Aswath Damodaran – In Practice 3a: Estimating ERP for a company

Published on Feb 19, 2016

In this session, I look at how to create customized ERP for individual companies.
Slides: http://www.stern.nyu.edu/~adamodar/pd…
Excel spreadsheet for customized ERP for this spreadsheet: http://www.stern.nyu.edu/~adamodar/pc…
Updated country risk premium spreadsheet: http://www.stern.nyu.edu/~adamodar/pc…

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0:00welcome back this session I'd like to talk about how do as the equity risk
0:06premium for an individual company now and thinking about it I'm gonna go back
0:11to a core principle that I think makes sense but people disagree with me
0:14sometimes on this and this is the corporates I think the equity risk
0:19exposure of a company should not come from where it's incorporated but from
0:23where it does business in other words if you are you s company that gets ninety
0:28percent of your revenues in Brazil I have to bring in Brazilian country risk
0:32when I think about how risky was so that's the principle that government how
0:37I think about estimating a great risk premiums for individual company because
0:41when I'm gonna do I'm gonna start off with a very speedy review of how I think
0:45about equity risk premium countries and then I'm going to use that to come up
0:50with an equity risk premium for individual company CEO is the process by
0:54which I tried as to meet Ecuador screens for individual countries I start with
0:59the you s not because of you eccentric but because I think the S&P 500 is the
1:03index on which I can get the most information and that's information I
1:07need because the start of every month in the USA esta me what I call it implied
1:12premium for the S&P 500 what's implied premium it's a forward-looking premium
1:17that I back out and the S&P 500 right now so I know what the prices in your
1:22paper so I can back out of the equity risk premium so started 2016 for
1:27instance that number of in about 6 percent that number of course is going
1:31to shift operations to 2016 that number's up to six and a half percent
1:35but let's take on january first to 2016 the base number six percent
1:40the second thing I did was a check for an individual countries now that you're
1:43not the USA check to see what your ratings if you are a triple A rated
1:47country by S&P or Moody's you can pick whichever ratings agency wants to let
1:52you Germany I give you the same equity risk premium that I have a West my
1:56argument being that Iran mature market into mature markets kind of different
2:00equity risk premium because in money will leave the lower premium market if
2:06you are sovereign rating is less than xxx double a single a triple be double
2:12me and have some work to do just what I do if you have a rating below xxx I look
2:18to see what defaults fred goes the reading and I can estimate the different
2:22spread in one of three ways I can compare the raid on a dog bond issued by
2:27a country with its Brazil or India Egypt compared to $1 dollar denominated bonds
2:32issued by the USA team and a dif will be the spread for your country that's based
2:38not on a bond issued by the country many countries though don't issue
2:41dollar-denominated boat's I could look up a shop and CD has spread so these are
2:46spreading into the market think of these is the fourth straight to the market
2:49things attached to your country they are more updated obviously that the ratings
2:54but they're also more or if you don't have the first you don't have a donate
2:58denominated borders Solvency II has spread I can look up your sovereign
3:02rating if you have and try to come up with a friend that goes with a trading
3:06update what if you're not rated I could give up on you
3:10well here's what I can try can try to find a country risk score for your
3:13country there are services that do this one of my favorite services called
3:17political risks visit to europe base political risk estimation and it gives a
3:22number to each country either number the rescuers country when I do is I tried to
3:27find another country with roughly the same school that has a rating an equity
3:31risk premium and I give you that that's desperation i'm absolutely have to make
3:37the best estimates yet so now I have it defaults trend for your country I did
3:42based on the rating on the CBS or by looking at the PRS corn finding another
3:46country with such roughly the same rate I'm not going to make an adjustment to
3:51the defense great wide as the default rate is we're going to charge your mind
3:55bonds issued by that country however you think money and usually equities are
4:00riskier than bonds so yes what I do I asked you made how much riskier equities
4:05bonds in your country and I can do that by looking up the standard deviation
4:09country and the standard deviation that government bond and looking at the ratio
