Wednesday, September 11, 2013

Many a slip between the cup & the lip: From forward value to value per share today

Valuing young, growth companies is never easy to do but it is well worth doing, partly because it forces you think through the business that the firm is in and what it is doing (or needs to do) to succeed. I know that many of you disagreed with my assumptions on the Tesla valuation and this post is not meant to refight that battle. There is one aspect of the Tesla valuation that I would like to focus on, not so much because of what it says about Tesla but for the more general lessons about what drives the value per share at young companies.

In the Tesla valuation, I made the judgment that Tesla would have Audi-like revenues and Porsche-like margins to conclude that the equity was worth $8.15 billion today. That puzzled a lot of people, since Audi currently has a market cap of $33 billion and that market cap would be even higher if the company commanded Porsche-like margins. So, why is my value for Tesla's equity so low today?

If you revisit my valuation and check the value that I have attributed to Tesla in year 10 (the year that I see them having Audi-like revenues and Porsche-margins), you will see an estimated value of $68.27 billion. To get from that expected value for a business in the future, estimated either using a DCF model like I did or by applying a multiple on earnings as many venture capitalists becomes a value today, you have to take into account the following “drags” on value:

1. Time value of money: Every finance/investments class begins with the proposition that a dollar today is worth more than a dollar ten years from now and that principle should not be abandoned when doing valuation. Thus, even if I take the unrealistic view that Tesla’s value in year 10 is guaranteed, I would have to discount that value back at the US T.Bond rate of 2.75% (at the time the valuation, used as the risk free rate) to arrive at the value today:
Estimated value for Tesla in year 10 = $68.27 billion
Present value of $68.27 billion @ 2.75% = $52.05 billion
Drag on value from time value of money = $68.27 - $52.05 billion = $16.22 billion

2. Business Risk adjustment: An uncertain dollar in the future is worth even less than a certain dollar at the same point in time, which is the logic behind using a risk-adjusted discount rate. In the case of Tesla, I used a cost of capital of 10.03% for the first five years, reflecting its mixed exposure to the automobile and technology businesses, and scaled that cost of capital down to 8% in year 10. The net effect is that a dollar in expected cash flow in year 10 is worth only about 40.65 cents today. Think of this as the compensation that you are asking for as an investor for the uncertainties and disappointments that will come over the next decade.
Present value of $68.27 billion @ 2.75% = $52.05 billion
Present value of $68.27 billion @ risk adjusted cost of capital = $27.75 billion
Drag on value from risk adjustment = $52.05 billion - $27.75 billion = $24.30 billion

3. Dilution/Reinvestment adjustment: Increasing revenues over time will require reinvestment. In the case of Tesla, that is the purpose of the sales to capital ratio of 1.41, requiring the company to reinvest a dollar in capital (in R&D, infrastructure, plant & equipment and acquisitions) for every $1.41 in revenues every year for the next decade. This reinvestment creates negative cash flows (for much of the next decade), which in turn will have to be financed with either new debt issues or new equity issues. I am assuming that much of the financing in Tesla will come from new equity (by assuming a debt ratio of only 2.6% in my cost of capital computation), which will raise the share count in the company. This is of course the proverbial dilution bogey man, and in the valuation, this is captured by the present value of the cash flows over the next decade. 
PV of terminal value discounted @ risk adjusted cost of capital = $27.75 billion
PV of expected cash flows @ risk adjusted cost of capital for next 10 years = $14.94 billion
Value of business after adjusting for the dilution = $ 27.75 billion - $14.94 billion = $12.81 billion
Drag on value from dilution = $14.94 billion

4. Failure Risk adjustment: Even the most promising growth companies face challenges to survival and don't have the wherewithal to survive a large shock either at the company level (a lawsuit) or at the macro level (a banking crisis, a severe recession). While I think highly of Tesla, I do think that there is  a residual risk of 10% that the firm will not make it, and if it fails, the proceeds it will get for its technology will be only 50% of the estimated value (since your bargaining position is shot).
Value of business before adjusting for failure risk = $12.81 billion
Value of business after adjusting for failure risk = $ 12.17 billion
Drag on value from failure risk = $0.64 billion

