IS Valuation Methods - Insights from Capital Markets Theory and Practice – Institut für...

IS Valuation MethodsIS Valuation Methods- Insights from Capital Markets Theory and Practice –- Insights from Capital Markets Theory and Practice –

Institut für WirtschaftsinformatikJ. W. Goethe University

Institute of Information SystemsJ. W. Goethe University

Mertonstraße 17, D-60054 Frankfurt am Main [email protected]

http://www.wiwi.uni-frankfurt.de/~tweitzel

Tim Weitzel, Cornelia Gellings, Daniel Beimborn, Wolfgang König

Valuing IT investments

How do capital market professionals valuate?

ROA to the rescue?

Research FrameworkResearch Framework

E-Finance Lab at Frankfurt University

„towards an industrialization of financial services“

smart sourcing „how can I evaluate different sourcing strategies?“

smart selling„how can I generate new revenue streams?“

The valuation problemThe valuation problem

IS valuation has long been a core IS research challenge

ROA for overcoming methodological shortcomings of NPV, esp. coping with uncertainties concerning?

the costs and benefits (“value”) of IS infrastructure flexibility

the costs and benefits implied by postponing IS investments (“option” to invest later)

the costs and benefits of partial investments

Goal: learn from capital markets about coping with uncertainty

how do capital markets valuate IT companies in theory and practice?

to what extent can we learn from them concerning the question of the true value underlying IS?

characteristics of IT investmentscharacteristics of IT investments

Information technology:

- uncertainty concerning future development- markets with network effects (standardization) - high innovation speed

IT investments

- often no direct monetary value/revenue impact- often long-term and adaptive- rarely profitable from beginning

Implications:

- no stopping rule for investments- quantify uncertainty and flexibility

IS sourcingIS sourcing

deciding on IS infrastructure

„Infrastructure is a necessary investment that business units of functional areas are unlikely to make“ [Taudes et al. 1999]

how to measure the value impact of IS investments?

how to evaluate and price ISIS sourcing decisions?


ROA to the rescue?


valuation approachesvaluation approaches

analogy: true value of software firms

value determination key challenge in IPO price determination

standard methods used in investment banking practise

DCFcomparable companiesreal options?

DCF determination of Intrinsic Asset ValueDCF determination of Intrinsic Asset Value

Discounted Cash Flow Approach

estimate future cash flows

estimate discount rates (reflects the risk involved)

estimate growth rate

estimate terminal value

)t(r)ED(

Dr

)DE(

EWACC de

1

Tt

tTt

t

)WACC(

ValueTerminal

)WACC(

FCFFlowsCashFreeofValuePresent

1 11

g r o w th p e r io d p e r io d o f s ta b le g r o w th

Revenue Forecasts

Cost and MarginForecasts

Change inWorking Capital

Capital Expenditures

Based onStable Growth Model, i.e.company’s cash flows beyondterminal year will grow at atconstant rate forever

2007

=

….

=

2002

=

2001Projections

Sales-Operating Cost= Earnings Before, Interest,Taxes , Depreciation and Amortization (EBITDA)

- Depreciation and amortisation

= Earnings Before Interest and Taxes (EBIT)

-Taxes (on EBIT)-Delta Working Capital-Capital Expenditure+Depreciation

= Free Cash Flow

Terminal Value

= Terminal Value

Net Present Value

Discounting

Advantages

analytically correct (based on assumptions of CAPM)

no impact of volatile market conditions

incorporates relative riskiness (discount rate derived from WACC)

no influence of accounting rules ( based on projected cash flow)

Shortcomings

esp. software sector characterized by fast change, often multiple options for future strategies occur which DCF does not capture

no consideration of management options, future investment opportunities, flexibility

terminal value often > 50% (sensitive to growth estimation)

beta estimation depends on choice of index

DCF approach depends on industry expertise of valuer

works best if cash flows are subject to little uncertainty and company is managed by static management team

DCF value of SAPDCF value of SAP

The DCF valuation of SAP

sum of cash flows: € 23,530.31 MM

WACC: 9% (beta = 1.15; risk free rate = 4.0%)

total NPV of all cash flows: € 12,715.81 MM

growth rate 4.5% (typical of software companies) terminal value of € 89,478 MM NPV of TV = € 34,675 MM.

