Pwc. PwC E-business Valuation Michael Churchill, Corporate FinancePartner – Technology October...

E-business ValuationMichael Churchill, Corporate FinancePartner – Technology

October 2001, University of Queensland

©2001 PricewaterhouseCoopers. PricewaterhouseCoopers refers to the individual member firms of the world-wide PricewaterhouseCoopers organisation. All rights reserved.

Agenda

Introduction – valuation of e-business

A recent history of e-business

E-business viewed as early-stage commercialisation

Key valuation concepts

Dealing with uncertainty

Conclusion – key messages

PricewaterhouseCoopers


E Business has transformed the way business is conducted

“E-Business is reshaping the business landscape, and the implications for PricewaterhouseCoopers are profound…. It will impact the way we do business, provide new arenas of opportunity, force change to our business model, and expose us to new forms of competition that are more agile than the competitive forces we have faced in the past….

……in sum, a huge opportunity - and an equal threat”


E-business is business

• What is e-business? For the purpose of today’s discussion we will define e-business as any form of commerce which involves at least partial completion via the internet (e.g. ordering, payment, delivery) but not simple “brochureware”

• Some questions emerge:– Is e-business really different to any other form of business

activity?– Is e-business an integral component of everyday business?

• Perhaps e-business can be viewed in a similar fashion to other early-stage commercialisation opportunities (more on this later!)

• The aim of today’s presentation is to provide some insights into valuation of e-businesses


Key messages

•As with many emerging or new markets, the e-business opportunity has attracted significant capital investment

•The period up until April 2000 presented great uncertainty as to how the market opportunity would evolve

•Significant over-estimation of market size and profitability of business models has seen many stand-alone e-business models fail and fall by the wayside

•The marketplace is maturing and profitable business models (and those with a clear path to profitability) continue to attract capital

•There is significant risk aversion as a result of the “tech wreck” of 2000 – venture capitalists are waryof investing in e-business; biotech has attracted significant attention

•“Tried and true” valuation principles are the order of the day in this phase of market adoption of e-business models


Deutsche Bank Technology Index Feb 1999 to October 2001


A sample of e-commerce stocks have closely followed the Technology Index

M2M

emitchMelbourne ITBMC media



• Not so many years ago we all started to subscribe to internet service providers (ISP’s) principally for the purpose of accessing research materials, e-mail and chat rooms

• Subscription to an ISP was probably one of the first on-line transactions we undertook

• Many saw the internet as providing a new economic model

• The “blue sky” of the internet attracted significant capital – many investors wanted to “stake a claim” to ensure their participation in the “new economy”

• Opportunities were priced based on rules of thumb and business models were driven by market share rather than profit (or even revenue!)

• Takeover transactions were undertaken based on multiples of revenue (e.g. ISP aggregation in Australia in early 2000 was often driven by revenue per subscriber of $1-3,000) or market share aspirations



• The flood of capital to e-business start-ups resulted in many being significantly over-priced relative to the likely returns – many investors (both small retail investors and institutional investors) were extremely concerned at “missing out” on participating in this business revolution

• The bubble burst on the realisation that returns were not being achieved anywhere close to expectations (e.g. recent online advertising survey results show that market size projections of only a year ago were wrong by a multiple of times the actual market size evidenced today)

• Today, the capital market values e-businesses like all business models – on the basis of likely realisable returns (we will explore this concept in more detail later on)


E-business as an early stage commercialisation opportunity

• Early stage commercialisation opportunities have some common features:– Intellectual property and its application are central– The market opportunity is often formative (the “s curve” of

adoption)– The commercialisation “chasm” often beats many great ideas– Commercialisation costs many times the IP development cost– Operating cost structures are often reasonably predictable BUT– Revenue uncertainties are extreme. Key drivers include:

– Market size– Adoption– Market share– Competitor strengths/activity– Price elasticity


Understanding the market opportunity

Marketdefinition

Marketdefinition

Market sizing

Market sizing

Segmentation/penetration

Segmentation/penetration

Competitivepositioning

Competitivepositioning

Channelstrategies

Channelstrategies

SWOTanalysis

SWOTanalysis

PESTanalysis

PESTanalysis

UncertaintyUncertainty

Marketanalysis

Operational &environmental

assessment

Othervalue issues

End-gamescenarios

Purchasedecisions

Purchasedecisions

ValueDecision-making

ValueDecision-making


E-business as an early stage commercialisation opportunity (cont)

• High degrees of uncertainty are not well-suited to estimation (and therefore valuation) by traditional cashflow projections (deterministic modelling)

• Uncertainty is best captured using stochastic methods where the uncertainty is explicitly recognised

• Two techniques we commonly employ are:– Monte carlo analysis– Real option valuation

• The valuation approaches relevant to early-stage businesses will be explored later.


