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Applying Value Drivers to Hotel Valuation.
Cornell Hotel & Restaurant Administration Quarterly • Oct, 2000 •
A cautionary tale far investors: Pay attention to the factors that create value in hotel investing.
This article is intended to serve as a valuation guide to hotel investing. The goal is to enable an investor to correctly define, build, and interpret the
results of a particular strategy undertaken in pursuit of an acquisition or development of hotel real estate. The article reviews a method of forecasting
cash flow during an explicit forecast period and calculating the investment reversion by applying a value-driver formula. It also provides the tools to
analyze the project's profitability by assessing its economic value added and to understand how return on investment changes with shifts in strategy.
The article goes through the following four steps in estimating the value of a hotel asset:
(1) Select the appropriate cash-flow build-up approach;
(2) Decide on the time horizon to fully implement a specific asset strategy;
(3) Estimate the value drivers and calculate the investment reversion; and
(4) Discount the cash flow to the present.
Selecting the Cash-flow Build-up Approach
Two approaches to hotel cash-flow build-up are the traditional accounting-driven approach and the value-driver approach. I review both of them here.
Accounting-driven approach. Over the years investors and appraisers alike have applied the accounting framework found in Uniform System of
Accounts for the Lodging Industry to build spreadsheets and forecast hotel cash flow. USALI is a profit-and-loss statement that consists of
departmental revenues and expenses, undistributed administrative costs, and fixed property charges. The typical USALI pro forma provides a great
deal of information about property operations, but masks some of the key value drivers that most investors should care about.
Value-driver approach. The better approach to forecasting cash flow guides an investor through the measures, or the drivers, that build value: namely,
growth, market share, level of services and amenities, and profit margin.
To best illustrate that approach, let's use as an example the acquisition of a full-service hotel that's in a good location and in a promising market. This
hotel, however, has been a weak performer due to the lack of consistent property upkeep and uneven management. A potential investor is intrigued by
the opportunity to purchase and upgrade the asset, install a management team of known ability, and, ultimately, create value for her capital partners.
The historical performance of the market and the subject hotel is summarized in Exhibit 1.
As observed, the performance of the competing full-service hotels in this particular market has been and continues to be strong. The market grew at 8.7
percent in the last period and is projected to increase another 5.0 percent in the most current period, whereas the subject hotel lagged behind. As a
result, the hotel's RevPAR penetration rate declined from 94 percent two years ago to 90 percent today. Despite the slowdown in growth and the
flattening of the top line, the hotel's profitability has slightly improved. Perhaps management has been keen on cutting departmental expenses and
overhead cost in preparation for the asset sale.
Seeing that the subject hotel has not performed up to its potential, the would-be investor intends to invest the necessary amount of capital to build the
property RevPAR back up to the market level and thus raise profitability. The investor's repositioning strategy is reflected in the cash-flow analysis
illustrated in Exhibit 2.
The top of the cash-flow forecast starts with the market RevPAR and its likely growth rate. The two measures provide a quantitative assessment of the
market's room rates, competitiveness, and growth potential. The strength of the asset, on the other hand, is illustrated in the lines that follow. The
hotel's market positioning and revenue-producing capacity are reflected in the hotel-penetration and room-revenue factors. The use of a target profit
margin produces the asset's expected profitability. This approach to forecasting provides an investor with a straightforward overview of the flow of
cash from the top to the bottom line.
Value-driver Approach
The value-driver approach to forecasting cash flow works as follows. First, the investor estimates top-line revenues. The hotel's chief source of revenue
is rooms (even if it has a spa, restaurant, or other revenue sources). Thus, it is crucial to analyze the drivers that build room revenue rather than trying
to guess how much money a hotel can extract from the restaurant, spa, or telephone department. Here is where solid market-feasibility work comes into
play. Studying the growth and the depth of the market, as well as the individual market segments, and benchmarking the existing and future
competition will help an investor to decide how to enter the market and where to position the subject hotel.
