is valuation methods - insights from capital markets theory and practice – institut für...
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IS Valuation MethodsIS Valuation Methods- Insights from Capital Markets Theory and Practice –- Insights from Capital Markets Theory and Practice –
Institut für WirtschaftsinformatikJ. W. Goethe University
Institute of Information SystemsJ. W. Goethe University
Mertonstraße 17, D-60054 Frankfurt am Main [email protected]
http://www.wiwi.uni-frankfurt.de/~tweitzel
Tim Weitzel, Cornelia Gellings, Daniel Beimborn, Wolfgang König
Research FrameworkResearch Framework
E-Finance Lab at Frankfurt University
„towards an industrialization of financial services“
smart sourcing „how can I evaluate different sourcing strategies?“
smart selling„how can I generate new revenue streams?“
The valuation problemThe valuation problem
IS valuation has long been a core IS research challenge
ROA for overcoming methodological shortcomings of NPV, esp. coping with uncertainties concerning?
the costs and benefits (“value”) of IS infrastructure flexibility
the costs and benefits implied by postponing IS investments (“option” to invest later)
the costs and benefits of partial investments
Goal: learn from capital markets about coping with uncertainty
how do capital markets valuate IT companies in theory and practice?
to what extent can we learn from them concerning the question of the true value underlying IS?
characteristics of IT investmentscharacteristics of IT investments
Information technology:
- uncertainty concerning future development- markets with network effects (standardization) - high innovation speed
IT investments
- often no direct monetary value/revenue impact- often long-term and adaptive- rarely profitable from beginning
Implications:
- no stopping rule for investments- quantify uncertainty and flexibility
IS sourcingIS sourcing
deciding on IS infrastructure
„Infrastructure is a necessary investment that business units of functional areas are unlikely to make“ [Taudes et al. 1999]
how to measure the value impact of IS investments?
how to evaluate and price ISIS sourcing decisions?
valuation approachesvaluation approaches
analogy: true value of software firms
value determination key challenge in IPO price determination
standard methods used in investment banking practise
DCFcomparable companiesreal options?
DCF determination of Intrinsic Asset ValueDCF determination of Intrinsic Asset Value
Discounted Cash Flow Approach
estimate future cash flows
estimate discount rates (reflects the risk involved)
estimate growth rate
estimate terminal value
)t(r)ED(
Dr
)DE(
EWACC de
1
Tt
tTt
t
)WACC(
ValueTerminal
)WACC(
FCFFlowsCashFreeofValuePresent
1 11
g r o w th p e r io d p e r io d o f s ta b le g r o w th
Revenue Forecasts
Cost and MarginForecasts
Change inWorking Capital
Capital Expenditures
Based onStable Growth Model, i.e.company’s cash flows beyondterminal year will grow at atconstant rate forever
2007
=
….
=
2002
=
2001Projections
Sales-Operating Cost= Earnings Before, Interest,Taxes , Depreciation and Amortization (EBITDA)
- Depreciation and amortisation
= Earnings Before Interest and Taxes (EBIT)
-Taxes (on EBIT)-Delta Working Capital-Capital Expenditure+Depreciation
= Free Cash Flow
Terminal Value
= Terminal Value
Net Present Value
Discounting
Advantages
analytically correct (based on assumptions of CAPM)
no impact of volatile market conditions
incorporates relative riskiness (discount rate derived from WACC)
no influence of accounting rules ( based on projected cash flow)
Shortcomings
esp. software sector characterized by fast change, often multiple options for future strategies occur which DCF does not capture
no consideration of management options, future investment opportunities, flexibility
terminal value often > 50% (sensitive to growth estimation)
beta estimation depends on choice of index
DCF approach depends on industry expertise of valuer
works best if cash flows are subject to little uncertainty and company is managed by static management team
DCF value of SAPDCF value of SAP
The DCF valuation of SAP
sum of cash flows: € 23,530.31 MM
WACC: 9% (beta = 1.15; risk free rate = 4.0%)
total NPV of all cash flows: € 12,715.81 MM
growth rate 4.5% (typical of software companies) terminal value of € 89,478 MM NPV of TV = € 34,675 MM.
