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Chapter
1: One Map of Value
The modern corporation faces a wide range of growth opportunities, from business-as-usual to e-commerce to corporate venture capital. Large companies make 2,000 to 10,000 capital investment decisions each year, yet we fail to credibly value growth projects. This chapter argues for a transparent approach to valuation that works for all types of growth opportunities and that aligns internal corporate valuations with financial market pricing of growth. A new approach to valuing growth leads to meaningful comparisons: Let’s put the sweep of corporate growth opportunities on one map of value. Here’s a simple exercise that demonstrates the importance of growth opportunities in corporate value. Pick a public company and get its current earnings. Assume the earnings stay at that level forever. Compare how much you are willing to pay for a share in the no-growth firm with the current stock price. Typically growth accounts for more than 75% of the value a company. Can you tell a story about the growth opportunities that supports the value of growth? Can you include reasonable numbers to back it up? Although simple, this short exercise is often difficult. Growth opportunities are uncertain. They need to be managed in a dynamic environment. Growth opportunities are a huge part of value, but we lack a lens to see their structure, a language to describe their features, and tools to quantify their value.
Growth opportunities are always risky, and consequently, they stir our emotions. Conversations about growth opportunities often stall. Suppose I'm your boss. As I talk about my growth vision, you get nervous, waiting for me to ask you to make a risky career move, to support a risky project or to attempt a stretch goal. Growth opportunities are a volatile combination of risk and people, and your reactions will shape the outcome. There's no avoiding the emotions of risk. An objective look at growth opportunities can help to defuse tension. Often we don't have a clear image of the growth opportunity and thus can't even begin to value it. This chapter identifies the features of a growth opportunity that most affect value and introduces a new verbal and visual language to describe them. The description of growth opportunities focuses on three diagnostic questions:
Chapter 3: Discounted Cash Flow - Valuing Sustainable Growth This is a book about the world of growth opportunities- big ideas, big visions, big upside potential. So why is the first tool in the expanded, growth-focused toolkit discounted cash flow? For two reasons: DCF is the right tool for valuing certain types of growth; and DCF is needed to complement decision analysis and real options in other growth opportunities. Think about restaurants, retail, and consulting. All are well?established industries with mature companies. New companies enter, but they use the same business models as the incumbents. This chapter takes a close look at the assumptions, and the misapplications, of DCF, the most often used valuation tool. The chapter uses the IPO of KPMG as an example of the challenges of using DCF in practice. Chapter 4: Real Options - Valuing Expansion Opportunities Real options has attracted much interest in recent years, particularly from corporations interested in using the real options approach to identify and articulate growth opportunities. This chapter shows how the tool can be used to quantify the value of upside potential. The calculations are made easy by the use of option value lookup tables. The chapter also identifies when and where the real options tool fails to correctly value growth. An example based on Amazon.com demonstrates how to logically bound the size of an expansion option. Much of the recent interest in the real options approach to valuation has been sparked by the desire to logically value public Internet companies. The search for an explanation of their high value became a search for a new valuation perspective. Arriving on the scene at the same time were a slew of books and articles introducing the real option approach to managers. The match was only somewhat fruitful. Two problems surfaced:
In practice, real options analysts have tried to thoughtfully extend real options to include private risk. But this has been done in an ad hoc manner, making it difficult for others to understand the extensions and use the results. Chapter 5: Decision Analysis - Designing Growth Opportunities Academics have long studied decision making under uncertainty. In the late 1960s, this work emerged as a separate field: decision analysis. While most of us are familiar with decision trees, the field of decision analysis is more systematic and rigorous than the simple (but very useful) decision trees suggest. How can decision analysis be used to value growth opportunities? This chapter takes a very focused approach to this question. Decision analysis is a much-needed addition to the expanded toolkit. DCF captures mature business opportunities, when it is expected that upcoming investment decisions will move forward as per plan. There's uncertainty, but managers don't anticipate changing the strategic plan in response to any of the outcomes. Real options captures the