Business valuation and corporate governance
Business valuation: Chapter 1: overview of valuation
Introduction
Valuation is central to most of what we do in financial analysis. When firms evaluate either an internally
generated investment project or an external acquisition, one of the first steps in the process is a
valuation of the opportunity. Moreover, when firms consider either share issuances or share
repurchases, an initial step in the evaluation process is the valuation of the firm’s own shares. Corporate
financial analysts also spend considerable amounts of time in valuing investment projects. Whether you
are valuing an ongoing business or an investment project, the procedure you follow is essentially the
same. In each case, you will need lots of information. Specifically, you will need to:
1. make estimates of the cash flows generated by the investment.
2. assess the riskiness of those cash flows and determine the appropriate discount rate.
3. identify comparable investments that are either publicly traded or have recently been
bought or sold.
Valuing the shared of a publicly traded firm is relatively strait forward as the company has history that
include past cash flow and stock returns and comparable data from other public firms. The information
about comparable firms will prove to be very helpful in estimating the value of the firm of interest. The
valuation of an investment project can be more challenging because you do not typically have the
benefit of historical data and are likely to have fewer comparable transactions that you can use to help
gauge how other market participants have evaluated similar investments. However, the valuation
process in each case is very much the same.
The nature of major investment decisions
Acquire productive capacity by assembling the necessary assets = project valuation OR they acquire
existing businesses = enterprise valuation.
The firm’s objective is to create wealth by generating future cash flows that are worth more than the
costs of the investment. Practically speaking, the firm expects to make its shareholders $50 million. In
the jargon of finance, the project has an expected net present value (NPV) of $50 million (Figure 1).
One possible explanation for failed investments is simply that firms invest in risky projects, and we
should not expect them to be right all the time. The fact is that analyzing capital expenditure choices can
be both complex and tedious, and managers must make their investment decisions based on incomplete
information about uncertain future events. In the face of this complexity and uncertainty, managers
often just “go with their gut” and initiate the investments that feel right. However, analytical tools, as
,well as sophisticated yet inexpensive and user-friendly computer software, can help managers see
through the complexity and work through the tedium inherent in the evaluation of a major investment.
Valuing projects and businesses
Example of Caspian Sea oil fields --> Both the state oil company of Azerbaijan and the
consortium would have the right to approve each step in the process based on the results of
the prior stage. Furthermore, a production-sharing agreement would define the revenue-
sharing agreement for the output from the investment if it were successful. Also, assuming that
all stages of the investment were successfully executed, the fact that the consortium had
developed expertise in the region would make it possible for each member of the consortium
to compete on favorable terms with would-be competitors for future investment opportunities.
Issues to consider when valuing an investment:
1. Does the “story” make sense? - By “make sense,” we mean that management must
be convinced that the potential gains from the investment are large enough to
warrant initial investigation. Also, management must believe that the firm’s
management team possesses (or can acquire) the expertise required to reap the
rewards of investing. The capability of a firm that undertakes the investment
compared to capabilities of others gives a competitive advantage = determines the
success or failure of an investment.
2. What are the risks involved in undertaking the investment? - Specifically, a careful
assessment of what might go wrong is perhaps even more important than an
analysis of what we hope will go right.
3. How can the investment be financed? - Moreover, the ability to secure attractive
financing is a key determinant of the value of the investment. In addition to asking
how much debt to use, the firm should also discuss the type of debt to use.
4. How does the investment affect near-term earnings? - Investors and equity analysts
use the firm’s reported earnings as an indicator of the firm’s success or failure.
When considering a large investment, managers will be keenly aware of its effect on
earnings. A project’s effect on earnings can be important for a variety of reasons in
determining whether managers are willing to initiate an investment.
5. Does the investment have inherent flexibilities that allow the firm to modify it in
response to changing circumstances? - Uncertain future events make it particularly
important that the project provide opportunities to react and adapt the investment
to changing circumstances.
a. Staging: Staging allows the firm to manage its risk exposure by making a series of
successively larger commitments based upon the success of the prior
investment. When the firm invests in the initial stages, it essentially acquires the
“option” to invest in later stages of the project (if the intermediate investments
prove fruitful). The flexibility to delay implementation of a project—to cut one’s
losses and abandon a project or to expand a successful investment—are
examples of optionality that can add considerable value to a project.
b. Follow-up investments: The opportunity to invest in a new product, market, or
technology can provide valuable “follow-on investment” opportunities.
, consequently, the valuation of investments with follow-on opportunities
requires consideration of two sets of cash flows: the cash flows provided by the
immediate opportunity as well as those from the possible subsequent projects.
c. Synergies: To the extent that the new investment shares existing production
and/or marketing resources, the opportunity exists to gain a comparative
advantage over the firm’s competitors.
Dealing with complexity – process and discipline
The investment evaluation process = This three-phase process captures the critical elements of
project or enterprise evaluation, beginning with idea generation and with a final go-no go
investment decision.
Phase I : investment (idea) origination and analysis
- Step 1: conduct a strategic assessment
- Step 2 Estimate the investment value (crunch the numbers) --> potential to create
value for stockholders. It involves applying valuation models such as discounted cash
flows and market bases multiples.
- Step 3: prepare the investment evaluation report and recommendations to
management --> at a minimum, the report will contain (a) an assessment of the
investment’s strategy for creating value and the firm’s comparative advantage in
carrying out the strategy, (b) an estimate of the value of the investment (net present
value), and (c) the supporting information and assumptions used in the analysis.
