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j Myth 1: A valuation is an objective search for ³true´ value

‡ Truth 1.1: All valuations are biased. The only questions are how much
and in which direction.
‡ Truth 1.2: The direction and magnitude of the bias in your valuation is
directly proportional to who pays you and how much you are paid.
j Myth 2.: A good valuation provides a precise estimate of value
‡ Truth 2.1: There are no precise valuations
‡ Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
j Myth 3: . The more quantitative a model, the better the valuation
‡ Truth 3.1: One¶s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
‡ Truth 3.2: Simpler valuation models do much better than complex ones.

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j The use of valuation models in investment decisions (i.e., in decisions

on which assets are under valued and which are over valued) are based
upon
‡ a perception that markets are inefficient and make mistakes in assessing
value
‡ an assumption about how and when these inefficiencies will get corrected
j In an efficient market, the market price is the best estimate of value.
The purpose of any valuation model is then the justification of this
value.

|
 
 
    
 

j A
: In discounted cash flow valuation, the value of an asset is

the present value of the expected cash flows on the asset.
j -  


: Every asset has an intrinsic value that can be
estimated, based upon its characteristics in terms of cash flows, growth
and risk.
j 

  : To use discounted cash flow valuation, you
need
‡ to estimate the life of the asset
‡ to estimate the cash flows during the life of the asset
‡ to estimate the discount rate to apply to these cash flows to get present
value
j @
 

  : Markets are assumed to make mistakes in
pricing assets across time, and are assumed to correct themselves over
time, as new information comes out about assets.
|
 
 
    
    
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+
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where CFt is the cash flow in period t, r is the discount rate appropriate
given the riskiness of the cash flow and t is the life of the asset.
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j ualue just the equity stake in the business

j ualue the entire business, which includes, besides equity, the other
claimholders in the firm

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j The value of equity is obtained by discounting expected cashflows to equity, i.e., the
residual cashflows after meeting all expenses, tax obligations and interest and principal
payments, at the cost of equity, i.e., the rate of return required by equity investors in the
firm.

t n
to quity t
Value of quity w (1+ k e )t
t 1
where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity
j : The dividend discount model is a specialized case of equity valuation, and the
value of a stock is the present value of expected future dividends. In the more general
version, you can consider the cashflows left over after debt payments and reinvestment
needs as the free cashflow to equity.

|
 
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j º




: The value of the firm is obtained by

discounting expected cashflows to the firm, i.e., the residual cashflows
after meeting all operating expenses and taxes, but prior to debt
payments, at the weighted average cost of capital, which is the cost of
the different components of financing used by the firm, weighted by
their market value proportions.
t= n
CF to Firmt
ualue of Firm= w (1 W CC)t
t =1

j -

: The value of the firm can also be written as the sum
of the value of the unlevered firm and the effects (good and bad) of
debt.
Firm ualue = Unlevered Firm ualue Pu of tax benefits of debt - Expected
Bankruptcy Cost

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D
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1.64 ÿur 1.75 ÿur 1.87 ÿur 1.99 ÿur 2.12 ÿur
Value o ÿquity per
share 20.48 ÿur ›
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ost o ÿquity
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verage beta or ÿuropean banks

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j Probability of distress
‡ Price of 8 year, 12 bond issued by Global Crossing = $ 653

8
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653
w

1
(1.05) t (1.05) 8

‡ Probability of distress = 13.53 a year

â
‡ Cumulative probability of survival over 10 years = (1- .1353)10 = 23.37
j istress sale value of equity
‡ Book value of capital = $14,531 million
‡ istress sale value = 15 of book value = .15*14531 = $2,180 million
‡ Book value of debt = $7,647 million
‡ istress sale value of equity = $ 0
j istress adjusted value of equity
‡ ualue of Global Crossing = $3.22 (.2337) $0.00 (.7663) = $0.75

|
 
 
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j In the adjusted present value approach, the value of the firm is written
as the sum of the value of the firm without debt (the unlevered firm)
and the effect of debt on firm value
j Firm ualue = Unlevered Firm ualue (Tax Benefits of ebt -
Expected Bankruptcy Cost from the ebt)
‡ The unlevered firm value can be estimated by discounting the free
cashflows to the firm at the unlevered cost of equity
‡ The tax benefit of debt reflects the present value of the expected tax
benefits. In its simplest form,
Tax Benefit = Tax rate * ebt
‡ The expected bankruptcy cost is a function of the probability of
bankruptcy and the cost of bankruptcy (direct as well as indirect) as a
percent of firm value.

|
 
 
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j ·ou can present any discounted cashflow model in terms of excess

returns, with the value being written as:
‡ ualue = Capital Invested Present value of excess returns on current
investments Present value of excess returns on future investments
j This model can be stated in terms of firm value (EuA) or equity value.

