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Papers and Research

This site will carry some papers that I have written that you can download in pdf form. Most of these papers are applied papers, relating to estimation issues that we commonly face in corporate finance, portfolio managment and valuation. Your comments are always welcome.

Paper Listing (Click on the paper to see a short abstract. You can download the paper as a pdf file)

   

Estimation Issues in DCF Valuation
1.Estimating Riskfree Rates
2. The Equity Risk Premium (2008 version, 2009 version, 2010 version, 2011 Edition, 2012 Edition, 2013 Edition)
3. Estimating Risk Parameters
4. Estimating Company Risk Exposure to Country Risk
5. Dealing with Operating Leases
6. Dealing with R&D
7 . 25 Questions on DCF Valuation
8. Measuring Returns: ROE, ROC and ROIC
10. Leases, Debt and Value
11.
Valuing Equity Claims: Voting and Liquidity Differences, Cash Flow Preferences and Financing Rights

Valuation: Special Situations
1. Valuing Distressed Firms
2. Valuing Financial Service Firms (2002 version)
3. Valuing Private Businesses
4. Valuing Acquisitions

Valuation: Different Sectors (Crisis version: 2009)
1. Valuing commodity and cyclical companies
2. Valuing financial service firms (2009 version)
3. Valuing companies with intangible assets
4. Valuing emerging market companies
5. Valuing multi-business, multinational enterprises

Loose Ends in Valuation
1. The Value of Transparency
2 . The Value of Control
3. Marketability and Value : The Illiquidity discount
4. The Value of Cash and Cross Holdings
5. Employee Stock Options, Restricted Stock and Value
5. The Value of Synergy
6. The Value of Intangibles
7. The Cost of Distress
7 . Value Enhancement: Back to Basics

Corporate Finance
1. Beyond Dividends: Stock Buybacks, Spin Offs and Tracking Stock
2. Dividends and Taxes: The Effect of the 2003 Tax Changes on Equity Values
3. Value and Risk: The Payoff to Risk Management
4. Financing Innovations

Relative Valuation and Real Options
1. Relative Valuation: First Principles
2 Real Option Applications in Corporate Finance and Valuation

A Closer Look at Risk
1. Simulations, Decision Trees and Scenario Analysis: Probabilistic Approaches to Risk
2. Value at Risk (VaR): A big picture perspective
3. To Hedge or Not to Hedge? That is the question...
4. Exploiting Risk: A Strategic View of Risk Management

General Papers

  1. A Survey Paper on ValuationTheory and Techniques

Valuation across the life cycle
1.
The Dark Side of Valuation: Valuing Young Companies (Dot-com version: 2000)
2. Valuing idea businesses, start-up firms and young companies (2009 version)
3. Valuing Growth Companies
4. Valuing Mature Businesses
5. Valuing Companies in decline and distress

What if?

  1. Into the Abyss: What if nothing is riskfree?
  2. A New Risky World Order: Unstable Risk Premiums and implications for practice
  3. Comatose Marktets: What if liquidity is not the norm?

 

Papers: Details and Downloads

Title
Description
Download
Equity Risk Premiums: The 2010 Edition Equity Risk premium paper, updated to reflect data through the start of 2010. Download paper as pdf file
Equity Risk Premiums: Post-Crisis Edition This is an updated version of the equity risk premium paper that takes a detailed look at how the equity risk premium and other risk measures have evolved since September 2008 (the date of the last version of the paper). Download paper as pdf file
Valuing commodity and cyclical companies Commodity and cyclical companies pose special challenges when doing valuation, because their earnings and risk measures move with commodity and economic cycles. In this paper, we examine techniques and approaches that we can use to compensate for this volatility. Download paper as pdf file
Valuing financial service firms (2009 version) It is difficult to estimate cash flows at financial service companies. As a consequence, they remain one of the last bastions for the dividend discount model. Inherent in the use of this model are two assumptions - that financial service companies pay out what they can afford to in dividends and that the regulatory constraints that they operate under will keep risk under control. In the crisis of 2008, both assumptions came under assault. In this paper, we look at ways of adapting to the changed enviornoment, when valung banks, insurance companies and invstment banks. Download paper as pdf file
Valuing young and start-up companies How do you value a young or start-up business with little to show in terms of operating performance? In this paper, we examine ways in which we can adapt valuation approaches to account for the absence of historical information and the possibility that many of the young firms that we value will not make it through to success. Download paper as pdf file
Valuing Declining and Distressed Companies (The 2009 edition) We face two key problems in valuing declining and distressed companies. The first is that these firms rather than growing over time may shrink, both in terms of revenues and margins. The second is that many of these firms will not survivie as going concerns. In this paper, we deal with both issues and how to reflect them in valuation. Download paper as pdf file
Valuing emerging market companies Companies in emerging markets often face additional risks, relative to their developed market counterparts, from polticial and economic turmoil in the countries in which they operate. In this paper, we look at how to incorporate this risk both into discounted cash flow and relative valuation models. Download paper as pdf file
Valuing companies with intangible assets Many companies derive their values from intangible assets, ranging from brand names to patents to technological know how. In this paper, we look at how accounting numbers may need to be mofified when valuing these companies and how we capture the full effects in value. Download paper as pdf file
Valuing the Octopus: The multinational, multibusiness company As globalization becomes a reality, many companies have operations spread over many different businesses across multiple countries. In this paper, we examine the ways of dealing with the tangle of different currencies and risk profiles that coexist within each company. In particuar, we look at the viability of sum of the parts valuation as opposted to valuting the aggregated company. Download paper as pdf file
Leases, Debt and Value When leases are categorized as operating leases, the expenses associated with them are treated as operating expenses and leases become as source of off-balance sheet debt (and assets). As the debate about this practice become heated, we look at the consequences of this practice for widely used measures of profitability and financial leverage as well as inputs into valuation models. Download pdf file
Operating lease converter
Industry averages
Estimating Riskfree Rates The riskfree rate is a fundamental input to most risk and return models. In practice, estimating riskfree rates becomes difficult when there are no default-free securities. In addition, the question of what riskfree rate to use (short term or long term, dollar or foreign currency) is a critical one. This paper examines these issues. Download pdf file
The Equity Risk Premium (2008 Edition) The equity risk premium (ERP) is a central input into discounted cash flow models, and more than any other number, it captures what investors think about stock prices in the aggregate. In this paper, we examiine the determinants of equity risk premiums and the three basic approaches used to estimate the number - surveys, historical returns and implied values. We look at why the approaches give you different answers and how to pick the right number to use in analysis. The Equity Risk Premium (ERP): Determinants, Estimation and Implications
Valuing Multiple Claims on Equity Equity claims can vary on a number of different dimensions - voting rights (control), liquidity and cash flows. We examine how to allocate the value of equity across multiple claims on equity in this paper. In the process, we examine the premium that should be paid for voting shares, the discount to be applied to illiqudid shares and the effect of contingent claims. Valuing Equity Claims
The Origins of Growth One of the most difficult challenges in valuing a business is estimating the expected growth rate in future years. In this chapters, we look at the three ways in which this growth rate can be estimated - from history, from analyst or management estimates and from fundamentals. We look at the pluses and minuses of each approach and why they may generate different estimates. Download paper as pdf file
Measuring Returns: ROE, ROC and ROIC The value of a firm ultimately depends on its capacity to earn returns on its investment that exceed its cost of funding those investments. Accounting measures of returns, primarily return on equity and capital, are significnant determinants of value. In this paper, we examine the motivation behind the focus on returns and how best to clean up accounting numbers to estimate and forecasts returns. Measuring Returns
A Survey Paper on Valuation People have been valuing businesses for as long as businesses have been around. We examine how valuation techniques have evolved over time and the common foundatation that different approaches share. Survey paper on Valuation (Download paper)
Simulations, Decision Trees and Scenario Analysis: Probabilistic Approaches to Risk With the advent of simulation software (like Crystal Ball and @Risk), a full-fledged simulation or scenrio analysis is well within the grasp of any analyst valuing a company or analyzing a project. However, what rold should simulations and scenario analysis play in valuation? And what is the relationship between these analysis and traditional expected value calculations (where we adjust for risk in the discount rate)? Probabilistic Approaches to Risk (Download paper)
Value at Risk (VaR) Value at Risk has acquired a cache, especially among financial service firms, as a new and sophisticated way of analyzing risk. We look at the basis for VaR, its pluses and minuses. Value at Risk (VaR) (Download paper)
To Hedge or Not to Hedge? That is the question.. Investors and businesses have more options and opportunities than ever before to hedge risk. But should firms hedge risk? What is the payoff to doing so? If a business or investor chooses to hedge risk, what is the best way to hedge risk (derivatives or insurance, for instance)? To hedge or not to hedge? (Download paper)
Exploiting Risk: A Strategic View of Risk Management Firms become successful, not by avoiding risk, but by seeking it out. Developing a template for deciding which risks to exploit is key to success. In this paper, we examine the potential competitive advantages that a firm can exploit to advantage. Strategic Risk Taking (Download paper)
The Value of Intangibles Intangibles are a large and growing part of many company's assets. Starting with the presumption that current accounting standards do not do a good job of assessing their value, we look at whether intangible assets can be reasonably valued, and if so, the best ways of accomplishing this task. We categorize intangible assets into three groups - independent, cash generating intangibles (like trademarks and franchises) that can be valued with conventional DCF models, composite intangibles that affect the sales of many products and not just cash flows (such as brand name) that are more difficult to isolate and value and intangibles with the potential to generate cash flows in the future that are best valued using option pricing models.

The Value of Intangibles(Download paper)

brandnamevalue.xls: Spreadsheet for valuing brand name

Marketability and Value: The Illiquidity Discount Investors prefer more liquid assets to otherwise similar illiquid assets, but how much at they willing to pay for liquidity? In this paper, we beign by examining our definition fo liqhidity and the empirical evideence on how much markets value liquidity. We consider the empirical evidence on the consequences of illiquidity for equity, fixed income and private equity markets and how best to inrorporate illiquidity into estimated value. Finally, we consider practical ways of estimating the illiquidity premium for illiquid companies (and ssets).

The Value Of Liquidity(Download paper)

liqdisc.xls: Spreadsheet to value liquidity

The Value of Cash, Cross Holdings and Other Non-operating Assets Most businesses carry cash on their balance sheets, though the motives for holding cash vary widely across firms. Some of the cash is held to cover operating needs (transactions), some to cover contingencies (precautionary motive) and some reflects managerial incentives. We consider how best to value cash in both discounted cash flow and relative valuations, and consider the net debt and gross debt approaches in valuation. We also examine how to incorporate the value of cross holdings, both majority and minority, into business valuations.

The Value of Cash and Cross Holdings (Download paper)

GrossvsNet.xls: Resolving the differences between gross and net debt approaches

The Value of Control How much is control worth? The answer to that question affects how much the control premium should be in acquisitions, how much of a premium voting shares should trade at and the discount that should be applied to minority stakes in private companies. This paper looks at how best to measure the value of control and how this can be useful in answering a variety of valuation questions.

The Value of Control (Download paper)

controlvalue.xls: Spreadsheet to value control

Employee Stock Options, Restricted Stock and Value Companies use employee stock options (ESOPs) and restricted stock issues to compensate employees. In this paper, we examine why their usage has increased over the last two decades and how best to deal with the option overhang in valuation. We also look at ways of incorporating future option grants into value per share today. ESOPs, Restricted Stock and Value (Download paper)
The Value of Synergy Often promised, seldom delivered is the best description for synergy, the most widely used rationale in corporate mergers. In this paper, we explore how synergy is created and how to value it. We also examine why companies miscalculate so often when it comes to synergy.

The Value of Synergy (Download paper)

synergyvaluation.xls: Spreadsheet to value synergy

25 Questions on DCF valuation Every valuation analyst has faced one or more of these questions in real world valuations and has had to come up with an answer. These are my very opinionated (and not necessarily correct) answers to the 25 top questions that we face in DCF valuation. Take it for a spin! Valuation Questions
Value and Risk We take far too narrow a view of risk in finance. When we talk about risk management, we often only talk about risk hedging and when we estimate value, the discount rate is the only place where we reflect risk. In reality, risk is both a threat and an opportunity and successful firms not only protect themselves against some types of risk but actively exploit other types of risk to establish competitive advantages. In this paper, we present a way of considering risk management in this broader sense and consider ways in which we can bring risk into the other components of value. We also consider what types of firms are most likely to benefit from risk hedging and from risk management.

Download paper (pdf)

Effects of risk on DCF value (spreadsheet)

Risk hedging as a put option (spreadsheet)

Measuring Company Risk Exposure to Country Risk It is common practice in valuation to assume that companies within an emerging market are all equally exposed to country risk and that companies that are incorporated and trade in developed markets like the United States are immune from it. This is clearly at odds with common sense, since companies within an emerging market can be exposed to different degrees to country risk and multinationals like Coca Cola and Nestle can be exposed to significant emerging market risk. In this paper, we propose a measure of company exposure to country risk called lambda and suggest ways in which we can estimate lambda.

Download paper (pdf)

Exports as percent of GDP (World Bank)

Lambda Estimates for Brazilian companies

Dividends and Taxes In January 2003, President Bush proposed that dividends be tax exempt to investors. While the ultimate shape of the tax reform is not clear, changing the tax rate on dividends can have significant effects on both equity values and on the corporate finance decisions - investment, capital structure and dividend policy- of companies.In this paper, I estimate the effect of making dividends tax exempt on the overall value of equity in the market (13-14%) and argue that there will be profound changes in the use of debt and stock buybacks, with both declining.

Download paper(pdf)

divtaxpremium.xls (effect on market)

stockvaldiv.xls (effect on individual stocks)

Information Transparency and Value: Can you value what you can’t see? It is clear that some firms are more forthcoming about their financial affairs than other firms, and that the financial statements of some firms are designed to obscure rather than reveal information about the firms. No matter how strict accounting standards are, firms will continue to use their discretionary power to spin and manipulate the news that they convey to financial markets. The questions we face in valuation are significant ones. How do we reflect the transparency (or the opacity) of a firm’s financial statements in its value? Should we reward firms that have simpler and more open financial statements and punish firms that have complex and difficult-to-understand financial statements? If so, which input in valuation should be the one that we adjust?

Download paper(pdf)

Download the complexity scoresheet

'Valuing Distressed Firms Traditional valuation techniques- both DCF and relative – short change the effects of financial distress on value. In most valuations, we ignore distress entirely in valuation and make implicit assumptions about the consequences of a firm being unable to meet its financial obligations and these assumptions often are unrealistic. Even those valuations that purport to consider the effect of distress do so incompletely. In this paper, we begin by considering how distress can be explicitly considered in both discounted cashflow and relative valuation models.

Download paper (pdf)

Download Global Crossing valuation

distress.xls (estimate the likelihood of default from bond price)

The Dark Side of Valuation Valuing a firm is difficult when it has negative earnings, a limited history or few comparables. When all three of these components come together, as is the case with many young start-up firms (Did someone say internet firms?), analysts all too often either assume that they cannot be valued or that new valuation models have to be devised. In this paper, we make an argument that these firms can be valued, albeit with noise, and use Amazon.com as a case study to illustrate the principles involved. Download paper (pdf)

Download Amazon valuation: 1/1/99

An Updated Amazon valuation: 1/1/2000

Real Option Applications in Corporate Finance and Valuation Are there options embedded in investment decisions? Undoubtedly. There are also options in financing and valuation. The real question is whether these options have value, and how much they are worth. In this paper, I examine the whole range of real option applications, from the options to expand, delay and abandon in investment options to the option to liquidate in the equity of the firm. I also look at potential applications of real options in R&D and valuing undeveloped natural resources, and suggest that real options need to pass a three-part test to have value. Download pdf file
Valuing Private firms The fundamentals that determine value for private firms as the same as those that determine publicly traded companies, but there are three critical issues. The first relates to the scarcity of information about private firms. The second issue is that of illiquidity and how it affects value. The final issue is the question of control and whether there should be a premium for control or a discount for the lack of it. Download pdf file
Valuing Financial Service Firms Financial service firms - banks, insurance companies and investment banks - are often difficult to value because cash flows cannot be easily estimated. In this paper (which is a chapter in the second edition of my valuation book), I look at the questions involved in valuing financial service firms. Download pdf file
Valuing Acquisitions This paper (which is a chapter from my corporate finance book) looks at how best to deal with the valuation of control and synergy in acquistions and related issues. Download paper (pdf)
Valuation Multiples: First Principles This paper (which is a chapter from my investment valuation book) looks at the first principles that we need to follow when using multiples Download paper (pdf)
Estimating Risk Parameters The beta or betas in risk and return models measure an asset's relative risk. We look at the limitations of standard approaches to beta estimation (such as regressions) and consider alternative approaches. Download pdf file
Dealing with Operating Leases Many firms lease the assets that they use. If the leases qualify as operating leases, they affect operating income and do not show up as part of capital. In this paper, we argue that this can distort measures of profitability and can affect the valuation of firms with substantial operating leases, and suggest ways in which we can correct earnings and cash flow measures.

Download pdf file

oplease.xls: Convert operating leases from operating to financial expenses

Dealing with R& D Expenses Accounting standards in the United States and in much of the rest of the world require that R&D be expensed. Since these are expenses that are designed to generate future growth, it is much more logical to treat them as capital expenditures. In this paper, we explore ways in which R&D expenses can be capitalized and the implications for earnings, cash flows, valuations and multiples.

Download pdf file

R&Dconv.xls: Convert R&D from operating to capital expense

Financing Innovations The last two decades have seen a stream of innovation in financial markets, especially in the corporate bond arena. Some of these innovations were designed to give firms more flexibility in designing cash flows on borrowings, allowing them to match up cash flows on financing more closely to cash flows on assets, thus increasing their debt capacity. Some firms are issuing these new and more complex securities for the wrong reasons - to keep up with other firms in their peer group, and to take advantage of loopholes in the way ratings agencies and regulatory agencies define debt and equity. In this paper, we take a big picture view of financing innovations, and some of the good and bad reasons for innovations. Download pdf file
Beyond Dividends This is a chapter from the second edition of my corporate finance book on spin offs, divestitures, equity carve outs and tracking stock. It is not path-breaking, by any stretch of the imagination, but it provides a comparison of the different actions, and why a firm may choose one over the other. Download pdf file
Value Enhancement: Back to Basics Value enhancement has become a hot topic of late. This paper examines the fundamentals of value creation and enhancement, from a valuation framework, and then considers the merits of EVA and CFROI as value enhancement devices. Download pdf file