Valuing IT InvestmentsValuing IT Investments

Ken PeffersUNLV

October 2004

Ken PeffersUNLV

October 2004

What’s different about IT Investments?

What’s different about IT Investments?

• Aren’t they just capital goods investments?• Value of knowledge

– Relationship of information and information processing to knowledge

– Intelligence scaling

• Technology acceleration – Transforming business processes– Transforming products– Transforming the industry– Moore’s Law

• Aren’t they just capital goods investments?• Value of knowledge

– Relationship of information and information processing to knowledge

– Intelligence scaling

• Technology acceleration – Transforming business processes– Transforming products– Transforming the industry– Moore’s Law

Furthermore…Furthermore…

• Geographic Scaling– Internet used for sales– Network externalities

• Organizational Scaling– Flat organizations– Little vertical integration– Increasing product diversity– Integration across the value chain

• Geographic Scaling– Internet used for sales– Network externalities

• Organizational Scaling– Flat organizations– Little vertical integration– Increasing product diversity– Integration across the value chain

Financial Accounting for Knowledge Assets

Financial Accounting for Knowledge Assets

• Accounting rules prevent capture of value– Use of historic costs– Arbitrary cost allocation rules– The conservatism principle leads to

undervaluation of assets– Development of product costs

• Purpose of accounting to create financial statements

• Accounting rules prevent capture of value– Use of historic costs– Arbitrary cost allocation rules– The conservatism principle leads to

undervaluation of assets– Development of product costs

• Purpose of accounting to create financial statements

Knowledge Capital—Baruch Lev

Knowledge Capital—Baruch Lev

• Expected earnings minus expected income from tangible assets = knowledge based earnings

• Assets poor predictor of earnings

• Other factors that account for earnings variation?

• Expected earnings minus expected income from tangible assets = knowledge based earnings

• Assets poor predictor of earnings

• Other factors that account for earnings variation?

Value maximization

• Managers objective to maximize firm value

• Value of the firm equals discounted value of all future cash flows

Discounted Cash Flow (DCF)

where,NPV = Net Present ValueC = Investment at the start of the projectAt = Cash flow at tT = Project lifer = Risk-based discount rate for the project

Firm Value Maximization

where,PV = Present Market ValueAt = Cash flow at tT = Firm lifer = Industry required rate of return

Contribution of NPV

• Objective

• Congruence with value maximization

• Better than undiscounted cash flow, simple payback, ROI

Limitations

• Estimates of revenues and costs– manipulated to justify projects already selected

• Biased toward prior opinions• Applied in the face of flawed incentive systems• Assume accurate estimates of future cash flows• Estimations of project risk• Second stage projects• Terminal value

More issues with DCFMore issues with DCF

• Cash flows not reported in financial statements

• Use of linear extrapolations • Provides point estimates; no variance• Betas needed to calculate the discount rate,

but not available• Short operating history for knowledge based

firms

• Cash flows not reported in financial statements

• Use of linear extrapolations • Provides point estimates; no variance• Betas needed to calculate the discount rate,

but not available• Short operating history for knowledge based

firms

The Comparable Valuation Approach

The Comparable Valuation Approach

• Valuing a firm based on the value of similar firms, in terms of risk, growth rate, capital structure and the size and timing of cash flows

• Valuing a firm based on the value of similar firms, in terms of risk, growth rate, capital structure and the size and timing of cash flows

Appropriate Appropriate

• When business model for the firm is well specified

• Highly comparable group of firms exists

• When business model for the firm is well specified

• Highly comparable group of firms exists

WeaknessesWeaknesses

• Need to choose comparable firms

• Need to ascertain value of other firms

• Not valid if the entire sector is over or undervalued

• Need to choose comparable firms

• Need to ascertain value of other firms

• Not valid if the entire sector is over or undervalued

The approachThe approach

• Determine that some parameter among the comparable firms drives value, e.g., the price earnings ratio.

• The firm can be valued at the average P/E for the group of the comparable firms

• Common measures include P/E, market to book ratio, price/revenue ratio

• Determine that some parameter among the comparable firms drives value, e.g., the price earnings ratio.

• The firm can be valued at the average P/E for the group of the comparable firms

• Common measures include P/E, market to book ratio, price/revenue ratio

The Venture Capitalist Approach

The Venture Capitalist Approach

• Assume that all of the value of the asset comes from the terminal value

• Justification: VCs typically expect a series of losses leading to an IPO, where they’ll cash out

• Assume that all of the value of the asset comes from the terminal value

• Justification: VCs typically expect a series of losses leading to an IPO, where they’ll cash out

The VC approachThe VC approach

75%-40 typicallyreturn, of rate target theis

IPO theuntil years ofnumber theis

multiple ingsprice/earn expected theis

earnings IPO theis

where

)1(

*

r

t

m

r

mvalue

t

The VC approachThe VC approach

• Prices out high risks for new firms

• Compensates for illiquidity

• Compensates for exaggerated expectations by entrepreneurs

• Prices out high risks for new firms

• Compensates for illiquidity

• Compensates for exaggerated expectations by entrepreneurs

Valuation in PartsValuation in Parts

• Calculate value of various parts of the firm separately, e.g., financing and operations, and add them together

• Calculate value of various parts of the firm separately, e.g., financing and operations, and add them together

Options PricingOptions Pricing

• Value of an IT investment is, in part, based on option to make further investments later

• Right, but not obligation, to make the later investments is similar to an American call option. An American call option confers the right, but not obligation, to purchase a security at a given strike price within a specified time period

• Value of an IT investment is, in part, based on option to make further investments later

• Right, but not obligation, to make the later investments is similar to an American call option. An American call option confers the right, but not obligation, to purchase a security at a given strike price within a specified time period

Raison D'etreRaison D'etre

• Expected value of a future investment can have a negative value

• DCF method uses discounted expected value• Option to make such an investment can never

have a negative value• Useful when the investment decision can be

deferred

• Expected value of a future investment can have a negative value

• DCF method uses discounted expected value• Option to make such an investment can never

have a negative value• Useful when the investment decision can be

deferred

Value of Managerial Flexibility

• DCF method assumes 2nd stage projects are undertaken

• Actually won’t be undertaken if value less than 0 at time of investment decision

Value of Managerial Flexibility Example

Value of Managerial Flexibility Example

• The value of a $1.00 investment today will generate either $0.80, $1.10, or $2.00 with equal probability after one year.

