What s It Worth?
A General Manager s
Guide to Valuation
by Timothy A. Luehrman
Harvard Business Review
Reprint 97305
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Valuation used to be the province of finance specialists. That s no longer true.
WHAT S IT WORTH?
A GENERAL MANAGER S
Most companies use a mix of approaches to esti-
by Timothy A. Luehrman
mate value. Some methodologies are formal, com-
Behind every major resource-allocation decision prising a theory and a model; others are informal,
a company makes lies some calculation of what operating by ad hoc rules of thumb. Some are ap-
that move is worth. Whether the decision is to plied explicitly, and others implicitly. They may be
launch a new product, enter a strategic partnership, personalized by individual executives styles and
invest in R&D, or build a new facility, how a com- tastes or institutionalized in a system with proce-
pany estimates value is a critical determinant of dures and manuals.
how it allocates resources. And the allocation of re- Though executives estimate value in many dif-
sources, in turn, is a key driver of a company s over- ferent ways, the past 25 years has seen a clear trend
all performance. toward methods that are more formal, explicit, and
Today valuation is the financial analytical skill institutionalized. In the 1970s, discounted-cash-
that general managers want to learn and master flow analysis (DCF) emerged as best practice for
more than any other. Rather than rely exclusively valuing corporate assets. And one particular ver-
on finance specialists, managers want to know how sion of DCF became the standard. According to that
to do it themselves. Why? One reason is that execu- method, the value of a business equals its expected
tives who are not finance specialists have to live future cash flows discounted to present value at the
with the fallout of their companies formal capital- weighted-average cost of capital (WACC).
budgeting systems. Many executives are eager to Today that WACC-based standard is obsolete.
see those systems improved, even if it means learn- This is not to say that it no longer works indeed,
ing more finance. Another reason is that under-
standing valuation has become a prerequisite for
Timothy A. Luehrman is a visiting associate professor of
meaningful participation in a company s resource- finance at the Massachusetts Institute of Technology s
allocation decisions. Sloan School of Management in Cambridge.
Copyright © 1997 by the President and Fellows of Harvard College. All rights reserved. DRAWING BY MARK STEELE
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GUIDE TO VALUATION
with today s improved computers and data, it prob- make a one-size-fits-all approach unnecessary and,
ably works better than ever. But it is exactly those in fact, suboptimal. Three complementary tools
advances in computers and software, along with one for each type of valuation problem will out-
new theoretical insights, that make other methods perform the single tool (WACC-based DCF) that
even better. Since the 1970s, the cost of financial most companies now use as their workhorse valua-
analysis has come down commensurately with the tion methodology.
cost of computing which is to say, breathtakingly.
One effect of that drop in cost is that companies do
Valuing Operations:
a lot more analysis. Another effect is that it is now
Adjusted Present Value
possible to use valuation methodologies that are
better tailored to the major kinds of decisions that The most basic valuation problem is valuing op-
managers face. erations, or assets-in-place. Often managers need to
What do generalists (not finance specialists) need estimate the value of an ongoing business or of
in an updated valuation tool kit? The resource-allo- some part of one a particular product, market, or
cation process presents not one, but three basic line of business. Or they might be considering a
types of valuation problem. Managers need to be new equipment purchase, a change in suppliers, or
able to value operations, opportunities, and owner- an acquisition. In each case, whether the operation
ship claims. The common practice now is to apply in question is large or small, whether it is a whole
the same basic valuation tool to all problems. Al- business or only a part of one, the corporation ei-
though valuation is always a function of three fun- ther has already invested in the activity or is decid-
damental factors cash, timing, and risk each ing now whether to do so. The question is, How
type of problem has structural features that set it much are the expected future cash flows worth,
apart from the others and present distinct ana- once the company has made all the major discre-
lytical challenges. Fortunately, today s computers tionary investments?
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Today most companies exe-
The Basic Logic of
cute discounted-cash-flow valu-
Discounted-Cash-Flow Valuation
ations using the following ap-
proach: First, they forecast
DCF valuation
business cash flows (such as rev-
The concept is
methodologies
enues, expenses, and new invest-
are all built on a future value = present value (1 + interest rate)
simple relationship ment), deliberately excluding
That concept produces
between present
future value
cash flows associated with the fi-
present value =
this relationship:
value and
1 + interest rate
nancing program (such as inter-
future value.
est, principal, and dividends).
