The Valuation of Poker X
Valuation in a new branch in the new economy
Arjan C. Smedes
April 2007
UNIVERSITY OF GRONINGEN
Faculty of Management and Organization / Economics MSc Finance
Supervisor:
Dr. W. Westerman
Preface
This year, I will finish my MSc Finance at the University of Groningen, by writing my thesis.
Because I could not wait to bring theory into practice, I decided to choose a practical subject, namely, the valuation of the internet company Poker X. This valuation is backed up by a literature study.
I was supported by several people during the writing of my thesis. Therefore I would first of all like to thank my mentor, dr W. Westerman, for his time and effort. He was a great help with his expertise on the topic. Secondly I want to thank the owners of Poker X for giving me the opportunity to valuate their company. I also thank my colleges at E&Y for providing me with useful information based on years of experience. Last but not least, I thank my girlfriend, my parents and my mother in law, for supporting me during this sometimes stressful period.
Heiloo, April 2007
A. C. Smedes
Wassenberghstraat 25
9718 LH Groningen
S1512846@student.rug.nl
Student number: S1512846
Table of contents
Preface 2
Table of contents 3
1 Introduction 4
2 Valuation methods 5
2.1 Asset based valuation 5
2.2 Multiples 7
2.3 DCF 11
2.4 Real Option 18
2.5 Value creation 23
3 Poker X 24
3.1 Internal environment 27
3.1.1 Mission & Objectives 27
3.1.2 Resources 29
3.1.3 Capabilities 30
3.2 External environment 31
3.2.1 Market 32
3.2.2 Competition 34
3.2.3 P.E.S.T. analysis 36
3.3 SWOT 38
4 Valuation of Poker X 39
4.1 DCF 39
4.1.1 Belgium and Portugal 46
4.1.2 Scenario analysis 48
4.2 Multiples 49
5 Conclusion 51
5.1 Reflection on the theoretical approach
and research methodology 52
5.2 Recommendations for future research 53
References 54
Appendix A 58
1 Introduction
The last decades a new phenomenon has arisen, the internet companies or as they are also called the dot-coms. All these organisations, that get their revenues from the internet, can be referred to as E-commerce firms. Because the e-commerce is a relatively young industry, with hardly any historical data, it is hard to predict its movements. This is enhanced by the rapid developments in the industry. Technological developments move rapidly and new internet companies are founded every day. This creates great new opportunities, but can also create large threats. The mentioned characters make it difficult to put a price on dot-coms because their future is difficult to predict with certainty. It seems that in the first stages of the E- commerce, all traditional valuation methods that were developed to valuate the traditional businesses, were abandoned. People no longer looked at the fundamentals that create value, like return on invested capital (ROIC) and growth. Instead, people valuated dot-coms based on expectations, which unfortunately were not always rational. People started to follow each others example. Between 1995 and 2000, the internet stock prices rose exponentially.
Eventually this resulted in the internet bubble of 2000. After the bubble deflated, one tried to explain the development of valuation of internet companies (see, Demers & Lev (2000) and Keating et al. (2000)). Nowadays people have returned to the traditional valuation methods.
The characteristics of the new economy still make it difficult to apply these methods however.
This paper helps to get insight in the valuation of internet companies, by actually valuing an internet company, disguised as Poker X. The company has created an online poker
community, gives information about poker and redirects players to international poker tables on the internet. It gets a commission every time one of its visitors joins an online poker table.
The dot-com is a young business, in the relatively new branch of online Poker. This fact together with the characteristics of the new economy makes it difficult to put a price on Poker X. Several offers have been made to buy the company but the owners refused these offers.
They expect to create more value than was offered for their company, but do not have any data to back this up. This paper is a guideline for the valuation of Poker X. Poker X can use this to calculate the value in different circumstances and use it as an aid for future
negotiations.
For the valuation several valuation methods can be used; asset based methods, multiples, the
discounted cash flow (DCF) method and the real option method. To get insight in the different
valuation methods an extensive literature research has been done. This research resulted in
chapter two. That chapter gives an description of the methods, gives the pros and cons of each
method and discusses which methods is best suitable for the valuation of Poker X. The third
chapter describes Poker X in more detail and researches the external environment that influences Poker X. Because the online gambling industry is a young industry, and online informative Poker sites only exist since the founding of Poker X in 2004, there is hardly any information about the topic. This research is one of the first to investigate the online Poker market in the Netherlands. Therefore it was necessary to get the information from the people that are active in the online Poker scene. Data was gathered by interviewing the owners of Poker X, searching for relevant information in the media (offline as well as online), talking with the direction of the Dutch Poker Society and talking to online poker players. These poker players were contacted through several forums, including the forum of Poker X. Chapter three is concluded by a Strengths & Weaknesses and Threats & Opportunities analysis (SWOT), which is a summary of the findings from an internal and an external analysis. With the obtained information from chapter three and the methods selected in chapter two, the actual valuation of Poker X is given in chapter four. The final chapter of the paper consists of the conclusions and the short comings of this research.
2 Valuation methods
This chapter addresses the four different valuation methods that are commonly used. These are: the asset based method, multiples, discounted cash flow methods and the option-based valuation.
2.1 Asset-based Methods
A company should at minimum be praised at the value of her assets. The basis for the asset- based valuation methods is that a company is worth as much as the book value of her equity.
This means the value of all her assets minus her liabilities; the value of her net assets.
Asset- based valuation methods can be divided in four segments: the book value, the fair value, the liquidation value and excess earnings.
Book Value - Is the simplest version of asset-based valuation. It is the value of the assets as
stated in the balance sheet less the liabilities as stated in the balance sheet. Most often the
book value is based on historical costs. Because the intangible assets are very difficult to
appraise, one often uses the tangible book value. Tangible book value is only different from
the book value, in that it does not take intangible assets into account. Valuations based on the
book value are often not accurate because the balance sheet does not always give a realistic indication of the true value of the assets. Also it does not take future cash flows into account.
It is therefore usually not used for valuations.
Current (Fair) value - Is the present value of the assets minus the present value of the
liabilities. Current valuation methods can be divided in the replacement cost, the market value and the DCF method. This last method is not an asset-based method and will be treated in part 2.3. Replacement value is the replacement cost of assets minus the replacement costs of liabilities. Replacement cost is the amount of money one has to pay to acquire a similar asset, or the cash that would be obtained if the same liability were incurred (Sutton, [2004], p. 173).