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j A
$: The value of any asset can be estimated by looking at

how the market prices ³similar´ or µcomparable´ assets.
j -  


: The intrinsic value of an asset is impossible (or
close to impossible) to estimate. The value of an asset is whatever the
market is willing to pay for it (based upon its characteristics)
j 

  : To do a relative valuation, you need
‡ an identical asset, or a group of comparable or similar assets
‡ a standardized measure of value (in equity, this is obtained by dividing the
price by a common variable, such as earnings or book value)
‡ and if the assets are not perfectly comparable, variables to control for the
differences
j @
 

  : Pricing errors made across similar or
comparable assets are easier to spot, easier to exploit and are much
more quickly corrected.
|
 
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j Equity versus Firm ualue

‡ Equity multiples (Price per share or Market value of equity)
‡ Firm value multiplies (Firm value or Enterprise value)
j Scaling variable
‡ Earnings (EPS, Net Income, EBIT, EBIT A)
‡ Book value (Book value of equity, Book value of assets, Book value of capital)
‡ evenues
‡ Sector specific variables
j Base year
‡ Most recent financial year (Current)
‡ ast four quarters (Trailing)
‡ Average over last few years (Normalized)
‡ Expected future year (Forward)
j Comparables
‡ Sector
‡ Market

|
 
 
   

j Is the multiple consistently defined?

‡ - 
  
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j Is the multiple uniformally estimated?
‡ The variables used in defining the multiple should be estimated uniformly
across assets in the ³comparable firm´ list.
‡ If earnings-based multiples are used, the accounting rules to measure
earnings should be applied consistently across assets. The same rule
applies with book-value based multiples.

|
 
 
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j There are a number of variants on the basic PE ratio in use. They are
based upon how the price and the earnings are defined.
j Price: is usually the current price
is sometimes the average price for the year
j EPS: earnings per share in most recent financial year
earnings per share in trailing 12 months (Trailing PE)
forecasted earnings per share next year (Forward PE)
forecasted earnings per share in future year

|
 
 
  
  

j What is the average and standard deviation for this multiple, across the
universe (market)?
j What is the median for this multiple?
‡ The median for this multiple is often a more reliable comparison point.
j How large are the outliers to the distribution, and how do we deal with
the outliers?
‡ Throwing out the outliers may seem like an obvious solution, but if the
outliers all lie on one side of the distribution (they usually are large
positive numbers), this can lead to a biased estimate.
j Are there cases where the multiple cannot be estimated? Will ignoring
these cases lead to a biased estimate of the multiple?
j How has this multiple changed over time?

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j What are the fundamentals that determine and drive these multiples?
‡ Proposition 2: Embedded in every multiple are all of the variables that
drive every discounted cash flow valuation - growth, risk and cash flow
patterns.
‡ In fact, using a simple discounted cash flow model and basic algebra
should yield the fundamentals that drive a multiple
j How do changes in these fundamentals change the multiple?
‡ The relationship between a fundamental (like growth) and a multiple
(such as PE) is seldom linear. For example, if firm A has twice the growth
rate of firm B, it will generally not trade at twice its PE ratio
‡ - , 

 


   

 
   

 
 

 

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@ 
 
  
  
PE atio    , isk, Payout atio
PBu atio -  (, Expected Growth, isk, Payout
PS atio @
 , Expected Growth, isk, Payout atio
Euu/EBIT A Expected Growth, -  
, Cost of capital
Eu/ Sales .
 @
 , Expected Growth, isk, einvestment

|
 
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j Given the firm that we are valuing, what is a ³comparable´ firm?

‡ While traditional analysis is built on the premise that firms in the same
sector are comparable firms, valuation theory would suggest that a
comparable firm is one which is similar to the one being analyzed in terms
of fundamentals.
‡ - /0  
  


 

 
 
 


  
 


 
 

 


 
j Given the comparable firms, how do we adjust for differences across
firms on the fundamentals?
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›ependent variable is: PE

squared = 66.2 squared (adjusted) = 63.1

uariable Coefficient SE t-ratio prob

Constant 13.1151 3.471 3.78 0.0010
Growth rate 121.223 19.27 6.29 ” 0.0001
Emerging Market -13.8531 3.606 -3.84 0.0009
Emerging Market is a dummy: 1 if emerging market
0 if not

|
 
 
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j Predicted PE = 13.12 121.22 (.075) - 13.85 (1) = 8.35

j At an actual price to earnings ratio of 8.9, Telebras is slightly
overvalued.

