Approaches to Valuation

1. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Approaches to Valuation • Discounted cashflow valuation. • Relative valuation. • Real option valuation: Uses option pricing models to measure the price of stocks whose value depends on assets that have option-like characteristics.

2. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Discounted Cashflow Valuation where, n = Life of the company CFt = Cashflow in period t r = Discount rate reflecting the riskiness of the estimated cashflows

3. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Advantages of DCF Valuation • Since DCF valuation is based upon an asset’s fundamentals, it should be less exposed to market moods and perceptions. • If good investors buy businesses, rather than stocks (the Warren Buffett adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset.

4. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Disadvantages of DCF Valuation • Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches • These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants.

5. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion When DCF Valuation works best • This approach is easiest to use for assets (firms) whose • cashflows are currently positive, and • can be estimated with some reliability for future periods, and • It works best for investors who either • have a long time horizon, allowing the market time to correct its valuation mistakes and for price to revert to “true” value or,

6. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Market Valuation of Digital Lightwave Share Price (close 4/24/02) : $4.87 52-week high : $57.56 52-week low : $4.56 Market Value : $153 million

7. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Market Valuation of Digital Lightwave

8. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Present Value of DLWave’s Cashflows • Current Market Capitalization of DLWave : $ 153 million. • 2001 Earnings of DLWave: $ 2.8 million. • 2001 Cashflow of DLWave: $6.2 million. • Assumptions • Annual growth during the next 5 years 25% • Cost of capital 18% • Low growth rate after next 5 years 10% • Number of years of low growth 5 • Present Value of DL Wave’s Cashflows : $66 million

9. Estimating Cashflows 1. Revenues - Operating expenses = Earnings before interest, taxes, depreciation, and amort. (EBITDA) 2. EBITDA - Depreciation and Amortization = Earnings before interest and taxes (EBIT) 3. EBIT - Interest Expenses = Earnings before taxes 4. Earnings before taxes – Taxes = Net Income 5. Net Income + Depreciation and Amortization = Cashflow from Operations 6. Cashflow from operations - Working Capital change - Capital spending - Principal Repayments + Proceeds from New Debt Issues = Free Cashflow to Equity.

10. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Relative Valuation of Digital LightwaveApril 2002

11. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Advantages of Relative Valuation • Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when the objective is to sell a security at that price today (as in the case of an IPO). • Relative valuation generally requires less information than discounted cash flow valuation.

12. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Disadvantages of Relative Valuation Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong.

13. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion • Value of Firm = • FCFF1: expected free cash flow to the firm • k: firm’s cost of capital • g: growth in the expected free cash flow to the firm • Dividing both sides by FCFF1 yields the Value/FCFF multiple for a stable growth firm:

14. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion • The Value/FCFF multiple for a stable growth firm: • Value/FCFF increases as g increases. • Value/FCFF decreases as k increases. • k is a function of the firm’s line of business.

15. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion • The Value/FCFF multiple for a stable growth firm: • Hence, picking a certain number for the Value/FCFF ratio implies certain assumptions about k and g. • Similarly, for • Price/Earnings, • Price/Sales, • Price/EBITDA, etc.

16. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion When relative valuation works best This approach is easiest to use when • there are a large number of assets comparable to the one being valued • these assets are priced in a market • there exists some common variable that can be used to standardize the price.

17. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Relative Valuation of Digital Lightwave Acterna Agilent Tektronix Industry Price/Sales Ratio 0.19 1.99 2.05 1.56 Digital Lightwave 15.7 164.8 170.0 129.2 ($ millions)

18. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion THE WALL STREET JOURNAL Tech Stocks Test the Old Valuation Rules “As the communications revolution advances, the technology bulls believe, companies will create entirely new products, services and markets, and do this so rapidly that trying to analyze stock value based on current products is futile.”

19. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion THE WALL STREET JOURNAL Tech Stocks Test the Old Valuation Rules “But classic valuation techniques have a big hole in them, say those who invest in the technology revolution: They don't take into account innovation. ...Investors in tech stocks aren't interested in extrapolations from present conditions -- they look for continued innovation.”

20. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion What is a Real Option? Traditional discounted cashflow approaches cannot properly capture the company’s flexibility to adapt and revise later - decisions in response to unexpected market developments. Traditional approaches assume an expected scenario of cashflows and presumes management’s passive commitment to a certain staticoperating strategy.

21. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion What is a Real Option? The real world is characterized by change, uncertainty and competitive interactions => • As new information arrives and uncertainty about market conditions is resolved, the company may have valuable flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities or to react so as to mitigate losses. • This flexibility is like financial options, and is known as Real Options.

22. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Source of value in an option Financial Options: A call option gives the owner the right, with no obligation, to acquire the underlying asset by paying a prespecified amount (the exercise price, X) on or before the maturity date. Value of a Call Option on the Maturity Date Stock Price on the Maturity Date Source of value in an option: The asymmetry from having the right but not the obligation to exercise the option. X

23. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Examples of Real Options • Option to invest in a new technology-based service/product, as the result of a successful R&D effort. • Equity in a firm with negative earnings and high leverage. • The patent and other intellectual property owned by a firm.

24. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Disadvantages of Real Option Valuation Models • When real options are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, R&D projects do not trade and thus getting a current value for a project or its variance may be a daunting task. • The option pricing models derive their value from an underlying asset. Thus, to do option pricing, you first need to value the assets. It is therefore an approach that is an addendum to another valuation approach.

25. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Real Option and Classical Valuation of DLWave • Current Market Capitalization of DLWave : $ 153 million. • 2001 Earnings of DLWave: $ 2.8 million. • Current Market Value = Present Value of Cashflows from Assets in Place + Present Value of Cashflows from Future Growth Opportunities • Discounted Cashflow Technique: More appropriate for valuing cashflows from Assets in Place. • Real Option Valuation: More appropriate for valuing cashflows from Future Growth Opportunities.

26. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Present Value of Cashflows from Assets in Place • 2001 Cashflow of DLWave: $6.2 million • Assumptions • Annual growth during the next 5 years 25% • Cost of capital 18% • Low growth rate after next 5 years 10% • Number of years of low growth 5 • Present Value of Cashflows from Assets in Place: $66 million

27. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Real Option Value Component of DLWave We use a modification of the Black-Scholes option pricing model to value the real options associated with DLWave: Value of real option = V e-yt N(d1) - X e -rt N(d2) . where, d1 = [ ln (V/X) + (r - y + (s2)/2) t ] / s(t) ½ . d2 = d1 - s (t) ½ . where, N (.) = Cumulative normal density function. continued...

28. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Real Option Value Component of DLWave Value of real option = V e-yt N(d1) - X e -rt N(d2) . where, d1 = [ ln (V/X) + (r - y + (s2)/2) t ] / s(t) ½ . d2 = d1 - s (t) ½ . where, V = Present value of expected cash inflows from investing in DLWave’s future opportunities (under base case assumptions) = $235 million. X = Present value of the costs of investing in DLwave’s future opportunities (under base case assumptions) = $226 million. Hence, classical discounted cashflow valuation technique would suggest a value of $9 million from investing in DLWave’s future opportunities.

29. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Real Option Value Component of DLWave Value of real option = V e-yt N(d1) - X e -rt N(d2) . where, d1 = [ ln (V/X) + (r - y + (s2)/2) t ] / s(t) ½ . d2 = d1 - s (t) ½ . where, s 2 = Variance in the expected cash inflows over time, allowing for technological, legal, and market changes = 40%. t = Number of years during which the real option can be exercised = 4 years. y = “Dividend yield” of the project before the option is exercised. r = Riskfree interest rate for t years = 3%.

30. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Real Option Value Component of DLWave Base Case Assumptions Population = 270 million Potential Market = 15% of population Likely penetration of potential market = 30% Annual revenues per customer = $12 Cost of capital = 18% Number of years of competitive advantage = 5 Variable operating costs = 70% of revenue Real Option Value = $86 million

31. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Real Option Value Component of DLWave • Current Market Value = Present Value of Cashflows from Assets in Place + Present Value of Cashflows from Future Growth Opportunities • Current Market Value = $66 million + $86 million = $152 million

32. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion Sensitivity Analysis of Real Option Value Component of DLWave

33. Introduction DCF Valuation Relative Valuation Real Option Valuation Conclusion The Bottom Line • Traditional valuation procedures cannot properly capture the company’s flexibility to adapt and revise later decisions in response to unexpected competitive/technological/market developments. • The real option technique can value the company’s flexibility to alter its initial operating strategy in order to capitalize on favorable future growth opportunities or to react so as to mitigate losses. • Valuations computed using the real option technique are often closer to market valuations for high-growth stocks in high-risk industries.