Market analysis. As I see it, a hotel-market analysis indicates to the investor the growth stage of the market from which to derive the likely RevPAR
growth and the time that the market would need to reach stability. In general, markets can be classified as emerging, moderately expanding, or stable. In
an emerging market, RevPAR growth rates could be two or three times as high as the growth rates observed in stable markets. In contrast, markets that
are topping out are likely to grow only at the rate of inflation. Hence, when investing in an emerging market, the explicit forecast period should extend
until that market is believed to reach stability and its RevPAR growth rate starts to run parallel with that of inflation.
In addition to estimating the market growth, the market analysis helps an investor to assess the appropriate level of RevPAR that the market can
support and sustain. This is important since investors in most cases have little control over the rate that guests are willing to pay in a particular market.
An investment strategy that assumes a particular hotel will achieve rates far above the market's RevPAR inherits a high risk. Such a strategy is product
focused instead of market driven.
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focused instead of market driven.
For purposes of building this investment analysis, the qualitative characteristics found in every market analysis are condensed to two specific
quantitative variables: current RevPAR and projected future growth. In our example, the market for selected full-service hotels should support
RevPAR of approximately $105. The second variable, the market growth rate, is initially projected at 5 percent, and then gradually levels off and
remains constant at 3 percent. The resulting decline in RevPAR growth can be attributed to an overall decline in the occupancy rates and moderating
rate growth as new hotels enter the market.
Competitive analysis. The purpose of the competitive analysis is to establish a benchmark set of hotels against which the subject hotel can be analyzed.
The most important piece of this analysis is estimating the market share the hotel is most likely to command with respect to its competitive set. This
analysis usually examines the extent of occupancy and rate penetration to show the relative strength and operating strategy of each competitor.
However, the ultimate factor that drives a hotel's room revenue is the yield--penetration rate, or the RevPAR-penetration rate. The relationship between
occupancy and rate penetration is already captured in the RevPAR yield. I also recommend that an investor run a RevPAR-sensitivity analysis, as
discussed in the box on the next two pages.
Calculating Cash Flow
Finding the hotel's cash flow involves a calculation of room revenue, total revenue, and earnings before taxes and debt service (EBITDA). This section
shows those calculations.
Room revenue. After diligently studying the market and the competitive hotels, one can estimate the appropriate market RevPAR and its growth, as
well as the subject penetration rate, and thus calculate the hotel room revenue. The calculation is as follows:
Market RevPAR x
Hotel Penetration Rate % x
No. of Rooms x No. of Days
For example:
Year-1 room revenue = $110.25 x 90% x 350 rooms x 365 days = $12,676,000
This approach to estimating room revenue requires the investor to think of the two factors that are the primary drivers of room revenue--namely,
growth and market share. Investors usually have no control over market growth, which proceeds at whatever rate the market can sustain. The subject
hotel can grow at a faster rate than the market--provided it can steal market share. Even if the hotel can do so, however, eventually its business will
grow no faster than the rest of the market.
Note that in our example the RevPAR-penetration rate expands from 90 percent in the first year to 100 percent by the fifth year and thereafter. In fact,
the rise in market share allows the hotel revenue to grow at a rate that is almost twice the market rate until the hotel reaches stabilization and starts to
grow with the market. This is based on the expectation that a new, effective management team will use the improved facility to gain more market share.
Total revenue. While room revenue is generally the most important source of revenue, as the hotel offers more amenities and services to its guests, the
size of other revenue sources as a proportion to total hotel revenue increases. As illustrated in Exhibit 3, room revenue for the average limited-service
hotel accounted for 95 percent of total revenue in 1997, whereas for a full-service property that percentage ranged from 62 percent to 72 percent
depending on the hotel's price category.
Instead of trying to guess or break out the revenues for each individual department during the preliminary analysis, it is simpler to build a single
assumption that is consistent with the rating, services, and amenities the hotel will offer and thus derive the hotel's total revenue. That assumption is a
room-revenue factor, or a percentage of the total revenue attributable to the rooms division.
Total Hotel Revenue = Room
Revenue [divided by] Room-revenue Factor %
For example, year-1 total revenue = $12,676,000 [divided by] 67% = $18,919,000
In our example, the room-revenue factor is targeted at 65 percent, which is not attained until the third year of the forecast. In the beginning, as the hotel
focuses on generating demand and building room revenue, the other sources of revenue may lag behind.