cases in which the magnitude of uncertainty is expected to change strategic plans. But in real options, the market-priced risk alone changes investment decisions. Typically, however, the most important contingent decisions in a growth opportunity are triggered by private risk. Decision analysis addresses this feature. Chapter 6: Tailored Valuation Templates Current tools fail to value growth opportunities for two reasons. First, they often fail to capture the important features of growth, particularly the nature of the risk and the presence of contingent decisions. When these features are ignored by valuation tools, the results feel irrelevant. The tools described in the previous chapters address this problem. But, there's another reason valuation tools fail growth opportunities: The tools, even those in the expanded tool kit, are too dense and too confusing for regular business use. A successful valuation tool is easy to use and clearly communicates the method and results. Only then will the results be used by a wide array of professionals inside and outside the firm. Chapter 6 introduces valuation templates, a method of calculation based on tailoring the expanded toolkit to the features of the growth opportunity at hand. Built on pre-calculated formulas and pre-codified data, valuation templates are designed for ease of use and clarity. Further, because they exploit the expanded toolkit, the templates quantify the value the important features of growth opportunities. Changing the form of the valuation tool creates an opportunity to be credible, clear, and useful to managers in everyday business life. Chapter 7: Valuing Staged Growth Staged growth opportunities require years of spending before a possible reward. Typically the stages are defined by budget cycles or when new information is revealed. Most growth opportunities have these features. Typically, the calculations for valuing staged growth projects are messy and opaque. Further, these calculations seldom incorporate market-priced risk, but as Chapter 6 shows, the presence of this factor changes project value and decisions. Chapter 7 shows how to build a valuation template for staged growth with private and market-priced risk. The chapter closes with applications of the template to the value of Webvan and to the impact of genomics on pharmaceutical drug development. Chapter 8: Growth Value Benchmarks from Venture Capital Venture capitalists - the partners in venture capital funds -- routinely value and invest in cash-needy growth opportunities. In recent years, venture capital has been a glamour industry. For example, the six partners at Benchmark Capital split a $1.5 billion gain from that firm's investment in Ebay. But by the end of 2001, the venture climate had chilled. Returns to previous investments appeared to be dismal and venture capitalists dramatically slowed their pace of investment in new start-ups. Ironically, venture capitalists were managing more money in 2001 than ever before -- funds waiting to be invested in start-ups. This chapter captures some of the expertise of a venture capitalist in a template for valuing venture-funded start-ups. The results quantify the large amount of private risk in venture-funded growth opportunities and the significant impact of stock market fluctuations on private equity value. The venture capital template is also used to value public company start-ups, those companies that historically would have remained private, but went public in the boom of 1999 and 2000. Chapter 9: A Close Look at Market-Priced Risk Very often managers and consultants focus on the private risk in growth opportunities, and their thinking ignores the role of market-priced risk. Managers with technical training -- a type that often leads a growth project-- feel far removed from the financial markets. They have a lot of skepticism about the rationality of stock market pricing. Much of this book was written in late 2000 and early 2001. Frankly, it is a challenge to write about the logic of valuation when the stock market plunges with each passing month. When high-flying growth companies such as Cisco, Intel, Yahoo! and Amazon.com have market values less than 20 percent of the year before, some readers might question a basic argument in this book-that private growth opportunity valuations should be aligned with valuations in the financial markets. Chapter 9 takes a close look at stock market valuations, and how well the expanded toolkit explains stock prices. It also addresses how the alignment of public market and private market valuations can enhance the ability of growth opportunities to attract funding. Chapter 10: Showing Value to Wall Street - Film Studios Movies are fun to see, and the movie business is fun to think about. Yet, it appears that this is a money-losing business. In 2000, the average cost to make and advertise a film was $78 million, while worldwide box office revenues per film were only $64 million. For years, films have lost money on average. It is no surprise that equity analysts have had a message to film studios: Make fewer movies. Traditional accounting and DCF measures show that films lose money on average. Yet, there seems to be value in a film studio - look at Disney, MGM, and Time Warner, look