ratios and Expected Growth: Interest Rate Scenarios
0
20
40
60
80
100
120
140
160
180
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expected Growth Rate
P
E

R
a
t
i
o
r=4%
r=6%
r=8%
r=10%
23
PE Ratios and Length of High Growth: 25%
growth for n years; 8% thereafter
24
PE and Risk: Effects of Changing Betas on PE
Ratio:
Firm with x% growth for 5 years; 8% thereafter
PE Ratios and Beta: Growth Scenarios
0
5
10
15
20
25
30
35
40
45
50
0.75 1.00 1.25 1.50 1.75 2.00
Beta
P
E

R
a
t
i
o
g=25%
g=20%
g=15%
g=8%
25
PE and Payout
26
I. Comparisons of PE across time: PE Ratio for
the S&P 500
PE Ratio for S&P 500: 1960-2005
0
5
10
15
20
25
30
35
1
9
6
0
1
9
6
2
1
9
6
4
1
9
6
6
1
9
6
8
1
9
7
0
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
P
E

R
a
t
i
o
Average over period = 16.82
27
Is low (high) PE cheap (expensive)?
A market strategist argues that stocks are over priced because the PE
ratio today is too high relative to the average PE ratio across time. Do
you agree?
Yes
No
If you do not agree, what factors might explain the higher PE ratio
today?
28
E/P Ratios , T.Bond Rates and Term Structure
EP Ratios and Interest Rates: S&P 500 - 1960-2005
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
1
9
6
0
1
9
6
2
1
9
6
4
1
9
6
6
1
9
6
8
1
9
7
0
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
Year
Earnings Yield
T.Bond Rate
Bond-Bill
29
Regression Results
There is a strong positive relationship between E/P ratios and T.Bond
rates, as evidenced by the correlation of 0.70 between the two
variables.,
In addition, there is evidence that the term structure also affects the PE
ratio.
In the following regression, using 1960-2005 data, we regress E/P
ratios against the level of T.Bond rates and a term structure variable
(T.Bond - T.Bill rate)
E/P = 2.10% + 0.744 T.Bond Rate - 0.327 (T.Bond Rate-T.Bill Rate)
(2.44) (6.64) (-1.34)
R squared = 51.35%
30
II. Comparing PE Ratios across a Sector
Company Name PE Growth
PT Indosat ADR 7.8 0.06
Telebras ADR 8.9 0.075
Telecom Corporation of New Zeal and ADR 11.2 0.11
Telecom Argentina Stet - France Tel ecomSA ADR B 12.5 0.08
Hell eni c Telecommunication Organi zati on SA ADR 12.8 0.12
Telecomuni caci ones de Chi l e ADR 16.6 0.08
Swi sscomAG ADR 18.3 0.11
Asia Satell i te Tel ecomHol di ngs ADR 19.6 0.16
Portugal Telecom SA ADR 20.8 0.13
Telefonos de Mexi co ADR L 21.1 0.14
Matav RT ADR 21.5 0.22
Telstra ADR 21.7 0.12
Gi lat Communications 22.7 0.31
Deutsche Tel ekomAG ADR 24.6 0.11
Bri ti sh Tel ecommunications PLC ADR 25.7 0.07
Tele Danmark AS ADR 27 0.09
Telekomuni kasi Indonesi a ADR 28.4 0.32
Cable & Wi rel ess PLC ADR 29.8 0.14
APT Satel li te Hol di ngs ADR 31 0.33
Telefoni ca SA ADR 32.5 0.18
Royal KPN NV ADR 35.7 0.13
Telecom Ital ia SPA ADR 42.2 0.14
Ni ppon Tel egraph & Tel ephone ADR 44.3 0.2
France Telecom SA ADR 45.2 0.19
Korea Tel ecomADR 71.3 0.44
31
PE, Growth and Risk
Dependent variable is: PE

R squared = 66.2% R squared (adjusted) = 63.1%

Variable Coefficient SE t-ratio prob
Constant 13.1151 3.471 3.78 0.0010
Growth rate 121.223 19.27 6.29 0.0001
Emerging Market -13.8531 3.606 -3.84 0.0009
Emerging Market is a dummy: 1 if emerging market
0 if not

32
Is Telebras under valued?
Predicted PE = 13.12 + 121.22 (.075) - 13.85 (1) = 8.35
At an actual price to earnings ratio of 8.9, Telebras is slightly
overvalued.
Given the R-squared on the regression, though, a more precise
statistical statement would be that the predicated PE for Telebras will
fall within a range. In this case, the range would be as follows:
Upper end of the range: 10.06
Lower end of the range: 6.64
As a general rule, the higher the R-squared the narrower the range for
the predicted values. The range will also tend to be tighter for firms
that fall close to the average and become wider for extreme values.
33
Using the entire crosssection: A regression
approach
In contrast to the 'comparable firm' approach, the information in the
entire cross-section of firms can be used to predict PE ratios.
The simplest way of summarizing this information is with a multiple
regression, with the PE ratio as the dependent variable, and proxies for
risk, growth and payout forming the independent variables.
34
PE versus Growth
Expected Growth in EPS: next 5 years
100 80 60 40 20 0 -20
C
u
r
r
e
n
t

P
E
300
200
100
0
-100 Rsq = 0.1500
35
PE Ratio: Standard Regression for US stocks -
January 2006

Mo del Summa ry
. 5 5 4
a
. 3 0 7 .3 0 6 1 41 1 . 52 8 2 67 1 64 7
Mo de l
1
R R Sq uar e
Adju s ted R
Squ ar e
Std . Er r or of t he
Es tima te
Pr ed icto r s: ( Co nst ant ), Ex p ect ed Gro wth in EPS: ne xt 5 year s ,
PAYOUT, Valu e Line Be ta
a.
Co ef fici ents
a,b
6 . 7 4 7 1 . 3 9 7 4 . 8 30 . 00 0
- . 91 9 1 . 2 0 5 - . 01 5 - . 76 3 . 44 6
7 . 3 25 E- 0 2 . 01 3 . 10 5 5 . 6 44 . 00 0
1 . 1 3 1 . 03 8 . 57 6 2 9. 65 7 . 00 0
(Co n st ant )
Va lu e Lin e Be ta
PAYOUT
Ex pect ed Gro wt h in
EPS: n ext 5 year s
Mo de l
1
B Std . Er ro r
Uns t and ar d iz ed
Coef ficie nt s
Bet a
St and ar dized
Co efficien ts
t Sig .
Depen d ent Va riable: Cur r ent PE a.
Weig ht ed Leas t Squ are s Regr ess ion - Weig hte d by Mar ke t Cap b .
36
Problems with the regression methodology
The basic regression assumes a linear relationship between PE ratios
and the financial proxies, and that might not be appropriate.
The basic relationship between PE ratios and financial variables itself
might not be stable, and if it shifts from year to year, the predictions
from the model may not be reliable.
The independent variables are correlated with each other. For example,
high growth firms tend to have high risk. This multi-collinearity makes
the coefficients of the regressions unreliable and may explain the large
changes in these coefficients from period to period.
37
The Multicollinearity Problem
Co rre la tio ns
1 . 11 9 ** . 41 4** . 18 4 **
. . 00 0 . 00 0 . 00 0
4 01 6 4 01 6 2 16 4 1 61 9
. 11 9 ** 1 . 15 4** - . 20 4 **
. 00 0 . . 00 0 . 00 0
4 01 6 7 09 6 2 54 6 1 61 9
. 41 4 ** . 15 4 ** 1 - . 15 8 **
. 00 0 . 00 0 . . 00 0
2 16 4 2 54 6 2 54 6 1 13 1
. 18 4 ** - . 20 4 ** - . 15 8 ** 1
. 00 0 . 00 0 . 00 0 .
1 61 9 1 61 9 1 13 1 1 61 9
Pea rs o n Co rr ela tio n
Sig . (2 - t ailed)
N
Pea rs o n Co rr ela tio n
Sig . (2 - t ailed)
N
Pea rs o n Co rr ela tio n
Sig . (2 - t ailed)
N
Pea rs o n Co rr ela tio n
Sig . (2 - t ailed)
N
Cur r ent PE
Va lu e Lin e Be ta
Ex pect ed Gro wt h in
EPS: n ext 5 year s
Payo ut Ratio
Cur r ent PE
Valu e Line
Be ta
Exp ect ed
Gr owt h in
EPS: n ext 5
year s Payou t Ratio
Cor r elatio n is s ig n if ica n t at th e 0 . 0 1 level (2- taile d). **.
38
Using the PE ratio regression
Assume that you were given the following information for Dell. The
firm has an expected growth rate of 10%, a beta of 1.20 and pays no
dividends. Based upon the regression, estimate the predicted PE ratio
for Dell.
Predicted PE =

