VALUATION The Art and Science of Corporate Investment Decisions Second Edition SHERIDAN TITMAN University of Texas at Austin JOHN D. MARTIN Baylor University Prentice Hall Boston Columbus Indianapolis New York San Francisco Upper Saddje River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo
Preface xix Acknowledgments xxvii CHAPTER 1 Overview of Valuation 1 1.1 Introduction 1 1.2 The Nature of Major Investment Decisions 2 1.3 Valuing Projects and Businesses 4 Project Valuation Investing in the Caspian Sea Oil Fields 4 Issues to Consider When Valuing an Investment 5 n Enterprise Valuation Mergers and Acquisitions 8 1.4 Dealing with Complexity Process and Discipline 9 The Investment Evaluation Process 9 1.5,Case Study CP3 Pharmaceuticals Laboratories Inc. 12 Example: Investing in a New Materials-Handling System 13 n Addressing the Possibility of Decision Bias 15 1.6 Summing Up and Looking Forward 16 Final Comments The Investment Decision-Making Process 16 D Looking Forward The Structure of the Rest of the Book 17 1.7 Summary 18 si. i PART I Project Analysis Using Discounted Cash Flow (DCF) 19 CHAPTER 2 Forecasting and Valuing Cash Flows 20 2.1 Discounted Cash Flows and Valuation 20 Example-Car Wash 20 a The Three-Step DCF Process 21 2.2 Defining Investment Cash Flows 22 Relevant Cash Flows 22 a Conservative and Optimistic Cash Flows 24 a Equity Versus Project Free Cash Flow 26 2.3 Comprehensive Example Forecasting Project Free Cash Flows 34 Lecion's Strategic Assessment of the Opportunity 34 a Estimating the Investment's Project Free Cash Flow (PFCF) 35 a Estimating Total Annual Expenses 37 2.4 Valuing Investment Cash Flows 39 Example Valuing Lecion's Project Cash Flows 39 XI
XII Contents Using NPV and IRR to Evaluate the Investment 40 a Mutually Exclusive Projects 41 2.5 Summary 46 Problems 46 CHAPTER 3 Project Risk Analysis 53 3.1 Introduction 53 3.2 Uncertainty and Investment Analysis 54 The Investment Process with Risky Cash Flows 54 a Example The Earthilizer Proposal 55 3.3 Sensitivity Analysis Learning More About the Project 58 Scenario Analysis 59 a Breakeven Sensitivity Analysis 59 Simulation Analysis 62 n Interpreting Simulation Results 68 B Using the Tornado Diagram to Perform Sensitivity Analysis 71 o Reflections on the Use of Simulation 73 3.4 Decision Trees Valuing Project Flexibility 75 Example Decision Tree Analysis of the Abandonment Option 76 3.5 Summary 80 Problems 81 Appendix: An Introduction to Simulation Analysis and Crystal Ball 92 Cost of Capital 97 CHAPTER 4 Estimating a Firm's Cost of Capital 98 4.1 Introduction 98 4.2 Value, Cash Flows, and Discount Rates 99 Defining a Firm's WACC 99 a Discounted Cash Flow, Firm Value, and the WACC 101 a Illustration Using Discounted Cash Flow Analysis to Value an Acquisition 101 4.3 Estimating the WACC 104 Evaluate the Firm's Capital Structure Weights Step 1 105 a The Cost of Debt-Step 2 106 n The Cost of Preferred Equity-Step 2 (continued) 110 Q The Cost of Common Equity Step 2 (continued) 110 a Calculating the WACC (Putting It All Together)-Step 3 132 D Taking a Stand on the Issues Estimating the Firm's Cost of Capital 134 4.4 Summary 136 Problems 136 Appendix: Extensions and Refinements of WACC Estimation 143
