Corporate Valuation - Mario Massari - ebook

Corporate Valuation ebook

Mario Massari

0,0
279,99 zł

Opis

Risk consideration is central to more accurate post-crisisvaluation Corporate Valuation presents the most up-to-date toolsand techniques for more accurate valuation in a highly volatile,globalized, and risky business environment. This insightful guidetakes a multidisciplinary approach, considering both accounting andfinancial principles, with a practical focus that uses case studiesand numerical examples to illustrate major concepts. Readers arewalked through a map of the valuation approaches proven mosteffective post-crisis, with explicit guidance toward implementationand enhancement using advanced tools, while exploring new models,techniques, and perspectives on the new meaning of value. Riskcentrality and scenario analysis are major themes among thetechniques covered, and the companion website provides relevantspreadsheets, models, and instructor materials. Business is now done in a faster, more diverse, moreinterconnected environment, making valuation an increasingly morecomplex endeavor. New types of risks and competition are shapingoperations and finance, redefining the importance of managinguncertainty as the key to success. This book brings thatperspective to bear in valuation, providing new insight, newmodels, and practical techniques for the modern financeindustry. * Gain a new understanding of the idea of "value," from bothaccounting and financial perspectives * Learn new valuation models and techniques, includingscenario-based valuation, the Monte Carlo analysis, and otheradvanced tools * Understand valuation multiples as adjusted for risk and cycle,and the decomposition of deal multiples * Examine the approach to valuation for rights issues and hybridsecurities, and more Traditional valuation models are inaccurate in that they hingeon the idea of ensured success and only minor adjustments toforecasts. These rules no longer apply, and accurate valuationdemands a shift in the paradigm. Corporate Valuationdescribes that shift, and how it translates to more accuratemethods.

Ebooka przeczytasz w aplikacjach Legimi na:

Androidzie
iOS
czytnikach certyfikowanych
przez Legimi
Windows
10
Windows
Phone

Liczba stron: 728




Table of Contents

Preface

A Roadmap for This Book

Acknowledgments

About the Author

Chapter 1: Introduction

1.1 What We Should Know to Value a Company

1.2 Valuation Methods: An Overview

1.3 The Time Value of Money

1.4 Uncertainty in Company Valuations

1.5 Uncertainty and Managerial Flexibility

1.6 Relationship between Value and Uncertainty

Chapter 2: Business Forecasting for Valuation

2.1 Introduction

2.2 Key Phases of the Business Plan Elaboration

2.3 What Drives the Preparation of a Business Plan?

2.4 The Main Methodological Issues

Chapter 3: Scenario Analysis

3.1 Introduction

3.2 What Is Scenario Analysis?

3.3 Difference between Scenario and Sensitivity Analysis

3.4 When to Perform Scenario Analysis

3.5 Worst and Best Cases and What Happens Next

3.6 Multi-Scenario Analysis

3.7 Pros and Cons

3.8 How to Perform Scenario Analysis in Excel

3.9 Conclusions

Chapter 4: Monte Carlo Valuation

4.1 Introducing Monte Carlo Techniques

4.2 Monte Carlo and Corporate Valuation

4.3 A Step-by-Step Procedure

4.4 Case Study: Outdoor Inc. Valuation

4.5 A Step-by-Step Guide Using Excel and Crystal Ball

Chapter 5: Determining Cash Flows for Company Valuation

5.1 Introduction

5.2 Reorganization of the Balance Sheet

5.3 Relationship between a Company's Balance Sheet and Income Statement

5.4 From the Economic to the Financial Standpoint

5.5 Cash Flow Definitions and Valuation Models

5.6 Business Plan and Cash Flow Projections

Chapter 6: Choosing the Valuation Standpoint

6.1 Debt and Value

6.2 First Problem: The Relationship between Leverage and Value

6.3 Second Problem: Alternative Valuation Techniques When Debt Benefits from a Fiscal Advantage

6.4 Third Problem: The Choice between an Asset-Side versus an Equity-Side Perspective

6.5 From the Asset Value to the Equity Value

Chapter 7: Leverage and Value in Growth Scenarios

7.1 Growth, Leverage, and Value

7.2 Nominal and Real Discounting

7.3 Problems with the Discount of Tax Benefit

7.4 Cost of Capital Formulas in Growth Scenarios

7.5 The WACC: Some Remarks

7.6 Real Dimension of Tax Benefits

Appendix 7.1: Derivation of the Formulas to Calculate the Cost of Capital

Appendix 7.2: Pattern of

in a Growth Context: Some Remarks

Chapter 8: Estimating the Cost of Capital

8.1 Defining the Opportunity Cost of Capital

8.2 A Few Comments on Risk

8.3 Practical Approaches to Estimate

K

eu

8.4 Approach Based on Historical Returns

8.5 Analysis of Stock Returns

8.6 Analysis of Accounting Returns

8.7 Estimating Expected Returns from Current Stock Prices

8.8 Models Based on Returns’ Sensitivity to Risk Factors

8.9 The Capital Asset Pricing Model

8.10 Calculating

R

F

8.11 Calculating

R

P

8.12 Estimating

β

8.13 Dealing with Specific Risks

8.14 Conclusions on the Estimation of the Opportunity Cost of Capital

8.15 Cost of Debt

8.16 Cost of Different Types of Debt

Appendix 8.1: CAPM with Personal Taxes

Chapter 9: Cash Flow Profiles and Valuation Procedures

9.1 From Business Models to Cash Flow Models

9.2 Cash Flow Profiles of Business Units versus Whole Entity

9.3 Examples of Cash Flow Profiles

9.4 Problems with the Identification of Cash Flow Models

9.5 Cash Flow Models in the Case of Restructuring

9.6 Debt Profile Analysis

9.7 Debt Profile beyond the Plan Horizon Forecast

9.8 The Valuation of Tax Advantages: Alternatives

9.9 Guidelines for Choosing Debt Patterns for Determining Valuations

9.10 Synthetic and Analytical Procedures Valuation

9.11 The Standard Procedure

Chapter 10: A Steady State Cash Flow Model

10.1 Value as a Function of Discounted Future Results

10.2 Capitalization of a Normalized Monetary Flow

10.3 The Perpetual Growth Formula

10.4 Formulas for Limited and Variable (Multi-Stage) Growth

10.5 Conclusions

Chapter 11: Discounting Cash Flows and Terminal Value

11.1 Explicit Projections

11.2 Estimation of the Terminal Value

11.3 Evaluation of Gas Supply Co.

Chapter 12: Multiples: An Overview

12.1 Preliminary Remarks

12.2 Theory of Multiples: Basic Elements

12.3 Price/Earnings Ratio (P/E)

12.4 The EV/EBIT and EV/EBITDA Multiples

12.5 Other Multiples

12.6 Multiples and Leverage

12.7 Unlevered Multiples

12.8 Multiples and Growth

12.9 Relationship between Multiples and Growth

12.10 PEG Ratio

12.11 Value Maps

Appendix 12.1: P/E with Growth

Chapter 13: Multiples in Practice

13.1 A Framework for the Use of Stock Market Multiples

13.2 The Significance of Multiples

13.3 The Comparability of Multiples

13.4 Multiples Choice in Valuation Processes

13.5 Estimation of “Exit” Multiples

13.6 An Analysis of Deal Multiples

13.7 The Comparable Approach: The Case of Wine Co.

Appendix 13.1: Capital Increases and the P/E Ratio

Chapter 14: The Acquisition Value

14.1 Definitions of Value: An Overview

14.2 Value Created by an Acquisition

14.3 Value-Components Model

14.4 Further Considerations in Valuing Acquisitions

14.5 Acquisition Value of Plastic Materials Co.

14.6 Acquisition Value of Controlling Interests

14.7 Other Determinants of Control Premium

14.8 Acquisition Value in a Mandatory Tender Offer

14.9 Maximum and Minimum Exchange Ratios in Mergers

14.10 Exchange Ratio and Third-Party Protection

Appendix 14.1: Other Value Definitions

Chapter 15: Value and Prices in the Market for Corporate Control

15.1 Price Formation in the Market for Control

15.2 Benefits Arising from Acquisitions

15.3 From the Pricing Model to the Fair Market Value

15.4 Fair Market Value Estimated Adjusting Stand-Alone Cash Flows

15.5 Premiums and Discounts in Valuation

15.6 The Most Common Premiums and Discounts

15.7 Value Levels and Value Expressed by Stock Prices

15.8 Estimating Control Premiums

15.9 Estimating Acquisition Premiums

15.10 Acquisition and Control Premiums in a Perfect World

15.11 Estimating the Value of Controlling Stakes: An Example

15.12 Minority Discount

15.13 Discount for the Lack of Marketability

15.14 Definitions of Value and Estimation Procedures

Chapter 16: Valuation Considerations on Rights Issues

16.1 Introduction to Rights Issues

16.2 Setting the Subscription Price

16.3 Value of Preemptive Rights

16.4 Conclusions

Chapter 17: Carbon Risk and Corporate Value

17.1 Why Carbon Risk Matters

17.2 From Carbon Risks to Carbon Pricing

17.3 Incorporating Carbon Risks in Corporate Valuation

17.4 Carbon Beta

Index

End User License Agreement

Pages

iv

ii

xi

xii

xiii

xiv

xv

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

100

101

102

103

104

105

106

107

108

109

110

111

112

113

114

115

116

117

118

119

120

121

122

123

124

125

126

127

128

129

130

131

132

133

134

135

136

137

138

139

140

141

142

143

144

145

146

147

148

149

150

151

152

153

154

155

156

157

158

159

160

161

162

163

164

165

166

167

168

169

170

171

172

173

174

175

176

177

178

179

180

181

182

183

184

185

186

187

188

189

190

191

192

193

194

195

196

197

198

199

200

201

202

203

204

205

206

207

208

209

210

211

212

213

214

215

216

217

218

219

220

221

222

223

224

225

226

227

228

229

230

231

232

233

234

235

236

237

238

239

240

241

242

243

244

245

246

247

248

249

250

251

252

253

254

255

256

257

258

259

260

261

262

263

264

265

266

267

268

269

270

271

272

273

274

275

276

277

278

279

280

281

282

283

284

285

286

287

288

289

290

291

292

293

294

295

296

297

298

299

300

301

302

303

304

305

306

307

308

309

310

311

312

313

314

315

316

317

318

319

320

321

322

323

324

325

326

327

328

329

330

331

332

333

334

335

336

337

338

339

340

341

342

343

344

345

346

347

348

349

350

351

352

353

354

355

356

357

358

359

360

361

362

363

364

365

366

367

368

369

370

371

372

373

374

375

376

377

378

379

380

381

382

383

384

385

386

387

388

389

390

391

392

393

394

395

396

397

398

399

400

401

402

403

404

405

406

407

408

409

410

411

412

413

414

415

416

417

418

419

420

421

422

423

424

425

426

427

428

429

430

431

432

433

434

435

436

437

438

439

440

441

442

443

444

445

446

447

448

449

450

451

452

453

454

455

456

457

458

459

460

461

462

463

464

465

466

467

468

469

470

471

472

473

474

475

476

477

478

479

480

481

482

483

484

485

486

487

488

489

490

491

492

493

494

495

496

Guide

Table of Contents

Begin Reading

List of Exhibits

Chapter 1: Introduction

Exhibit 1.1 An overview of the main valuation methodologies/approaches

Exhibit 1.2 Investment cash flow profile and mechanics of discounting

Exhibit 1.3 Uncertainty analysis

Exhibit 1.4 Valuation framework as a function of uncertainty and managerial flexibility

Exhibit 1.5 Moderate uncertainty scenario

Exhibit 1.6 High uncertainty scenario

Exhibit 1.7 Risk profiles and cash flows modeling

Chapter 2: Business Forecasting for Valuation

Exhibit 2.1 Competitive strategy at corporate level

Exhibit 2.2 Competitive strategy at the single business activity level (the Alfa case, 1st part)

Exhibit 2.3 Competitive strategy at the single business activity level (the Alfa case, 2nd part)

Exhibit 2.4 Definition of the necessary actions to implement the strategy (the Beta case)

Exhibit 2.5 The definition of the quantitative assumptions (the Gamma case)

Exhibit 2.6 Revenues as is vs. additional revenue from new commercial activities

Exhibit 2.7 Evolution in sales volumes (€)

Exhibit 2.8 Evolution in unitary prices (€)

Exhibit 2.9 Evolution in revenues (€)

Exhibit 2.10 Evolution in the unitary cost for each production factor

Exhibit 2.11 Hypotheses underlying trade credit, trade debts, and inventory

Exhibit 2.12 Evolution in the number of points of sale

Exhibit 2.13 Evolution of managed commercial surface

Exhibit 2.14 Evolution in revenue per square meter for the managed surface (€)

Exhibit 2.15 Evolution of the percentage contribution margin

Exhibit 2.16 Evolution of average rental cost per sqm

Exhibit 2.17 Expected revenues composition over business plan horizon

Exhibit 2.18 Time distribution of capex and equity injection

Exhibit 2.19 Traffic volume evolution (k km, for vehicle category)

