Valuation II et 1 private equity Course Objectives

Valuation II

• Key learning objectives: using comparables, computing DCF, using option pricing theory, and using the venture capital method.

Limitations of DCF Method

• Does not account for flexibility in projects, such as increasing or decreasing production rates, deferring development, or abandoning the project.
• Often fails to account for multiple rounds of financing, which can be seen as options to make follow-on investments.

Option Pricing Theory

• A call option: the right to buy an asset at a specified exercise price on or before the exercise date, representing a right, not an obligation.

Black-Scholes Model

• Required components: underlying stock price, exercise price, volatility of stock returns, time to option expiration, and risk-free rate.

Financial Options vs. Real Options

• Financial options: involve assets like stocks, while real options relate to a firm's operational decisions, such as exercising the option to expand, defer, or abandon a project.

Option Value of a Project

• Captures the value of managerial flexibility in investment decisions, such as the option to expand, defer, or abandon a project.

Negative NPV Projects

• Can become positive when considering real options, as it mitigates risks and enhances potential returns.

Venture Capital Method

• Steps: compute final value using a multiple of future sales or earnings, discount the final value, determine required final percent ownership, and account for future dilution.

Factors Affecting Option Value

• Stock price, exercise price, volatility of stock returns, time to expiration, and risk-free interest rate.

Weaknesses of Option Pricing

• Estimating volatility is difficult, real-world opportunities are complex, and the Black-Scholes formula may not suit nested call options.

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Valuation I

• Key learning objectives: using comparables, computing DCF, and recognizing caveats for start-ups.

Using Comparables

• Steps: identify firms with similar characteristics, identify relevant valuation ratios, and multiply ratios to obtain an implied market value.

Accounting-Based Comparables

• May be less suitable for valuing unprofitable or rapidly growing companies, where non-financial, industry-specific measures might be more appropriate.

Valuation Ratios

• Typical ratios used in public markets: Price-Earnings Ratio (P/E), Market-to-Book Ratio, and Market Value to Total Revenue Ratio.

Discounted Cash Flow (DCF) Method

• Calculates the value of a project by discounting its future cash flows to the present value using a discount rate.

Computing Cash Flows

• Formula: CFt = EBITt - Corporate Taxes t + DEPRt - CAPEXt - ΔNWCt + other t

Depreciation

• Added back to compute cash flows because it's a non-cash expense, reflecting the actual cash flow generated by the business.

Terminal Value (TV)

• Formula: TVt = [CFt * (1 + g)] / (r - g), where g is the growth rate in perpetuity and r is the discount rate.

Weighted Average Cost of Capital (WACC)

• The average rate of return a company is expected to pay to all its security holders, calculated as r = (D/V) * rd * (1 - τ) + (E/V) * re.

DCF Method Limitations for Start-ups

• Lack of comparable companies to find current beta and estimate target capital structure, high sensitivity of terminal value to assumptions, and questionable appropriateness of beta as a measure of firm risk.