Second, they adjust the discount
To apply the fundamental DCF relationship to a business, we modify the relationship so
rate to pick up whatever value is
that present value equals the sum of the future cash flows adjusted for timing and risk.
created or destroyed by the fi-
Cash Flow and Risk
nancing program. WACC is by far
the most common example of
Future value corresponds to future business cash
flows, CF. But business cash flows are uncertain, so we such an adjustment. It is a tax-
discount expected cash flows: E(CF).
adjusted discount rate, intended
to pick up the value of interest
tax shields that come from using
n
an operation s debt capacity.
E(CF)t
present value =
The practical virtue of WACC
(1 + k)t
t=0
is that it keeps calculations used
Timing
in discounting to a minimum.
Risk Anyone old enough to have dis-
Because business cash
counted cash flows on a handheld
flows occur over many
Because business cash
calculator a tedious, time-con-
future periods, we locate
flows are risky, investors
them in time, then discount
suming chore will understand
demand a higher return:
and add them all.
the discount rate, k, immediately why WACC be-
contains a risk premium.
came the valuation methodology
of choice in the era before per-
sonal computers.
That is precisely the problem at which tradition- But WACC s virtue comes with a price. It is suit-
al DCF methods are aimed. A discounted-cash-flow able only for the simplest and most static of capital
analysis regards businesses as a series of risky cash structures. In other cases (that is, in most real situa-
flows stretching into the future. The analyst s task tions), it needs to be adjusted extensively not only
is first, to forecast expected future cash flows, peri- for tax shields but also for issue costs, subsidies,
od by period; and second, to discount the forecasts hedges, exotic debt securities, and dynamic capital
to present value at the opportunity cost of funds. structures. Adjustments have to be made not only
The opportunity cost is the return a company (or its project by project but also period by period within
owners) could expect to earn on an alternative in- each project. Especially in its sophisticated, multi-
vestment entailing the same risk. Managers can get layered, adjusted-for-everything versions, the
benchmarks for the appropriate opportunity cost by WACC is easy to misestimate. The more compli-
observing how similar risks are priced by capital cated a company s capital structure, tax position, or
markets, because such markets are a part of in- fund-raising strategy, the more likely it is that mis-
vestors set of alternative opportunities. takes will be made. (See the insert The Limita-
Opportunity cost consists partly of time value tions of WACC. )
the return on a nominally risk-free investment. Today s better alternative for valuing a business
This is the return you earn for being patient with- operation is to apply the basic DCF relationship to
out bearing any risk. Opportunity cost also in- each of a business s various kinds of cash flow and
cludes a risk premium the extra return you can then add up the present values. This approach is
expect commensurate with the risk you are willing most often called adjusted present value, or APV. It
to bear. The cash-flow forecasts and the opportuni- was first suggested by Stewart Myers of MIT, who
ty cost are combined in the basic DCF relationship. focused on two main categories of cash flows:
(See the exhibit The Basic Logic of Discounted- real cash flows (such as revenues, cash operating
Cash-Flow Valuation. ) costs, and capital expenditures) associated with the
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WHAT S IT WORTH?
business operation; and side effects associated in charge of realizing individual pieces of value.
with its financing program (such as the values of in- APV is a natural way to get information about those
terest tax shields, subsidized financing, issue costs, pieces to managers or for them to generate that in-
and hedges).1 More generally, APV relies on the formation for themselves.
principle of value additivity. That is, it s okay to Executives are discovering that APV plays to the
split a project into pieces, value each piece, and strength of now-ubiquitous spreadsheet software:
then add them back up. each piece of the analysis corresponds to a subsec-
What are the practical payoffs from switching tion of a spreadsheet. APV handles complexity with
to APV from WACC? If all you want from a valua- lots of subsections rather than complicated cell for-
tion analysis is to know whether the net present mulas. In contrast, WACC s historical advantage
value is positive or negative and if you already use was precisely that it bundled all the pieces of an
WACC properly, the payoff will be low. The two analysis together, so an analyst had to discount
approaches, skillfully applied, seldom disagree on only once. Spreadsheets permit unbundling, a capa-
that question. But there is a lot of room for im- bility that can be powerfully informative. Yet tradi-
provement once you have answered it. tional WACC analyses do not take advantage of it.
