Lecture Topic 14: Value and Valuation – An Overview

Presentation to Cox MBA Students

FINA 6214: International Financial Markets

Presentation to Cox Business Students

FINA 3320: Financial Management

What is Value? • Economic Value defined as: “The intrinsic worth

of a financial asset”– Intrinsic value derived from long-term cash flow generating

ability of a company or project

– Intrinsic value measured by discounted cash flow (DCF)

• DCF used to evaluate– Specific investment opportunities

– Strategy of a business unit

– An entire company

• DCF used to obtain economic value of any financial asset (including human capital!)

Discounted Cash Flow (DCF) • Calculating present value is called discounting

• Interest rate used in discounting is called discount rate

• General formula for the present value of $1 to be received n periods from now at discount rate i (per period) is:

tRPV

)1(

1$

Discounted Cash Flow (DCF) • A useful tool in analyzing the timing of cash flows

is a diagram known as a time line

• For example, assume you plan to invest a certain amount of money at 10% annually in order to receive $1,000 two years from now

• How much money would you have to invest?

0 1 2

$1,000

-$826.452 years @ 10%

Discounted Cash Flow (DCF) • Most financial assets require an investment at the

beginning of the asset’s life– In addition, most financial assets generate multiple cash

flows rather than a single cash flow

• In such an instance, each cash flow is discounted back to the present

• Summing the present value of each cash flow provides the net present value (NPV) of the financial asset– NPV is the value of the financial asset today (i.e., at

time = 0)

Discounted Cash Flow (DCF) • For example, assume you invest $1,000 now and

expect to receive $500 one year from now and $750 two years from now– Also assume the discount rate is 10%

• Question: What is the NPV of this project?

• Answer: The NPV of this project equals $74.380 1 2

$750

$619.83

-$1,000 $500

$454.55

Why Value Value? • This lecture is about how to value projects (or

firms)

• This lecture is also about how to use information to make wiser investment decisions– Basic belief: Managers who focus on building

shareholder value create healthier companies– Healthier companies create…

• …Stronger economies

• …Higher living standards

• …More career and business opportunities

• Why should managers focus on shareholder value?

Ascendancy of Shareholder Value • Six factors playing role in ascendancy of

shareholder value– (1) Emergence of market for corporate control in 1980s

• Prior to 1980s many managers sought to maximize their own utility rather than shareholder value

– This led to hostile takeovers as effective means of corporate governance

– Managers learned that if they failed to maximize value, they could lose their jobs!

– (2) Recent large scale corporate corruption and scandals• After bubble burst, shareholders, boards of directors, and

regulators started challenging management’s decision making– Greater discipline imposed on managers to focus on long-term value

creation for shareholders

Ascendancy of Shareholder Value – (3) Equity-based features in executives’ pay packages

• In 1970s academics called for redesign of management’s incentives to align with shareholders’

– By 2000, estimated PV of stock options represented 45% of median pay package for CEO in public corporations

– (4) Increased equity holdings by households• Strong performance of equity increased ownership

– In 1975, 25 million people (12% of US) owned equity

– By 1995, 69 million people (26% of US) owned equity (mutual funds)

– (5) Growing recognition of social security insolvency• Growing crisis worldwide of pay-as-you-go retirement systems

– (6) Stock market trends or fads rather than value creation• Asset pricing bubbles – lots of them! (the “New Economy”)

– Fundamental principles of economics lead to value creation

Question?

Do Shareholder-Oriented Economies Perform Better?

Answer • YES! The US is the world’s most shareholder-

friendly economy of the developed world

– Economists widely agree that the dominant measure of an economy’s success is GDP per capital

– US has a lead of more than 20% over other major developed countries as of the early 2000s

– Up to 1975 these other countries were catching up, but since then the US lead has been widening!

Question?

How can the US be outperforming other countries with a savings rate

that is often deplored as wholly inadequate?

Answer • The US is investing their deplorably small savings

in more productive (i.e., economically profitable or value creating) products than Japan or Germany or any of the other developed countries!

– In 1776, Adam Smith postulated that the most productive and innovative companies would create the highest returns to shareholders and attract better worker, who would be more productive and increase returns further – a virtuous cycle!

– Companies destroying value would create a vicious cycle and eventually wither away

Which Value Metric? • Managers are bombarded about which value metric

to use to measure performance– Real purpose of value metric to:

• Help manager make value-enhancing decisions

• Orient all company employees toward value creation– Not all value metrics are equal

• Economic preferred to accounting metric because:– Cash flows rather than accounting earnings drive value– Easier to understand short- versus long-term tradeoffs– Better able to understand sources of value

• There is no perfect performance metric– However, DCF drives value of a company

Value Metrics Framework• Stock market is ultimate measure of shareholder

value creation (total returns to shareholders or TRS)– Unfortunately, many factors affecting stock market are

beyond the control of managers• Shareholder value creation in stock market must be linked to

some measure of intrinsic value

• DCF and real options valuation are two main intrinsic value measures– Intrinsic value driven by cash flow generating ability