Dell is actually trading at 22 times earnings. What does the predicted
PE tell you?
39
The value of growth
Time Period Value of extra 1% of growth Equity Risk Premium
January 2006 1.131 4.08%
January 2005 0.914 3.65%
January 2004 0.812 3.69%
July 2003 1.228 3.88%
January 2003 2.621 4.10%
July 2002 0.859 4.35%
January 2002 1.003 3.62%
July 2001 1.251 3.05%
January 2001 1.457 2.75%
July 2000 1.761 2.20%
January 2000 2.105 2.05%
40
Brazil: Cross Sectional Regression
January 2006

Mod el Summa ry
. 65 3
a
. 42 7 . 34 9 1 4 3 8. 2 01 9 75 8 4 93 2
Mo de l
1
R R Sq u are
Adjus t ed R
Sq uar e
Std . Er r or o f th e
Es t ima te
Pr ed ictor s: ( Co nst an t), Payou t Ratio, BETA, Ex pect ed Earn ing s Gr owth
(if availa ble)
a.
Co ef fici ents
a,b
23 . 0 84 7. 3 1 4 3. 1 5 6 . 00 5
.2 4 5 . 2 4 1 . 1 7 9 1. 0 1 6 . 32 1
- 1 4 .0 5 6 5. 3 8 9 - . 4 23 - 2. 6 08 . 01 6
.2 1 6 . 0 9 3 . 4 0 8 2. 3 2 6 . 03 0
(Co n st ant )
Ex pected Earn ing s
Gr owt h (if availab le )
BETA
Payo ut Ratio
Mo de l
1
B Std . Er r or
Un s tan dard ized
Co efficien ts
Be ta
Stan dar d ized
Coef ficie nt s
t Sig.
Depen d ent Va riable: PE a.
Weig ht ed Leas t Squ are s Regr ess ion - Weig hted by Mar ke t Cap (local cu rr ency) b .
41
Value/Earnings and Value/Cashflow Ratios
While Price earnings ratios look at the market value of equity relative to earnings to
equity investors, Value earnings ratios look at the market value of the firm relative to
operating earnings. Value to cash flow ratios modify the earnings number to make it a
cash flow number.
The form of value to cash flow ratios that has the closest parallels in DCF valuation is
the value to Free Cash Flow to the Firm, which is defined as:
Value/FCFF = (Market Value of Equity + Market Value of Debt-Cash)
EBIT (1-t) - (Cap Ex - Deprecn) - Chg in WC
Consistency Tests:
If the numerator is net of cash (or if net debt is used, then the interest income from the cash
should not be in denominator
The interest expenses added back to get to EBIT should correspond to the debt in the
numerator. If only long term debt is considered, only long term interest should be added back.
42
Value of Firm/FCFF: Determinants
Reverting back to a two-stage FCFF DCF model, we get:




V
0
= Value of the firm (today)
FCFF
0
= Free Cashflow to the firm in current year
g = Expected growth rate in FCFF in extraordinary growth period (first
n years)
WACC = Weighted average cost of capital
g
n
= Expected growth rate in FCFF in stable growth period (after n
years)
V
0
=
FCFF
0
(1+ g) 1-
(1 + g)
n
(1+ WACC)
n
|
\

|
.
|
WACC - g
+
FCFF
0
(1+ g)
n
(1+ g
n
)
(WACC- g
n
)(1+ WACC)
n
43
Value Multiples
Dividing both sides by the FCFF yields,




The value/FCFF multiples is a function of
the cost of capital
the expected growth
V
0
FCFF
0
=
(1+g) 1-
(1+g)
n
(1+WACC)
n
|
\

|
.
WACC - g
+
(1+g)
n
(1+ g
n
)
(WACC- g
n
)(1+WACC)
n
44
Value/FCFF Multiples and the Alternatives
Assume that you have computed the value of a firm, using discounted
cash flow models. Rank the following multiples in the order of
magnitude from lowest to highest?
Value/EBIT
Value/EBIT(1-t)
Value/FCFF
Value/EBITDA
What assumption(s) would you need to make for the Value/EBIT(1-t)
ratio to be equal to the Value/FCFF multiple?
45
Illustration: Using Value/FCFF Approaches to
value a firm: MCI Communications
MCI Communications had earnings before interest and taxes of $3356
million in 1994 (Its net income after taxes was $855 million).
It had capital expenditures of $2500 million in 1994 and depreciation
of $1100 million; Working capital increased by $250 million.
It expects free cashflows to the firm to grow 15% a year for the next
five years and 5% a year after that.
The cost of capital is 10.50% for the next five years and 10% after that.
The company faces a tax rate of 36%.

V
0
FCFF
0
=
(1.15) 1 -
(1.15)
5
(1.105)
5

|
\

|
.
.105 - .15
+
(1.15)
5
(1.05)
(.10 - .05)(1.105)
5
= 3 1 . 2 8
46
Multiple Magic
In this case of MCI there is a big difference between the FCFF and
short cut measures. For instance the following table illustrates the
appropriate multiple using short cut measures, and the amount you
would overpay by if you used the FCFF multiple.
Free Cash Flow to the Firm
= EBIT (1-t) - Net Cap Ex - Change in Working Capital
= 3356 (1 - 0.36) + 1100 - 2500 - 250 = $ 498 million
$ Value Correct Multiple
FCFF $498 31.28382355
EBIT (1-t) $2,148 7.251163362
EBIT $ 3,356 4.640744552
EBITDA $4,456 3.49513885

47
Reasons for Increased Use of Value/EBITDA
1. The multiple can be computed even for firms that are reporting net losses, since earnings
before interest, taxes and depreciation are usually positive.
2. For firms in certain industries, such as cellular, which require a substantial investment in
infrastructure and long gestation periods, this multiple seems to be more appropriate
than the price/earnings ratio.
3. In leveraged buyouts, where the key factor is cash generated by the firm prior to all
discretionary expenditures, the EBITDA is the measure of cash flows from operations
that can be used to support debt payment at least in the short term.
4. By looking at cashflows prior to capital expenditures, it may provide a better estimate of
optimal value, especially if the capital expenditures are unwise or earn substandard
returns.
5. By looking at the value of the firm and cashflows to the firm it allows for comparisons
across firms with different financial leverage.
48
Value/EBITDA Multiple
The Classic Definition



The No-Cash Version



When cash and marketable securities are netted out of value, none of
the income from the cash and securities should be reflected in the
denominator.
Value
EBITDA
=
Market Value of Equity + Market Value of Debt
Earnings before Interest,Taxes and Depreciation

