Business Model: Capital Budgeting, Equity Valuation and Returns AttributionFMRC Conference Vanderbilt University

ByThomas S. Y. HoThomas Ho Companytom.ho@thomasho.com

Sang Bin LeeHanyang UniversityMay 19-20, 2005

Introduction

What is a business model? How does a firm generate profit? A verbal plan or a written dream?

Stoll dealers model Business strategies A provider of liquidity, compensated by the

spread Equilibrium model and market structure

A business model Assumptions Financial modeling

Problem Statement

Use of the NPV capital budgeting approach in the presence of fixed operating costs?

How should we compare the valuation of the firms in a similar industry in terms of growth and cost of capital with different operating leverage?

How do the financial leverage, operating leverage, growth options affect the stock price?

A more general business model for valuation and corporate financial decisions

Real Option Approach

Trigeorgis (1993a) values projects as multiple real options on the underlying asset value.

Botteron, Chesney and Gibson-Asner (2003) uses barrier options to model the flexibility in production and sales of multinational enterprises under exchange rate uncertainties.

Brennan and Schwartz model (1985) and Fimpong and Whiting (1997) determine the growth model of a mining firm.

Outline

Describe a business model of a retail chain store

The model can be generalized Impact of fixed costs on the capital

budgeting decisions Building blocks of value for a firm Impact of the change in revenue on

the stock price Conclusions

Model Assumptions

Primitive firm follows a martingale process

The fixed operating costs viewed as perpetual “debt”, senior to corporate liabilities.

The capital asset generates perpetual revenues

A lattice framework

Primitive Firm Valuation

Cost of capital of the business depends on the risk of gross returns on investment, GRI

Revenues of the primitive firm depends on the capital asset CA.

Use the risk neutral valuation valuation by the change of measure.

( , )( , )P

GRI n i CAV n i

Terminal Conditions and the Free Cash Flows

The “perpetual debt” of the fixed cost is risky

( ) ( , ) ( , ) ,( , )

( ) ( , ) ( ( , ) ) 0,

p

p

V FC T GRI T i CA T i FCV T i Max

V FC T GRI T i CA T i I FC I

( , ) ,p

GRI T i CA T iV

( , ) ( , ) ,CF n i GRI n i CA n i FC

Capital Investments and the Growth Options

I is the investment outlay

( 1,2 ) ( 1,2 1) ( , ) ( , )CA n i CA n i CA n i I n i

, ( , ) ,Sales n i I n i GRI n i

Simulation Results on Capital Budgeting Decisions

Given the fixed operating costs, some positive NPV projects are not taken

The fixed operating cost is more significant to the capital budgeting decision when the firm may default on the fixed operating cost.

Implicit fixed cost =0 when the probability of default =0. The traditional case

Extending Myer’s wealth transfer problem to a contingent claim framework: distress or start up scenarios, traditional method does not apply

Top Down Optimal Investment Decision vs the NPV Decisions

Debt Structure and Capital Budgeting Decisions

Myers (1977) Issuing risky debt reduces the present

market value of a firm holding real options by inducing a suboptimal investment strategy or by forcing the firm and its creditors to bear the costs of avoiding the suboptimal strategy.

Corporate borrowing is inversely related to the proportion of market value accounted for by real options.

Fixed Cost Factor DMPV = PV.D –I >0

Fixed Cost Factor

0

0.2

0.4

0.6

0.8

1

1.2

-100 0 100 200 300 400

%change in Firm Value

dis

cou

nt

fact

or

Series1

Implications

Valuation of a store front depending on the retail chain store

Value of an acquisition depends of the operating cost of the acquiring firm. Eg communication companies, start ups

The fixed cost discount can be established for each firm, based on the business model

