d i g e s t - cbv institute · 2018-11-29 · in this issue business valuation d i g e s t volume 6...

IN THISISSUE

BUSINESS VALUATIO ND I G E S T

VOLUME 6ISSUE 1

MAY 2000

BY DRIEK DESMET, TRACY FRANCIS, ALICE HU, TIMOTHY M. KOLLER AND GEORGE A. RIEDEL

The Canadian Institute of Chartered Business Valuators

A publica tion devotedto articles on BusinessVa lua tion and rela tedma tters.

Valuing dot–coms

Valuing dot–coms . . 1Making Persuasive Presentations in Court . . . . . . . . . 8

What’s it Worth?A General ManagersGuide to Valuation.. 14The investmentValue of BrandFranchise. . . . . . 26

The Business Valuation Digest is apublication of The Canadian Institute ofChartered Business Valuators. It ispublished semi-annually and is supplied free of charge to all Members,Subscribers and Registered Studentsof the Institute.

Statements and opinions expressed bythe authors and contributors in thearticles published in the Digest aretheir own, and are not endorsed by,nor are they necessarily those of theInstitute or the Editorial AdvisoryBoard.

EDITOR:Blair Roblin, CBV, LLB

EDITORIAL ADVISORY BOARD: Mark L. Berenblut, CA, CBVNora V. Murrant, CA, FCBVJohn E. Walker, CA, CBV, LLB

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IntroductionYou don’t have to step through the looking glassinto a parallel universe to understand thevaluations of Internet stocks. Discounted-cash-flowanalysis can focus your mind on the right issues,help you see the risks, and separate the winnersfrom the losers.

I n the present era of cheap and accessiblecapital, I nternet entrepreneurs havesucceeded in quickly transforming theirbusiness ideas into billion-dollar valuationsthat seem to defy the common wisdom aboutprof its, multiples, and the short-term focusof capital markets. Valuing these high-growth , high-uncertainty, high-loss f irms hasbeen a challenge, to say the least; somepractitioners have even descr ibed it as ahopeless one.

I n this article, we respond to thatchallenge by using a classic discounted-cash-f low (D C F) approach to valuation , buttressedby microeconomic analysis and probability-weighted scenarios. A lthough D C F maysound suspiciously retro, we believe that itworks where other methods fail, rein forcingthe continuing relevance of basic economicsand f inance, even in uncharted I nternetter ritory1. Yet it is important to bear in mindthat while the valuation techniques we sketchout can help bound and quantify uncertainty,

they won’t make it disappear . I nternet stocksare highly volatile for sound and logicalreasons, and they will remain highly volatile.

DCF analysis when there is no CF to DT hree related factors make it hard to valueInternet companies. F irst, like many start-ups, they typically have losses or very smallprof its for a few years, partly because of thehigh marketing costs (aimed at attractingcustomers) that they must write off againstcurrent earnings. Second , these companiesare growing at very high rates; successfulones will increase their revenues by 100times or more in the early going. F inally,the fate of these companies is quiteuncertain .

Shorthand valuation approaches, includingprice-to-earnings and revenue multiples, aremeaningless when there are no earnings andrevenues are growing astronomically. Someanalysts have suggested benchmarks such asmultiples of customers or multiples ofrevenues th ree years out. T hese approachesare fundamentally f lawed: speculating abouta future that is only th ree or even f ive yearsaway just isn't very useful when high growthwill continue for an additional ten years.More important, these shorthand methodscan't account for the uniqueness of eachcompany.

T he best way of valuing I nternetcompanies is to return to economicfundamentals with the D C F approach , which

1For a complete discussion of the DCF approach, see Tom Copeland,Timothy M. Koller, and Jack Murrin, Valuation: Measuring and Managingthe Value of Companies, second edition, New York: John Wiley & Sons,1995. Chapter 3 "Cash Is King," may be of particular interest.

B U S I N E S S V A L U A T I O N D I G E S T2

makes the distinction between expensed andcapitalized investment, for example,unimportant because accounting treatmentsdon't af fect cash f lows. T he absence ofmeaningful historical data and positiveearnings to serve as the basis for p rice-to-earnings multiples also doesn't matter ,because the D C F approach , by relying solelyon forecasts of per formance, can easilycapture the worth of value-creating businessesthat lose money for their f irst few years. T heD C F approach can't eliminate the need tomake dif f icult forecasts, but it does addressthe problems of ultrahigh growth rates anduncertainty in a coherent way.

I n this discussion , we assume that thereader has a basic knowledge of the D C Fapproach . T hree twists are required to makethis approach more useful for valuingInternet companies: starting f rom a f ixedpoint in the future and working back to thepresent, using probability-weighted scenariosto address high uncertainty in an explicitway, and exploiting classic analyticaltechniques to understand the underlyingeconomics of these companies and to forecasttheir future per formance.

We illustrate this approach with a valuationof A mazon .com , the archetypal I nternetcompany. I n the four years since its launch , ithas built a customer base of ten million andexpanded its of ferings f rom books to compactdiscs, videos, digital video discs, toys,consumer electronics goods, and auctions. I naddition , A mazon has invested in brandedInternet players such as pets.com anddrugstore.com , and since the end ofSeptember 1999 it has allowed other retailersto sell their wares on its Web site th roughwhat it calls its "associates p rogram . " I ndeed ,the company has become a symbol of thenew economy; market research shows that101 million people in the U nited Statesrecognize the A mazon brand name.

A ll this activity has been rewarded with ahigh market capitalization: $25 billion as ofmid-N ovember 1999. Yet A mazon has never

T H E C A N A D I A N I N S T I T U T E O F C H A R T E R E D B U S I N E S S V A L U A T O R S

tu rned a prof it and is expected to lose at least $300million for the year , so it has become the focus of adebate about whether I nternet stocks are greatlyovervalued .

Start from the FutureI n forecasting the per formance of high-growthcompanies like A mazon , don't be constrained bycurrent per formance. I nstead of starting f rom thepresent - the usual p ractice in D C F valuations -start by thinking about what the industry and thecompany could look like when they evolve f romtoday's high-growth , unstable condition to asustainable, moderate-growth state in the future;and then extrapolate back to current per formance.T he future growth state should be def ined bymetrics such as the ultimate penetration rate,average revenue per customer , and sustainablegross margins. Just as important as thecharacteristics of the industry and company in thisfuture state is the point when it actually begins.Since I nternet-related companies are new, morestable economics p robably lie at least 10 to 15 yearsin the future.

But consider what A mazon has already achieved .I ts ability to enter and dominate categories isunprecedented , both in the off- and the on-lineworlds. I n 1998, for example, it took the companyonly a bit more than three months to banishC D N OW to second place among on-line purveyorsof music. I n early 1999, A mazon assumed theleadership among on-line purveyors of videos in 45days; recently, it became the leading on-lineconsumer electronics purveyor in 10.

Let us create a fair ly optimistic scenario based onthis record . Suppose that A mazon were the nextWal-Mart, another US retailer that has radicallychanged its industry and taken a signif icant shareof sales in its target markets. Say that by 2010,A mazon continues to be the leading on-line retailerand has established itself as the overall leadingretailer , both on- and off-line, in certain markets. I fthe company could take a 13 and 12 percent shareof the total US book and music markets,respectively, and captured a roughly comparableshare of some other markets, it would haverevenues of $60 billion in 2010, when Wal-Mart's

B U S I N E S S V A L U A T I O N D I G E S T 3

exceeding the nominal growth rate of thegross domestic p roduct2. To estimateA mazon's current value, we discount theprojected f ree cash f lows back to the present.T heir p resent value, including the estimatedvalue of cash f lows beyond 2025, is $37billion .

H ow can we credibly forecast ten or moreyears of cash f lows for a company likeA mazon? We can't. But our goal is not todef ine precisely what will happen but insteadto offer a r igorous descr iption of what could.

Weighting for ProbabilityU ncertainty is the hardest part of valuinghigh-growth technology companies, and theuse of p robability-weighted scenarios is asimple and straightforward way to deal withit. T his approach also has the advantage ofmaking cr itical assumptions and interactionsfar more transparent than do other modelingapproaches, such as Monte Carlo simulation .T he use of p robability-weighted scenariosrequires us to repeat the process ofestimating a future set of f inancials for a fullrange of scenarios - some more optimistic,some less. For A mazon , we have developedfour of them (E xhibit 1).


revenues will p robably have exceeded $300 billion .

W hat operating prof it margin could A mazon .comearn on that $60 billion? T he superior marketshare of the company is likely to give it signif icantpurchasing power . Remember too that A mazon willearn revenues and incur few associated costs f romother retailers using its site. I n this optimisticscenario, A mazon , with an average operatingmargin in the area of 11 percent, would most likelydo a bit better than most other retailers.

A nd what about capital? I n the optimisticscenario, A mazon may well need less workingcapital and fewer f ixed assets than traditionalretailers do. I n almost any scenario, it should needless inventory because it can consolidate its stock-in-trade in a few warehouses, and it won't need retailstores at all. We assume that A mazon's 2010 capitaltu rnover (revenues divided by the sum of workingcapital and f ixed assets) will be 3.4, compared with2.5 for typical retailers.

Combining these assumptions gives us thefollowing f inancial forecast for 2010: revenues, $60billion; operating prof it, $7 billion; total capital, $18billion . We also assume that A mazon will continueto grow by about 12 percent a year for the next 15years after 2010 and that its growth will decline to5.5 percent a year in perpetuity after 2025, slightly

2Real GDP growth has averaged about 3 percent a year for the past 40 years, andthe long-term expected inflation rate built into current interest levels is probablyabout 2 to 2.5 percent a year.

79

37

15

3



I n Scenario A , A mazon becomes the second-largest retailer (on- or off-line) based in theU nited States. I t uses much less capital thantraditional retailers do because it is p rimarilyan on-line operation . I t captures much higheroperating margins because it is the on-lineretailer of choice; even i f its p rices arecomparable to those of other on-line retailers,it has more purchasing clout and loweroperating costs. T his scenario implies thatA mazon was worth $79 billion in the fourthquarter of 1999.

Scenario B has A mazon capturing revenuesalmost as large as it does in Scenario A , butits margins and need for capital fall in therange between those of the f irst scenario andthe margins and capital requirements of atraditional retailer . T his second scenarioimplies that A mazon had a value of $37billion as of the fourth quarter of 1999.

A mazon becomes quite a large retailer inScenario C , though not as large as it does inScenario B , and the company's economics arecloser to those of traditional retailers. T histhird scenario implies a value for A mazon of$15 billion .

F inally, in Scenario D , A mazon becomes afair-sized retailer with traditional retailereconomics. O n-line retailing mimics mostother forms of the business, with manycompetitors in each f ield . Competitiontransfers most of the value of going on-lineto consumers. T his scenario implies thatA mazon was worth only $3 billion .

We now have four scenarios, in which thecompany's value ranges f rom $3 billion to$79 billion . A lthough the spread is quitelarge, each scenario is plausible3. N ow comesthe cr itical phase of assigning probabilitiesand generating the resulting values forA mazon (E xhibit 2). We assign a lowprobability, 5 percent, to Scenario A , forthough the company might achieve

outrageously high returns, competition is likely toprevent this. A mazon's current lead over itscompetitors suggests that Scenario D too isimprobable. Scenarios B and C - both assumingattractive growth rates and reasonable returns - aretherefore the most likely ones.

W hen we weight the value of each scenario,depending on its p robability, and add all four ofthese values, we end up with $23 billion , whichhappened to be the company's market value onO ctober 31, 1999. I t therefore appears thatA mazon's market valuation can be supported byplausible forecasts and probabilities.

N ow, however , look at the sensitivity of thisvaluation to changing probabilities. A s E xhibit 3shows, relatively small variations lead to big swingsin value. I ndeed , the volatility of the share prices ofcompanies like A mazon has been precipitated by

3We capture cash-flow risk through the probability-weighting of scenarios,so the cost of equity applied to each of them shouldn't include any extrapremium; it can consist of the risk-free rate, an industry-average beta, anda general market-risk premium.

16 23 32

small changes in the market's view of the likelihoodof dif ferent outcomes. N othing can be done aboutthis volatility.

