Papers and Research
Papers and Research
This site will carry some recent papers that I have written (or co-written) that you can download in pdf form. Most of these papers are applied papers, relating to estimation issues that we commonly face in corporate finance, portfolio managment and valuation. Your comments are always welcome.
Paper Listing (Click on the paper to see a short abstract. You can download the paper as a pdf file)
| The Equity Risk Premium | The equity risk premium (ERP) is a central input into discounted cash flow models, and more than any other number, it captures what investors think about stock prices in the aggregate. In this paper, we examiine the determinants of equity risk premiums and the three basic approaches used to estimate the number - surveys, historical returns and implied values. We look at why the approaches give you different answers and how to pick the right number to use in analysis. | The Equity Risk Premium (ERP): Determinants, Estimation and Implications |
| Valuing Multiple Claims on Equity | Equity claims can vary on a number of different dimensions - voting rights (control), liquidity and cash flows. We examine how to allocate the value of equity across multiple claims on equity in this paper. In the process, we examine the premium that should be paid for voting shares, the discount to be applied to illiqudid shares and the effect of contingent claims. | Valuing Equity Claims |
| Measuring Returns: ROE, ROC and ROIC | The value of a firm ultimately depends on its capacity to earn returns on its investment that exceed its cost of funding those investments. Accounting measures of returns, primarily return on equity and capital, are significnant determinants of value. In this paper, we examine the motivation behind the focus on returns and how best to clean up accounting numbers to estimate and forecasts returns. | Measuring Returns |
| A Survey Paper on Valuation | People have been valuing businesses for as long as businesses have been around. We examine how valuation techniques have evolved over time and the common foundatation that different approaches share. | Survey paper on Valuation (Download paper) |
| Simulations, Decision Trees and Scenario Analysis: Probabilistic Approaches to Risk | With the advent of simulation software (like Crystal Ball and @Risk), a full-fledged simulation or scenrio analysis is well within the grasp of any analyst valuing a company or analyzing a project. However, what rold should simulations and scenario analysis play in valuation? And what is the relationship between these analysis and traditional expected value calculations (where we adjust for risk in the discount rate)? | Probabilistic Approaches to Risk (Download paper) |
| Value at Risk (VaR) | Value at Risk has acquired a cache, especially among financial service firms, as a new and sophisticated way of analyzing risk. We look at the basis for VaR, its pluses and minuses. | Value at Risk (VaR) (Download paper) |
| To Hedge or Not to Hedge? That is the question.. | Investors and businesses have more options and opportunities than ever before to hedge risk. But should firms hedge risk? What is the payoff to doing so? If a business or investor chooses to hedge risk, what is the best way to hedge risk (derivatives or insurance, for instance)? | To hedge or not to hedge? (Download paper) |
| Exploiting Risk: A Strategic View of Risk Management | Firms become successful, not by avoiding risk, but by seeking it out. Developing a template for deciding which risks to exploit is key to success. In this paper, we examine the potential competitive advantages that a firm can exploit to advantage. | Strategic Risk Taking (Download paper) |
| The Value of Intangibles | Intangibles are a large and growing part of many company's assets. Starting with the presumption that current accounting standards do not do a good job of assessing their value, we look at whether intangible assets can be reasonably valued, and if so, the best ways of accomplishing this task. We categorize intangible assets into three groups - independent, cash generating intangibles (like trademarks and franchises) that can be valued with conventional DCF models, composite intangibles that affect the sales of many products and not just cash flows (such as brand name) that are more difficult to isolate and value and intangibles with the potential to generate cash flows in the future that are best valued using option pricing models. | The Value of Intangibles(Download paper) brandnamevalue.xls: Spreadsheet for valuing brand name |
| Marketability and Value: The Illiquidity Discount | Investors prefer more liquid assets to otherwise similar illiquid assets, but how much at they willing to pay for liquidity? In this paper, we beign by examining our definition fo liqhidity and the empirical evideence on how much markets value liquidity. We consider the empirical evidence on the consequences of illiquidity for equity, fixed income and private equity markets and how best to inrorporate illiquidity into estimated value. Finally, we consider practical ways of estimating the illiquidity premium for illiquid companies (and ssets). | The Value Of Liquidity(Download paper) liqdisc.xls: Spreadsheet to value liquidity |
