Some afternoons dog walking I bump into Maurice (human) and Maggie (Labradoodle) and aside from dog discipline the conversation turns to valuation techniques. Maurice is an expert in valuing high tech companies. The answer? You could read this article from AFR Boss in 2002 and have a crack at Real Options Theory. Or it could be that value is in the eye of the beholder.
What’s it worth?
WHEN a model becomes standard, two things happen: critics start to pick holes in it, and innovators look at ways to improve it. After 30 years of service, this is what is happening to the foundation of financial forecasting, the capital asset pricing model (CAPM).
First, the critics. They’re led by Melbourne actuary and academic, Richard Fitzherbert, who says CAPM – a method of valuing future assets to compare them against the value of the original outlay – is substantially flawed. He outlined his radical opinion last year in a paper called "Volatility, beta and return. Was there ever a meaningful relationship?"
To illustrate, he used the example of $1 million invested in shares on the New York Stock Exchange in 1931. CAPM would value that portfolio at $2.4 billion after 35 years. His calculations, using the benefit of hindsight and the S&P Index, put the portfolio closer to $90 million. His problem with the CAPM is its overemphasis of the relationship between risk and return. “A model is not much use if it doesn’t at least imitate the real world in some sense,” he told The Age newspaper at the time. There was some disagreement, but many actuaries conceded that Fitzherbert had a valid point.
Across the globe, companies pay ever-increasing amounts to acquire assets or develop new markets. How can they be sure they are getting the best deal for shareholders and the future health and wealth of the organisation? For every startling acquisition or successful product development, there is a skeleton – sometimes of FAI’s calibre or NAB’s Homeside – lurking in the cupboard. The people crunching the numbers, and their tried-and-tested methods, are under unprecedented pressure to avoid disasters.
Cash flow-based valuation methods and CAPM are still the foundation stones of the MBA finance syllabus, and many blue-chip companies, including Telstra and Holden, still use them. For now.
Rae Weston, professor of management at the Macquarie Graduate School of Management, maintains that it is mainly academics from the US who are clinging to CAPM. “It’s a huge waste of time,” she declares. While Macquarie’s students are taught the CAPM, Weston is at pains to explain to students why the model doesn’t work. She argues that the method’s failing is its use of a single risk factor. In calculating that risk factor (known as ?), the Australian stock market – with, for example, News Corporation taking up about 9 per cent of the capitalisation of the ASX100 (in late May) – is not diversified enough and too volatile.
Weston says that in reality several discount rates should be used for any one project. The problem with using the CAPM is that it is only valid on the day of calculation. It won’t factor in interest rate rises, stock market booms or crashes – or world-shattering events such as September 11.
“In recent years we have had a lot of short-term volatility,” says Weston. “We’ve been having more interest rate movements in a year than in the whole of the 1950s and 60s put together. Volatility means that ?s are not stable. They clearly are not.” With one analysis of the volatility of a company’s shares varying daily, “your decision on what project you fund depends whether it is Monday or Friday,” she says.
Others reckon traditional methods are still valuable.
Paul Rizzo, a former Telstra CFO and dean of the Melbourne Business School, says: “I think if I summarised 35 years of experience, the basics are more relevant today than at any other time.” And Richard Stewart, corporate finance and recovery partner at PricewaterhouseCoopers, says: “I think it would be premature to say that discounted cash flow is no longer of any use.”
According to Stewart, while CAPM is still used, there are projects where a great deal of care needs to be taken. “When you’ve got a start-up situation a discounted cash flow will often lead you down the wrong path,” he says. “You tend to use a discount rate to try and capture a whole lot of other risks and you end up with a negative number, which means you don’t go ahead.”
Now, the innovators. The vogue is to use real options valuation, which is similar in method to the valuation of stock options. This technique often breaks down a project into a number of milestones and assigns a value to the option to proceed on a project. It allows management the flexibility to start, close, defer or incrementally invest by valuing a project’s option price. It is particularly useful for industries where there is a lot of R&D or risk.