From Probability to RealityT he last di f f icult aspect of valuing very high-growthcompanies is relating future scenarios to currentper formance. H ow can you tell a soon-to-besuccessful I nternet play f rom a soon-to-be-bankruptone? H ere, classic micro-economic and strategicskills play a cr itical role because building soundscenarios for a business and understanding thatbusiness both require knowledge of what actuallydrives the creation of value. For A mazon and manyother I nternet companies, customer-value analysis isa useful approach . F ive factors d rive the customer-value analysis of a retailer like A mazon:

• T he average revenue per customer per year f rom purchases by its customers, as well as revenues f rom advertisements on its site and f rom retailers that rent space on it to sell their own products

• T he total number of customers

• T he contribution margin per customer (before the cost of acquiring customers)

• T he average cost of acquiring a customer

• T he customer churn rate (that is, the proportion of customers lost each year)

Let us see how A mazon could achieve thef inancial per formance predicted by Scenario B andcompare this with the company's currentper formance. A s E xhibit 4 shows, the biggestchanges over the next ten years involve the numberof A mazon's customers and the average revenue for



each . I n Scenario B , A mazon's customer baseincreases f rom 9 million a year in 1999 toabout 120 million worldwide by 2010 - 84million in the U nited States and 36 millionoutside it. We assume that A mazon willremain the number-one US on-line retailerand achieve an attractive position abroad .

Scenario B also calls for A mazon's averagerevenue per customer to r ise to $500 by2010, f rom $140 in 1999. T hat $500 couldbe accounted for by two C Ds at $15 each ,th ree books at $20 each , two bottles ofper fume at $30 each , and one personalorganizer at $350. A mazon will p robablycontinue to dominate its core book and musicmarkets. I t will p robably enter adjacentcategories and may come to dominate them .

I n Scenario B , A mazon's 2010 contributionmargin per customer before the cost ofacquiring customers is 14 percent, a f igure inline with that of current top-notch large-scaleretailers - Wal-Mart, for instance. Despitecompetition , this seems rational in view ofA mazon's likely ability to gain offsettingeconomies of scale th rough devices such asrenting other retailers space to market theirproducts on A mazon's Web sites.

Scenario B predicts that A mazon will haveacquisition costs per customer of $50 in 2010.Despite the argument that these costs will r iseonce all on-line customers have been claimed ,this is a reasonable f igure i f the company canachieve brand dominance and advertisingeconomies of scale. T he cost of acquiringnew customers is closely linked to thecustomer churn rate, which at 25 percentsuggests that once A mazon acquirescustomers it will keep them four years. T hisimplies a truly world-class (or addictive)customer offer and a deeply loyal (or lazy)customer base.

Looking at customer economics in this waymakes it possible to generate the kind ofin formation that is assigned to assess theprobabilities needed to various scenarios.Consider how two hypothetical youngcompanies, Loyalty.com and Turnover .com ,

revenues per customer than Loyalty.com does andhas similar contribution margins, its economicmodel is not sustainable. Loyalty.com will f ind itmuch easier to grow because it doesn't have to f indas many new customers each year . SinceLoyalty.com will have substantially lower customeracquisition costs than Turnover .com , Loyalty.com'sf igures for earnings before income tax (E B I T ) willtu rn more positive quickly. I f Loyalty.com andTurnover .com invested the same amount of moneyin ef forts to acquire customers over the next tenyears, and other factors remained the same, therevenue growth and E B I T patterns of the twocompanies would vary a good deal (E xhibit 6). T hisin tu rn means that their D C F values would dif ferradically, despite similar short-term f inancial results.

Uncertainty is Here to StayBy using the adapted D C F approach outlined here,we can generate reasonable valuations for seeminglyunreasonable businesses. But investors andcompanies entering fast-growth markets like thoserelated to the I nternet face huge uncertainties.Look at what could happen under our fourscenarios to an investor who holds a share ofA mazon stock for ten years after buying it in 1999.

I f Scenario A plays out, the investor will earn a23 percent annual return , and it will seem that in



with dif ferent customer economics might evolveover time (E xhibit 5, on page 6). Each had$100 million in revenues in 1999 and anoperating loss of $3 million . O n traditionalf inancial statements, the two companies lookvery much the same. Deeper analysis, however ,using the customer economics model, revealsstr iking dif ferences.

T he li fetime value of a typical Loyalty.comcustomer is $50 over an average of f ive years;the typical Turnover .com customer is worth -$1over two years. T he dif ference in the value of acustomer ref lects the churn rate (20 percentattr ition each year for Loyalty.com versus 46percent for Turnover .com) and Turnover .com'shigher acquisition costs.

Even though Turnover .com earns higher



1999 the market signif icantly undervalued A mazon .I f Scenario C plays out, the investor will earn about7 percent a year , and it will seem that the companywas substantially overvalued in 1999. T hese high orlow returns should not, however , be interpreted asimplying that its 1999 share price was ir rational;they ref lect uncertainty about the future.

A great deal of this uncertainty is associated withthe problem of identi fying the winner in a largecompetitive f ield: in the world of high-tech initialpublic of ferings, not every I nternet company canbecome the next Microsoft or C isco systems.H istory shows that a small number of players willwin big while the vast majority will toil away amidobscurity and worthless options, and it is hard topredict which companies will p rosper and whichwill not4. N either investors nor companies can doanything about this uncertainty, and that is whyinvestors are always told to diversi fy their portfolios- and why companies don't pay cash whenacquiring I nternet f irms.The authors thank Pat Anslinger, Ennius Bergsma,

Michael Drexler and Jan Schultink for theircontributions to the methods described in thisarticle.Driek Desmet is a principal in McKinsey’s Londonoffice; Tracy Francis is an alumna of the Sydneyoffice; Alice Hu is a consultant and Tim Koller is aprincipal in the Amsterdam office; and GeorgeRiedel is a principal in the Sydney office. Thisarticle is adapted from a chapter in the thirdedition of Valuation: Measuring and Managing theValue of Companies (New York: John Wiley &Sons), to be published in the United States insummer 2000. Copyright © 2000 McKinsey &Company. All rights reserved.www.mckinseyquarterly.com

4Morgan Stanley research on 1,243 technology initial public offerings has shown thatmore than 86 percent of the value created in them during the past decade came fromonly 5 percent of the companies.

Reprinted with the permission from the McKinseyQuarterly.

your job to present your case to the tr ier of factin a convincing and help ful manner . Soconcentrate on them , speak to them , and readtheir reactions. Remember the tr ier of fact isyour audience.

2. Be Conversational

Many, i f not most, people speak dif ferently whenthey are deposed or testi fying than when havinga normal conversation .

H owever , our most ef fective communicationgenerally occurs when we talk to peoplenaturally. A ccordingly, try to maintain yournormal conversation style and tone. I fappropriate, you should occasionally speak moresoftly, causing the tr ier of fact to " listen up " ,when presenting key points and/or immediatelyafter key points. Remember your objective is tobe understood and remembered .

3. Time - Use It Wisely

T he attention span of most judges and ju rors isvery short. You have only about 15 to 20 secondsto communicate your ideas and/or answers toquestions (the average broadcast sound bite).A ccordingly, get to the point immediately and beconcise.

4. Visit the Courtroom

V isit the courtroom before the tr ial so you havean accurate view of the layout, including whereyou will be in relation to the judge and ju ry.Determine i f the courtroom is setup for videodisplays or overheads and i f microphones areavailable.

Before preparing your exhibits, think about howfar the exhibit will be f rom the judge and ju ry.T hen consider the point type and type selectionneeded to read the exhibits comfortably. I n orderto read an exhibit comfortably f rom 10 to 15 feetyou should consider a minimum of a 36-pointtype and preferably a 48-point type. H owever ,readability also depends on type selection -characteristics of the font in terms of characterweight, width , and spacing. Because of these

BY DENNIS BINGHAM, CBA, CMA, CFM Making PersuasivePresentations in Court



IntroductionBusiness appraisers frequently encounter

problems effectively communicating financial datato non-financially oriented audiences. Because ofthis communication gap with users, the value ofeffective communications by business appraiserscannot be emphasized enough.

Appraisers frequently present data in a formatsuitable for their own needs and forget the needsof their audience. Consequently, an important stepin improving the communication of data isrecognizing that users - business owners, attorneys,judges, and jurors - generally have non-financialbackgrounds.

According to E laine Lewis, a nationally knownwitness consultant, " although it is of great valueto have an expert who is thorough in hisvaluations, if the material isn't 'packaged' well incourt, it is difficult to persuade anyone to 'buy' itover the other product. Therefore, once an expertis clear on how to handle the basics, it is time togive attention to other techniques that can makepresentation of the expert - experienced or not -more powerful and persuasive in court. " 1

Presentation IdeasT he remainder of this article p resents

ideas for making your presentations morepersuasive, and more likely to be understoodand remembered . N ot all of these ideas willbe applicable in all circumstances. U se yourjudgment as to which of these ideas are mostappropriate for a particular case.

1. Know Your Audience

Remember your audience is the tr ier of fact (i.e., judge, ju ry, or arbitrator). Your audience is not the attorneys or other experts in the case.

T he opposing counsel and expert mayobject, roll their eyes, groan , or fu riouslytake notes. Ignore them! I t is their job topresent their case and to refute yours. I t is

factors, typefaces that are equal in point size maynot actually look as though they are they sameheight.

5. Use Graphics

W hile we are all familiar with the old adage "apictu re is worth a thousand words, " it issurprising how often presentations fail to fullyutilize graphics.2 You should remember that whilein formation shown in f inancial statements mayindicate a trend . T he use of graphics can morequickly communicate this same in formation .G raphs are particularly useful when you want tocommunicate simple trends.

For example, the use of a chart such as thatshown in F igure 1 would likely stay in the tr ierof fact's mind longer than a row of numbers.

6. Eliminate Unnecessary Data

Strive to eliminate unnecessary and/or redundantin formation when preparing f inancialp resentations. Remember , your goal is to help theuser understand your data, and the best way toaccomplish this goal is to keep the in formationrelevant.

For instance, suppose you believe a 30 percent



control p remium is appropriate in yourvaluation and to support this position youpresent table 1 as shown at the bottom ofthis page.

A closer look at this table indicates it may be possible to present only a f raction of the in formation and still support your proposed premium . T he user would then be dealing with only the most pertinent portion of the original data.

I n his book " The Articulate Executive " G ranville Toogood3 states "Putting too much on a slide is counterproductive in a number of ways:

• T he more in formation , the smaller the numbers and letters, and the more dif f icult to read .

• T he more in formation , the larger the distraction f rom what you are saying andthe more likely the audience will be out of sync with that you are saying.

• T he more in formation , the bigger the chance of confusion and questions whichlead to f rustration .

Figure 1Returns on Investment

40.0%

30.0%

20.0%

10.0%

0.0%

1994 1995 1996 1997

ROAROE

Table 1Review of Control Premiums Sorted By Year of Acquisitions

PremiumYear Observations P/E B/Book Value P/Revenue TIC/EDITDA 5 Day 30Day1992 60 21.08 N/A 0.53 N/A 23.4% 32.3%1993 120 17.58 N/A 0.66 N/A 31.5% 36.1%1994 201 20.42 N/A 0.69 N/A 26.2% 36.1%1995 279 19.15 3.75 1.23 11.4 28.1% 39.2%1996 414 23.51 2.87 1.39 9.42 23.9% 31.1%1997 372 23.87 2.84 1.84 9.09 26.0% 37.8%

All Years 1446 22.17 2.97 1.33 9.42 27.0% 35.7%

Source: George P. Roach, Control Premiums and Strategic Movers, Business Valaution Review, June 1998, p.44.

Table 2Review of Control Premiums Sorted By Year

of Acquisitions (Amended)

PremiumYear Observations 5 Day 30Day

1992 60 23.4% 32.3%1993 120 31.5% 36.1%1994 201 26.2% 33.5%1995 279 28.1% 39.2%1996 414 23.9% 31.1%1997 372 28.0% 37.8%

All Years 1446 27.0% 35.7%

Source: George P. Roach, Control Premiums and Strategic Movers, Business Valaution Review, June 1998, p.44.

• T he more in formation , the more likely that you are straying away f rom the central theme and telling the audience more - maybe a lot more - than they have to know.

I n addition to slides, I believe the abovecomments apply equally well to all types ofexhibits; charts, and overheads.