Enterprise Value
EBITDA
=
Market Value of Equity + Market Value of Debt - Cash
Earnings before Interest,Taxes and Depreciation
49
Enterprise Value/EBITDA Distribution - US
0
100
200
300
400
500
600
700
800
N
u
m
b
e
r

o
f

f
i
r
m
s
<2 2-4 4-6 6-8 8-10 10-12 12-16 16-20 20-25 25-30 30-35 35-40 40-45 45-50 50-75 75-
100
>100
EVMultiple
EV to Operating Income Multiples - US firms in January 2006
EV/EBIT
EV/EBITDA
50
EV/EBITDA Multiple: Brazil in January 2006
0
5
10
15
20
25
30
<2 2-4 4-6 6-8 8-10 10-12 12-14 14-16 16-18 18-20 20-25 >25
EV/EBITDA
EV/EBITDA: Brazil in January 2006
Lowest EV/EBITDA
CEDO3 1.56
MTBR3 1.74
CRBM3 1.99
GOAU3 2.10
CEEB5 2.31
51
The Determinants of Value/EBITDA Multiples:
Linkage to DCF Valuation
Firm value can be written as:



The numerator can be written as follows:
FCFF = EBIT (1-t) - (Cex - Depr) - A Working Capital
= (EBITDA - Depr) (1-t) - (Cex - Depr) - A Working Capital
= EBITDA (1-t) + Depr (t) - Cex - A Working Capital
V
0
=
FCFF
1

WACC - g

52
From Firm Value to EBITDA Multiples
Now the Value of the firm can be rewritten as,



Dividing both sides of the equation by EBITDA,

Value =
EBITDA (1- t) + Depr (t) - Cex - A Working Capital
WACC - g

Value
EBITDA
=
(1- t)
WACC- g
+
Depr (t)/EBITDA
WACC -g
-
CEx/EBITDA
WACC - g
-
A Working Capital/EBITDA
WACC - g
53
A Simple Example
Consider a firm with the following characteristics:
Tax Rate = 36%
Capital Expenditures/EBITDA = 30%
Depreciation/EBITDA = 20%
Cost of Capital = 10%
The firm has no working capital requirements
The firm is in stable growth and is expected to grow 5% a year forever.
54
Calculating Value/EBITDA Multiple
In this case, the Value/EBITDA multiple for this firm can be estimated
as follows:

Value
EBITDA
=
(1 - .36)
.10 -.05
+
(0.2)(.36)
.10 -.05
-
0.3
.10 - .05
-
0
.10 - .05
= 8.24
55
Value/EBITDA Multiples and Taxes
56
Value/EBITDA and Net Cap Ex
57
Value/EBITDA Multiples and Return on Capital
Value/EBITDA and Return on Capital
0
2
4
6
8
10
12
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Return on Capital
V
a
l
u
e
/
E
B
I
T
D
A
58
Value/EBITDA Multiple: Trucking Companies
Company Name Value EBITDA Value/EBITDA
KLLMTrans. Svcs. 114.32 $ 48.81 $ 2.34
Ryder System 5,158.04 $ 1,838.26 $ 2.81
Rollins Truck Leasing 1,368.35 $ 447.67 $ 3.06
Cannon Express Inc. 83.57 $ 27.05 $ 3.09
Hunt (J.B.) 982.67 $ 310.22 $ 3.17
Yellow Corp. 931.47 $ 292.82 $ 3.18
Roadway Express 554.96 $ 169.38 $ 3.28
Marten Transport Ltd. 116.93 $ 35.62 $ 3.28
Kenan Transport Co. 67.66 $ 19.44 $ 3.48
M.S. Carriers 344.93 $ 97.85 $ 3.53
Old Dominion Freight 170.42 $ 45.13 $ 3.78
Trimac Ltd 661.18 $ 174.28 $ 3.79
Matlack Systems 112.42 $ 28.94 $ 3.88
XTRA Corp. 1,708.57 $ 427.30 $ 4.00
Covenant Transport Inc 259.16 $ 64.35 $ 4.03
Builders Transport 221.09 $ 51.44 $ 4.30
Werner Enterprises 844.39 $ 196.15 $ 4.30
Landstar Sys. 422.79 $ 95.20 $ 4.44
AMERCO 1,632.30 $ 345.78 $ 4.72
USA Truck 141.77 $ 29.93 $ 4.74
Frozen Food Express 164.17 $ 34.10 $ 4.81
Arnold Inds. 472.27 $ 96.88 $ 4.87
Greyhound Lines Inc. 437.71 $ 89.61 $ 4.88
USFreightways 983.86 $ 198.91 $ 4.95
Golden Eagle Group Inc. 12.50 $ 2.33 $ 5.37
Arkansas Best 578.78 $ 107.15 $ 5.40
Airlease Ltd. 73.64 $ 13.48 $ 5.46
Celadon Group 182.30 $ 32.72 $ 5.57
Amer. Freightways 716.15 $ 120.94 $ 5.92
Transfinancial Holdings 56.92 $ 8.79 $ 6.47
Vitran Corp. 'A' 140.68 $ 21.51 $ 6.54
Interpool Inc. 1,002.20 $ 151.18 $ 6.63
Intrenet Inc. 70.23 $ 10.38 $ 6.77
Swift Transportation 835.58 $ 121.34 $ 6.89
Landair Services 212.95 $ 30.38 $ 7.01
CNF Transportation 2,700.69 $ 366.99 $ 7.36
Budget Group Inc 1,247.30 $ 166.71 $ 7.48
Caliber System 2,514.99 $ 333.13 $ 7.55
Knight Transportation Inc 269.01 $ 28.20 $ 9.54
Heartland Express 727.50 $ 64.62 $ 11.26
Greyhound CDA Transn Corp 83.25 $ 6.99 $ 11.91
Mark VII 160.45 $ 12.96 $ 12.38
Coach USA Inc 678.38 $ 51.76 $ 13.11
US 1 Inds Inc. 5.60 $ (0.17) $ NA
Average 5.61
59
A Test on EBITDA
Ryder System looks very cheap on a Value/EBITDA multiple basis,
relative to the rest of the sector. What explanation (other than
misvaluation) might there be for this difference?
60
US Market: Cross Sectional Regression
January 2006

Mo del Summary
. 71 4
a
. 51 0 . 50 9 81 7 . 99 46 9 3 69 3 54 00 0
Mo de l
1
R R Sq u are
Adjus t ed R
Sq uar e
St d. Er ro r o f th e
Es timate
Pr ed ict or s: ( Con st an t), Ex pected Gr owt h in Reven ue s: n ex t 5 year s, Eff
Tax Rate, Re in ves tmen t Rat e, ROC
a.
Co ef ficient s
a,b
3 .3 27 E- 0 2 . 80 7 . 04 1 . 96 7
- 5. 1 40 E- 0 2 . 02 2 - .0 4 6 - 2 . 33 9 . 01 9
1 .2 01 E- 0 2 . 01 5 .0 1 6 . 78 2 . 43 4
- 1. 6 84 E- 0 2 . 00 6 - .0 6 2 - 3 . 05 2 . 00 2
1 .2 96 . 03 8 .7 2 6 3 4. 32 3 . 00 0
(Con st ant )
Ef f Tax Rat e
ROC
Reinves tmen t Rate
Ex pect ed Gro wth in
Reven ues: nex t 5 year s
Mo de l
1
B St d. Er ro r
Uns tan dar d iz ed
Coefficien ts
Bet a
St an d ar dized
Co efficien ts
t Sig .
Dep en d en t Va riable: EV/ EBITDA a.
Weig ht ed Leas t Sq uare s Regr es sio n - We ig h te d b y Mar ket Cap b.
61
Price-Book Value Ratio: Definition
The price/book value ratio is the ratio of the market value of equity to
the book value of equity, i.e., the measure of shareholders equity in
the balance sheet.
Price/Book Value = Market Value of Equity
Book Value of Equity
Consistency Tests:
If the market value of equity refers to the market value of equity of
common stock outstanding, the book value of common equity should be
used in the denominator.
If there is more that one class of common stock outstanding, the market
values of all classes (even the non-traded classes) needs to be factored in.
62
Book Value Multiples: US stocks
0
100
200
300
400
500
600
700
<0.25 0.25-
0.5
0.5-
0.75
0.75-1 1-1.25 1.25-
1.5
1.5-
1.75
1.75-2 2-2.25 2.25-
2.5
2.5-
2.75
2.75-3 3-3.35 3.5-4 4-4.5 4.5-5 5-10 >10
BV Multiples: US in January 2006
Price/BVof Equity Value/BV EV/Invested Capital
63
Book Value Multiples: Brazil
0
5
10
15
20
25
<0.25 0.25-
0.5
0.5-
0.75
0.75-1 1-1.25 1.25-
1.5
1.5-
1.75
1.75-2 2-2.5 2.5-3 3-4 4-5 5-10 >10
BV Ratio
BV Ratios: Brazil in January 2006
P/BV of Equity Firm Value/ BV of Capital
Lowest PBV
CESP3 0.22
ELET3 0.34
SAPR4 0.46
Highest PBV
DASA3 10.27
GETI3 10.39
CYRE3 12.10
LREN3 15.41
ENMA3 17.52
64
Price Book Value Ratio: Stable Growth Firm
Going back to a simple dividend discount model,