Stewart says real options valuation helps management understand the benefit of spending a little bit of money rather than dropping “a whole bunch of change”. “Option valuation techniques have the greatest value where it’s on the cusp of a yes or no decision. As you find out more about the success of that project, the risks of the subsequent valuations change. “Real options valuation quantifies that decision and avoids the situation when people say ‘I need to make a decision that doesn’t stack up on paper; I need to make it because it’s strategically the right thing to do’.” Useful though the real options technique is, few use it. Michael Mileo, corporate adviser at valuation specialist Leadenhall, says: “It’s got a long way to go before general widespread acceptance.”
One of the most authoritative texts on the subject is Real Options: A practitioner’s guide by Tom Copeland and Vladimir Antikarov. But like many other texts on the subject, it is difficult for anyone but specialists to understand.
Mileo, who recently reviewed current valuation techniques for a client, says that he hasn’t used real options valuation in Australia. “The only issue with real options is whether it is understood. We have found that people in boardrooms don’t adequately get their head around it. It’s still a little complex to understand for the average person who’s not financial.”
Traditionally real options has been the preserve of the more sophisticated companies in the energy, pharmaceutical or new-media industries. It is used by companies such as Merck, Dell, Philips Electronics, ABB, BP and, locally, BHP Billiton.
BHP Billiton’s global practice leader of uncertainty management, Geoff McKinley, wants to cut through the academic hype associated with real options. He says the company is concerned with applying the technique to the real world, where there is a difference between a physical asset and an option. “We are looking at practical applications (for real options),” he says. “It is terribly complicated and fraught with pitfalls for real assets. The big debate is between the academics and the realists, who know that real assets aren’t as liquid as options.”
For most of 2001 BHP Billiton trialled real options to assess the financial viability of its R&D projects. Ten projects were selected: three in the petroleum sector, four in minerals and three in steel.
“We started to apply it to R&D projects because there is lots of uncertainty with R&D,” says technology planning and assessment manager Ross Davies, who now works with the uncertainty management team to apply real options throughout the company’s projects. “They were being unfairly dealt with by conventional methods of valuation. We picked those we thought would need large amounts of money, or could be difficult projects or would be very risky.”
Davies says conventional DCF methods of valuation are “very deterministic”. They come up with a single number to indicate viability. Previously, BHP used net present value (NPV) to calculate a distribution of answers under different financial conditions. “If you’re not using real options you have to make all the decisions up front,” says Davies. “With real options those decisions can be made later in the process.”
Other problems with NPV calculations are that they use a single risk rate and are volatile to expectations of success.
In the real world, management likes simple techniques. Guy Ford, a lecturer in management at the Macquarie Graduate School of Management, says many MBA students claim that in business they use a discount rate of 10 per cent – to simplify calculations. Such models could mean that companies may be dismissing viable projects as unprofitable. PWC’s Stewart says: “There are projects and companies where it is inappropriate to use just the 10 per cent, particularly in smaller companies.” And Mileo agrees: “Absolutely, it is naive. No two projects are the same within any organisation . . . With any modelling, the validity and appropriateness of the outcomes is based on knowing the right questions to ask.”
Rizzo says that valuations of short-term projects with fixed costs are approached differently to more complex longer-term projects. He believes that for large investment a belt and braces approach is best: “The larger the investment, the more cross-checking you do.” This means using techniques such as net present value, internal rate of return and capital asset pricing model. “There is no one right answer from these methods,” says Rizzo. “They are only decision aids.”
CAPM
Economists William F Sharpe, Harry Markowitz and Merton Miller shared the 1990 Nobel Prize for economics for developing the capital asset pricing model (CAPM) in the 1950s and 60s. CAPM correlates the risk of investing in a company with return. Risk is divided into alpha (the competency of the company’s management) and beta (the volatility of the market). Alpha can be eliminated by diversifying the investment portfolio, leaving beta as the main variable. Beta is used as a discount factor in discounted cash flow calculations. Put simply, these calculations take the sum of net cash flows discounted by the beta factor over a period of time. Besides portfolio managers, CAPM is now used by companies to calculate the viability of projects and brand valuation. CAPM is less reliable in Australia because the stockmarket volatility is overly dependent on a few large stocks, such as News Ltd, which dictate local market movements.