Exhibit 2.20 Toll per km evolution

Chapter 3: Scenario Analysis

Exhibit 3.1 The DCF valuation model in Excel

Exhibit 3.2 The assumptions for the scenarios

Exhibit 3.3 The discount rate (cost of capital) for each scenario

Exhibit 3.4 Summing up the scenarios' assumptions

Exhibit 3.5 Locating the What-if Analysis in Excel

Exhibit 3.6 The Scenario Manager command in Excel

Exhibit 3.7 The summary of defined Scenarios

Exhibit 3.8 The editing command for Scenarios

Exhibit 3.9 Entering the values for the changing cells

Exhibit 3.10 The Scenarios created

Exhibit 3.11 Entering the results cells

Exhibit 3.12 The Scenario Analysis result

Chapter 4: Monte Carlo Valuation

Exhibit 4.1 Outdoor financials

Exhibit 4.2 Revenue growth for Outdoor

Exhibit 4.3 Financing profile for Outdoor

Exhibit 4.4 Working capital evolution for Outdoor

Exhibit 4.5 The assumptions for Outdoor valuation

Exhibit 4.6 Revenues–costs correlation

Exhibit 4.7 Gumbel distribution used for

Outdoor

's market size

Exhibit 4.8 Min./Max. values assumed for each market

Exhibit 4.9 Potential prices of iron

Exhibit 4.10 Potential prices of aluminum

Exhibit 4.11 Modeling the working capital dynamics

Exhibit 4.12 Future expected cash flows in the explicit forecast period

Exhibit 4.13 Distribution of the equity value

Exhibit 4.14 Distribution of the

NPV

of the investment

Exhibit 4.15 Probability of getting a return above a determined threshold

Exhibit 4.16 Variables with the strongest impact

Exhibit 4.17 Main Crystal Ball interface

Exhibit 4.18 Defining assumptions in Crystal Ball

Exhibit 4.19 Entering assumptions in Crystal Ball

Exhibit 4.20 Distribution assumptions: case 1

Exhibit 4.21 Distribution assumptions: case 2

Exhibit 4.22 Distribution assumptions: case 3

Exhibit 4.23 Running trials in Crystal Ball

Exhibit 4.24 Starting trials

Exhibit 4.25 Simulation outcome depending on the number of trials

Exhibit 4.26 Simulation outcome depending on the number of trials

Exhibit 4.27 Simulation outcome depending on the number of trials

Exhibit 4.28 Simulation outcome depending on the number of trials

Exhibit 4.29 Simulation IV outcome

Exhibit 4.30 Simulation IV outcome

Exhibit 4.31 Simulation IV outcome

Exhibit 4.32 Simulation IV outcome

Exhibit 4.33 Correlation analysis in Crystal Ball

Exhibit 4.34 Accepting the correlation in Excel

Exhibit 4.35 Adding assumptions

Exhibit 4.36 Setting up correlation coefficients

Exhibit 4.37 Choosing an adequate correlation

Exhibit 4.38 Full list of correlations

Exhibit 4.39 Entering values for the correlation coefficients

Exhibit 4.40 Choosing to adjust the correlations

Exhibit 4.41 Correlation matrix

Exhibit 4.42 DCF results depending on the number of trials

Exhibit 4.43 DCF results depending on the number of trials

Exhibit 4.44 DCF results depending on the number of trials

Exhibit 4.45 DCF results depending on the number of trials

Exhibit 4.46 IV results depending on the number of trials

Exhibit 4.47 IV results depending on the number of trials

Exhibit 4.48 IV results depending on the number of trials

Exhibit 4.49 IV results depending on the number of trials

Chapter 5: Determining Cash Flows for Company Valuation

Exhibit 5.1 Balance sheet reorganized

Exhibit 5.2 Representation of the net operating invested capital (NIC)

Exhibit 5.3 The structure of the financing sources

Exhibit 5.4

Printing Co

.'s Income Statement reorganized according to the functional principle (in Euro/000)

Exhibit 5.5

Printing Co

.'s net invested capital and coverage (in euro/000)

Exhibit 5.6 Synthetic income statement reorganization model

Exhibit 5.7 Printing Co.'s reorganized income statement (in euro/000)

Exhibit 5.8 Financial statement outline

Exhibit 5.9 FCFO calculation

Exhibit 5.10 FCFE calculation

Exhibit 5.11 Printing Co. main assumptions

Exhibit 5.12 Printing Co.'s provisional balance sheet

Exhibit 5.13

Printing Co

.'s provisional income statement

Exhibit 5.14 Printing Co.'s free cash flow from operations (FCFO) projection

Exhibit 5.15 Printing Co.'s free cash flow to equity (FCFE) projection

Chapter 6: Choosing the Valuation Standpoint

Exhibit 6.1 Balance sheet items and related flow (without taxation)

Exhibit 6.2 Relationship between

K

el

and leverage (

D

/

E

)

Exhibit 6.3 Proof of the law of conservation of value

Exhibit 6.4 Company's flow and corporate taxes

Exhibit 6.5 Increase in value due to tax savings

Exhibit 6.6 Discount rates, leverage, and tax benefits

Exhibit 6.7 Assets-side and equity-side perspective

Exhibit 6.8 Different approaches in valuing the equity of a company

Exhibit 6.9

W

assets

and

W

equity

Chapter 7: Leverage and Value in Growth Scenarios

Exhibit 7.1 Scenarios' assumptions

Exhibit 7.2 Relationship between and

K

eu

Exhibit 7.3 Relationship between

WACC

* and

K

eu

Exhibit 7.4 Expected cash flows

Exhibit 7.5 Cost of capital parameters

Exhibit 7.6 Actual leverage and debt

Exhibit 7.7 Debt and tax shield value

Exhibit 7.8 Levered company's value and debt

Exhibit 7.9 Cash flow with corporate and personal taxes

Exhibit 7.10 Leverage, growth, and cost of capital

Exhibit 7.11 Patterns of under different assumptions

Exhibit 7.12

Chapter 8: Estimating the Cost of Capital

Exhibit 8.1 Approaches/methods to estimate opportunity cost of capital

Exhibit 8.2 The licensee example

Chapter 9: Cash Flow Profiles and Valuation Procedures

Exhibit 9.1 Understanding the business model and choosing a valuation procedure

Exhibit 9.2 Multi-business company valuation

Exhibit 9.3 Cash flow examples:

public utility

(natural gas distribution)

Exhibit 9.4 Cash flow examples:

public utility

(hydroelectric)

