Valuing IT Investments Ken Peffers UNLV October 2004 Ken Peffers UNLV October 2004

What’s different about IT Investments? Aren’t they just capital goods investments? Value of knowledge –Relationship of information and information processing to knowledge –Intelligence scaling Technology acceleration –Transforming business processes –Transforming products –Transforming the industry –Moore’s Law Aren’t they just capital goods investments? Value of knowledge –Relationship of information and information processing to knowledge –Intelligence scaling Technology acceleration –Transforming business processes –Transforming products –Transforming the industry –Moore’s Law

Furthermore… Geographic Scaling –Internet used for sales –Network externalities Organizational Scaling –Flat organizations –Little vertical integration –Increasing product diversity –Integration across the value chain Geographic Scaling –Internet used for sales –Network externalities Organizational Scaling –Flat organizations –Little vertical integration –Increasing product diversity –Integration across the value chain

Financial Accounting for Knowledge Assets Accounting rules prevent capture of value –Use of historic costs –Arbitrary cost allocation rules –The conservatism principle leads to undervaluation of assets –Development of product costs Purpose of accounting to create financial statements Accounting rules prevent capture of value –Use of historic costs –Arbitrary cost allocation rules –The conservatism principle leads to undervaluation of assets –Development of product costs Purpose of accounting to create financial statements

Knowledge Capital—Baruch Lev Expected earnings minus expected income from tangible assets = knowledge based earnings Assets poor predictor of earnings Other factors that account for earnings variation? Expected earnings minus expected income from tangible assets = knowledge based earnings Assets poor predictor of earnings Other factors that account for earnings variation?

Value maximization Managers objective to maximize firm value Value of the firm equals discounted value of all future cash flows Managers objective to maximize firm value Value of the firm equals discounted value of all future cash flows

Discounted Cash Flow (DCF) where, NPV= Net Present Value C=Investment at the start of the project A t =Cash flow at t T=Project life r= Risk-based discount rate for the project

Firm Value Maximization where, PV= Present Market Value A t =Cash flow at t T=Firm life r= Industry required rate of return

Contribution of NPV Objective Congruence with value maximization Better than undiscounted cash flow, simple payback, ROI Objective Congruence with value maximization Better than undiscounted cash flow, simple payback, ROI

Limitations Estimates of revenues and costs –manipulated to justify projects already selected Biased toward prior opinions Applied in the face of flawed incentive systems Assume accurate estimates of future cash flows Estimations of project risk Second stage projects Terminal value Estimates of revenues and costs –manipulated to justify projects already selected Biased toward prior opinions Applied in the face of flawed incentive systems Assume accurate estimates of future cash flows Estimations of project risk Second stage projects Terminal value

More issues with DCF Cash flows not reported in financial statements Use of linear extrapolations Provides point estimates; no variance Betas needed to calculate the discount rate, but not available Short operating history for knowledge based firms Cash flows not reported in financial statements Use of linear extrapolations Provides point estimates; no variance Betas needed to calculate the discount rate, but not available Short operating history for knowledge based firms

The Comparable Valuation Approach Valuing a firm based on the value of similar firms, in terms of risk, growth rate, capital structure and the size and timing of cash flows

Appropriate When business model for the firm is well specified Highly comparable group of firms exists When business model for the firm is well specified Highly comparable group of firms exists

Weaknesses Need to choose comparable firms Need to ascertain value of other firms Not valid if the entire sector is over or undervalued Need to choose comparable firms Need to ascertain value of other firms Not valid if the entire sector is over or undervalued

The approach Determine that some parameter among the comparable firms drives value, e.g., the price earnings ratio. The firm can be valued at the average P/E for the group of the comparable firms Common measures include P/E, market to book ratio, price/revenue ratio Determine that some parameter among the comparable firms drives value, e.g., the price earnings ratio. The firm can be valued at the average P/E for the group of the comparable firms Common measures include P/E, market to book ratio, price/revenue ratio

The Venture Capitalist Approach Assume that all of the value of the asset comes from the terminal value Justification: VCs typically expect a series of losses leading to an IPO, where they’ll cash out Assume that all of the value of the asset comes from the terminal value Justification: VCs typically expect a series of losses leading to an IPO, where they’ll cash out

The VC approach

Prices out high risks for new firms Compensates for illiquidity Compensates for exaggerated expectations by entrepreneurs Prices out high risks for new firms Compensates for illiquidity Compensates for exaggerated expectations by entrepreneurs

Valuation in Parts Calculate value of various parts of the firm separately, e.g., financing and operations, and add them together

Options Pricing Value of an IT investment is, in part, based on option to make further investments later Right, but not obligation, to make the later investments is similar to an American call option. An American call option confers the right, but not obligation, to purchase a security at a given strike price within a specified time period Value of an IT investment is, in part, based on option to make further investments later Right, but not obligation, to make the later investments is similar to an American call option. An American call option confers the right, but not obligation, to purchase a security at a given strike price within a specified time period

Raison D'etre Expected value of a future investment can have a negative value DCF method uses discounted expected value Option to make such an investment can never have a negative value Useful when the investment decision can be deferred Expected value of a future investment can have a negative value DCF method uses discounted expected value Option to make such an investment can never have a negative value Useful when the investment decision can be deferred

Value of Managerial Flexibility DCF method assumes 2nd stage projects are undertaken Actually won’t be undertaken if value less than 0 at time of investment decision DCF method assumes 2nd stage projects are undertaken Actually won’t be undertaken if value less than 0 at time of investment decision

Value of Managerial Flexibility Example The value of a $1.00 investment today will generate either $0.80, $1.10, or $2.00 with equal probability after one year. The expected value is ($ $ $2.00)/3 - $1.00 = $0.30 But if the manager can wait until next year to determine whether the cash flow could be $0.80, then next year the expected value will be either $0.30 or $0.55 ($ $2.00)/2 - $1.00 = $0.55 The value of the real option to delay the decision is $0.25 The value of a $1.00 investment today will generate either $0.80, $1.10, or $2.00 with equal probability after one year. The expected value is ($ $ $2.00)/3 - $1.00 = $0.30 But if the manager can wait until next year to determine whether the cash flow could be $0.80, then next year the expected value will be either $0.30 or $0.55 ($ $2.00)/2 - $1.00 = $0.55 The value of the real option to delay the decision is $0.25

The Value of an Option In making an initial investment in IT the manager is purchasing an option to make a subsequent investment later if the value of the second stage project is positive Of course real problems don’t present themselves with such simple configurations In making an initial investment in IT the manager is purchasing an option to make a subsequent investment later if the value of the second stage project is positive Of course real problems don’t present themselves with such simple configurations

Exchange one risky asset for another risky asset Dos Santos B.L., "Justifying Investments in New Information Technologies," Journal of Management Information Systems, Vol. 7, No. 4, Spring 1991, Journal of Management Information Systems

Options method cont.

Estimating the model Necessary to estimate B1, C1, var B1, var C1, corr BC Estimating variation. Intuitively: “there is approximately a 2/3 probability that the revenues (costs) will vary up or down by no more than X%)” Estimating the corr BC. Intuitively: “approximately X% of the variation in revenues is attributable to variations in the development costs. The remainder is attributable to other factors. The corr BC is the squareroot of X.” Necessary to estimate B1, C1, var B1, var C1, corr BC Estimating variation. Intuitively: “there is approximately a 2/3 probability that the revenues (costs) will vary up or down by no more than X%)” Estimating the corr BC. Intuitively: “approximately X% of the variation in revenues is attributable to variations in the development costs. The remainder is attributable to other factors. The corr BC is the squareroot of X.”

Advantages Provides a value for the option, even though the option cannot be traded

Limitations Credibility of the option value in the organizational decision making process Some managers might think that the value of the option cannot be well quantified Credibility of the option value in the organizational decision making process Some managers might think that the value of the option cannot be well quantified

Residual Income Similar concepts: abnormal earnings, economic earnings Earnings beyond the required rate of equity investment returns for the industry Used by General Motors in the 1920s to evaluate investments Concept: a firm creates value only if return on capital is greater than cost of capital Similar concepts: abnormal earnings, economic earnings Earnings beyond the required rate of equity investment returns for the industry Used by General Motors in the 1920s to evaluate investments Concept: a firm creates value only if return on capital is greater than cost of capital

Residual Income

Residual Income Present Value

Advantages Similarity to DCF Uses accounting earnings—easily obtained for ongoing business, not too easy for speculative investments Similarity to DCF Uses accounting earnings—easily obtained for ongoing business, not too easy for speculative investments

Predictive Value of Measures As a predictor of stock value –GAAP earning: 12.8% –Residual income: 7.3% –Cash flow: 2.8% As a predictor of stock value –GAAP earning: 12.8% –Residual income: 7.3% –Cash flow: 2.8%

Economic Value Added Variation on residual income promoted by consultant Stern Steward Adjustments (about 150) to correct perceived deficiencies caused by use of accounting income Variation on residual income promoted by consultant Stern Steward Adjustments (about 150) to correct perceived deficiencies caused by use of accounting income

Might We Infer… …that we have a long way to go before we have adequate methods to evaluate IT investments?