EBITDA margin. The profit margin, or earnings before income taxes and debt service, should not be put into the model in a vacuum. It should reflect
the industry norms, the specific local market characteristics, and the management's track record in operating similar hotels. As shown in Exhibit 3,
EBITDA margins for full-service hotels in the United States for 1997 were around 30 percent, and for limited-service hotels, 45 percent.
Gross-operating-profit (GOP) performance registered similar results. Limited-service hotels were at the top of the profitability chart with a GOP
margin of 53 percent, whereas full-service hotels operated at between 36 and 39 percent.
Although the example applies the EBITDA margin, I recommend that investors estimate the GOP margin first and, after adjusting for the correct
amount of fixed charges and management fees, calculate the EBITDA line (see Exhibit 4).
In summary the value-driver approach to cash-flow build-up should replace accounting pro formas in the investment analysis. By thinking through the
value drivers-growth, RevPAR, market share, room-revenue factor, and profit margin--the investor can gain a meaningful grasp on an appropriate
strategy for the asset.
Integrating the Value-driver Approach
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Integrating the Value-driver Approach
Note that the value-driver framework of analyzing cash flow does not supersede the accounting approach to forecasting revenues and expenses. It
rather seeks to avoid the complexity and rigidity found in the accounting-valuation framework. Using the value-driver approach, an investor should use
the accounting pro forma to calculate the value drivers and use them as inputs in the investment-analysis section of her model. This way the investor
can preserve the discipline required in the underwriting of the pro forma and at the same time achieve the flexibility needed in the investment analysis
and capital rationing process.
Choosing a Time Horizon
A common practice among hospitality consultants and investors is to use a 10-year forecast horizon, which is perhaps an artifact of a time when the
hotel business was more stable than it is today. An investor needs to determine whether a 10-year window is the right time period one should use and,
if not, what forecast period should apply.
The purpose of determining a specific forecast period is to capture correctly the expected changes in the marketplace and hotel operations that directly
affect cash flow and return on invested capital. The forecast horizon should, therefore, span as many years as it takes for the market and the property to
reach stability. The value of the property should not be manipulated simply by extending or shortening the length of the forecast period. The only
change should be in the distribution of the property value between the explicit forecast period and the period that follows, or the continuing (reversion)
value, as illustrated in Exhibit 5.
Assuming a five-year forecast, continuing value accounts for as much as 72 percent of the total, and the value in the holding period accounts for only
28 percent of the total, whereas in a 25-year forecast the continuing value drops to 11 percent and the explicit value is 89 percent of the whole. In both
cases, the total value of the property does not change. The value is still $48.4 million; only its distribution derived from the explicit forecast and
continuing value changes.
Selecting a different horizon period can erroneously produce a deviation in values if the underlying assumptions used in the calculation of the
continuing value are not consistent with the rest of the forecast. For instance, it was a common mistake among the investors in the 1980s to forecast
that revenues would grow at a higher rate than expenses. This approach to cash-flow build-up led to the creation of hotel pro formas that showed an
ever-increasing profit margin. Correspondingly, if the explicit forecast horizon were to be extended, then the extension would have led to an increase in
value, solely due to the increasing profit margin. Stated in another way, the longer the explicit forecast period, the higher the value! Most investors
probably realized the illusory nature of that assumption after the market slumped in the early 1990s.
Holding-period effects. Each investor has a different plan for holding the asset. As I just explained, the value of the property should not change as a
result of extending or shortening the length of either the explicit forecast horizon or the holding period. As the holding period changes, however, the
internal rate of return (IRR) will certainly change. This change is triggered not by a variation in the value of the hotel, but by a change in the rate of
return over the time the investment is held. Furthermore, the change in IRR will reflect the change in the risk of the investment, as explained by the
increase or decrease in the variability of the projected cash flow.