APV helps when you want to know more than Indeed, many managers use their powerful spread-
merely, Is NPV greater than zero? Because the basic sheets merely to generate dozens of bundled valua-
idea behind APV is value additivity, you can use it tion analyses, rather than to produce unbundled
to break a problem into pieces that make mana- analyses that would be managerially relevant.
gerial sense. Consider an acquisition. Even after the WACC still has adherents, most of whom argue
deal has closed, it helps to know how much value that it works well enough when managers aim for a
is being created by cost reductions rather than oper- constant debt-to-capital ratio over the long run.
ating synergies, new growth, or tax savings. Or Some go even further, saying that managers ought
consider an investment in a new plant. You may to aim for exactly that and so therefore WACC is
negotiate specific agreements with, for example, appropriate. But whether managers ought to behave
equipment suppliers, financiers, and government thus is highly questionable; that they do not, in
agencies. In both examples, different people will be fact, follow this prescription is indisputable. To de-
New Valuation Practices Are on the Way
Valuation practices are changing already. The ques- purpose of such evaluation will not be to arbitrate go-
tion is not whether companies will adapt, but when. or-no-go decisions (Should we invest or not?) but to
Business schools and textbooks continue to teach the make more refined comparisons (Should we invest
method based on the weighted-average cost of capital this way or that way?) and to support line managers
(WACC) because it is the standard, not because it per- with more formal analyses (How can we take further
forms best. But some business schools already teach advantage of our position in this market?).
alternative methodologies. Consulting and profes- Enhanced analytical capabilities will reside inside
sional firms are actively studying and modifying their corporations, not solely in fee-for-service professional
approaches to valuation. And new valuation books, boutiques. The power of valuation analyses is en-
software, and seminars are appearing on the market. hanced more by a deep understanding of the business
Here s some of what s coming: than by general experience with valuation. Insiders
Companies will routinely use more than one formal can learn valuation more readily than outsiders can
valuation methodology. The primary purpose will not learn the business.
be redundancy (to get more than one opinion about Good corporate capital-budgeting processes will be
a project s value), but analytical tailoring (to use a less rigid and more adaptive. Not mere systemizations
methodology that fits the problem at hand). of a single valuation approach, they will synthesize in-
Discounted cash flows will remain the foundation sights from different approaches according to the busi-
of most formal valuation analyses. But WACC will be ness characteristics of the project or opportunity. This
displaced as the DCF methodology of choice by adjust- should come as good news to line managers.
ed present value or something very much like it. The trend toward more active participation by the
Many companies will routinely evaluate the oppor- CFO and other financial executives in strategy formu-
tunities inherent in such activities as R&D and mar- lation and business development (both of which pre-
keting by using tools derived from option pricing, sim- cede capital budgeting) should continue. In fact, it
ulation, and decision-tree analysis. The primary may accelerate.
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The Limitations of WACC
The WACC formula is a tax-adjusted discount rate. required by a complex capital structure. How many
That is, when used as a discount rate in a DCF calcula- corporations inhabit a world so neat that one parame-
tion, WACC is supposed to pick up the tax advantage ter can summarize it? Accordingly, some specialists
associated with corporate borrowing. For a simple cap- customize their estimates of WACC with subtle ad-
ital structure: justments. Unfortunately, the adjustments then are
buried in an intimidating formula, one and a half lines
WACC = (debt/debt+equity)(cost of debt)(1- corporate long, in a single cell of a spreadsheet. Errors and as-
tax rate) + (equity/debt+equity)(cost of equity). sumptions, whatever they are, will probably remain
hidden from view.
The cost of debt and the cost of equity are both op- And errors are indeed likely. The automatic fea-
portunity costs, each consisting of time value and its ture of WACC relies on fairly restrictive assump-
own risk premium. But WACC also contains capital tions to get the value of interest tax shields just right.
structure ratios and an adjustment reflecting the term With non-plain-vanilla debt securities (such as high-
1 minus the corporate tax rate. Together, these have yield debt, floating-rate debt, original-issue-discount
the effect of modestly lowering WACC. This in turn debt, convertible debt, tax-exempt debt, and credit-
gives a higher present value than one would obtain by enhanced debt), WACC has an excellent chance of
discounting at a non-tax-adjusted opportunity cost. misvaluing the interest tax shields or, which is prob-
When WACC works as intended, the exact value of in- ably worse, misvaluing the other cash flows asso-
terest tax shields is automatically included in the ciated with the project or its financing. In general, com-
present value of the project. panies with complex tax positions will be poorly
Note that to use WACC in this fashion is to rely on served by WACC. It is even more unrealistic for the
one term 1 minus the corporate tax rate in the dis- sort of complexity encountered in, for example, cross-
count rate to automatically make all the adjustments border capital-budgeting problems.
cree that managers should maintain constant debt that time, they join the queue of other investments
ratios because that policy fits the WACC model is under consideration for funding. Critics have long
to let the tail wag the dog. decried this practice as myopic; they claim that it
leads companies to undervalue the future and
hence, to underinvest.