• Projects, strategies, or entire company can be evaluated in terms of intrinsic value

• DCF and real options are valuable strategic analysis tools used to evaluate future, rather than historic, performance

Value Metrics Framework• Financial indicator measures can be used to link

DCF to historic performance– Return On Invested Capital (ROIC) and growth in

revenues or profits are financial drivers of cash flows and DCF value

• Intrinsic values of DCF and real options can be translated into short- and medium-term financial targets

• Short-term financial measures may signal changes in value creation too late

– Further, cash flows in any given year can be easily manipulated by delaying capital spending or cutting back R&D expenditures

• ROIC and growth help managers understand sources of value creation

Value Metrics Framework• Managers need operating and strategic measures

(e.g., market share and per unit cost) called value drivers– Monitoring these value drivers avoids sacrificing long-

term value creation for short-term financial returns• Value drivers are also helpful in identifying value enhancing

opportunities

• Value drivers serve as leading indicators of performance

How is Value Created?• Value results from set of interrelated activities that

most firms already have in place• The issue is to what extent behaviors that promote value

creation are a part of the corporate culture

• Prerequisite for value creation is that firm’s actions be based on a foundation of value thinking

– Value thinking has two dimensions• (1) Value Metrics based on management’s understanding of

how value is created and how the stock market values firms– Management’s ability to balance short-and long-term results

• (2) Value Mindset refers to how much management cares about shareholder value creation

– Management’s willingness to make unpopular decisions if these are necessary to maximize shareholder value in the long-term

Project Analysis and Valuation

An Introduction

Data Collection

Feasibility Study

Pro Forma Construction

Sensitivity/Scenario Analysis

Free Cash Flows

Capital Budgeting Process

Valuation

Investment Decision

Market Research Financial Research

Risk Identification

Risk Management

Cost of Capital

Time Value of Money

Net Present Value

Data Collection• First step is to collect data to address viability of

project• General area of data collection:

– Financial

– Marketing

• Specific Analyses– Needs Analysis: What is the need for this product/service?

– Customer Analysis: Who will purchase this product/service?

– Market Analysis: What are the attributes of the target market?

– Competitor Analysis: How do the major competitors stack up?

– Environmental Analysis: What is the context within which the new product/service must exist?

– Financial Analysis: Is the product economically viable?

Market Research: Porter Model

• Porter’s Five Forces Model of Industry Competition– Threat of New Entry into an Industry

– Intensity of Rivalry among Existing Competitors

– Pressure from Substitute Products

– Bargaining Power of Buyers

– Bargaining Power of Suppliers

• Collective Strength of 5 Forces Determines Return on Capital in an Industry and Influences Strategies

• Since introduction of Porter’s model in 1980, today’s new business world needs augmented model

Market Research: Update Porter

• Updated Five Forces Model of Industry Competition– (1) New Entry, (2) Rivalry, (3) Substitutes, (4) Buyer Power, (5) Supplier Power

Suppliers

Risk and Strategy

Customers

Complementors

Market Turbulence

Composite Competition

Market Growth

Three Revisions to Porter’s Model

• First, Composite Competitive Rivalry Force– (a) Pressure from substitutes and (b) Threat of new entry

combined with traditional competitors into the single category

• Second, Additional Role of Complementors– Market participant considered a complementor if buyers value

company’s product more highly when they have access to complementor’s product

• Third, Addition of Market Turbulence and Market Growth– Considers impact of changing market conditions on risk and

strategy

Financial Research: New Perspective

• Financial Research should determine value proposition– Answer Question: Does capital budgeting project create or destroy value?

• Value creation should be management’s primary goal!– Discounted Cash Flow (DCF) is primary technique to measure value as

Net Present Value (NPV)

– However, DCF technique does not measure value of flexibility (i.e., NPV does not include value of flexibility)

• New technique needed to incorporate real (growth) options– Growth options include opportunity to expand capacity, make new product

introductions, expand basic research, increase advertising

– Value of the option is the present value of expected cash flows plus the value of any new growth opportunity

New Technique: Real Options• Real options technique overcomes restrictiveness of

NPV– DCF understates project’s value (NPV) due to increased flexibility and

additional growth opportunities

• Real options challenge conventional wisdom about capital budgeting– Accepting negative NPV project justified if it creates growth

opportunities and sum of NPV of these new opportunities is positive

and greater than initial project’s negative NPV

• Real options advantage is that is integrates capital budgeting with long-range planning– Investment decisions today can create basis for future investment

decisions

Feasibility Study

• Feasibility study is first step to successful project• Feasibility studies require management to…

– Conduct up-front due diligence

– Understand project’s risk analysis, cost analysis, completion time frame, stakeholders’ analysis, etc.