Defining the return on equity (ROE) = EPS
0
/ Book Value of Equity,
the value of equity can be written as:




If the return on equity is based upon expected earnings in the next time
period, this can be simplified to,


P
0
=
DPS
1
r g
n
P
0
=
BV
0
*ROE*Payout Ratio*(1+ g
n
)
r-g
n
P
0
BV
0
= PBV =
ROE*Payout Ratio*(1+ g
n
)
r-g
n
P
0
BV
0
= PBV =
ROE*Payout Ratio
r-g
n
65
PBV/ROE: European Banks




Bank Symbol PBV ROE
Banca di Roma SpA BAHQE 0.60 4.15%
Commerzbank AG COHSO 0.74 5.49%
Bayerische Hypo und Vereinsbank AG BAXWW 0.82 5.39%
Intesa Bci SpA BAEWF 1.12 7.81%
Natexis Banques Populaires NABQE 1.12 7.38%
Almanij NV Algemene Mij voor Nijver ALPK 1.17 8.78%
Credit Industriel et Commercial CIECM 1.20 9.46%
Credit Lyonnais SA CREV 1.20 6.86%
BNL Banca Nazionale del Lavoro SpA BAEXC 1.22 12.43%
Banca Monte dei Paschi di Siena SpA MOGG 1.34 10.86%
Deutsche Bank AG DEMX 1.36 17.33%
Skandinaviska Enskilda Banken SKHS 1.39 16.33%
Nordea Bank AB NORDEA 1.40 13.69%
DNB Holding ASA DNHLD 1.42 16.78%
ForeningsSparbanken AB FOLG 1.61 18.69%
Danske Bank AS DANKAS 1.66 19.09%
Credit Suisse Group CRGAL 1.68 14.34%
KBC Bankverzekeringsholding KBCBA 1.69 30.85%
Societe Generale SODI 1.73 17.55%
Santander Central Hispano SA BAZAB 1.83 11.01%
National Bank of Greece SA NAGT 1.87 26.19%
San Paolo IMI SpA SAOEL 1.88 16.57%
BNP Paribas BNPRB 2.00 18.68%
Svenska Handelsbanken AB SVKE 2.12 21.82%
UBS AG UBQH 2.15 16.64%
Banco Bilbao Vizcaya Argentaria SA BBFUG 2.18 22.94%
ABN Amro Holding NV ABTS 2.21 24.21%
UniCredito Italiano SpA UNCZA 2.25 15.90%
Rolo Banca 1473 SpA ROGMBA 2.37 16.67%
Dexia DECCT 2.76 14.99%
Average 1.60 14.96%
66
PBV versus ROE regression
Regressing PBV ratios against ROE for banks yields the following
regression:
PBV = 0.81 + 5.32 (ROE) R
2
= 46%
For every 1% increase in ROE, the PBV ratio should increase by
0.0532.
67
Under and Over Valued Banks?
Bank Actual Predicted Under or Over
Banca di Roma SpA 0.60 1.03 -41.33%
Commerzbank AG 0.74 1.10 -32.86%
Bayerische Hypo und Vereinsbank AG 0.82 1.09 -24.92%
Intesa Bci SpA 1.12 1.22 -8.51%
Natexis Banques Populaires 1.12 1.20 -6.30%
Almanij NV Algemene Mij voor Nijver 1.17 1.27 -7.82%
Credit Industriel et Commercial 1.20 1.31 -8.30%
Credit Lyonnais SA 1.20 1.17 2.61%
BNL Banca Nazionale del Lavoro SpA 1.22 1.47 -16.71%
Banca Monte dei Paschi di Siena SpA 1.34 1.39 -3.38%
Deutsche Bank AG 1.36 1.73 -21.40%
Skandinaviska Enskilda Banken 1.39 1.68 -17.32%
Nordea Bank AB 1.40 1.54 -9.02%
DNB Holding ASA 1.42 1.70 -16.72%
ForeningsSparbanken AB 1.61 1.80 -10.66%
Danske Bank AS 1.66 1.82 -9.01%
Credit Suisse Group 1.68 1.57 7.20%
KBC Bankverzekeringsholding 1.69 2.45 -30.89%
Societe Generale 1.73 1.74 -0.42%
Santander Central Hispano SA 1.83 1.39 31.37%
National Bank of Greece SA 1.87 2.20 -15.06%
San Paolo IMI SpA 1.88 1.69 11.15%
BNP Paribas 2.00 1.80 11.07%
Svenska Handelsbanken AB 2.12 1.97 7.70%
UBS AG 2.15 1.69 27.17%
Banco Bilbao Vizcaya Argentaria SA 2.18 2.03 7.66%
ABN Amro Holding NV 2.21 2.10 5.23%
UniCredito Italiano SpA 2.25 1.65 36.23%
Rolo Banca 1473 SpA 2.37 1.69 39.74%
Dexia 2.76 1.61 72.04%
68
Looking for undervalued securities - PBV
Ratios and ROE : The Valuation Matrix
MV/BV
ROE-r
High ROE
High MV/BV
Low ROE
Low MV/BV
Overvalued
Low ROE
High MV/BV
Undervalued
High ROE
Low MV/BV
69
Price to Book vs ROE: US companies in
January 2005
Return on Equity
80 60 40 20 0
P
B
V

R
a
t
i
o
18
16
14
12
10
8
6
4
2
0
BUD
PBR
BA
DOW
NSANY
FRE
ERICY
YHOO
UNH
WYE
D
MDT
VIA/B
UL
FNM
MRK
EBAY
AMGN
TWX
EDP
KO
DELL
RD
GSK
PG
IBM
70
PBV Matrix: Telecom Companies
71
PBV, ROE and Risk: Large Cap US firms
4 7 0
PBV Rat io
2
4
TSM
6 0
6
FNM
ORCL
UL
8
3
BUD
1 0
AMAT
AOL
5 0
MRK
1 2
PFE
1 4
G
PG
1 6
VIA/ B
4 0
FRE
MMM
SC
2
EBAY
KMB
ROE
Reg ressio n Beta
QCOM
WMT
MDT
3 0
D
1
2 0
1 0
0
0
72
PBV versus ROE: Brazilian companies in
January 2006
ROE
2 00 1 00 0 - 100 - 200
P
B
V
2 0
1 0
0
CYRE3
GETI3
LREN3
DASA3
ENMA3
LEVE3
CGOS3
AVPL3
SGAS3
IDNT3
IGBR3
73
IBM: The Rise and Fall and Rise Again
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Year
P
r
i
c
e