Valuing Opportunities: Option Pricing
What actually happens appears to be more com-
Opportunities the second type of commonly en- plicated and to depend a great deal on how man-
countered valuation problem may be thought of agers are evaluated and rewarded. The absence of a
as possible future operations. When you decide how formal valuation procedure often gives rise to per-
much to spend on R&D, or on which kind of R&D, sonal, informal procedures that can become highly
you are valuing opportunities. Spending now cre- politicized. Champions arise to promote and defend
ates, not cash flow from operations, but the oppor- the opportunities that they regard as valuable, often
tunity to invest again later, depending on how resulting in overinvestment rather than under-
things look. Many marketing expenditures have investment.
the same characteristic. Spending to create a new or Some companies use a formal DCF-based ap-
stronger brand probably has some immediate pay- proval process but evaluate strategic projects with
off. But it also creates opportunities for brand ex- special rules. One such rule assigns strategic
tensions later. The opportunity may or may not be projects a lower hurdle rate than routine invest-
exploited ultimately, but it is valuable nonetheless. ments to compensate for DCF s tendency to under-
Companies with new technologies, product devel- value strategic options. Unfortunately, in many
opment ideas, defensible positions in fast-growing cases DCF s negative bias is not merely overcome
markets, or access to potential new markets own but overwhelmed by such an adjustment. Once
valuable opportunities. For some companies, op- again, overinvestment can occur in practice where
portunities are the most valuable things they own. theory would have managers worry about underin-
How do corporations typically evaluate opportu- vestment. Another special rule evaluates strategic
nities? A common approach is not to value them opportunities off-line, outside the routine DCF sys-
formally until they mature to the point where an tem. For better or worse, experienced executives
investment decision can no longer be deferred. At make a judgment call. Sometimes that works well,
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WHAT S IT WORTH?
but even the best executives (perhaps especially the business evolves. (See the exhibit What Makes
best) inform their judgment with sound analyses Opportunities Different? )
when possible. Because it handles simple contingencies better
In general, the right to start, stop, or modify a than standard DCF models, option-pricing theory
business activity at some future time is different has been regarded as a promising approach to valu-
from the right to operate it now. A specific impor- ing business opportunities since the mid-1970s.
tant decision whether or not to exploit the oppor- However, real businesses are much more compli-
tunity has yet to be made and can be deferred. The cated than simple puts and calls. A combination of
right to make that decision optimally that is, to do factors big, active competitors, uncertainties that
what is best when the time comes is valuable. A do not fit neat probability distributions, and the
sound valuation of a business opportunity captures sheer number of relevant variables makes it im-
its contingent nature: If R&D proves that the con- practical to analyze real opportunities formally.
cept is valid, we ll go ahead and invest. The un- Just setting up the valuation problem, never mind
stated implication is that if it doesn t, we won t. solving it, can be daunting. As a result, option pric-
The crucial decision to invest or not will be made ing has not yet been widely used as a tool for valu-
after some uncertainty is resolved or when time ing opportunities.
runs out. In financial terms, an opportunity is anal- Interest in option pricing has picked up in recent
ogous to an option. With an option, you have the years as more powerful computers have aided so-
right but not the obligation to buy or sell some- phisticated model building. Nevertheless, models
thing at a specified price on or before some future remain the domain of specialists. In my view, gen-
date. A call option on a share of stock gives you the eralists will get more out of option pricing by tak-
right to buy that share for, say, $100 at any time ing a different approach. Whereas technical experts
within the next year. If the share is currently worth go questing for objective truth they want the
$110, the option clearly is valuable. What if the right answer generalists have a business to
stock is worth only $90? The option still is valuable manage and simply want to do a better job of it.
because it won t expire for a year, and if the stock Getting closer to the truth is good, even if you don t
price rises in the next few months, it may well ex- get all the way there. So an options-based analysis
ceed $100 before the year passes. Corporate oppor- of value need not be perfect in order to improve on
tunities have the same feature: If R&D proves that current practice.
the concept is valid is analogous to if the stock The key to valuing a corporate investment oppor-
price rises in the next few months. Similarly, tunity as an option is the ability to discern a simple
we ll go ahead and invest is analogous to we ll correspondence between project characteristics and
exercise the option. 2
So an option is valuable, and its
value clearly depends on the value of
The absence of formal valuation
the underlying asset: the stock. Yet
owning the option is not the same as
procedures often gives rise to
owning the stock. Not surprisingly,
one must be valued differently than
informal procedures that can
the other. In considering opportuni-
ties, cash, time value, and risk all
become highly politicized.
still matter, but each of those factors
enters the analysis in two ways. Two
types of cash flows matter: cash from the business option characteristics. The potential investment to
and the cash required to enter it, should you choose be made corresponds to an option s exercise price.
