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Integrating DCF, IAVA and Real Options
Revised Discussion Paper - Nicholas Beale 13 August, 2000
This note is to provide a thought starter for an eventual note which we hope will be a consensus
from the various parties on how and when DCF, IA and Real Options approaches should be used
in understanding the value of New Economy businesses. It has been revised after an interim
meeting today with Jan and Michael. Revisions are in blue. We plan to run a series of case
studies on this integrated approach, and post them or summaries on the extranet. Until we have
done this, the recommendations in the note are, of course, provisional.
Ideally add a basic discussion of each model using consistent notation – words and formulae.
Benchmarks… eg Historical Growth, sector IA returns. Output of Analysis should not be a price
but a Std…
1) Each approach has its strengths and weaknesses – a rounded picture is best.
a) DCF – Strengths:
i) Widely understood – at least at some level.
ii) Allows you to understand value in terms of explicitly articulated long-term scenarios,
whose probability can then be assessed.
iii) Copes, at least in principle, with financial vagaries such as tax, debt structure.
b) DCF – Weaknesses:
i) Uncertainty increases as you project further unless discount rate >> growth rate.
ii) Terminal values tend to dominate, unless you go so far into the future that forecasts
are even more meaningless than usual.
iii) Doesn’t distinguish between investment and expense: this is a particular problem with
Intellectual Assets since conventional accounting doesn’t identify them either.
iv) Entirely based on projections, thus risks losing touch with reality (J-Curve).
v) Difficult to model Network Economics effects.
vi) Beta famously problematic1
c) Real Options – Strengths:
i) Distinguishes some sorts of investment (real options) from expense.
ii) Based on elaborate mathematics and experience of financial options.
iii) Encourages systematic thinking about market uncertainty as an opportunity.
iv) At least partly rooted in market fact (historic volatilities) and not projections.
v) Many industrial investment opportunities (eg oil wells) are like options.
d) Real Options – Weaknesses
i) Assumptions used in Financial Options theory (eg Law of One Price, existence of
Hedging Portfolio, log-Normal or Binomial distributions) often inapplicable2.
1
One FTSE 40 stock had an observed Beta which varied from 1.41 (weekly, 1 year, starting on a Wednesday) to
0.69 (Weekly, 5 year, starting on a Friday). Source: Jim McNulty – Warburg Dillon Reed – Euromoney workshop on
Advanced Techniques for Calculating the Cost of Capital – Oct 1998).
ii) Some forms of Intellectual Asset (eg Brands, Skills) are not at all like Options. Also
there is important value in the non-Options-like parts of R&D.
iii) Outside heavily traded commodities historic performance of financial markets may be
highly unreliable guide to ‘true’ future volatilities. And there is something worryingly
circular in the idea that Internet Companies are valuable because they have high
volatilities, as observed by the volatility of their stocks.
iv) Gives valuations for single ‘projects’ viewed as options but difficult to cope with
large aggregates especially since the risk profiles of different ‘real options’ in a
typical company's portfolio of Intellectual Assets are very strongly correlated.
v) Difficult to benchmark performance against competitors and comparators.
vi) Often difficult to know what the relevant dimensions of volatility are and how they
correlate.
vii) Actually excercising a real option often requires substantial investment, new IA and
management skills. This tends to be ignored in the maths.
e) IAVA – Strengths
i) Focuses explicitly on Intellectual Assets and the returns achieved with them.
ii) Forces valuations to consider historic and projected performance together.
iii) Forces valuations to consider ‘amortization’ of IA – eg Customer Churn Rates,
Technological Obsolescence.
iv) Easy to benchmark performance against competitors and comparators.
v) Offers solution to Terminal Value Problem which provides reality check to DCF
Scenarios.
vi) Offers framework for analysing Network Economics.
f) IAVA – Weaknesses
i) Not widely understood or used (yet).
ii) Ignores tax, financing and cash timing issues (at present).
iii) Terminal Values depend on assets held at end point plus estimates of growth and fade
which are (like the future) fairly uncertain.
iv) Sometimes needs stochastic or Real Options extensions to deal with uncertainty.