7. Round Numbers

T here is no one right answer as to how orwhen to round numbers. H owever , youshould consider rounding to aid in thecommunication of in formation to theuser(s) of the data. I n addition , roundingcan indicate the estimated accuracy withwhich a rate or value is known .4

You should be aware that… "when trying tounderstand numbers, most people roundthem mentally. T his brings them to a sizethat the mind can manipulate more easily.In practice, the rounding is to two figures."5

H owever; when rounding to two f iguresnot all numbers are rounded the same. Toillustrate:

• 10,452 would be rounded to 10,000• 1,497 to 1,500• 923 to 920• 16.3 to 16• 4.3 to 4.3 (no rounding necessary)

A ccording to D r . Targett, " rounding to twoeffective f igures puts numbers in the formin which mental arithmetic is naturallydone. T he numbers are thereforeassimilated more quickly. "

Considering this in formation , it would seemwe would be well advised to establish alogical and consistent approach concerningwhen and how to round numbers.4

8. Rank Order the Data

F inancial data will be better understoodand relationships more easily identi f ied , i fnumbers are ar ranged in size order .Generally, the basis of how data should beordered is a matter of which data in thechart is the most important in your case.Tables 3 and 4 provide an example of how



data might be rank ordered . (N ote: the data hasbeen rounded .) Table 3 is ordered alphabeticallyby product, while table 4 is rank ordered byrevenue.

9. Present Important Comparisons Down Columns

T he most important comparisons should bepresented down columns, not across rows.Comparing numbers in a column rather than arow generally places important numbers closertogether allowing for easier analysis, speediercomparisons, and easier mathematicalmanipulation . For example, Tables 5 and 6:

Table 3Product Line Sales and Gross Profit

Gross ProfitProduct Revenue Dollars Margin

A $ 538,000 $ 147,600 27.5%B 296,000 24,700 8.3%C 704,000 50,400 7.2%D 64,000 17,300 27.0%

Total $1,600,000 $ 240,000 15.0%

Table 4Product Line Sales and Gross Profit

Gross ProfitProduct Revenue Dollars Margin

A $ 538,000 $ 147,600 27.5%B 296,000 24,700 8.3%C 704,000 50,400 7.2%D 64,000 17,300 27.0%

Total $1,600,000 $ 240,000 15.0%

Table 5Region

Revenue East South North West TotalProduct A $ 1,400 $ 1,100 $ 1,300 $ 1,200 $ 5,000Product B 720 530 430 570 2,250Total Revenue $ 2,120 $ 1,630 $ 1,730 $ 1,770 $ 7,250

Table 6Product

Region A B Total

East $ 1,400 $ 720 $ 2,120North !,300 430 1,730West 1,200 570 1,770South 1,100 530 1,630

TotalRevenue $ 5,000 $ 2,250 $ 7,250



10. Provide Summary Measures

Summary measures p rovide a focus for the eyeand make it easier to determine i f a number fallsabove or below the general level of the rest ofthe row or column .

Many users of f inancial data do not understandindustry jargon such as mean and median .A ccordingly, when appropriate, it is better to usethe word average instead of mean as shown inTable 7 below. I n addition , perhaps we shouldeven consider using the term middle value ormid-point to describe the median .

11. Minimize the Use of White Space

T he inclusion of gridlines and unnecessary whitespace can make the task of reading andunderstanding tables di f f icult.

" W hen you plan tables with columns of f iguresor words, place the columns as close together aspossible, not spread out to f ill the pages width .T he most di f f icult task for a reader of a table isto read f rom one column to another withoutgetting lost. A nything to reduce eye travelbetween columns will help . "6 I n addition , it iseasier to identi fy patterns and exceptions whengridlines and white space are removed .

Table 9 provides the tr ier of fact with the samein formation as Table 8, but is much easier toread and absorb than Table 8.

12. Use Meaningful T itles and/or Captions

T itles and/or captions should be used tohelp charts, tables, and graphs to beunderstood without explanation .

Suppose you are testi fying in court and areasked to present a demonstrative exhibit(F igure 2) justi fying why you selected a 20percent capitalization rate.

W hich of the following choices most clearlycommunicates the message you want thetrier of fact to remember?

T itle: ABC's Capitalization Rate is 20%

Caption: Small Privately H eld CompaniesRequire H igher Rates of Return Than LargePublic Companies

T he answer , it depends. W hat idea,concept, or message do you want the tr ier

Table 7

Analysis of Restricted Stock StudiesRegarding Marketability Discounts

Summary Results of Ten Restricted Stock Studies

Number ofStudy Observations Average Medians

SEC Institutional Investor Study 398 25.8% 23.6%

Milton Gelman 89 33.0% 33.0%

Robert Trout 60 33.5% na

Robert Moroney 146 35.6% 33.0%

Michael Maer 34 35.4% 33.0%

Standard Research Consultants 28 na 45.0%

Willamette Management 33 na 31.2%

William Sibler 69 33.8% 35.0%

Hal/Polacek 100+ 23.0% na

Management Planning 27.7% 29.0%

Averages 31.0% 32.8%

Figure 2CAPTION or TITLE?

20.0%

15.0%

10.0%

5.0%

0.0%Bond Stock Stock ABC

Large Small

of fact to remember? Possibly both aconcise, descr iptive title and anexplanatory caption are appropriate.

13. Add Interest With Colour

Computer software allows for the use of avast range of colours. H owever , somesimple principles of colour can help inselecting the r ight colour(s) for yourpresentation .

A lthough colours are neither warm norcool in a physical sense, they can impartfeelings of warmth or coolness. To theeye, warm colours tend to advance andcool colours tend to recede. Generally,cool colours are good for close-up viewingand warm colours are better for dramaticdisplays. Red , orange, and yellow areconsidered "warm" colours; green , blue,and violet are considered "cool" colours.

W hen using colour , use it to emphasizeimportant points and use it consistently torepresent categories or classes th roughoutyour presentation . Remember , you canuse too much colour!

N ote: Colour can often be confusing when attempting to present an ordered



hierarchy. H owever , because grays have a natural hierarchy, varying shades can often show quantities better than colour .

14. Review Your Presentation For Reasonableness

T he last idea for making your presentationsmore persuasive is to review your presentation .A sk yourself the following questions:

H as the source of the data been disclosed?

• H as the data been obtained f rom a reliable neutral source or has the data been obtained f rom a source with a possible bias?

• Is the data representative of the entity being valued?

H as a complete and accurate descr iption of thedata analysis been provided?

• H ave terms such as "average" been def ined . For example: in most disputes each side indicates a dif ferent value for average earnings. A re earnings after taxes, before taxes, before taxes and interest, or before taxes, interest and depreciation?

• W hat time period was used in determining average earnings - the most recent twelve months, the most recent f iscal years or a weighted average of several years?

Table 8Number of Average Range

Classification Partnerships Discount High Low

Leveraged / nondistributing 21 67.6% 86.1% 51.7%

Low debt / nondistributing 4 60.9% 67.1% 52.8%

Leveraged / lessthan 5% distributing 11 60.7% 80.9% 45.0%

Low debt / lessthan 5% distributing 16 47.4% 66.0% 24.3%

High Distributing - more than 5% 41 34.0% 57.3% 14.2%

Table 9Number of Average Range

Classification Partnerships Discount High Low

Leveraged / nondistributing 21 67.6% 86.1% 51.7%

Low debt / nondistributing 4 60.9% 67.1% 52.8%

Leveraged / lessthan 5% distributing 11 60.7% 80.9% 45.0%

Low debt / lessthan 5% distributing 16 47.4% 66.0% 24.3%

High Distributing - more than 5% 41 34.0% 57.3% 14.2%



Conclusion:T he bottom line, i f your audience does notunderstand or remember what you have said ,it will make no dif ference how well youunderstand or prepare a business appraisal.Focus on your audience's needs in order toimprove the likelihood that they willunderstand and remember your message.

Reprinted with the permission from The BusinessAppraisal Practice.

Dennis Bingham, CBA, CMA, CFM is President ofCorporate Appraisal, Inc. in Eden Prairie, MN.

H as a scale been clearly indicated for all graphs?

• Is the scale clearly shown on the graph? I f a scale is not shown or concealed , the wrong impression may be drawn .

• I f more than one variable is shown in a graph , have dif ferent scales been used? D if ferent scales can lead to the wrong impression being drawn .7

Is the conclusion consistent with the facts?

• Is there a casual relationship shown by the analysis?

• Is your premise really supported by the data presented?

T hese questions can also be used when reviewingan opposing expert's p resentation .

1Elaine Lewis, Guest article - Preparing for Trial: Packaging thepresentation, Shannon Pratt's Business Valuation Update, October 1998,pp. 1-3.2Litigation Support and Expert Witness Training for The Business Appraiser- An Interactive Workshop, The Institute of Business Appraisers, 1997, pg.84.3Granville N. Toogood, The Articulate Executive. McGraw-Hill, 1996, pp.141-142.4Raymond C. Miles, Rounding Value Estimates, Business ValuationReview, June 1988, pp. 50-53.

5David Targett, Quantitative Methods, Heriot-Watt Business School MBASeries, Pitman Publishing, 1995, p. 3/3.6Philip Brady, Using Type Right, NTC Business Books, 1998, p. 527Edward R. Tufte, The Visual Display of Quantitative Information, GraphicsPress, 1983, page 154.



IntroductionThe following journal article from the H arvard

Business Review was originally printed in 1997and provides an excellent discussion of theWeighted Average Cost of Capital (WACC)valuation method and the tradeoffs that a valuatorfaces in order to gain the simplicity the WACCmethod had to offer. With some benefit of hindsightit is interesting to consider the author’s “prediction”that usage of the WACC method is likely to wane infavour of other methods such as the adjustedPresent Value method.

Behind every major resource-allocationdecision a company makes lies somecalculation of what that move is worth .W hether the decision is to launch a newproduct, enter a strategic partnership , investin R& D , or build a new facility, how acompany estimates value is a cr iticaldeterminant of how it allocates resources.A nd the allocation of resources, in tu rn , is akey driver of a company's overallper formance.

Today valuation is the f inancial analyticalskill that general managers want to learn andmaster more than any other . Rather than relyexclusively on f inance specialists, managerswant to know how to do it themselves. W hy?O ne reason is that executives who are notf inance specialists have to live with the falloutof their companies' formal capital-budgetingsystems. Many executives are eager to seethose systems improved , even i f it meanslearning more f inance. A nother reason isthat understanding valuation has become aprerequisite for meaningful participation in acompany's resource-allocation decisions.

Most companies used a mix of approachesto estimate value. Some methodologies are

formal, comprising a theory and a model; others arein formal, operating by ad hoc rules of thumb. Someare applied explicitly, and others implicitly. T heymay be personalized by individual executives' stylesand tastes or institutionalized in a system withprocedures and manuals.

T hough executives estimate value in manydif ferent ways, the past 25 years has seen a cleartrend toward methods that are more formal, explicit,and institutionalized . I n the 1970s, discounted-cashflow analysis (D C F) emerged as best p ractice forvaluing corporate assets. A nd one particular versionof D C F became the standard . A ccording to themethod , the value of a business equals its expectedfuture cash f lows discounted to present value at theweighted-average cost of capital (WAC C).

Today that WAC C-based standard is obsolete.T his is not to say that it no longer works – indeed ,with today's improved computers and data, itp robably works better than ever . But it is exactlythose advances in computers and software, along withnew theoretical insights, that make other methodseven better . Since the 1970s, the cost of f inancialanalysis has come down commensurately with the costof computing – which is to say, breathtakingly. O neeffect of that drop in cost is that companies do a lotmore analysis. A nother effect is that it is now possibleto use valuation methodologies that are bettertailored to the major kinds of decisions thatmanagers face.

W hat do generalists (not f inance specialists) needin an updated valuation tool kit? T he resource-allocation process p resents not one, but th ree basictypes of valuation problem . Managers need to be ableto value operations, opportunities and ownership claims.T he common practice now is to apply the same basicvaluation tool to all p roblems. A lthough valuation isalways a function of th ree fundamental factors –cash , timing and risk – each type of p roblem hasstructu ral features that set it apart f rom the othersand present distinct analytical challenges.

BY TIMOTHY A. LUEHRMAN What’s It Worth?A General Manager’s GuideTo Valuation

has already invested in the activity or isdeciding now whether to do so. T he questionis, H ow much are the expected future cashflows worth , once the company has made allthe major discretionary investments?