Exhibit 9.5 Cash flow examples:

print on demand

Exhibit 9.6 Cash flow profile examples: waste management company

Exhibit 9.7 Cash flow profiles: cyclical sector

Exhibit 9.8 Cash flow profiles: savings and loans (traditional business)

Exhibit 9.9 Cash flow profiles: savings and loans (portfolio management)

Exhibit 9.10 Cash flow profiles: savings and loans (investment banking)

Exhibit 9.11 Relevant forecasts in evaluating

W

TS

(mln / €)

Exhibit 9.12 Debt patterns after the plan horizon forecast (assumptions 1 and 2)

Exhibit 9.13 Debt pattern beyond the plan horizon forecast (assumption 3)

Exhibit 9.14 Debt pattern beyond the plan horizon (assumption 4)

Exhibit 9.15 Debt profiles with constant repayment (A) and decreasing repayment (B)

Exhibit 9.16 Valuation of tax benefits (plan horizon)

Exhibit 9.17 Valuation of tax shields (mln /€)

Exhibit 9.18 Typical cash flow projection in DCF valuations

Chapter 10: A Steady State Cash Flow Model

Exhibit 10.1 Steady-state/neutral inflation scenario

Exhibit 10.2 Valuation formulas in steady-state/neutral inflation scenario

Exhibit 10.3 Hydroelectric Co. financial statements

Exhibit 10.4 Debt profile

Exhibit 10.5 Cash flow dynamic in a constant-growth scenario

Exhibit 10.6 Flow dynamic in constant growth scenario (ROE =

K

e

)

Exhibit 10.7 Valuation formulas in a perpetual growth scenario

Exhibit 10.8 Valuation formulas: limited growth

Exhibit 10.9 Valuation formulas in a variable-growth scenario

Chapter 11: Discounting Cash Flows and Terminal Value

Exhibit 11.1 Basic DCF: alternative methods

Exhibit 11.2 Gas Supply Co.—profile of free cash flow from operations net of taxes (FCFO) assumed for the evaluation

Exhibit 11.3 Expected consumption of natural gas in Italy

Exhibit 11.4 Gas Supply Co.: asset and liability statement (in mln €)

Exhibit 11.5 Gas Supply Co.: income statement (in million €)

Exhibit 11.6 Gas Supply Co. cash flow statement (FCFO) (in million €)

Exhibit 11.7 Discounted cash flows

Exhibit 11.8 Gas Supply Co.: debt, interest payments, and tax shield from

t

1

to

t

4

(in million €)

Chapter 12: Multiples: An Overview

Exhibit 12.1 Stock market and deal multiples

Exhibit 12.2 Examples of business multiples

Exhibit 12.3 The most frequently used multiples and their formulas

Exhibit 12.4 Balance sheet expressed in market values and its corresponding multiples

Exhibit 12.5 Direct and indirect multiples

Exhibit 12.6 Factors that influence the P/E multiple

Exhibit 12.7 The relationship between P/E and leverage

Exhibit 12.8 Theoretical relationship between the EV/EBIT ratio and leverage

Exhibit 12.9 Figure theoretical relationship between the P/BV ratio and leverage

Exhibit 12.10 Trend of the P/BV multiple with different leverage levels

Exhibit 12.11 Adjustment of P/E

Exhibit 12.12 P/E trend with respect to the growth rate

Exhibit 12.13 Trend of the P/E ratio with respect to the growth rate

Exhibit 12.14 Map of multiples with respect to growth

Exhibit 12.15 Value maps for a sample of financial companies

Chapter 13: Multiples in Practice

Exhibit 13.1 The relevance of tax credits

Exhibit 13.2 Trend of the Price/Book value multiple in a sample of transactions in the banking industry

Exhibit 13.3 Characteristics of comparable companies (sample of European companies)

Exhibit 13.4 European companies multiples

Exhibit 13.5 Estimates of the fiscal effects

Exhibit 13.6 Calculation of the present value of the tax benefits linked to tax concessions

Exhibit 13.7 Adjusted multiples of European companies

Exhibit 13.8 Value of “Wine” through multiples

Exhibit 13.9 Multiples trend in the last four years

Exhibit 13.10 Multiple estimation during the period of a capital increase

Chapter 14: The Acquisition Value

Exhibit 14.1 Value-components model

Exhibit 14.2 Company A and B financials

Exhibit 14.3 Elements (layers) that form the value of acquisition

Exhibit 14.4 Plastic Materials Co.: stand-alone cash flow

Exhibit 14.5 The case of Plastic Materials Co

Exhibit 14.6 Trend of the unit acquisition value of shares as a function of the capital fraction acquired

Exhibit 14.7 Trend of the unit acquisition value of the shares as a function of the risk of not obtaining the desired synergies

Exhibit 14.8 Private benefits related to control

Exhibit 14.9 Possible exchange ratios in relation to the size of the benefits expected in the merger

Exhibit 14.10 Movement in exchange ratio in presence of indivisible benefits

Chapter 15: Value and Prices in the Market for Corporate Control

Exhibit 15.1 Positioning of fair market value

Exhibit 15.2 Alpha's financials €/000

Exhibit 15.3 Revised Alpha's financials (€/000)

Exhibit 15.4 Delta: cash flow projection (€/billion)

Exhibit 15.5 Stand-alone value for Delta

Exhibit 15.6 Delta: businesses' cash flow (€/bln)

Exhibit 15.7 Delta: modified cash flow (€/billion)

Exhibit 15.8 Break-up valuation for Delta

Exhibit 15.9 Beta: cash flow projection (€/billion)

Exhibit 15.10 Stand-alone valuation for Beta

Exhibit 15.11 Beta: modified cash flow (€/bln)

Exhibit 15.12 Acquisition and control premium

Exhibit 15.13 Simulation of the acquisition and control premiums

Exhibit 15.14 Premium as a function of the acquired fraction of capital

Exhibit 15.15 Levels of value

Chapter 16: Valuation Considerations on Rights Issues

Exhibit 16.1 Calculation of TERP

Exhibit 16.2 Influence of different factors on the level of discount to TERP

Exhibit 16.3 Calculation of the theoretical value of rights at announcement of the terms

Exhibit 16.4 Separation of rights ($)

Exhibit 16.5 Separation of rights and positive share price reaction ($)

Exhibit 16.6 Separation of rights and negative share price reaction ($)

Exhibit 16.7 Shareholders' net worth should not be affected by the level of discount to TERP

Exhibit 16.8 Discount to TERP and dilution

Chapter 17: Carbon Risk and Corporate Value

Exhibit 17.1 An overview of the main carbon risks relevant for companies

Exhibit 17.2 Frequency distribution of internal carbon prices (in $) per ton of

Exhibit 17.3 Estimates of the social cost of CO2, 2015–2050

Exhibit 17.4 Cash flow estimate

Exhibit 17.5 Cash flow estimates under scenarios

Exhibit 17.6 Probability of each scenario

Exhibit 17.7 Carbon beta of European utilities

Corporate Valuation

Measuring the Value of Companies in Turbulent Times

MARIO MASSARIGIANFRANCO GIANFRATELAURA ZANETTI

 

 

 

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, visit our website at www.WileyFinance.com.