Contents XIII CHAPTER 5 Estimating Required Rates of Return for Projects 151 5.1 Introduction 151 5.2 Pros and Cons of Multiple Risk-Adjusted Costs of Capital 152 The Rationale for Using Multiple Discount Rates 152 The Benefits of Using a Single Discount Rate 155 Weighing the Costs and Benefits of Multiple versus Single Discount Rates 157 5.3 Choosing a Project Discount Rate 157 Method #1: Divisional WACC (Industry-Based Divisional Costs of Capital) 158 a Method #2: Project-Specific WACCs 163 5.4 Hurdle Rates and the Cost of Capital 176 Mutually Exclusive Projects 177 n High Hurdle Rates May Provide Better Incentives for Project Sponsors 177 n Accounting for Optimistic Projections and Selection Bias 177 5.5 Summary 179 Problems 179 PART III Financial Statements and Valuation 185 CHAPTER 6 Forecasting Financial Performance 186 6.1 Introduction 186 6.2 Understanding Financial Statements and Cash Flow 187 The Income Statement 187 o The Balance Sheet 190 n Statement of Cash Flow 196 n Free Cash Flow Computations 196 Reconciling the Cash Flow Statement with Firm FCF 200 o Free Cash Flow and Nonoperting Income 201 6.3 Forecasting Future Financial Performance 202 Step 1: Perform an Analysis of Historical Financial Statements 203 n Step 2: Prepare Pro Forma Financial Statements for the Planning Period 204 a Step 3: Convert Pro Forma Financial Statements to Cash Flow Forecasts 210 n Step 4: Estimate the Terminal Value of Firm Free Cash Flows 210 6.4 Looking Ahead The Mechanics of Calculating Enterprise Value 212 Planning Period and Terminal Value 212 6.5 Summary 214 Problems 215 Appendix: Detecting Financial Fraud 220
xiv Contents CHAPTER 7 Earnings Dilution, Incentive Compensation, and Project Selection 222 7.1 Introduction 222 7.2 Are Reported Earnings Important? 224 Why Managers Care About Earnings 224 7.3 Project Analysis Earnings per Share and Project Selection 225 Example #1 Bad Project with Good Earnings Prospects: The Equity-Cost Problem 226 n Example #2 Good Project with Back-Loaded Earnings Prospects 235 7.4 Economic Profit and the Disconnect Between EPS and NPV 236 Economic Profit (aka, EVA ) 238 Using Economic Profit to Evaluate the Equity-Cost Problem 240 Using Economic Profit to Evaluate the Back- and Front-Loaded Earnings Problems 242 7.5 Practical Solutions Using Economic Profit Effectively 243 Modifying the Calculation of Economic Profit 244 Modifying the Method Used to Pay Bonuses Based on Economic Profit 250 7.6 Summary 251 Problems 253 PART I V Enterprise Valuation 257 CHAPTER 8 Relative Valuation Using Market Comparables 258 8.1 Introduction 258 8.2 Valuation Using Comparables 259 Valuing Residential Real Estate Using Comparables 260 Valuing Commercial Real Estate 262 8.3 Enterprise Valuation Using EBITDA Multiples 270 Enterprise Value Versus Firm Value 270 n The Airgas EBITDA Multiple 271 EBITDA and Firm Free Cash Flow 272 Why Use EBITDA Multiples Rather than Cash Flow Multiples? 273 a The Effects of Risk and Growth Potential on EBITDA Multiples 274 a Normalizing EBITDA 275 a Adjusting the Valuation Ratio for Liquidity Discounts and Control Premiums 275 8.4 Equity Valuation Using the Price-Earnings Multiple 276 Example Valuing ExxonMobil's Chemical Division Using the P/E Method 276 PIE Multiples for Stable-Growth Firms 278 a P/E Multiple for a High-Growth Firm 281 8.5 Pricing an Initial Public Offering 285
Contents xv 8.6 Other Practical Considerations 286 Selecting Comparable Firms 286 s Choosing the Valuation Ratio 286 a Valuation Ratios Versus DCF Analysis 291 8.7 Summary 292 Problems 293 CHAPTER 9 Enterprise Valuation 312 9.1 Introduction 312 9.2 Using a Two-Step Approach to Estimate Enterprise Value 313 Example Immersion Chemical Corporation Acquires Genetic Research Corporation 314 a Sensitivity Analysis 327 a Scenario Analysis 328 9.3 Using the APV Model to Estimate Enterprise Value 329 Introducing the APV Approach 330 Using the APV Approach to Value GRC Under the Growth Strategy 330 a Using an EBITDA Multiple to Calculate the Terminal Value 336 n Comparing the WACC and APV Estimates ofgrc's Enterprise