T hat is p recisely the problem at whichtraditional D C F methods are aimed . Adiscounted-cash-f low analysis regardsbusinesses as a series of r isky cash f lowsstretching into the future. T he analyst's taskis f irst, to forecast expected future cash f lows,period by period , and second , to discount theforecasts to present value at the opportunitycost of funds. T he opportunity cost is the

return a company (or its owners)could expect to earn on an alternativeinvestment entailing the same risk .Managers can get benchmarks for the appropriateopportunity cost by observing how similarrisks are priced by capital markets, because suchmarkets are a part of investors' set ofalternative opportunities.

O pportunity cost consistspartly of time value – the returnon a nominally r isk-f reeinvestment. T his is the returnyou earn for being patientwithout bearing any risk .O pportunity cost also includes arisk premium – the extra returnyou can expect

commensurate with the r isk youare willing to bear . T he cash-f low forecasts and the opportunity cost are combined

in the basic D C F relationship . (See the exhibit, " T he BasicLogic of Discounted-Cash-F low Valuation . ")

Today most companies executediscounted-cash f low valuations using thefollowing approach: F irst, they forecastbusiness cash f lows (such as revenues,

Fortunately, today's computers make a one-size-f its-allapproach unnecessary and , in fact, suboptimal.T hree complementary tools – one for each type ofvaluation problem - will outper form the single tool(WAC C-based D C F) that most companies now use astheir workhorse valuation methodology.

Valuing Operations: Adjusted Present Value

T he most basic valuation problem is valuingoperations, or assets-in-place. O ften managers need to

estimate the value of an ongoing business or of somepart of one – a particular product, market or line ofbusiness. O r they might be considering a newequipment purchase, a change in suppliers, or anacquisition . I n each case, whether the operation inquestion is large or small, whether it is a wholebusiness or only a part of one, the corporation either



The Basic Logic ofDiscounted-Cash-Flow ValuationDCF valuation methodologies The concept are all built on a future value = present value (1 + interest rate)simple relationship between present That concept produces present value = future valuevalue and this relationship: 1 + interest ratefuture value.

To apply the fundamental DCF relationship to a business, we modify the relationship so that the present value equals the sum of the future cash flows adjusted for timingand risk.

Cash Flow and Risk

Future value corresponds to future business cash flows, CF. But business cash flows are uncertain, so we

discount expected cash flows: E(CF).

n

present value = Σ E(CF)t

t=0 (1 + k)t

Timing

Because business cash Riskflows occur over many

future periods, we locate Because business cashthem in time, then discount flows are risky, investors

and add them all. demand a higher return:the discount rate, k,contains a risk premium.



expenses, and new investment), deliberatelyexcluding cash f lows associated with thef inancing program (such as interest,principal, and dividends). Second , they adjustthe discount rate to pick up whatever value iscreated or destroyed by the f inancingprogram . WAC C is by far the most commonexample of such an adjustment. I t is a tax-adjusted discount rate, intended to pick up thevalue of interest tax shields that come f romusing an operation's debt capacity.

T he practical virtue of WAC C is that itkeeps calculations used in discounting to aminimum . A nyone old enough to havediscounted cash f lows on a handheldcalculator – a tedious, time-consuming chore– will understand immediately why WAC Cbecame the valuation methodology of choicein the era before personal computers.

But WAC C 's virtue comes with a price. I tis suitable only for the simplest and most

static of capital structu res. I n other cases (that is, inmost real situations), it needs to be adjustedextensively – not only for tax shields but also forissue costs, subsidies, hedges, exotic debt securities,and dynamic capital structu res. A djustments have tobe made not only project by project but also periodby period within each project. Especially in itssophisticated , multi-layered , adjusted-for-everythingversions, the WAC C is easy to misestimate. T hemore complicated a company's capital structu re, taxposition , or fund-raising strategy, the more likely itis that mistakes will be made. (See the insert " T heL imitations of WAC C . ")

Today's better alternative for valuing a businessoperation is to apply the basic D C F relationship toeach of a business's various kinds of cash f low andthen add up the present values. T his approach ismost often called adjusted present value, or A P V. I twas f irst suggested by Stewart Myers of MI T , whofocused on two main categories of cash f lows: " real"cash f lows (such as revenues, cash operating costs,

Valuation practices are changing already. T hequestion is not whether companies will adapt, butwhen . Business schools and textbooks continue toteach the method based on the weighted-averagecost of capital (WAC C) because it is the standard ,not because it per forms best. But some businessschools already teach alternative methodologies.Consulting and professional f irms are activelystudying and modifying their approaches tovaluation . A nd new valuation books, software, andseminars are appearing on the market.

H ere's some of what's coming:• Companies will routinely use more than one

formal valuation methodology. T he primary purpose will not be redundancy (to get more than one opinion about a project's value), but analytical tailoring (to use a methodology that f its the problem at hand).

• Discounted cash f lows will remain the foundation of most formal valuation analyses. But WAC C will be displaced as the D C F methodology of choice by adjusted present value or something very much like it.

• Many companies will routinely evaluate the opportunities inherent in such activities as R& D and marketing by using tools derived f rom option pricing, simulation , and decision-

New Valuation Practices Are on the Waytree analysis. T he primary purpose of such evaluation will not be to arbitrate go-or-no-go decisions (Should we invest or not?) but to make more ref ined comparisons (Should we invest this wayor that way?) and to support line managers with more formal analyses (H ow can we take further advantage of our position in this market?.

• E nhanced analytical capabilities will reside inside corporations, not solely in fee-for-service professional boutiques. T he power of valuation analyses is enhanced more by a deep understandingof the business than by general experience with valuation . I nsiders can learn valuation more readily than outsiders can learn the business.

• Good corporate capital-budgeting processes will be less r igid and more adaptive. N ote mere systemizations of a single valuation approach , they will synthesize insights f rom dif ferent approaches according to the business characteristics of the project or opportunity. T his should comes as good news to line managers.

• T he trend toward more active participation by the C F O and other f inancial executives in strategy formulation and business development (both of which precede capital budgeting) should continue. I n fact, it may accelerate.



and capital expenditures) associated with thebusiness operation; and "side effects" associated withits f inancing program (such as the values of interesttax shields, subsidized f inancing, issue costs andhedges).1 More generally, A P V relies on theprinciple of value additivity. T hat is, it's okay to splita project into pieces, value each piece, and thenadd them back up .

W hat are the practical payoffs f rom switching toA P V f rom WAC C? I f all you want f rom a valuationanalysis is to know whether the net p resent value ispositive or negative and i f you already use WAC Cproperly, the payoff will be low. T he twoapproaches, skill fully applied , seldom disagree onthat question . But there is a lot of room forimprovement once you have answered it.

A P V helps when you want to know more thanmerely, Is N P V greater than zero? Because thebasic idea behind A P V is value additivity, you canuse it to break a problem into pieces that makemanagerial sense. Consider an acquisition . Even afterthe deal has closed , it helps to know how muchvalue is being created by cost reductions rather

than operating synergies, new growth , or taxsavings. O r consider an investment in a newplant. You may negotiate speci f ic agreementswith , for example, equipment suppliers,f inanciers, and government agencies. I n bothexamples, di f ferent people will be in chargeof realizing individual pieces of value. A P V isa natural way to get in formation about thosepieces to managers – or for them to generatethat in formation for themselves.

E xecutives are discovering that A P V playsto the strength of now-ubiquitous spreadsheetsoftware: each piece of the analysiscorresponds to a subsection of thespreadsheet. A P V handles complexity withlots of subsections rather than complicatedcell formulas. I n contrast, WAC C 's historicaladvantage was p recisely that it bundled all thepieces of an analysis together , so an analysthad to discount only once. Spreadsheetspermit unbundling, a capability that can bepower fully in formative. Yet traditional WAC Canalyses do not take advantage of it. I ndeed ,

The Limitations of WACCT he WAC C formula is a tax-adjusted discount rate.

T hat is, when used as a discount rate in a D C Fcalculation , WAC C is supposed to pick up the taxadvantage associated with corporate bor rowing. For asimple capital structu re:

WAC C = (debt/debt+equity)(cost of debt)(1- corporate tax rate) + (equity/debt+equity)(cost of equity).

T he cost of debt and the cost of equity are both opportunity costs, each consisting of time value and its own risk premium . But WAC C also contains capitalstructu re ratios and an adjustment ref lecting the term 1minus the corporate tax rate. Together , these have the ef fectof modestly lowering WAC C . T his in tu rn gives a higher present value than one wouldobtain by discounting at a non-tax-adjusted opportunitycost. W hen WAC C works as intended , the exact value ofinterest shields is automatically included in the presentvalue of the project.

N ote that to use WAC C in this fashion is to rely onone term - 1 minus the corporate tax rate - in this discountrate to automatically make all the adjustments required bya complex capital structu re. H ow many corporationsinhabit a world so neat that one parameter can summarize

it? A ccordingly, some specialists customize theirestimates of WAC C with subtle adjustments.U nfortunately, the adjustments then are buried inan intimidating formula, one and a half lines long,in a single cell of a spreadsheet. E r rors andassumptions, whatever they are, will p robablyremain hidden f rom view.

A nd er rors are indeed likely. T he "automatic "feature of WAC C relies on fair ly restr ictiveassumptions to get the value of interest tax shieldsjust r ight. With non-plain-vanilla debt securities(such as high-yield debt, f loating-rate debt,original-issue-discount debt, convertible debt, tax-exempt debt, and credit-enhanced debt), WAC Chas an excellent chance of misvaluing the interesttax shields or , which is p robably worse, misvaluingthe other cash f lows associated with the project orits f inancing. I n general, companies with complextax positions will be poorly served by WAC C . I t iseven more unrealistic for the sort of complexityencountered in , for example, cross-border capital-budgeting problems.



many managers use their power fulspreadsheets merely to generate dozens ofbundled valuation analyses, rather than toproduce unbundled analyses that would bemanagerially relevant.

WAC C still has adherents, most of whomargue that it works well enough whenmanagers aim for a constant debt-to-capitalratio over the long run . Some go evenfurther , saying that managers ought to aimfor exactly that – and therefore WAC C isappropriate. But whether managers ought tobehave thus is highly questionable; that theydo not, in fact, follow this p rescr iption isindisputable. To decree that managers shouldmaintain constant debt ratios because thatpolicy f its the WAC C model is to let the tailwag the dog.

Valuing Opportunities: Option Pricing

O pportunities – the second type ofcommonly encountered valuation problem –may be thought of as possible futureoperations. W hen you decide how much tospend on R& D , or on which kind of R& D ,you are valuing opportunities. Spending nowcreates, not cash f low f rom operations, butthe opportunity to invest again later ,depending on how things look . Manymarketing expenditures have the samecharacteristic. Spending to create a new orstronger brand probably has some immediatepayoff. But it also creates opportunities forbrand extensions later . T he opportunity mayor may not be exploited ultimately, but it isvaluable none-theless. Companies with newtechnologies, p roduct development ideas,defensible positions in fast-growing markets,or access to potential new markets ownvaluable opportunities. For some companies, opportunities are the most valuable things they own .

H ow do corporations typically evaluateopportunities? A common approach is not tovalue them formally until they mature to thepoint where an investment decision can no

longer be defer red . At that time, they join thequeue of other investments under consideration forfunding. C ritics have long decr ied this p ractice asmyopic; they claim that it leads companies toundervalue the future and hence, to underinvest.

W hat actually happens appears to be morecomplicated and to depend a great deal on howmanagers are evaluated and rewarded . T he absenceof a formal valuation procedure often gives r ise topersonal, in formal procedures that can becomehighly politicized . C hampions arise to promote anddefend the opportunities that they regard asvaluable, often resulting in overinvestment ratherthan underinvestment.

Some companies use a formal D C F-basedapproval p rocess but evaluate strategic p rojects withspecial rules. O ne such rule assigns strategicprojects a lower hurdle rate than routineinvestments to compensate for D C F 's tendency toundervalue strategic options. U n fortunately, inmany cases D C F 's negative bias is not merelyovercome but overwhelmed by such an adjustment.O nce again , overinvestment can occur in practicewhen theory would have managers wor ry aboutunderinvestment. A nother special rule evaluatesstrategic opportunities of f-line, outside the routineD C F system . For better or worse, experiencedexecutives make a judgment call. Sometimes thatworks well, but even the best executives (perhapsespecially the best) in form their judgment withsound analyses when possible.

