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Q: What's wrong with our current valuation methods? Q: What is the most frequent mistake in valuing growth opportunities? Q: Why did you write about Discounted Cashflow (DCF) in a book about growth opportunities? Q: How do you compare real options, decision analysis and DCF? Q: What is the difference between private risk and market-priced risk? Q. How should a staged-growth opportunity be valued? Q. Can the Value Sweep method be used in venture capital investing? Q. Is there hope that a superior valuation model can explain the level of a company's stock price? Q. How can companies use the methods in Value Sweep for evaluating internal growth projects?
Q: What's wrong with our current valuation methods? Here are some of the key problems:
Q: What is the most frequent mistake in valuing growth opportunities? Not telling a story. The most frequent mistake also leads to enormous valuation errors. Geoff Moore, author of Crossing the Chasm and other books, is now affiliated with a venture capital firm. Moore has a Ph.D. in English, so it is not surprising that he screens startup business plans by their plot development. He treats a business plan like a novel: How might the plot unfold to a successful outcome? Which side character (business partners or technology) must move first? How does the central character (the company) move to center stage? Moore argues that a complete plot line is part of a good business plan.
Q: Why did you write about Discounted Cashflow (DCF) in a book about growth opportunities? 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. The centerpiece of a DCF analysis is the projection of future cash inflows and outflows. What's often not recognized is that these form a strategy roadmap. The investment plan is the result of an optimization; it is the best rollout (timing and amount) of investment, given the sales forecast. DCF does not include contingent decisions; its embedded strategy is "straight ahead."
Q: How do you compare real options, decision analysis and DCF? DCF best values opportunities without contingent decisions while real options and decision analysis best value opportunities with larger level of uncertainty and valuable flexibility. Further, decision analysis is best at capturing the effects of private risk, while real options captures market-priced risk. The following figure is a useful guide to the three valuation tools: Valuation Tools Matched to the Type of Growth Opportunity
Q: What is the difference between private risk and market-priced risk? Private risks are those uncertainties unique to a growth opportunity, and market-priced risks are the uncertainties that also influence the price of traded securities. Examples of private risk include geological uncertainty in oil exploration, technology uncertainty in high-tech, consumer acceptance in consumer goods industries. Oil price risk is a market-priced risk, there is an active market for many oil price securities including futures, options and so on. Similarly many other commodities have market-priced risk. But be careful, one cannot infer market-priced risk from spot prices, the risk is inferred from traded securities in markets that include short selling or its equivalent.
Real options grew out of the method to value financial option contracts. In 1973, when the breakthrough option pricing research was published, the options markets were thinly traded, in part because the traders lacked a clear valuation model. What was so difficult? The option had an uncertain payoff that depended in some way on the stock price. But how? The answer won Robert Merton and Myron Scholes the 1997 Nobel Prize for Economics (Fisher Black, who also originated the theory, died in 1995). The exact mathematical relationship of how the value of an option contract depends on the price of the stock was captured in one formula, the Black-Scholes equation. The solution required only five inputs, four of which can be directly observed. The transparency of logic and the simplicity of the inputs led to an explosion in the volume of traded option contracts and to the practice of financial engineering-use of the same logic to design innovative securities. Since it was developed, the Black-Scholes equation has proven to be a robust pricing model, and it is used widely. From the start, many recognized that corporate growth opportunities had the flavor of financial options. MIT professor Stewart Myers first used the phrase real options in a 1984 paper to highlight corporate growth opportunities. This book relies on easy-to-use real option pricing tools.
As its name suggests, decision analysis method to help managers reach a conclusion. It has been used in a wide range of significant projects -- assessing nuclear power plant risk, deciding wh ether to seed hurricanes, selecting the optimal configuration for probes to Mars. Decision analysis has also become an industry. There are a number of consulting firms and software providers, as well as several start-ups, that target tailored databases and decision-analysis tools to specific industries or business problems. The key to using decision analysis for valuation is in the selection of applications. Often decision analysis is used to structure and make decisions that do not have only monetary objectives - such as when to expensive pre-natal testing. In this book decision analysis is used for valuation and this requires all of the objectives and gains to be measured in financial terms.
Q. How should a staged-growth opportunity be valued? Staged-growth opportunities are a series of investments that finally have a payoff. The hard issue for valuation is that any potential gains can be years away. But using a combination of real options and decision analysis, Value Sweep shows how to value staged growth opportunities in a straight-forward way and in calibration with stock market pricing. For example, imagine you are starting a microbrewery and at maturity you expect to have a company that is similar to Sam Adams. The current pricing of Sam Adams, or similar companies, by the stock market will determine the value of your ultimate goal. But between today and that final outcome are a series of risky investments. Value Sweep shows how to organize information about the size of the investment, the time it takes to resolve risk and the magnitude of the risk so that the early stages can be valued. For example, if the payoff (being like Sam Adams) is 100, the framework can be used to show that a Sam Adams-like startup with customers might be worth 30 and a Sam Adams startup that is just beginning might be worth 3. (See Chapter 7)
Q. Can the Value Sweep method be used in venture capital investing? First, let's be clear: venture capitalists don't use and generally don't want a new valuation tool. In practice, venture capitalists simultaneously determine the value of the startup and the amount they will invest through negotiations with the entrepreneurs. The results are determined by balancing a number of issues, many of which are not captured in formal models. But, models can be built that capture two effects in venture capital pricing: pricing by stage of the company; and pricing by level of the stock market. (See Chapter 8.) An interesting result is that the model shows how a change in stock market pricing, say of mature high-tech firms, leads to relatively larger changes in the valuations of start-ups in the same space. For example, if Intel falls 20%, then the value of startup semiconductor companies can fall by 40% or more. The model puts some rationality and quantitative benchmarks behind the "down" rounds of venture capital financing in the last two years. (A down round is when the valuation of the company is less than at the previous financing, regardless of technology or customer accomplishments.) While the model can explain aggregate behavior and drivers, on a deal-by-deal basis venture capitalist will continue to use rules-of-thumb and recent deals as their main pricing methods because of the many other factors a play to closing a reasonable deal.
Q. Is there hope that a superior valuation model can explain the level of a company's stock price? In the dot.com craze, many decided that the stock market was irrationally pricing these companies. Now, in our more tempered times, can one find a way to "rationally" explain stock prices? My own answer is that the tools are not surgical instruments - they are not able to dissect stock prices down to the last penny. They are useful as windows into the structure of value, as indicators of which questions to ask management and as sorting devices (buy, sell, hold) for long-term investment strategies. For example, in April 1999 one industry analyst issued a report showing that cable companies were trading at their DCF value, but that the companies held a tangible option for expansion. Recognizing the option and the arguments behind it showed that the sector was undervalued. Stock prices for cable companies rose upon the release of the report. (See Chapter 4.) But valuation models will not be able to tell you -- with any reasonable precision - whether Amazon should trade at $14 per share or $17 per share. Our tools are not that precise.
Q. How can companies use the methods in Value Sweep for evaluating internal growth projects? There are three immediate takeaways for companies from Value Sweep.
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