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


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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Please note that I do not read comments posted here, nor respond to messages here. I don't have the time. If you want my attention, you must seek it directly at my blog. Aswath Damodaran is the Kerschner Family Chair Professor of Finance at the Stern School of Business at New York University. He teaches the corporate finance and equity valuation courses in the MBA program. He received his MBA and Ph.D from the University of California at Los Angeles. His research interests lie in valuation, portfolio management and applied corporate finance. He has written three books on equity valuation (Damodaran on Valuation, Investment Valuation, The Dark Side of Valuation) and two on corporate finance (Corporate Finance: Theory and Practice, Applied Corporate Finance: A User’s Manual). He has co-edited a book on investment management with Peter Bernstein (Investment Management) and has a book on investment philosophies (Investment Philosophies). His newest book on portfolio management is titled Investment Fables and was released in 2004. His latest book is on the relationship between risk and value, and takes a big picture view of how businesses should deal with risk, and was published in 2007. He was a visiting lecturer at the University of California, Berkeley, from 1984 to 1986, where he received the Earl Cheit Outstanding Teaching Award in 1985. He has been at NYU since 1986, received the Stern School of Business Excellence in Teaching Award (awarded by the graduating class) in 1988, 1991, 1992, 1999, 2001, 2007, 2008 and 2009, and was the youngest winner of the University-wide Distinguished Teaching Award (in 1990). He was profiled in Business Week as one of the top twelve business school professors in the United States in 1994.