t
o

B
o
o
k
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
R
e
t u
r
n

o
n
E
q
u
i
t y
PBV ROE
74
PBV Ratio Regression: US
January 2006
Mod el Su mmary
. 74 6
a
. 55 6 . 55 6 1 64 . 9 25 0 31 73 83 89 5 00
Mo de l
1
R R Sq u are
Adjus t ed R
Sq uar e
St d. Er ro r o f th e
Es t imate
Pr ed ict or s: ( Con st an t), ROE, PAYOUT, Ex pe ct ed Gro wth in EPS: n ex t 5
year s, Valu e Lin e Beta
a.
Co ef fici ents
a,b,c
- . 84 1 . 08 7 - . 18 5 - 9 . 62 6 . 00 0
. 11 7 . 00 4 . 40 9 2 6. 81 1 . 00 0
1 . 4 06 E- 0 3 . 00 0 . 03 3 3 . 8 58 . 00 0
. 17 0 . 00 3 . 76 7 5 7. 40 0 . 00 0
Va lu e Lin e Be ta
Ex pect ed Gro wt h in
EPS: n ext 5 year s
PAYOUT
ROE
Mo de l
1
B Std . Er ro r
Uns t and ar d iz ed
Coef ficie nt s
Bet a
St and ar dized
Co efficien ts
t Sig .
Depen d ent Va riable: PBV Rat io a.
Linear Reg r es sio n th ro u gh the Origin b .
Weigh ted Least Sq uar es Reg re ss ion - Weig h ted b y Mar ket Cap c.
75
PBV Regression: Brazil in January 2006
Mod el Summa ry
. 47 5
a
. 22 6 . 22 0 2 60 . 1 57 9 5 50 5 65 60 3 0 0
Mo de l
1
R R Sq u are
Adjus t ed R
Sq uar e St d. Er ro r o f th e Est imate
Pr ed ict or s: ( Con st an t), ROE a.

Co ef fici en ts
a,b
1 . 8 68 . 44 5 4 . 1 98 . 00 0
9 . 2 47 E- 0 2 . 01 5 . 47 5 6 . 0 37 . 00 0
(Con st ant )
ROE
Mo de l
1
B St d. Er ro r
Uns t an d ar d iz ed
Coef ficie nt s
Bet a
St and ar dized
Co efficien ts
t Sig .
Dep en d en t Va riable: PBV a.
Weig ht ed Leas t Squ are s Regr ess io n - We ig hte d b y Mar ket Cap (lo cal cu r ren cy) b.
76
Price Sales Ratio: Definition
The price/sales ratio is the ratio of the market value of equity to the
sales.
Price/ Sales= Market Value of Equity
Total Revenues
Consistency Tests
The price/sales ratio is internally inconsistent, since the market value of
equity is divided by the total revenues of the firm.
77
Revenue Multiples: US stocks
0
100
200
300
400
500
600
<0.1 0.1-
0.2
0.2-
0.3
0.3-
0.4
0.4-
0.5
0.5-
0.75
0.75-1 1-1.25 1.25-
1.5
1.5-
1.75
1.75-2 2-2.5 2.5-3 3-3.5 3.5-4 4-5 5-10 >10
Revenue Multiple
Revenue Multiples - US in January 2006
Price/Sales EV/Sales EV/Trailing Sales
78
Revenue Multiples: Brazil
0
2
4
6
8
10
12
14
16
<
.
1
0
.
1
-
0
.
2
0
.
3
-
0
.
3
0
.
3
-
0
.
4
0
.
4
-
0
.
5
0
.
5
-
0
.
6
0
.
6
-
0
.
7
0
.
7
-
0
.
8
0
.
8
-
0
.
9
0
.
9
-
1
.
0
1
-
1
.
2
5
1
.
2
5
-
1
.
5
1
.
5
-
1
.
7
5
1
.
7
5
-
2
2
-
2
.
5
2
.
5
-
3

3
-
4

4
-
5

5
-
1
0
>
1
0
Revenue Multiple
Revenue Multiples: Brazil in January 2006
P/Sales EV/Sales
Lowest EV/Sales
DPPI3 0.07
PTIP3 0.13
MTBR3 0.18
SGAS3 0.22
CEDO3 0.24
79
Price/Sales Ratio: Determinants
The price/sales ratio of a stable growth firm can be estimated
beginning with a 2-stage equity valuation model:


Dividing both sides by the sales per share:

P
0
=
DPS
1
r g
n
P
0
Sales
0
= PS=
Net Profit Margin*Payout Ratio*(1+ g
n
)
r-g
n
80
PS/Margins: European Retailers - September
2003
81
Regression Results: PS Ratios and Margins
Regressing PS ratios against net margins,
PS = -.39 + 0.6548 (Net Margin) R
2
= 43.5%
Thus, a 1% increase in the margin results in an increase of 0.6548 in
the price sales ratios.
The regression also allows us to get predicted PS ratios for these firms
82
Current versus Predicted Margins
One of the limitations of the analysis we did in these last few pages is
the focus on current margins. Stocks are priced based upon expected
margins rather than current margins.
For most firms, current margins and predicted margins are highly
correlated, making the analysis still relevant.
For firms where current margins have little or no correlation with
expected margins, regressions of price to sales ratios against current
margins (or price to book against current return on equity) will not
provide much explanatory power.
In these cases, it makes more sense to run the regression using either
predicted margins or some proxy for predicted margins.
83
A Case Study: The Internet Stocks
ROWE
GSVI
PPOD TURF BUYX
ELTX
GEEK RMII
FATB TMNT
ONEM
ABTL INFO
ANET
ITRA
IIXL
BIZZ
EGRP
ACOM
ALOY
BIDS SPLN
EDGR
PSIX ATHY AMZN
CLKS
PCLN APNT
SONE NETO
CBIS
NTPA CSGP
INTW
RAMP
DCLK
CNET
ATHM MQST
FFIV
SCNT
MMXI
INTM
SPYG
LCOS
PKSI
-0
10
20
30
-0.8 -0.6 -0.4 -0.2
AdjMargin
A
d
j
P
S
84
PS Ratios and Margins are not highly
correlated
Regressing PS ratios against current margins yields the following
PS = 81.36 - 7.54(Net Margin) R
2
= 0.04
(0.49)
This is not surprising. These firms are priced based upon expected
margins, rather than current margins.
85
Solution 1: Use proxies for survival and
growth: Amazon in early 2000
Hypothesizing that firms with higher revenue growth and higher cash
balances should have a greater chance of surviving and becoming
profitable, we ran the following regression: (The level of revenues was
used to control for size)
PS = 30.61 - 2.77 ln(Rev) + 6.42 (Rev Growth) + 5.11 (Cash/Rev)
(0.66) (2.63) (3.49)
R squared = 31.8%
Predicted PS = 30.61 - 2.77(7.1039) + 6.42(1.9946) + 5.11 (.3069) =
30.42
Actual PS = 25.63
Stock is undervalued, relative to other internet stocks.

86
Solution 2: Use forward multiples
Global Crossing lost $1.9 billion in 2001 and is expected to continue to lose
money for the next 3 years. In a discounted cashflow valuation (see notes on
DCF valuation) of Global Crossing, we estimated an expected EBITDA for
Global Crossing in five years of $ 1,371 million.
The average enterprise value/ EBITDA multiple for healthy telecomm firms is
7.2 currently.
Applying this multiple to Global Crossings EBITDA in year 5, yields a value
in year 5 of
Enterprise Value in year 5 = 1371 * 7.2 = $9,871 million
Enterprise Value today = $ 9,871 million/ 1.138
5
= $5,172 million
(The cost of capital for Global Crossing is 13.80%)
The probability that Global Crossing will not make it as a going concern is 77%.
Expected Enterprise value today = 0.23 (5172) = $1,190 million

