Valuation: Bridging the Gap Between Academics and Industry Practice

1. Valuation: Bridging the Gap Between Academics and Industry Practice Sheridan Titman Financial Management Association October 2005

2. Valuation • We devote a substantial amount of our teaching to valuation • However, relatively little research dedicated to this topic • Plenty of good research describing the “mechanics” of valuation, but • Ideally, we’d like to better understand • How firms actually evaluate projects • Why firms do what they do • Existing survey based studies evaluate these issues but only scratch the surface • My impression is that there is a substantial disconnect between our research, our teaching, and actual industry practice

3. The Lack of Research on Valuation • Valuation research is primarily normative • making it difficult to empirically test • The lack of research has resulted in slow progress, if not stagnation in how we teach this topic (GT still considered cutting edge) • In my teaching I’ve found the gap between industry practice and the classroom striking  why are we so comfortable with this gap?

4. Differences in the classroom and practice • Valuing flexibility (real options) • Discount rates • Multiple versus single • Discount rates that are “too high” • The importance of accounting/earnings

5. Why Do the Differences Exist? • Is academia ahead of industry practice? • Perhaps, but not the entire story • Why are we so much ahead of industry on this topic but not others? • My view: practitioners and academics are solving different problems • In particular, firms must consider how valuation methodology influences other operational issues. For example: • Internal politics • Managerial effort • Perceptions of fairness

6. Example #1: “Inflexible” Discount Rates • In theory, projects with different risks should be evaluated with different discount rates • Most firms, however, have a single corporate discount rate that is used to evaluate all their projects • Almost all claim to use a small number of discount rates

7. Example #2: Evaluating Projects in Emerging Markets • Firms often use discount rates that are higher than theory suggests • For example, consider a power plant in Indonesia • Firms agree that these have relatively low β’s • But use hurdle rates close to 20%

8. Example #2.1: Evaluating Private Equity Deals • What do venture capitalists and other private equity firms typically consider an appropriate rate of return on projects that they initiate? • Are these projects particularly risky as defined by academic risk/return models (e.g., the CAPM)?

9. Explanations • Multiple discount rates: • Managers understand risk/return tradeoffs and require higher estimated “NPVs” for riskier projects • High discount rates: • Managers use a high discount rate for Indonesia because “expected” cash flows ignore political risk and tend to be optimistic in other ways • Venture capitalists use high discount rates because they know that entrepreneurs tend to be overly optimistic

10. But are these really explanations? • Academic response: Firms would make better investment decisions if they discounted true expected cash flows at appropriate risk adjusted discount rates. • Question: Why do practitioners prefer to discount “hoped for cash flows” at inflated discount rates?

11. Research Agenda: Understanding the Valuation Process • What are the implications of the project evaluation and review process? • Most projects have • Project sponsors: who identify investment opportunities and write proposals • What are their incentives? • Project evaluators: who can accept or reject the proposal • What are their incentives? • How does the valuation methodology affect the behavior of project sponsors?

12. Research Agenda (continued) • What are the costs and benefits associated with having the flexibility to set a different hurdle rate for different projects? • The benefits are fairly obvious – you should make better decisions if the discount rate reflects the risk of the project. • However, flexibility can create influencecosts: • politics will enter the setting of discount rates • the persuasiveness of the project sponsor rather than the fundamentals of the project become important • a more discretionary process can be viewed as less fair

13. Research Agenda (continued) • What are the costs and benefits of having a higher or lower hurdle rate? • Again, there is a benefit to having a discount rate that reflects the risk of the project evaluated • However, the project sponsor may work harder to find a better project if the required rate of return is higher  Use high discount rates when: • effort is hard to evaluate • where the marginal benefit of higher effort is higher, e.g. in emerging markets • “High” discount rates can also address sponsor overconfidence and/or optimism

14. Research Agenda (continued) • Why not adjust the cash flow estimates? • Political implications – do we really want to include the probability of sovereign default in our analysis • Behavioral implications – • Does the VC really want to curb the entrepreneur’s enthusiasm? • “Advantages” to having ambitious targets – helps incentives

15. Research Agenda (continued) • To what extent do firms use the cash flow forecasts, used to evaluate projects, as targets that affect future bonuses? • Do firms systematically compare forecasted cash flows to realized cash flows? Is there a clear bias? • Private equity firms generally use very high discount rates – do these rates vary cross-sectionally? Do we see higher discount rates in more ambiguous projects that are more difficult to evaluate?

16. Research Agenda (continued) • Firms generally have different groups for evaluating internally generated projects and for acquisitions. • Do these groups use different discount rates and different methodologies? • Major oil companies use different oil price assumptions for external acquisitions than for development investments – why is this? • Do firms implicitly account for differences in risk when they use the same discount rate for each project? • Implicitly require higher NPV hurdle for riskier projects • Use project debt to finance safer investments

17. Research Agenda (continued) • How do firms account for the value of flexibility? • Do they require higher hurdle rates for projects that can be delayed? • Do they require lower hurdle rates for initiating projects that can be implemented in stages? • Do they require lower hurdle rates for projects that are more liquid?