Market value is the difference between the appraised value of assets, and the appraised value of liabilities (Renwick and Szente, http://www.buyabusiness.co.za).
Liquidation value - Is the worth of the assets in case of liquidation. Because of the short time span the assets are likely to be sold under market value.
Excess Earnings – Szente and Renwick (http://www.buyabusiness.co.za) refer to it as the difference between earnings of a business before a sale, and the earnings after the sale. These excess earnings are capitalized and are then added to the appraised value of net assets as a premium. The discounting of future earnings makes this method a not pure asset based method. It has more resemblance with the DCF method.
Asset based valuation methods can be used as a factor, but are seldom used to retrieve the real value of companies. One of the reasons for this is the fact that it is difficult to define the value of intangible assets like goodwill, patents, etc. It can therefore not be used for companies with high levels of intangibles and low levels of tangibles (internet companies). Like Schneider (2002) says, a company’s website name can be its most valuable asset. Renwick and Szente (http://www.buyabusiness.co.za) argue that asset-based valuation methods are often not used for the valuation of companies because they ignore the importance of earnings and cash flow.
Even though asset-based methods are often crude, they can be very useful in multiple
circumstances. The most logical example is in case of a company that has been running even,
or at a loss. Companies, that own a great quantity of tangible assets and little intangible assets,
could also be valued correctly with an asset-based method. Based on these arguments certain
airlines might very well be valued using an asset-based method. When a company has little or
no track record and no certain future earnings, one might also use the asset-based valuation
method. In that case one would however not attribute any value to future performance.
Overall the asset-based method is not commonly used, but if it can result in a realistic valuation, one should use it because of its simplicity in comparison to other method.
POKER X
Even though Poker X does not have a long track record and future earnings are difficult to predict, none of the assets based methods will be used for the valuation of Poker X. The method can simply not be used because Poker X hardly has any assets, besides retained profits. Its biggest asset is its name and reputation, which is an intangible asset that is difficult to value.
2.2 Multiples (comparables)
Companies can be valued by comparing their performance to that of a peer group of its closest competitors. Performance is estimated by looking at ratios (for example price-to-earnings) based on financial or operating information. An average (multiple) of the ratios of the peer group will be combined with data from the company, to obtain the value of the enterprise. The valuation will be more accurate, if the peer group is more similar to the company, that is to be valued. For the selection of a peer group, one can use industry classification systems like Standard Industrial Classification (SIC) codes, or Global Industry Classification Standard (GICS) system. Boatsman and Baskin (1981) found that the valuation errors are smaller when peers, with similar historical earnings and growth, are chosen instead of being chosen at random. Alford (1992) found that valuation errors decline when industry definition, used to select the peer group, is narrowed from a broad, single digit SIC code to classifications based on two and three digits. The four-digit classification did not seem relevant. He also found that
“controlling for size and earnings growth, over and above industry controls, does not reduce valuation errors”. Once the peer group is found one should compare the different companies in more detail. “If strategic advantages translate to superior ROIC and growth rate, better positioned companies should trade at a higher multiple” (Koller et al. [2005], p. 377).
In this paper multiples will be divided into, multiples based on earnings, enterprise value
multiples, non-financial multiples and alternative multiples. Each is described below.
Earnings
The simplest way of valuing a company is looking at its earnings (net income). The earnings per share (EPS) are an example of a ratio based on earnings. Without the price of the share, this ratio has got no measuring value however. Therefore the more common Price to Earnings (P/E) ratio is used. Koller et al. (2005) advices using forecasted earnings instead of historical earnings, because future performance is the basis for value. Kim and Ritter (1999) show in their research that P/E multiples, based on forecasted earnings, result in better valuations than all other multiples.
The P/E ratio is easy to use and is a quick way of comparing companies. It would however be wrong to solely use the P/E ratio of the peer group to access the value of the company because it has two major flaws (Koller et al. [2005], p. 379). First the P/E ratio is affected by the capital structure through the cost of debt and the debt to value ratio. Second it commingles operating non-operating and financial characteristics.
Enterprise value multiples
These are multiples that focus on enterprise value instead of equity like the P/E ratio. The enterprise-value to EBITA ratio is driven by four factors. This represented by the formula:
V / EBITA = ((1-T)(1-g / ROIC)) / (WACC – g) (Koller et al. [2005], p. 374)
T = tax rate G = growth rate
ROIC = return on invested capital
WACC = weighted average cost of capital
The tax rate and the costs of capital are often similar for companies within the same industry.
Therefore ROIC and growth are the two variables that actually drive this ratio. Instead of the V / EBITA ratio one could also use the V / EBITDA ratio. The enterprise value ratios are not as affected by capital structure or non-operating results like the P/E ratio. Therefore it results in better estimate of the value of a company. The ratios still commingle non-operating,
operating and financial data. Therefore the multiples must be adjusted for non-operating parts
in the enterprise value and EBIT (D) A. Just like for the P/E ratio Koller et al.(2005) advise using forecasted data instead of historical data.
Other financial multiples
Leslie (2000) mentions two alternative multiples that could be used; the price to sales (P/S) ratio and the price-earnings-growth (PEG) ratio. The P/S ratio can only be used to compare companies with similar operating margins. It can be useful to use the P/S ratio when companies are temporarily losing money due to short-term circumstances instead of
mismanagement. The sales and therefore revenue can be a sign for positive future earnings.
Original PEG ratio = (P/E) / EPS, the adjusted PEG = 100 * (V / EBITA) / (expected g for EBITA). The PEG ratio makes comparison possible between companies with different growth rates and therefore often different life cycle stages.
Non-financial multiples
In certain circumstances financial data do not give a representative picture of the
performance. Examples are internet companies that have to make great start-up investments and therefore have negative earnings. In that case multiples are constructed by relating non- financial data to market value. The data can consist of a wide rang of non financial data but should have somehow be tied to ROIC and growth to be a reasonable predictor of future value creation (Koller et al, [2005]). Examples are website hits, webpage views, unique visitors, subscribers. Non-financial multiples are researched in several studies. Schonfeld (2000) suggests using a market value-to-customers ratio to estimate the value of internet companies.
Amazon.com for example was traded at $1.400 per customer. Gupta and Lehman (2001) write that a value can be calculated if the long term value of a customer and the growth of the client base can be estimated. For this they introduce the concept of lifelong customer value (lv).
This is calculated by discounting future profit obtained from a customer and using a customer
loyalty measure. Lv = profitmargin per customer / (1 + discount % - loyalty %). Amir and
Lev (1996) conclude that non-financial indicators drive stock prices in the cellular industry,
but that earnings also helps in explaining the prices. Trueman, Wong and Zhang (2000a) show
that net income does not affect stock prices significantly, but gross profit does. They also
found that pageviews and unique visitors provide incremental explanatory power for stock
prices of internet firms. In a second study (Trueman et al., [2000b]) they found that growth in unique visitors, minutes spent on site and pageviews all have incremental explanatory power for internet firm revenues.
Demers and Lev (2000)also conclude that these web traffic
measurements explain market values of internet companies during 1999 and 2000.
Other researchers are less convinced about the use of non-financial information. Hand (2000a, b) concludes that web traffic does not drive internet stock prices and found that within, web traffic measures (pageviews, minutes, unique visitors), only the number of visitors is relevant for prices. Instead he found that current book equity, forecasted one year ahead earnings and forecasted long-run earnings growth, drive internet stock prices. In addition, he also found that the average age and the average income of visitors was not relevant for market values.
Rajgopal et al. (2000) find that web traffic is not relevant when strategies to increase traffic are taken into account in the value-relevance model. Also they demonstrate that traffic contains no predictive information about future revenues, besides past revenues. In addition, they show that the stock market uses traffic as a measure of the ability to create network effects. The market values of internet companies increase non-linearly with traffic. Jorion and Talmot (2001) introduce a new factor in their research, namely the different stages of a lifecycle. They find that, in the early stages of the lifecycle, conventional financial data is less relevant for the stock price than web traffic data. However, when the industry matures
financial data gets increasingly value relevant and the value relevance of web traffic data materially diminishes.
Overall it is accepted that non-financial multiples can be useful in estimating the value of a company. However as Koller et al. (2005, p 389) say, these multiples should only be used if they provide incremental explanatory power above financial multiples and if the non-financial data can be translated in profits and cash flow.
POKER X
The greatest difficulty of the multiples methods is finding a correct peer group. If information
can be found on a peer group, then multiples is the easiest way to get an estimate of the value
of a company. Because of this, multiples is one of the methods that will be used to value
Poker X. One of the major difficulties is the fact that Poker X is not listed and should
therefore be compared to similar unlisted firms. Unlisted firms however have little publicly
accessible data. If a peer group of listed companies is used then Poker X will probably be
valued at a discount. The assumptions underlying the multiples make it an inaccurate
measurement. Another danger is the possibility that all analysts are wrong which makes the peer groups value useless (Koedijk et al. 2001). This method will therefore only be used as a rough estimate of the value and as a comparison to the value that is calculated threw the DCF method.
Both the V / EBITA multiple and the non-financial multiple, Value/ Unique Visitor will be used. The first is used because the literature rightly recommends using this multiple if
possible. On top of this multiple the V/ UV ratio will be used because it is believed to provide incremental explanatory power above financial multiples. Poker X is very dependent on the number of visitors, because the number of redirected visitors results in profit. So this non- financial data can be translated in profits and cash flow. Possible differences between the two multiples will be discussed.
2.3 Discounted Cash Flow (DCF)
DCF is the most excepted tool for investment decisions and valuation. It basically calculates the present value of projected cash flows from an investment of some kind, by discounting it at a discount rate that reflects the risk of the investment, as demonstrated in the following formula:
Present value = future cash flow / (1+discount rate)ⁿ In short: PV = CF / (1+d)ⁿ
n represents the periods in which the cash flows fall. For the end of year 1, n is 1, end year 2, it is 2, etcetera.
The DCF was first developed as a tool for calculations concerning compound interest. The
DCF was further developed by Fisher (1907, 1965), John Burr Williams’ (1938) text "The
Theory of Investment Value" and in later years also by Hirschleifer (1958). According toAndersen (2001) it took about halve a century for the DCF method to be used, because of the
lack of understanding and education. Nowadays the DCF method is used for capital budgeting
(investment decisions), security valuation and firm valuation. For the firm valuation, cash
flow is often seen as equal to earnings before interest, taxes, depreciation and amortization
(EBITDA). In his article “Methods of Corporate Valuation” I.H. Giddy (http://giddy.org/)
explains why he looked at earnings before interest, taxes, depreciation and amortization. He
states that cash flow is designed to focus on the operating business and not on secondary costs or profits. Therefore, interest income and expense, as well as taxes are ignored. He points out that taxes can cause dramatic fluctuations in earnings power because of their dependence on the vagaries of the laws in a given year. Because cash flow should not focus on secondary costs or profits, EBITDA is also adjusted for any one-time charges or benefits. Giddy states that depreciation and amortization should also be tossed aside because they are non-cash charges. There is no actual outflow of money. In short, he says that a company's operating cash flow should exclude accounting conventions that might mask cash strength.
Most recently the DCF analysis has developed into two new concepts. The free cash flow (FCF) and economic value added (EVA). The FCF differs from the regular cash flow as stated above in the fact that it also subtracts investments in new capital. Not all cash flow is free to give to the investors. A company most invest in fixed assets like equipment and real estate and in working capital enable to sustain. The formula for FCF is:
FCF = net operating profit less adjusted taxes – invested capital(
t+1) –invested capital
(t)In short: FCF = NOPLAT – net investments
Adjusted taxes stands for taxes related to core operations NOPLAT = Invested Capital / ROIC
EVA is a method that uses economic profit in stead of cash flow to calculate the value of a firm. Therefore it is also referred to as discounted economic profit method. For present value calculations one adds the present value of projected economic profit (EP) to the invested capital. The formula for EP is:
EP = NOPLAT – (invested capital * WACC)
The EP model and the DFCF method result in the same valuation. The difference is that the
EP model gives a better idea of the performance in a particular year. One can’t compare actual
cash flow to projected cash flow because it is easily manipulated by shifting investments. The
performance of a particular year is of less relevance in this case. For this research it was
decided to look at the actual cash flow figures instead of the economic profits. Therefore the
Free Cash Flow concept is used.
As is mentioned by Renwick and Szente, (www.buyabusiness.co.za), the so-called DFCF analysis consists of three major components:
1a) First the expected future free cash flows must be forecasted. This means making financial forecasts of the balance sheet and the income statement. These will then be fitted in a
spreadsheet. From this financial statement one can extract the free cash flow and ROIC necessary for the DFCF method. There is not a specific timeframe for this forecasting period.
Leslie (2000) recommends a period of 10-15 years. This could be shorter though. The remaining years are calculated into the terminal value (point 3) that will be discounted to the present. Because continuing value methods to calculate the terminal value are based on a static state performance, it depends on the amount of years a company is expected to take until a steady state is reached. Koller et al. (2005) classify that a company is in a steady state when:
· it grows at a constant rate and reinvests a constant proportion of its operating profits into the business each year.
· it earns a constant rate of return on new capital invested (RONIC).
· it earns a constant rate of return on its base level of invested capital.
Koller et al. (2005) even recommend a longer forecasting period if companies experience rapid growth. This, because a too short period would undervalue the firm unless a bold and probably not very realistic assumption is made concerning the perpetual growth rate. For a long forecasting period however, it can be difficult to appraise individual line items more than 10 years in the future. As a solution Koller et al. (2005) split the explicit forecast period into two periods.
· A detailed short forecast of approximately five years, which develops complete balance sheets and income statements with as many links to real variables as possible.
· A simplified forecast for the remaining years, focusing on a few important variables, such as revenue growth, margins, and capital turnover.
It is better to focus on the competitive advantages and her long term economics than to focus on individual line items. Actually one should research the whole of economic developments;
microeconomics, mesoeconomics and macroeconomics. On the microeconomic level one
should research the firm itself; what are her strengths and where can she improve upon. On
the mesoeconomic level one should research the industry in which the company operates and determine her position in that industry. An important factor of mesoeconomics is competition.
Not only relative to the direct competitors in the same business but also towards suppliers and customers; what is your competitive position. On the macroeconomic level the political, economical, social and technical (P.E.S.T.) factors should be taken into account. This means researching what the developments are in the land of origin as well as globally.
1b) In order to obtain the free cash flows, one must forecast the balance sheet and the income statement. The balance sheet and the income statement are all influenced by revenue. This makes the revenue an important variable. Revenue can be forecasted using a top-down and/or a bottom-up method (Koller et al, 2005). In the top down method revenue is estimated by determining the total market, market share and future prices. The bottom-up approach looks at current customers, potential customers and customer turnover to forecasts revenue.
The top down approach is especially used for mature markets because one can use
professional forecasts of the aggregate market and focus on the current and potential market share. The company’s competitive advantages compared to its competition.
For the short-term, top-down forecasts one should use the company's announced
intentions and capabilities for growth as starting point. In emerging-product markets, the top-down approach requires more work because there are more unknown variables: total market, market share, penetration speed, total competition, market prices. These difficulties can be overcome by looking at comparable markets and by applying a clear structure for the analysis.
Using the bottom-up approach short-term forecasts can be based on the current customers.
Revenue forecasts based on this should be corrected downward if customer turnover is significant. For the long term forecasts one most look at the potential to attract new customers.
Either method produces long term forecasts that are imprecise. We live in a dynamic world were customer preferences, technologies, and corporate strategies can change. This
uncertainty can be projected by using different scenarios for the forecasts. A scenario analysis will “provide greater depth of understanding and add sophistication to the appraisal”
(Buckley et al, 2002).
Revenue is of little interest if one does not have an estimate of the costs and investments.
Based on the revenue expectations, future costs and investments can be determined. Some
costs and investments will grow equally with revenue, others will have an independent growth
rate. For a detailed description of how to estimate the balance sheet, the income statement and the statement of retained income, see Koller et al. (2005).
2) The second step involves deriving an appropriate discount rate. The discounted cash flow method uses the weighted average cost of capital as its discount rate (WACC). The discount rate reflects the risks of the financial investment in the company. It consists of a risk free rate plus a risk premium to compensate for risk. The riskier the investment, the higher the discount rate. This is why new companies, which have not yet created a reputation of growth and profitability, have higher discount rates then mature companies with a positive reputation. The same reasoning can be used for companies with uncertain futures, or companies who have a lot of debt. The weighted average cost of capital is defined by:
WACC = (E / C) * e + (D / C) * d (1-t) Where C = E + D
E = equity and equity equivalents D = debt and leases
C = total capital invested in the going concern t = corporate tax rate
e = cost of equity d = cost of debt
If the capital consists of other components then equity and debt, then the formula will be extended with an additional term. Examples of these components are preferred stock and convertible bonds. The cost of debt is the yield to maturity of the bonds of the company, or the interest rates of the loans to the company. The cost of equity capital is the expected rate of return of a company’s equity. This can be calculated with the help of the capital asset pricing model (CAPM). In this model the expected return is the risk free rate plus a premium. The formula used in the CAPM is:
E(Ri) = r + βi (E(Rm) – r) (Koller et al., 2005)
E(Ri) = expected return security i r = risk free rate
βi = security’s beta
E(Rm) = expected return of the market
The β measures the covariance of the security with the market. The risk free rate is the return on a security that has a β of zero. For r, the long term government bonds with an AAA-rating are used, because of the low covariance of these bonds to the market, which results in a low β.
The expected market return can be based on historical market return or by discounting future dividends. A more detailed discussion of the different components of the CAPM can be found in Koller et al. (2005).
3) Finally this discount rate most be applied to the future cash flows and terminal value. The terminal value is the value of all future cash flows, beyond the explicit forecast period,
discounted back to the end of the forecast period. The use of the terminal value is based on the going concern principal, that the company will generate free cash flow till infinity. Future assumptions most be made for the cash flow beyond the explicit forecast period and the growth. The terminal value is calculated through the so called cash flow perpetuity formula:
Terminal value = FCF / (WACC - g ) g = growth rate
The discounted values are then added up and corrected with the so called mid-year adjustment factor. In the calculation of the free cash flow it is assumed that revenues are received at the end of the year even though this occurs all threw the year. This is corrected by multiplying with the mid-year adjustment factor which is equal to 1 + 0,5 * WACC.
Pros and cons of DFCF
Much literature has accepted DFCF as the most adequate valuation method. According to
Copeland et al (1995) the DFCF is useful in explaining companies’ market values. A study
by Moret Ernst & Young (1997) concludes that DFCF gives a good approximation of the
final transaction price. Ben MCclude (2003, www.investopedia.com) even says that DFCF
produces the closest thing to the intrinsic value of a firm. Giddy (2006) says that DFCF is the only method that makes sense in many situations. A study by Coopers & Lybrand (1994) shows that the DFCF valuation method is used for 75% of the transactions. Steenbeek and Van Vliet (2000) call the DFCF method without a doubt the most current method to estimate the market value of a company, used by stock analysts and corporate finance departments of financial institutions. They state that DFCF is the most used valuation method because of its simplicity and clarity, even though other more refined methods are known. According to Nussbaum (2006) the DFCF is still “arguably the most fundamentally sound investment approach for valuing investments of any type”
.The main advantage of the DFCF according to this literature is the fact that it takes cash flows, multiple periods and risk into account. This makes it a better measure for performance than earnings and less vulnerable for
manipulation threw accounting (Ben McClure, 2003). The cash flow approach shows the ability to earn cash without being overshadowed by depreciation and amortization. The time aspect takes into account that companies are going concerns that generate future cash flows. The risk factor takes uncertainty and the capital structure into account. An
additional advantage of the DFCF method is that it gives a detailed picture of the business and her internal operations.
However the DFCF also has some drawbacks. The DFCF method requires more inputs than previous methods and is therefore more labor intense. These inputs are based on assumptions that can make the DFCF method less accurate. The results of the DFCF valuation are as good as its inputs. Not only the cash flows, are based on a lot of
assumptions, but also the discount rate used. Unexpected events can have a great effect on the valuation. A small change of the interest rates (WACC) for example has a great effect on the value. Jong de Berend et al. (1999, www.ejise.com) also mentions the inability of the DFCF method to value intangible benefits and costs. In more recent literature (Busby et al.
(1997), Damadoran (2000), Buckley et al. (2002), Neufville (2002) and Smith (2004)) the
greatest disadvantage of the DFCF is said to be the fact that it does not capture managerial
flexibility. Managerial flexibility is the ability to change the strategy in the future and thereby
possibly create additional value. This flexibility can represent several options like cancelling,
postponing or expanding. The DFCF method assumes that the future cash flows are fixed and
can be estimated with certainty. This is seldom the case and some researchers advise using the
DFCF only in certain circumstances. As Copeland et al. (1998) put it: only use it when there
is little uncertainty about the operations of the company, and there is no scope to change
course, based on future information. Damodaran (2000) adds that there should be a good
proxy for risk to calculate the discount rate.
POKER X
DFCF is one of the methods that will be used in the valuation of Poker X. In spite of the drawbacks mentioned above, the DFCF is still one of the best valuation methods known to science. The usefulness of DFCF in valuation is proclaimed in theory as well as in practice, in contrast to the real options valuation method (ROV), (section 2,4), which has not (yet) proven its usefulness in practice. One of the drawbacks is said to be the number of inputs and its labour intensity. This research assumes that a higher number of inputs in combination with the labour intensity results in better results. Moreover it is better to make assumptions about several inputs than simply ignoring these inputs by using more simple valuation methods.
Simpler is not always better. The assumptions that will be made will be backed up by thorough research. At the microeconomic level an internal analysis will be made. At mesoeconomic level the branch will be researched. At macroeconomic level the political, economical, social and technical developments will be mapped. Based on this research, several potential scenarios will be implemented into the valuation model.
The fact that the DFCF does not capture managerial flexibility is not relevant in this case.
There are no clear options for the management of Poker X. They are working on expansion abroad, but this is not an option because the decision to invest is already made. The
investment is so low that it presents hardly any risk. Future investments might create options but these are not clear at this point. The possibility of successful expansion will be
implemented in the scenario analysis. A separate valuation will be made of POKER X without expansion and the expansion itself.
Overall the DFCF does not give an exact value but gives the best estimate possible at this time.
2.4 The option theory
Until recently researchers did not take the manager flexibility into account that is mentioned
in the previous section. Therefore DCF was long seen as the best technique for the valuation
of companies. Now a new method has been developed that looks at time, cash flow, risk as
well as flexibility. This method is called the Real Options Valuation method (ROV). The
ROV is based on the black-scholes model that was created in 1973 by Fischer Black and
Myron Scholes to value options in the financial world. Robert Merton adjusted the model by
subtracting the value of dividends paid. This resulted in the following equation that calculates option value in the financial markets:
Leslie (2000)
S = stock price, X = exercise price, δ = dividends, r = risk-free rate,
σ = uncertainty (standard deviation), t = time to expiry
N(d) = cumulative normal distribution function.
N(d1) = the proportion of shares required to replicate the call option N(d2) = the probability that the call option will be exercised on expiry.
This equation is also thought to be useful for the valuation of certain non-financial options, so called real options. Buckley et al. (2002) describe these options as the ability of managers to react to new information by changing their policy and tactical direction to create value. Jong de Berend et al. (1999, www.ejise.com) give some examples of studies that use ROV in certain practical cases; in oil industry (Brennan & Schwartz 1985), insurance (Marcus et al.
1984), timberland (Zinkhan 1991) and mining (Palm et al. 1986). Damodaran (2000) describe the three most basic options, (1) the option to delay a project, (2) the option to expand a project and (3) the option to abandon a project. These options are similar to financial options in that they represent a certain uncertainty and flexibility. Smith (2004) gives examples of studies for each of these options; Brennan and Schwartz (1985), Paddock (1988), Ingersoll and Ross (1992), Kester (1984), Grinyer and Daing ( 1993).
A great difference between real options and financial options, as pointed out by Smith (2004), is the fact that financial options have a greater database of historical performance to assist in estimating future uncertainty levels and future value. The ROV can only be used if the appropriate data is obtainable. Several studies (Leslie (2000), Damodaran (2000), Buckley et al. (2002)) convert the variables of the BSM equation into the following real option
equivalents.