| The Value of Cash, Cross Holdings and Other Non-operating Assets | Most businesses carry cash on their balance sheets, though the motives for holding cash vary widely across firms. Some of the cash is held to cover operating needs (transactions), some to cover contingencies (precautionary motive) and some reflects managerial incentives. We consider how best to value cash in both discounted cash flow and relative valuations, and consider the net debt and gross debt approaches in valuation. We also examine how to incorporate the value of cross holdings, both majority and minority, into business valuations. | The Value of Cash and Cross Holdings (Download paper) GrossvsNet.xls: Resolving the differences between gross and net debt approaches |
| The Value of Control | How much is control worth? The answer to that question affects how much the control premium should be in acquisitions, how much of a premium voting shares should trade at and the discount that should be applied to minority stakes in private companies. This paper looks at how best to measure the value of control and how this can be useful in answering a variety of valuation questions. | The Value of Control (Download paper) controlvalue.xls: Spreadsheet to value control |
| Employee Stock Options, Restricted Stock and Value | Companies use employee stock options (ESOPs) and restricted stock issues to compensate employees. In this paper, we examine why their usage has increased over the last two decades and how best to deal with the option overhang in valuation. We also look at ways of incorporating future option grants into value per share today. | ESOPs, Restricted Stock and Value (Download paper) |
| The Value of Synergy | Often promised, seldom delivered is the best description for synergy, the most widely used rationale in corporate mergers. In this paper, we explore how synergy is created and how to value it. We also examine why companies miscalculate so often when it comes to synergy. | The Value of Synergy (Download paper) synergyvaluation.xls: Spreadsheet to value synergy |
| 25 Questions on DCF valuation | Every valuation analyst has faced one or more of these questions in real world valuations and has had to come up with an answer. These are my very opinionated (and not necessarily correct) answers to the 25 top questions that we face in DCF valuation. Take it for a spin! | Valuation Questions |
| Value and Risk | We take far too narrow a view of risk in finance. When we talk about risk management, we often only talk about risk hedging and when we estimate value, the discount rate is the only place where we reflect risk. In reality, risk is both a threat and an opportunity and successful firms not only protect themselves against some types of risk but actively exploit other types of risk to establish competitive advantages. In this paper, we present a way of considering risk management in this broader sense and consider ways in which we can bring risk into the other components of value. We also consider what types of firms are most likely to benefit from risk hedging and from risk management. | |
| Measuring Company Risk Exposure to Country Risk | It is common practice in valuation to assume that companies within an emerging market are all equally exposed to country risk and that companies that are incorporated and trade in developed markets like the United States are immune from it. This is clearly at odds with common sense, since companies within an emerging market can be exposed to different degrees to country risk and multinationals like Coca Cola and Nestle can be exposed to significant emerging market risk. In this paper, we propose a measure of company exposure to country risk called lambda and suggest ways in which we can estimate lambda. | |
| Dividends and Taxes | In January 2003, President Bush proposed that dividends be tax exempt to investors. While the ultimate shape of the tax reform is not clear, changing the tax rate on dividends can have significant effects on both equity values and on the corporate finance decisions - investment, capital structure and dividend policy- of companies.In this paper, I estimate the effect of making dividends tax exempt on the overall value of equity in the market (13-14%) and argue that there will be profound changes in the use of debt and stock buybacks, with both declining. | |
| Information Transparency and Value: Can you value what you can’t see? | It is clear that some firms are more forthcoming about their financial affairs than other firms, and that the financial statements of some firms are designed to obscure rather than reveal information about the firms. No matter how strict accounting standards are, firms will continue to use their discretionary power to spin and manipulate the news that they convey to financial markets. The questions we face in valuation are significant ones. How do we reflect the transparency (or the opacity) of a firm’s financial statements in its value? Should we reward firms that have simpler and more open financial statements and punish firms that have complex and difficult-to-understand financial statements? If so, which input in valuation should be the one that we adjust? | |
| 'Valuing Distressed Firms | Traditional valuation techniques- both DCF and relative – short change the effects of financial distress on value. In most valuations, we ignore distress entirely in valuation and make implicit assumptions about the consequences of a firm being unable to meet its financial obligations and these assumptions often are unrealistic. Even those valuations that purport to consider the effect of distress do so incompletely. In this paper, we begin by considering how distress can be explicitly considered in both discounted cashflow and relative valuation models. |
