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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

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valuation bridging the gap between academics and industry practice

Valuation: Bridging the Gap Between Academics and Industry Practice

Sheridan Titman

Financial Management Association

October 2005

  • 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
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
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
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
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
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
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)?
  • 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
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
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
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 influencecosts:
      • 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 continued13
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 continued14
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 continued15
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 continued16
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 continued17
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?