The curve can be used to determine the optimal operating leverage

Relative Valuation of Similar Firms

A comparison of Target, Lowe’s, Wal-Mart, Darden

Lowe’s: second largest US home improvement chain, with 1090 stores

Darden: leading operator of casual dining restaurants with 1,300 locations

Wal-Mart: world largest retailer, 5,200 stores

Target: 4th largest general merchandise retailer, with 1000 stores

Inputs to the Model:Financial Ratios

Target Lowe's Wal-Mart Darden

GRI 2.9769 2.5807 4.8082 2.2823

Gross profit margin(m) 0.3169 0.2880 0.2274 0.2222

Fixed cost/total asset(FC/CA) 0.6564 0.4684 0.7907 0.2293

Capital investment (I/CA) 0.1563 0.2381 0.1530 0.1130

Leverage(CA/E) 1.7218 1.2965 1.3033 1.7190

Wal-Mart and its Comparables

High gross return on investments 4.8%

Significant fixed operating costs, 79% of the total asset

Low gross profit margin, 22%

Calibration Results

Reported Estimated Reported Estimated Reported Estimated Reported Estimated

S/E 5.1009 5.3231 5.3543 5.4717 7.6893 7.8420 3.1623 3.2699

S/V 0.8321 0.8500 0.9054 0.9089 0.9351 0.9363 0.8634 0.8779

Cost of capital

Volatility 0.2776

0.0821

0.3908

Darden

0.3149

0.1036

0.3772

0.0860 0.0702

Target Lowe's Wal-Mart

Calibration Results

Sales, gross profit margin, operating fixed cost, growth rate are taken from the financial statements

Calibrating the discount rate for the business and the business risk (GRI) volatility to the equity multiple, price earnings, debt/ratio (market)

Market uses a lower business cost of capital for Wal-Mart business, 7.02%, with business volatility of 40%

Value Decomposition

Target Lowe's Wal-Mart Darden

Mkt equity S 41840 36520 275270 3385

Primitive firm V* 161313 84728 762427 9612

Mkt value fixed cost F 129766 60269 568304 6438

Growth option G 17674 15722 99878 682

Mkt value of debt D 7382 3661 18732 471

Book equity E 7860 6674 35102 1035

Estimated S/E 5.3231 5.4717 7.8420 3.2699

Value Decomposition

Target Lowe's Wal-Mart Darden

Vp/CA 11.9200 9.7913 16.6651 5.4017

Vfc /Vp 0.1956 0.2887 0.2546 0.3302

V/Vfc 1.5602 1.6428 1.5145 1.2148

CA/E 1.7218 1.2965 1.3033 1.7190

S/V 0.8500 0.9089 0.9363 0.8779

S/E 5.3231 5.4717 7.8420 3.2699

Book Value(E/shares) 8.7062 8.6044 7.8004 5.8818

Decomposition of Relative Valuation

Wal-Mart has the highest market to book multiple, 7.5957: which are the main value contributors?

The primitive firm value is the main value contributor, with the business multiple, 16.66

The fixed-operating cost is quite high, accounting for over 75% of the business value

Growth option is 51%

Return Attribution for 1% Change in Revenue

Target Lowe's Wal-Mart Darden

ln(Vp/CA) 0.0100 0.0100 0.0100 0.0100

ln(Vfc /Vp) 0.0138 0.0085 0.0107 0.0070

ln(V/Vfc) -0.0022 -0.0014 -0.0022 0.0003

ln(S/V) 0.0027 0.0010 0.0013 0.0016

ln(CA/E) 0.0000 0.0000 0.0000 0.0000

ln(Book value(E/shares)) 0.0000 0.0000 0.0000 0.0000

ln(Stock price) 0.0244 0.0180 0.0197 0.0189

Equity Return Attribution

1% increase in the gross return on investment leads to 1% rise in the business value, by definition

1.07% and 0.134% increase in the equity value attributed to the operating leverage and financial leverage respectively

The growth option value increase is lower than that of the business value, resulting in a fall in 0.22%

Importance of the Business Model Approach

Relate financial statements to firm valuation

Combine analysis of the fixed operating leverage and financial leverage on the equity value and risks

A framework to analyze different industry sectors

An approach to value credit risks incorporating the business model

Conclusions

The method can be generalized to other industries

The primitive firm and the option approach provide a multi-period model framework

Treatment of the fixed operating costs in capital budgeting decisions

Broad range of applications of the value decomposition and return attribution

Selected References

Stoll, Hans R. (1978) The Supply of Dealer Services in Securities Markets. Journal of Finance (September)

Ho, Thomas S. Y. and Sang Bin Lee, (2004a), The Oxford Guide to Financial Modeling, Oxford University Press, New York.