1 Approaches to Valuation Discounted cashflow valuation. Relative valuation. Real option valuation:...

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Approaches to ValuationApproaches to ValuationDiscounted cashflow valuation.

Relative valuation.

Real option valuation: Uses option pricing models to measure the price of stocks whose value depends on assets that have option-like characteristics.

Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion

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Advantages of DCF ValuationAdvantages of DCF Valuation

Since DCF valuation is based upon an asset’s fundamentals, it should be less exposed to market moods and perceptions.

If good investors buy businesses, rather than stocks (the Warren Buffett adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset.


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Disadvantages of DCF ValuationDisadvantages of DCF Valuation

Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches

These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants.


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When DCF Valuation works bestWhen DCF Valuation works best This approach is easiest to use for assets (firms)

whose – cashflows are currently positive, and – can be estimated with some reliability for future

periods, and It works best for investors who either

– have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to “true” value or,


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Market Valuation of Digital LightwaveMarket Valuation of Digital Lightwave

Share Price : $4.87

52-week high : $57.56

52-week low : $4.56

Market Value : $153 million


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Present Value of DLWave’s Cashflows Present Value of DLWave’s Cashflows Current Market Capitalization of DLWave : $ 153 million. 2013 Earnings of DLWave: $ 2.8 million. 2013 Cashflow of DLWave: $6.2 million.

Assumptions Annual growth during the next 5 years 25% Cost of capital 18% Low growth rate after next 5 years 10% Number of years of low growth 5

Present Value of DL Wave’s Cashflows : $66 million


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Relative Valuation of Digital LightwaveRelative Valuation of Digital Lightwave

Digital Lightwave

TeleComm Equipment Industry

Market

Price/Sales 2.78 1.56 1.28

Price/Earnings - - 64.74

Price/Book 2.06 2.90 2.53

Price/Cashflow 24.35 (23.28) 15.30


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Advantages of Relative ValuationAdvantages of Relative Valuation

Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation.

Relative valuation generally requires less information than discounted cash flow valuation.


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Disadvantages of Relative ValuationDisadvantages of Relative Valuation

Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.


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Value of Firm =

FCFF1: expected free cash flow to the firm

k: firm’s cost of capital g: growth in the expected free cash flow to the firm

Dividing both sides by FCFF1 yields the Value/FCFF multiple for a stable growth firm:


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The Value/FCFF multiple for a stable growth firm:

Hence, picking a certain number for the Value/FCFF ratio implies certain assumptions about k and g.

Similarly, for Price/Earnings, Price/Sales, Price/EBITDA, etc.


2013 Valuation

Facebook Microsoft Google

Industry Median

Market Median1

Price/Sales Ratio 10.87 3.57 5.36

5.18 1.19 Price/Earnings

Ratio 121.95 15.48 20.83

27.10 17.12

Price/Book Ratio 3.06 3.91 3.57

3.46 1.90 Price/Cash Flow

Ratio 26.74 8.33 14.62

16.29 7.78

Price/Cash Flow Ratio for different k (in bold) and g (in italics)k --> 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

g 0.5% 10.53 9.52 8.70 8.00 7.41 6.90 6.45 6.06 5.71 5.41 5.13

1.0% 11.11 10.00 9.09 8.33 7.69 7.14 6.67 6.25 5.88 5.56 5.26

1.5% 11.76 10.53 9.52 8.70 8.00 7.41 6.90 6.45 6.06 5.71 5.41

2.0% 12.50 11.11 10.00 9.09 8.33 7.69 7.14 6.67 6.25 5.88 5.56

2.5% 13.33 11.76 10.53 9.52 8.70 8.00 7.41 6.90 6.45 6.06 5.71

3.0% 14.29 12.50 11.11 10.00 9.09 8.33 7.69 7.14 6.67 6.25 5.88

3.5% 15.38 13.33 11.76 10.53 9.52 8.70 8.00 7.41 6.90 6.45 6.06

4.0% 16.67 14.29 12.50 11.11 10.00 9.09 8.33 7.69 7.14 6.67 6.25

4.5% 18.18 15.38 13.33 11.76 10.53 9.52 8.70 8.00 7.41 6.90 6.45

5.0% 20.00 16.67 14.29 12.50 11.11 10.00 9.09 8.33 7.69 7.14 6.67

5.5% 22.22 18.18 15.38 13.33 11.76 10.53 9.52 8.70 8.00 7.41 6.90

6.0% 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09 8.33 7.69 7.14

6.5% 28.57 22.22 18.18 15.38 13.33 11.76 10.53 9.52 8.70 8.00 7.41

7.0% 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09 8.33 7.69

7.5% 40.00 28.57 22.22 18.18 15.38 13.33 11.76 10.53 9.52 8.70 8.00

8.0% 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09 8.33

8.5% 66.67 40.00 28.57 22.22 18.18 15.38 13.33 11.76 10.53 9.52 8.70

9.0% 100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 9.09

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When relative valuation works bestWhen relative valuation works best

This approach is easiest to use when– there are a large number of assets

comparable to the one being valued – these assets are priced in a market– there exists some common variable that

can be used to standardize the price.