I find it unwise for investors to adjust the value of the asset to maintain a particular IRR assumption. That approach would break the integrity of the
valuation analysis, because the required rate of return on invested capital would not accurately reflect the risk profile of the projected cash flow. Thus,
it would be unrealistic for an investor to seek a premium rate of return after the hotel is stabilized, even if a high cash flow (and a high risk) during the
initial work-out period justifies requiring a premium rate of return. As cash-flow variability decreases, the value of the asset will likewise decrease. But
in this instance, the lower value would be solely attributable to the investor's demand of a high rate of return for the asset, whose risk profile changed
after stabilization and as such would warrant lower risk-adjusted rate of return. Hence the drop in the IRR.
Calculating the Investment Reversion
By definition the continuing value, or the investment reversion, is analyzed as an annuity investment that pays a perpetual cash flow that is either
constant through time or grows at a constant rate. As mentioned above, the explicit forecast period should span as many years as necessary for the
property to reach a stable rate of operations by the end of that period. This is imperative since the integrity of the investment reversion relies on the
following key assumptions:
* hotel profit margin stays constant; and
* hotel cash flow grows at a constant rate, sustained by a continuous investment drawn off the replacement reserve.
Most hotel investors are familiar with the growing free-cash-flow perpetuity formula. It is:
Value = [NOI.sub.t+1] % R
where
[NOI.sub.t+1] = normalized level of cash flow after reserve for replacement in the first year after the explicit forecast period, and
R = capitalization rate.
An alternative technique is the value-driver formula, which breaks down and expresses the growing free-cash-flow perpetuity formula in terms of the
value drivers: profit margin, ongoing capital requirement, cost of capital, and growth. That formula is as follows:
Value =
[EBITDA.sub.t+1] X (1-RR%PM) (WACC-g)
where
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where
[EBITDA.sub.t+1] = normalized level of cash flow before reserve for replacement in the first year after the explicit forecast period;
RR = reserve-for-replacement percentage;
PM = expected stabilized EBITDA profit-margin percentage;
WACC = weighted average cost of capital; and
g = expected growth in cash flow in perpetuity.
The value-driver formula is the algebraic representation of the growing cash-flow perpetuity formula where the hotel EBITDA is forecasted to grow at
the same rate g and is only valid if g is less than WACC. The expression WACC-g corresponds to the hotel cap rate R, whereas the numerator
decomposes the hotel NOI in the form of the key value drivers of profit margin and necessary continuous capital investment. The expression RR%PM
represents the investment rate or the proportion of cash flow allocated for property upkeep and FF&E replacement. The overall expression should read:
Cash flow (EBITDA) times one minus the investment rate equals free cash flow, or NOI.
All of the components used in the formula above are present in the hotel pro forma, except for the weighted average cost of capital. WACC is a
function of the target debt-to-equity capital structure and the corresponding required rates of return. Real estate is one of the few industries where one
can reasonably predict cash flow and, thus, leverage can be relatively high. Typical loan-to-value or loan-to-cost ratios range from 60 percent to 75
percent. Leverage above that range bears high risk and should command high equity returns. The result is that WACC cannot simply be lowered by
adding leverage and keeping the equity required rate of return constant.
In our acquisition example the borrowed capital amounts to as much as 75 percent of the purchase price and bears an interest rate of 9 percent. If the
loan is to be paid off based on an amortization schedule, then the loan mortgage constant should be included in the WACC calculation. In our case, the
loan is structured as an interest-only balloon, and the principal amount is to be returned at the end of the term. Equity holders, on the other hand, are in
the deal looking for a 25- percent return on their invested capital. Hence the weighted average between the debt and equity cost of capital is calculated
at 13 percent [(.75 x .09) + (.25 x .25)].