• The expected value is ($0.80 + $1.10 + $2.00)/3 - $1.00 = $0.30

• But if the manager can wait until next year to determine whether the cash flow could be $0.80, then next year the expected value will be either $0.30 or $0.55 ($1.10 + $2.00)/2 - $1.00 = $0.55

• The value of the real option to delay the decision is $0.25

• The value of a $1.00 investment today will generate either $0.80, $1.10, or $2.00 with equal probability after one year.

• The expected value is ($0.80 + $1.10 + $2.00)/3 - $1.00 = $0.30

• But if the manager can wait until next year to determine whether the cash flow could be $0.80, then next year the expected value will be either $0.30 or $0.55 ($1.10 + $2.00)/2 - $1.00 = $0.55

• The value of the real option to delay the decision is $0.25

The Value of an Option

• In making an initial investment in IT the manager is purchasing an option to make a subsequent investment later if the value of the second stage project is positive

• Of course real problems don’t present themselves with such simple configurations

Exchange one risky asset for another risky asset

Exchange one risky asset for another risky asset

functiondist prob std ecummulativ =N

costst developmen expected luecurrent va

benefits expected luecurrent va

where

)()(

1

1

2111

C

B

dNCdNBVopt

Dos Santos B.L., "Justifying Investments in New Information Technologies," Journal of Management Information Systems, Vol. 7, No. 4, Spring 1991, 71-89.

Options method cont.Options method cont.

exercised bemust option thebefore timeoflength

project stage 2ndfor revenue & costs dev ofn correlatio

revenuein changes of rate of variance

costst developmenin changes of rate of variance

2

2/)/ln(

12

12

12

12

12

122

12

2

111

t

tdd

ttCBd

BC

C

B

BCCBCB

Estimating the modelEstimating the model

• Necessary to estimate B1, C1, var B1, var C1, corr BC

• Estimating variation. Intuitively: “there is approximately a 2/3 probability that the revenues (costs) will vary up or down by no more than X%)”

• Estimating the corr BC. Intuitively: “approximately X% of the variation in revenues is attributable to variations in the development costs. The remainder is attributable to other factors. The corr BC is the squareroot of X.”

• Necessary to estimate B1, C1, var B1, var C1, corr BC

• Estimating variation. Intuitively: “there is approximately a 2/3 probability that the revenues (costs) will vary up or down by no more than X%)”

• Estimating the corr BC. Intuitively: “approximately X% of the variation in revenues is attributable to variations in the development costs. The remainder is attributable to other factors. The corr BC is the squareroot of X.”

AdvantagesAdvantages

• Provides a value for the option, even though the option cannot be traded

• Provides a value for the option, even though the option cannot be traded

LimitationsLimitations

• Credibility of the option value in the organizational decision making process

• Some managers might think that the value of the option cannot be well quantified

• Credibility of the option value in the organizational decision making process

• Some managers might think that the value of the option cannot be well quantified

Residual IncomeResidual Income

• Similar concepts: abnormal earnings, economic earnings

• Earnings beyond the required rate of equity investment returns for the industry

• Used by General Motors in the 1920s to evaluate investments

• Concept: a firm creates value only if return on capital is greater than cost of capital

• Similar concepts: abnormal earnings, economic earnings

• Earnings beyond the required rate of equity investment returns for the industry

• Used by General Motors in the 1920s to evaluate investments

• Concept: a firm creates value only if return on capital is greater than cost of capital

Residual IncomeResidual Income

book value period of beginning the

periodin capitalequity ofcost the

periodfor incomenet accounting al tradition the

periodfor income residual the

where

][

1

1

t

t

t

t

tttt

tCE

tI

t

CEI

Residual Income Present Value

Residual Income Present Value

book value period of beginning the

periodin capitalequity ofcost the

periodfor incomenet accounting al tradition the

periodfor income residual the

income residual of value the

][

where

)1(

1

1

01

t

t

t

t

RI

tttt

t t

tRI

tCE

tI

t

V

CEI

CEV

AdvantagesAdvantages

• Similarity to DCF

• Uses accounting earnings—easily obtained for ongoing business, not too easy for speculative investments

• Similarity to DCF

• Uses accounting earnings—easily obtained for ongoing business, not too easy for speculative investments

Predictive Value of Measures

Predictive Value of Measures

• As a predictor of stock value– GAAP earning: 12.8%– Residual income: 7.3%– Cash flow: 2.8%

• As a predictor of stock value– GAAP earning: 12.8%– Residual income: 7.3%– Cash flow: 2.8%

Economic Value AddedEconomic Value Added

• Variation on residual income promoted by consultant Stern Steward

• Adjustments (about 150) to correct perceived deficiencies caused by use of accounting income

• Variation on residual income promoted by consultant Stern Steward

• Adjustments (about 150) to correct perceived deficiencies caused by use of accounting income

Might We Infer…Might We Infer…

…that we have a long way to go before we have adequate methods to evaluate IT investments?

…that we have a long way to go before we have adequate methods to evaluate IT investments?