total NPV of €MM 47,391

NPV/share € 151

actual market capitalization of SAP €MM 45,000 (€151.07/share)

sensitivity analysissensitivity analysis

[in € MM]

2001E 2002E 2003E 2004E 2005E 2006E 2007E 2008E 2009E 2010E 2011E Sum TVSales 7,400.00 8,510.00 9,786.50 11,254.48 12,830.10 14,626.32 16,527.74 18,676.34 20,917.50 23,427.60 26,004.64 169,961.22 28,865.15Growth Rate 15% 15% 15% 14% 14% 13% 13% 12% 12% 11% 11%EBIT 1,443.00 1,659.45 1,908.37 2,194.62 3,849.03 4,387.89 4,958.32 5,602.90 6,275.25 7,028.28 7,801.39 8,659.55

EBIT margin 0.20 0.20 0.20 0.20 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.3Tax -548.34 -630.59 -687.01 -702.28 -1,231.69 -1,404.13 -1,586.66 -1,792.93 -2,008.08 -2,249.05 -2,496.45 -2,771.05Tax rate 0.38 0.38 0.36 0.32 0.32 0.32 0.32 0.32 0.32 0.32 0.32 0.32Depreciation 230.00 270.00 320.00 380.00 451.00 535.00 634.00 751.00 889.00 1,052.00 1,293.00 1496

Earnings 1,124.66 1,298.86 1,541.36 1,872.34 3,068.34 3,518.77 4,005.66 4,560.97 5,156.17 5,831.23 6,597.95 7,384.49Capital Expenditures -250.00 -270.00 -320.00 -380.00 -451.00 -535.00 -634.00 -751.00 -889.00 -1,052.00 -1,254.00 -1385Delta Working Capital -427.00 -280.00 -367.00 536.00 -632.00 -746.00 -880.00 -1,039.00 -1,226.00 -1,446.00 -1,753.00 -1973Free Cash Flow 447.66 748.86 854.36 2,028.34 1,985.34 2,237.77 2,491.66 2,770.97 3,041.17 3,333.23 3,590.95 23,530.31 4,026.49

410.70 630.30 659.72 1,436.93 1,290.34 1,334.31 1,363.02 1,390.66 1,400.24 1,407.99 1,391.61 12,715.81NPV of CF 12,715.81

Terminal Value NPV of TVTerminal growth rate Terminal growth rate

4.0% 4.5% 5.0% 4.0% 4.5% 5.0%8.5% 89,478 100,662 115,043 8.5% 36,474 41,034 46,896

WACC 9.0% 80,530 89,478 100,662 WACC 9.0% 31,208 34,675 39,0109.5% 73,209 80,530 89,478 9.5% 26,978 29,676 32,973

Total Net Present Value NPV per share

Terminal growth rate Terminal growth rate4.0% 4.5% 5.0% 4.0% 4.5% 5.0%

8.5% 49,190 53,749 59,611 8.5% 157 171 190WACC 9.0% 43,924 47,391 51,726 WACC 9.0% 140 151 165

9.5% 39,694 42,392 45,689 9.5% 126 135 146

Sensitivity Analysis

Difference19,918 €MM

Comparable Companies ApproachComparable Companies Approachprice/earning ratioprice/earning ratio

value based on market price of similar companies

(P/E) ratio

also: Earnings/Revenue multiples etc.

quality of CC approach based on selection of the peer group

share per Earnings

share per price MarketRatioEarnings Price

CC value of SAPCC value of SAP

Applying CC approaches results in a forecasted SAP AG value of €26,311.32 MM.