5. Net Debt adjustment: The equity investors in a business have to take into account the debt outstanding in the business, since they are entitled to only the residual claim. This can be partially offset by the cash balance that the business has, which has not been counted in the value so far. In the case of Tesla, the debt and cash balances from the most recent annual report yield a net debt value of $0.37 billion. (That may be outdated already since Tesla's cash balance has climbed and it has repaid its loan from the Department of Energy. However, the effect of updating this number will neither make nor break this valuation).
Value of business after adjusting for failure risk = $12.17 billion
Value of equity after net debt adjustment = $11.80 billion
Drag on value from net debt = $0.37 billion

6. Option overhang: The equity in a company has to be shared by the common stockholders in the company with employees (and others) who have options that have been granted to them over time by that company. With Tesla, this is a significant factor affecting the value of common stock, since the company has 25.06 million options with an average strike price of $21.20 (well below the current stock price). The value of these options is approximately $3.65 billion.
Value of equity after net debt adjustment = $11.80 billion
Value of equity after option overhang adjustment = $8.15 billion
Drag on value from employee/management options = $3.65 billion

Bringing together all of these adjustments into one picture shows the cumulated effect of all of these drags on value, reducing the estimated value of $68.27 billion in year 10 for the business to the $8.15 billion in value for equity today.

I don't intend to rekindle debates about Tesla's value but almost all of the arguments that I have heard from those who believe that Tesla is worth more than I do can be crystallized into one of these adjustments:
  1. Operating value in year 10 is too low: If you believe that Tesla is capable of generating much higher revenues than I have estimated, while maintaining high margins, you are, in effect, arguing that the terminal value of $68.27 billion (that I estimated) is too low and that you think that Tesla will have a higher value in year 10.
  2. Business risk adjustment is too high: Some of you have argued that Tesla's business model may expose them to less risk. While I don't quite understand the full details of this argument, it is a an argument for a smaller risk adjustment than the $24.3 billion than I have made. Note that even giving Tesla the cost of capital of a low risk US company (8%) all the way through results in a risk adjustment of $20.4 billion. In the same vein, you may not feel that there is any chance of Tesla failing and eliminate that adjustment as well. You may, of course, take the view that Tesla is a riskless investment and eliminate this adjustment entirely.
  3. Dilution/ Reinvestment: This may be the area where there is the most room for disagreement. My assumptions about reinvestment are animated by my view that Tesla is an automobile company and that scaling up will eventually require large investments in plant and equipment. The counter argument that I have heard from some is that Tesla can develop a model where it licenses technology or focuses on power train/battery sales rather than car sales. That may very require less reinvestment than I have assumed and create much smaller drag on value. 
You may not believe me but I really have no desire to talk you out of investing in Tesla and I certainly have no interest in pushing the stock price down.  If you do make the choice of investing in Tesla, though, I would like you to engage in this debate about value and think through the assumptions that you are making and whether you are comfortable with them. You don't have to convince me. All you have to do is convince yourself that you are making a good investment.

Steering the discussion away from Tesla, this decomposition does provide some general lessons or propositions about investing in and valuing young companies. 
  1. Be wary of per share values: While equity research analysts and investors are fond of focusing on earnings per share and other per share metrics, you have to be cautious about any per share values with young, growth companies, where the share count is a moving target.
  2. Forward values are misleading: Another favored technique used by analysts in valuing young, growth companies is to forecast out earnings in a future period and applying a multiple to these earnings to estimate a forward value. That forward value is often used to back out the return you will make if you invest in the company today, at its current value. This misses the dilution effect that is part of investing in a young, growth company and the potential for failure.
In the months to come, I will value other young, high growth companies (Linkedin, Amazon and Netflix are on my list of must-do valuations) and I will try to present this terminal value decomposition with each of them. 


Anonymous said...

Maybe I'm missing something but my understanding was that the risk of failure is built into to business risk adjustment (ie businesses with higher risks of failure have a higher cost of capital). Obviously no business has 0 risk of failure over a 10 year horizon which is a key part of why the cost of capital is above the risk free rate. Aren't you double counting this?

ArchedRoof said...

Promise me you'll go for a test drive in a Model S before you post your next expert opinion on the stock.

Anonymous said...

You have always said that your valuation is 'your own' valuation rather than 'the' valuation of a firm.

