Aswath Damodaran, the author of "The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit," told readers he was considering buying shares of 3M (MMM, Financial).
In chapter three of his book, Damodaran said he had information about the company that would allow him to estimate the expected cash flows and assess the risk in those cash flows. How he got from these initial pieces of data to a decision is the process for establishing intrinsic value.
The first issue he tackles in this exercise is deciding which of two valuation approaches he would take:
- The firm or enterprise valuation: “You can value 3M as a business and subtract out the debt the company owes to get to the value of its shares.”
- An equity valuation: “Or, you can value the equity in the company directly, by focusing on the cash flows 3M has left over after debt payments and adjusting for the risk in the stock.”
According to Damodaran, if both approaches are done correctly, the results should be about the same. Regardless of the approach, a person doing an analysis needs four basic sets of data:
Cash flows
What the author calls the “simplest and most direct measure” is cash flow received in the form of dividends. However, that was becoming more complicated when the book was being written because an increasing number of companies were buying back shares. In the latter situation, Damodaran suggests adjustments can be made by looking at the cumulative cash returned to stockholders. One complication in this is that stock buybacks are often less predictable than dividends.
There is another thorn: managers do not always pay out, via dividends or buybacks, any cash left over once operating and reinvestment capital are satisfied. Then, and now, it is common for companies to carry large amounts of cash on their books. To get a sense of the magnitude, Damodaran uses a metric called free cash flow to equity. “Intuitively, the free cash flow to equity measures the cash left over after taxes, reinvestment needs, and debt cash flows have been met,” he wrote.
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He also wants to measure reinvestment, which involves subtracting depreciation from capital expenditures. This produces what’s called the net capital expenditure, which represents how much has been invested in long-term assets. The analyst ends up with the potential dividend, or free cash flow to equity.
To calculate FCFE, subtract (net capital expenditures + change in non-cash working capital) from the company’s after-tax operating income.
Risk
For obvious reasons, riskier cash flows should not be valued as highly as more stable cash flows; alternatively, higher discount rates are attached to riskier cash flows and vice versa. Damodaran argued risk will be defined by:
- A whole-business valuation.
- Strictly an equity valuation.
On a business-wide basis, the analysis will consider operational risks. Part of that risk is the amount of debt the company has taken on. This type of risk is captured in the cost of capital.
In an equity valuation, the obvious risk is in the equity itself; while the author does not lay out any examples, we might expect them to include share prices, dilution of shareholder interests and bad allocation of capital. This is measured in the cost of equity.
Three elements contribute to estimating the cost of equity; Damodaran uses figures from 3M’s financial statements for 2007:
- Risk-free rate: Defined here with 10- to 30-year bonds: 3.72%.
- Equity risk premium: What investors demand for going beyond risk-free investments. Between 1928 and 2010, this rate average 4.31% per year. For 3M for this specific year, the author has estimated it to be 4%.
- Relative risk or beta: How much the stock moves in relation to the overall market.
Pulling that information together, he provides this formula: Cost of equity = Risk-free rate + Beta + Equity Risk Premium, or 3.72% + 1.29 * 4% = 9.16%.
To arrive at a figure for calculating the cost of capital, Damodaran uses these figures from 3M:
- Market value of equity: $57 billion.
- Debt: $5.3 billion.
- Cost of equity: 9.16%.
- After-tax cost of debt: 2.91%.
And, cost of capital = 9.16% (57/(57+5.3)) + 2.91% (5.3/(57 + 5.3) = 8.63%.
Growth rates
To estimate growth rates, investors and analysts have often depended on extrapolations from the past, but Damodaran observed there are several problems. They include which measure of earnings to use and how to compute the average. In the case of 3M, historical growth rates ranged from 6% to 12% depending on the variables used. Those who lack confidence in the historical numbers might turn to experts, including company management, but these, too, are unreliable.
A couple of potential solutions are available: measuring the rate of efficiency growth (cost cutting, etc.) and new investment growth. Efficiency growth, though, tends to be limited. On the other hand, new investment growth can be sustainable and measurable. The measurability factor will be based on two elements:
- How much the company is reinvesting into its business.
- The rate of return on these investments.
Terminal value
Theoretically, every stream of cash flow could go on forever, but, as a practical matter, analyses generally stop somewhere in the medium- to long-term future. In such cases, the valuation model runs a cash flow for a specified number of years and then concludes with a final estimated value, terminal value.
Damodaran posits two “legitimate” ways of estimating terminal value:
- A liquidation value, based on the assumption all assets are sold in the final year, at market-based prices. Alternatively, estimates are made for assets that are not so readily valued.
- A going-concern value, assuming operations continue as usual, based on cash flows growing at a constant rate afterward. When using this model, “three key constraints” must be observed: the company cannot grow faster than the growth rate of the economy; they receive the characteristics of stable growth companies; and a stable growth company needs to reinvest enough capital to maintain the assumed growth rate.
The author wound up the chapter with a couple of useful points. First, if the intrinsic value you calculated is significantly different than the market price, there are three possibilities: You made unrealistic or erroneous assumptions about future growth; the risk premiums for the entire market are incorrect; or the market price is wrong and you have identified an over-or undervaluation. In the latter case, you must be prepared to wait, possibly for many years, for the market to correct its assessment.
Second, Damodaran’s calculation of 3M’s intrinsic value in September 2008 came to $86.95, which was higher than the then-current market price of $80. While there was clearly an undervaluation opportunity, the author did not act on it. Why? Because the degree of undervaluation was less than 10%, thus within the margin of error. He went back to the stock a few months later and found a more favorable outlook: Intrinsic value of $72 and a market price of $54, so he then bought.
The author: Aswath Damodaran is the author of three books on valuation and is a professor of finance and the David Margolis teaching fellow at the Stern School of Business at New York University. There he teaches corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance.
This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
