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Abstract:
If there has been a shift in corporate finance and valuation in recent years, it has been towards giving excess returns a more central role in determining the value of a business. While early valuation models emphasized the relationship between growth and value - higher growth firms were assigned higher values - more recent iterations of these models have noted that growth unaccompanied by excess returns creates no value. With this shift towards excess returns has come an increased focus on measuring and forecasting returns earned by businesses on both investments made in the past and expected future investments. In this paper, we examine accounting and cash flow measures of these returns and how best to forecast these numbers for any given business for the future.

Accounting returns, ROIC, ROE, ROC, Return on equity, Return on Invested Capital

Abstract:
Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile. We look at two other approaches to estimating equity risk premiums - the survey approach, where investors and managers ar asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in non-equity markets. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the "right" number to use in analysis. (In an addendum, we also look at equity risk premiums during the market crisis, starting on September 12, 2008 through October 16, 2008.)

Equity Risk Premium, ERP, Implied Premium, Risk, Default spreads

Abstract:
In corporate finance and valuation, we start off with the presumption that the riskfree rate is given and easy to obtain and focus the bulk of our attention on estimating the risk parameters of individuals firms and risk premiums. But is the riskfree rate that simple to obtain? Both academics and practitioners have long used government security rates as riskfree rates, though there have been differences on whether to use short term or long-term rates. In this paper, we not only provide a framework for deciding whether to use short or long term rates in analysis but also a roadmap for what to do when there is no government bond rate available or when there is default risk in the government bond. We look at common errors that creep into valuations as a consequence of getting the riskfree rate wrong and suggest a way in which we can preserve consistency in both valuation and capital budgeting.

riskfree rate, cost of equity, discount rate, valuation

Abstract:
In a typical leveraged buyout, there are three components. The acquirers borrow a significant portion of a publicly traded firm's value (leverage), take a key role in the management of the firm (control) and often take it off public markets (going private). None of these three components is new to markets and there can clearly be good reasons for each of them. Starting with traditional corporate finance first principles, we examine the conditions that are necessary for each component to make sense. Using the aborted Harman LBO, where KKR and Goldman were lead players, as a case study, we argue that choosing the wrong target for a leveraged buyout is a recipe for disaster even for the most reputed players in the business. In other words, no amount of deal expertise can overcome poor financial fundamentals. In closing, we argue that the three components in an LBO are separable and that bundling them together as essential pieces of every deal is a mistake.

LBO, Leveraged Buyout, private equity, control, leverage, private

Abstract:
Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. We begin this paper by looking at the economic determinants of equity risk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile. We look at two other approaches to estimating equity risk premiums - the survey approach, where investors and managers ar asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in non-equity markets. We also look at the relationship between the equity risk premium and risk premiums in the bond market (default spreads) and in real estate (cap rates) and how that relationship can be mined to generated expected equity risk premiums. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the “right” number to use in analysis. (In an addendum, we also look at equity risk premiums during the market crisis, starting on September 12, 2008 through December 31, 2008, and then track the shift the changes through September 30, 2009.)

Equity Risk Premiums, default spreads, Crisis, valuation, cost of equity

Abstract:
Young companies are difficult to value for a number of reasons. Some are start-up and idea businesses, with little or no revenues and operating losses. Even those young companies that are profitable have short histories and most young firms are dependent upon private capital, initially owner savings and venture capital and private equity later on. As a result, many of the standard techniques we use to estimate cash flows, growth rates and discount rates either do not work or yield unrealistic numbers. In addition, the fact that most young companies do not survive has to be considered somewhere in the valuation. In this paper, we examine how best to value young companies. We use a combination of data on more mature companies in the business and the company’s own characteristics to forecast revenues, earnings and cash flows. We also establish processes for estimating discount rates for private capital and for adjusting the value today for the possibility of failure. In the process, we argue that the venture capital approach to valuation that is widely used now is flawed and should be replaced.

valuation, growth companies, venture capital approach

Abstract:
Many acquisitions and some large strategic investments are often justified with the argument that they will create synergy. In this paper, we consider the various sources of synergy and categorize them into operating and financial synergies. We then examine how best to value synergy in any investment and how sensitive this value is to different assumptions. We also look at how this synergy value should be divided between the parties (or companies) involved in the investment. We conclude with an empirical examination of how much synergy is actually created in corporate mergers, and how much is paid. Synergy, we conclude, is so seldom delivered in acquisitions because it is incorrectly valued, inadequately planned for and much more difficult to create in practice than it is to compute on paper.

