Corporate Valuation - Massari Mario

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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– related ventures originated at the end of the nineties, we can identify the typical characteristics referable to area C of Exhibit 1.4:

      ● The operators' expectations assumed strong growth in the market.

      ● A high degree of uncertainty characterized the assumptions about Internet users' behavior and technological evolution.

      ● Entry barriers on the market were modest: Internet companies could have adapted the business model to eventual shifts.

      After the radical U-turn in scenarios and expectations with respect to high-tech stocks, in the first half of 2000, the dynamic valuation models have been harshly criticized. Despite many excesses, the euphoria that drove markets and the analysts has left us an important contribution: the models adopted and the debate that followed have brought attention, also out of the academic studies, to the fact that managerial flexibility can be an appreciable factor in the valuation of businesses and acquisitions, and not only in well-defined investment niches (R&D, natural resources search and development, etc.). On the practical side, the key issue of the dynamic approach is the need for restricting the analysis only to the credible development of a business model.

      1.6 RELATIONSHIP BETWEEN VALUE AND UNCERTAINTY

The basis for the determination of the cash flow that best represents the future expected performance of the business lies in the analysis of the risk profile of the business itself. This section aims at classifying some typical situations of uncertainty, and at representing the cash flows that best describe them. Exhibit 1.7 provides us with a general initial reference framework, which by the way proves useful in multiple valuation settings as well by enabling the expert to carry out a more refined comparability assessment.

Exhibit 1.7 Risk profiles and cash flows modeling

      Exhibit 1.7 shows how valuations of businesses whose financial results are driven mainly by market factors or macroeconomic parameters are based generally on a single cash flow profile, referring to the scenario that management deems the most likely one (“management scenario”).

      These valuations yield accurate results only when the distribution of expected results is symmetric. This condition is satisfied, for example, when the relevant risk factors depict a continuous distribution. Furthermore, it should be noted that such cash flow representation type requires historical data be both available and reliable. When there are multiple risk factors, the traditional representation centered on the management scenario may lead to undesired informational gaps.

      Simulation techniques, like for instance the Monte Carlo, may in these cases improve the informational quality through the use of numerous combinations of the risk factors, yielding different expected results and different related results and valuations.

      A second case is represented by the businesses subjected to idiosyncratic risks, which by their own nature are characterized by discrete (and at an extreme binary) outcomes distribution (e.g., businesses whose activity is based on the renewal of a concession). In these situations, the informational quality increases by projecting a cash flow pattern in each of the major scenarios that could take place. In practice, a final valuation can be obtained by weighting the valuations obtained in the different scenarios. As said, it is worth stressing the fact that this proceeding is sensible in those situations when risks have discrete distributions. Otherwise, the applicable case turns back to scenario A, which envisages the representation of the cash flow profile of only the most likely scenario.

      For some businesses (case C of Exhibit 1.7), which are typically articulated along distinct sequential phases, risks depict a sequential structure in that value creation process is subordinated to the successful crossing of some key critical steps in the project life. This is the case, for instance, of some pharmaceutical businesses, or of the projects subjected to articulated authorization itinera (e.g., wind farms). In such situations, cash flow profiles linked to the business can be analyzed through the techniques of the event trees and of the decision trees. These techniques to deal with uncertainty have the advantage to highlight the key critical aspects in the formation of the value of a project along its life. Typically, during the initial phases idiosyncratic risks are the prevailing ones, and they can determine the survival or abandonment of an initiative. Once the uncertainty surrounding the first phases of the life cycle of an initiative has been solved, systemic (market) risk factors tend to emerge.

      Such analyses on the risk profiles have important consequences on the choices regarding the determination of which is the most appropriate discount rate to be applied. Indeed, if the dominant risk is an idiosyncratic one, the risk-free rate can be used assuming a Capital Asset Pricing Model framework (Chapter 8). In the opposite case, some more complex techniques deriving from the valuation models of financial option should be used.

Chapter 2

      Business Forecasting for Valuation

      2.1 INTRODUCTION

      The business plan is the document that represents both the management strategies and the results that management expects from their implementation. As a consequence, analysts carrying out the valuation should always include the business plan in their valuation report. When the business plan is provided by the company itself (or by its advisors), a careful assessment – from both a qualitative and quantitative point of view – is a phase of paramount importance within the valuation process. Bearing this in mind, we devote this chapter to illustrate, by means of several examples, three aspects:

      ● The key phases of any business plan preparation

      ● The structure of the business plan as a function of the nature and the features of the activities carried out by the company

      ● The main practical issues arising when preparing or assessing a business plan.

      2.2 KEY PHASES OF THE BUSINESS PLAN ELABORATION

      Business plan preparation consists of several interrelated phases:

      ● Thorough analysis of the company features, of the market(s) it competes in, of its positioning within such market(s), and of the past performance achieved

      ● Definition of the precise competitive strategies that the management is expected to pursue the future

      ● Definition of the actions that need to be implemented to pursue those competitive strategies

      ● Definition of the quantitative assumptions underpinning the forecast income statement, balance sheet, and cash flow statement

      ● Preparation of the forecast income statement, balance sheet, and cash flow statement

      2.2.1 Markets, Competitive Positioning, and Past Results

      In order to prepare accurate and reliable forecasts, it is necessary to deeply understand and analyze the markets the company is operating in.

      The articulation and the complexity of the analysis to be carried out are a function of several variables, including the number of business segments the company

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For introductory reading on applications of real options in capital budgeting and investment policies, see Chapters 1 and 2 of A. Dixit, R. Pindyck, Investments under Uncertainty (Princeton, NJ: Princeton University Press, 1994), and W. C. Kester, “Today's Options for Tomorrow's Growth,” Harvard Business Review, 60 (1984): 153–160. For an in-depth presentation of the real option applications, see L. Trigeorgis, E. S. Schwartz, Real Options and Investment under Uncertainty: Classical Readings and Recent Contributions (Cambridge: The MIT Press, 2001); N. Kulatilaka, M. Amram, Real Option: Managing Strategic Investment in an Uncertain World (Boston: Harvard Business School Press, 1999); T. Copeland, V. Antikarov, Real Options: a Practitioner's Guide (Texere, 2001). Though the real option approach is extremely insightful in terms of the logic underlying investment decisions, its real-world applications are limited; therefore this book will not cover the real option issue.