Now let's recall what we have to do when we try to value an investment project.
So here I will put some steps that we talked,
about that we applied and saw examples.
Now is just the time to put them together.
So, I put like steps in project valuation.
Well, the first group of steps clearly deals with
determining cash flows because
remember that we sort of agreed to always,
whenever possible, use the NPV approach,
therefore we need some numerators,
namely cash flows and then later the nominators that will be on the next list.
Those will be discount rate.
So what do we have to keep in mind about these cash flows?
First of all, we use past data as a basis.
Well, again if applicable,
because if you are talking about the greenfield project then there is little past data.
Obviously, you can find some similar projects and then try to
compare with them but that is just a basis and not always the best basis.
But if you do have this information,
if you do have the story of the company or other projects,
then you can draw some conclusions from that.
Now, the next thing here clearly,
this is the forecasts.
And these forecasts may be at the level of a company,
at the level of the industry,
at the level of the economy,
at the level of the world economy if you will.
Now, here I would specify that you don't have to be
overwhelmed with the idea to go from the trends in
the global economy down to the trends in the national economy,
down to the trends in the industry because unfortunately,
if you start so far away,
then the quality of the result will be very low.
You will have a hugely wide range of these forecasts that will
not help you to narrow this down to any meaningful valuation.
Now, the next thing is that both past data and forecasts,
they have to be based on something that is extracted
from the company financial statements.
Well, we study exactly what people extract in greater detail in our next course that is
devoted to issues in accounting that are pertinent
to project valuation both in financial accounting and in cost accounting.
But for now I'm just saying that the financial statements of the company,
this is the source from which normally we take some initial inputs to later
build the models and then use the NPV to evaluate these models.
And then, another thing that deals with determining cash flows here,
then I will specify that.
You have to clearly differentiate between,
I would say the clear differentiative cost.
So here here sunk costs,
you ignore, then opportunity costs you do take into account.
Then also you have to deal with
overhead allocation and the final thing,
again this is sort of an accounting issue,
then you have to deal with relevant costs.
And all that is easier said than done because not only do we devote
the whole big portion of the next course to these important issues but in reality,
especially if you are not in the area of greenfield project,
if you're operating a company with some history,
with some preferences, this is actually not such an easy thing.
So you just have to keep this in mind and then the major idea is not to commit
significant mistakes and if at all possible then to
try to be as correct and as close to reality as you can.
So this is the first group of steps that are dealing with cash flows.
Now the next thing, as I mentioned,
this is the discount rates.
Well, remember we had
a very detailed example when we
calculated the weighted average cost of capital in beta
of a company with several divisions.
So here you can say,
we start with traded competitors
and from here we arrive at weighted average cost of capital.
So this is the approach that is used for
practical reasons and for practical goals in reality,
so that's what people do.
Now, unfortunately that is not always realistic when you talk about
securities and also derivatives because
here you can see that r's may
be stochastic and even path dependent.
So unfortunately, here we will put a big,
both exclamation and interrogatory mark
because if this is the area in which you do have to
use advanced mathematical models but that is
fortunately not the area of most real life projects.
So if you specialize in securities valuation then you clearly have to
be more advanced in math and then you will use some models.
Again, the logic there is the same.
You will always see that NPV will keep popping up in all these models.
But in order to come up with some realistic results,
you will have to be somewhat more detailed.
Now, here I'd like to wrap up because
about options and some other things I will stock
in the next episode because that is worth it.
But for now I can say that whenever,
in a real project valuation,
you see some challenges that something becomes
progressively hard to understand and progressively messy,
now I would say there are at least two major recommendations.
One is this abbreviation KISS, Keep It Simple Stupid.
Well, here often times this is used in presentations or so but by the same token here.
Remember that most investors,
they do not have time to go deeper in that.
Even if you are dealing with,
let's say, advanced securities valuation,
you place these balances,
this cash to a company that actually does this management.
If they do that great,
then you keep it.
If they lose your money,
then you withdraw your money.
But the idea is that a client is rarely
in the position and in the ability to understand what these people are doing.
They somewhat explain that that might be a problem that might create a certain wall of
misunderstanding or a veil of
unobservability if we used our buzzwords from the capital market scores.
But this is reality.
And the final thing that is the most important,
I would say be realistic.
If, for example, you make some assumptions and these assumptions are,
in order to sort of be able to
calculate something but these assumptions are far from reality, don't make them.
If sometimes you cannot, in an easy,
in an understandable way,
value something then just keep this in mind,
you can pronounce that to the people who are stakeholders in this story.
But you don't have to pretend that you know how to do it.
You are better off if you said,
"Well, this is somewhat a messy thing
because otherwise if you don't pay any attention to that, this is a blunder."
But if you try to,
let's say look smarter than you are,
or make your project look better than it is,
that might be a much worse option
and that may result in significant problems in the future.
So these are the major steps in
project valuation until we reached the potential options stage.
In the next episode we will talk about options once again,
not in that detail that we used last week but to have some wrap up here too.
Konstantin KontorDirector and Professor of Finance and Strategy