total NPV of €MM 47,391
NPV/share € 151
actual market capitalization of SAP €MM 45,000 (€151.07/share)
sensitivity analysissensitivity analysis
[in € MM]
2001E 2002E 2003E 2004E 2005E 2006E 2007E 2008E 2009E 2010E 2011E Sum TVSales 7,400.00 8,510.00 9,786.50 11,254.48 12,830.10 14,626.32 16,527.74 18,676.34 20,917.50 23,427.60 26,004.64 169,961.22 28,865.15Growth Rate 15% 15% 15% 14% 14% 13% 13% 12% 12% 11% 11%EBIT 1,443.00 1,659.45 1,908.37 2,194.62 3,849.03 4,387.89 4,958.32 5,602.90 6,275.25 7,028.28 7,801.39 8,659.55
EBIT margin 0.20 0.20 0.20 0.20 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.3Tax -548.34 -630.59 -687.01 -702.28 -1,231.69 -1,404.13 -1,586.66 -1,792.93 -2,008.08 -2,249.05 -2,496.45 -2,771.05Tax rate 0.38 0.38 0.36 0.32 0.32 0.32 0.32 0.32 0.32 0.32 0.32 0.32Depreciation 230.00 270.00 320.00 380.00 451.00 535.00 634.00 751.00 889.00 1,052.00 1,293.00 1496
Earnings 1,124.66 1,298.86 1,541.36 1,872.34 3,068.34 3,518.77 4,005.66 4,560.97 5,156.17 5,831.23 6,597.95 7,384.49Capital Expenditures -250.00 -270.00 -320.00 -380.00 -451.00 -535.00 -634.00 -751.00 -889.00 -1,052.00 -1,254.00 -1385Delta Working Capital -427.00 -280.00 -367.00 536.00 -632.00 -746.00 -880.00 -1,039.00 -1,226.00 -1,446.00 -1,753.00 -1973Free Cash Flow 447.66 748.86 854.36 2,028.34 1,985.34 2,237.77 2,491.66 2,770.97 3,041.17 3,333.23 3,590.95 23,530.31 4,026.49
410.70 630.30 659.72 1,436.93 1,290.34 1,334.31 1,363.02 1,390.66 1,400.24 1,407.99 1,391.61 12,715.81NPV of CF 12,715.81
Terminal Value NPV of TVTerminal growth rate Terminal growth rate
4.0% 4.5% 5.0% 4.0% 4.5% 5.0%8.5% 89,478 100,662 115,043 8.5% 36,474 41,034 46,896
WACC 9.0% 80,530 89,478 100,662 WACC 9.0% 31,208 34,675 39,0109.5% 73,209 80,530 89,478 9.5% 26,978 29,676 32,973
Total Net Present Value NPV per share
Terminal growth rate Terminal growth rate4.0% 4.5% 5.0% 4.0% 4.5% 5.0%
8.5% 49,190 53,749 59,611 8.5% 157 171 190WACC 9.0% 43,924 47,391 51,726 WACC 9.0% 140 151 165
9.5% 39,694 42,392 45,689 9.5% 126 135 146
Sensitivity Analysis
Difference19,918 €MM
Comparable Companies ApproachComparable Companies Approachprice/earning ratioprice/earning ratio
value based on market price of similar companies
(P/E) ratio
also: Earnings/Revenue multiples etc.
quality of CC approach based on selection of the peer group
share per Earnings
share per price MarketRatioEarnings Price
CC value of SAPCC value of SAP
Applying CC approaches results in a forecasted SAP AG value of €26,311.32 MM.
P/E 23,060-30,640
Enterprise value/Sales 25,370-28,190
Enterprise value/EBIT 21,250-76,260
valuation ranges for SAP company valuevaluation ranges for SAP company value
0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 180,000 200,000
DCF
EV/EBIT
P/E
EV/Sales
€MM
Median
Advantages and Disadvantages Advantages and Disadvantages of Valuation Methodsof Valuation Methods
Approach Advantages Disadvantages
DCF
- theoretically sound
- not influenced by temperamental market conditions
- appropriate for mature businesses with strong and stable cash flows
- highly sensitive to underlying assumptions for cash flow, terminal value, and discount rate
- terminal value significant part of total value
Comparable
Companies
- based on public information
- market efficiency ensures that results reflect industry trends, risks, growth potential
- value obtained does not include a control premium
- difficult to find truly comparable companies
- trading valuation may be affected by thin trading activities or small capitalization
- stock prices influenced by M&A activity
- result reflects what the market “tells” no matter if it is right or wrong
Real options to the rescue?Real options to the rescue?
„challenge of an uncertain future“
business strategy of a company resembles a series of options rather than a single projected cash flow [Trejo 2000]
disregarding management flexibility leads to a systematic undervaluation of companies [Hommel 2000]
survey on IT portfolio of global enterprise finds 27 of 31 projects to contain at least one option [Kennealy/Lichtenstein 2002]
DCF values do not differentiate between possible scenarios (e.g. successful product launch, development of an innovative technology, failure of an innovation)
esp. software design and sourcing strategies are largely processes of decision-making under uncertainty [Sullivan et al. 1999] making ROAs well suited for valuing IS strategies
Applying ROAApplying ROA
idea: include option premium for uncertainty and flexibility
total value of a company NPV (using DCF method) plus option premium (determined using ROA)
examples
option to learn (delay project) option to grow (pilot projects, new markets) option to quit (e.g. source back)
without flexibility
Cash Flows
pro
b
with flexibility
option value
Tiscali valuation using ROATiscali valuation using ROA
Tiscali is valued using the ROA
IPO was priced using trad. methods in October 1999 at €46
theoretical IPO price calculated by the Real Options Group €309
0
100
200
300
400
Net present value of
Fixed-voice line business
plus value of the option to
enter eCommerce
plus value of the option to
expand to Europe
plus value of the option to enter UMTS
Total estimated
value
~80%
€
Status quo of ROA in practiseStatus quo of ROA in practise
extensive personal interviews with investment bankers from Merrill Lynch, Morgan Stanley, Deutsche Bank, Commerzbank
ROA not (yet) applied
complexity problems estimating the underlying parameters lower acceptance analysts lack necessary knowledge clients do not accept this approach as they lack understanding for it
In most cases, a company is valued using the DCF and CC approach
DCF result is often used to check the value based on the CC approach for plausibility
Status quo of ROA in practiseStatus quo of ROA in practise
tendencies to apply the ROA in the field of Equity Research when valuing new emerging technologies, for example in the semiconductor industry
ROA is quite popular within the oil industry
Advantages and shortcomings of ROAAdvantages and shortcomings of ROA
Advantages
incorporates (value of) flexibility, contingency, or volatility
standard finance: higher volatility higher discount rates lower NPV
ROA: higher volatility higher implicit option due to the asymmetry of payoff schemes [Copeland/Koller/Murrin 2000, 428] [Mauboussin 1999]
Shortcomings
practical knowledge not yet widespread
very time-consuming approach
cannot „bargain“ with ROA model
underlying assumptions of the Black-Scholes formula (e.g. known volatility, fixed interest rates, zero dividends) very strict and typically cannot be assumed in reality.
readiness to adapt this method is currently relatively small.
ROA in IS researchROA in IS research
growing ROA community for IS valuation problem
esp. valuing IS flexibility and the associated problem of optimal IT investment time and scope are focused [Taudes/Feurstein/Mild 2000] [Gaynor/ Bradner 2001]
ROA for overcoming deficiencies of controlling theory when applied to network problems (e.g. fair prices for the future production of IS services) [Kargl 2000] [Krcmar 2000] [Emigh 2001] [Riepl 1998] [Wiese 2000]
We will use the ROA as part of a network analysis framework supporting sourcing decisions for financial service providers by modeling the cash flow implications of different IS infrastructures and choice of sourcing partners.
„When NPV was introduced in the mid 1960’s,
it was rejected for having unrealistic assumptions and for being overly complex.”
[Tallon et al. 2002]
examplesexamples
when outsourcing ISIS elements...
...what happens if I reduce my ISIS investments by 20%?
...or increase by 20%?
