Class 3 - Valuation continued Flashcards
Describe real options and game theory in the context of VC investments
VCs utilise pas littéralement des real options mais cest la meme facon,
decision tree qui te permet de reajust your decision et les probs que ce soit successful
you decide wether you stay or not. you dont put litteraly a number but intuitively you do it because you invest in stages.
you also use the intuitive assessment of the option : you like the volatility. if the vol is high the value of the option is high
in the money and out of the money concept : VC you can buy in the money the investments you make.with the negociations you can can buy it at a value lower than what you calculated
VCs are a series of sequential investment. i have some information that tells me i may be successful, with the new information you can make better decisions
you never make an investment with full information : si ce letait, le discount rate serait le risk free!
the way to catch the value of the new information is to allow yourself to exercice the option once you have new information.
however, the assumptions of the models to value the real options are not valid : arbitrage is possible, not liquid etc
in real options you however dont need to be that precise, you just have to be right about the overall magnitude : if its a big number you invest or not
what are the 2 vc methods
2 vc methods of setting the value of a company : use a huge discount rate as we did in the exos
Reason for a high discount rate : Premium for lack of liquidity
Premium for VC services
Adjustment for overly optimistic projections
… and the risk!
Metrick: or using a probability of success with a flat base discount rate
metric takes a different approach
instead of using a big discount rate, he uses a prob of success
he calculated the historical return of VC funds
correspondance between the discount rate and the prob of success using a 15% base discount rate so depending on the number of years and the probability of sucess, you have the discount rate you should use.
What is the adjustment for the dilution
Upward adjustment for possible dilution because dilution is bad
when you calculate how much you need to keep your 16% part in the compagny :
0,161,201,30 = 0,25
retention ratio : 1/1,20 / 1,30 = 0,64
tu divises 1 par les deux rondes de financement externes 1/1,20/1,30 = retention ratio
What are the weaknesses of the dcf
Model based on the predictability of cash flows
The need to set a fixed discount rate (cost of capital)
One scenario
A single model of determined cash flow forecasts is insufficient : Cash flows are random
The totality of risks cannot be represented by a single factor: the cost of capital
Constant changes and adjustment are brought to the project
Reliable estimates of the probability of success must be reliably estimated based on…
Historical data
Market data
Informed estimates of an “expert”
The flexibility to invest in stages must be taken into account
Risk factors need to be properly identified and assessed (Technology risks
Business risks (economic)
Competition risk
The model should be as realistic as possible : The valuation model must adapt to the business model
… and the business model to the model!
The model must address problems of intuition or perception
what are some proposed tools to make up for the dcf’s weaknesses
Monte Carlo Simulation
Real options
Binomial trees
Game Theory
but they have modelling limitations : oversimplification of the reality, difficult to adapt the model to the reality of the project
difficult to use because of the defiance of intuition and the complex mathematical notation
BUT, they take experience and reality into account, they represent a more faithful reality (option to abandon)
Describe the monte carlo simulation
NPV of predictable cash flows
Sensitivity analysis to account for the vagaries (idiosyncrasies)
better tool : Excel model + Monte Carlo simulation
sensitivity analysis : Identifying important variables
Identification of the probability distribution profile for each important variable
distribution patterns : Uniform distribution
Triangular distribution
Normal distribution
Log-normal distribution
Benefits
The ability to “simulate” several variables simultaneously
The ability to model the dependence of variables between them (correlation)
Mathematical tool for calculating the accumulation of probabilities at a given point on the probability curve
Takes advantage of the power and availability of computational tools
Model based on a familiar representation of financial results
use the results to manage risk factors
Explain the real options
The use of real options in the investment decision corresponds to a “dynamic DCF valuation”
the assessment and the intuitivity is more important the the actual rpecise number. you want to have a sense and a rule of thumb of what it is without having the precise number
Better account of risk…
… and the uncertainty
Initial decision is not irreversible
Possibility of delaying a decision or part of the decision
Advantage of waiting for new information
Allows to represent the variability of phenomena akin to volatility
Allows uncertainty to be valued
Reduces the cost of uncertainty by valuing future information
Relevance :
Research and development is done in stages
The risk is high :Reduces the impact of a “bad” decision in the evaluation
Allows risk to be assessed with a market “proxy”
Allows risk to be assessed based on subjective assessment
Reduces the impact of using “too” high a discount rate
Allows to represent (technological) risk more directly by isolating it from general business risk
Requires to “reduce” the model to a few key decisions
Main difficulty : the discount rate
Choosing a discount rate appropriate to the new risk profile that takes flexibility into account
Benefits of the binomial tree :
the binomial tree is a more realistic method than the black scholes model, Opportunity to model “complex” options, Simplification of option value calculations
Allows the calculation of the current value of an investment project taking into account the value of flexibility
