Valuation Concepts and Methods 2nd Semester SY.
2020-2021
Special Situations
VALUING FLEXIBILITY
Flexibility refers to choices between alternative plans that managers may
make in response to events.
For example, if they have planned to stage their investments in the business start-
up, they may decide whether to proceed or not at each stage, depending on
information arising from the stage before. For cases where managers expect to
respond flexibly to events, we need a special, contingent valuation approach.
To recognize opportunities for creating value from flexibility when assessing
investment projects or strategies, managers should try to be as explicit as possible
about the following details:
a. Events
b. Decisions
c. Payoffs
VALUATION IN EMERGING MARKETS
• Inflation, which is often high in emerging markets, should be factored into the
cash flow projections, using a combination of insights from both real and
nominal financial analyses.
• Emerging-market risks such as macroeconomic or political crises can be
incorporated by following the scenario DCF approach.
• The cost of capital estimates for emerging markets builds on the assumption
of a global risk-free rate, market risk premium, and beta, following guidelines
similar to those used for developed markets.
• Since the values of companies in emerging markets are often more volatile
than values in developed markets, we recommend triangulating the scenario
DCF results with two other valuations: one based on discounting cash flows
developed in a business-as-usual projection but using a cost of capital that
includes a country risk premium, and another valuation based on multiples.
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Valuation Concepts and Methods 2nd Semester SY. 2020-2021
VALUING HIGH-GROWTH COMPANIES
When valuing an established company, the first step is to analyze historical
performance. But in the case of a high-growth company, historical financial results
provide limited clues about future prospects.
Therefore, begin with the future, not with the past. Focus on sizing the
potential market, predicting the level of sustainable profitability, and estimating the
investments necessary to achieve scale.
To make these estimates, choose a point well into the future, at a time when
the company’s financial performance is likely to stabilize, and begin forecasting.
Once you have developed a long-term future view, work backward to link the
future to current performance. Accounting records of current performance are likely
to mix together investments and expenses, so when possible, capitalize hidden
investments, even those expensed under traditional accounting rules. This is
challenging, as the distinction between investment and expense is often
unobservable and subjective.
VALUING CYCLICAL COMPANIES
A cyclical company is one whose earnings demonstrate a repeating pattern of
significant increases and decreases.
The earnings of such companies, including those in the steel, airline, paper,
and chemical industries, fluctuate because of large changes in the prices of their
products. In the airline industry, earnings cyclicality is linked to broader
macroeconomic trends.
In the paper industry, cyclicality is largely driven by industry factors, typically
related to capacity. Volatile earnings within the cycle introduce additional complexity
into the valuation of these cyclical companies.
The probabilistic approach avoids the traps of a single forecast and allows
exploration of a wider range of outcomes and their implications.
VALUING BANKS
Banks are among the most complex businesses to value, especially from the
outside in.
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Valuation Concepts and Methods 2nd Semester SY. 2020-2021
Published accounts give an overview of a bank’s performance, but the clarity
of the picture they present depends largely on accounting decisions made by
management.
External analysts must therefore make a judgment about the appropriateness
of those decisions. Even if that judgment is favorable, analysts are still bound to lack
vital information about the bank’s economics, such as the extent of its credit losses
or any mismatch between its assets and liabilities, forcing them to fall back on rough
estimates for their valuation.
Moreover, banks are highly levered, making bank valuations even more
contingent on changing economic circumstances than valuations in other sectors.
Finally, most banks are in fact multi-business companies, requiring separate
analysis and valuation of their key business segments. So-called universal banks
today engage in a wide range of businesses, including retail and wholesale banking,
investment banking, and asset management. Yet separate accounts for the different
businesses are rarely available.
For banks, however, we cannot value operations separately from interest
income and expense, since these are the main categories of a bank’s core
operations. We need to value the cash flow to equity, which includes both the
operational and financial cash flows.
For valuation of banks, the equity DCF method is recommended.
