Introduction to Valuation: Methods and Models in Applied Corporate Finance
Every day, businesses face decision choices. For example, should a bank choose to expand organically by opening new branches, or should it expand by acquiring another bank with its own network of branches. Or, should a technology company release a new version of a product line now, and thereby cannibalize sales of its existing product line, or should it wait a year at the risk of giving its competitors time to catch up. The key to success in business is to make sound, or value-creating, business decisions. Every choice a business manager can potentially make has risk associated with it.1 In turn, every choice also has some upside, or positive return, associated with it. A sound decision is one that balances this risk and return to create value for the owners of the business, whether those are public shareholders or a private ownership group.2 However, to make value-creating business decisions, a manager needs to be able to first quantify, or measure, the risk and return inherent in each of the decision choices he is facing, and then convert these risk-return combinations into ex-ante measures of value creation. This is where the topic of valuation comes into play. Valuation is simply the conversion of risk and return into monetary value. The value could be of intangible assets like ideas or potential projects, or it could be of tangible assets like a manufacturing plant or the shares of a business. The common theme underlying valuation, however, is that it allows managers to make better business decisions by quantifying into a single metric the risk and return inherent in all business decision choices.
Every decision that a business faces can be conceptualized as a node on a decision tree, as shown in Figure 1.1. A manager facing a decision is trying to decide which of multiple paths emanating from this node he wants to take for the business. The figure illustrates the example of a manager deciding whether to build a manufacturing plant. The two possible paths are to build the plant or to not build the plant. Once the initial decision to build or not build is made, the decision tree branches off again into the capacity of the plant and again to the number of assembly lines. Each of the branches represents a set of possible outcomes that could occur. The role of valuation, then, is to quantify the value created (or destroyed) by deciding to head down a specific path. For example, the value created by building a plant with a 100,000 unit capacity containing one large assembly line would need to be quantified, as would the value created by not building a plant at all.
Figure 1.1 Decision tree for building a manufacturing plant
Note, however, that this path is only a decision path; it is not an outcome path. While a manager may decide to take a particular path, the result from taking the path is uncertain, and it might take many years before it becomes a known quantity. A more quantitative way to state this is that there is a probability distribution of possible results from the decision to take a path. Therefore, the process of valuation must take into account this probability distribution of outcomes (or risk) involved in taking a specific path.