2) Ideally we’d seek a fully integrated conceptual model. The RO model reduces to the DCF
model when the volatility is zero, and the IA model reduces to DCF when there are no IA.
a) Thus we could envisage an equation:
NPV(X) = NPV (CFX) + NPV (TTNFAX) + NPV (TIAX) + NPV(PTIAX) + NPV(TOCX)
where TTNFA
TIA
2
= Terminal Tangible and Net Financial Assets
= Terminal Intellectual Assets
At an initial dialogue between the Physicists and the Economists at the Santa Fe Institute, the Economists explained
some of their basic assumptions to the Physicists and responded to their objection that these assumptions were
unlikely to be valid with “yes, but we need them to make the maths work”. The LTCM fiasco was a hard lesson that
the assumptions of options theory do not always apply even in financial markets. And the whole point of being in
business is to make an ‘arbitrage profit’ between your inputs and outputs. Thus if there is a significant business
opportunity, the fundamental assumption of Real Options theory does not apply: and if the opportunity is not
significant, then it is questionable whether it is worth including it in the analysis.
PTIA
TOC
= Post-Terminal IA – ie IA created after the terminal time
= Terminal Options Correction
b) The concept of a Terminal Options Correction is needed because both Tangible and
Intellectual Assets may contain implicit or explicit options already that correlate in a
significant way. For example a company (XCo) may have a significant R&D programme
in technology X and a minority stake in a start-up (YCo) developing technology Y with
an option to purchase the rest. The value of that option is not, (pace Amram et al)
dependent on the volatility of YCo’s stock but on the extent to which technology Y is
likely to be valuable to company X in the event that technology Y is successful3.
c) However in most practical cases the use of scenarios over DCF and IA models is likely to
be sufficient, and Real Options analysis should only be used when it adds value.
3) A possible recommended approach to understanding New Economy Valuations could then be
as follows:
a) Make an explicit forecast scenario for the company in question, over a period where you
think forecasting is pretty reasonable. Consider profits, cashflow, tangible assets and IA.
b) Look at the IA implications of that forecast – consider whether they are reasonable:
whether the patterns of projected return on IA (RoCIA) are plausible. If not, refine the
forecast. You should consider the IA behaviour of the company for a reasonable period
before the forecast begins, and may wish to consider the IA performance of other
comparable companies. You should also explicitly consider whether there are any
important Network Economics effects and model them in the IA model if there are.
c) Consider whether the final RoCIA and Amortization of IA – or some other figure – are
reasonable estimates of the average RoCIA and Amortization over the lifetime of the IA
at the end of the forecast period. Use these to derive a Terminal Value for the IA.
Consider whether there are any special factors (such as unusual relationships between
cashflow and profit) which require an adjustment4.
d) Consider whether the book value of the Terminal Tangible and Net Financial Assets
needs any adjustment for a realistic Terminal Value5. If so, make it. In particular, some
‘new economy’ businesses have Tangible Assets (such as installed fiber) whose economic
rent is far from being historic cost times a cost of capital.
e) Consider whether there are any significant Real or Financial Options in the assets (or
liabilities) of the business that require a Terminal Options Correction (TOC). This will
be the case if the net effect of volatility in a particular dimension is significant (for
example, if there is an oilfield and a hedging option on crude then there may be no net
volatility). If so, then consider the principal dimensions of volatility that drive the option
value and estimate (with due caution) the appropriate Terminal Options Correction to the
implied Terminal Values of the relevant set of assets. Use the maths with caution –
unless there is a sufficiently liquid market with underlying traded securities and no reason
to be very concerned about extreme values the formulae may not be appropriate.
See my note on IA and Network Economics for more on this – in progress at present I’m afraid but I’ll post a
working draft on the extranet site at ia_network.doc.
3
Usually this will be taken care of by the ‘rent’ on working capital, but some industries and accounting systems book
profits long before it would be ‘prudent’ to do so and suitable adjustments may need to be made. There can also be
tax implications, although most regimes tax IA hardly at all.
4
5
This may be due eg to accounting conventions that value buildings at cost, even in areas where there has been a
large increase in property values.
f) Consider what you have to believe about the IA in order to justify the DCF Terminal
Values and vice versa.
g) Iterate the above for a number of other scenarios.
h) Assess their overall probability and derive an expected value.