Download Global Crossing valuation distress.xls (estimate the likelihood of default from bond price) |
| The Dark Side of Valuation | Valuing a firm is difficult when it has negative earnings, a limited history or few comparables. When all three of these components come together, as is the case with many young start-up firms (Did someone say internet firms?), analysts all too often either assume that they cannot be valued or that new valuation models have to be devised. In this paper, we make an argument that these firms can be valued, albeit with noise, and use Amazon.com as a case study to illustrate the principles involved. | Download paper (pdf) |
| Real Option Applications in Corporate Finance and Valuation | Are there options embedded in investment decisions? Undoubtedly. There are also options in financing and valuation. The real question is whether these options have value, and how much they are worth. In this paper, I examine the whole range of real option applications, from the options to expand, delay and abandon in investment options to the option to liquidate in the equity of the firm. I also look at potential applications of real options in R&D and valuing undeveloped natural resources, and suggest that real options need to pass a three-part test to have value. | Download pdf file |
| Valuing Private firms | The fundamentals that determine value for private firms as the same as those that determine publicly traded companies, but there are three critical issues. The first relates to the scarcity of information about private firms. The second issue is that of illiquidity and how it affects value. The final issue is the question of control and whether there should be a premium for control or a discount for the lack of it. | Download pdf file |
| Valuing Financial Service Firms | Financial service firms - banks, insurance companies and investment banks - are often difficult to value because cash flows cannot be easily estimated. In this paper (which is a chapter in the second edition of my valuation book), I look at the questions involved in valuing financial service firms. | Download pdf file |
| Valuing Acquisitions | This paper (which is a chapter from my corporate finance book) looks at how best to deal with the valuation of control and synergy in acquistions and related issues. | Download paper (pdf) |
| Valuation Multiples: First Principles | This paper (which is a chapter from my investment valuation book) looks at the first principles that we need to follow when using multiples | Download paper (pdf) |
| Estimating Riskfree Rates | The riskfree rate is a fundamental input to most risk and return models. In practice, estimating riskfree rates becomes difficult when there are no default-free securities. In addition, the question of what riskfree rate to use (short term or long term, dollar or foreign currency) is a critical one. This paper examines these issues. | Download pdf file |
| Estimating Risk Parameters | The beta or betas in risk and return models measure an asset's relative risk. We look at the limitations of standard approaches to beta estimation (such as regressions) and consider alternative approaches. | Download pdf file |
| Dealing with Operating Leases | Many firms lease the assets that they use. If the leases qualify as operating leases, they affect operating income and do not show up as part of capital. In this paper, we argue that this can distort measures of profitability and can affect the valuation of firms with substantial operating leases, and suggest ways in which we can correct earnings and cash flow measures. |
oplease.xls: Convert operating leases from operating to financial expenses |
| Dealing with R& D Expenses | Accounting standards in the United States and in much of the rest of the world require that R&D be expensed. Since these are expenses that are designed to generate future growth, it is much more logical to treat them as capital expenditures. In this paper, we explore ways in which R&D expenses can be capitalized and the implications for earnings, cash flows, valuations and multiples. |
R&Dconv.xls: Convert R&D from operating to capital expense |
| Financing Innovations | The last two decades have seen a stream of innovation in financial markets, especially in the corporate bond arena. Some of these innovations were designed to give firms more flexibility in designing cash flows on borrowings, allowing them to match up cash flows on financing more closely to cash flows on assets, thus increasing their debt capacity. Some firms are issuing these new and more complex securities for the wrong reasons - to keep up with other firms in their peer group, and to take advantage of loopholes in the way ratings agencies and regulatory agencies define debt and equity. In this paper, we take a big picture view of financing innovations, and some of the good and bad reasons for innovations. | Download pdf file |
| Beyond Dividends | This is a chapter from the second edition of my corporate finance book on spin offs, divestitures, equity carve outs and tracking stock. It is not path-breaking, by any stretch of the imagination, but it provides a comparison of the different actions, and why a firm may choose one over the other. | Download pdf file |
| Value Enhancement: Back to Basics | Value enhancement has become a hot topic of late. This paper examines the fundamentals of value creation and enhancement, from a valuation framework, and then considers the merits of EVA and CFROI as value enhancement devices. | Download pdf file |