Tuesday, October 21, 2008

The New World Order: How this crisis affects valuation

Given how much this market crisis has shaken our faith in systems and numbers, it is no surprise to me that the most common question that I have faced these last few weeks is about how this crisis has changed the way I do valuation.
Before I answer, let me specify what has not changed for me. The intrinsic value of a business is still a function of its capacity to generate cash flows in the future. In other words, I am not going to create new paradigms for valuation just because we are in turmoil. In terms of estimates, though, here is what I believe has changed in these last 6 weeks:
1. The risk premiums we demand for investing in equities as a class and in corporate bonds has increased significantly. On September 12, the equity risk premium in the US was 4.2%. On October 16, it was greater than 6%. The key question we face is whether this is an aberration, in which case equities are massively under valued or whether we are facing a structural break, where we face higher risk premiums from now on. I think the answer lies somewhere in the middle. This crisis has increased equity risk premiums and default spreads for the next couple of years, but I believe that risk premiums will revert back to lower values (4-4.5%) in the long term. (Equity risk premiums in emerging markets have to be scaled up accordingly)
2. It is beyond debate now that there will be consequences for economies globally. The slowdown will affect real economic growth (and consequently earnings growth) next year for companies around the world.
3. The long term consequences for individual companies is likely to be mixed. The shake out and more limited access to capital will put smaller companies at risk and drive many of them out of business. Larger companies will strong balance sheets and significant competitive advantages will emerge the winners from this turmoil. The higher excess returns that they will earn will give them higher values.
I just put together a presentation this morning on the crisis and its impact. If you are interested, you can download it by clicking on the link below.
Hope you find it useful!


Sravanthi...... said...

Hi, That was an interesting note. Have a question.. when you say that the equity risk premium would increase in the near term, do you really see an increase in the business risk apart from the financial risk. Given that capital, equity in particular is in scarce, do you see an overall shift in the risk premiums irrespective of the duration?

Aswath Damodaran said...

I think investors have become more risk averse and there is more business risk in the system. (Banking crises affect real economies). The net effect will be a higher equity risk premium.

Smirnova Ekaterina said...

Hi! I am glad to find your blog.
Whether I understand properly, that when you discount cash flows you use the one rate for the first two years and the other (lower) for the all following years?

Aswath Damodaran said...

If you look at my 3M valuation, in the pdf file, I use the higher risk premium and cost of equity for the next 5 years, and then revert back to a more reasonable longer term rate.

Smirnova Ekaterina said...

I see now. Thank you.

imtiaz said...

Dear Sir Damodaran,
Thanks for this note and presentation.

P R A N G G O N O said...

Very nice presentation professor, i might check with my country investment behavior.

Thank you.

Hadi Pranggono

Tom Low said...

Hi professor. I am also very thankful to all the published data, books and other class materials on your website. ERP is always an interesting topic to me.

1. For the purpose of removing current market sentiment and estimating the intrinsic value of a U.S company, shouldn't we apply just one ERP (say 4.5%) throughout our projections? Since we derive this estimate from a long US history which has already reflected both good and bad economic times, using a higher ERP for the next 5 years doesn't seem to be an intrinsic valuation.

2. You discussed several methods to deal with small cap premiums. Do we resolve the issue by simply using betas of similar small cap companies with similar operating leverage and capital structure?