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.

Copyright © 2016 by Mario Massari, Gianfranco Gianfrate, and Laura Zanetti.

All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com.

For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data is available:

ISBN 9781119003335 (Hardcover)

ISBN 9781119003359 (ePDF)

ISBN 9781119003342 (ePub)

Cover Design: Wiley

Cover Image: © Alicia_Garcia/iStockphoto

Preface

A ROADMAP FOR THIS BOOK

The value of a business is essentially related to three main factors: its current operations, its future prospects, and its embedded risk. The advent of globalization, new technologies, and the consequences of the recent financial crisis completely reshaped these elements, thus making more elusive the definition of company “value” and of the metrics to measure it.

Firstly, firms do business in a context becoming progressively faster, more diverse, and more interconnected so that also valuing their current operations is a task less straightforward than in the past. Secondly, forecasting future macro and business related dynamics is getting less standardized in a business environment characterized by inherent difficulty in predicting changes—both on the upside and on the downside—and by constant innovation for companies that are more and more exposed to hyper-competitive industry dynamics. Thirdly, new types of risks and competition, so far unknown (think for example of climate change risks), are shaping both the operational and the financial side of enterprises, redefining the importance of managing uncertainty as a key element to achieve success.

In this context, the book is organized in three parts. In the first part of the book (Chapters 1 to 4), the main focus is on the relationship between value and business/economic uncertainty. In an environment characterized by an increased complexity where the concept of value itself is challenged, we provide a definition of corporate value based on a holistic approach, thus encompassing both the accounting and the financial perspective (Chapter 1).

Moving to relationship between uncertainty and value, we focus on the business modeling tools available to forecast corporate results and determine company value. Depending on the level of uncertainty, on the information available, and the time and effort investable in the analysis, it is possible to pick one out of three possible approaches. We start from a standard situation when uncertainty is limited and there is a clearly dominant, likely scenario (Chapter 2).

When there is a significant amount of uncertainty and there is one or more scenario(s) that are alternative to the most likely one and that could have extreme—either positive or negative—consequences for company's value, the scenario-based approach is to be preferred (Chapter 3).

Stochastic simulation (Chapter 4) is to be used when detailed data is available (or assumed) regarding the probability distributions of key variables affecting future cash flows. This approach, as discussed, is mathematically complex but it can be handled by software packages easily available.

Having tackled the uncertainty modeling aspects, the second part of the book is focused on the main valuation approaches that can be used in practice. The chapters from 5 to 13 present therefore the main principles of corporate valuation starting from the reorganization of the financial statement data and business plan figures (Chapter 5). The relationship between financial leverage and corporate value is then presented (Chapter 6), followed by the discussion of how corporate growth and, financial leverage are interrelated (Chapter 7).

Chapter 8 presents the main techniques and tools to estimate the cost of capital. From Chapter 9 to Chapter 11, the discounted cash flow analysis is presented in depth highlighting the various approaches that can be used in practice.

Moving to relative valuation, Chapters 12 and 13 present respectively the theory and practice of multiple-based valuation for companies.

The third and final section of the book comprises Chapter 14 and 15, which introduce the main elements of valuations in the market for corporate control and models to structure corporate valuations in the framework of M&A transactions.

Chapter 16 features a topic, the valuation of right issues, seldom mentioned by corporate finance handbooks but which is becoming crucial in many financial markets.

Chapter 17 closes by introducing a topic that is receiving increasing attention by investors and policymakers, namely the incorporation of environmental risks in corporate valuation.

The key message of the book is that standard business planning and valuation, which assume high visibility of firms' future performances, tend to prove more and more inadequate. In the context of high market volatility and recurring disruptive economic events associated with the post-financial crisis business world, companies' operations face systematically new points of discontinuity and increased risks. As a consequence, traditional standard valuation techniques may provide insufficient information in an economic environment characterized by high uncertainty. This book treats risk not as one of the input variables used in the valuation process but as the main driver to be considered when approaching the estimation of corporate value.

Acknowledgments

Of course, we owe a very great debt of thanks to friends, colleagues, and students who have contributed to this work. First, we thank greatly Marco Villani, a valuation expert who read and commented on chapters. Second, Federico D'Agruma provided extensive and invaluable assistance for the preparation and revision of the manuscript. We would like to also thank Marco Ghitti who prepared the supporting materials for the book. We are also grateful to John Carusone, Alberto Maria Ghezzi and Kim Salvadori, who helped in the revision of some sections of the manuscript. We are immensely grateful to the Wiley team—especially to Meg Freeborn, Bill Falloon, and Caroline Maria Vincent—who assisted us in the book preparation and showed incredible patience with our consistent missing of deadlines.

About the Author

Mario Massari is Full Professor of Corporate Finance and former Head of the Finance Department at Bocconi University (Milan). He has written extensively on business valuation and corporate finance topics, and he is considered one of the leading experts in Italy in the field of Business Valuation. He serves as board member at several listed and unlisted companies and he is a member of the Executive Committee of the OIV (the Italian valuation principles setter).

[email protected]

Gianfranco Gianfrate is a Giorgio Ruffolo Fellow at the Harvard Kennedy School (Cambridge, MA) and a research affiliate of Tufts University (Medford, MA). He has authored several books and articles on business valuation and corporate governance issues.

Previously, he was a consultant at Deloitte (Milan), a manager at Hermes Fund Managers (London), and served as member of the Investment Committee at Eumedion (Amsterdam). He has also been a member of the IPO Best Practice Committee at the Italian Stock Exchange, co-authoring the official Listing Guide for going public companies.

[email protected]

Laura Zanetti is Associate Professor of corporate finance at Bocconi University (Milan), where she teaches company valuation and is research fellow within CAREFIN, centre for applied research in finance.

She has been the director of the Master of Science in Finance at Bocconi, visiting scholar at Massachusetts Institute of Technology (Cambridge, MA) and London School of Economics and Political Sciences (London).