I n general, the r ight to start, stop , or modify abusiness activity at some future time is di f ferentf rom the right to operate it now. A speci f icimportant decision – whether or not to exploit theopportunity – has yet to be made and can bedefer red . T he right to make that decision optimally– that is, to do what is best when the time comes –is valuable. A sound valuation of a businessopportunity captures its contingent nature: " I f R& Dproves that the concept is valid , we'll go ahead andinvest. " T he unstated implication is that " i f itdoesn't, we won't" .

T he crucial decision to invest or not will bemade after some uncertainty is resolved or whentime runs out. I n f inancial terms, an opportunity isanalogous to an option . With an option , you have



the r ight – not the obligation – to buy or sellsomething at a speci f ied price on or before somefuture date. A call option on a share of stock givesyou the right to buy that share for , say, $100 at anytime within the next year . I f the share is currentlyworth $110, the option clearly is valuable. W hat i fthe stock is worth only $90? T he option still isvaluable because it won't expire for a year , and i fthe stock price rises in the next few months, it maywell exceed $100 before the year passes. Corporateopportunities have the same feature: " I f R& Dproves that the concept is valid " is analogous to " i fthe stock price rises in the next few months. "Similarly, "we'll go ahead and invest" is analogous to"we'll exercise the option . "2

So an option is valuable, and its value clearlydepends on the value of the underlying asset: thestock . Yet owning the option is not the same asowning the stock . N ot surprisingly, one must bevalued dif ferently than the other . I n consideringopportunities, cash , time value, and risk all stillmatter , but each of those factors enters the analysisin two ways. Two types of cash f lows matter : cashf rom the business and the cash required to enter it,should you choose to do so. T ime matters in twoways: the timing of the eventual cash f lows and howlong the decision to invest may be defer red .Similarly, r isk matters in two ways: the r iskiness ofthe business, assuming that you invest in it, and therisk that circumstances will change (for better orworse) before you have to decide. Even simpleoption-pricing models must contain at least f ive orsix variables to capture in formation about cash ,time, and risk and organize it to handle thecontingencies that managers face as the businessevolves. (See the exhibit " W hat Makes O pportunities

D if ferent?")

Because it handles simple contingencies betterthan standard D C F models, option-pricing theoryhas been regarded as a p romising approach tovaluing business opportunities since the mid-1970s.H owever , real businesses are much morecomplicated than simple puts and calls. Acombination of factors – big, active competitors,uncertainties that do not f it neat p robabilitydistr ibutions, and the sheer number of relevantvariables – makes it impractical to analyze real

opportunities formally. Just setting up thevaluation problem , never mind solving it,can be daunting. A s a result, option pricinghas not yet been widely used as a tool forvaluing opportunities.

I nterest in option pricing has picked upin recent years as more power ful computershave aided sophisticated model building.N evertheless, models remain the domain ofspecialists. I n my view, generalists will getmore out of option pricing by taking adif ferent approach . W hereas technicalexperts go questing for objective truth - theywant the " r ight" answer – generalists have abusiness to manage and simply want to do abetter job of it. Getting closer to the truth isgood , even i f you don't get all the waythere. So an options-based analysis of valueneed not be per fect in order to improve oncurrent practice.

T he key to valuing a corporate invest -ment opportunity as an option is the abilityto discern a simple correspondence betweenproject characteristics and optioncharacteristics. T he potential investment tobe made corresponds to an option's exerciseprice. T he operating assets the companywould own , assuming it made theinvestment, are like the stock one wouldown after exercising a call option . T helength of time the company can wait beforeit has to decide is like the call option's timeto expiration . U ncertainty about the futurevalue of the operating assets is captured bythe variance of returns on them; this isanalogous to the variance of stock returnsfor call options. T he analytical tactic here isto per form this mapping between the realproject and a simple option , such as aE uropean call option . (A E uropean call canbe exercised only on the expiration date,making it the simplest of call options.) I f thesimple option captures the contingent natureof the project, then by pricing the option wegain some additional, albeit imper fect,insight into the value of the project.

To illustrate, suppose a company is

considering whether to invest $1 million tomodify an existing product for an emergingmarket. A D C F analysis of the expected cashflows shows them to be worth only about$900,000. H owever , the market is volatile, sothat value is likely to change. A combinationof patents and know-how will p rotect thecompany's opportunity to make thisinvestment at least two more years. A fterthat, the opportunity may be gone. V iewedconventionally, this p roposal's N P V isnegative $100,000. But the opportunity towait a couple of years to see what happens isvaluable. I n ef fect, the company owns a two-year call option with an exercise price of $1million on underlying assets worth $900,000.We need only two more pieces ofin formation to value this businessopportunity as a E uropean call option: therisk-f ree rate of return (this is the same asthe time value refer red to above - supposeit's 7%); and some measure of how risky thecash f lows are. For the latter , suppose thatannual changes in the value of these cashflows have a standard deviation of 30% peryear , a moderate f igure for business cashflows. N ow, a simple option-pricing model,such as the Black-Scholes model, gives thevalue of this call as about $160,000.3

W hat did the company learn f rom option



pricing? T he value of the opportunity is positive,not negative. T hat is always true as long as timeand uncertainty remain . T he company should notinvest the $1 million now – to do so would be towaste $100,000 ˜ but neither should it forget aboutever investing. I n fact, the odds are pretty goodthat it will want to invest two years f rom now. I nthe meantime, the product or country managermonitors developments. H e or she focuses not onlyon N P V but also on the proper timing of aninvestment. A lternatively, i f the company doesn'twant to invest and doesn't want to wait and see, itcan think about how to capture the value of theopportunity now. T he option value gives it an ideaof what someone might pay now for a license tointroduce the new product. I n the same way, theoption value can help a company think about howmuch to pay to acquire such a license or to acquirea small business whose most interesting asset is suchan opportunity.

Long-lived opportunities in volatile businessenvironments are so poorly handled by D C Fvaluation methods than an option-pricing analysisdoes not have to be very sophisticated to produceworthwhile insight. A pragmatic way to use optionpricing is as a supplement, not a replacement, forthe valuation methodology already in use. T heextra insight may be enough to change, or leastseriously challenge, decisions implied by traditionalD C F analyses.

What Makes Opportunities different?Assets-in-place looks like this: Opportunities look like this:

Here we make a decision, then find out what happens. Here we find out what happens before we make a decision.Traditional DCF methods are designed for this kind of problem. Traditional DCF methods work poorly here.

These two scenarios must have different values; they also must be managed differently.

good news

bad news

good news

bad news

cash flow

cash flow

cash flow

cash flow

invest

don’t invest

invest

don’t invest

invest

don’t invest

cash flow

cash flow

cash flow

cash flow

good news

bad news


company participates in joint ventures,partnerships, or strategic alliances, or makeslarge investments using project f inancing, itshares ownership of the venture with otherparties, sometimes many others. Managersneed to understand not simply the value ofthe venture as a whole but also the value oftheir company's interest in it. T hatunderstanding is essential to decidingwhether or not to participate as well as howto structu re the ownership claims and writegood contracts.

Suppose your company is consideringinvesting in a joint venture to develop anoff ice building. T he building itself has apositive N P V – that is, constructing it willcreate value. W hat's more, the lead developeris confident that lenders will p rovide thenecessary debt f inancing. You are being askedto contribute funds in exchange for an equityinterest in the venture. Should you invest? I fall you've done is value the building, youcan't tell yet. I t could be that your partnerstands to capture all the value created , soeven though the building has a positive N P V ,your investment does not. A lternatively,some ventures with negative N P V s are goodinvestments because a partner or the project'slenders make the deal very attractive. Somepartners are simply imprudent, but others -governments, for example – deliberatelysubsidize some projects.

A straightforward way to value yourcompany's equity is to estimate its share ofexpected future cash f lows and then discountthose f lows at an opportunity cost thatcompensates the company for the r isk it isbearing. T his is often refer red to as theequity cash flow (E C F) approach; it is alsocalled flows to equity. I t is, once again , a D C Fmethodology, but both the cash f lows and thediscount rate are dif ferent f rom those usedeither in A P V or the WAC C-based approach .T he business cash f lows must be adjusted forf ixed f inancial claims (for example, interestand principal payments), and the discountrate must be adjusted for the r isk associatedwith holding a f inancially leveraged claim .


H ere's another way to think about the analyticalstrategy I am recommending. Values for fair lyilliquid or one-of-a-kind assets (real estate, forexample) are often benchmarked against values ofassets or transactions regarded as comparable butnot identical. Many ter ri f ic business opportunitiesare one-of-a-kind , and many are illiquid . Lacking acomparable benchmark for the example above(modifying our product to enter an emergingmarket), the company synthesized one by setting upa simple E uropean call option . By pricing thesynthetic opportunity (the call option), it gainedadditional insight into the real opportunity (theproduct introduction proposal). T his insight isvaluable as long as the company doesn't expect thesynthesis or the resulting estimate of value to beper fect.

W hat the generalist needs, then , is an easy tolearn tool that can be used over and over tosynthesize and evaluate simple options. F urther-more, because the goal is to complement, notreplace, existing methods, managers would like atool that can share inputs with a D C F analysis, orperhaps use D C F outputs as inputs. My favouritecandidate is the Black-Scholes option-pricing model,the f irst and still one of the simplest models. A nintuitive mapping between Black-Scholes variablesand project characteristics is usually feasible. A ndeven though the model contains f ive variables,there is an intuitive way to combine these f ive intotwo parameters, each with a logical, managerialinterpretation . T his intuitive process lets a managercreate a two-dimensional map , which is much easierthan creating one with f ive variables. F inally, theBlack-Scholes model is widely available incommercial software, which means that i f you cansynthesize the comparable option , your computercan price it for you . T he crucial skills for thegeneralist are to know how to recognize realoptions and how to synthesize simple ones, not howto set up or solve complex models.

Valuing ownership Claims: Equity Cash Flows

Claims that companies issue against the value oftheir operations and opportunities are the lastmajor category of valuation problem . W hen a


H andling leverage properly is mostimportant when leverage is high , changingover time, or both . I n those situations,lenders' interests may diverge f rom those ofshareholders, and dif ferent shareholders'interests may diverge f rom one another .Such divergence is especially common intransactions that p roduce or anticipatesubstantial changes in the business or itsorganization – in mergers, acquisitions, andrestructu ring, for example.

U nfortunately, leverage is most di f f icult totreat p roperly precisely when it is high andchanging. W hen leverage is high , equity islike a call option , owned by shareholders, onthe assets of the company. I f the business issuccessful, managers acting in the bestinterests of shareholders will "exercise theoption " by paying lenders what they areowed . Shareholders get to keep the residualvalue. But i f the business runs into serioustrouble, it will be worth less than the loanamount, so the bor rower will default. I n thatsituation , the lenders will not be repaid infull; they will, however , keep the assets insatisfaction of their claim .

I t is widely understood that highly leveredequity is like a call option because of the r iskof default. W hy not use an option-pricingapproach to value the equity? Because theoptions involved are too complicated . Everytime a payment (interest) or principal) is dueto lenders, the bor rower has to decide againwhether or not to exercise the option . I neffect, levered equity is a complex sequenceof related options, including options onoptions. Simple option-pricing models arenot good enough , and complicated modelsare impractical. T hat is why it's worthwhile tohave E C F as a third basic valuation tool.

I t's important to state that an E C Fvaluation , no matter how highly ref ined , isnot option pricing, and therefore will notgive a "correct" value for a levered equityclaim . But E C F can be executed so that itsbiases all run in the same direction - towarda low estimate. So, although the answer will


be wrong, the careful analyst knows that it will below, not high , and why.

T he key to using E C F is to begin the analysis ata point in the future beyond the period in whichdefault r isk is high . At that point, an analyst canestablish a future value for the equity usingconventional D C F methods. T hen E C F worksbackward year by year to the present, carefullyaccounting for yearly cash f lows and changes in r iskalong the way, until it ar rives at a present value.T he procedure is quite straightforward when builtinto a spreadsheet, and i f certain formulaic rulesare adopted for moving f rom later to earlier years,E C F 's biases contrive to underestimate the trueequity value. T he formulaic rules amount to anassumption that bor rowers will not really walk awayf rom the debt even when it is in their best intereststo do so. O bviously, this assumption deprives themof something valuable – in real li fe, they mightindeed walk away, so the real-li fe equity is morevaluable than the contrived substitute.

