Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Approaches to Valuation 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.

Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Discounted Cashflow Valuation

t = n CF t Value = t t =1 (1 + r)
where, n = Life of the company CFt = Cashflow in period t r = Discount rate reflecting the riskiness of the estimated cashflows
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Advantages of DCF Valuation 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.

Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Disadvantages 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

When 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,
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Market Valuation of Digital Lightwave Share Price (close 4/24/02) 52-week high 52-week low Market Value : $4.87 : $57.56 : $4.56 : $153 million
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Market Valuation of Digital Lightwave

Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Present Value of DLWaves Cashflows

Current Market Capitalization of DLWave : 2001 Earnings of DLWave: 2001 Cashflow of DLWave: Assumptions Annual growth during the next 5 years Cost of capital Low growth rate after next 5 years Number of years of low growth Present Value of DL Waves Cashflows

$ 153 million. $ 2.8 million. $6.2 million.

25% 18% 10% 5 : $66 million

Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Relative Valuation of Digital Lightwave April 2002

Digital Lightwave Price/Sales Price/Earnings Price/Book Price/Cashflow 2.78 2.06 24.35
TeleComm Equipment

Market

Industry 1.56 2.90 (23.28) 1.28 64.74 2.53 15.30

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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Advantages of Relative Valuation

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.
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Disadvantages 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.
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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:

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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.

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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.

Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

When 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.

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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Relative Valuation of Digital Lightwave

Acterna Price/Sales Ratio 0.19 Agilent Tektronix Industry 1.99 2.05 1.56

Digital Lightwave ($ millions)

15.7

164.8

170.0

129.2

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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation Conclusion

THE WALL STREET JOURNAL

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.
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

THE WALL STREET JOURNAL

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.

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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

What is a Real Option?

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.
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

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.
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Source 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

X 22

Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Examples 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.
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Disadvantages of Real Option Valuation Models

When real options are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, R&D 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.
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Real Option and Classical Valuation of DLWave

Current Market Capitalization of DLWave : 2001 Earnings of DLWave:

$ 153 million. $ 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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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Present Value of Cashflows from Assets in Place

2001 Cashflow of DLWave: Assumptions Annual growth during the next 5 years Cost of capital Low growth rate after next 5 years Number of years of low growth

$6.2 million

25% 18% 10% 5

Present Value of Cashflows from Assets in Place: $66 million

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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Real 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 + (s2)/2) t ] / s(t) . d2 = d1 - s (t) .
where, N (.) = Cumulative normal density function. continued...
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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Real Option Value Component of 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) . d2 = d1 - s (t) .

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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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Real Option Value Component of 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) . d2 = d1 - s (t) . 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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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Real Option Value Component of DLWave

Base Case Assumptions

Population = Potential Market = Likely penetration of potential market = Annual revenues per customer = Cost of capital = Number of years of competitive advantage = Variable operating costs = 270 million 15% of population 30% $12 18% 5 70% of revenue

Real Option Value =

$86 million

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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Real 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

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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

Sensitivity Analysis of Real Option Value Component of DLWave

Real Option Value vs. Cashflow Standard Deviation
Real Optio n Valu e ($millions)
150 100 50 0 20 30 40 50 Std. Dev. (%) 60

Real Option Value vs. Market Penetration

160 140 120 100 80 60 40 20 0 10 30 50 Market Penetration (%)

Real Option Value ($ millions)

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Introduction

DCF Valuation

Relative Valuation

Real Option Valuation

Conclusion

The Bottom Line

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.

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