87
PS Regression: United States - January 2006
Model Su mmary
. 76 5
a
. 58 5 . 58 4 1 58 . 5 45 2 33 25 55 66 5 0
Mo de l
1
R R Sq u are
Adjus t ed R
Sq uar e
St d. Er ro r of th e
Es timate
Pr ed ict or s: ( Con st an t), Net Marg in , Ex p ect ed Gr owth in EPS: nex t 5
year s, PAYOUT, Value Lin e Beta
a.
Co ef fici ents
a,b
- 1 . 64 8 . 15 6 - 10 . 55 1 . 00 0
. 36 1 . 14 6 . 04 0 2 . 4 76 . 01 3
8 . 8 00 E- 0 2 . 00 4 . 31 6 1 9. 63 1 . 00 0
1 . 1 74 E- 0 3 . 00 0 . 05 2 3 . 4 88 . 00 0
. 23 6 . 00 5 . 70 4 4 6. 89 2 . 00 0
(Co n st ant )
Va lu e Lin e Be ta
Ex pect ed Gro wt h in
EPS: n ext 5 year s
PAYOUT
Net Mar g in
Mo de l
1
B Std . Er ro r
Uns t and ar d iz ed
Coef ficie nt s
Bet a
St and ar dized
Co efficien ts
t Sig .
Depen d ent Va riable: PS_RATIO a.
Weig ht ed Leas t Squ are s Regr ess ion - Weig hte d by Mar ke t Cap b .
88
EV/Sales Regression: Brazil in January 2006

Mo del Summary
. 50 8
a
. 25 8 . 24 6 12 3 . 61 03 6 6 10 3 35 71 0
Mo de l
1
R R Sq u are
Adjus t ed R
Sq uar e
St d. Er ro r o f th e
Es timate
Pr ed ict or s: ( Con st an t), Mark et Debt t o Cap it al, Af ter - tax Ma rg in a.
Co ef ficient s
a,b
2 . 2 7 2 . 41 7 5 . 4 50 . 00 0
6 . 3 68 E- 0 2 . 01 6 . 34 8 4 . 0 39 . 00 0
- 2 .2 90 E- 0 2 . 00 8 - . 24 5 - 2 . 84 9 . 00 5
(Con st ant )
Aft er - t ax Mar gin
Mar ket Deb t t o Cap it al
Mo de l
1
B Std . Er ro r
Uns t and ar d iz ed
Coef ficie nt s
Bet a
St and ar dized
Coefficien ts
t Sig .
Dep en d ent Va riable: EV/ Sales a.
Weig ht ed Leas t Squ are s Regr ess io n - We ig hte d by Mar ke t Cap (lo cal cu r rency) b .
89
Choosing Between the Multiples
As presented in this section, there are dozens of multiples that can be
potentially used to value an individual firm.
In addition, relative valuation can be relative to a sector (or comparable
firms) or to the entire market (using the regressions, for instance)
Since there can be only one final estimate of value, there are three
choices at this stage:
Use a simple average of the valuations obtained using a number of
different multiples
Use a weighted average of the valuations obtained using a nmber of
different multiples
Choose one of the multiples and base your valuation on that multiple
90
Picking one Multiple
This is usually the best way to approach this issue. While a range of
values can be obtained from a number of multiples, the best estimate
value is obtained using one multiple.
The multiple that is used can be chosen in one of two ways:
Use the multiple that best fits your objective. Thus, if you want the
company to be undervalued, you pick the multiple that yields the highest
value.
Use the multiple that has the highest R-squared in the sector when
regressed against fundamentals. Thus, if you have tried PE, PBV, PS, etc.
and run regressions of these multiples against fundamentals, use the
multiple that works best at explaining differences across firms in that
sector.
Use the multiple that seems to make the most sense for that sector, given
how value is measured and created.
91
A More Intuitive Approach
Managers in every sector tend to focus on specific variables when
analyzing strategy and performance. The multiple used will generally
reflect this focus. Consider three examples.
In retailing: The focus is usually on same store sales (turnover) and profit
margins. Not surprisingly, the revenue multiple is most common in this
sector.
In financial services: The emphasis is usually on return on equity. Book
Equity is often viewed as a scarce resource, since capital ratios are based
upon it. Price to book ratios dominate.
In technology: Growth is usually the dominant theme. PEG ratios were
invented in this sector.
92
In Practice
As a general rule of thumb, the following table provides a way of picking a
multiple for a sector
Sector Multiple Used Rationale
Cyclical Manufacturing PE, Relative PE Often with normalized earnings
High Tech, High Growth PEG Big differences in growth across
firms
High Growth/No Earnings PS, VS Assume future margins will be good
Heavy Infrastructure VEBITDA Firms in sector have losses in early
years and reported earnings can vary
depending on depreciation method
REITa P/CF Generally no cap ex investments
from equity earnings
Financial Services PBV Book value often marked to market
Retailing PS If leverage is similar across firms
VS If leverage is different

93
Reviewing: The Four Steps to Understanding
Multiples
Define the multiple
Check for consistency
Make sure that they are estimated uniformly
Describe the multiple
Multiples have skewed distributions: The averages are seldom good
indicators of typical multiples
Check for bias, if the multiple cannot be estimated
Analyze the multiple
Identify the companion variable that drives the multiple
Examine the nature of the relationship
Apply the multiple
94
Real Options: Fact and Fantasy
Aswath Damodaran
95
Underlying Theme: Searching for an Elusive
Premium
Traditional discounted cashflow models under estimate the value of
investments, where there are options embedded in the investments to
Delay or defer making the investment (delay)
Adjust or alter production schedules as price changes (flexibility)
Expand into new markets or products at later stages in the process, based
upon observing favorable outcomes at the early stages (expansion)
Stop production or abandon investments if the outcomes are unfavorable
at early stages (abandonment)
Put another way, real option advocates believe that you should be
paying a premium on discounted cashflow value estimates.
96
A Real Option Premium
In the last few years, there are some who have argued that discounted
cashflow valuations under valued some companies and that a real
option premium should be tacked on to DCF valuations. To
understanding its moorings, compare the two trees below:
A bad investment.. Becomes a good one..

+100
-120
1/2
1/2
Today
Success
Failure
+20
-20
1/3
2/3
+80
-100
2/3
1/3
STOP
Now
1. Learn at relatively low cost
2. Make better decisions based on learning
97
Three Basic Questions
When is there a real option embedded in a decision or an asset?
When does that real option have significant economic value?
Can that value be estimated using an option pricing model?
98
When is there an option embedded in an
action?
An option provides the holder with the right to buy or sell a specified
quantity of an underlying asset at a fixed price (called a strike price or
an exercise price) at or before the expiration date of the option.
There has to be a clearly defined underlying asset whose value changes
over time in unpredictable ways.
The payoffs on this asset (real option) have to be contingent on an
specified event occurring within a finite period.
99
Payoff Diagram on a Call
Price of underlying asset
Strike

Price
Net Payoff
on Call

100
Example 1: Product Patent as an Option
Present Value of Expected
Cash Flows on Product
PV of Cash Flows
from Project
Initial Investment in
Project
Project has negative

NPV in this section
Project's NPV turns

positive in this section
101
Example 2: Undeveloped Oil Reserve as an
option
Value of estimated reserve
of natural resource
Net Payoff on
Extraction
Cost of Developing
Reserve
102
Example 3: Expansion of existing project as an
option
Present Value of Expected
Cash Flows on Expansion
PV of Cash Flows
from Expansion
Additional Investment
to Expand
Firm will not expand in