E-business portfolios within large corporates

•Many large corporates have constructed a portfolio of e-business initiatives. Some initiatives will succeed, others are likely to fail.

•Like the pharmaceutical industry, many of these corporates are adopting a “fail fast” mode of viability assessment

•E-business initiatives are qualitatively tested against the goals of the corporate. Examples include:

– Capturing market share– Increasing distribution channel capabilities– Promoting corporate image– Achieving target ROI

• Ultimately the corporate e-business portfolio is evaluated in the same way as other capital expenditure/new business opportunities (e.g. research and development portfolios)


E-business portfolios within large corporates

Many corporate e-business initiatives are assessed by the anticipated impact of implementation. For example, initiatives could be:

• Cost Savings measures (e.g. participation in reverse on-line auctions, e-markets in order to accelerate corporate procurement)

• Cost Savings measure enabling penetration of new market segments (through re-development of the product offering and e-delivery)

• Product development process improvement (R&D)

• Sales Channel measures

• Customer Perceptions measures

• New Products or Services


Key valuation concepts

•Value is an ambiguous concept: it is dependant upon the context of the

user, the date and a host of other factors

•Usually “value” means the value to the average investor who is not in a hurry to buy/sell in a well-informed (“fully-informed”?) market

•Why worry about value? A deep secondary market is all we need isn’t it?

•Value in exchange vs value from holding to derive income: key issue is existence (or otherwise) of a “market”

•Value is not dependant on “hard” assets – intellectual property is equally valuable – subject to the returns being present


Why value e-businesses?

•Typically, e-businesses are valued to:– Support a transaction (such as sale, purchase, recapitalisation)– Price a fresh capital raising (from strategic partners, initial public offering,

development capital etc)– Enable portfolio capital allocation– Support carrying values in balance sheets– Establish cost bases for capital gains tax purposes

•The key to successfully valuing e-businesses lies in:– assessing the market opportunity (in order to project revenues)– determining the cost structure of the business model– assessing the investment capital necessary to develop and commercialise

the IP of the business model

• In short, the key lies in anticipating the various possible future states of the world in which the business will operate


Predicting or anticipating the future?

Predicting the future has to be one of the hardest gigs around. That is why I have huge doubts about horoscopes. If we still can’t predict interest rates how the hell can anyone predict that Neptune is going to have an effect on my personal finances?

• Rob Sitch, Business Review Weekly, 23.9.96


Did the market really get it that wrong?

•Earlier, we said that the capital markets significantly over-priced e-business opportunities.

•We’d like to refine that notion now by proposing that what the capital markets had implicitly done was to hold an optimistic view of the likely future returns and the inherent optionality in e-business (e.g. Amazon’s market capitalisation at the height of the e-boom was represented by cashflows 10% and growth options 90%)

•The next section introduces real options valuation (ROV) and how ROV assists with dealing with the uncertainty associated with early-stage commercialisation opportunities


There is a revolution underway in business planning

•Simply forecasting trends and adding incremental capabilities to services does not guarantee a place in the future.

•Far more uncertainty also means far more opportunity to create new forms of value.

•The game is shifting from forecasting to anticipating

• and from pre-determination to learning and capitalising on discoveries.

•This requires a new management tool set that plans for learning and embraces a range of future outcomes - ROV offers that tool.

•ROV employs decision trees and probabilistic approaches to developing cashflow projections – including a value profile such as the example on the following page


Valuation risk profile: more than just one number...

0

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

-50000 -25000 0 15000 40000 65000 90000 125000 150000 175000 200000

18% chancevalue is negative

Expected value:$30 M

10% chance value is

over $100 M

Cum

ula

tive

pro

babi

lity

Value in $000’s


How is ROV different from typical discounted cash flow?

