CONTENTS PREFACE xv ACKNOWLEDGMENTS xix 1 THE DARK SIDE OF VALUATION 1 DEFINITION OF A TECHNOLOGY FIRM2 THE SHIFT TD TECHNOLOGY3 OLD TECH TO NEW TECH6 EXTENSION OF THE VALUATION METRICS7 THE IMPLICATIONS FOR VALUATION9 NEW PARADIGMS DR OLD PRINCIPLES: A LIFE CYCLE PERSPECTIVE11 ILLUSTRATIVE EXAMPLES 16 SUMMARY 17 ENDNOTES 17 2 SHOW ME THE MONEY: THE FUNDAMENTALS or DISCOUNTED CASH FLOW VALUATION 19 DISCOUNTED CASH FLOW VALUE 20 VALUING AN ASSET WITH GUARANTEED CASH FLOWS21 INTRODUCING UNCERTAINTY INTO VALUATION22 Valuing an Asset with Default Risk 23 Valuing an Asset with Equity Risk 26 Valuing an Asset with Equity Risk and finite Life 28 VALUING AN ASSET WITH AN INFINITE LIFE29 Equity and Firm Valuation 29 Dividends and Equity Valuation 32 A Broader Measure of Cash Elows to Equity 37 From Valuing Equity to Valuing the Firm 40 VALUING TECHNOLOGY STOCKS43 Estimated Cash Flow to the Firm 44 Expected Growth 45 Discount Rate 46 Asset Life 47 Bringing It All Together 48 SUMMARY SO ENDNOTES5O 3 THE PRICE OF RISK: ESTIMATING DISCOUNT RATES53 COST OF EQUITY54 Risk and Return Models 54 Estimation Issues 58 FROM COST OF EQUITY TD COST OF CAPITAL87 Calculating the Cost of Debt 88 Calculating the Cost of Hybrid Securities 92 Calculating the Weights of Debt and Equity Components 94 Estimating the Cost of Capital 99 SUMMARY 100 ENDNOTES101 4 CASH is KING: ESTIMATING CASH FLOWS 105 DEFINING THE CASH FLOW TD THE FIRM IDS OPERATING EARNINGS (EBIT) 106 Updated Earnings 107 Adjustments to Operating Earnings109 THE TAX EFFECT125 Effective versus Marginal Tax Rate125 The Effect of Net Operating Losses127 The Tax Benefits of R&D Expensing 129 REINVESTMENT NEEDS 13O Net Capital Expenditures 130 Noncash Working Capital Investments 133 SUMMARY 134 ENDNOTES 138 5 LOOKING FORWARD: ESTIMATING GROWTH 141 THE IMPORTANCE OF GROWTH 142 Growth Assets and Assets in Place143 Growth Assets at Technology Firms 145 Estimating Historical Growth145 The Usefulness of Historical Growth149 Historical Growth at Technology Firms153 ANALYST ESTIMATES OF GROWTH155 Number of Analysts Following Technology Firms155 The Quality of Earnings Forecasts156 THE FUNDAMENTAL DETERMINANTS OF GROWTH 159 Scenario: Stable Return on Capital159 Scenario: Positive and Changing Return on Capital165 Scenario: Negative Return on Capital167 THE QUALITATIVE ASPECTS OF GROWTH 17S THE QUESTION OF DETAIL180 SUMMARY 181 ENDNOTES 181 6 ESTIMATING FIRM VALUE 183 CLOSURE IN VALUATION 184 Multiple Approach 184 Liquidation Value 185 Stable Growth Model 186 VALUING OPERATING ASSETS 197 THE SURVIVAL ISSUE2DB Life Cycle and Firm Survival208 Likelihood of Failure and Valuation 209 CASH AND NONOPERATING ASSETS 2 ID Cash and Marketable Securities 211 Holdings in Other Firms 213 Other Nonoperating Assets216 FIRM VALUE AND EQUITY VALUE219 SUMMARY221 ENDNOTEB221 7 MANAGEMENT OPTIONS, CONTROL, AND LIQUIDITY225 MANAGEMENT AND EMPLOYEE OPTIONS 226 The Magnitude of the Option Overhang 226 Options in Existence 229 Future Option Grants239 VALUE ar CONTROL243 Voting Shares versus Nonvoting Shares243 Valuing Control244 Control in Private Businesses245 VALUE OF LIQUIDITY245 Determinants of Illiquidity