Phase II: managerial review and recommendation
(Investment review committee makes sure that the assumption are responsible, and noting is forgotten)
- Step 4: evaluate the investment’s strategic assumptions
- Step 5: review and evaluate the methods and assumptions used to estimate the NPV of the
investment
Step 6: adjust for inherent estimation errors induces by bias and formulate a recommendation
regarding the investment. (Decision bias)
Phase III: Managerial decision and approval
- Step 7: make a decision --> combining top management sense of the firm’s strategy with the
recommendation of the committee
- Step 8: Seek final managerial and possibly board approval
Summing up and looking forward
- The process can be very costly. The process of project origination, evaluation, and
approval is expensive and time-consuming. Of course, skimping on the analysis of major
projects can be even more expensive if it leads to project failures or missed
opportunities.
- The process can be subject to biased estimates of project value arising out of conflicts
of interest and incentive problems. Individuals within the process often have conflicting
motives. Furthermore, there is often a financial incentive attached to getting the project
approved. For example, year-end bonuses may be tied to getting “deals done.” This
, incentive can easily lead employees to portray a project’s prospects in a more optimistic
way than may be warranted. On the other hand, the members of the various units
within the firm who must analyze and “sign off” on the project are often skeptics. They
typically are staff personnel whose role is to ferret out bias in the investment analysis
and provide a control over overzealous project champion
- The process is affected by problems arising out of differences in the information available to
project champions and the internal review or control group (the strategic planning committee
in our earlier example). Specifically, the control group in Phase II of the process is generally less
well informed about the project’s inner workings than the project proponents from Phase I. In
the interest of efficiency, this situation would ordinarily support delegation of decision-making
authority to the managers and project champions who know the most about the project.
However, incentive issues and the natural bias that project champions often exhibit require that
some type of control system (such as the strategic planning and review committee) be put in
place, and this is exactly what we see in business practice.
Summary
Valuation is more than discounting cash flows. The evaluation of new investment opportunities, ranging
from the smallest capital budgeting exercise up to the acquisition of an entire firm, has come a long way
since the early days in which the focus was solely on the present value of estimated future cash flows.
Although the importance of net present value (NPV) has not changed, analysts now consider a broad set
of factors.
- Cash flow estimation. The first step in valuing an investment is to estimate future cash flows.
One must ask how certain these cash flow estimates are, as well as how sensitive the estimates
are to unexpected changes in the economic environment.
- Risk assessment. Major new investments by multinational firms often involve com-mitting funds
to emerging markets. Such investments typically come with significant additional risks: political
risk, commodity price risk, interest rate risk, and exchange rate risk. Risk must be assessed as
well as managed, and it plays an important role in determining the rate at which cash flows are
discounted as well as the financing of the investment project.
- Financing opportunities. Financing can offer an important source of value for an investment
project and can be a key determinant of the investment’s cost of capital.
- The effects on the firm’s near-term earnings. Although the value of an investment is created by
the cash flows generated by the investment, managers are keenly aware of how a project affects
earnings. In practice, an investment’s effect on the earnings of a firm will have a large influence
on whether the investment is ultimately taken.
- Staged investments. The decision to initiate an investment essentially involves acquiring the
“option” to invest in later stages of the project (assuming the intermediate stages prove fruitful).
Thus, analysts can use option valuation techniques to evaluate whether to postpone, speed up,
or cancel future investments.
- “Follow-on” investment opportunities. Previous investments are a primary source of new
investment opportunities. Thus, it is important that we consider the impact of major investment
projects on future opportunities.
, Chapter 4: Estimating a Firm’s Cost of Capital
The firm’s weighted average cost of capital (or WACC, pronounced “whack”) is the weighted
average of the expected after-tax rates of return of the firm’s various sources of capital. As we
will discuss in this chapter, the WACC is the discount rate that should be used to discount the
firm’s expected free cash flows to estimate firm value. A firm’s WACC can be viewed as its
opportunity cost of capital, which is the expected rate of return that its investors forgo from
alternative investment opportunities with equivalent risk.
In addition to providing the appropriate discount rate to calculate the firm’s value, firms
regularly track their WACC and use it as a benchmark for determining the appropriate discount
rate for new investment projects, for valuing acquisition candidates, and for evaluating their
own performance.
Value, Cash flows and Discount Rates
If you are trying to estimate the value of the equity invested in the project (i.e., equity value),
then you will estimate equity free cash flows and use a discount rate that is appropriate for the
equity investors. On the other hand, if you are estimating the value of an entire firm, which
equals the value of the combined equity and debt claims, then the appropriate cash flow is the
combination of debt and equity cash flows. In that case, the appropriate discount rate is a
combination of the debt- and equity-holder rates, or what we will refer to as the weighted
average cost of capital.
The weighted average cost of capital (WACC) is a weighted average of the after-tax costs of the
various sources of invested capital raised by the firm to finance its operations and investments.
We define the firm’s invested capital as capital raised through the issuance of interest-bearing
debt and equity (both preferred and common). Note that the above definition of invested
capital specifically excludes all non-interest-bearing liabilities such as accounts payable, as well
as unfunded pension liabilities and leases. This is because we will be calculating what is known
as the firm’s enterprise value, which is equal to the sum of the values of the firm’s equity and
interest-bearing liabilities. Note, however, that these excluded sources of capital (e.g.,