I don't know why there was so much of excitement from T-bulls. They should also be aware that for every T-bull there is a T-bear. Arguments can also be made on lower growth, lower margins and higher cost of capital.

No one knows what the future holds. But that is not the point.

You give your estimates, and people are afraid of losing their money lest the market price adjusts to your views. That shows weakness in their own valuation than anything else. They are indirectly giving power to you.

Rohit said...

ArchedRoof- The car is truly amazing. It is beautifully designed and seems like an engineering masterpiece. I would be very proud to own one someday.
However like the professor observed in his last post about Apple in the 1980's, great products don't automatically make great investments.

Eagerly hoping to see your analysis on Google and Groupon as well.

Aswath Damodaran said...

The conventional wisdom is that the risk of failure is built into discount rates, but it is very difficult to do. DCF valuation is a going concern approach to valuation and discount rates are designed more to capture continuous than discrete risk. Thus, risks like distress, failure and nationalization are better dealt with, using probabilities and expected values, than in the discount rate.

Anonymous said...

Do you work with or for shorters?

Marco said...

Thanks professor, please don't let the negative comments discourage you. Keep them coming!

Apprentice of Agamas said...

To the Anonymous questioning the Prof on a "possible paling around with shorts":
If you knew anything about this Prof, you'd realize:
- Pretty much his raison d'etre is to teach. He cares not for manipulations like what you are probably accustomed to in your world. If there's an audience (and I have my suspicions, even if there isn't), he teaches.

- He recognizes his inherent bias (yes, the Prof is human) and goes to great lengths to declare that up-front and play both sides of a game (ie: provide a value analysis for and against a stock)

If you want to accuse him of something, accuse him of not having the wisdom to find out what he's missing out in his valuation of Tesla. Then, be brave and provide and quantify that missing ingredient in a fitting valuation rebuttal to silence the Prof and I will be applauding you no end.

(though of course, the Prof will not be silenced guessed it..he loves to teach. So he'll learn from you and teach the missing ingredient that you taught)

ArchedRoof said...

My point, is that Aswath Damodaran may have logically put his ideas and thoughts down on paper which everyone can agree with, but hasn't yet determined why the share price is at the level it is - and is continuing to rise.

To do that, may I suggest he takes a deeper look into the company, its products and its roadmap. A good place to start is to take a test drive in the Model S.

Apprentice of Agamas said...

"but hasn't yet determined why the share price is at the level it is - and is continuing to rise. "

I give you insight into one of my weapons from Chapter 8 of a certain book:

"Let us close this section with something in the nature of a parable.

Imagine that in some private business you own a small share
that cost you $1,000.

One of your partners, named Mr. Market, is very obliging indeed.

Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.

Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.

Often, on the other hand, Mr.
Market lets his enthusiasm or his fears run away with him, and the
value he proposes seems to you a little short of silly.

If you are a prudent investor or a sensible businessman, will you
let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise?

Only in case you agree with him, or in case you want to trade with him.

You may be happy to sell out to him when he quotes you a ridiculously
high price, and equally happy to buy from him when his price is low.

But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company
about its operations and financial position.

But note this important fact: The true investor scarcely ever is
forced to sell his shares, and at all other times he is free to disregard the current price quotation.

He need pay attention to it and act upon it only to the extent that it suits his book, and no more."

Unknown said...

Hello from Denmark...

I have read a couple of your books and followed both you corporate finance and valuation class online. This blog is nothing less than outstanding with great examples of the theory applied. I'm looking forward to your next post...

Thank you very much it's highly appreciated, also from Denmark :-)

Anonymous said...

Hi from Bulgaria
I am following your Valuation class fall 2013 but the suond of online lectures is very poor. It's difficult to hear your explanations. I have followed your online lectures of corporate finance Spring 2013 and this problem didn't exist. Please contact your assistants to improve the quality of the sound of your sessions. The webcasts are perfect.

Varadha said...

I am surprised that even with the supposed intelligentsia that reads this blog, the number of people who are way too optimistic about Tesla at this price.

Such a beautiful illustration of the "halo bias" and the "oversimplification bias" - that a great product that is currently doing well in California will rule the world in the foreseeable future and how even the most optimistic assumptions are'nt quite optimistic enough.