A n E C F analysis also shows explicitly howchanges in ownership structu res af fect cash f lowand risk , year by year , for the equity holders.U nderstanding how a program of change affectsthe company's owners helps to predict theirbehavior – for example, how certain shareholdersmight vote on a proposed merger , restructu ring, orrecapitalization of the venture. Such insight isavailable only f rom E C F or its variations.

W hat do companies use now instead of E C Fanalysis? Some evaluate equity claims by f irstvaluing the entire business (with WAC C F-basedD C F) and then subtracting the value of any debtclaims and other partners' equity interests. T hisapproach requires managers to presume they knowthe true value of those other claims. I n practice,they don't know those values unless they apply E C Fto estimate them . A nother common approach is toapply a price-earnings multiple to your company'sshare of the venture's net income. T hat has thevirtue of simplicity. But f inding or creating theright multiple is tr icky, to say the least. Skill fullychosen price-earnings ratios may indeed yieldreasonable values, but even then they don'tcontribute the other managerial insights that f lownaturally f rom the structu re of an E C F analysis.


sequence of good investments, and gettingeven one of them wrong can be veryexpensive. O r consider industr ies with only afew signif icant players that compete head-onin nearly all aspects of their businesses.Companies able to take swift advantage of acompetitor 's mistakes should expect thebenef its of insightful analyses – and thepenalties for poor analyses – to beparticularly high . Similarly, any companyworking now to exploit a f irst moveradvantage is highly dependent on the successof early investments.

T he costs of upgrading capabilities arelikely to be low for companies that meet oneor more of the following three cr iteria:


Learning New Tools: Costs and Benefits

A s companies adopt valuation techniques mademore power ful or accessible by desktop computers,the good news is that the tools a generalist needsare not very hard to learn . T he time and effortnecessary before the techniques pay off naturallywill depend on a company's situation and itscurrent f inance capabilities.

Benefits will be high for companies that expectto invest heavily in the near future. For them , thesuboptimal execution of a large, multiyearinvestment program will be costly. Consider , forexample, an industry such as telecommunications,in which capital intensity is coupled with rapidgrowth and technological change. Success requires a

Taxanomy of Valuation Problems and Methods

What are the different types of valuation problems encountered?Think of a stylized “balanced sheet” for the business.

Balance sheet

Assets Liabilities and equity

Past investment decisions 1. Operations (assets-in-place) Debt claims

Future investment decisions 2. opportunities (real options) 3. Equity claims Securities issued

Each type of problem calls for a different valuation method.

Companies use a broad range of valuation methodologies.

Problem types Recommended valuation sampling of alternate valuation methodsmethod less formal more formal

Sales multiples EBIT WACC-basedmultiples DCF

1. Operations Adjusted present valueBook-value Cash-flow Monte Carlo(assets-in-place)

multiples multiples simulation

Installed-base Simulationmultiples scenario analysis

2. Opportunities Simple option pricingCustomer Decision Fancy option(real options)

subscriber multiples trees pricing

Net incomemultiples WACC-based DCF Simulation

3. Equity claims Equity cash flowP/E ratios

minus debt scenarios analysis


• T hey already use D C F valuation in their capital-budgeting processes and have

built the related systemsfor use on desktop computers.

• T hey have many managers, not just f inance staf f who are comfortable with thebasics of modern corporate f inance and will not f ind the new tools di f f icult to acquire.

• T hey are currently upgrading their staf f capabilities for other reasons, so the incremental cost of installing a better system is minor .

Let's look at what's involved in learning thethree valuation methods:

Adjusted Present Value. T here are few toolsas power ful and versatile as A P V that requireas little time to learn . My experience is thatexecutives already schooled in WAC C canlearn the basics of A P V in about two hours,either on their own or with an instructor .Within another half a day, people alreadycomfortable with spreadsheet software areable to apply A P V effectively to realproblems. Today it is no exaggeration to saythat a company not using spreadsheets forvaluation is far behind the times. A ndcompanies that are using spreadsheets, notA P V , are underutilizing their software.Generally speaking, systems that canaccommodate WAC C can handle A P V.

Option Pricing. T his tool is costlier . T here'smore to learn , and for some people, it is lessintuitive. N evertheless, it is by no meansinaccessible. Basic option pricing can belearned f rom a textbook . W hat is moredif f icult is the application of this tool tocorporate problems, as opposed to simpleputs and calls.

Corporate applications require a synthesisof option pricing and D C F-based valuation;that is, a way to use D C F outputs as option-pricing inputs and a way to reconcile thedif ferent values generated by eachmethodology. Simple f rameworks embodyingsuch a synthesis can be learned in a day or


less. Simple applications require another day.N ormally, half of this time is devoted to runningnumbers and the other half to a more subtle butimportant tasks of interpreting and quali fyingresults and exploring the limitations of both thef ramework and the methodology.

O ption pricing does not f it naturally into mostcompanies' existing capital-budgeting systems.N either , for that matter , do tools such as decision-tree analysis, simulation , or scenario analysis, whichare sometimes of fered as alternatives to optionpricing. T hus, the most p ractical way to beginusing options-based analyses is to run them insequence with D C F analyses. I mean that in twosenses: f irst, in the sense that you do option pricingafter you've already done a D C F analysis (such aspresent values and capital expenditures) becomeinputs for option-pricing (such as underlying assetvalue and exercise price). Most companies will notf ind it worthwhile to build separate systems tosupport each methodology. I ndeed , i f D C F andoption pricing are set up as mutually exclusiverivals – you pick one or the other , but not both –option pricing will lose, for now.

Eventually, many companies will locate theirmost high-powered technical expertise within asmall f inance or business-development group . T herest of the company, both line managers and top-level managers, will be trained to use that resourceeffectively. T herefore, the ability to formulatesimple option-pricing analyses will be widespread .I f only the specialists know anything about valuingopportunities, either of two unattractive outcomes islikely: the model builders will become high priestswho dominate the capital-budgeting process; orthey will become ir relevant geeks whose valuabletalents go unexploited .

Equity Cash Flows. Managers already familiar withsome kind of D C F valuation tool can learn E C F ,along with a basic application , in less than a day.Companies that might be heavy users of this toolwill want to adapt it to the particular kind ofbusiness or transactions they engage in mostf requently. Probably the most common uses are inproject and trade f inance, mergers and acquisitions,buyouts, and joint ventures and alliances.

A dapting E C F and corporate systems to each


you to develop those capabilities faster than apassive, laissez-faire approach , and it ought toyield more focused and power ful results. O fcourse, it's also probably more expensive.H owever , the question is not whether it'scheaper to let nature take its course, butwhether the more power ful corporatecapability will pay for itself. T hat is, howmuch is that capability worth?

Reprinted with the permission from the Harvard

Business Review

Timothy A. Luehrman is a visiting associate professor of

finance at the Massachusetts Institute of Technology,

Sloan School of Management in Cambridge.


other is not necessarily dif f icult or costly but needsto be assessed case by case. E C F is a morespecialized valuation tool than either A P V or optionpricing because it addresses a more speci f icquestion . A P V and option pricing ask , W hat is thevalue of this bundle of operations andopportunities? I n contrast, E C F asks, W hat is thevalue of an equity claim on this bundle of assetsand opportunities, assuming they are f inanced inthis fashion? E C F therefore requires more supportor , at a minimum , more inputs f rom corporatef inancial and capital-budgeting systems. Butpresumably, a company engaged in signif icantnumbers of joint ventures or p roject f inancings, forexample, must support these activities anyway,regardless of the valuation tools it chooses to buildinto a particular system .

For most companies, getting f rom where theyare now to this vision of the future is not acorporate f inance problem – the f inancial theoriesare ready and waiting – but an organizationaldevelopment project. Motivated employees trying todo a better job and advance their careers willnaturally spend time learning new skills, evenf inancial skills. T hat is already happening. T he nextstep is to use this broadening base of knowledge asa platform to support an enhanced corporatecapability to allocate and manage resourceseffectively.

A n active approach to developing new valuationcapabilities – that is, deciding where you want yourcompany to go and how to get there – should allow

1. See Stewart C. Myers, "Interactions of Corporate Financing andInvestment Decisions - Implications for Capital Budgeting," Journal ofFinance, vol. 29, March 1974, pp. 1-25. APV is sometimes called valuationin parts or valuation by components.

2. For a more formal and extended discussion of such options, seeAvinash K. Dixit and Robert S. Pindyck, "The Options Approach to CapitalInvestment," HBR May-June 1995, pp. 105-15. In particular, Dixit andPindyck highlight the common, critically important characteristic ofirreversibility in capital investments. When a risky investment is bothirreversible and deferrable, common sense suggests waiting to invest.

3. For the model, see Fischer Black and Myron Scholes, "The Pricing ofOptions and Corporate Liabilities," Journal of Political Economy, vol. 81,May-June 1973, pp. 637-54.


Brand loyalty manifests itself in consumers'willingness to pay a higher price for the brand theyprefer. Some manufacturers choose to limit theiroutput, sell only to customers loyal to their brand(their franchise), and charge the higher price. O therschoose to charge a lower price rather than limit theiroutput. Because franchises can contribute as much, ormore, to future cash flows as their plants contribute,companies in the first group support their franchisesby large investments in advertising, introducing newversions of their products, and so on. Accountants,however, are reluctant to capitalize the expendituresthat support franchises, which causes gaps betweenmarket value and book value. I f the fixed marketingcosts can be identified, however, analysts can estimatethe investment value of the franchise and themanufacturer's efficiency in defending it.

E conomists have a lot to say about the value of plant, p roperty, and equipment, but they are silent on an element of investment value that, for some companies, is even more important – brand f ranchise. I nvestors cannot af ford to ignore the value of a brand f ranchise for a company's future cash f lows. Economists, by indiscr iminately invoking the Law of O ne Price, treat all industr ies as commodity industr ies, in which brand f ranchise has no value. A s a result of the strategic choices companies make, however , consumers experience the reality – the Law of Two Prices – on the shelves of their f r iendly retailers every day. T he neglect by economists of the reality of f ranchise pricing results in a wholly unnecessary mystique regarding these high prices – unnecessary because the marketing and economic aspects of brand f ranchises are easily linked .

A ccounting principles exacerbate theproblem of valuing brand f ranchises. C hurchillonce said that the U nited States and Britainwere two nations separated by a commonlanguage. I nvestment analysts and marketing


strategists are two groups of p rofessionals separatedby the language of accounting, which callsinvestments in brand f ranchises (e.g., research anddevelopment, advertising) "expenses. " T he neglect byaccountants of the implications brand f ranchises havefor future cash f lows results in high price-to-bookratios and high price-to-earnings ratios.

T his article descr ibes an approach analysts canuse, i f the f ixed costs of supporting a brandf ranchise can be identi f ied , to estimating theinvestment value of a manufactu rer 's f ranchise andthe manufactu rer 's ef f iciency in defending it. T hevaluation model has elements recognizable to themarketing strategist – such as f ranchise, marketingeffort, and level of r ivalry – as well as elementsrecognizable to the investment analyst – such as cashflow, p resent value, and return on investment. Butthe model can hardly be called "traditional. " T hetraditional approach to estimating value has been toask what data public companies p rovide and then tolet those data def ine the valuation methods. T hisarticle def ines what data analysts and investors needto value a company's investment in its brandf ranchise and explains how to use the data.

A valuation model cannot be formulated , ofcourse, with total disregard for the kind of data themodel requires. T he data required for a satisfactorymodel should have the following characteristics:

• T he data should be veri f iable, at least in principle. W hen data are veri f iable, "objectivity" ceases to be an issue. T he data should not be opinions about the future. O pinions cannot be veri f ied .

• Data speci f ic to a particular asset should ref lect the speci f ics of the asset-not the interaction of the asset with general economic conditions or someone's opinion about future prosperity. A simple test for the speci f icity of the data is whether the data would be the same in a dif ferent economic or market climate.