this section
Expansion becomes
attractive in this section
103
When does the option have significant
economic value?
For an option to have significant economic value, there has to be a
restriction on competition in the event of the contingency. In a
perfectly competitive product market, no contingency, no matter how
positive, will generate positive net present value.
At the limit, real options are most valuable when you have exclusivity
- you and only you can take advantage of the contingency. They
become less valuable as the barriers to competition become less steep.
104
Exclusivity: Putting Real Options to the Test
Product Options: Patent on a drug
Patents restrict competitors from developing similar products
Patents do not restrict competitors from developing other products to treat
the same disease.
Natural Resource options: An undeveloped oil reserve or gold mine.
Natural resource reserves are limited.
It takes time and resources to develop new reserves
Growth Options: Expansion into a new product or market
Barriers may range from strong (exclusive licenses granted by the
government - as in telecom businesses) to weaker (brand name,
knowledge of the market) to weakest (first mover).
105
Determinants of option value
Variables Relating to Underlying Asset
Value of Underlying Asset; as this value increases, the right to buy at a fixed price
(calls) will become more valuable and the right to sell at a fixed price (puts) will
become less valuable.
Variance in that value; as the variance increases, both calls and puts will become
more valuable because all options have limited downside and depend upon price
volatility for upside.
Expected dividends on the asset, which are likely to reduce the price appreciation
component of the asset, reducing the value of calls and increasing the value of puts.
Variables Relating to Option
Strike Price of Options; the right to buy (sell) at a fixed price becomes more (less)
valuable at a lower price.
Life of the Option; both calls and puts benefit from a longer life.
Level of Interest Rates; as rates increase, the right to buy (sell) at a fixed price
in the future becomes more (less) valuable.
106
The Building Blocks for Option Pricing Models:
Arbitrage and Replication
The objective in creating a replicating portfolio is to use a combination
of riskfree borrowing/lending and the underlying asset to create the
same cashflows as the option being valued.
Call = Borrowing + Buying A of the Underlying Stock
Put = Selling Short A on Underlying Asset + Lending
The number of shares bought or sold is called the option delta.
The principles of arbitrage then apply, and the value of the option has
to be equal to the value of the replicating portfolio.
107
The Binomial Option Pricing Model
50
70
35
100
50
25
K = $ 40
t = 2
r = 11%
Option Details
Stock
Price
Call
60
10
0
50 D - 1.11 B = 10
25 D - 1.11 B = 0
D = 0. 4, B = 9.01
Call = 0. 4 * 35 - 9. 01 = 4. 99
Call = 4.99
100 D - 1.11 B = 60
50 D - 1.11 B = 10
D = 1, B = 36. 04
Call = 1 * 70 - 36.04 = 33. 96
Call = 33.96
70 D - 1.11 B = 33.96
35 D - 1.11 B = 4.99
D = 0. 8278, B = 21. 61
Call = 0. 8278 * 50 - 21. 61 = 19.42
Call = 19.42
108
The Limiting Distributions.
As the time interval is shortened, the limiting distribution, as t -> 0, can
take one of two forms.
If as t -> 0, price changes become smaller, the limiting distribution is the
normal distribution and the price process is a continuous one.
If as t->0, price changes remain large, the limiting distribution is the
poisson distribution, i.e., a distribution that allows for price jumps.
The Black-Scholes model applies when the limiting distribution is
the normal distribution , and explicitly assumes that the price process
is continuous and that there are no jumps in asset prices.
109
The Black Scholes Model
Value of call = S N (d
1
) - K e
-rt
N(d
2
)
where,



d
2
= d
1
- o t
The replicating portfolio is embedded in the Black-Scholes model. To
replicate this call, you would need to
Buy N(d1) shares of stock; N(d1) is called the option delta
Borrow K e
-rt
N(d
2
)

d
1
=
ln
S
K
|
\
|
.
+ (r +
o
2
2
) t
o t
110
The Normal Distribution
d N(d) d N(d) d N(d)
-3.00 0.0013 -1.00 0.1587 1.05 0.8531
-2.95 0.0016 -0.95 0.1711 1.10 0.8643
-2.90 0.0019 -0.90 0.1841 1.15 0.8749
-2.85 0.0022 -0.85 0.1977 1.20 0.8849
-2.80 0.0026 -0.80 0.2119 1.25 0.8944
-2.75 0.0030 -0.75 0.2266 1.30 0.9032
-2.70 0.0035 -0.70 0.2420 1.35 0.9115
-2.65 0.0040 -0.65 0.2578 1.40 0.9192
-2.60 0.0047 -0.60 0.2743 1.45 0.9265
-2.55 0.0054 -0.55 0.2912 1.50 0.9332
-2.50 0.0062 -0.50 0.3085 1.55 0.9394
-2.45 0.0071 -0.45 0.3264 1.60 0.9452
-2.40 0.0082 -0.40 0.3446 1.65 0.9505
-2.35 0.0094 -0.35 0.3632 1.70 0.9554
-2.30 0.0107 -0.30 0.3821 1.75 0.9599
-2.25 0.0122 -0.25 0.4013 1.80 0.9641
-2.20 0.0139 -0.20 0.4207 1.85 0.9678
-2.15 0.0158 -0.15 0.4404 1.90 0.9713
-2.10 0.0179 -0.10 0.4602 1.95 0.9744
-2.05 0.0202 -0.05 0.4801 2.00 0.9772
-2.00 0.0228 0.00 0.5000 2.05 0.9798
-1.95 0.0256 0.05 0.5199 2.10 0.9821
-1.90 0.0287 0.10 0.5398 2.15 0.9842
-1.85 0.0322 0.15 0.5596 2.20 0.9861
-1.80 0.0359 0.20 0.5793 2.25 0.9878
-1.75 0.0401 0.25 0.5987 2.30 0.9893
-1.70 0.0446 0.30 0.6179 2.35 0.9906
-1.65 0.0495 0.35 0.6368 2.40 0.9918
-1.60 0.0548 0.40 0.6554 2.45 0.9929
-1.55 0.0606 0.45 0.6736 2.50 0.9938
-1.50 0.0668 0.50 0.6915 2.55 0.9946
-1.45 0.0735 0.55 0.7088 2.60 0.9953
-1.40 0.0808 0.60 0.7257 2.65 0.9960
-1.35 0.0885 0.65 0.7422 2.70 0.9965
-1.30 0.0968 0.70 0.7580 2.75 0.9970
-1.25 0.1056 0.75 0.7734 2.80 0.9974
-1.20 0.1151 0.80 0.7881 2.85 0.9978
-1.15 0.1251 0.85 0.8023 2.90 0.9981
-1.10 0.1357 0.90 0.8159 2.95 0.9984
-1.05 0.1469 0.95 0.8289 3.00 0.9987
-1.00 0.1587 1.00 0.8413
d
1
N(d
1
)
111
When can you use option pricing models to
value real options?
The notion of a replicating portfolio that drives option pricing models
makes them most suited for valuing real options where
The underlying asset is traded - this yield not only observable prices and
volatility as inputs to option pricing models but allows for the possibility
of creating replicating portfolios
An active marketplace exists for the option itself.
The cost of exercising the option is known with some degree of certainty.
When option pricing models are used to value real assets, we have to
accept the fact that
The value estimates that emerge will be far more imprecise.
The value can deviate much more dramatically from market price because
of the difficulty of arbitrage.
112
Valuing a Product Patent as an option: Avonex
Biogen, a bio-technology firm, has a patent on Avonex, a drug to treat
multiple sclerosis, for the next 17 years, and it plans to produce and
sell the drug by itself. The key inputs on the drug are as follows:
PV of Cash Flows from Introducing the Drug Now = S = $ 3.422 billion
PV of Cost of Developing Drug for Commercial Use = K = $ 2.875 billion
Patent Life = t = 17 years Riskless Rate = r = 6.7% (17-year T.Bond rate)
Variance in Expected Present Values =o
2
= 0.224 (Industry average firm
variance for bio-tech firms)
Expected Cost of Delay = y = 1/17 = 5.89%
d1 = 1.1362 N(d1) = 0.8720
d2 = -0.8512 N(d2) = 0.2076
Call Value= 3,422 exp
(-0.0589)(17)
(0.8720) - 2,875 (exp
(-0.067)(17)
(0.2076)= $
907 million
113
Valuing an Oil Reserve
Consider an offshore oil property with an estimated oil reserve of 50
million barrels of oil, where the cost of developing the reserve is $ 600
million today.
The firm has the rights to exploit this reserve for the next twenty years
and the marginal value per barrel of oil is $12 per barrel currently
(Price per barrel - marginal cost per barrel). There is a 2 year lag
between the decision to exploit the reserve and oil extraction.
Once developed, the net production revenue each year will be 5% of
the value of the reserves.
The riskless rate is 8% and the variance in ln(oil prices) is 0.03.
114
Valuing an oil reserve as a real option
Current Value of the asset = S = Value of the developed reserve
discounted back the length of the development lag at the dividend
yield = $12 * 50 /(1.05)
2
= $ 544.22
(If development is started today, the oil will not be available for sale
until two years from now. The estimated opportunity cost of this delay
is the lost production revenue over the delay period. Hence, the
discounting of the reserve back at the dividend yield)
Exercise Price = Present Value of development cost = $12 * 50 = $600
million
Time to expiration on the option = 20 years
Variance in the value of the underlying asset = 0.03
Riskless rate =8%
Dividend Yield = Net production revenue / Value of reserve = 5%
115
Valuing the Option
Based upon these inputs, the Black-Scholes model provides the
following value for the call:
d1 = 1.0359 N(d1) = 0.8498
d2 = 0.2613 N(d2) = 0.6030
Call Value= 544 .22 exp
(-0.05)(20)
(0.8498) -600 (exp
(-0.08)(20)
(0.6030)= $
97.08 million
This oil reserve, though not viable at current prices, still is a valuable
property because of its potential to create value if oil prices go up.
Extending this concept, the value of an oil company can be written as
the sum of three values:
Value of oil company = Value of developed reserves (DCF valuation)
+ Value of undeveloped reserves (Valued as option)
116
An Example of an Expansion Option
Ambev is considering introducing a soft drink to the U.S. market. The
drink will initially be introduced only in the metropolitan areas of the
U.S. and the cost of this limited introduction is $ 500 million.
A financial analysis of the cash flows from this investment suggests
that the present value of the cash flows from this investment to Ambev
will be only $ 400 million. Thus, by itself, the new investment has a
negative NPV of $ 100 million.
If the initial introduction works out well, Ambev could go ahead with
a full-scale introduction to the entire market with an additional
investment of $ 1 billion any time over the next 5 years. While the
current expectation is that the cash flows from having this investment
is only $ 750 million, there is considerable uncertainty about both the
potential for the drink, leading to significant variance in this estimate.
117
Valuing the Expansion Option
Value of the Underlying Asset (S) = PV of Cash Flows from
Expansion to entire U.S. market, if done now =$ 750 Million
Strike Price (K) = Cost of Expansion into entire U.S market = $ 1000
Million
We estimate the standard deviation in the estimate of the project value
by using the annualized standard deviation in firm value of publicly
traded firms in the beverage markets, which is approximately 34.25%.
Standard Deviation in Underlying Assets Value = 34.25%
Time to expiration = Period for which expansion option applies = 5
years
Call Value= $ 234 Million
118
One final example: Equity as a Liquidatiion
Option
Value of firm
Net Payoff
on Equity
Face Value
of Debt
119
Application to valuation: A simple example
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%,
how much is the equity worth?
What should the interest rate on debt be?
120
Valuing Equity as a Call Option
Inputs to option pricing model
Value of the underlying asset = S = Value of the firm = $ 100 million
Exercise price = K = Face Value of outstanding debt = $ 80 million
Life of the option = t = Life of zero-coupon debt = 10 years
Variance in the value of the underlying asset = o
2
= Variance in firm value = 0.16
Riskless rate = r = Treasury bond rate corresponding to option life = 10%
Based upon these inputs, the Black-Scholes model provides the following
value for the call:
d1 = 1.5994 N(d1) = 0.9451
d2 = 0.3345 N(d2) = 0.6310
Value of the call = 100 (0.9451) - 80 exp
(-0.10)(10)
(0.6310) = $75.94 million
Value of the outstanding debt = $100 - $75.94 = $24.06 million
Interest rate on debt = ($ 80 / $24.06)
1/10
-1 = 12.77%
121
The Effect of Catastrophic Drops in Value
Assume now 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?
It will drop in value to $ 25.94 million [ $ 50 million - market value of
debt from previous page]
It will be worth nothing since debt outstanding > Firm Value
It will be worth more than $ 25.94 million
122
Valuing Equity in the Troubled Firm
Value of the underlying asset = S = Value of the firm = $ 50 million
Exercise price = K = Face Value of outstanding debt = $ 80 million
Life of the option = t = Life of zero-coupon debt = 10 years
Variance in the value of the underlying asset = o
2
= Variance in firm
value = 0.16
Riskless rate = r = Treasury bond rate corresponding to option life =
10%
123
The Value of Equity as an Option
Based upon these inputs, the Black-Scholes model provides the
following value for the call:
d1 = 1.0515 N(d1) = 0.8534
d2 = -0.2135 N(d2) = 0.4155
Value of the call = 50 (0.8534) - 80 exp
(-0.10)(10)
(0.4155) = $30.44
million
Value of the bond= $50 - $30.44 = $19.56 million
The equity in this firm drops by, because of the option characteristics
of equity.
This might explain why stock in firms, which are in Chapter 11 and
essentially bankrupt, still has value.
124
Equity value persists ..
Value of Equity as Firm Value Changes
0
10
20
30
40
50
60
70
80
100 90 80 70 60 50 40 30 20 10
Value of Firm ($ 80 Face Value of Debt)
V
a
l
u
e

