Valuation for financial modeling can be a tricky subject, and the approach of Damodaran provides a framework to work with. The approach uses three financial modeling methods to generate an estimate of a company’s intrinsic value.

The first method estimates the present value of expected cash flows from a company. It looks at the company’s historical performance, projecting future cash flows and discounting them back to their present value.

The second method considers the cost of capital, which is the rate of return that an investor expects in exchange for providing money to a company. The cost of capital helps determine the value of future investments and the amount of debt a company can use.

The third method uses an industry-level approach to valuing a company. It looks at comparable companies in the industry and assesses their relative strengths against a benchmark.

By combining all three methods, Damodaran’s approach helps to provide a more accurate assessment of a company’s intrinsic value. Let’s learn more.

What Is Damodaran’s Approach to Valuation?

Damodaran’s approach to valuation is a three-step process for valuing companies using financial modeling. It combines expected cash flows, the cost of capital, and the residual value to arrive at a company’s intrinsic value.

The approach has been widely used by financial professionals and investors since it was introduced in the mid-1980s by Professor Aswath Damodaran of NYU Stern School of Business.

The three steps in the process are:

• Estimate Expected Cash Flows: To start the process, you will need to forecast future cash flows for the company. It includes both the expected operating cash flows and the residual value.
• Estimate Cost of Capital: The cost of capital helps discount future cash flows back to present value. It is composed of the cost of debt and the cost of equity and should reflect the riskiness of the company’s operations.
• Calculate Intrinsic Value: Once you have estimated expected cash flows and the cost of capital, you can calculate the intrinsic value of the company by discounting all future cash flows back to present value using the cost of capital.

Benefits of the Damodaran Approach

The Damodaran approach to valuation is a comprehensive and rigorous method of arriving at an estimated intrinsic value. It has the following benefits.

• Flexibility: The Damodaran approach can be applied to a wide range of companies, from startups to large corporations, from high-tech to low-tech, and from domestic to international.
• Accuracy: The Damodaran approach is based on detailed data and rigorous calculations. That allows for a more accurate estimation of the company’s value, which can be relied upon with greater confidence.
• Cost-Effectiveness: The Damodaran approach avoids the need to hire expensive external advisors and consultants, as it is entirely self-contained.

How to Use Damodaran’s Approach for Financial Modeling?

Do you want to learn how to use Damodaran’s approach for financial modeling? Here’s a step-wise guide.

Step 1: Understand the Basics

Before you start any financial modeling, it is important to understand the basics of this valuation approach. Quite simply, it’s a culmination of value-oriented elements associated with business operations.

These include the company’s financial statements, balance sheets, income statements, and cash flow forecasts. All of these elements are extremely important to identify a business’s underlying value and potential.

Step 2: Analyze Financial Statements

As part of Damodaran’s approach, you need to analyze a company’s financial statements to identify any weaknesses or strengths associated with its operations. It will enable you to make a more accurate assessment of the business’s underlying value and potential.

Step 3: Estimate the Present Value of Expected Cash Flows

Next, you need to estimate the present value of expected cash flows to understand how much money the company will likely generate in the future. Doing this shows the company’s actual worth and whether it is a good investment opportunity.

Step 4: Calculate the Cost of Capital

The Damodaran approach also includes determining the cost of capital, which is used to evaluate the expected returns from a particular investment. The cost of capital refers to the return rate a company must pay for its capital investments.

For example, the cost of equity capital includes any dividends from the company’s stock and other forms of compensation, such as stock options. On the other hand, the cost of debt capital is the rate of interest a company must pay for its debt.

Step 5: Conduct a Comparable Analysis

Look at other startups in the same industry to get an idea of how much they are worth and what their market capitalizations are. Let’s say you’re a healthtech SaaS company.

The average market capitalization for healthtech SaaS companies in the past year was around $15 million. You can use this figure to develop a comparative analysis and compare your company’s worth with the industry average.

Step 6: Evaluate Risk Factors

Every financial model should also include a risk analysis that evaluates the various risks associated with the company’s operations. The risks could be:

• Political: Is there political instability within the country that could potentially impact the company’s operations?
• Market: Are there any new entrants into the market that could potentially threaten the company’s market share?
• Financial: Could financial constraints potentially limit the company’s growth prospects?

These are all important elements to consider when evaluating a company’s underlying value and potential.

Drawbacks of Damodaran’s Valuation Approach

Although the Damodaran approach is a comprehensive and flexible way of valuing companies, there are several drawbacks. First, the model relies heavily upon subjective input and assumptions, meaning that two analysts may arrive at different valuations for the same company.

As a result, it can be difficult to compare results with other analysts and hard to reach a consensus. Second, because the model is so complex and involves many variables, it can be difficult to properly evaluate the impact of changes to different elements in the model.

Finally, many of Damodaran’s assumptions are from U.S. markets, so they may not apply to other markets. Therefore, analysts need to consider and adjust the model according to their specific region.

Leave Financial Modeling to Us 

At Numberly, we use the Discounted Cash Flow approach to value your company for a financial model. Since we work closely with you to create a well-tailored financial model, you can rest easy knowing the model will follow your business trajectory and provide actual insights you can use. Schedule a call with us today.