Valuation: Bridging the Gap Between Academics and Industry Practice Sheridan Titman Financial Management Association October 2005

Valuation We devote a substantial amount of our teaching to valuation However, relatively little research dedicated to this topic  Plenty of good research describing the “mechanics” of valuation, but  Ideally, we’d like to better understand How firms actually evaluate projects Why firms do what they do Existing survey based studies evaluate these issues but only scratch the surface My impression is that there is a substantial disconnect between our research, our teaching, and actual industry practice

The Lack of Research on Valuation Valuation research is primarily normative  making it difficult to empirically test The lack of research has resulted in slow progress, if not stagnation in how we teach this topic (GT still considered cutting edge) In my teaching I’ve found the gap between industry practice and the classroom striking  why are we so comfortable with this gap?

Differences in the classroom and practice Valuing flexibility (real options) Discount rates  Multiple versus single  Discount rates that are “too high” The importance of accounting/earnings

Why Do the Differences Exist? Is academia ahead of industry practice?  Perhaps, but not the entire story  Why are we so much ahead of industry on this topic but not others? My view: practitioners and academics are solving different problems In particular, firms must consider how valuation methodology influences other operational issues. For example:  Internal politics  Managerial effort  Perceptions of fairness

Example #1: “Inflexible” Discount Rates In theory, projects with different risks should be evaluated with different discount rates Most firms, however, have a single corporate discount rate that is used to evaluate all their projects Almost all claim to use a small number of discount rates

Example #2: Evaluating Projects in Emerging Markets Firms often use discount rates that are higher than theory suggests For example, consider a power plant in Indonesia  Firms agree that these have relatively low β’s  But use hurdle rates close to 20%

Example #2.1: Evaluating Private Equity Deals What do venture capitalists and other private equity firms typically consider an appropriate rate of return on projects that they initiate? Are these projects particularly risky as defined by academic risk/return models (e.g., the CAPM)?

Explanations Multiple discount rates:  Managers understand risk/return tradeoffs and require higher estimated “NPVs” for riskier projects High discount rates:  Managers use a high discount rate for Indonesia because “expected” cash flows ignore political risk and tend to be optimistic in other ways  Venture capitalists use high discount rates because they know that entrepreneurs tend to be overly optimistic

But are these really explanations? Academic response: Firms would make better investment decisions if they discounted true expected cash flows at appropriate risk adjusted discount rates. Question: Why do practitioners prefer to discount “hoped for cash flows” at inflated discount rates?

Research Agenda: Understanding the Valuation Process What are the implications of the project evaluation and review process?  Most projects have Project sponsors: who identify investment opportunities and write proposals  What are their incentives? Project evaluators: who can accept or reject the proposal  What are their incentives?  How does the valuation methodology affect the behavior of project sponsors?

Research Agenda (continued) What are the costs and benefits associated with having the flexibility to set a different hurdle rate for different projects?  The benefits are fairly obvious – you should make better decisions if the discount rate reflects the risk of the project.  However, flexibility can create influence costs: politics will enter the setting of discount rates the persuasiveness of the project sponsor rather than the fundamentals of the project become important a more discretionary process can be viewed as less fair

Research Agenda (continued) What are the costs and benefits of having a higher or lower hurdle rate?  Again, there is a benefit to having a discount rate that reflects the risk of the project evaluated  However, the project sponsor may work harder to find a better project if the required rate of return is higher  Use high discount rates when: effort is hard to evaluate where the marginal benefit of higher effort is higher, e.g. in emerging markets  “High” discount rates can also address sponsor overconfidence and/or optimism

Research Agenda (continued) Why not adjust the cash flow estimates?  Political implications – do we really want to include the probability of sovereign default in our analysis  Behavioral implications – Does the VC really want to curb the entrepreneur’s enthusiasm? “Advantages” to having ambitious targets – helps incentives

Research Agenda (continued) To what extent do firms use the cash flow forecasts, used to evaluate projects, as targets that affect future bonuses? Do firms systematically compare forecasted cash flows to realized cash flows? Is there a clear bias? Private equity firms generally use very high discount rates – do these rates vary cross- sectionally? Do we see higher discount rates in more ambiguous projects that are more difficult to evaluate?

Research Agenda (continued) Firms generally have different groups for evaluating internally generated projects and for acquisitions.  Do these groups use different discount rates and different methodologies?  Major oil companies use different oil price assumptions for external acquisitions than for development investments – why is this? Do firms implicitly account for differences in risk when they use the same discount rate for each project?  Implicitly require higher NPV hurdle for riskier projects  Use project debt to finance safer investments

Research Agenda (continued) How do firms account for the value of flexibility?  Do they require higher hurdle rates for projects that can be delayed?  Do they require lower hurdle rates for initiating projects that can be implemented in stages?  Do they require lower hurdle rates for projects that are more liquid?