synergy, acquisitiion, valuation

Abstract:
Should investors be willing to pay higher prices for more liquid assets than for otherwise similar assets that are less liquid? If the answer is yes, how much should the premium be for liquid assets? Conversely, how do we estimate the discount for illiquid assets? In this paper, we argue that it is a mistake to think of some assets as illiquid and others as liquid and that liquidity is a continuum, where some assets are more liquid than others. We then examine why liquid assets may be priced more highly than otherwise similar illiquid assets and why some investors value liquidity more than others. We follow up be presenting the empirical evidence that has accumulated over time and across different assets - financial and real - on the cost of illiquidity. Finally, we consider how we can use the theory and evidence on illiquidity to estimate the effect of illiquidity on the value of an asset or business.

marketablity, illiquidity discount, liquidity discount, liquidity

Abstract:
It is not uncommon in private company and acquisition valuations to see large premiums attached to estimated value to reflect the 'value of control'. But what, if any, is the value of control in a firm, and if it exists, how do we go about estimating it? In this paper, we examine the ingredients of the control premium. In particular, we argue that the value of controlling a firm has to lie in being able to run it differently (and better). Consequently, the value of control will be greater for poorly managed firms than well run ones. The value of control has wide ranging implications beyond acquisitions. We show that the expected likelihood of control changing is built into the price of every publicly traded company and that this provides a way of measuring the payoff to strong corporate governance. We also argue that getting a better handle on the value of control can allow us to better explain the differences between voting and non-voting share prices and the minority discount in private company valuations.

Control premium, voting shares, minority discounts, hostile acquisitions

Abstract:
The most difficult companies to value are at either end of the life cycle, with young growth companies and declining companies posing the biggest challenges. In this paper, we focus on companies that are at the tail end of their life cycles and examine how best to value companies with flat and declining revenues and stagnant or dropping profit margins. Since many of these companies also have significant debt burdens, we also evaluate ways to incorporate the possibility of distress and default into value. We argue that conventional discounted cash flow valuations, premised on firms being going concerns, will tend to overstate the value of distressed companies, and suggest ways in which we can correct for the bias.

Distress, DCF valuation, declining firms

Abstract:
Cyclical and commodity companies share a common feature, insofar as their value is often more dependent on the movement of a macro variable (the commodity price or the growth in the underlying economy) than it is on firm specific characteristics. Thus, the value of an oil company is inextricably linked to the price of oil just as the value of a cyclical company is tied to how well the economy is doing. Since both commodity prices and economies move in cycles, the biggest problem we face in valuing companies tied to either is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious misvaluations. In this paper, we look at the consequences of this dependence on cycles and how best to value companies that are exposed to this problem.

valuation, cyclial, commodity, normalized earnings

Abstract:
In the last decade, firms have increasingly turned to offering employees options and restricted stock (often with restrictions on trading) as part of compensation packages. Some of this trend can be attributed to the entry of young, cash poor technology firms into the market, many of which have to use equity because they have no choice. However, many larger market cap firms that can afford to pay cash compensation have used stock based compensation as a way of aligning managerial interests with stockholder interests. In this paper, we begin by looking at motives, good and bad, for using equity based compensation, and trends over the last few years. We then turn to the accounting rules, old and new, that govern how equity compensation is recorded and reported. Finally, we consider how best to incorporate employee options and restricted stock - both past and prospective - into discounted cash flow and relative valuation models.

employee stock options, ESOP, restricted stock, management options

Abstract:
Risk can be both a threat to a firm's financial health and an opportunity to get ahead of the competition. Most analysts, when they refer to risk management, focus on the threat posed by risk and emphasize protecting against that threat (i.e. risk hedging). In keeping with this narrow definition of risk management, the risk associated with an investment is almost always reflected in the discount rate in conventional discounted cash flow models. Since we also assume that only market risk affects discount rates, it follows that firms that expend time and resources in hedging firm-specific risk will lose value to the extent that risk management is expensive. Firms that reduce exposure to systematic risk will see no effect on value, if risk-hedging products are fairly priced. In this paper, we consider ways in which we can broaden both the definition of risk management to include ways of exploiting risk to gain a competitive advantage and the analysis of the effects on value. We argue that risk management can affect expected cash flows by altering investment policy and creating competitive advantages, which in turn can have consequences for expected growth rates and excess returns. This offers the potential for a payoff to risk management for many firms that may not benefit from risk hedging. In the closing part of this paper, we consider the steps involved in developing a comprehensive strategy for dealing with risk