– Follows the ‘ready, aim, fire’ model rather than ‘ready, fire, aim’

• Benefits of accurate and reasonable feasibility study– Avoids danger of loading up evidence in one direction in order to

support a priori decision

– It locks company into a mode of planning first, then executing, which avoids potential waste

Pro Forma Construction• Pro forma, or projected, financial statements reflect

expected future performance of firm or project• Pro forma financial statements constructed and used

to…– Evaluate expected future financial condition of firm or

project

– Project financing requirements

– Determine how alternative courses of action are likely to impact firm’s financial conditions and financial requirement

– Provide a standard against which to evaluate actual results

Free Cash Flows• Primary outcome of pro forma financial statement is

ability to forecast free cash flows• Free cash flows are the amount of cash a firm or

project can pay out to investors– Usually annual cash flows after paying for all investments

necessary for growth

• Pro forma Excel models typically incorporate a spreadsheet designed to calculate free cash flows– Purpose of such spreadsheet models is to be used as a

managerial decision-making tool

– Permits managers to test potential outcomes of various scenarios

Time Value of Money

• Economic value defined as the intrinsic worth of a financial asset– Intrinsic value derived from long-term cash flow generating

ability of a financial asset (e.g., capital project)

• To determine economic value future cash flows must be discounted to the present– Calculating present values is called discounting

– Interest rate used in discounting is discount rate

• Most financial assets require investment at beginning of asset’s life and generate multiple flows in the future– Each cash flow is discounted back to the present and

summed to obtain the net present value (NPV)

Net Present Value• NPV is the appropriate value measurement managers

should use to determine viability of capital project– NPV recognizes time value of money (i.e., dollar today worth

more than dollar tomorrow)• Dollar today can be invested to start earning interest immediately

– NPV depends solely on forecasted cash flows from the project and the project’s opportunity cost of capital

• NPV unaffected by manager’s taste, company’s choice of accounting method, profitability of company’s other independent projects. Therefore, it will not lead to inferior decisions based on these extraneous factors

– Because present values are all measured in today’s dollars, they can be added up (additive property)

• Once calculated, can be summed to determine expected value creation

Risk Identification

• Although easy to understand, risk may be difficult to define and quantify– Markowitz defined risk of a security as the standard

deviation of returns around the mean or expected return

– Factors causing higher dispersion may be harder to identify

• What factors cause one security to have a higher standard deviation of returns than another security?

• In order to manage risks, managers must first be able to identify the factors underlying risk

Risk Analysis and Management• Managers often take risks as given

– To some extent managers can choose risk their business or project undertakes

– Certain risk can be hedged or insured against

• View risk as uncertainty– Uncertainty resolved through passage of time, actions, and events

– Managers can make appropriate mid-course corrections through change in decisions and strategies

• Real options incorporate learning model akin to having a strategic road map– Manager can reduce risk by building flexibility into project

– Traditional analyses neglect managerial flexibility and therefore undervalue certain projects and strategies

Cost of Capital

• The cost of capital is the firm’s discount rate applied to the average risky project’s cash flows in order to determine the present value of those cash flows– Often referred to as the Weighted Average Cost of Capital

(WACC)

• The 4-step process to determine the discount rate, or WACC, is to determine firm’s:– (1) Optimal capital structure

– (2) Capital requirements

– (3) Component costs of capital

– (4) WACC

Sensitivity and Scenario Analyses• Prior steps of Project Analysis provide information to

conduct sensitivity and scenario analyses– These analyses determine whether results are robust under

alternative assumptions

• Sensitivity analysis determines key variables of project– Project’s ultimate value depends upon controlling these key

variables

• Scenario analysis enables manager to combine key variables into probable situations or outcomes

• Managers use these two analyses to:– Measure change in value due to changes in decisions

– Determine probable range of value that the project creates

Capital Budgeting Process• Capital budgeting process summarizes how firms

identify and commit to capital investment projects• Process entails how companies:

– Develop plans and budgets for capital investments

– Authorize specific projects to be undertaken

– Check to determine whether projects perform as expected and promised

• Benefits of properly designed capital budgeting process– Process provides means of obtaining accurate information and

forecasts to decision-makers

– Process insures managers are rewarded for adding value to firm

– Process provides performance measurement

Valuation• Companies thrive when they create real economic value

to shareholders– Firms create value by investing capital at rates of return that

exceed their cost of capital

– The more capital invested at attractive rates or return, the more value created

• Value creation principles must be part of important managerial decision-making– Value creation plans must be grounded in realistic assessments

of product market opportunities and the competitive environment

– Managers must be able to create tangible links between their strategies and value creation

Investment Decision• Investment decision is the beginning of learning

– As soon as decision is made, managers should begin learning • About business conditions, competitors’ actions, quality of preparations, etc.

– Managers must respond flexibly to what they learn

• Investment decisions are made under uncertainty– Requires approach to valuation that assists managers to think

strategically• Approach should capture value of managing actively rather than passively

– Capital budgeting project is a series of options rather than series of static cash flows

• Executing project involves making sequence of decisions, some now and some in the future

– Decision to undertake project sets framework within which future decisions will be made

• But at the same time leaves room for learning and for discretion to act based on what is learned

Thank You!

Charles B. (Chip) Ruscher, PhD

Department of Finance and Business Economics