to do so. Time matters in two ways: the timing of The operating assets the company would own, as-
the eventual flows and how long the decision to in- suming it made the investment, are like the stock
vest may be deferred. Similarly, risk matters in two one would own after exercising a call option. The
ways: the riskiness of the business, assuming that length of time the company can wait before it has to
you invest in it, and the risk that circumstances decide is like the call option s time to expiration.
will change (for better or worse) before you have to Uncertainty about the future value of the operating
decide. Even simple option-pricing models must assets is captured by the variance of returns on
contain at least five or six variables to capture infor- them; this is analogous to the variance of stock re-
mation about cash, time, and risk and organize it to turns for call options. The analytical tactic here is
handle the contingencies that managers face as the to perform this mapping between the real project
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WHAT S IT WORTH?
and a simple option, such as a European call option. Black-Scholes model, gives the value of this call as
(A European call can be exercised only on the expi- about $160,000.3
ration date, making it the simplest of all options.) If What did the company learn from option pricing?
the simple option captures the contingent nature of The value of the opportunity is positive, not nega-
the project, then by pricing the option we gain some tive. That is always true as long as time and un-
additional, albeit imperfect, insight into the value certainty remain. The company should not invest
of the project. the $1 million now to do so would be to waste
To illustrate, suppose a company is considering $100,000 but neither should it forget about ever
whether to invest $1 million to modify an existing investing. In fact, the odds are pretty good that it
product for an emerging market. A DCF analysis of will want to invest two years from now. In the
the expected cash flows shows them to be worth meantime, the product or country manager moni-
only about $900,000. However, the market is tors developments. He or she focuses not only on
volatile, so that value is likely to change. A combi- NPV but also on the proper timing of an invest-
nation of patents and know-how will protect the ment. Alternatively, if the company doesn t want
company s opportunity to make this investment for to invest and doesn t want to wait and see, it can
at least two more years. After that, the opportunity think about how to capture the value of the oppor-
may be gone. Viewed conventionally, this propos- tunity now. The option value gives it an idea of
al s NPV is negative $100,000. But the opportunity what someone might pay now for a license to intro-
to wait a couple of years to see what happens is duce the new product. In the same way, the option
valuable. In effect, the company owns a two-year value can help a company think about how much to
call option with an exercise price of $1 million on pay to acquire such a license or to acquire a small
underlying assets worth $900,000. We need only business whose most interesting asset is such an
two more pieces of information to value this busi- opportunity.
ness opportunity as a European call option: the risk- Long-lived opportunities in volatile business en-
free rate of return (this is the same as the time value vironments are so poorly handled by DCF valuation
referred to above suppose it s 7%); and some mea- methods that an option-pricing analysis does not
sure of how risky the cash flows are. For the latter, have to be very sophisticated to produce some
suppose that annual changes in the value of these worthwhile insight. A pragmatic way to use option
cash flows have a standard deviation of 30% per pricing is as a supplement, not a replacement, for
year, a moderate figure for business cash flows. the valuation methodology already in use. The ex-
Now, a simple option-pricing model, such as the tra insight may be enough to change, or least seri-
What Makes Opportunities Different?
Opportunities look like this:
Assets-in-place look like this:
cash flow cash flow
good news invest
invest good news
bad news
don t invest
cash flow cash flow
cash flow cash flow
good news invest
don t invest bad news
bad news
don t invest
cash flow cash flow
Here we make a decision, then find out what happens. Here we find out what happens before we make a decision.
Traditional DCF methods are designed for this kind of problem. Traditional DCF methods work poorly here.
These two scenarios must have different values; they also must be managed differently.
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ously challenge, decisions implied by traditional Managers need to understand not simply the value
DCF analyses. of the venture as a whole but also the value of their
Here s another way to think about the analytical company s interest in it. That understanding is es-
strategy I am recommending. Values for fairly illiq- sential to deciding whether or not to participate as
uid or one-of-a-kind assets (real estate, for example) well as how to structure the ownership claims and
are often benchmarked against values of assets or write good contracts.