· Stock price equivalent (S) - present value of cash flows expected from the investment opportunity underlying the option.
· Exercise price equivalent (X) - present value of all the fixed capital expenditure expected over the lifetime of the investment opportunity.
· Uncertainty equivalent (s ) - volatility of the asset movements: more precisely, the standard deviation of the growth rate of the value of future cash inflows associated with the asset.
· Time to expiry equivalent (t) - period for which the investment opportunity is valid, dependent on technology, competitive advantage and contracts.
· Dividends equivalent (d) - value that drains away over the duration of the option, such as costs incurred to preserve the option, information leakage and cash flows lost to competitors.
· Risk-free interest rate equivalent (r) - is the yield of a risk less security with the same maturity as the duration of the option (same for financial options).
Smith R. (2004) state the similarities between the financial option and a real option
by using Leslies’ (2000) hexagon.Figure 1: Similarities between Financial and Real Options
Source: Smith R. (2004), p. 3. (Leslies’ [2000] hexagon)
Two variables are especially difficult to convert for the real option valuation, namely the
measure of uncertainty and the dividends. The historical data and dividends paid on stocks
make these variables much more obtainable for financial option. For real options it is more
difficult to give an accurate estimate of the losses during the duration of the option and the
volatility of the underlying asset. Damadoran (2000) gives some suggestions for the measure
of volatility in the present value of the cash flows from projects:
1. Use the variance in the cash flows from similar projects.
2.a Assign probabilities to various market scenarios, estimate cash flows under each scenario and estimate the variance across present values.
2.b Estimate the probability distributions for each of the inputs into the project analysis and simulations used to estimate the variance in the present values.
3. Use the variance in the market value of companies involved in the same business as an estimate.
Pros and cons of ROV
As mentioned before, ROV is the latest valuation method that takes time, cash flow, risk as well as flexibility into account. This makes ROV a good complement for DCF valuation, in circumstances were DCF alone does not suffice (Smith, 2004). Damodoram (2000) writes that using the ROV can have certain implications that lead to better investment decisions. First of all, a negative NPV does not have to lead to the conclusion that the rights to this project are worthless. Secondly, positive NPV investments might not yet be accepted because the option to delay creates value. Finally, factors that can make a project less attractive in a static analysis, can actually make the rights to the project more valuable.
Besides a possible superior valuation, the ROV is often ((Amram (2000), Smith (2004)) praised for its creation of awareness. It forces managers to quantify the information on which strategic policy is based, in stead of reacting intuitively. It minimizes biases and creates an awareness which is necessary for a good business strategy.
The ROV does however have a lot of drawbacks. First of all it is complex and in–intuitive, as
the formula in the beginning of this section shows. The inputs are difficult to obtain and are
often based on assumptions which makes the result receptive for manipulation. According to
Busby (1997) and Jong de Berend et al. (1999, www.ejise.com), the complexity makes ROV
an impractical tool for most business manager. In the previous part volatility and dividends
were mentioned as two important variables that were difficult to obtain. Damororam (2000)
and Buckley et al. (2002) point out that time is also difficult to estimate because a firms
opportunities are hard to quantify both in terms of exclusivity and in terms of time. Buckley
et al. add to this that the value of real options is highly sensitive to changes. Jong de Berend et
al. (1999, www.ejise.com) conclude that the ROV does not solve the problem of predicting
cash flows and discount rates but only creates more problems.
Most literature on ROV does however agree that it can be applied in certain cases. This research found three main criteria for the use of ROV. First, there should be a clear option. If there is no clear option foreseen by the management, then there will be no need to use the ROV. Second, it should be possible to estimate the variables in the ROV. If there is no clear path for the estimation of the variables, then the ROV will be of little significance. In that case one could simply use the DCF method and add a premium for the options. Amram (2000) advises the use of ROV when the risk can be correlated to a portfolio of securities; the so called market risk. Third, the option should contain value. If the option is of little value than using ROV is not worth the effort. The value under ROV increases if the duration of the option and the volatility increases (in contrast to DCF). Buckley (2002) and Damadoram (2000) add to this that the option should have some exclusivity in certain cases. If entry barriers are low, then competition can easily copy the strategy, which reduces the value of the option. Entry barriers can be sustainable competitive advantages or exclusive rights.
If the ROV can not be applied but options with a certain value still exist, then some researchers (Jong de Berend et al. (1999, www.ejise.com), Curtis (2002) and Copeland &
tufano 2004) recommend using a more simple method of option valuation namely decision trees. One calculates the present value of possible outcomes of an option and estimates the probability of the outcomes. For example, a company has the option to install a new machine or not install it. If it is installed it will have a 60% probability of generating a present value of
€1000, and a 40% probability of generating a present value of €-500. In the DCF method this would result in a option value of 0,6 * 1000 + 0,4 * -500 = €400. Using option thinking, however this results in 0,6 * 1000 + 0,4 * 0,0 = €600. For a more detailed description of the use of decision trees in option valuation you are redirected to the mentioned literature.
POKER X
The main criterion for the use of the ROV method is the existence of a clear option. As is mentioned in the previous section about DCF, Poker X has no clear options. The expansion plans are no options, because there are no alternatives. Moreover the entry barriers for
competition are low which reduces the value of a possible option. The use of the ROV method
would have led to impossible assumptions in the case of Poker X. First an option that might
appear in the future should be thought up and then the consequences of exercising and not
exercising should be determined. The future is too unpredictable to make realistic valuations
of future options. Even if the POKER X did have clear options it would still be to difficult to use the ROV method. The variables volatility, dividend and time would be impossible to obtain. Based on the arguments above it was decided not to use the ROV method. The use of the ROV could however be useful in the future if clear options arise. Also it can be a
guideline for strategic decisions.
2.5 Value Creation
Because it is important to realize what is at the heart of value creation, the following chapter will discuss what lies beneath value. For this the book of Koller et al.(2005) was consulted.
People tend to look at the earnings (net income) because these figures are often easy to obtain and can be used for a quick overview. Examples are earnings per share (EPS), return on equity (ROE), and the price-to-earnings ratio (P/E). They may give some indication of performance but do not a give a correct picture of the value. Earnings do not give an
indication of the capital that was invested. To get an idea of value one has to compare profits to the invested capital and the costs of capital. Economic profit and cash flow do so and are therefore helpful figures to calculate the value of a company. Both the cash flow (see section 2.3) and economic profits are driven by the return on invested capital (ROIC). ROIC is calculated as “net operating profit less adjusted taxes / invested capital”. The economic profit is calculated as “invested capital x (ROIC – weighted average cost of capital)”. For the ROIC to result in a positive cash flow it first has to offset the cost of capital. So ROIC must be higher then the WACC for the company to have a positive cash flow and therefore create value. The higher the profits are per dollar invested the higher the value of the firm. But it is not only the level of ROIC that matters, but also the trend. A declining ROIC can be a bad sign and a growing ROIC a good one.
ROIC is not the only driver of value; equally important is growth. Growth is a product of the
return on new capital and the investment rate; ROINC * IR. Companies create value by
earning rates of return on their investments that are greater than their cost of capital. If that is
the case then a higher investment rate will result in a higher growth and therefore a higher
value. The importance of growth as well as ROIC explains why stocks of similar companies
with comparable ROIC trade at different multiples. The P/E ratio and comparable multiples
like enterprise value/invested capital (EV/IC), or price-to-book value (P/B), are influenced by
growth as well as ROIC.
POKER X
An important question for Poker X is, how to obtain a sufficient ROIC and growth figure. The costs of Poker X are small, in comparison to the revenue of Poker X, and are not expected to change much in the future. Therefore costs have little impact on the ROIC. The invested capital is very minimal and is not expected to change drastically in the future. Because of the stability of both costs and invested capital, ROIC is mainly influenced by revenue. Poker X gets its main revenues from visitors of her site that are redirected to online Poker tables. Other revenues, like from the sales of Poker X merchandise, are small and can be neglected. Overall it can be said that Poker X’s visitors underly her value drivers. Poker X must focus on
attracting as much visitors as possible and keeping them.
3 Poker X
Valuation is only possible when one has a good picture of the company and her internal and external environment. This chapter starts with a global description of Poker X and an overview of its historical data. Section 3.1 will address the internal environment in more detail while section 3.2 will address the external environment. Finally section 3.3 gives a summary of the chapter, using a SWOT analysis.
Poker X is an internet company that gives information about Poker online and more
importantly has created an online Poker community. It owns around fifty domain names and has about 10 active sites. All these sites direct the visitor to the main site of Poker X. The firm was founded in 2003, by two enthusiastic poker players. In 2004 a third partner bought
himself into the firm. The three owners now each own one third of Poker X. The site was an immediate success. Visitors numbers grew daily and is still growing. It is now the largest informative poker site in The Netherlands. It has over 80000 unique visitors a month and receives approximately 600 posts on their forum every day.
The core business of Poker X is still the online poker community and informing its visitors.
To keep the site interesting for its community it has however also developed other activities.
It sells poker related objects in its online store, organizes poker courses and poker trips to
foreign countries and is active in poker tournaments. Poker X comes up with new ideas
constantly to keep their visitors happy and interested. According to Poker X, one of their
goals is making poker more popular in The Netherlands and to inform, to amuse and to give
insight into strategic depths of the game poker.
The dot-com is a young business in the new branch of online Poker. Therefore there is little historical data. Poker X has only recently started to hold an administration. Based on the data, received from Poker X, the following income statement and balance sheet were made.
Table 1: Income statement
Historical Income Statement 2006 Revenues commission € 330.932
Other Revenues € 3.367
Costs of internet hosting € 13.016
Business trips € 10.228
Selling, Gen & Admin Expenses € 4.148
Promotion costs € 6.065
Other Operating Expense € 10.775
EBITDA € 290.067
Depreciation Expense € 0
EBITA € 290.067
Amortization of Intangibles € 0 Non-Operating Income € 0
Interest Income € 0
Interest Expense € 0
Earnings Before Taxes € 290.067
Income Taxes € 131.156
Net Income € 158.912
Poker X’ earnings consist mainly of commission that they receive from the online poker sites, every time one of its visitors joins an online poker table through Poker X. Other earnings consist of commercial fees, earnings from tournaments & courses and earnings from the online store. Costs of hosting consist of costs for domain names and the hosting costs of the sites that are actually online. The business trips consist of trips for international poker tournaments and negotiations abroad. These are necessary to sustain the network and to stay informed about the main events in the poker scene. Selling and administrative costs consist of all costs linked to sales and administration. These are among others the costs of office
supplies and the accountant’s fee. The promotion costs were made by ads in magazines,
sponsoring poker events, giving away prices on the site and promotional clothing. Other
operating expenses consist of all costs that could not be placed under another heading. This is
largely made up by cost of poker related goods. These goods consist of books about poker,
poker tables, official poker sets etcetera.
Table 2: Balance sheet
Historical Balance Sheet 2006
Operating Cash € 158.912
Total Current Assets € 158.912
Computers € 4.000
Total fixed assets € 4.000
Total Assets € 162.912
Total Current Liabilities € 0 Total Long Term Liabilities € 0
Total equity € 162.912
Total Liabs and Equity € 162.912
For this research, the little assets owned by Poker X were put in a balance sheet. Based on the argument that Poker X has no assets the accountant had not even made up a balance sheet.
The “asset operating” cash consists of the net income of the owners that has not been paid out yet. The computer hardware consists of four computers, six LCD screens and additional equipment.
To get an idea of the growth of Poker X the following table shows the growth of monthly unique visitors in 2005 / 2006. Unique means that visitors are only measured ones in a particular month. Sequence visits in that month are not added to the count.
Table 3: Visitors Poker X
Internet data ( x 1000)
Month Page Loads Unique Visitors First Time Visitors Returning Visitors
01-02-05 27 12 4 9
01-03-05 44 19 5 13
01-04-05 51 21 6 15
01-05-05 66 26 7 19
01-06-05 62 25 6 19
01-07-05 66 26 6 20
01-08-05 89 31 6 25
01-09-05 88 32 6 25
01-10-05 115 41 9 32
01-11-05 120 50 14 37
01-12-05 125 51 11 39
01-01-06 145 61 14 47
01-02-06 133 59 13 46
01-03-06 162 73 17 56
01-04-06 153 71 15 56
01-05-06 154 74 16 58
01-06-06 140 68 14 54
01-07-06 145 71 17 54
Internet data ( x 1000)
Month Page Loads Unique Visitors First Time Visitors Returning Visitors
01-08-06 161 81 21 60
01-09-06 142 70 16 55
01-10-06 143 76 19 57
01-11-06 149 76 24 51
01-12-06 159 78 23 55
01-01-07 158 81 24 57
3.1 Internal environment
According to Hamel and Prahalad (2002) a company should not focus on her core business but on her core competences to survive. They say that core competences will lead to core business activities. Core competences are the unique skills of a company that are difficult to copy by competitors. They consist of resources and capabilities that give a competitive
advantage. This paper will address Poker X’s core competencies by doing an internal analysis.