4:15it's a little messy because it's actually difficult to find a magic
4:18market trade very fair trade actively taken to using a proxy that I use across
4:25much
4:25tickets I look up to standard deviation in emerging market equity index S&P
4:30emerging market equity index and a look at the standard deviation the emerging
4:35market public morning and I look at the start of 2016 for its at trade shows 1.3
4:42for what am I going to do with that if you are spread is two percent based on
4:47your rating I'm gonna multiply the two percent by 1.34 2.68% dad is going to
4:53become the additional risk premium on a charge of your country additional and
4:57what on the six percent that I estimated for the S&P 500 ended up with an equity
5:02risk premium for a country that 26 percent of the base premium for the us-
5:06plus the extra premium that I attached to you because I think your ski country
5:11in a measuring rest still using it to fortress she has what the world looks
5:15like to me at the start of 2016 if you look at this table you noticed lots of 6
5:21percent That's My aus S&P 500 equity risk premium and its populating
5:26countries to latex Canada Germany Australia and so if you look at the
5:32other countries though you notice a premium so great at 6% the red numbers
5:36here at the additional country risk premiums I'm estimating a country that I
5:40add on to the six percent to the Colombian for its coming up with a 2.84%
5:45additional risk premium that I'm adding to the six percent to come up the total
5:48equity risk premium 3.84% the way I get that additional countries by doing what
5:54I described in the previous space beautiful it's pretty nice canada buy
5:57that 1.3 for standardized so now I have an equity risk premium for individual
6:03countries have equity risk premium for regions in equity risk premium for
6:09europe of 7.6% you might as well come up with that West 7.16 percent I take an
6:15average across Western European countries but not a simple average but
6:19wait I we Germany a lot more than 30 because it's a much larger economy and I
6:24waited based in GDP so those regional averages that you see for Western Europe
6:30the Middle East or Africa or Asia reflects the weighted averages of the
6:35equity risk premium in that region
6:37so that's my big picture with the world looks like let me turn my attention to
6:42individual companies I'm gonna start easy first I'm gonna take a company
6:46which actually broke down its revenues by country this is actually fairly
6:50usually not that many companies actually breakdown by country but this was this
6:56was a bad now before I go then let me explain why I used revenues to Dubai
7:02waiting there are three choices you have you could use the advantage of revenues
7:06is available for most most companies break down the revenues by region second
7:11account the least chance to mess with this number is always positive so what
7:15the weights can deposit which is a good thing the disadvantages revenue might
7:21not capture your risk exposure of your factories are all in a very risky part
7:25of the world mining operations it risky part of the world at least get rid of
7:31the cards you can use operating income by region
7:35advantages probably more closely tied to value the disadvantages internet contact
7:39number there might be other considerations that drive why some
7:42regions show more profits and taxes which means your way to get me negative
7:48which is not good and many companies don't you could even break it down but
7:52production our operations not only the one subset of companies are am inclined
7:56to do this is a natural resource companies because you could argue that
8:00your exposure is an oil company doesn't come from where you get the on the
8:05advantages you know tying the risk to what your most exposed to riches way of
8:09mining reserves are we are all the results are disadvantages companies
8:13don't always break down their operations and production by region so I'm going to
8:18go back to revenues and as i said im going to start this is embedded in 2012
8:23they broke their revenues down by region so basically doesn't it millions of
8:29dollars are hundreds of millions of dollars you can see that if you look at
8:32the revenues brazil is about 63.7% revenues in the remaining revenues have
8:38broken out mostly across Latin
8:40with a chunk of meat reviewer from can you add up to 80 percent so basically
8:45the way I get the way to divide each country's revenue by the total grab it
8:48for me to come up with a way to wait of course at 200% those of the equity risk
8:54premiums I had to those countries in 2000 obviously those numbers are
8:58different today
8:59you were doing this trade update the revenues and the equity risk premiums
9:03till waited equity risk premium based on the country's is 9.28 percent said that