transactions regarded as comparable but not identi- Suppose your company is considering investing
cal. Many terrific business opportunities are one- in a joint venture to develop an office building. The
of-a-kind, and many are illiquid. Lacking a compa- building itself has a positive NPV that is, con-
rable benchmark for the example above (modifying structing it will create value. What s more, the lead
our product to enter an emerging market), the com- developer is confident that lenders will provide the
pany synthesized one by setting up a simple Euro- necessary debt financing. You are being asked to
pean call option. By pricing the synthetic opportu- contribute funds in exchange for an equity interest
nity (the call option), it gained additional insight in the venture. Should you invest? If all you ve done
into the real opportunity (the product introduction is value the building, you can t tell yet. It could be
proposal). This insight is valuable as long as the that your partner stands to capture all the value cre-
company doesn t expect the synthesis or the result- ated, so even though the building has a positive
ing estimate of value to be perfect. NPV, your investment does not. Alternatively,
What the generalist needs, then, is an easy-to- some ventures with negative NPVs are good invest-
learn tool that can be used over and over to synthe- ments because a partner or the project s lenders
size and evaluate simple options. Furthermore, be- make the deal very attractive. Some partners are
cause the goal is to complement, not replace, simply imprudent, but others governments, for
existing methods, managers would like a tool that example deliberately subsidize some projects.
can share inputs with a DCF analysis, or perhaps A straightforward way to value your company s
use DCF outputs as inputs. My favorite candidate is equity is to estimate its share of expected future
the Black-Scholes option-pricing model, the first cash flows and then discount those flows at an op-
and still one of the simplest models. Arguably not portunity cost that compensates the company for
the easiest to learn, it is perhaps the most versatile the risk it is bearing. This is often referred to as the
of the simpler models. An intuitive mapping be- equity cash flow (ECF) approach; it is also called
tween Black-Scholes variables and project charac- flows to equity. It is, once again, a DCF methodolo-
teristics is usually feasible. And even though the gy, but both the cash flows and the discount rate are
model contains five variables, there is an intuitive different from those used either in APV or the
way to combine these five into two parameters, WACC-based approach. The business cash flows
each with a logical, managerial interpretation. This must be adjusted for fixed financial claims (for ex-
intuitive process lets a manager create a two-di- ample, interest and principal payments), and the
mensional map, which is much easier than creating discount rate must be adjusted for the risk associ-
one with five variables. Finally, the Black-Scholes ated with holding a financially leveraged claim.
model is widely available in commercial software, Handling leverage properly is most important
which means that if you can synthesize the compa- when leverage is high, changing over time, or both.
rable option, your computer can price it for you. In those situations, lenders interests may diverge
The crucial skills for the generalist are to know from those of shareholders, and different sharehold-
how to recognize real options and how to synthe- ers interests may diverge from one another. Such
size simple ones, not how to set up or solve com- divergence is especially common in transactions
plex models. that produce or anticipate substantial changes in
the business or its organization in mergers, acqui-
sitions, and restructurings, for example.
Valuing Ownership Claims:
Unfortunately, leverage is most difficult to treat
Equity Cash Flows
properly precisely when it is high and changing.
Claims that companies issue against the value of When leverage is high, equity is like a call option,
their operations and opportunities are the last ma- owned by the shareholders, on the assets of the
jor category of valuation problem. When a company company. If the business is successful, managers
participates in joint ventures, partnerships, or stra- acting in the best interests of shareholders will ex-
tegic alliances, or makes large investments using ercise the option by paying lenders what they are
project financing, it shares ownership of the ven- owed. Shareholders get to keep the residual value.
ture with other parties, sometimes many others. But if the business runs into serious trouble, it will
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WHAT S IT WORTH?
be worth less than the loan amount, so the borrow- An ECF analysis also shows explicitly how
er will default. In that situation, the lenders will changes in ownership structures affect cash flow
not be repaid in full; they will, however, keep the and risk, year by year, for the equity holders. Under-
assets in satisfaction of their claim. standing how a program of change affects the com-
It is widely understood that highly levered equity pany s owners helps to predict their behavior for
is like a call option because of the risk of default. example, how certain shareholders might vote on a
Why not use an option-pricing approach to value proposed merger, restructuring, or recapitalization
the equity? Because the options involved are too of the venture. Such insight is available only from
complicated. Every time a payment (interest or ECF or its variations.
principal) is due to lenders, the borrower has to de- What do companies use now instead of ECF
cide again whether or not to exercise the option. In analysis? Some evaluate equity claims by first valu-
effect, levered equity is a complex sequence of re- ing the entire business (with WACC-based DCF)
lated options, including options on options. Simple and then subtracting the value of any debt claims
option-pricing models are not good enough, and and other partners equity interests. This approach
complicated models are impractical. That is why requires managers to presume they know the true
it s worthwhile to have ECF as a third basic valua- value of those other claims. In practice, they don t
tion tool. know those values unless they apply ECF to esti-
It s important to state that an ECF valuation, no mate them. Another common approach is to apply
matter how highly refined, is not option pricing, a price-earnings multiple to your company s share
and therefore will not give a correct value for a of the venture s net income. That has the virtue of
levered equity claim. But ECF can be executed so simplicity. But finding or creating the right multi-
that its biases all run in the same direction to- ple is tricky, to say the least. Skillfully chosen
ward a low estimate. So, although the answer will price-earnings ratios may indeed yield reasonable
be wrong, the careful analyst knows that it will be values, but even then they don t contribute the oth-
low, not high, and why. er managerial insights that flow naturally from the
The key to using ECF is to begin the analysis at a structure of an ECF analysis.