EBITDA Cap Rate
One of the benefits of the value-driver formula is that it allows one to express the EBITDA-capitalization rate using the key value drivers, as follows:
[R.sub.EBITDA] = (WACC-g)[divided by](1-RR[divided by]PM)
The above equation demonstrates that one can add value by focusing on improving just one of the value drivers (i.e., cost of capital, growth, profit
margin, or required investment). Obviously, a reduced cost of capital will allow an investor to bid up a price. The two other factors that drive the price
multiple up are growth and profit margin. Higher future growth translates into a lower cap rate and ultimately into a higher price. The same reasoning
holds for the profit margin. The higher the profit margin, the greater the proceeds for the investors, and the higher the price. However, it is important to
note that these two value drivers do not come free of charge. Keeping an asset competitive in the market, growing cash flow, and sustaining a healthy
profit margin require continuous investment in property upkeep and FF&E replacement. The higher the investment required to achieve a given growth
rate and sustain a given profit margin, everything else held constant, the higher the cap rate will be, which will push the purchase price lower.
About cap rates. By applying the simple perpetuity formula (NOI[divided by]R) when valuing acquisitions, many analysts fall into a circular reasoning
that the cap rate, R, applied in the investment reversion will equal the cap rate paid for the asset. For example, the assumption is that if one buys an
asset at an 8-percent cap rate, one should be able to sell that asset for the same 8-percent cap rate at the end of the holding period. In most cases,
however, the reason someone is willing to pay a low cap rate for an acquisition is that he or she believes that earnings potential can be improved
greatly. So the effective cap rate paid on the improved level of earnings will be much higher than 8 percent. Once the improvements are in place and
earnings are up, buyers would not be willing to bid the same cap rate unless they can make additional improvements.
The expected growth, profit margin, additional investment, and cost of capital are the primary determinants of the asset EBITDA cap rate, and all are in
the value-driver formula. Unless one is comfortable using an arbitrary cap rate, one is much better off by applying the value-driver formula to analyze
which factor drives the price of the asset the most and whether that is consistent with the investor's span of control, overall strategy, and competency.
Discounting the Cash Flow
Exhibit 6 summarizes the DCF-valuation analysis of the hotel cash flow derived from the pro-forma build-up example discussed earlier in this article.
[1] Remember that the investor plans to reposition the asset up to the quality level present at the other competitive hotels. To do so, the investor plans
to spend $7 million in capital expenditures during the first two years. After discounting the additional capital outlay and the projected cash flow at a
13-percent cost of capital, the DCF value of the hotel investment is calculated at approximately $48.4 million. Clearly, at an acquisition price of $45.5
million, the investment today is expected to add shareholder value of $2.9 million over the life of the project. Note also that by applying the
value-driver formula, the EBITDA cap rate is calculated at 12 percent, given the 3-percent projected growth rate, 30-percent profit margin, 5-percent
replacement reserve, and 13-percent weighted average cost of capital. Since no changes are expected in the underlying economic assumption after the
fifth year, extending the forecast to 10 years will yield the same result as the five-year forecast.
The above investment analysis assumes that after the hotel is repositioned and profitability improved, the investor would hold the asset in perpetuity, or
at least for a relatively long period of time. Such a strategy and valuation framework would be appropriate and consistent if the investor is a hotel
company looking to expand and build equity in its brand. In this case, the investor would view the property as being a key asset located in an important
market with no expectation of selling it in the immediate future.
An opportunity fund, on the other hand, would approach valuing the same asset differently. Constrained by the equity partners' short-term investment
objective, such an investor would plan at the time of purchase to cash out of the asset after capturing the increased value that would result from
improved profitability. That assumption would change the valuation framework to reflect the anticipated investment requirements-probably an
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improved profitability. That assumption would change the valuation framework to reflect the anticipated investment requirements-probably an
investment horizon of from three to five years.
For undertaking the risk of buying an underperforming asset and turning it around by deploying additional capital, the opportunistic investors will seek
a relatively high rate of return. Consequently, the free cash flow during the forecast window and the net proceeds from the sale of the asset need to be
discounted at the investors' weighted average cost of capital. However, when estimating the reversion value at the end of the holding period, one should
apply a lower cost of capital in the value-driver formula to arrive at the appropriate EBITDA capitalization rate. Such an adjustment is necessary since
the risk class of the asset would have improved and an investor seeking a stabilized asset and yield predictability would require a lower risk-adjusted
rate of return. Such an investor would assign a higher value than what the asset would be worth if held by the opportunity investor in perpetuity. The
opportunity investor should be aware, though, that at the time of sale the fund would need to sell the asset at the projected lower yield to another
investor who would be willing to accept it.
