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Es#ma#ngERPforDisney:November2013

¨  Incorpora#on:Theconven#onalprac#ceonequityriskpremiumsistoes#mateanERPbaseduponwhereacompanyisincorporated.Thus,thecostofequityforDisneywouldbecomputedbasedontheUSequityriskpremium,becauseitisaUScompany,andtheBrazilianERPwouldbeusedforVale,becauseitisaBraziliancompany.

¨  Opera#ons:Themoresensibleprac#ceonequityriskpremiumistoes#mateanERPbaseduponwhereacompanyoperates.ForDisneyin2013:

Aswath Damodaran

Region/ Country Proportion of Disney’s Revenues ERP

US& Canada 82.01% 5.50%Europe 11.64% 6.72%Asia-Pacific 6.02% 7.27%La#nAmerica 0.33% 9.44%Disney 100.00% 5.76%

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ERPfortheRest:November2013

Aswath Damodaran

Company Region/ Country Weight ERPBookscape United States 100% 5.50%

Vale

US & Canada 4.90% 5.50%Brazil 16.90% 8.50%Rest of Latin America 1.70% 10.09%

China 37.00% 6.94%Japan 10.30% 6.70%Rest of Asia 8.50% 8.61%Europe 17.20% 6.72%Rest of World 3.50% 10.06%Company 100.00% 7.38%

Tata Motors

India 23.90% 9.10%China 23.60% 6.94%UK 11.90% 5.95%United States 10.00% 5.50%Mainland Europe 11.70% 6.85%Rest of World 18.90% 6.98%Company 100.00% 7.19%

Baidu China 100% 6.94%

Deutsche Bank

Germany 35.93% 5.50%North America 24.72% 5.50%Rest of Europe 28.67% 7.02%Asia-Pacific 10.68% 7.27%South America 0.00% 9.44%Company 100.00% 6.12%

In November 2013, the mature market premium used was 5.5%

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ACompositewayofes#ma#ngERPforcountriesStep1:Es#mateanequityriskpremiumforamaturemarket.Ifyourpreferenceisforaforwardlooking,updatednumber,youcanes#mateanimpliedequityriskpremiumfortheUS(assumingthatyoubuyintotheconten#onthatitisamaturemarket)

¤  Myes#mate:InJanuary2016,myes#matefortheimpliedpremiumintheUSwas5.25%.Thatwillalsobemyes#mateforamaturemarketERP.

Step2:Comeupwithagenericandmeasurabledefini#onofamaturemarket.

¤  Myes#mate:AnyAAAratedcountryismature.Step3:Es#matetheaddi#onalriskpremiumthatyouwillchargeformarketsthatarenotmature.Youhavetwochoices:

¤  Thedefaultspreadforthecountry,es#matedbasedeitheronsovereignra#ngsortheCDSmarket.

¤  Ascaledupdefaultspread,whereyouadjustthedefaultspreadupwardsfortheaddi#onalriskinequitymarkets.

Aswath Damodaran

Black #: Total ERPRed #: Country risk premiumAVG: GDP weighted average

ERP

: Jan

201

6

57

6Applica#onTest:Es#ma#ngaMarketRiskPremium¨  Foryourcompany,getthegeographicalbreakdownofrevenuesin

themostrecentyear.Baseduponthisrevenuebreakdownandthemostrecentcountryriskpremiums,es#matetheequityriskpremiumthatyouwoulduseforyourcompany.

¨  Thiscomputa#onwasbaseden#relyonrevenues.Withyourcompany,whatconcernswouldyouhaveaboutyoures#matebeingtoohighortoolow?

BloombergDESPg4

Aswath Damodaran

58

III.TheBeta

¨  Thebetaofastock(asset)measuresitsexposuretomarketrisk,i.e.,theriskthatcannotbediversifiedawaybythemarginalinvestors.Itisthereforeameasureofexposuretobroadmacroeconomicriskfactors.

¨  Thebetaofastockisstandardizedaroundone.¤  Abetathatisgreaterthanoneindicatesabove-averagerisk¤  Abetathatisclosetooneindicatesaveragerisk¤  Abetalessthanoneindicatesbelowaveragerisk¤  Abetabelowzeroisaindica#onofamarketriskreducinginvestment

¨  Implica#ons:¤  Theweightedaveragebetaofstocksinanymarket(eventhemost

riskyones)isone.Thus,betacannotcarrytheweightofcountryrisk.¤  Astockcanberiskyandhavealowbeta,ifmostoftheriskinthestock

isfirm-specificrisk.