She published several books and articles on corporate governance, valuation, M&A, and industrial performance. She is a Certified Public Accountant, Certified Auditor in Italy, and board member of listed and private companies.

[email protected]

Chapter 1Introduction

1.1 WHAT WE SHOULD KNOW TO VALUE A COMPANY

This book is based on the idea that mastering valuation techniques is possible only after having gained a sound theoretical knowledge. But theory is not enough. In order to evaluate an enterprise or an acquisition, an analyst should have enough first-hand experience: such experience usually does not depend on the quantity of the previous valuations carried-out but on the quality of the work done.

A distinguishing feature of the valuation process is that to produce convincing valuations, analysts should master various areas of expertise, and three in particular:

Industrial economics and business strategy

with reference to the analysis of the industry and competitive context devoted to understanding the validity of the company's business model, its past results, and its future plans

Theory and techniques of finance

with regard to the basic principles of net present value, to the underlying links between leverage and value, to models that explain stock prices on financial markets, and finally to the techniques which correctly depict the business plan in terms of cash flow

Economic theory

, in particular with regard to the relationship between uncertainty and value

1

in all those cases in which the simplifications assumed in the standard models presented in the finance textbooks do not permit the development of convincing valuations

Despite the fact that theoretical contributions in all three disciplines are widely known, valuation is more than a collage of knowledge and technique. In a valuation, critical drivers are so bound together that the real distinguishing element is the “glue” that holds them together. This glue consists of the ability to balance the different choices made in each phase of which the evaluation process is composed, of correctly weighing the empirical evidence, and of the ability to perform coherent estimates within the final objectives of the valuation work.

1.2 VALUATION METHODS: AN OVERVIEW

Finance textbooks offer several different options to perform the valuation of a firm or of an acquisition. Furthermore, financial institutions and consulting firms typically work out tailor-made models expanding the spectrum of available techniques. In the end, in assessing value of firms belonging to particular industries, several empirical techniques have gained quite a standing among practitioners.

Given the number of methodologies made available by theorists and practitioners, we find it useful, before getting into the core of this book, to explore a classification of the most widely used methodologies (Exhibit 1.1).

Exhibit 1.1 An overview of the main valuation methodologies/approaches

Exhibit 1.1 shows that the methodologies available (excluding simplistic empirical approaches) can be grouped into four fundamental approaches, each a function of the relevant link between corporate value and relevant value driver. A methodology is then a choice of the relevant driver, chosen out of the above-mentioned four approaches in order to assess value:

Income approach

Economic profit approach

Market approach

Net asset approach

The first approach expresses the value of a company or an investment as a function of the expected returns it generates. The so-called financial method (or, better, discounted cash flow, or DCF) falls into this approach and is the methodology most consistent with those found in standard finance textbooks.

The second approach is based on the idea that the value of a company is determined by two components: net asset value and earnings that exceed the “normal” return of the assets (economic profit is then the difference—when positive—between realized returns and “normal” industry returns).

The third approach is empirical: valuations are performed through a comparison with comparable assets traded on the market.

Finally, the fourth approach determines value from the estimation of the assets (tangible and intangible) that, net of the liabilities, constitute the net invested capital of the firm.

1.2.1 Common Practices in the Accounting and Financial Communities

Often, professionals separate methodologies into two main approaches to valuation: the first is the standard practice adopted by the financial community; the second one is the most widely used by accounting professionals.

The common practice in the financial community can be traced back to the methodologies adopted by investment and merchant banks—in particular:

The DCF method based on the discounting of future cash flows derived from the company's business plan or assumed by the analyst

Stock market multiples or multiples derived from comparable transactions

In other professional fields, the other methods set forth in Exhibit 1.1 seem to be preferred, partly because of cultural affinities and partly because of the specific goal of the valuation.

Indeed, some methods (particularly those based on excess earnings):

better fit into some economic and accounting environment;

follow, therefore, a logic more understandable to the actors for whose benefit the valuation is performed; and

allow one to effectively and convincingly deal with special valuation problems, such as third-party interests or tax benefit valuations.

1.2.2 Approach of This Book

Despite the widespread use of alternative methodologies, most of this book will be devoted to the DCF analysis.

The reason for this choice is that DCF valuation processes allow a clear focus on the fundamental principles underlying valuation conditions that need to be met, and also when the professional believes a different methodology to better fit the final valuation objective.

In this chapter, we introduce, following a logical order that teaching experience has shown to be effective, the basic principles and themes that form the pillars of the DCF valuation approach:

The net present value (NPV) principle

How to deal with uncertainty

The relationship between uncertainty and value

The need for preventing, when possible, subjective judgments in value determination

1.3 THE TIME VALUE OF MONEY

Irving Fisher is considered the founding father of modern finance theory, not only for his market equilibrium model, which explains investment and consumption decisions, but also because of his almost-obsessive insistence on the need to determine any asset value exclusively as a function of its expected discounted cash flows.

Thanks to Fisher, since the early 1920s the main building block of valuation has been identified as follows: any asset value (financial or real) is a function of the cash flows it can generate and of the time distributions of the cash flows.2

Through Fisher's contribution, the concept of time value of money became solidified, thus building the rationale for the universally agreed need for a present value approach to valuation.

So, without uncertainty, or, as it is often said, in a deterministic framework, an investment, firm, or more generally any asset value can be obtained by the following:

Calculate the asset relevant cash flows and their time distributions.

Discount any cash flows at a rate expressing the time value of money.

Typically, this rate is the return rate of investments whose issuers are virtually free of any insolvency risk, such as government bonds (so-called risk-free rate). Exhibit 1.2 shows the concept.

Exhibit 1.2 Investment cash flow profile and mechanics of discounting

1.4 UNCERTAINTY IN COMPANY VALUATIONS

In order to set forth in an organized fashion the crucial problem of every evaluation, it is necessary to understand the reasoning that guides the process of valuation in a context in which the results of an investment, or of a business, cannot be certainly determined in advance, but can only be estimated.

In order to introduce the problem of uncertainty with the pragmatic approach more suitable to the needs of a business or financial analyst, it is useful to start from some basic concepts:

The performance of industries is characterized by different degrees of predictability and, therefore, uncertainty

. For example, trend in demand in the public utilities sector shows a significant correlation with the trend in the GDP, or the total family income. In other sectors, demand is a function of different macroeconomic variables, such as industrial investments, interest rates, etc. Generally, though, these correlations are more weak because some factors, such as lifestyle evolution or consumer behaviour, can have a great influence on the demand. Further, some other industries are extremely sensitive to economic trends (typically, the intermediate sectors, investment goods sectors for which demand is formed by other industries). Finally, some industries are less cyclical (e.g., some food sectors, and the pharmaceutical industry).

