August 2006
Intermediate to advanced
696 pages
23h 12m
English
Content preview from Damodaran on Valuation
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16.1. AN EXPERIMENT
Consider the following experiment. You are analyzing two firms with the same overall market risk exposure and the same financial leverage. Assume that both firms have the same operating earnings and similar returns on capital and that you expect the same growth rate in the operating income. Finally, assume that firm A is a firm in a single business with open and easy-to-understand financial statements whereas firm B is a firm in multiple businesses with complex and difficult-to-decipher financial statements. Given that they have the same financial fundamentals, should they trade at the same value? If not, which of these two firms should be valued more highly and why?
In conventional discounted cash flow (DCF) valuation, we would attach the same value to both firms.[] After all, the after-tax cash flow for a firm comes from its operating income and reinvestment needs, and no adjustments are made for how complex a firm is in this calculation. The discount rate is computed based on the nondiversifiable risk in the equity of the firm and the default risk of its debt. It is true that the beta for a multibusiness company will be a weighted average of the betas of the different businesses it is in, but that does not penalize a diversified firm. In fact, we often give diversified (and complicated) firms a slight advantage in discounted cash flow valuations by allowing them to carry more debt and have lower costs of capital.
[] Since the firms have similar risk exposure ...
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