o
f

E
q
u
i
t
y
125
Obtaining option pricing inputs in the real
worlds
Input Estimation Process
Value of the Firm - Cumulate market values of equity and debt (or)
- Value the assets in place using FCFF and WACC (or)
- Use cumulated market value of assets, if traded.
Variance in Firm Value - If stocks and bonds are traded,
o
2
firm
= w
e
2
o
e
2
+ w
d
2
o
d
2
+ 2 w
e
w
d

ed
o
e
o
d
where o
e
2
= variance in the stock price
w
e
= MV weight of Equity
o
d
2
= the variance in the bond price w
d
= MV weight of debt
- If not traded, use variances of similarly rated bonds.
- Use average firmvalue variance from the industry in which
company operates.
Value of the Debt - If the debt is short term, you can use only the face or book value
of 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.
Maturity of the Debt - Face value weighted duration of bonds outstanding (or)
- If not available, use weighted maturity
126
Valuing Equity as an option - Eurotunnel in
early 1998
Eurotunnel has been a financial disaster since its opening
In 1997, Eurotunnel had earnings before interest and taxes of -56 million
and net income of -685 million
At the end of 1997, its book value of equity was -117 million
It had 8,865 million in face value of debt outstanding
The weighted average duration of this debt was 10.93 years
Debt Type Face Value Duration
Short term 935 0.50
10 year 2435 6.7
20 year 3555 12.6
Longer 1940 18.2
Total 8,865 mil 10.93 years
127
The Basic DCF Valuation
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
Revenues will grow 5% a year in perpetuity.
The COGS which is currently 85% of revenues will drop to 65% of
revenues in yr 5 and stay at that level.
Capital spending and depreciation will grow 5% a year in perpetuity.
There are no working capital requirements.
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.
The beta for the stock will be 1.10 for the next five years, and drop to 0.8
after the next 5 years.
The long term bond rate is 6%.
128
Other Inputs
The stock has been traded on the London Exchange, and the
annualized std deviation based upon ln (prices) is 41%.
There are Eurotunnel bonds, that have been traded; the annualized std
deviation in ln(price) for the bonds is 17%.
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%.
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
The 15-year bond rate is 6%. (I used a bond with a duration of roughly
11 years to match the life of my option)
129
Valuing Eurotunnel Equity and Debt
Inputs to Model
Value of the underlying asset = S = Value of the firm = 2,312 million
Exercise price = K = Face Value of outstanding debt = 8,865 million
Life of the option = t = Weighted average duration of debt = 10.93 years
Variance in the value of the underlying asset = o
2
= Variance in firm value
= 0.0335
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:
d1 = -0.8337 N(d1) = 0.2023
d2 = -1.4392 N(d2) = 0.0751
Value of the call = 2312 (0.2023) - 8,865 exp
(-0.06)(10.93)
(0.0751) =
122 million
Appropriate interest rate on debt = (8865/2190)
(1/10.93)
-1= 13.65%
130
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