New ventures, or firms that develop innovative strategies, face a different kind of uncertainty than traditional or consolidated industries

. In fact, in traditional industries historical information helps to identify systematic correlations between the economic environment and a firm's expected results. In innovative ventures lacking significant historical comparisons, uncertainty can be associated with the idea of probability as an expectation of future events: therefore, estimates are largely subjective (uncertainty = belief).

3

Such a concept of uncertainty, in general, is contrasted by academics with the notion of probability that past events repeat themselves (in such case, the concept of probability is associated with that of frequency).

Firms, as organizations of individuals competing on the market, generate evolutionary phenomena that constitute risk factors for other firms, which in turn react by generating new changes

. Therefore, we must abandon the idea, implicitly accepted by finance theorists, that uncertainty is a situation passively faced by firms. In the real world, uncertainty is managed by firms that seek to exploit favorable opportunities and limit the downside of unfavorable events. Management, indeed, by its own decisions continuously molds the risk profile characteristic of its core activity. That is, management style, interaction with the economic environment, and adopting innovative approaches rather than passive adaptation are fundamental factors in adjusting the degree of uncertainty associated with external factors, common to all the firms belonging to the same strategic business area.

In the valuation of investments, acquisitions, or businesses, different forms of uncertainty can coexist—although, generally, one form tends to prevail over the others.

On the one hand, there are valuations of companies that operate in highly stable macroeconomic contexts, in highly predictable industry, and whose future performance is characterized by high visibility. Such cases of “easy” valuations become less and less frequent in the current context of erratic economies and turbulent financial markets.

1.4.1 Organizing the Analysis

Financial analysts approach the issue of uncertainty in forecasting by adopting logical tools and models developed in the area of industrial economics and of strategy. Exhibit 1.3 shows a simplified description of a typical analysis workflow.

Exhibit 1.3 Uncertainty analysis

Business Model Analysis

Typically, analysts use the expression business model to assess the characteristics of the products or services offered by a firm, the marketing choices adopted, and the production decisions. In the business model analysis, analysts seek to understand the cost/revenues structure of the firm or of the investment project. An example can help clarify the concept.

Alpha is the European leader in automated equipment for manufacturing and packaging for the pharma industry (blisters, boxes, wrappers, case packers, and palletizers). In the pharma industry, a fundamental feature of production equipment is reliability while price is a secondary issue. Alpha has consolidated its leadership position by systematically investing a significant portion of its revenues in improving equipment for specific functions and researching innovative technical solutions. Non-core components production has been assigned to different companies. Equipment is marketed by a European and North American distribution network. Technical support, spare parts sales, and equipment updates represent a significant fraction of the overall gross margin.

This scant information defines the “business model” and lets us understand that the revenue share emerging from equipment sales, being related to the pharmaceutical industry, is only marginally affected by cycles and is complemented by further revenues, with high margins and no cyclicity (as, for instance, in the after-sales support business).

Under the cost structure planning, assembly, setup, and a significant share of the R&D costs are largely inelastic, because they require a highly specialized staff, which is a strategic resource of the company and is fundamental to the growth outlook for Alpha.

Production costs are, on the other hand, relatively flexible: as previously noted, Alpha assigns the manufacturing of noncore components of its own products to a small selected number of suppliers, mostly located in the same geographical area.

Market and Competitors Analysis

The next step consists of the analysis of the environment external to the company, in order to understand the firm's market positioning relative to competitors and therefore the prospects for growth and profit. At this stage the analysis focuses on the business lifecycle and the competitive pressure which characterize the industry, the threat of substitute products, the entry barriers and potential competitors, and the relationship between customers and suppliers.

In the Alpha case, the pharmaceutical industry is characterized by a sustained growth rate, both in Europe and in the USA (over 7% per year in real terms). Industry analysts believe this trend is destined to last in the future.

By examining balance sheets for the most important pharmaceutical firms, one observes a strong correlation between revenue growth rate and spending on technical investments.

Just a small number of competitors are active in Alpha's market niche. Potential supply is represented by packaging equipment firms, which generally develop less reliable technologies than the standard pharma industry requirements.

Risk Profile Analysis

Typically the assessment of risk profile begins with a classical SWOT analysis of the competitive environment and the competitors.4

The case under consideration doesn't show significant risk factors: entry in the industry is limited by specific technical competence needed to produce the equipment targeted for the pharmaceutical industry and by the market reputation of Alpha. Thus, there are no reasons to induce the analyst to delineate alternative competitive scenarios (for instance, the entry of a newcomer with resulting reduction of market share or margin squeezes). Yet, this approach can be easily shared provided Alpha can keep up with a growth rate consistent with the pharma industry rate and can complete its product range by acquiring competitors working in related market niches.

Consolidating Alpha's market share could allow for an extension of the product range offered: from mere equipment sales to planning the whole production cycle as a general contractor. Moreover, Alpha could step into the business machines used in the cosmetic industry that, although not as demanding in terms of the technological specifications as the pharma industry ones, show significant similarities.

1.5 UNCERTAINTY AND MANAGERIAL FLEXIBILITY

In a traditional approach, closer to financial modeling than strategic analysis, estimate of value stems from a passive attitude toward risk. Yet, we have observed that in reality businesses are by far more articulated: in fact, up to a certain level, the phenomena of change can be managed or turned to one's favor through opportune intervention.

1.5.1 Static versus Dynamic Assumption

As a first step, when facing the valuation of an investment plan, acquisition, or firm, it is worth asking which standpoint should be adopted:

A static view assuming that the current business model will continue to work as it is

A dynamic view which takes into account the adaptation of the business model to new scenarios

If we want to frame the issue in general terms, the valuation boundaries are determined—with regard to the choice of the correct standpoint—by two main factors:

The level of uncertainty, which characterizes the estimate measured as the impact that information unavailable at the time of the valuation can have on the valuation result itself; or, in other words, how far it is from the idea of probability based on the repetition of past results

Managerial flexibility—that is, how much the business model allows management to handle unfavourable scenarios or pick new opportunities in favorable situations

Exhibit 1.4 presents a graph that permits us to frame the context that drives the valuation with respect to the degree of uncertainty and management flexibility.

Exhibit 1.4 Valuation framework as a function of uncertainty and managerial flexibility

Limited Uncertainty and Flexibility

In Exhibit 1.4, area A identifies situations in which the frame of reference of the estimate is delineable in clear terms and the business model does not permit significant room to manoeuvre. A typical example is the business of gas and electricity grids; in these business areas, results emerge from a model in which relationships between macroeconomic variables, tariffs, transported volumes, and costs are definable with a close approximation and can be consistently projected in the future with a high degree of credibility.