First the mission and objectives of Poker X and her competitive advantages are described.
Then the resources, Poker X has to achieve her mission, will be described. Finally the capabilities of Poker X are given.
3.1.1 Mission & objectives
Around 1999 the first online poker tables were founded. This online poker became
increasingly popular in a very short time span and people all over the world started playing online. Within a couple of years the growing popularity of poker was also noticeable in The Netherlands. There was however still no Dutch site that informed the Dutch market about poker. For this reason the owners of Poker X decided to create a site of their own. It should be a site that would give all kinds of information about poker and give poker players a forum to interact with each other. Within a year the forum produced a relatively large and renowned online community. This has made Poker X the largest informative poker site in The
Netherlands so far. The growing popularity of the game has done the rest.
Poker X its mission was and is becoming the best and the biggest Dutch informative poker
site. Its objectives are (in sequence of importance):
· Continuity of the firm (keep staff employed)
· Continuing to be the largest informative poker site in The Netherlands
· Inform, amuse their visitors and give them insight into the game Poker
· Make poker more popular in the Dutch community
· Continuous improvement of the services to the visitors
· Expanding to other countries
· Continuous growth in their activities surrounding poker
Poker X is planning to achieve her mission through several competitive advantages.
First of all Poker X has its first mover advantage. Because Poker X was the first in its kind it is very well known within the poker society. The biggest strength of Poker X according to the owners of the site is her online poker community. This community consists of a large (and growing) group of poker players that communicate through the forum of Poker X. All big players are part of the community and practically any question about poker can be answered.
The members of the community can count on the support and contacts of Poker X if necessary. An online community like this, which has been build up over the years cannot easily be taken over by the competition. Another aspect of the first mover advantage is that it can stay ahead of the game. For example; Poker X has perfected her site and can now focus on Google optimization (increasing the Poker X hits on Googles search engine) while other companies are still focusing on the first stages of building a site.
Poker X is planning to also create this first mover advantage by setting up sites in foreign countries. Until now it has concentrated mainly on the Netherlands, but a Belgian site has been launched recently and a Portuguese site is in the making.
Because Poker X was the first and has been developing ever since, she also has the advantage of being the largest. Being the largest has several advantages. The most basic one is the fact that being the largest creates publicity all by itself. Poker X has repeatedly been in the media, since the media finally noticed the popularity of the game. Being the largest also means having more cash flow at your disposal. This can be used for promotion, service
improvements, expansion etcetera. Another advantage of being the largest is that it gives you a better bargaining position against the online poker tables. Poker X can offer better deals for playing at certain sites.
But all advantages mentioned above can be lost easily if the company is not managed
properly. This brings us to the third competitive advantage, management. The management
consists of the three owners of Poker X. They are all three well known poker players and have
therefore a lot of inside information. They are not only very knowledgeable about the game
poker, but also about the world surrounding poker. This is why they have been asked to write a book on poker and also cooperate with a television program about poker. They still play poker very frequently and read a lot of material on the subject, which keeps their knowledge up to date. It also gives them the opportunity to share their experiences and their findings with the visitors of their site. In order to maintain this know-how in the company they also get their employees from the poker scene. The fact that the owners are still very active in the poker scene does not mean that they do not invest time and effort into their company. They
passionately work on the development of Poker X. The combination of their know-how about poker and their passion for the company and the game results in creative and innovative developments of the company. Every week there are new items to be found on the site; not only new articles but also tournaments and poker courses (amateur as well as professional) set up by Poker X. Recently the site was given a facelift, which has resulted in an improved and more mature site. It has grown, from a student hobby site, to a serious business.
The development of Poker X as serious business brings us at the flaw in the company. A professional company needs a professional approach. The mission and objectives as
mentioned above were developed in cooperation with the owners, but were not concrete until that point. The development of Poker X has gone so fast that they have not yet been able to set up an actual business plan. Because of the small real life size of the organisation, it has not been a problem so far. It will be necessary in the future to have a clear idea of the
organisational structure and the direction the company is heading. This lack of structure will also be addressed under the heading “Capabilities”
3.1.2 Resources
Pokers X’s resources are the means to achieve her mission and objectives. They can be divided in tangible, intangible and human resources.
Tangible
Poker X has not got many tangible assets, as is not uncommon within internet companies. It consists for a small part of computer hardware and the rest consists of excess cash which is the profit after tax, that has not been paid to the owners yet. Some of this money can be
invested in the company if necessary. Poker X her access to cash is her greatest tangible asset.
Intangible
The largest intangible asset is the brand Poker X. The first mover advantage of Poker X in combination with the popularity of the game has resulted in a large initial popularity of the site. By constantly developing the site and improving and expanding the services, Poker X has created a good reliable reputation towards the visitors of the site. Because of the increased and increasing popularity of Poker X’s site, she also has gotten a good reputation with the online poker tables.
Another less important intangible asset is the technological know-how. Certain know-how is needed to develop and maintain a site like Poker X. Other ICT-ers also have the general technological knowledge, but not the specific knowledge based on Poker X. The
technological know-how lies solely with one of the owners.
The know-how is a link to the final intangible asset, human resource. The three owners and the two employees are all active in the poker scene and are therefore quite knowledgeable about the subject. Based on the results and the discussions with the three owners, it can be said that they are successful in their management. The two employees consist of one voluntary forum moderator and a forum moderator who also does the public service & data processing. These employees were offered a job because Poker X noticed their striking expertise on the forum. The love for the game of these employees results in a great commitment and in employees that can attribute to the improvement of the site.
3.1.3. Capabilities