9:10was easy
9:11well it was easy because I used on my country uses slightly messy
9:17country perhaps because in 70 countries they break it down by region and you are
9:24you can almost do what I did in the previous page using those regional
9:28waited outside did that for europe I did that Latin America did not I did that
9:32for asia I used the regional averages of 2008 what does weighted averages as they
9:38did banded together Africa the Middle East and what they call eurasia so I
9:43included I took the weighted average of those two regions and that's what do you
9:47see as my 8.9% I get a weighted average for so many companies break the revenues
9:54down by region and regions match up to the region said I showed you on that map
9:59now comes the messiest case what is the breakdown doesn't fit the regional
10:06breakdowns I had in my mouth I take issue with many us' companies that are
10:10particularly exposed to this particular problem this is for intern and his own
10:15integrity of 2016 after I updated all the numbers to February 2016 thinking
10:22about sixty four billion dollars of revenue is not America 36 billion in the
10:26rest of the way
10:2764% America 36% restore here's how I came up with the equity risk premium but
10:37not America I used of course the six-point 47 percent just updated the
10:41reason it's higher than six hours a day to preview the S&P not america is at
10:46least as far as Amazon is conservative candidates mostly us' look at the rest
10:52is not rest of the world on that picture that you see yourself I'm going to try
10:57to compute the equity risk premium for the rest of the way this is actually a
11:01spreadsheet have attached to this video and you can play with it but this has
11:05the equity risk premium for all the country's 4440 countries are so that I
11:10screamed at the start of 2016 this is actually the February 2016 update with a
11:18six-point 47 percent is now my base number so what it has in addition to
11:22equity risk premium which isn't calling me you also had the GDP of each country
11:28in column B if you go to the bottom of the spreadsheet you'll actually noticed
11:31that I've read the weighted averages by region and 7.7% number again to estimate
11:37right the case of Amazon you want to get the equity for the rest of the world not
11:42counting dus is easy way to do it going to north america there is right there
11:47us' change that GDP to Sierra now before you do any of this stuff save this
11:53spreadsheet as a pure has been cheated then you can muck it up because if you
11:57change these numbers obviously everything's going to change if you get
12:00it changed back it's going to be a prob he changed it going to do about it
12:04notice now that my global averages 8.4 percent that is the equity risk free for
12:09the rest the word that's what do you see as my equity risk premium for the rest
12:13of the world for so let's go back and fix it the way I figured if I didn't do
12:18the typing in zero but this is actually a device you can use for instance many
12:22companies break their revenues down in Asia Japan and the rest of Asia let's
12:27suppose that is the case the equity risk premium for asia's 8.1% if you want to
12:32see what it looked like Japan were not there all you need to do is change Japan
12:3620 and there's 8.13 percent to that age without Japan again let me fix it so
12:43that's actually the way you can create your own customized equity risk premium
12:47so play with this page which obviously will get updated as you go through so
12:51make sure you get the most updated version and if you do you should have no
12:54trouble creating your own customized ERP
12:57be closed this discussion trees when you try to compute the equity risk premium
13:02for accompanied with the needy
13:05have not to date he wished you had your gonna be pressed read with some of the
13:08data companies give you and wish they didn't do this rested it was broken down
13:12but did not a nice you do this you have to make some assumptions like what
13:17when she said weighted average for asia as eurasia exposure you are assuming
13:21that the revenues of your company are in direct proportion the GPS of those
13:25countries say whether that's not true if you have some reason to believe it's not
13:29true and you can base those and you can put some numbers on those trees go ahead
13:33and do that pretty don't this is the best you can do to make your best
13:37assumption and move on
13:39don't get too freaked out about getting the equity risk premium is a point to
13:443.41% it's not going to make or break evaluation make your best estimates make
13:50assumptions get a number of your equity risk premium move on that's my
13:55suggestion I hope you found it useful
13:58thank you very much for listening

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