BY JACK TREYNOR The Investment Value of Brand Franchise


Exhibit 1. Life-Cycle CharacteristicsF ledgling I ndustry Mature I ndustry

Product concept evolving Product concept rapidly stabilized

Size of market uncertain Market established

Process-centered Product-centered manufactu ring manufactu ring

F luid supplier relationships Stable supplier relationships

Q uality hard to control Q uality easy to control

Consumer disappointments Consumer common disappointments rare

Later , when the role of the product iswell def ined and potential demand is clearer ,manufactu rers build production facilitiesdedicated to the new product (what Bu ffacalled "p roduct-focused production "). Day inand day out, the same people per form thesame steps in the manufactu ring process.T he source of quality problems is identi f ied .Learning takes place, and as p roductionproblems are solved , knowledge aboutsolutions circulates th roughout the industry.

Consumers, however , cannot forget thepain of the early disappointments. T hey arestill anxious, which is what gives the power tobrand names. I ndeed , brands can continue tobe important long after the industry hassolved its quality p roblems. T he dayconsumers do conquer the last of theiranxieties is the day the industry becomes acommodity industry. F resh milk is anexample. W hen pasteurization was new, thereputation of the dairy (e.g., Borden ,Beatrice, H ood) was important. Today,nobody worries about milk quality, and dairybrands with their p remium prices havelargely disappeared .

Marketing is most important in themiddle of the cycle, when brand identitieshave been established in consumers' mindsbut consumers are still wor ried about quality:" A lmost as good as a X erox . " " N ot exactly likeH ertz. " Marketing experts have known foryears that consumers deal with their anxiety


• T he data should not depend on arbitrary decisions by anybody-not the U .S. SE C , not the F inancial A ccounting Standards Board , and certainly not the reporting company.

Brand Franchise PowerT he key to the value of brand f ranchises lies inconsumer anxiety. T he Law of O ne Price assertsthat, in the absence of transportation anddistr ibution costs, roughly simultaneous transactionsin a given good or service will have the same price.T he law assumes, however , that the parties to thetransaction have what lawyers call a "meeting of theminds. " I n actual transactions, the parties have theirown mental images of what is being transacted , andthese two images are rarely the same.

For example, in many markets, the seller knowsmore than the buyer . T his in formation asymmetryis typical of the markets for used cars and second-hand watches, and even more characteristic ofmarkets for consumables-headache remedies,toothpaste, corn f lakes, ketchup , soup , and so on .I n consumables, the manufactu rer knows what rawmaterials, what equipment, and what workers wereused in the product's manufactu re. I n most cases,all the consumers can see at the point of purchaseis an opaque container .

T he result is anxiety in the mind of theconsumer , which often has its origins in the waythe product is manufactu red over its li fe cycle.Exhibit 1 summarizes the dif ferences between af ledgling and a mature industry. W hen an industryis new, the very def inition of the product is f luidand demand is low. So, using general-purposerather than dedicated machine shops, foundries,and heat-treating facilities makes economic sense(what Bu ffa [1984] called "p rocess-focused"production). Q uality at this stage is inevitablyuneven and almost impossible to control. But it isprecisely at this point in the li fe cycle of theproduct that consumers are having their f irstexperiences with the product and forming f irstimpressions that will be as lasting as their f irstimpressions of people.


about transactions by focusing on the manu-factu rer 's brand . I n a process not unlikefalling in love, consumers replace theirgeneralized ideal of what a product should bewith the highly particularized image of aspeci f ic brand . I f they prefer Fords, thenevery way in which a C hevy dif fers f rom aFord makes the C hevy less desirable. T heirprefer red brands become the standards bywhich all other similar p roducts are judged .Consumers are not unwilling to buy theothers, but they are willing to pay more fortheir ideal brands. O f course, whichcompeting product is the ideal di f fers fordif ferent consumers. Each brand , C hevy andFord , has its own group of loyal customers –its brand f ranchise.

Marketing and the Brand FranchiseI deally, a manufactu rer would price each saletransaction according to whether the buyerwas in its f ranchise or not, but this approachis usually impractical. I n practice, themanufactu rer that chooses the lower pricecan sell everything that it can economicallymake at that lower price (in economics, canrealize the full value of the scarcity rents onits plant capacity) and , of course, becausesales are not restr icted to its f ranchise, themanufactu rer who chooses to sell at the lowerprice is f ree not to engage in productinnovation , advertising, or p romotion . T hemanufactu rer that chooses the higher price isrestr icting its branded output, ir respective ofhow much capacity the manufactu rer has, tothe size of its f ranchise market. T herefore,this manufactu rer does whatever it can toincrease its f ranchise- product innovation ,advertising, and promotion . T hemanufactu rer uses the higher-pricedmarketing effort to increase (or defend) itsshare of the f ranchise in its industry.

W hen consumers choose to buy at thelower price, they are not affecting totalsupply or total demand . So, their choice isnot af fecting the scarcity of p roductioncapacity or the scarcity rents on that capacity.Because the choice merely shifts consumers


f rom one brand to another or to unbrandedcompetitive products, it has nothing to do withscarcity or market equilibrium-hence, nothing to dowith price theory. So, the task of analyzing thevalue of a f ranchise has little in common with thetask of analyzing the value of plant, p roperty, andequipment.

T he costs of marketing often include asignif icant f ixed element.1 W hen the size of thatelement is not known (i.e., when f irms do notreport their f ixed costs separately formanufactu ring and for marketing), p ricing thatinvestment is a challenge. But analysts can estimatethe costs. T his discussion of how to value a brandf ranchise considers th ree issues that brandf ranchise raises for investors:

• the estimation problem in the case where f ixed costs are either known or small enough to ignore,

• the economics of brand f ranchise when f ixed costs are important, and

• the impact of brand f ranchise on monopoly power , with particular attention to f ixed costs, sunk costs, and ease of entry.

The Estimation Problem.

Customers are f ickle. A n industry may appear tohave stable and unchanging f ranchise shares, but itis actually in constant f lux . T he competitors'f ranchise shares are like swimming holes in a r iver ;water is constantly f lowing in and f lowing out,although the overall level of each hole may changelittle. To maintain its f ranchise, a manufactu rermust take customers away f rom its competitors asfast as they are taking away customers f rom themanufactu rer .

To begin estimating the costs of supporting abrand f ranchise, assume that, net of any f ixedmarketing costs in the industry, a competitor canromance away twice as many potential customers i fit spends twice as much and vice versa. I f amanufactu rer 's f ranchise is measured by its grosscash " f low-back , " z (f ranchise share multiplied bybrand premium) and its marketing effort net off ixed marketing costs is def ined as ν (both variablesat annual rates), then one-period changes in gross


N ow, consider a single-variable regression ofΔz/z on∑ν∑z: T he suppressed explanatoryvariable ν/z is plausibly uncorrelated with∑ν∑z, both across competitors and acrosstime. We use the resulting estimate of α̂ tocompute values of α for each data point (i.e.,for each competitor at each point in time).

We can use this result to distinguish ,competitor by competitor and period byperiod , between level of marketing effort andeff iciency. A small gain in f ranchise shareachieved with high eff iciency may represent abetter job of marketing management than alarge gain achieved with an exorbitant effort.We can make this useful distinction , however ,only when f ixed costs are little known orunimportant.

The Economic Impact of Fixed Costs.

T he f ixed costs of p roduct development andadvertising represent the competitor 'sadmission ticket to the variable-cost game.2

We can measure competitors' total marketingefforts by the cash outf low u and their totalf ixed marketing costs (assuming the costs canbe measured) by F (all variable annual rates).T hen , the variable-cost portion of acompany's marketing effort is u - F . I nindustr ies where f ixed advertising anddevelopment costs are important, change inf ranchise is

Δz = α(u - F) – βz. (8)

T he value of z to investors is reduced by themarketing effort required to maintain thecompany's market share. T he maintenancevalue of u (the value at which f ranchise gainsjust of fset f ranchise losses) can be termed u*;substituting u* for u in the expression forf ranchise change produces

α(u* – F) - βz =0,

u* – F = β ,z α

and

u* = β

z + F.α (9)

N et f low-back f rom the investment is grossf low-back minus the maintenance level of


f low-back , Δz, satisfy the equation

Δz = αν - βz, (1)

where α and β are coeff icients that express thesensitivity of change in f ranchise to, respectively,marketing effort and initial f ranchise size.

At every point in time, gains and losses in f ranchiseshare sum to zero; that is,

∑Δz = 0; (2)

so, i f we assume that β, unlike α, is the same for allcompetitors, then

0 = ∑αν – β∑z, (3)

with the result that

β =∑αν

. (4)∑z

O bviously, β, even i f it is the same for allcompetitors at a point in time, can vary across time.

But the eff iciency with which competitorstransform dollars of marketing effort into change inf ranchise (gross of the β-related losses) is in acertain sense relative to the other competitors. So,then , an appropriately weighted average of theindividual ef f iciencies should be constant acrosstime-even i f individual ef f iciencies or associatedweights are changing. Let that average be α̂. T hen ,without any loss of generality, we can write

∑αν = α̂∑ν, (5)

and assert that α̂ is constant across time.

T he basic model then becomes

Δz = αν - α̂∑ν

z

(6) ∑z

,

where the expression in parentheses, like ν, isobservable. T he unknown coeff icient α is notnecessarily constant across time for the samecompetitor .

Consider regression estimates of the undeterminedcoeff icients α and α̂: I n the cross-section , large ν'sare likely to be associated with large z's and ,therefore, with large values of (∑ν/∑z

z. So, the

two independent variables are highly correlated .Standard er rors of estimate will be correspondinglylarge. We can minimize this p roblem by recastingthe regression in the form

Δz= α(ν - α̂

∑ν(7)z z

∑z


effort, or

u* =z [β z + ]z– – α F

=z β

– F.

(10)

1 – α

For the industry as a whole, we have

∑Δz = α∑u – α∑F – β∑z (11)

= 0

hence,

α∑(u – F) = β∑z (12a)

and

β= ∑(u – F)

.α ∑z(12b)

Substituting in the expression for net f low-back produces

u* = z [ ∑ (u–F)]z – 1 –∑z

–F . (13)

Recall that our f irst cr iterion for asatisfactory model was that the data beveri f iable. O ne variable in the formula formeasuring f ranchise value should probably betreated as a forecast rather than as averi f iable fact – and , indeed , a forecast thatdepends on events outside the industry. T hatvariable is ∑z – the industry's total f ranchise,measured in gross cash f low. I t depends onoverall industry sales, which usually dependon prosperity beyond the industry. W heninvestors forecast this number , they are"timing" the industry. T he way to avoid suchtiming is to use the forecast that best explainsthe current market p rices of companies inthe industry. ( T he current value of ∑z isobservable but probably not relevant.)

T he other variables in the formula areveri f iable. T hey are speci f ic to the f irm andits industry, and they are not in f luenced byanybody's forecasts or anybody's arbitraryrules:

Δz= α ( ν – α̂

∑ν(14)z z ∑z

Maintenance level v* of v is def ined by


0 = α ( ν* – α̂∑ν

(15)z ∑z .

so

v* = z ( α̂ ∑ν (16)

α ∑z

.

T hen , net f low-back is

v* = z [ (α* ∑ν ]z – 1 – α

∑z. (17)

In this result, f ixed costs are not explicit. W hen weintroduced f ixed costs, we def ined v as equal to u -F and ν* as equal to u* – F i f , on average, allcompetitors have the same f ixed costs. O n the otherhand , Equations 13-19 assume away dif ferences inmarketing eff iciency-that is, assume α = α̂ fordif ferent competitors.

T he present value of a f ranchise share zdiscounted at market rate ρ is

z= [ ∑(u – F)] F

.ρ 1 –

∑z ρ (18)

For an established competitor , the incremental rateof return is

∂ (z – u*) = ∂ (z – u*) ∂z ,∂u ∂z ∂u

(19)

= [ ∑(u – F)]α 1 –∑z

< α .

T he rate of return goes up with the gross f low-back f rom the industry's f ranchise, goes down withthe level of r ivalry, ∑u and goes up with thenumber of competitors.

Brand Franchise and Monopoly Power.