risk management, value

Abstract:
It is clear that some firms are more forthcoming about their financial affairs than other firms, and that the financial statements of a few firms are designed to obscure rather than reveal information. While differences in accounting standards across countries was viewed as the primary culprit for this lack of transparency until recent years, the convergence in accounting standards globally has made it clear that no matter how strict accounting standards are, firms will continue to use their discretionary power to spin and manipulate the numbers that they convey to financial markets. The questions we face in valuation are significant ones. How do we reflect the transparency (or the opacity) of a firm's financial statements in its value? Should we reward firms that have simpler and more open financial statements and punish firms that have complex and difficult-to-understand financial statements? If so, which input in valuation should be the one that we adjust? This paper begins by examining the phenomenon of opacity in financial statements and why some firms choose to be opaque. It follows up by considering some of the empirical evidence on whether markets discount the value of complex firms to reflect the difficult faced in valuing them. It closes by evaluating some of the ways in which we can adjust discounted cash flow valuation models for this difficulty.

transparency, opacity, complexity, valuation

Abstract:
Most businesses hold cash, often in the form of low-risk or riskless investments that can be converted into cash at short notice. The motivations for holding cash vary across firms. Some hold cash to meet operating needs whereas others keep cash on hand to weather financial crises or take advantage of investment opportunities. In the first part of this paper, we will begin by looking at the extent of cash holdings at publicly traded firms and some of the motives for the cash accumulation. We will also look at how best to value these cash holdings in both discounted cash flow and relative valuation models. In the second part of the paper, we will turn to a trickier component - cross holdings in other companies. We will begin by looking at the way accountants record these holdings and the implications for valuation. We will then consider how to incorporate the value of these cross holdings in a full information environment, followed by approximations that work when information about cross holdings is partial or missing.

cash, cross holdings, non-operating assets

Abstract:
When analyzing or the value of a firm, there are three basic questions that we need to address: How much is the firm generating as earnings? How much capital has been invested in its existing investments? How much has the firm borrowed? In answering these questions, we depend upon accounting assessments of earnings, book capital and debt. We assume that the reported operating income is prior to any financing expenses and that all debt utilized by the firm is treated as such on the balance sheet. While this assumption, for the most part, is well founded, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease payments are treated as part of operating expenses, but we will argue that they are really financing expenses. Consequently, the stated operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have far reaching implications for profitability, financial leverage and assessed value at firms.

leases, profitability, leverage, valuation

Abstract:
When analyzing or the value of a firm, there are three basic questions that we need to address: How much is the firm generating as earnings? How much capital has been invested in its existing investments? How much has the firm borrowed? In answering these questions, we depend upon accounting assessments of earnings, book capital and debt. We assume that the reported operating income is prior to any financing expenses and that all debt utilized by the firm is treated as such on the balance sheet. While this assumption, for the most part, is well founded, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease payments are treated as part of operating expenses, but we will argue that they are really financing expenses. Consequently, the stated operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have far reaching implications for profitability, financial leverage and assessed value at firms.

operating leases, financial leverage, debt

Abstract:
Traditional valuation techniques - both DCF and relative - short change the effects of financial distress on value. In most valuations, we ignore distress entirely and make implicit assumptions that are often unrealistic about the consequences of a firm being unable to meet its financial obligations. Even those valuations that purport to consider the effect of distress do so incompletely. In this paper, we begin by considering how distress is dealt with in traditional discounted cash flow models, and when these models value distress correctly. We then look at ways in which we can incorporate the effects of distress into value in discounted cashflow models. We conclude by looking at the effect of distress on relative valuations, and ways of incorporating its effect into relative value.

distress, value, adjusted present value, survival

Abstract:
The growth of financial markets in Asia and Latin America and the allure of globalization have made the analysis and assessment of country risk a critical component of valuation in recent years. In this paper, we consider two issues. The first is the whether country risk should be considered explicitly in valuation, and if the answer is yes, how to do it. Generically, there are two ways of incorporating country risk; we can either adjust the cash flows or change the discount rate and we will consider both approaches. The second and equally important issue is how to assess a company's exposure to country risk and we will emphasize two points. The first is that not all companies in an emerging market are equally exposed to country risk and that we need to differentiate between firms. The second is that a company's exposure to country risk comes not from where it incorporates and trades but from where it does its business. In other words, assessing and dealing with country risk can be important even for companies that trade in developed markets, if they get a significant portion of their revenues in emerging markets.