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MeasuringBeta

¨  Thestandardprocedureistoregressstockreturns(Rj)againstmarketreturns(Rm):Rj=a+bRm

¨  Riskmeasure:Theslopeoftheregression(b)correspondstothebetaofthestock,andmeasurestheriskinessofthestock.Theregressionyieldsarangeonthebetathatcanbecomputedfromthestandarderrorofthebetaes#mate.¤ Plus(minus)onestandarderrors:67%confidenceinterval¤ Plus(minus)twostandarderrors:95%confidenceinterval

¨  Performancemeasure:Theintercept(a)oftheregressionisameasureofhowwellorbadlythestockperformedduringtheperiodoftheregression,aferadjus#ngforriskandmarketperformance.Iftheregressionisrunwithrawreturns,theintercepthastobecomparedtoRf(1-Beta)tomeasurewhat’scalledJensen’salpha(a–Rf(1-Beta))a>Rf(1-b):Posi#veJensen’salpha=Stockdidbeierthanexpectedduringregressionperiod

a=Rf(1-b)::ZeroJensen’salpha=Stockdidaswellrthanexpectedduringregressionperioda<Rf(1-b):Nega#veJensen’salpha=Stockdidworsethanexpectedduringregressionperiod

¨  Risksource:TheRsquared(R2)oftheregressionprovidesanes#mateofthepropor#onoftherisk(variance)ofafirmthatcanbeaiributedtomarketrisk.

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SelngupfortheEs#ma#on

¨  Decideonanes#ma#onperiod¤  Servicesuseperiodsrangingfrom2to5yearsfortheregression¤  Longeres#ma#onperiodprovidesmoredata,butfirmschange.¤  Shorterperiodscanbeaffectedmoreeasilybysignificantfirm-specific

eventthatoccurredduringtheperiod.¨  Decideonareturninterval-daily,weekly,monthly

¤  Shorterintervalsyieldmoreobserva#ons,butsufferfrommorenoise.¤  Noiseiscreatedbystocksnottradingandbiasesallbetastowardsone.

¨  Es#matereturns(includingdividends)onstock¤  Return=(PriceEnd-PriceBeginning+DividendsPeriod)/PriceBeginning¤  Includeddividendsonlyinex-dividendmonth

¨  Chooseamarketindex,andes#matereturns(inclusiveofdividends)ontheindexforeachintervalfortheperiod.

Aswath Damodaran

61

Disney:BetaRegression

The risk free rate used in the Jensen’s alpha is the average, short term risk free rate during the period of the regression.

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MeasuringPerformance

TheJensen’salphaforDisneyis7.19%.Thissuggeststhatthestockearnedanannualreturn7.19%morethanthemarket,aferadjus#ngforrisk.DoesitfollowthatthemanagersofDisneydidagoodjobduringthisperiod?

a.  Yesb.  NoExplain.

Aswath Damodaran

63

TheBeta

ThebetaforDisneyinthisregressionis1.25.IfyoucheckDisney’sbetafromadifferentservice(Yahoo,ValueLine),wouldyouexpecttoseethesamenumber?

a.  Yesb.  No

Ifthebetasaredifferent,howdoyoudecidewhichonetouse?a.  Thehighestofthenumbersb.  Thelowestofthenumbersc.  Theaverageofthenumbersd.  OtherAswath Damodaran

64

TheR-squared

TheR-squaredmeasuresthepropor#onofriskinDisneythatcomesfromthemarket.Ifyouareadiversifiedinvestor,wouldyouwantthisnumbertobeahighoralownumber?

a.  Highb.  LowWouldyouranswerbedifferentifyouwerenotdiversified?

Aswath Damodaran

65

Es#ma#ngExpectedReturnsforDisneyinNovember2013

¨  Inputstotheexpectedreturncalcula#on¤ Disney’sBeta=1.25¤  RiskfreeRate=2.75%(U.S.ten-yearT.BondrateinNovember2013)

¤  RiskPremium=5.76%(BasedonDisney’sopera#ngexposure)

ExpectedReturn=RiskfreeRate+Beta(RiskPremium) =2.75%+1.25(5.76%)=9.95%

Aswath Damodaran

66

UsetoaPoten#alInvestorinDisney

¨  Asapoten#alinvestorinDisney,whatdoesthisexpectedreturnof9.95%tellyou?¤  ThisisthereturnthatIcanexpecttomakeinthelongtermonDisney,

ifthestockiscorrectlypricedandtheCAPMistherightmodelforrisk,¤  ThisisthereturnthatIneedtomakeonDisneyinthelongtermto

breakevenonmyinvestmentinthestock¤  Both

¨  Assumenowthatyouareanac#veinvestorandthatyourresearchsuggeststhataninvestmentinDisneywillyield12.5%ayearforthenext5years.Basedupontheexpectedreturnof9.95%,youwould¤  Buythestock¤  Sellthestock

Aswath Damodaran

67

Howmanagersusethisexpectedreturn

¨  ManagersatDisney¤  needtomakeatleast9.95%asareturnfortheirequityinvestorstobreakeven.

¤  thisisthehurdlerateforprojects,whentheinvestmentisanalyzedfromanequitystandpoint

¨  Inotherwords,Disney’scostofequityis9.95%.¨  Whatisthecostofnotdeliveringthiscostofequity?

Aswath Damodaran

68

RegressionDiagnos#csforTataMotors

Beta = 1.8367% range1.67-1.99

Jensen’s α= 2.28% - 4%/12 (1-1.83) = 2.56% Annualized = (1-.0256)12-1= 35.42%Average riskfree rate (2008-13) = 4%

69% market risk31% firm specific

Expected Return (in Rupees)= Riskfree Rate+ Beta*Risk premium= 6.57%+ 1.83 (7.19%) = 19.73%

Aswath Damodaran