You could have had this conversation in mid-2000 about Yahoo or webvan and there would have been visionaries who could have talked about how the internet was supposed to take over the world.

A Tesla for all its' worth is a well executed electric car - it is not a car that runs on energy from free air or water. It's the Lexus of this decade - nothing more.

MSPESB said...

Thank you for your excellent posts. Question on the reinvestment ratio, depreciation, and the impact on FCFF. In the model, on the Valuation Output sheet, Reinvestment does not seem to be offset by any Depreciation. Should Depreciation be added back in since it's non cash for FCFF calculation? What am I missing? Thanks again.

Aswath Damodaran said...

Reinvestment, as I define it = Cap ex - Depreciation + Change in non-cash working capital. Thus, you are effectively adding back depreciation when you do this. For a firm to be reinvesting to increase its capital base, cap ex has to exceed depreciation.

I admire the enthusiasm you show for the Tesla and think that any company that gets this much loyalty from its customers/test customers is doing a lot of things right. I promise I will try to drive a Tesla though I am not a great target customer for the company. I drive a Honda Civic and view a car as a purely functional device to get from point A to point B and back.

Anonymous (though I don't know which one),
I can understand why you are suspicious about my motives and nothing I say will set those suspicions to rest. Please visit my website, and I hope that its gives you a sense of where I am coming from.

UniverseofRisks said...

All this information on tesla has really just clouded my view on its future. The only strategy I would use to invest in tesla is by using an out of the money collar. I would also load up on put options when I feel the stock has topped. My 2 cents...

ValueFactors said...

Completely agree!

ArchedRoof said...


Let's make this fun :)

I will wager you £5 that you will buy a Model S within three months of going for a test drive.


BG said...


Isn't your valuation dependent on a key assumption? Namely that the "risk-free rate" (2.75%) doesn't change during the time frame of your DCF analysis? Let's say for the sake of an example that, next year, the T Bond rate jumps to 6% as a result of skyrocketing inflation. Wouldn't this change render today's valuation completely incorrect?

BG said...


One follow up point. Wouldn't you say that the notion of a "risk-free rate" in general should be extinct, in light of the fact that the current T Bond rate of 2.75% is: (a) Fed-manipulated; (b) provides, after inflation, a negative real return; (c) is historically low, by US standards; (d) is paid by a country with a debt to GDP ratio in excess of 100% and rising.

Even Warren Buffett has said that, at today's prices, bonds are one of the riskier investments around.

Only in academia can a T Bond still be considered "risk-free" in my opinion, similar to the conventional wisdom back in 2006 was that "house prices never go down".

Anonymous said...

"The conventional wisdom is that the risk of failure is built into discount rates, but it is very difficult to do. DCF valuation is a going concern approach to valuation and discount rates are designed more to capture continuous than discrete risk. Thus, risks like distress, failure and nationalization are better dealt with, using probabilities and expected values, than in the discount rate."

Whether or not a discount rate can adequately account for discrete risks is a debatable point but I think you are still double counting if you use the standard discount rate and then add another discount for discrete risk on top of that.

If you want to pull the discrete risk out of the discount rate, shouldn't the discount rate you use be much lower than the standard discount rate which does attempt to price in these discrete risks?

Aswath Damodaran said...

You are right. Discount rates can be increased to incorporate the risk of default risk, as many VCs do but I see no place in my estimate that allows for it. The only input that allows for explicit incorporation of discount rates is the cost of debt and Tesla has almost none. The cost of equity, at least as I compute it, is based on the betas of the businesses that you are in and captures macro economic risk exposure. Default at a young firm is often due to idiosyncratic reasons.
Bottom line. It is true that some measures of discount rates incorporate the risk of failure but mine does not. So, I have to bring it in through the probability of distress.

Anonymous said...

Hello from Brazil.

I am following your Valuation class fall 2013 and reading yours books and the research papers. You are fantastic. You've done really a good work. Thank you so much for share your knowledge.

Shiv said...

Great stuff. Eagerly wait your post on AMZN, which I bought in the great crash, but find terribly expensive today. Also suggest you add Twitter; though I suppose info is hard to come by.

Shiv said...

Suggest you unpublish comments from the loonie fringe. The sort that say do you work for or with shorters don't belong here.

