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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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,
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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:
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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)
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
21
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
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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...
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
23
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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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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%.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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Real Option Value Component of DLWaveReal Option Value Component of DLWave
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
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
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Real Option Value Component of DLWaveReal Option Value Component of DLWave
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
= $152 million
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
27
Sensitivity Analysis of Real Option Value Component of DLWave
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
Real Option Value vs. Cashflow Standard Deviation
0
50
100
150
20 30 40 50 60Std. Dev. (%)
Rea
l Op
tio
n
Val
ue
($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.
Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion
QUESTIONS?