Value 338 n A Brief Summary of the WACC. and APV Valuation Approaches 339 a Estimating the Value of Subsidized Debt Financing 340 9.4 Summary 341 Problems 342 CHAPTER 10 Valuation in a Private Equity Setting 354 10.1 Introduction' 354 10.2 Overview of the Market for Private Equity 356 Market for Private Equity Financial intermediaries 357 a Investors The Suppliers of Private Equity Finance 357 Investments The Demand for Private Equity Finance 357 10.3 Valuing Investments in Start-Ups and Deal Structuring 360 The Cost of Capital for Venture Capital Financing 360 a Valuing a VC Investment and Structuring the Deal 364 a Summing Up the Venture Capital Method 367 a Pre- and Post-Money Value of the Firm's Equity 368 Refining the Deal Structure 369 10.4 Valuing LBO Investments 371 Alternative LBO Acquisition Strategies Bust-Ups and Build-Ups 373 a Example Buiid-Up LBOs 374 A Limitation of the Industry Private Equity (LBO) Valuation Approach 381 ta Valuing PMG Inc. Using the Hybrid APV Approach 382 10.5 Summary 385 Problems 386
xvi Contents PART V Futures, Options, and the Valuation of Real Investments 395 CHAPTER 11 Using Futures and Options to Value Real Investments 398 11.1 Introduction 399 11.2 The Certainty-Equivalence Method 402 Forward Prices as Certainty-Equivalent Cash Flows 403 11.3 Using Forward Prices to Value Investment Projects 404 Example 404 a Convincing Your Skeptical Boss 406 11.4 Using Option Prices to Value Investment Opportunities 410 Option Value and Nonrecourse Financing 411 a Convincing Your Skeptical Boss 412 11.5 Caveats and Limitations Tracking Errors 413 How Liquid Are Futures, Forward, and Option Markets? 414 a Uncertain Quantities and Operating Costs 414 u Basis Risk 415 11.6 Using an Option Pricing Model to Value Investments 416 "' Example Valuing the Cotton Valley Investment Using the Binomial Option Pricing Model 416 a How Does Volatility Affect Option Values? 420 n Calibrating Option Pricing Models 421 11.7 Summary 421 Problems 422 Appendix A: Option Basics A Quick Review 426 Appendix B: Multiperiod Probability Trees and Lattices 431 Appendix C: Calibrating the Binomial Option Pricing Model 433 CHAPTER 12 Managerial Flexibility and Project Valuation: Real Options 436 12.1 Introduction 436 12.2 Types of Real Options 437 Real Options to Consider Before an Investment Launch 438 Real Options to Consider After an Investment Launch 438 12.3 Why Real Option Valuation Is Difficult 439 12.4 Valuing Investments That Contain Embedded Real Options 439 The Option to Invest: Staged Investments 440 Option to Abandon 448 12.5 Analyzing Real Options As American-Style Options 450 Evaluating National Petroleum's Option to Drill 450 o Real Option Valuation Formula 459 12.6 Using Simulation to Value Switching Options 463 Option to Switch Inputs 464
Contents xvii 12.7 Summary 470 Problems 474 Appendix: Constructing Binomial Lattices 479 CHAPTER 13 Strategic Options: Evaluating Strategic Opportunities 481 13.1 Introduction 481 13.2 Where Do Positive-NPV Investments Come From? 483 13.3 Valuing a Strategy with Staged Investments 484 Description of Vespar's New Coal Technology 485 Stand-Alone Project Analysis of the Initial Plant 485 a Analyzing Projects As a Part of a Strategy 487 n The Anatomy of Vespar's Power Plant Strategy 496 a Sensitivity Analysis of Vespar's Power Plant Strategy 496 13.4 Strategic Value When the Future Is Not Well Defined 501 Which Investments Generate Strategic Options? 501 How Does Corporate Structure Affect Strategic Option Value? 502 o Management Incentives, Psychology, and the Exercise of Strategic Options 503 13.5 Summary 506 Problems 507 Epilogue 509 Index 511