point in the future beyond the period in which de-
fault risk is high. At that point, an analyst can es-
Learning New Tools:
tablish a future value for the equity using conven-
Costs and Benefits
tional DCF methods. Then ECF works backward
year by year to the present, carefully accounting for As companies adopt valuation techniques made
yearly cash flows and changes in risk along the way, more powerful or accessible by desktop computers,
until it arrives at a present value. The procedure is the good news is that the tools a generalist needs
quite straightforward when built into a spread- are not very hard to learn. The time and effort nec-
sheet, and if certain formulaic rules are adopted for essary before the techniques pay off naturally will
depend on a company s situation and
its current finance capabilities.
Benefits will be high for compa-
As companies adopt new
nies that expect to invest heavily in
the near future. For them, the subop-
valuation techniques, the good
timal execution of a large, multiyear
investment program will be costly.
news is that the tools a generalist
Consider, for example, an industry
such as telecommunications, in
needs are not very hard to learn.
which capital intensity is coupled
with rapid growth and technological
moving from later to earlier years, ECF s biases con- change. Success requires a sequence of good invest-
trive to underestimate the true equity value. The ments, and getting even one of them wrong can be
formulaic rules amount to an assumption that bor- very expensive. Or consider industries with only a
rowers will not really walk away from the debt few significant players that compete head-on in
even when it is in their best interests to do so. Obvi- nearly all aspects of their businesses. Companies
ously, this assumption deprives them of something able to take swift advantage of a competitor s mis-
valuable in real life, they might indeed walk away, takes should expect the benefits of insightful analy-
so the real-life equity is more valuable than the ses and the penalties for poor analyses to be par-
contrived substitute. ticularly high. Similarly, any company working
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A Taxonomy of Valuation Problems and Methods
Where are the different types of valuation problems encountered?
Think of a stylized balanced sheet for the business.
Balance sheet
Assets Liabilities and equity
Past investment decisions 1. Operations (assets-in-place) Debt claims
Future investment decisions 2. Opportunities (real options) 3. Equity claims Securities issued
Each type of problem calls for a different valuation method.
Companies use a broad range of valuation methodologies.
Problem types Recommended valuation A sampling of alternative valuation methods
method
less formal more formal
EBIT WACC-based
Sales multiples
multiples DCF
1. Operations Adjusted present value
Cash-flow Monte Carlo
Book-value
(assets-in-place)
multiples simulation
multiples
Installed-base
Simulation;
multiples
scenario analysis
2. Opportunities Simple option pricing
Fancy option
Decision
(real options) Customer,
pricing
trees
subscriber multiples
Net income
WACC-based DCF,
multiples Simulation;
3. Equity claims Equity cash flow
minus debt
scenario analysis
P/E ratios
now to exploit a first-mover advantage is highly de- time to learn. My experience is that executives al-
pendent on the success of early investments. ready schooled in WACC can learn the basics of
The costs of upgrading capabilities are likely to APV in about two hours, either on their own or
be low for companies that meet one or more of the with an instructor. Within another half a day, peo-
following three criteria: ple already comfortable with spreadsheet software
They already use DCF valuation in their capital- are able to apply APV effectively to real problems.
budgeting processes and have built the related sys- Today it is no exaggeration to say that a company
tems for use on desktop computers. not using spreadsheets for valuation is far behind
They have many managers, not just finance staff, the times. And companies that are using spread-
who are already comfortable with the basics of sheets, but not APV, are underutilizing their soft-
modern corporate finance and will not find the new ware. Generally speaking, systems that can accom-
tools difficult to acquire. modate WACC can handle APV.
They are currently upgrading their staff capabili- Option Pricing. This tool is costlier. There s more
ties for other reasons, so the incremental cost of in- to learn, and for some people, it is less intuitive.
stalling a better system is minor. Nevertheless, it is by no means inaccessible. Basic
Let s look at what s involved in learning the three option pricing can be learned from a textbook.
valuation methods: What is more difficult is the application of this tool
Adjusted Present Value. There are few tools as to corporate problems, as opposed to simple puts
powerful and versatile as APV that require as little and calls.