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Relative Valuation of Digital Lightwave

Acterna Agilent Tektronix Industry

Price/Sales Ratio 0.19 1.99 2.05 1.56

Digital Lightwave 15.7 164.8 170.0 129.2

($ millions)


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What is a Real Option?What is a Real Option?

Traditional discounted cashflow approaches cannot properly capture the company’s flexibility to adapt and revise later - decisions in response to unexpected market developments. Traditional approaches assume an expected scenario of cashflows and presumes management’s passive commitment to a certain static operating strategy.


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What is a Real Option?What is a Real Option?

The real world is characterized by change, uncertainty and competitive interactions => – As new information arrives and uncertainty

about market conditions is resolved, the company may have valuable flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses.

– This flexibility is like financial options, and is known as Real Options.


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Source of value in an optionSource of value in an option Financial Options:

A call option gives the owner the right, with no obligation, to acquire the underlying asset by paying a prespecified amount (the exercise price, X) on or before the maturity date.

Value of a Call Option

on the

Maturity Date

Stock Price on the Maturity Date

Source of value in an option: The asymmetry from having the right but not the obligation to exercise the option.

X


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Examples of Real OptionsExamples of Real Options

Option to invest in a new technology-based service/product, as the result of a successful R&D effort.

Equity in a firm with negative earnings and high leverage.

The patent and other intellectual property owned by a firm.


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Real Option and Classical Valuation of DLWaveReal Option and Classical Valuation of DLWave

Current Market Capitalization of DLWave : $ 153 million. 2013 Earnings of DLWave: $ 2.8 million.

Current Market Value = Present Value of Cashflows from Assets in Place+ Present Value of Cashflows from Future Growth

Opportunities

Discounted Cashflow Technique: More appropriate for valuing cashflows from Assets in Place.

Real Option Valuation: More appropriate for valuing cashflows from Future Growth Opportunities.


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Present Value of Cashflows from Assets in PlacePresent Value of Cashflows from Assets in Place

2013 Cashflow of DLWave: $6.2 million

Assumptions Annual growth during the next 5 years 25% Cost of capital 18% Low growth rate after next 5 years 10% Number of years of low growth 5

Present Value of Cashflows from Assets in Place: $66 million


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Real Option Value Component of DLWaveReal Option Value Component of DLWave

We use a modification of the Black-Scholes option pricing model to value the real options associated with DLWave:

Value of real option = V e-yt N(d1) - X e -rt N(d2) .where,

d1 = [ ln (V/X) + (r - y + (2)/2) t ] / (t) ½ .

d2 = d1 - (t) ½ .

where,N (.) = Cumulative normal density function.

continued...


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Real Option Value Component of DLWaveReal Option Value Component of DLWaveValue of real option = V e-yt N(d1) - X e -rt N(d2) .where,

d1 = [ ln (V/X) + (r - y + (2)/2) t ] /(t) ½ .

d2 = d1 - (t) ½ .

where,V = Present value of expected cash inflows from investing in

DLWave’s future opportunities (under base case assumptions) = $235 million.

X = Present value of the costs of investing in DLwave’s future opportunities (under base case assumptions)

= $226 million.Hence, classical discounted cashflow valuation technique would suggest a value of $9 million from investing in DLWave’s future opportunities.


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Real Option Value Component of DLWaveReal Option Value Component of DLWaveValue of real option = V e-yt N(d1) - X e -rt N(d2) .where,

d1 = [ ln (V/X) + (r - y + (2)/2) t ] / (t) ½ .

d2 = d1 - (t) ½ .

where, 2 = Variance in the expected cash inflows over time, allowing for technological, legal, and market changes = 40%.

t = Number of years during which the real option can be exercised = 4 years.

y = “Dividend yield” of the project before the option is exercised.

r = Riskfree interest rate for t years = 3%.


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Base Case AssumptionsPopulation = 270 million

Potential Market = 15% of population

Likely penetration of potential market = 30%

Annual revenues per customer = $12

Cost of capital = 18%

Number of years of competitive advantage = 5

Variable operating costs = 70% of revenue

Real Option Value = $86 million


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Current Market Value =

Present Value of Cashflows from Assets in Place

+ Present Value of Cashflows from Future Growth Opportunities

Current Market Value = $66 million + $86 million

= $152 million


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Sensitivity Analysis of Real Option Value Component of DLWave


Real Option Value vs. Cashflow Standard Deviation

0

50

100

150

20 30 40 50 60Std. Dev. (%)

Rea

l Op

tio

n

Val

ue

($m

illio

ns)

Real Option Value vs. Market Penetration

020406080

100120140160

10 30 50

Market Penetration (%)

Rea

l Op

tio

n V

alu

e ($

mill

ion

s)

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The Bottom LineThe Bottom Line Traditional valuation procedures cannot properly capture the

company’s flexibility to adapt and revise later decisions in response to unexpected competitive/technological/market developments.

The real option technique can value the company’s flexibility to alter its initial operating strategy in order to capitalize on favorable future growth opportunities or to react so as to mitigate losses.

Valuations computed using the real option technique are often closer to market valuations for high-growth stocks.


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