at the transaction prices of film libraries. This chapter reconciles these observations, using the expanded toolkit to revisit the value of motion-picture production and the film studio business model. Chapter 11: Valuing More than the Idea - Intellectual Property Intellectual property (IP) is a magical notion: Somehow we can get paid for our ideas. And in recent years this magic has gone further. Texas Instruments routinely makes $500 million a year from licensing its IP; 15 percent of IBM's profits in 2000 - more than $1.7 billion -- came from its IP licenses. Intellectual property appears to be a valuable asset in our modern economy. Yet we lack a credible valuation approach for intellectual property. This slows transactions and complicates compliance with new accounting standards. Without quantitative benchmarks, intellectual property is often overvalued: It takes more than a patent to build a new business. This chapter lays out a valuation model for intellectual property and looks at the business model of two firms, MIPS Technologies and ARM Holdings, whose sole product is their intellectual property. Chapter 12: Selecting the Investment - Information Technology Why do valuation tools fail? Sometimes a growth opportunity can't be neatly valued - there are too many assumptions, too many poorly defined components, and lots of risk. In other cases, underneath the complexity there's just not a lot of value, there is no long-term sustainable competitive advantage. IT has both these features, making it a good example of why valuation tools fail. This chapter makes two somewhat contentious arguments. The first is about the limits to valuation methods:
These points are illustrated through several topical examples including automation technology for call centers, customer relationship management software, and supply chain initiatives. Chapter 13: Creating the Credible Growth Engine Here's the challenge: On paper your company appears to have lots of growth value. Yet Wall Street doesn't give you any credit. Or, Wall Street did give you credit - and your stock price soared - but now you can't meet their expectations. This chapter is about the corporate growth engine, the set of activities that delivers value year after year. Examples from P&G, Anadarko Petroleum, Texaco and Cargill Dow highlight the hard realities and the successful strategies. A key point : It takes more than good growth projects to build corporate value. Venture capitalists can appear to be cold-blooded about cutting off funding to failing firms. But most companies aren't that disciplined about triaging failing projects, wasting corporate resources by trying to keep them alive. For these companies, venture capital valuation norms would lead to over-valuation of internal projects. The valuation method must reflect actual business practices. This chapter is about the following question "How is the abstract value of a growth opportunity affected by the fact that it is people working in companies that give shape, form, and life to the endeavor?" While the previous thirteen chapters are about how to clearly articulate and establish authoritative, concise, and reliable valuation models, this chapter addresses how the living, human story of growth is captured in the valuation results. The focus is on the leaders, how to lead the shaping of growth ideas, and how to bring a big-picture perspective into corporate processes. Each is a soft issue, yet critically important. For example, without that one person or small team, there is no sparkle, no catalyst, and no growth opportunity. Chapter 14 introduces some of the tension that is intrinsic to growth opportunities: Achieving valuable growth depends on the talents of a few key people. Chapter 15: Marking a Spot on the Map of Value If there's one map of value, where are your growth opportunities located? It's easy to get caught up in tools and techniques, but experience shows that most errors in valuing growth opportunities arise when managers lose sight of the big picture. This chapter contains the closing thoughts that summarize the insights from tools and perspectives in this book. Here's a sample: The Value of a Better Number Right now, we can't have a rational argument about the value of growth opportunities because we don't have the shared images, the common language, or the same set of valuation tools. Valuation arguments are won by the party that holds a key asset -- money, an audit credential, or an important contract - not by a rational argument. A new approach to valuation, which results in a better number, also results in a defensible location on the map of value. Let's use the tools and perspectives in this book and have a rational argument. We can refine the estimate of value through a shared understanding about the value structure of growth. We can mark the spot, and know why it is there, for all of the growth opportunities across the sweep of value. An improved valuation model, a better number, is not the goal. The gain from new valuation tools is to change decisions, to increase choices, and to smooth the way for faster and more valuable growth. The valuation results from improved tools are simply the means to the end.
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