Income taxes. The reader will have noticed that the model as presented so far has not accounted for income and capital-gains taxes. Partly the omission
is for the sake of simplicity. The other reason for not considering taxes is that tax liability varies from one investor to another. Pension funds and
REITs, for example, are exempt from paying income taxes, whereas C-corps can typically pay taxes as high as 40 percent of the net profits. One thing,
though, is certain: no one will pay any taxes if the project is not profitable.
For those investors who are required to include taxes in their valuation analysis, the value-driver model can be easily adjusted to account for income
taxes while still preserving its integrity. To do this, an investor should make a separate tax calculation that is consistent with the investor's profile and
deal-transaction structure. After calculating the correct taxes for each year, the hotel EBITDA should be reduced by the tax provision amount as
presented in Exhibit 7 -- thus becoming earnings after taxes (but before debt service). The discount rate, or WACC, should be adjusted to an after-tax
basis as well.
Rather than be driven heavily by tax consequences, investors should be concerned with estimating the right value drivers, building competencies
around them, making the right investment choices, raising the necessary amount of capital, and meeting the objectives and claims of each of the
stakeholders involved in the transaction. Investment in real estate does, of course, provide tax shelters such as depreciation and interest, but the lesson
of the 1980s is that those factors should not be chief motivating factors for a hotel purchase.
An investor can analyze the profitability and assess the risk of any hotel investment in many different ways. However, by using the value-driver
build-up and valuation framework, an investor can be assured of properly forecasting, discounting, and analyzing hotel cash flow. Forecasting cash
flow based on the value drivers helps an investor discern more easily the flow of cash though the property. Discounting the cash flow by using the
value-driver formula ensures that investors solve for their expected return without overextending their span of control and capability.
A graduate of the Cornell University School of Hotel Administration, Oggie Ganchev is with the New York real-estate investment-banking group at
Credit Suisse First Boston [much less than]oggie.ganchev@csfb.com[much greater than].
(1.) For a discussion of the DCF methodology, see: Stephen Rushmore, "Seven Current Hotel-valuation Techniques," Cornell Hotel and Restaurant
Administration Quarterly, Vol.33, No.4 (August 1992), pp. 49-56.
The Further Step of Risk Analysis
Risk analysis should be considered as an integral part of any valuation analysis. By no coincidence, the value-driver hotel-valuation framework
presented in the accompanying article lends itself well to performing this task. The key part is that any of the value drivers could and should be
analyzed as a distribution of probabilities. Achieving the targeted hotel market penetration rate or profitability margin is not really that certain. What is
more likely to happen is that the actual results would fall within a range of possibilities that would be centered around the forecasted value drivers.
One of the tools any investor could use is @ Risk software, which returns distributions of possible outcomes and the probabilities of getting those
results. [1] The software can help an investor not only by showing what could happen in a given situation, but also presenting how likely it is that it
will happen. The example presented at the beginning of the accompanying article illustrates the use of risk analysis and the utility of @Risk. In a
stabilized year, the value drivers were assumed at 100-percent RevPAR penetration, 65-percent room-revenue factor, and 30-percent EDITDA margin.
A more likely scenario is that the property RevPAR penetration could go as high as 102 percent or as low as 97 percent of the market, the
room-revenue factor could be plus or minus a couple of points, and the EBITDA margin could range anywhere from 27 percent to 32 percent. By
using @Risk software, the investor could incorporate this uncertainty by creating the following distributions, which employ functions found in the
appli cation.