DCF

Static - addresses fixed conditions

Deterministic - uses a single forecast or limited treatment of uncertainty through the use of scenario planning/sensitivities

Inflexible; ignores optionality - relies on single business case that ignores the flexibility to act in response to uncertain changing conditions

ROV

Dynamic - responds to changing conditions

Probabilistic - incorporates more complete consideration of uncertainty through events and probabilities

Flexible; captures optionality - incorporates a business plan that captures flexibility to act in response to uncertain changing conditions


Example: valuing a new venture with Real Option Valuation

A start-up venture needs:

• $4 million in first two years to begin product and distribution channel development

• $12 million after two years for its market launch

•Option value identified in the product and distribution channel development stage

• costly launch undertaken if market conditions in two years’ time are sufficiently attractive


Decision tree

Launch

Do not launch Low

Market Launch

Launch

Do not launch Nominal

Launch

Do not launch

High

Invest

Market Condition

Do not Invest

New Venture

-$12 M

$0 M

-$12 M

$0 M

-$12 M

$0 M

-$4 M

-$0 M

$10 M

$0 M

$20 M

$0 M

$30 M

$0 M

Revenue


The ROV Decision Tree Solution

Launch

-2

[-6]

Do_Not_Launch

0

[-4]

Market_Launch Low

.600

[-4]

Launch

8

[4]

Do_Not_Launch

0

[-4]

Market_Launch Nominal

.250

[4]

Launch

18

[14]

Do_Not_Launch

0

[-4]

Market_Launch High

.150

[14]

Market_Condition Invest

-4

[0.7]

Do_Not_Invest

0

[0]

New_Venture [0.7]


Comparison between DCF and ROV values

•$700,000

•-$500,000 •DCF

•ROV


E-business often presents significant optionality

•Option to defer

•Time-to-build option (eg. 3 years vs 6 years)

•Option to alter operating scale (eg. Expand, contract, shut down & re-start)

•Option to abandon

•Option to switch (eg. Outputs or inputs)

•Growth options (eg. R&D, strategic acquisition)

•Multiple interacting options


R_D_Outcome With_InfoSat_0_Cap [116.592]


ComNet_Accepts Reactor [2032.04]

ComNet_Accepts Accelerator [2138.75]

Competitive_Response Very_High

.269

[2138.75]



Competitive_Response High

.443

[1779.2]



Competitive_Response Low

.243

[1245.43]



Competitive_Response Very_Low

.044

[628.887]

Market_Growth_2001 None

.700

[1695.03]

ComNet_Accepts Reactor [-47.9915]


Competitive_Response Very_High

.269

[292.278]



Competitive_Response High

.443

[119.638]


ComNet_Accepts Accelerator [-99.9615]

Competitive_Response Low

.243

[-99.9615]


ComNet_Accepts Accelerator [-390.207]

Competitive_Response Very_Low

.044

[-390.207]

Market_Growth_2001 Compete

.300

[90.0537]

NordStar_Competitive_Response Aggressive [1157.26]

NordStar_Competitive_Response Cautious [711.955]

No [0]

Implement_Technology High_Success

.225

[1157.26]

NordStar_Competitive_Response Aggressive [286.881]


No [0]

Implement_Technology Nominal_Success

.450

[338.003]

NordStar_Competitive_Response Aggressive [-266.827]


No [0]

Implement_Technology Low_Success

.225

[71.3933]

Failure

.100

[0]


No [0]

Partnering_Strategy Yes [411.988]

No [0]

Research_Strategy [411.988]

1. Identify and quantify

uncertainties

2. Drill deeper into those options we learn about

over time

3. Identify creative future, adaptive decisions

ROV provides a dynamic roadmap for maximising value and managing risks over time


• Valuation of e-businesses requires the same basic approach as other early-stage technology/IP commercialisation opportunities

• There is limited capital availability at present due to the “tech wreck” of 2000

• Consequently, the value of likely future cashflows is likely to be greater than the amount that the market will pay today – there is an opportunity to buy e-businesses “cheaply”

• The best way to assess the value of highly uncertain investment opportunities is by explicitly recognising uncertainty – using Monte Carlo or ROV techniques

Conclusion


E-business is like all other business – returns must justify investment

There’s nothing more nervous than capital and if one feels claustrophobic one moves one’s capital to somewhere where the climate is a little warmer.

• CanWest Chief Executive and (former) Network Ten owner Izzy Asper, December 1995

Pwc. PwC E-business Valuation Michael Churchill, Corporate FinancePartner – Technology October...

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