Chapter 9 New Venture Valuate in Practice: The Investor’s Perspective Copyright¸ 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation

Chapter 9

New Venture Valuate in Practice: The Investor’s

Perspective

Copyright¸ 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Learning Objectives • How to use the CAPM to value an investment by either

the CEQ or RADR method.• How to use the First Chicago Method and the Venture

Capital Method of valuation.• Recognize the strengths and weaknesses of each

valuation approach.• Estimate project betas and required rates of return by

alternative methods.• Estimate correlation between project returns and market

returns, risk-free rate, and standard deviation of market returns.

• How to use multipliers to estimate the continuing value of a new venture.

• Recognize and use opportunities to take advantage of valuation short-cuts.

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 9

Common Valuation Approaches

• Asset-based approaches– Book Value– Adjusted Book Value– Replacement Cost– Liquidation Value

• Market comparisons– Secondary-market financial claims on comparables– Primary-market transactions on comparables– Acquisition transactions

• Revenue, Earnings, and Cash Flow-based approaches– Capitalization of Revenues– Capitalization of Earnings– Discounted Cash Flow (VC Method, First Chicago

Method, Other)• The objective is always to value future cash flows


Criteria for Selecting a New Venture Valuation Method

• Discounted cash flow methods often are the only feasible approaches.

• Is the method based on expected cash flows?• Is cost of capital used as the discount rate?• How important is dealing with cash flows that vary in

risk?• How important are embedded options and complex

financial claims?• How difficult is the method to use?• What are the information requirements?


Using Continuing Value to Estimate the Worth of a New Venture


Figure 9-1

Using Continuing Value Instead of Explicit Cash Flow Projections

1) Identify the “Explicit Value Period” and the “Continuing Value Period”.

2) Estimate cash flows in the explicit value period.

3) Decide which multiplier (sales, earnings, etc.) to use for continuing value.

4) Forecast the multiple at the end of the explicit value period, using an appropriate method and data.

5) Estimate continuing value using the multiple.


Price Earnings Ratio of S&P 500 Index 1995-1997Figure 9-2


Discounted Cash Flow Methods of New Venture Valuation

• The Venture Capital Method• The First Chicago Method• The RADR Method

– Based on the CAPM• The CEQ Method

– Based on the CAPM


The RADR Discount Rate• Opportunity Cost of Capital

• All measures are based on holding period returns


Implementing Valuation by the RADR Form of the CAPM

• Information requirements:– Expected cash flows– Risk-free rate– Market risk premium– Beta (standard deviations of asset and market

returns, correlation)• Estimating expected cash flows


Implementing Valuation by the RADR Form of the CAPM

• Estimating the risk-free rate• Estimating the market risk premium• Estimating beta

– Comparable firms– Public venture funds– Scenarios

• Implicit estimates of cost of capital


SIC Grouping by Two-digit SIC Range and Equity Beta Range


Figure 9-3

Beta Estimates (S&P 500)


Figure 9-4 Number

of Obs. Mean Beta

All Observations 2623 0.993 Industry Biotechnology 501 0.747 Broadcast and Cable TV 105 0.804 Communication Equipment 247 1.157 Communication Services 407 1.019 Computer Networks 130 1.023 Computer Services 440 0.811 Catalog/Mail Order (Internet) 39 1.240 Software 754 1.202 Age (Years After IPO) 0-1 years 1263 0.930 2-3 years 957 0.958 >3 years 403 1.270 Financial Condition No Revenue 102 0.824 Revenue, Negative Income 1475 1.139 Positive Income 1033 0.821 Employees 0 – 25 187 0.586 26 – 100 496 0.861 Over 100 1661 1.138

Standard Deviation of the Market Return (S&P 500)


Correlation Coefficients (S&P 500)Figure 9-6


Number of Obs.

Mean

All Observations 2623 0.195 Industry Biotechnology 501 0.149 Broadcast and Cable TV 105 0.237 Communication Equipment 247 0.215 Communication Services 407 0.241 Computer Networks 130 0.208 Computer Services 440 0.172 Catalog/Mail Order (Internet) 39 0.217 Software 754 0.200 Age (Years After IPO) 0-1 years 1263 0.162 2-3 years 957 0.212 >3 years 403 0.259 Financial Condition No Revenue 102 0.165 Revenue, Negative Income 1475 0.197 Positive Income 1033 0.200 Employees 0 – 25 187 0.117 26 – 100 496 0.153 Over 100 1661 0.231

The CEQ Form of the CAPM

• CAPM


Implementing Valuation by the CEQ Form of the CAPM

• Information requirements:– Expected cash flows– Standard deviation of asset cash flows– Standard deviation of market– Correlation of cash flows with market– Risk-free rate

• Estimating the CEQ Model– Scenario analysis as a way to estimate cash flow beta– Standard deviation of market returns– Correlation between project cash flows and market

• Reality check• Caveat for valuing high-risk cash flows


Illustration



Figure 9-7


Figure 9-8


Figure 9-9

Documents

Chapter 9 New Venture Valuate in Practice: The Investor’s Perspective Copyright¸ 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation