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Dark Side of Valuation, The: Valuing Old Tech, New Tech, and New Economy Companies

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Dark Side of Valuation, The: Valuing Old Tech, New Tech, and New Economy Companies

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  • Copyright 2001
  • Edition: 1st
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  • ISBN-10: 0-13-040652-X
  • ISBN-13: 978-0-13-040652-1

  • The comprehensive guide to valuing technology companies
  • Projections for future revenues, earnings, cash flows, the impact of stock options, and more
  • 5 detailed case studies cover the entire tech lifecycle: Amazon.com, Ariba, Cisco, Motorola, and a new IPO
  • Presented by one of the world's leading experts in valuation
  • State-of-the-art tools for assessing the value of any technology company

Technology companies have exploded in importance, yet investors and analysts face unprecedented challenges in valuing them. In The Dark Side of Valuation, one of the world's leading valuation experts reviews every approach, demonstrating exactly how to adapt traditional techniques to minimize risks and maximize returns.

Aswath Damodaran begins with an overview of the markets' dramatic shift towards technology stocks — specifically new technology stocks. He then identifies key valuation principles and techniques, demonstrating them through five case studies that encompass the entire technology company lifecycle: Amazon.com, Ariba, Cisco, Motorola, and a new IPO-ready startup. Coverage includes:

  • Adaptation of discounted cash flow models for tech companies with limited histories, shifting business mixes, and volatile stock prices
  • The limitations of traditional accounting definitions in measuring technology company cash flows
  • Superior processes for estimating future revenues, earnings, and cash flows
  • Evaluation of the impact of management and employee stock options on share value and earnings multiples
  • An in-depth assessment of PEG and price-to sale ratios
  • Relative valuation: fundamentals, earnings multiples, and revenue multiples
"What a refreshing book to read! Damodaran's book is essential if capital markets are going to accurately gauge the contributions of emerging companies...His insights are illuminating and his mastery of financial analysis is unmatched."

—Louis Columbus
Director of Marketing, Linksys

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Valuation: Management Options, Control,and Liquidity

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Table of Contents

1. The Dark Side of Valuation.

Definition of a Technology Firm. The Shift to Technology. Old Tech to New Tech. Extension of the Valuation Metrics. The Implications for Valuation. New Paradigms or Old Principles: A Life Cycle Perspective. Illustrative Examples. Summary. Endnotes.

2. Show Me the Money: The Fundamentals of Discounted Cash Flow Valuation.

Discounted Cash Flow Value. Valuing an Asset with Guaranteed Cash Flows. Introducing Uncertainty into Valuation. Valuing an Asset with Default Risk. Valuing an Asset with Equity Risk. Valuing an Asset with Equity Risk and Finite Life. Valuing an Asset with an Infinite Life. Equity and Firm Valuation. Dividends and Equity Valuation. A Broader Measure of Cash Flows to Equity. From Valuing Equity to Valuing the Firm. Valuing Technology Stocks. Estimated Cash Flow to the Firm. Expected Growth. Discount Rate. Asset Life. Bringing It All Together. Summary. Endnotes.

3. The Price of Risk: Estimating Discount Rates.

Cost of Equity. Risk and Return Models. Estimation Issues. From Cost of Equity to Cost of Capital. Calculating the Cost of Debt. Calculating the Cost of Hybrid Securities. Calculating the Weights of Debt and Equity Components. Estimating the Cost of Capital. Summary. Endnotes.

4. Cash is King: Estimating Cash Flows.

Defining the Cash Flow to the Firm. Operating Earnings (EBIT). Updated Earnings. Adjustments to Operating Earnings. The Tax Effect. Effective versus Marginal Tax Rate. The Effect of Net Operating Losses. The Tax Benefits of R&D Expensing. Reinvestment Needs. Net Capital Expenditures. Noncash Working Capital Investments. Summary. Endnotes.

5. Looking Forward: Estimating Growth.

The Importance of Growth. Growth Assets and Assets in Place. Growth Assets at Technology Firms. Historical Growth. Estimating Historical Growth. The Usefulness of Historical Growth. Historical Growth at Technology Firms. Analyst Estimates of Growth. Number of Analysts Following Technology Firms. The Quality of Earnings Forecasts. The Fundamental Determinants of Growth. Scenario: Stable Return on Capital. Scenario: Positive and Changing Return on Capital. Scenario: Negative Return on Capital. The Qualitative Aspects of Growth. The Question of Detail. Summary. Endnotes.

6. Estimating Firm Value.

Closure in Valuation. Multiple Approach. Liquidation Value. Stable Growth Model. Valuing Operating Assets. The Survival Issue. Life Cycle and Firm Survival. Likelihood of Failure and Valuation. Cash and Nonoperating Assets. Cash and Marketable Securities. Holdings in Other Firms. Other Nonoperating Assets. Firm Value and Equity Value. Summary. Endnotes.

7. Management Options, Control, and Liquidity.

Management and Employee Options. The Magnitude of the Option Overhang. Options in Existence. Future Option Grants. Value of Control. Voting Shares versus Nonvoting Shares. Valuing Control. Control in Private Businesses. Value of Liquidity. Determinants of Illiquidity Discount. Quantifying the Liquidity Discount. Liquidity Discounts at Publicly Traded Firms. Summary. Endnotes.

8. Relative Valuation.

Use of Relative Valuation. Reasons for Popularity. Potential Pitfalls. Standardized Values and Multiples. Earnings Multiples. Book Value or Replacement Value Multiples. Revenue Multiples. Sector-Specific Multiples. The Four Basic Steps to Using Multiples. Definitional Tests. Descriptional Tests. Analytical Tests. Application Tests. Reconciling Relative and Discounted Cash Flow Valuations. Summary. Endnotes.

9. Earnings Multiples.

Price-Earnings Ratio (PE). Definitions of PE Ratio. Cross-Sectional Distribution of PE Ratios. Determinants of the PE Ratio. Using the PE Ratio for Comparisons. The PEG Ratio. Definition of the PEG Ratio. Cross-Sectional Distribution of the PEG Ratio. Determinants of the PEG Ratio. Using the PEG Ratio for Comparisons. Other Earnings Multiples. Price to Future Earnings. Price to Earnings Before R&D Expenses. Enterprise Value to EBITDA. Summary. Endnotes.

10. Other Multiples.

Revenue Multiples. Definition of Revenue Multiple. Cross-Sectional Distribution. Analysis of Revenue Multiples. Using Revenue Multiples in Analysis. Multiples of Future Revenues. Sector-Specific Multiples. Definitions of Sector-Specific Multiples. Determinants of Value. Analysis with Sector-Specific Multiples. Summary. Endnotes.

11. Real Options in Valuation.

Basics of Option Pricing. Call Options: Description and Payoff Diagrams. Put Options: Description and Payoff Diagrams. Determinants of Option Value. American versus European Options: Variables Relating to Early Exercise. Option Pricing Models. A Few Caveats on Applying Option Pricing Models. Barrier, Compound, and Rainbow Options. The Option to Delay. The Payoff Diagram on the Option to Delay. Valuing the Option to Delay. Practical Considerations. Implications for Project Analysis and Valuation. Valuing a Patent. From Patent Value to Firm Value. The Option to Expand. Practical Considerations. Implications for Valuation. When Are Real Options Valuable? Some Key Tests. Quantitative Estimation. Key Tests. Summary. Endnotes.

12. Value Enhancement.

Value Creation: A Discounted Cash Flow (DCF) Perspective. Value-Creating and Value-Neutral Actions. Ways of Increasing Value. The Value Enhancement Chain. Alternatives to the Traditional Valuation Model. Economic Value Added. Cash Flow Return on Investment. Summary. Endnotes.

13. A PostScript.

Fundamentals Don't Change. Cash Flow, Growth, and Risk. Lessons for Investors. Lessons for Managers. Grow, Grow, Grow? Growth and Value. Lessons for Investors. Lessons for Managers. The Expectations Game. Expectations, Information, and Value. Lessons for Investors. Lessons for Managers. Live with Noise. Noise in the Valuation of Technology firms. Implications for Investors. Implications for Managers. Summary. Endnotes. References.




Do the old rules still apply? Do we need new valuation metrics, or are the old metrics flexible enough to deal with the companies that constitute the new economy? Can you value a company that has no earnings, no history, and no comparable firms? These are the questions that I have heard repeatedly over the last few years. I have always believed the fundamentals that determine value are the same, no matter what company you value and what market it is in. Increasingly, though, I have faced skeptical audiences who are unwilling to take this belief at face value and have demanded proof that America Online, Amazon.com, or Priceline.com can be valued with traditional models.

The genesis for this book was a paper I did on valuing Amazon.com in March 2000, where a discounted cash flow model yielded a value of $34 per share. Since the stock was trading at $80 at that time, there were many who viewed the valuation as either excessively pessimistic or as missing something. The interest in the paper led me to think about writing a book, but I expanded it to cover both new technology and old technology firms. While there are differences in estimation that arise across these firms, I believe that they have far more in common. Why technology firms? I believe that traditional valuation books and models (and I count my book on investment valuation among the culprits) have tended to concentrate on valuing manufacturing or traditional service firms. Technology firms are different. They expand by investing in research and through acquisitions and not by building plant and equipment. Many of them have astronomical growth rates in revenues and often, very little in current earnings. Their assets are often patents, technology, and skilled employees. I look at how the notions of capital expenditures, operating income, and working capital have to be redefined for these firms.

I begin this book by laying out the facts on the growth of technology and, in particular, new technology stocks in the equity market and argue that although the principles of valuation might not shift, the focus can change as firms move through their life cycles. This discussion is followed by an extended section (Chapters 2-7) on applying traditional discounted cash flow models to value technology stocks, with an emphasis on the estimation of cash flows, growth, and discount rates for these firms. In the next three chapters, I look at the use of relative valuation to value technology companies, both in terms of adapting existing multiples (such as price-earnings and price-to-sales ratios) and developing new ones (value per Web site visitor, for instance). In Chapter 11, "Real Options in Valuation," I consider an argument made by many for the large premiums paid on technology stocks (i.e., they represent real options to expand into a potentially huge e-commerce market), and consider some questions that a skeptic should ask before accepting this argument. In Chapter 12, "Value Enhancement," I consider how managers of technology firms can enhance the value of their firms through better investment and financing decisions.

The book is structured around the valuations of five technology firms-Motorola, Cisco, Amazon.com, Ariba, and Rediff.com. The first three are household names but represent three different points in the technology spectrum. Motorola is an old technology firm with substantial investments in existing assets. It is also a firm that has fallen on hard times in the last few years, largely as a consequence of poor investments and strategic choices. Cisco is one of the great success stories of the 1990s, but a great deal of the market value of the firm reflects expectations about the future. It is also a firm that has chosen to grow through acquisitions and has done it very well. Amazon.com is the poster child (for better or worse) for the new economy stocks that have entered the market in recent years, and the popular press has documented its ups and downs in extensive detail. Ariba and Rediff.com are more recent entrants into the new economy, with Ariba representing the promise (and peril) of the Business-to-Business (B2B) Internet model, and Rediff the potential of an Internet portal serving a market (India) that could be a huge market in the future.

One of the limitations of valuing real companies is that your mistakes are there on the printed page for all to see over time, but that prospect does not bother me. At the risk of giving away the punch line, I do find discounted cash flow values for all five companies: Motorola ($32.39), Cisco ($44.92), Amazon.com ($34.37), Ariba ($72.13), and Rediff.com ($19.05). For what it is worth, at the time that I did the valuations in June 2000, I found Amazon to be overvalued at $48 per share and Cisco to be overvalued at $64.88. Motorola at $34.25 per share and Ariba at $75 per share were fairly valued, and Rediff.com was significantly undervalued at $10 per share. By the time I finished the book, Amazon had dropped in value to $30 per share, and Cisco was trading at $51. Motorola had gone from being fairly valued to undervalued, Ariba saw its stock price double, and Rediff remained undervalued. I have no doubt that you will disagree with me on some of the inputs I have used, and the values that you assign these firms will be different from mine. What I would emphasize, therefore, is not the values that I arrive at for these firms, but the process by which I got there.

Finally, I want this book to be useful to a wide audience: individual investors who hold technology stocks in their portfolios, equity research analysts, venture capitalists, and managers at technology firms. There are portions of the book that I must confess are not easy reading, but I have tried as much as I can to provide an intuitive rationale for everything that I do. Technology firms, notwithstanding the back and forth of markets, are here to stay, and valuing them is something we all need to grapple with. I hope you find this book useful in that endeavor.


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