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Wednesday, March 25, 2015

Valuation Steps

Product managers, corporate risk assessors, project managers, project financiers and many other types of business analysts often need to value uncertainty in their business strategies. In this small blog posting we take a look at the steps that would generally be followed for a typical sound valuation of 'corporate risk'.

Valuation Steps
There are many different and well accepted 'industry standard' models that might be used by analysts to value the risk in a new venture and from the outset; we need to accept that each model paints a slightly different picture of corporate uncertainty because it prices this risk from alternate perspectives.  No single model is going to be perfect, all models have constraints or limitations and it follows that there is going to be no one set price or valuation of strategic risk. A solid valuation activity should be evaluating many potential outcomes from different types of uncertainty or business scenarios the asset under investigation may suffer from.

The schematic below shows the typical steps that would be followed in a valuation exercise to derive a price or cost of uncertainty. This is all beyond the simple process of viewing the Net Present Value of a potential future cash flow or even better, the Expected Net Present Value of weighted scenarios in a business model.  

A strong modelling approach would normally begin with the default business scenario that constructs a cash flow, often resulting in the creation of a single Earnings Before Interest and Taxes line that will eventually be represented in a Discounted Cash Flow spread sheet. It is here, right at step one when business assumptions are expressed and simulated where most model error is found.

Assuming the business assumptions and the way in which they have been used to generate an EBIT cash line is logically sane, there are several other critical areas of the overall valuation exercise that are worthy of prudent oversight.

Part 3 & 4 Risk Premiums and WACC
Identifying the cost to finance the objective, taking in the risk premiums for the type of business strategy being explored is a very important analytic exercise to progress through. All too often I see analysts pluck weighted average cost metrics out of thin air and this really is unacceptable in my opinion.  There is a streamlined and separate process for identifying risk premiums on relative projects that should be followed through with and don't misunderstand me; the methodology of relative valuation is a minefield full of traps. All this aside, that doesn't mean to say the relative valuation activity should be abandoned for the simple fact that it is problematic. I will write a separate blog article on this unique effort at another time because it needs its own explanation.  

Part 5 Risk Free Rates
Along with calculating suitable risk premiums for a project valuation is the process of identifying the appropriate Risk Free Rate from the outset. Analysts often select a risk free rate that is not inline with a project's tenor or designed from instruments that aren't a good representative of a risk free rate.

Generating a Yield Curve with the Nelson-Siegel-Svensson Method | Mithril Money
My favorite method for solving the Risk Free Rate issue on a corporate or project valuation is to use a Nelson-Seigel-Svensson model and the video above walks through the process in a wonderfully easy to follow manner.

Part 7 Pricing in Contingency
The final part of the risk valuation journey is the process of pricing in contingency.  If projects use vanilla financing methods or when they run as they are anticipated, the Discounted Cash Flow model should perform as it has been designed but that is a fantasy in the real world. Projects that run over schedule, require additional funding or are valued at break points throughout the project development life-cycle, need to price in these contingent or contractual breaks. Again this is a massive area of financial valuation that deserves its own topic space and in time we will publish more articles on Real Options Valuation.

So there we have it, our ten steps of project valuation and in time we'll release some example case studies on this blog to explore how risk premiums can be evaluated.

1 comment:

  1. A simply way to think about risk when using a DCF Model is to determine a downside scenario and figuring out what needs to happen in order to have such scenario.