P/E 23,060-30,640

Enterprise value/Sales 25,370-28,190

Enterprise value/EBIT 21,250-76,260

valuation ranges for SAP company valuevaluation ranges for SAP company value

0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 180,000 200,000

DCF

EV/EBIT

P/E

EV/Sales

€MM

Median

Advantages and Disadvantages Advantages and Disadvantages of Valuation Methodsof Valuation Methods

Approach Advantages Disadvantages

DCF

- theoretically sound

- not influenced by temperamental market conditions

- appropriate for mature businesses with strong and stable cash flows

- highly sensitive to underlying assumptions for cash flow, terminal value, and discount rate

- terminal value significant part of total value

Comparable

Companies

- based on public information

- market efficiency ensures that results reflect industry trends, risks, growth potential

- value obtained does not include a control premium

- difficult to find truly comparable companies

- trading valuation may be affected by thin trading activities or small capitalization

- stock prices influenced by M&A activity

- result reflects what the market “tells” no matter if it is right or wrong


ROA to the rescue?


Real options to the rescue?Real options to the rescue?

„challenge of an uncertain future“

business strategy of a company resembles a series of options rather than a single projected cash flow [Trejo 2000]

disregarding management flexibility leads to a systematic undervaluation of companies [Hommel 2000]

survey on IT portfolio of global enterprise finds 27 of 31 projects to contain at least one option [Kennealy/Lichtenstein 2002]

DCF values do not differentiate between possible scenarios (e.g. successful product launch, development of an innovative technology, failure of an innovation)

esp. software design and sourcing strategies are largely processes of decision-making under uncertainty [Sullivan et al. 1999] making ROAs well suited for valuing IS strategies

Applying ROAApplying ROA

idea: include option premium for uncertainty and flexibility

total value of a company NPV (using DCF method) plus option premium (determined using ROA)

examples

option to learn (delay project) option to grow (pilot projects, new markets) option to quit (e.g. source back)

without flexibility

Cash Flows

pro

b

with flexibility

option value

Tiscali valuation using ROATiscali valuation using ROA

Tiscali is valued using the ROA

IPO was priced using trad. methods in October 1999 at €46

theoretical IPO price calculated by the Real Options Group €309

0

100

200

300

400

Net present value of

Fixed-voice line business

plus value of the option to

enter eCommerce

plus value of the option to

expand to Europe

plus value of the option to enter UMTS

Total estimated

value

~80%

€

Status quo of ROA in practiseStatus quo of ROA in practise

extensive personal interviews with investment bankers from Merrill Lynch, Morgan Stanley, Deutsche Bank, Commerzbank

ROA not (yet) applied

complexity problems estimating the underlying parameters lower acceptance analysts lack necessary knowledge clients do not accept this approach as they lack understanding for it

In most cases, a company is valued using the DCF and CC approach

DCF result is often used to check the value based on the CC approach for plausibility

Status quo of ROA in practiseStatus quo of ROA in practise

tendencies to apply the ROA in the field of Equity Research when valuing new emerging technologies, for example in the semiconductor industry

ROA is quite popular within the oil industry

Advantages and shortcomings of ROAAdvantages and shortcomings of ROA

Advantages

incorporates (value of) flexibility, contingency, or volatility

standard finance: higher volatility higher discount rates lower NPV

ROA: higher volatility higher implicit option due to the asymmetry of payoff schemes [Copeland/Koller/Murrin 2000, 428] [Mauboussin 1999]

Shortcomings

practical knowledge not yet widespread

very time-consuming approach

cannot „bargain“ with ROA model

underlying assumptions of the Black-Scholes formula (e.g. known volatility, fixed interest rates, zero dividends) very strict and typically cannot be assumed in reality.

readiness to adapt this method is currently relatively small.

ROA in IS researchROA in IS research

growing ROA community for IS valuation problem

esp. valuing IS flexibility and the associated problem of optimal IT investment time and scope are focused [Taudes/Feurstein/Mild 2000] [Gaynor/ Bradner 2001]

ROA for overcoming deficiencies of controlling theory when applied to network problems (e.g. fair prices for the future production of IS services) [Kargl 2000] [Krcmar 2000] [Emigh 2001] [Riepl 1998] [Wiese 2000]

We will use the ROA as part of a network analysis framework supporting sourcing decisions for financial service providers by modeling the cash flow implications of different IS infrastructures and choice of sourcing partners.

„When NPV was introduced in the mid 1960’s,

it was rejected for having unrealistic assumptions and for being overly complex.”

[Tallon et al. 2002]

AppendixAppendix

examplesexamples

when outsourcing ISIS elements...

...what happens if I reduce my ISIS investments by 20%?

