Approaches to Valuation

1
Approaches to Valuation
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Discounted 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.

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Discounted Cashflow Valuation
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• where,
• n Life of the company
• CFt Cashflow in period t
• r Discount rate reflecting the riskiness of the
  estimated cashflows

3
Advantages of DCF Valuation
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Since DCF valuation is based upon an assets
  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.

4
Disadvantages of DCF Valuation
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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.

5
When DCF Valuation works best
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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,

6
Market Valuation of Digital Lightwave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Share Price (close 4/24/02) 4.87
• 52-week high 57.56
• 52-week low 4.56
• Market Value 153 million

7
Market Valuation of Digital Lightwave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion
8
Present Value of DLWaves Cashflows
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Current Market Capitalization of DLWave 153
  million.
• 2001 Earnings of DLWave 2.8 million.
• 2001 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 Waves Cashflows 66
  million

9
Relative Valuation of Digital LightwaveApril 2002
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion
10
Advantages of Relative Valuation
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Relative valuation is much more likely to reflect
  market perceptions and moods than discounted cash
  flow valuation. This can be an advantage when it
  is important that the price reflect these
  perceptions as is the case when the objective is
  to sell a security at that price today (as in the
  case of an IPO).
• Relative valuation generally requires less
  information than discounted cash flow valuation.

11
Disadvantages of Relative Valuation
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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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Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Value of Firm
• FCFF1 expected free cash flow to the firm
• k firms 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

13
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• The Value/FCFF multiple for a stable growth firm
• Value/FCFF increases as g increases.
• Value/FCFF decreases as k increases.
• k is a function of the firms line of business.

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Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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.

15

• Estimating Cashflows
• 1. Revenues - Operating expenses
• Earnings before interest, taxes,
  depreciation, and amort. (EBITDA)
• 2. EBITDA - Depreciation and Amortization
• Earnings before interest and taxes (EBIT)
• 3. EBIT - Interest Expenses
• Earnings before taxes
• 4. Earnings before taxes Taxes Net Income
• 5. Net Income Depreciation and Amortization
• Cashflow from Operations
• 6. Cashflow from operations - Working Capital
  change - Capital spending - Principal Repayments
  Proceeds from New Debt Issues Free Cashflow
  to Equity.

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When relative valuation works best
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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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THE WALL STREET JOURNAL
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Tech Stocks Test the Old Valuation Rules
• As the communications revolution advances, the
  technology bulls believe, companies will create
  entirely new products, services and markets, and
  do this so rapidly that trying to analyze stock
  value based on current products is futile.

19
THE WALL STREET JOURNAL
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Tech Stocks Test the Old Valuation Rules
• But classic valuation techniques have a big hole
  in them, say those who invest in the technology
  revolution They don't take into account
  innovation.
• ...Investors in tech stocks aren't interested in
  extrapolations from present conditions -- they
  look for continued innovation.

20
What is a Real Option?
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

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

21
What is a Real Option?
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• The real world is characterized by change,
  uncertainty and competitive interactions gt
• 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 option
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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 Options
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Option to invest in a new technology-based
  service/product, as the result of a successful
  RD 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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Disadvantages of Real Option Valuation Models
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• When real options are valued, many of the inputs
  for the option pricing model are difficult to
  obtain. For instance, RD projects do not trade
  and thus getting a current value for a project or
  its variance may be a daunting task.
• The option pricing models derive their value from
  an underlying asset. Thus, to do option pricing,
  you first need to value the assets. It is
  therefore an approach that is an addendum to
  another valuation approach.

25
Real Option and Classical Valuation of DLWave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Current Market Capitalization of DLWave 153
  million.
• 2001 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 Place
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 2001 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 DLWave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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 (s2)/2) t /
  s(t) ½ .
• d2 d1 - s (t) ½ .
• where,
• N (.) Cumulative normal density function.
• continued...

28
Real Option Value Component of DLWave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Value of real option V e-yt N(d1) - X e
  -rt N(d2) .
• where,
• d1 ln (V/X) (r - y (s2)/2) t /
  s(t) ½ .
• d2 d1 - s (t) ½ .
• where,
• V Present value of expected cash inflows
  from investing in
• DLWaves future opportunities (under base case
  assumptions)
• 235 million.
• X Present value of the costs of investing
  in DLwaves future opportunities (under base
  case assumptions)
• 226 million.
• Hence, classical discounted cashflow valuation
  technique would suggest a value of 9 million
  from investing in DLWaves future opportunities.

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Real Option Value Component of DLWave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Value of real option V e-yt N(d1) - X e
  -rt N(d2) .
• where,
• d1 ln (V/X) (r - y (s2)/2) t /
  s(t) ½ .
• d2 d1 - s (t) ½ .
• where,
• s 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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Real Option Value Component of DLWave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Base Case Assumptions
• Population 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

31
Real Option Value Component of DLWave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• 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

32
Sensitivity Analysis of Real Option Value
Component of DLWave
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion
33
The Bottom Line
Introduction DCF Valuation Relative Valuation
Real Option Valuation Conclusion

• Traditional valuation procedures cannot properly
  capture the companys flexibility to adapt and
  revise later decisions in response to unexpected
  competitive/technological/market developments.
• The real option technique can value the companys
  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 in high-risk industries.