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WHAT S IT WORTH?
Corporate applications require a synthesis of op- project and trade finance, mergers and acquisitions,
tion pricing and DCF-based valuation; that is, a way buyouts, and joint ventures and alliances.
to use DCF outputs as option-pricing inputs and Adapting ECF and corporate systems to each oth-
a way to reconcile the different values generated by er is not necessarily difficult or costly but needs to
each methodology. Simple frameworks embodying be assessed case by case. ECF is a more specialized
such a synthesis can be learned in a day or less. Sim- valuation tool than either APV or option pricing be-
ple applications require another day. Normally, half cause it addresses a more specific question. APV
of this time is devoted to running numbers and the and option pricing ask, What is the value of this
other half to the more subtle but important tasks bundle of operations and opportunities? In contrast,
of interpreting and qualifying results and exploring ECF asks, What is the value of an equity claim on
the limitations of both the framework and the this bundle of assets and opportunities, assuming
methodology. they are financed in this fashion? ECF therefore re-
Option pricing does not fit naturally into most quires more support or, at a minimum, more inputs
companies existing capital-budgeting systems. from corporate financial and capital-budgeting sys-
Neither, for that matter, do tools such as decision- tems. But presumably, a company engaged in signif-
tree analysis, simulation, or scenario analysis, icant numbers of joint ventures or project financ-
which are sometimes offered as alternatives to op- ings, for example, must support these activities
tion pricing. Thus, the most practical way to be- anyway, regardless of the valuation tools it chooses
gin using options-based analyses is to run them in to build into a particular system.
sequence with DCF analyses. I mean that in two
senses: first, in the sense that you do option pricing For most companies, getting from where they are
after you ve already done a DCF analysis, to com- now to this vision of the future is not a corporate fi-
plement, not replace, the latter; and second, in the nance problem the financial theories are ready
sense that outputs from a DCF analysis (such as and waiting but an organizational development
present values and capital expenditures) become in- project. Motivated employees trying to do a better
puts for option-pricing (such as underlying asset job and advance their careers will naturally spend
value and exercise price). Most companies will not time learning new skills, even financial skills. That
find it worthwhile to build separate systems to sup- is already happening. The next step is to use this
port each methodology. Indeed, if DCF and option broadening base of knowledge as a platform to sup-
pricing are set up as mutually exclusive rivals you port an enhanced corporate capability to allocate
pick one or the other, but not both option pricing and manage resources effectively.
will lose, for now. An active approach to developing new valuation
Eventually, many companies will locate their capabilities that is, deciding where you want your
most high-powered technical expertise within a company to go and how to get there should allow
small finance or business-development group. The you to develop those capabilities faster than a pas-
rest of the company, both line managers and top- sive, laissez-faire approach, and it ought to yield
level managers, will be trained to use that resource more focused and powerful results. Of course, it s
effectively. Therefore, the ability to formulate sim- also probably more expensive. However, the ques-
ple option-pricing analyses will be widespread. If tion is not whether it s cheaper to let nature take its
only the specialists know anything about valuing course, but whether the more powerful corporate
opportunities, either of two unattractive outcomes capability will pay for itself. That is, how much is
is likely: the model-builders will become high that capability worth?
priests who dominate the capital-budgeting pro-
1. See Stewart C. Myers, Interactions of Corporate Financing and Invest-
cess; or they will become irrelevant geeks whose
ment Decisions Implications for Capital Budgeting, Journal of Finance,
vol. 29, March 1974, pp. 1-25. APV is sometimes called valuation in parts
valuable talents go unexploited.
or valuation by components.
Equity Cash Flows. Managers already familiar
2. For a more formal and extended discussion of such options, see Avinash
with some kind of DCF valuation tool can learn
K. Dixit and Robert S. Pindyck, The Options Approach to Capital Invest-
ment, HBR May-June 1995, pp. 105-15. In particular, Dixit and Pindyck
ECF, along with a basic application, in less than a
highlight the common, critically important characteristic of irreversibili-
day. Companies that might be heavy users of this
ty in capital investments. When a risky investment is both irreversible
and deferrable, common sense suggests waiting to invest.
tool will want to adapt it to the particular kind of
3. For the model, see Fischer Black and Myron Scholes, The Pricing of
business or transactions they engage in most fre-
Options and Corporate Liabilities, Journal of Political Economy, vol. 81,
quently. Probably the most common uses are in May-June 1973, pp. 637-54.
Reprint 97305 To place an order, call 1-800-545-7685.
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