...what price should I be ready to pay for ISIS services?
...what service levels should I demand from my provider?
what about influence of provider attributes like size, market share, etc.?
What is the “true” underlying value What is the “true” underlying value to new technologies?to new technologies?
0
10
20
30
40
50
60
70
1890 1898 1906 1915 1923 1931 1940 1948 1956 1965 1973 1981 1990 199819101900 1920 1930 1940 1950 1960 1970 1980 1990 2000
1901: Introduct ionof electrical power
1966: First computersand space travel drivestocks to new heights
1999/2000: Internet, Biotech, and MobileNetworks fuelspeculations about a “New Economy”
1929: Assembly lineproduction and auto-mobile boom createthe f irst “bubble”
Inflation adjusted price history of S&P Composite Stock Price Index (rebased)
profit impact of ITprofit impact of IT
Average Excess Returns of 97 firms when announcing IT investment (financial, manufacturing) [Dos Santos/Peffers/Mauer]
0,09 %
0,40 %-0,08 %
1,03 %-0,09 %-0,46 %
Full SampleBreakdown by Industry
Manufacturing (33)Finance (64)
Breakdown by Type of InvestmentInnovative (25)Not Innovative (42)Unclassified (30)
AERSample Category
0,09 %
0,40 %-0,08 %
1,03 %-0,09 %-0,46 %
Full SampleBreakdown by Industry
Manufacturing (33)Finance (64)
Breakdown by Type of InvestmentInnovative (25)Not Innovative (42)Unclassified (30)
AERSample Category
the costs and benefits (“value”) of IS infrastructure flexibility
the costs and benefits implied by postponing IS investments (“option” to invest later)
the costs and benefits of partial investments.
learn from capital markets’ experiences about coping with future uncertainty:
Comparable Companies ApproachComparable Companies Approachrevenue multiplesrevenue multiples
Revenue Multiples
Earnings Multiples
Revenues
Cash) - Debt of ValueMarket Equity of Value(MarketRatioSalestoValueEnterpise
EBIT(DA)
Cash) - Debt of ValueMarket Equity of Value(MarketRatio EBIT(DA) to ValueEnterprise
advantages and disadvantages of multiplesadvantages and disadvantages of multiples
Multiple Advantages Disadvantages
P/E- Simple- Most often applied multiple
- Sensitive to corporate tax rate- Sensitive to capital structure
PEG - Considers future earnings expectations
- Limited applicability if growth ratios low
EV/Sales
- Simple- applicable if no or negative earnings- Facilitates cross-border comparisons
- Ignores financial structures- Does not consider profitability
EV/EBIT(DA)
- Avoids bias caused by different taxation rates, capital structure- Facilitates cross-border comparisons
- Equity value is very sensitive to net debt for highly leveraged companies
CCCC
Empirical evidence:
precision increases using companies with similar historic earnings growth rates (instead of same industry classification)
no improvement from adjustments in risk, growth differences, leverage
better results when using forecasted (not historic) earnings
ROA definedROA defined
ROA employs the financial option theory based on the Black-Scholes formula
idea: option provides the holder with the right, but not the obligation, to sell or buy a specified quantity of an underlying asset at a fixed price, called the strike price.
15
2 64 10 128 14 16 2018 222
10
5
20
25
30 Base case:expected average revenues
Breakeven
„Intrinsic“ value
Real options value
Curve of distribution ofpossible final outcome
In this area, outcomes arepotentially negative, thereforecompany abandons venture,and outcome becomes zero
Equity Value
Expected future revenues
ROA in IS research ROA in IS research
lowhigh
high
flexibility
unce
rtai
nty sensitivity analysis,
simulation
statistical net presentvalue methods(DCF, NPV)
option price methods
dynamic net present value methods,option price methods
low
Applying ROAApplying ROA
1. NPV has to be determined, using the DCF approach
2. build an event tree, based on the set of combined uncertainties that drive the volatility of the company’s value
3. put the decisions that management may make into the nodes of the event tree to turn it into a decision tree
4. valuation of the payoffs in the decision tree using the method of replicating portfolios applying the Black-Scholes formula