Uncertainty factors consist of the evolution of energy consumption that, as is well known, is a function, in the short term, of climate factors and, in the long term, of the general trend of the industry as a whole; changes in industry regulations; and the intensity of competitive pressure from the supply side.

In these businesses, shifts in consumption translate directly into operating margin decreases/increases since the cost structure is extremely rigid and management has very limited flexibility to keep up with unfavorable trends in demand.

In the previously sketched framework, the representation of uncertainty is consistent with the assumptions generally adopted by finance textbooks. In particular, it is possible to forecast different scenarios and to expect credibly that realized results of the business will fall in between the two most extreme cases (the most and the least favorable).

To keep the analysis simple, analysts in general limit themselves to just three scenarios (optimistic, the most probable, and pessimistic). Therefore, uncertainty can effectively be depicted by means of a triangular distribution.

In the case of public utilities, the gap between scenarios is generally quite small; in other industries, the gap can significantly widen. Generally speaking, the scenario expected in average conditions is also the most likely to happen. Exhibit 1.5 graphically depicts the point.

Exhibit 1.5 Moderate uncertainty scenario

In the framework similar to Exhibit 1.5, it is not unusual for analysts to work out only the most probable scenario5 with respect to cash flow projections.

High Uncertainty and Limited Flexibility

Area B in Exhibit 1.4 identifies those situations in which information useful to assess the performance of a business is not available at the time of the valuation, and flexibility to manage unfavorable events or to improve favorable ones is very limited.

For example, a company in the waste management industry had assumed the construction of a new landfill in its business plan. The project kickoff, though, was under litigation with the environmental groups that opposed the project, despite the fact that set-aside for dumping was a part of a regional plan.

The legal experts had identified a negligible risk of abandoning the project.

In similar situations, the following procedure could be adopted that has the merit of highlighting the risk profile of the venture:

Delineate the scenarios (in our case, accomplishment of the dumping or abandonment of the venture).

Calculate the net present value for each of the scenarios.

The procedure described has unquestionable effectiveness in terms of information transparency: it avoids the assessment of an “average” result (the mathematical average of two different scenarios) because this “average” event cannot, by definition, take place.

An example can clarify the idea. The existing landfill can generate returns equal to 400 per year, in the most probable scenario. The construction of the new facility can generate additional returns of 1,200. The total expected returns if the project is completed are therefore 1,600. Yet, the probability of making the second facility is 50 percent. Exhibit 1.6 depicts the situation.

Exhibit 1.6 High uncertainty scenario

One can see that the representation is very different than that presented in Exhibit 1.5. In this case, the uncertainty framework is closer to a coin toss: as a matter of fact, either you get the favorable scenario or the unfavorable one.

In valuating businesses, similar situations are rather frequent and involve:

The valuation of start-ups, of ventures in the initial phases of their life cycle, and of innovative businesses

The valuations with specific risk characters (e.g., license or contract renewals, environmental risks, strategic supplier dependence, high customer concentration, dependence on key persons)

High Uncertainty and Flexibility

Area C in Exhibit 1.4 depicts situations in which high uncertainty is accompanied by a wide range of managerial choices, which can, consequently, open new scenarios (in other words, some scenarios are extremely management decisions–related, decisions that can be the response to alternative scenarios).

Going back to the public utilities case, many analysts have approached the valuation of energy distribution firms by estimating the value of the growth opportunities offered by the option of using the commercial network to offer different services to the final users.

Given the uncertainty associated with such initiatives, it is reasonable to assume that a multiservice business model can be developed using a step-by-step process: the firm can, in an early stage, offer just services related to the core business (e.g., combine the energy distribution with the sale activities, installation and maintenance of home appliances), to further expand into a wider range of services in case of success of the trial phase (in-house insurance, consumer credit services, etc.).

Average Uncertainty and Flexibility

In Area D in Exhibit 1.4 fall the situations that form the background of an evaluation: the scenarios can be credibly delineated and it is likely that management can take the necessary steps or seize the opportunity offered by change.

With regard to the situations referred to in Area C of Exhibit 1.4, change does not arise as a disruptive and intermittent phenomenon, but can lead back to the observable dynamics of the present.

As an example, in the valuation analysis of an important business in the spirit industry, the team doing the business analysis had described two scenarios. The first assumed decreasing sale volumes, consistently with the life cycle of a mature industry as observed in other firms within the same industry. The second one assumed instead, due to the strong brand value, a constant sale volume not affected by the general trend in the industry.

Given the notoriety of the brand and the strength of the commercial network of the business, it was unlikely to assume that management would have reacted passively to a reduction in sales. More realistically, it would have differentiated the products between the traditional ones and the new ones (“white” spirits, etc.).

Therefore, considering the operational flexibility permitted by the strength of the brand, the unfavorable scenario was modified assuming, after an initial decrease in sales, a return to the original levels with slightly lower margins given the increase in advertising costs.

The example shows a typical process of financial analysts, which translates into an upgrading of expectations in comparison to the industry due to the strength points of the business that confirm the hypothesis that the management can effectively react to unfavorable market conditions.

Obviously, the opposite reasoning also holds: when the firm under valuation is weaker than competitors, the average industry expectations can be modified and generate worse scenarios.

Growth opportunities for firm Alpha can also fall in Area D of Exhibit 1.4. Entering the business of packaging for cosmetic products and offering new services to pharmaceutical companies are a natural evolution of the core business of Alpha. Alpha has in fact adequate technological and managerial resources to sustain growth in those businesses which are similar to the niche in which it already has a leadership position.

1.5.2 Some Conclusions on Uncertainty and Managerial Flexibility

The approach outlined in the previous paragraph departs from traditional analysis since it tries to contemplate whether, with different scenarios, the firm's business model can be adapted to new assumptions and what those assumptions imply in terms of the creation of value.

From a historical standpoint, the first attempts to assess managerial flexibility, when future opportunities in the evolution of a business exist, have concerned themselves with R&D investments, brand and patent acquisition, development of new technologies, and the research and exploitation of natural resources. These attempts assume as a starting point the explicit representation of a firm's results as a consequence of managerial decisions expected to be taken in the future. Generally speaking, these methodologies today fall into the field of so-called real option valuation (ROV).6

In this framework, the value of a project is just the sum of two elements:

1.5.3 Valuing Companies Assuming a Dynamic Standpoint

The dynamic approach was first used in valuations of Internet companies and Internet stocks.

Looking at the background in which the so-called new economy