...or increase by 20%?

...what price should I be ready to pay for ISIS services?

...what service levels should I demand from my provider?

what about influence of provider attributes like size, market share, etc.?

What is the “true” underlying value What is the “true” underlying value to new technologies?to new technologies?

0

10

20

30

40

50

60

70

1890 1898 1906 1915 1923 1931 1940 1948 1956 1965 1973 1981 1990 199819101900 1920 1930 1940 1950 1960 1970 1980 1990 2000

1901: Introduct ionof electrical power

1966: First computersand space travel drivestocks to new heights

1999/2000: Internet, Biotech, and MobileNetworks fuelspeculations about a “New Economy”

1929: Assembly lineproduction and auto-mobile boom createthe f irst “bubble”

Inflation adjusted price history of S&P Composite Stock Price Index (rebased)

profit impact of ITprofit impact of IT

Average Excess Returns of 97 firms when announcing IT investment (financial, manufacturing) [Dos Santos/Peffers/Mauer]

0,09 %

0,40 %-0,08 %

1,03 %-0,09 %-0,46 %

Full SampleBreakdown by Industry

Manufacturing (33)Finance (64)

Breakdown by Type of InvestmentInnovative (25)Not Innovative (42)Unclassified (30)

AERSample Category

0,09 %

0,40 %-0,08 %

1,03 %-0,09 %-0,46 %

Full SampleBreakdown by Industry

Manufacturing (33)Finance (64)

Breakdown by Type of InvestmentInnovative (25)Not Innovative (42)Unclassified (30)

AERSample Category

the costs and benefits (“value”) of IS infrastructure flexibility

the costs and benefits implied by postponing IS investments (“option” to invest later)

the costs and benefits of partial investments.

learn from capital markets’ experiences about coping with future uncertainty:

Comparable Companies ApproachComparable Companies Approachrevenue multiplesrevenue multiples

Revenue Multiples

Earnings Multiples

Revenues

Cash) - Debt of ValueMarket Equity of Value(MarketRatioSalestoValueEnterpise

EBIT(DA)

Cash) - Debt of ValueMarket Equity of Value(MarketRatio EBIT(DA) to ValueEnterprise

advantages and disadvantages of multiplesadvantages and disadvantages of multiples

Multiple Advantages Disadvantages

P/E- Simple- Most often applied multiple

- Sensitive to corporate tax rate- Sensitive to capital structure

PEG - Considers future earnings expectations

- Limited applicability if growth ratios low

EV/Sales

- Simple- applicable if no or negative earnings- Facilitates cross-border comparisons

- Ignores financial structures- Does not consider profitability

EV/EBIT(DA)

- Avoids bias caused by different taxation rates, capital structure- Facilitates cross-border comparisons

- Equity value is very sensitive to net debt for highly leveraged companies

CCCC

Empirical evidence:

precision increases using companies with similar historic earnings growth rates (instead of same industry classification)

no improvement from adjustments in risk, growth differences, leverage

better results when using forecasted (not historic) earnings

ROA definedROA defined

ROA employs the financial option theory based on the Black-Scholes formula

idea: option provides the holder with the right, but not the obligation, to sell or buy a specified quantity of an underlying asset at a fixed price, called the strike price.

15

2 64 10 128 14 16 2018 222

10

5

20

25

30 Base case:expected average revenues

Breakeven

„Intrinsic“ value

Real options value

Curve of distribution ofpossible final outcome

In this area, outcomes arepotentially negative, thereforecompany abandons venture,and outcome becomes zero

Equity Value

Expected future revenues

ROA in IS research ROA in IS research

lowhigh

high

flexibility

unce

rtai

nty sensitivity analysis,

simulation

statistical net presentvalue methods(DCF, NPV)

option price methods

dynamic net present value methods,option price methods

low

Applying ROAApplying ROA

1. NPV has to be determined, using the DCF approach

2. build an event tree, based on the set of combined uncertainties that drive the volatility of the company’s value

3. put the decisions that management may make into the nodes of the event tree to turn it into a decision tree

4. valuation of the payoffs in the decision tree using the method of replicating portfolios applying the Black-Scholes formula

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