country risk, emerging markets, beta

Abstract:
A standard critique of valuation models, in general, and discounted cash flow models in particular is that they fail to fully account for the many intangible assets possessed by firms. There have been attempts to value brand name, trade marks and copyrights and bring them on to the balance sheet. Other intangible assets include patents and customer lists. We would expand this list to consider the flexibility that a firm may preserve to expand its market or enter new markets. In this paper, we consider a variety of ways in which these assets can be valued and the consequences for investors.

intangibles, brand name, patents, real options

Abstract:
A key input, when valuing businesses, is the expected growth rate in earnings and cash flows. Allowing for a higher growth rate in earnings usually translates into higher value for a firm. But why do some firms grow faster than others? In other words, where does growth come from? In this paper, we argue that growth is not an exogenous input subject to the whims and fancies of individual analysts, but has to be earned by firms. In particular, we trace earnings growth back to two forces: investment in new assets, also called sustainable growth, and improving efficiency on existing assets, which we term efficiency growth. We use this decomposition of growth to examine both historical growth rates in earnings across firms and the link between value and growth. We close the paper by noting that the relationship between growth and value is far more nuanced than most analysts assume, with some firms adding value as they grow, some staying in place and some destroying value.

growth, sustainable growth, value, excess returns

Abstract:
In traditional valuation models, we begin by forecasting earnings and cash flows anddiscount these cash flows back at an appropriate discount rate to arrive at the value of a firm or asset. This task is simpler when valuing firms with positive earnings, a long history of performance and a large number of comparable firms. In this paper, we look at valuation when one or more of these conditions does not hold. We begin by looking ways of dealing with firms with negative earnings, and note that the process will vary depending upon the reasons for the losses. In the second part of the paper, we look at how to value young firms, often a year or two from start-up, with negative earnings, small ornegligible revenues and few comparables. We will argue that while estimation of cashflows and discount rates is more difficult for these firms, the fundamentals of valuation continue to apply. Finally, we look at how best to do relative valuation for young firms with negative earnings and few comparables.

Abstract:
In recent years, practitioners and academics have made the argument that traditional discounted cash flow models do a poor job of capturing the value of the options embedded in many corporate actions. They have noted that these options need to be not only considered explicitly and valued, but also that the value of these options can be substantial. In fact, many investments and acquisitions that would not be justifiable otherwise will be value enhancing, if the options embedded in them are considered. In this paper, we examine the merits of this argument. While it is certainly true that there are options embedded in many actions, we consider the conditions that have to be met for these options to have value. We also develop a series of applied examples, where we attempt to value these options and consider the effect on investment, financing and valuation decisions.

Abstract:
Most firm valuation models start with the after-tax operating income as a measure of the operating income on a firm and reduce it by the reinvestment rate to arrive at the free cash flow to the firm. Implicitly, we assume that the operating expenses do not include any financing expenses (such as interest expense on debt). While this assumption, for the most part, is true, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease expenses are treated as part of the operating expenses, but we will argue that they really represent financing expenses. Consequently, the operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have significant effects not just on valuation model inputs, but also on some multiples such as Value/EBITDA ratios that are widely used in valuation.

Abstract:
Most valuation models begin with a measure of accounting earnings to arrive at cash flow estimates. When using accounting earnings, we implicitly assume that the income is obtained by netting out only those expenses that are operating expenses, i.e., expenses designed to generate revenues in the current period. Expenses that are intended to provide benefits over multiple periods are assumed to be considered as capital expenditures, andthese expenses are depreciated or amortized over multiple periods. In addition, whencomputing profitability measures such as return on equity and capital, we stick with this assumption that operating income measures income generated by assets in place. In this paper, we examine the accounting treatment of research and development expenses, and the effects of the treatment on operating income, capital and profitability. We argue that research and development expenses should be treated as tax-deductible capital expenditures, for purposes of valuation, and this can have significant effects on operating income, capital and expected growth measures for firms with substantial research expenses.