RevPAR penetration =
Room revenue factor =
RiskTriang(97%, 100%, 102%), which specifies a triangular distribution [2] with a minimum value of 97 percent, a most-likely value of 100 percent,
and a maximum value of 102 percent;
EBITDA margin =
RiskNormal(65%, 1%), which specifies a normal distribution [3] with a mean of 65 percent and a standard deviation of 1 percent; and
By entering the distribution formulas above in the valuation spreadsheet, the investor has defined the uncertainty of the investment. Before jumping
into the simulation analysis, however, it is important to account for any correlation among the input variables, or the selected value drivers. For
example, when the hotel RevPAR penetration is relatively high, the rooms revenue as a percent of total sales is most likely to be high as well, thus
forming a positive correlation between the RevPAR penetration and room-revenue factor. This positive correlation is even stronger between the
RevPAR penetration and the EBITDA margin. Since the highest profit margins are achieved in the rooms department, the higher the rooms sales
relative to the total revenue mix, the higher the room-revenue factor, thus the higher the EBITDA margin.
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RiskUniform(27%,32%), which specifies a uniform distribution [4] with a minimum value of 27 percent and a maximum value of 32 percent.
After quantifying the dependency among the value drivers, the investor can proceed with the simulation analysis, which involves running hundreds or
even thousands of iterations of the valuation model until sufficient results are returned. The accompanying table provides a summary of the simulation
results, as well as graphs illustrating the expected profitability of the contemplated hotel investment.
Both the NPV and the IRR profitability distributions show that the investment is expected to be profitable. Even though the project could produce a
negative NPV (see the summary statistics), the chances of that happening is less than 10 percent. Hence the proposed investment should increase
shareholder value 90 percent of the time. Likewise, the equity IRR will most likely be around 27 percent, further safeguarded by the 80-percent
probability of earning approximately 22 percent or higher.
(1.) [less than][less than]www.palisade.com[greater than][greater than]
(2.) The direction of the "skew" of the triangular distribution is set by the size of the most-likely value relative to the minimum and the maximum. The
probability of the minimum and maximum values occuring is zero.
(3.) The traditional "bell shaped" curve applicable to distributions of outcomes in many data sets.
(4.) Every value across the range of the uniform distribution has an equal likelihood of occurring.
Summary of @RISK simulation results
The power of combining the value-driver valuation framework and @Risk software comes into play also in capital rationing. Most hotel investors limit
themselves to calculating only the expected returns, the NPV, and the IRR, but they generally don't quantify the risk associated with achieving specific
returns. The most widely accepted measure of risk in finance is the standard deviation, which is easily calculated by @ Risk. In the example, the risk of
increasing shareholders' value by $2.09 million is quantified at $1.98 million per standard deviation. The same risk-and-return profile is also calculated
for the project IRR. Provided that an investor is presented with multiple projects, the expected returns along with their corresponding risk profiles can
be plotted on a graph and matched to specific investments. Rather than using a standard deviation, an investor could choose another measure of risk
and plot the expected return against it. Other good measures of risk are the probability of a project NPV to b e less than zero and the probability that
the hotel's cash flow would be insufficient to cover debt service in a given year.
The graphs show the probability distribution of a hypothetical project's profitability after multiple iterations of @RISK software. While the project
could lose money, as indicated by the lefthand part of the graph at upper left, that probability distribution shows a greater likelihood of a solid profit.
The upper right graph shows only about a 10-percent probability of a reduction in value. The probabilities for internal rate of return (IRR) are similar,
as depicted in the lower graphs.
Economic-value-added Technique
The economic-value-added (EVA) technique shows the profits that a project earns in excess of its cost of capital. The EVA helps the investor evaluate
the asset performance in any single year, while the DCF shows the investment returns over the entire life of the project. Measuring the value created by
the asset in a single period of time, the EVA is defined as follows:
EVA = Invested Capital x (ROIC -- WACC)
That is, EVA equals the spread between the EBITDA property yield (ROIC) and the cost of capital (WACC), times the amount of the invested capital.
If the yield is higher than the cost of capital, economic value is being created. The opposite is also true. When the yield is less than the cost of capital,
value is being destroyed.
The EVA approach looks at the incremental value added over the property's invested capital at the beginning, during, and after the forecast period. The
total value of the asset is as follows:
Value =
Invested capital PV of forecasted at beginning of forecast + PV of forecasted economic profit during explicit forecast period + PV of forecasted
explicit economic profit after explicit forecast period
Provided the same financial projections, the EVA technique produces the same value as the DCF approach. The accompanying table (on the next page)
illustrates this.