I n a marketing war , the level of r ivalry is so highthat net f low-back becomes negative. T he biggerthe f ranchise share, the bigger the rate of loss.Marketing wars are basically wars of attr itionintended to exhaust competitors' bor rowing power .For example, i f Competitor A has the same sizef ranchise as Competitor B (and the same marketingeff iciency) but more untapped bor rowing power , Bwill run out of steam sooner than A ; A will win thewar . I f , on the other hand , A and B have equaluntapped bor rowing power but A 's f ranchise


Differentiating the maintenance costexpression with respect to F produces

∂u* =1 – nz .∂F ∑z (22)

A new competitor 's maintenance level of uwill fall with increasing F i f its f ranchisesatisf ies

z > – ∑z = Average z.n (23)

So, acquiring competing companies, i fthey are large, evidently pays. (Consider theextreme case of Company Q acquiring acompany of negligible size: Company Q 's zdoes not increase, but its n falls by 1.)Calculating

∂ ∑z ∑z , (24)∂n n

= – n2

shows that when a company is acquired (i.e.,when n falls by 1), the industry averageincreases by ∑z/n2. So, the rule is: N everacquire a company with f ranchise z such thatz<∑z/(n2). Large established f irms benef it byencouraging new f irms, not merely becauseentry reduces their maintenance costs, butbecause it lowers the threshold for acquisitiontargets. (Small companies who would preferto be priced as potential takeover targets willalso favor entry.)

The Two Meanings of "Competition"W hen economists talk about competition ,their ideal is an industry that pushes outputup to the point where marginal cost equalsprice. U nless demand is per fectly p riceelastic, however , increments in output willlower equilibrium price-penalizing all outputand causing marginal revenue to be less thanprice. So, it usually pays an industry not toproduce up to the per fectly competitive level.

T he owner of the industry's marginalcapacity, however , is concerned only with theprice penalty on its own output. I f thismanufactu rer is small – i f it has limitedcapacity – the price penalty will be less


(hence, its rate of loss) is bigger , then B will winthe war . To win such a war , a company must havea higher ratio of bor rowing power to f ranchisethan its competitors have. Because the purpose of amarketing war is to force a competitor to abandonits f ranchise, no rational lender will rely onf ranchise value as the security for a loan . So,borrowing power depends on the value of the plant(less liabilities).3 A marketing war ends when acompetitor either exhausts its bor rowing power or ,seeing that its cause is hopeless, abandons defenseof its f ranchise. E ither way, a marketing war shiftsf ranchise share toward the competitor with thehighest ratio of bor rowing power to f ranchise. A ndbecause marketing wars benef it those competitors,they can be more aggressive in marketing peace.W hen rivalry escalates, high-ratio competitors leadthe way, with low-ratio competitors following willy-nilly.

But there is no point entering an industry i fyou aren't suff iciently well capitalized to defendyour entry. Companies do not have to compete forf ranchise in order to enter an industry, but whenthey enter the battle for brand f ranchise, they incurthe maintenance-level costs of their marketingefforts. So, maintenance cost (see Equation 9),

u* = z ∑ (u–F)

∑z+ F . (20a)

can be used as the measure of ease for entrantsthat expect to compete for f ranchises. We canrewrite this expression as

u* = F nz ∑u

1 –

∑z + z

∑z (20b)

Dif ferentiating with respect to n produces

∂u* = Fz .∂n ∑z (21)

Because F , z, and ∑z are all positive, entry of acompetitor always lowers maintenance cost forexisting competitors. We conclude that whatestablished competitors should fear is not entry but,rather , entry of f inancially strong competitors.

Lawyers often assume that higher f ixed costswill make entry more dif f icult. Does it payestablished competitors to increase the industry'sf ixed marketing costs-for example, by increasing thef requency of new-product introductions?


important to it than i f it is big. T hemanufactu rer will push output closer to thepoint at which the unit cost of p roducing onthe marginal capacity equals the price-that is,behaving more like the economist's ideal. So,the economist wor ries when , as a result ofbusiness combinations or bar riers p reventingnew entrants f rom starting small, an industryis divided up among a few large f irms.

T he word "competition " has a dif ferentmeaning for marketing strategists than itsmeaning for economists or accountants. T heyuse it to refer to the battle for brandf ranchise. I n industr ies where such f ranchisesare valuable, companies often spendhundreds of millions of dollars a year in thebattle. (A s in "competitive sports, " onecompany's f ranchise gain is another 's loss.)W hen the level of r ivalry is high enough ,however , it takes more money than the branditself can generate. At that point, competitorstu rn to their other f inancial resources –scarcity rents on their plant capacity. But theonly plant capacity with high scarcity rents iscapacity with a low variable unit cost ofproducing, which , of course, is why thevaluable f ranchises end up in the hands oflow-cost p roducers.

" Low" and "high " as they apply to cost,however , are relative. H ow does the high-production-cost type survive in such anindustry? By not competing for f ranchiseshare. I nstead , their output is distr ibuted asoff-brand , generic, or house brand products.So, such industr ies have two types ofcompanies – competitors who battle forf ranchise share and producers who do not –and two kinds of entry.

T he producer type is cr itical to theindustry's willingness to use its high-costcapacity. Because producer types own thatcapacity, they decide whether or not to use it,even though the decision affects selling pricesfor all the companies in the industry,including the competitor types.

I f the industry has important f ixed coststhat are the same for small companies as for


large companies small-scale attempts at entry willfail.4 I f marketing expenditures entail signif icantf ixed costs – space in national media, creative spotsfor ads good enough to justi fy the space,development of new products good enough tojusti fy the ads – it does not pay a company to havea f ranchise unless it is a big f ranchise.(I ntroductions of new brands into such an industrymay be few and far between .) A big marketingeffort is needed to defend a big f ranchise. A nd i fthe industry requires low-cost capacity to defend af ranchise, it takes a lot of low-cost capacity todefend a big f ranchise. I n such industr ies, lowproduction costs and big f ranchises tend to gotogether .

W hen competitor types are large, they have abig stake in industry pricing. W hen competitors arelow cost, they have a big stake in output. Will they,nevertheless, withhold some of their p roduction? I fa competitor produces less than its own f ranchisedemands, the competition benef its at the expenseof the competitor , which weakens the competitor 'sability to defend its f ranchise. (Because marginalproducers will increase their output when a low-costcompetitor reduces its output, the net reduction inindustry output a competitor can achieve is nevermore than half its gross reduction .)

E ntry into the battle for f ranchise is obviouslydaunting. But for a producer type, entry requiresonly some plant with a high unit variable cost ofproducing and , hence, a low second-hand value.Some industr ies have f ixed costs of p roduction , buteven those costs are usually small compared withthe f ixed costs of marketing. So, in an industrywith high f ixed marketing costs, p roducer typestend to be small compared with competitor types.

Implications for AntitrustW hen high f ixed costs in an industry are associatedwith marketing rather than production , they putpressure on competitor types to become as large aspossible, which discourages entry into the battle forf ranchise and produces industr ies in which the low-cost companies are large and the high-costcompanies are small – which is to say, industr ies inwhich the companies that own the marginalcapacity have little incentive not to use it.


O ne kind of investment has social value;the original investor is merely the f irst ofwhat may ultimately be several owners. T hesunk cost has value only to the originalinvestor .

By this test, investment in capital goods –in productive capacity – is rarely a sunk cost.I n particular , i f the original buyer fails, theplant still has potential value to other buyers.( To be sure, most capital goods are not asliquid as securities. T hey raise the same kindof uncertainties in a potential buyer 's mindthat a used car raises.)

By the same test, investment in a brandf ranchise is almost always a sunk cost:

• I t has no social value. I nstead , it merely transfers f ranchise f rom one competitor toanother .

• I f the owner abandons the brand , or an acquiring f irm replaces it with its own brand , all p rior investment in that brand becomes worthless.

T hese considerations suggest that i f sunkcosts pose a special p roblem for new entrants,it is the costs of marketing, rather than thecosts of p roduction , that pose the problem .


H igh f ixed costs may have discouraged entryand competitive pricing in the commodityindustr ies-the railroads, steel companies, and oilcompanies-that p reoccupied trust busters in the1890s. Trying to extrapolate that experience to thekind of modern industr ies discussed here may leadto confusion between the two meanings of"competition " with consequences that aredisappointing or even perverse.

Appendix A: Sunk Costs versus Fixed CostsA ntitrust lawyers have recently discovered theconcept of sunk costs. T he lawyers' discovery atteststo their recognition of industr ies in whichmarketing, as well as p roduction , is important – inwhich competitor types as well as p roducer typesare important.

A sunk cost is an investment that is certain tobe worthless i f you change your mind . E xamplesare

• leasehold improvements,

• creative costs of a discarded advertising program ,

• investment in a discarded brand , and

• abandoned new-product development programs.

Sunk costs di f fer f rom simply making riskyinvestments. I f you make an investment in a liquidsecurity and change your mind , although you haveno guarantee that you can recover the cost (so, theinvestment is r isky), you do have a chance torecover it. I f the buyer 's expectations aresuff iciently rosy, you can sell the investment andrecover the cost. Sunk costs are gone with nopossibility of recovery.


Notes1. Classic examples of fixed marketing costs are thecreative costs of an advertising campaign – costs thatmust be incurred before a single TV spot or page inNewsweek has run. Costs of developing a new productmay also be considered part of marketing costs.Development costs must be incurred before the sales forcecan sell the product, before advertising can promote it, andso on. Typically, these fixed costs must be incurred inorder for the "variable" costs of marketing to have anyvalue, and the fixed costs are independent of the scale ofthe marketing program-specifically, of sales volume, thesize of the sales force, the size of the media buy, and soon. A car maker can choose to economize on itsmanufacturing fixed costs-rearranging the chrome, forexample, when a competitor introduces a genuinely newmodel. But this choice is not rigidly dictated by the size ofits franchise or the scale of its marketing effort. And thecar maker is deferring, rather than actually reducing, itscosts. For long-range planning or investment analysis,representative or long-term averages of fixed marketingcosts are appropriate.

2. The cost of product development is a marketing cost.Does the competitor develop its new products (or productimprovements) in a corner of the factory? Do the keyprofessionals wear laboratory smocks rather than thepower suits favored by the company's salesforce? If so,should we conclude that product development is a cost ofproduction rather than marketing? No because whatmatters (in analyzing production, as well as marketing) isthe purpose for which the competitor incurs the costs.

When we distinguish between competitors, who careabout the size of their brand franchise, and producers, whodo not, we find that product development, like advertising,is a cost producers choose not to incur. So, we know whatthe purpose of product development is.

3. The value of the plant derives from its economic, orscarcity, rent. This rent is the difference between the unitvariable cost of producing in that plant and (in acompetitive industry) marginal cost – the unit cost ofproducing in the marginal plant. On the one hand, per unitof capacity, the higher the unit variable cost of producingin the plant, the lower the rent on the plant. On the otherhand, the risk regarding the future rent depends only onthe unit cost for the industry's marginal plant (i.e., onuncertainty about which plant will be marginal). So, theabsolute risk is the same for all plants irrespective of theabsolute rent. And when industry demand expectationschange, competitors' borrowing power does not changeproportionately. Still, a useful generalization is possible:Other things being equal, the competitors with low-costplants cope more effectively with both marketing wars andmarketing peace.

4. Keep in mind that lawyers make an importantdistinction between fixed costs and sunk costs (seeAppendix A).


ReferencesA xelrod , Robert. 1984. The Evolution of Cooperation. N ewYork: Basic Books.

Buffa, E lwood S. 1984. Meeting the Competitive Challenge.H omewood , I L : Dow Jones-I rwin .

O xenfeldt, A lf red R . 1962. Models of Markets. N ew York:Columbia U niversity Press.

Porter , Michael E . 1976. Interbrand Choice, Strategy andBilateral Market Power. Cambridge, M A : H arvardU niversity Press.

---. 1985. Competitive Advantage. N ew York: F ree Press.

Reis, A l, and Jack Trout. 1981. Positioning: The Battle forYour Mind. N ew York: Mc G raw-H ill.

---. 1986. Marketing Warfare. N ew York: Mc G raw-H ill.

Spence, A . Michael. 1974. Market Signaling. Cambridge,M A : H arvard U niversity Press.

Srivastava, Rajendra K ., Tasadduq A . Shervani, and L iamFahey. 1998. " Market-Based A ssets and ShareholderValue: A F ramework for A nalysis. " Journal of Marketing,vol. 62, no. 1 (January): 2-18.

Yip , George S. 1982. Barriers to Entry. Lexington , M A :Lexington Books.

Copyright, 1999, Financial Analysts Journal. Reproducedand Republished with permission from the Association forInvestment Management and Research. All rightsReserved.

Jack Treynor is president of

Treynor Capital Management, Inc.

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