Shiv said...

I'm working with this:
Top Price Great Bear Price
TSLA 116 30
NFLX 214 46
LNKD 173 30
AMZN 215 55
Twitter $15.25b 3b
AAPL 556 373

Love to see where you come out.

Aswath Damodaran said...

I remove comments that are solicitations for commercial businesses but I don't censor or remove comments from people who may disagree with me or question my motives. Most of the most egregious comments reveal more about the commenter than they do about me.
P.S: A Twitter post is coming later today.

Anonymous said...

Prof: I noted from your class that cost of capital can be calculated using any currency as long as we use the same currency for valuation purposes.

Let's say we convert a weaker currency into us dollars. Here I am confronted with a problem:

1)Assume that return on capital is 15%. This should remain the same for both the currencies since these are book numbers.

2)Now if I use US$ cost of capital, which is lower (say,10%) it would appear that the firm is earning excess returns, ie. ROC less WACC (15% - 10% = 5%);

3) Instead, if I use the weaker currency, the cost of capital would be much higher (say, 17%). Here, there might not be any excess returns, ie. 15% - 17% = -2%.

We know that the firm that earns excess returns grows in value.

How can then be the same firm (with same book ROC in both currencies) have excess returns in one currency (usd) and none in another (weaker) currency?

Am I missing something?


Aswath Damodaran said...

Technically, you may be right but intuitively, you are not. The return on capital is computed as operating income this year divided by invested capital at the start of the year. In a high inflation environment, the return on capital will be higher in a high inflation currency since the operating income will get pushed up and the invested capital will not. (The problem is that computed value from accounting statements won't always capture this.)

steve said...

Professor: Given that many seem to view the current interest rate environment as somewhat of a deviation from the norm, why would you not use an historical average for the ten yr US T for discounting purposes? It might also negate the need for having to frequent update valuation work when nothing other than interest rates have changed.

Thiago said...

Prof Damodaran,

I (humbly) believe you are right in your approach to value Tesla (especially the part in which you derive Tesla's earnings growth rate).

You look at the current earnings in the market and assume that within 10 years, Tesla will have the same sales as Audi.

However, my question is: You do everything in nominal terms (if I did not misunderstand you).

So, an Audi-equivalent firm in 10 years would have higher earnings than Audi has today, right? Assuming that Audi grows at the same rate as the economy, shouldnt you compound your 10 years target earnings by the risk free rate as well? Or equivalently, add the economy's growth rate to Tesla's growth rate?

Sorry if I am making a stupid question...

Best wishes,

PS: Your valuation lectures are awesome! Thanks again for that :)

Anonymous said...

Some of the bull Tesla guys make me want to short the stock. "just drive the car", "are you working for short investors?" and other comments sound like stuff I read in 1999

Ameya Kanetkar said...

Namaste Professor!
Your valuations are, as always a treat to read.
As the sage says...valuation is subjective..
I have a point...i feel that the cost of capital (the discount rate) must incorporate the rate of risk-free on t bills. The reason is, more than risk, the t bill rates are measure of depreciation of currency. Risk factor is incorporated by beta and the actual expected return is the risk-free return (which is the min acceptable return) plus risk-adjusted premium. It would be absurd to consider risk-free rate differently as its already and it will be the part and parcel of cost of capital.
The people who are saying that t bills rates may change at doesnt make adjust to the same as it is a macro economic factor affecting all the industries at the same time!

keep posting professor...enjoyed all the posts i read!

Ameya Kanetkar said...

hello thiago...
the reason u cannot compound or add the risk-free rate is..its your opportunity cost in a sense!
You cannot invest with the same money in risk free secs and the share of tesla at the same time.
risk-free rate is not growth rate but the rate which tells you the value of currency. Or simply, what the $1 will be worth tomorrow.
When u discount the future earnings with risk-free rate, you actually consider the effect of depreciation of currency.

hope it helped!

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cityfcf said...

Good day professor, how about competition that is other companies right now doing r&d on the same technology, or product line.


I am a civil engineer and I always use factor of safety in my calculations so another discount to price we need to consider all

Other unknowns
Wrong assumptions
Using 10 year horizon the chance of having at least one financial crises is high