Like the application of the value-driver formula in the DCF calculation of the reversion value, the EVA continuing-value formula relies on the same
value drivers expressed as follows:
EVA CV = [EVA.sub.t+1] [divided by] WACC + [EBITDA.sub.t+1] X RR[divided by]PM x ((g x PM[divided by]RR) -- WACC) (WACC x
(WACC-g))
where
[EVA.sub.t+1] = normalized economic profit in the first year after the explicit forecast period;
[EBITDA.sub.t+1] = normalized level of cash flow before reserve for replacement in the first year after the explicit forecast period;
RR = reserve-for-replacement percentage;
PM = expected stabilized EBITDA profit-margin percentage;
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PM = expected stabilized EBITDA profit-margin percentage;
WACC = weighted average cost of capital; and
g = expected growth in cash flow in perpetuity.
The EVA continuing-value formula comprises two distinct value creating components. The first expression returns the present value of the economic
profit, or the spread between the EBITDA yield and WACC, in the first year after the explicit forecast in perpetuity. The second expression looks at
any incremental economic profit created by sustaining a higher profit margin producing additional growth at returns exceeding the cost of capital.
The expression RR[divided by]PM represents the investment rate. Furthermore, the investment rate times the growth rate expresses the return on newly
invested capital. Hence, additional value is created if the return on newly invested capital is higher than the cost of capital. The inverse holds true as
well, If the return on newly invested capital is less than the cost of capital, then holding on to an under performing asset would destroy shareholder
value in the long run. Finally, if the return on newly invested capital equals the cost of capital then incremental economic value is neither being created
nor destroyed.
For instance, if the profit margin were to drop from the projected 30 percent to about 22 percent, as shown in our example, assuming that the additional
investment remains at 5 percent of revenue and cash flow keeps growing at a 3-percent clip, then the return on newly invested capital would equal
WACC. As a result, the second component of the EVA continuing-value formula would equal zero. In such a case, any additional investment in FF&E
would simply match the investors' cost of capital. Cash flow would still grow, but at a rate of return no higher than the investors' implied cost of
capital--thus producing no incremental economic profit that would be over and above the economic profit produced by the initial capital investment.
The EVA approach to investment analysis provides the link between the DCF--IRR academic mentality and real-life cash-yield narrow-mindedness. In
the example provided, the unleveraged IRR is calculated at 13.6 percent, whereas the fourth-year EBITDA yield is 13.7 percent (yield is based on total
investment including the additional capital expenditures). More often than not, the two investment returns are close to each other. As one can see, the
yield climbs considerably in the first three years and then levels off as the property reaches a stabilized level of operations and cash flow starts to grow
with the rate of inflation. As a rule of thumb, one could guess with a great level of confidence that the project's IRR would fall anywhere between the
third and fifth year EBITDA yield, depending on the perpetual-growth and profit-margin assumptions.
Veterans in the industry prefer to use yields to measure investment returns simply because they are easier to calculate and understand. The IRR requires
more sophisticated calculation, which oftentimes can be overstated by inflating the sale price or jacking up the growth rate. Most troublesome,
however, is the calculation of cash-on-cash return, or NOI over the total invested capital. In this calculation the yield is understated since cash flow is
reduced by the replacement-reserve expenditures without recognizing the benefit of this additional investment. That benefit is not realized and readily
observable until the next period in the forecast, during which the hotel is able to grow cash flow and sustain its profit margin mainly because of the
investments made during the previous period. The capital spent on upgrading and replacing tired FF&E is not lost. In fact, the return on this
incremental capital investment is easily measured by calculating the incremental cash flow realized in the following period. Such returns are one of the
highest in the industry since the initial investment is already made and subsequent smaller investments can leverage off the fixed asset base and
produce higher rates of return. Cash-on-cash yields calculated based on EBITDA over total investment are the appropriate yields investors should use
when estimating their return on capital or measuring economic performance against their cost of capital.
COPYRIGHT 2000 Cornell University Reproduced with permission of the copyright holder. Further reproduction or distribution is prohibited without
permission.
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