Discount 245 Quantifying the Liquidity Discount 246 Liquidity Discounts at Publicly Traded Firms 247 SUMMARY 24B ENDNOTES 249 8 RELATIVE VALUATION251 USE ar RELATIVE VALUATION252 Reasons for Popularity252 Potential Pitfalls 253 STANDARDIZED VALUES AND MULTIPLES253 Earnings Multiples 253 Book Value or Replacement Value Multiples 254 Revenue Multiples 254 Sector-Specific Multiples 255 THE FOUR BASIC STEPS TO USING MULTIPLES256 Definitional Tests256 Descriptional Tests 259 Analytical Tests 262 Application Tests 265 RECONCILING RELATIVE AND DISCOUNTED CASH FLOW VALUATIONS271 SUMMARY272 ENDNOTES273 9 EARNINGS MULTIPLES275 PRICE-EARNINGS RATIO (PE)275 Definitions of PE Ratio276 Cross-Sectional Distribution of PE Ratios 277 Determinants of the PE Ratio282 Using the PE Ratio for Comparisons 289 THE PEG RATIO297 Definition of the PEG Ratio 297 Cross-Sectional Distribution of the PEG Ratio 299 Determinants of the PEG Ratio 303 Using the PEG Ratio for Comparisons 307 OTHER EARNINGS MULTIPLES313 Price to Future Earnings 313 Price to Earnings Before R&D Expenses 315 Enterprise Value to EBITDA 316 SUMMARY317 ENONOTES3 IB 10 OTHER MULTIPLES319 REVENUE MULTIPLES320 Definition of Revenue Multiple 320 Cross-Sectional Distribution321 Analysis of Revenue Multiples 324 Using Revenue Multiples in Analysis 333 Multiples of Future Revenues 343 SECTOR-SPECIFIC MULTIPLES344 Definitions of Sector-Specific Multiples 345 Determinants of Value 346 Analysis with Sector-Specific Multiples 350 SUMMARY 351 ENDNDTES 352 11 REAL OPTIONS IN VALUATION353 BASICS OF OPTION PRICING354 Call Options: Description ond Payoff Diagrams 354 Put Options: Description ond Payoff Diagrams 356 DETERMINANTS OF OPTION VALUE357 American versus European Options: Variables Relating to Early Exercise 359 Option Pricing Models 359 A Few Caveats on Applying Option Pricing Models 372 Barrier, Compound, ond Rainbow Options 373 THE OPTION TO DELAY376 The Payoff Diagram on the Option to Delay 376 Valuing the Option to Delay 378 Practical Considerations 382 Implications for Project Analysis ond Valuation383 Valuing o Patent 384 From Patent Value to Firm Value 387 THE OPTION TO EXPAND391 Practical Considerations 393 Implications for Valuation394 WHEN ARE REAL OPTIONS VALUABLE? SOME KEY TESTS397 Quantitative Estimation 397 Key Tests 397 SUMMARY400 ENDNOTES401 12 VALUE ENHANCEMENT403 VALUE CREATION: A DISCOUNTED CASH FLOW (DCF) PERSPECTIVE4O4 Value-Creating and Value-Neutral Actions 404 Ways of Increasing Value 406 The Value Enhancement Chain 432 ALTERNATIVES TO THE TRADITIONAL VALUATION MODEL434 Economic Value Added 435 Cash Flow Return on Investment 442 SUMMARY449 ENDNOTES451 13 A POSTSCRIPT 453 FUNDAMENTALS DON'T CHANGE454 Cash Flow, Growth, and Risk454 Lessons for Investors455 Lessons for Managers 455 GROW, GROW, GROW..456 Growth and Value456 Lessons for Investors457 Lessons for Managers458 THE EXPECTATIONS GAME459 Expectations, Information, and Value459 Lessons for Investors460 Lessons for Managers 461 LIVE WITH NOISE462 Noise in the Valuation of Technology firms 462 Implications for Investors463 Implications for Managers464 SUMMARY465 ENDNOTES465 REFERENCES 467 INDEX473