Real Asset Valuation: A Back-to-basics Approach
This paper was written with two colleagues, Raul Guerrero of Asymmetric Strategy LLC and Don Lessard of the MIT Sloan School of Management, at the invitation of the Journal of Applied Corporate Finance. It is available from the publisher to subscribers of the journal or for a price (none of which goes to the authors) - here.
Figures 3-5 in the published paper do not have good colour contrast. Clearer copies of these figures are available for download in .pdf format: figure 3, 4, 5.
The paper uses an example of carbon capture and storage to illustrate several points. A complete description of this example will be available shortly at this website. If you wish to receive a copy once it is available, please contact us.
Different valuation methods can lead to different corporate investment decisions, and the conventional "static, single discount rate" DCF approach in particular is biased against many of the kinds of decisions that corporate managers tend to view as "strategic." Reducing the bias from valuations involves two main tasks: treating risk in a way that is consistent with observed market pricing, and accounting for the ability of companies to make decisions "dynamically" over time. The authors propose two separate tools, market-based valuation and complete decision tree analysis, for accomplishing these two improvements in valuation.
The authors also suggest working with the full distribution of future cash flows, one possible realization at a time, rather than working with the aggregate measure of expected cash flow. From a technical perspective, it is necessary to work with the full distribution to value real options properly. Valuing the cash flows one realization at a time also leads to a much better understanding of the interaction between economy-level, systematic risks and local asset-level, technical risks. Just as important, the proposed approaches support an effective division of labor between local asset managers, who are better positioned to model technical considerations and other asset specifics, and the central finance staff, who can ensure the consistent treatment of economy-wide risk and to create the rules of engagement for evaluating opportunities.
After presenting an overview of both the valuation and the organizational issues, the authors present a case involving a corporate investment in carbon capture and storage that illustrates both the application of the proposed methods and the various sources of bias in the typical DCF analysis.
The photo, taken by Dr. Laughton, is of the West Fraser pulp mill at Hinton, Alberta. It was taken on the way home from a weekend hiking in Jasper National Park.