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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 l.jpg

Valuation: Bridging the Gap Between Academics and Industry Practice

Sheridan Titman

Financial Management Association

October 2005


Valuation l.jpg
Valuation Practice

  • 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


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The Lack of Research on Valuation Practice

  • 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?


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Differences in the classroom and practice Practice

  • Valuing flexibility (real options)

  • Discount rates

    • Multiple versus single

    • Discount rates that are “too high”

  • The importance of accounting/earnings


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Why Do the Differences Exist? Practice

  • 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


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Example #1: “Inflexible” Discount Rates Practice

  • 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


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Example #2: Evaluating Projects in Emerging Markets Practice

  • 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%


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Example #2.1: Evaluating Private Equity Deals Practice

  • 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)?


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Explanations Practice

  • 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


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But are these really explanations? Practice

  • 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?


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Research Agenda: Understanding the Valuation Process Practice

  • 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?


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Research Agenda (continued) Practice

  • 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


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Research Agenda (continued) Practice

  • 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


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Research Agenda (continued) Practice

  • 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


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Research Agenda (continued) Practice

  • 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?


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Research Agenda (continued) Practice

  • 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


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Research Agenda (continued) Practice

  • 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?