Abstract:
The last two decades have seen a stream of innovation in financial markets, especially in the corporate bond arena. Some of these innovations were designed to give firms moreflexibility in designing cash flows on borrowings, allowing them to match up cash flows on financing more closely to cash flows on assets, thus increasing their debt capacity. These changes have been for the most part good news for corporate treasurers, but the relentless torrent of innovation has also resulted in some firms issuing these new and more complex securities for the wrong reasons. Some have done so to keep up with other firms in their peer group, and other to take advantage of loopholes in the way ratingsagencies and regulatory agencies define debt and equity. In this context, it is worth noting that as corporate bonds have become more complex, investment bankers oncemore become indispensable to the process, proving both pricing and selling support. It is important that firms recognize when complexity serves their interests, and when it can end up hurting them.

Abstract:
In conventional valuation, we assume that all equity claims are identical and divide the value of equity by the number of claims (shares) to get the value per claim (share). In practice, though, claims on equity can vary on a number of dimensions. First, the claim can be a direct and perpetual one (standard equity) or it can be contingent on the value changing (equity option). Second, some equity investors have preferential claims on the cash flows- dividends in some cases and cash flows in liquidation in other cases. Third, some equity claims have superior control rights over other claims: this can take the form of differential voting rights in some cases and a bigger role in board composition and management in others. In some instances, the power is triggered by a control event such as an acquisition or an initial public offering. Fourth, some equity investors are provided with special rights to protect their interests when the firm acts in later periods. These can include disproportionate rights in subsequent financing decisions - the right to partake in the financing at a fixed price, for instance, or veto rights over new financing - as well as redemption rights, where they can reclaim the capital that they have invested. Finally, equity claims can vary in terms of liquidity, with some claims being more marketable than others. All of these differences can affect value, resulting in some equity claims having higher value than others.

valuation, dual class shares, liquidity, voting vs non-voting shares, dividend preferences

Abstract:
In recent years, firms have turned to their attention increasingly to ways in which they can increase their value. A number of competing measures, each with claims to being the "best" approach to value creation, have been developed and marketed by investment banking firms and consulting firms. In this paper, we begin with a generic discounted cash flow model,and consider the ways in which value can be created or destroyed in a firm. We then look at two of the most widely used value enhancement measures, Economic Value Added and Cash Flow Return on Investment, and consider where these approaches yield similar results to those obtained from traditional valuation models, and where (and why) there might be differences. In conclusion, we show that there is little that is new or unique in these competing measures, and while they might be simpler than traditional discounted cash flow valuation, the simplicity comes at a cost that is substantial for high growth firms with shifting risk profiles.

Abstract:
Many studies argue that differences in information across securities explain much of the cross-sectional variation in stock return volatility. We offer an explanation beyond that previously identified in the literature by developing a proxy for differential information. Our proxy follows from our simple model development where the amount of information regarding a firm is positively related to how similar it is to its comparables (i.e., firms in the same industry). We call this measure of differential information the degree of comparability. In all our empirical tests, we consistently find a negative and highly significant relationship between volatility and the degree of comparability (after controlling for other factors the literature has found affect volatility). Moreover, in some tests, the degree of comparability is the most significant factor in explaining volatility.

Abstract:
The growth of financial markets in Asia and Latin America and the allure of globalization has made the analysis and assessment of country risk a critical component of valuation in recent years. In this paper, we consider two issues. The first is the whether country risk should be considered explicitly in valuation, and if the answer is yes, how to do it. Generically, there are two ways of incorporating country risk; we can either adjust the cash flows or change the discount rate and we will consider both approaches. The second and equally important issue is how to assess a company's exposure to country risk and we will emphasize two points. The first is that not all companies in an emerging market are equally exposed to country risk and that we need to differentiate between firms. The second is that a company's exposure to country risk comes not from where it incorporates and trades but from where it does its business. In other words, assessing and dealing with country risk can be important even for companies that trade in developed markets, if they get a significant portion of their revenues in emerging markets.

Abstract:
Risk can be both a threat to a company's financial health and an opportunity to get ahead of the competition. Most analysts, when referring to risk management, focus on the threat and emphasize protecting against that threat (i.e., risk hedging). The risk associated with an investment is generally reflected in the discount rate used in conventional discounted cash flow models, and because analysts also assume that only market risk affects discount rates, the firms that spend time and resources on hedging company-specific risk may well lose value. But risk management can increase firm value - by altering investment policy and creating competitive advantages, which can have consequences for expected growth rates and excess returns.

Equity Investments, Fundamental Analysis, Valuation Models, Risk Measurement, Management, Firm/Enterprise Risk, Corporate Finance, Capital Investment Decisions