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j Options have several features

‡ They derive their value from an underlying asset, which has value
‡ The payoff on a call (put) option occurs only if the value of the underlying
asset is greater (lesser) than an exercise price that is specified at the time
the option is created. If this contingency does not occur, the option is
worthless.
‡ They have a fixed life
j Any security that shares these features can be valued as an option.

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j Traditional discounted cashflow models under estimate the value of

investments, where there are options embedded in the investments to
‡ ›elay or defer making the investment (delay)
‡ Adjust or alter production schedules as price changes (flexibility)
‡ Expand into new markets or products at later stages in the process, based
upon observing favorable outcomes at the early stages (expansion)
‡ Stop production or abandon investments if the outcomes are unfavorable
at early stages (abandonment)
j Put another way, real option advocates believe that you should be
paying a premium on discounted cashflow value estimates.

|
 
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j When is there a real option embedded in a decision or an asset?

‡ There has to be a clearly defined underlying asset whose value changes over time
in unpredictable ways.
‡ The payoffs on this asset (real option) have to be contingent on an specified event
occurring within a finite period.
j When does that real option have significant economic value?
‡ For an option to have significant economic value, there has to be a restriction on
competition in the event of the contingency.
‡ At the limit, real options are most valuable when you have exclusivity - you and
only you can take advantage of the contingency. They become less valuable as the
barriers to competition become less steep.
j Can that value be estimated using an option pricing model?
‡ The underlying asset is traded - this yield not only observable prices and volatility
as inputs to option pricing models but allows for the possibility of creating
replicating portfolios
‡ An active marketplace exists for the option itself.
‡ The cost of exercising the option is known with some degree of certaint

|
 
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j The Option Test:

‡ Underlying Asset: Oil or gold in reserve
‡ Contingency: If value > Cost of development: ualue - ›ev Cost
If value < Cost of development: 0
j The Exclusivity Test:
‡ Natural resource reserves are limited (at least for the short term)
‡ It takes time and resources to develop new reserves
j The Option Pricing Test
‡ Underlying Asset: While the reserve or mine may not be traded, the commodity is. If we
assume that we know the quantity with a fair degree of certainty, you can trade the underlying
asset
‡ Option: Oil companies buy and sell reserves from each other regularly.
‡ Cost of Exercising the Option: This is the cost of developing a reserve. Given the experience
that commodity companies have with this, they can estimate this cost with a fair degree of
precision.
j Bottom ine: eal option pricing models work well with natural resource options.

|
 
 
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j The Option Test:

‡ Underlying Asset: Product that would be generated by the patent
‡ Contingency:
If Pu of CFs from development > Cost of development: Pu - Cost
If Pu of CFs from development < Cost of development: 0
j The Exclusivity Test:
‡ Patents restrict competitors from developing similar products
‡ Patents do not restrict competitors from developing other products to treat the same disease.
j The Pricing Test
‡ Underlying Asset: Patents are not traded. Not only do you therefore have to estimate the
present values and volatilities yourself, you cannot construct replicating positions or do
arbitrage.
‡ Option: Patents are bought and sold, though not as frequently as oil reserves or mines.
‡ Cost of Exercising the Option: This is the cost of converting the patent for commercial
production. Here, experience does help and drug firms can make fairly precise estimates of the
cost.
j Bottom ine: Use real option pricing arguments with caution.

|
 
 
      
*

9"- : 

j The Options Test

‡ Underlying Asset: Expansion Project
‡ Contingency
If Pu of CF from expansion > Expansion Cost: Pu - Expansion Cost
If Pu of CF from expansion < Expansion Cost: 0
j The Exclusivity Test
‡ Barriers may range from strong (exclusive licenses granted by the government) to weaker
(brand name, knowledge of the market) to weakest (first mover).
j The Pricing Test
‡ Underlying Asset: As with patents, there is no trading in the underlying asset and you have to
estimate value and volatility.
‡ Option: icenses are sometimes bought and sold, but more diffuse expansion options are not.
‡ Cost of Exercising the Option: Not known with any precision and may itself evolve over time
as the market evolves.
j Bottom ine: Using option pricing models to value expansion options will not only
yield extremely noisy estimates, but may attach inappropriate premiums to discounted
cashflow estimates.

|
 
 
 
 /   |
/

j There are real options everywhere.

j Most of them have no significant economic value because there is no
exclusivity associated with using them.
j When options have significant economic value, the inputs needed to
value them in a binomial model can be used in more traditional
approaches (decision trees) to yield equivalent value.
j The real value from real options lies in
‡ ecognizing that building in flexibility and escape hatches into large
decisions has value
‡ Insights we get on understanding how and why companies behave the way
they do in investment analysis and capital structure choices.

|
 
 
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