REAL OPTIONS
Real options asks the question: what will be the value of pursuing this project at various given dates? It gives management the chance to look at options to defer, alter the scale, abandon or sell to somebody else. The theory is almost an exact parallel to stock market options theory. If an investor has an option to buy a share for $100 over the next three months and the actual price is $105, then clearly the option is worth near $105. If the share price is $95, there is still value in the option as there is three months left to run. Real options is most valuable for investments in risky projects such as oil fields and pharmaceutical products. It is also being used for IT investments. In making the calculation on a spreadsheet, real options uses the same basic formula as a net present value calculation, but breaks the project down using decision-tree analysis – which allows management to examine many different scenarios.
REINVENTING THE MONARO
“Skunkworks” is motor industry jargon for the prototypes engineers and designers build in their spare time. For many industries these activities might be an annoyance. But at Holden they are the lifeblood of new investment, such as the new Monaro. In 1998 one particular project flew under the radar to the attention of Peter Hanenberger, then executive director of technical development at German sister company Opel. It was nothing more than a concept car – a one-off blue sky vehicle. But in June 1999, when Hanenberger arrived in Australia as chairman and managing director of Holden, three months of number crunching began. His team began building a business case for production of the vehicle. “In September we made the decision to do this vehicle. We were all of the opinion that this was the vehicle that we needed to do.”
Hanenberger says the decision was not wholly financial – there were many emotional factors. The idea was to launch a flagship car for Holden, building on the 1970s nostalgia and popularity of the original Monaro; the car would enhance its brand image among consumers and unleash the imagination of staff. He says: “Here was this beautiful car; for excitement and the brand we had to do it because it was just an icon vehicle.”
Hanenberger explains: “We had a synergy. We had a beautiful sports car, on the one hand, which everybody loved. We had a name sitting there that had all this heritage. We did it to give this company a new kind of an imagination.”
During the number crunching the Monaro team used common techniques, all of which are based on discounted cash flows, and analyse the economic sensitivity of the project.
Bernhard Lothschuetz, executive director, finance, says: “DCF covered internal rate of return and payback as well as net present value. It is all part of the same process, the methodology we usually use to evaluate business cases. Over and above this we look at car line profitability, net margin and what our program delivers over the longer term.
“But these are all to a large degree technical aspects – there are also strategic considerations in a business case you have to cover as well.”
Hanenberger says that a sensitivity analysis – what could go right as well as wrong – was especially important because of the car’s relatively low volumes. Hanenberger reckons 4,000 to 4,500 Monaros, costing between $47,990 and $56,990, will be shifted in 2002, but admits that predicting sales for the second year are difficult because its sales are dictated by the vagaries of the zeitgeist.
With $40 million invested in plant and equipment, and about $20 million on engineering and design, Hanenberger expects to see profitability within two years.
Key to the calculation is assessing the risk of the project. Like many others, Holden uses the capital asset pricing model (CAPM) in assessing a discount rate. Lothschuetz says: “The risk depends very much on the revenue stream as well and what kind of price you can achieve in the marketplace. I think it determines to a large degree what your break-even point is. Then a lot of judgment and market intelligence comes into play in assessing what volumes we can presumably achieve in the marketplace. We can pretty much assess what our risk profile is.”
Reading list
* Australian valuation handbook (CD-ROM) Tim Lebbon Centre for Professional Development, June 2000
* Real options: A practitioner’s guide Tom Copeland and Vladimir Antikarov Texere, February 2001
* Valuation: Measuring and managing the value of companies McKinsey & Company, Tom Copeland, Tim Koller and Jack Murrin John Wiley & Sons, July 2000, third edition
* The dark side of valuation Aswath Damodaran Financial Times, Prentice Hall, February 2001
* Valuation matters Alfred Rappaport and Michael J. Mauboussin Harvard Business Review, March 2002
* What’s it worth? A general manager’s guide to valuation Timothy A. Luehrman Harvard Business Review, May-June 1997
* Real options, real opportunities James Alleman optimizemag.com January, 2002