Competitive Advantage Period: The Neglected Value Driver

VOLUME 4
BUSINESS VALUATION
ISSUE 1
JUNE 1998
D I G E S T
A publication devoted
to articles on Business
Valuation and related
matters.
BY MICHAEL MAUBOUSSIN AND PAUL JOHNSON
IN THIS Competitive Advantage Period: The

ISSUE Neglected Value Driver
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5XjUbhU[YDYf]cX. Although the notion of competitive advantage periods that do not properly reflect competitive
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JUì]b[5ihcacV]`Y it is a subject that has not been explicitly - the number of years a company is expected
8YU`Yfg\]dg! addressed in finance textbooks in a way to generate excess returns on incremental
CjYfj]Yk""""" 10 commensurate with its importance. Further, investments _ is critical as it weds competitive
Cdh]cbDf]W]b[. many analysts and strategic planners that adhere advantage (strategy) to valuation (finance). CAP
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to a discounted-cash-flow framework reduce plays an important role in linking valuation
a]b]b[ the model’s validity by using explicit forecast theory and practice.
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In 1991, a Goldman Sachs limited problem. However, to understand the

partner, Barrie Wigmore, released a study solution there must be a recognition that
that attempted to determine what factors share prices are not set by capitalizing
drove the stock market’s above-average accounting-based earnings, which are at best
returns in the decade of the 1980s. After flawed and at worst substantially misleading.
carefully accounting for earnings growth, It appears that this was precisely the
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diV`]WUh]cbcZH\Y7UbUX]Ub=bgh]hihY interest rate declines, M&A activity, and paradigm under which both Wigmore and
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analysts’ “too-rosy” forecasts, it appeared that the Wall Street Journal were operating. The
gidd`]YXZfYYcZW\Uf[YhcU`ÀYaVYfg a full 38% of the shareholder value created focus must be on the economic drivers
GiVgWf]VYfgUbXFY[]ghYfYXGhiXYbhgcZ
h\Y=bgh]hihY" in the 1980s remained unexplained. Dubbed of a business, which can be defined as
GhUhYaYbhgUbXcd]b]cbgYldfYggYXVm the “X” factor, this mysterious driver of cash flow (cash-in versus cash-out), risk (and
h\YUih\cfgUbXWcbhf]Vihcfg]bh\Y
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value left Wigmore and the Wall Street appropriate demanded return), and what we
h\Y]fckb UbXUfYbchYbXcfgYXVm Journal (Lowenstein, 1991) at a loss. Given have dubbed “competitive advantage period”
bcfUfYh\YmbYWYggUf]`mh\cgYcZ
h\Y=bgh]hihYcfh\Y9X]hcf]U`5Xj]gcfm overwhelming evidence of well-functioning (CAP) or how long returns above the cost of
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EDITOR:
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unsatisfactory to attribute such a large “value-growth duration”2 and “T”3,4 in the
EDITORIAL ADVISORY BOARD:
component of share price performance economic literature. CAP is also similar in
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to some unidentifiable and seemingly concept to “fade rate.”
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inexplicable force.1

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:Ul.(%*!-++!,),) The Canadian Institute of Chartered Business Valuators
2 BUSINESS VALUATION DIGEST
In this context, we believe Wigmore’s X evidence suggests that the stock market deems cash
factor can be explained by the market’s flow to be more important than earnings, holds
extension of expectations for above-cost- true to the risk/reward relationship over time, and
of-capital returns. As Wigmore’s analysis recognizes cash flows many years into the future.6
suggests, the length and relative change of Second, most companies use a forecast period
CAP can have a substantial impact on the for strategic-planning purposes (usually three to
value of a business and the market overall. five years) that is substantially different from their
For example, the revision in expectations CAP. As a result, investor communication is geared
of Corporate America’s ability to generate more toward internal company-based expectations
returns above its cost of capital is a powerful rather than external market-based expectations. If
indicator that investors believed that America the determination of stock prices is approached
was more competitive at the end of the with an economically sound model, as we argue it
1980s than it was entering the decade. This should be, the concept of CAP becomes
conclusion was later supported by economic immediately relevant, as we show below.
analysis.
It should be noted that in a well- I. CAP Defined
functioning capital market all assets, including CAP is the time during which a company is
bonds and real estate, are valued using expected to generate returns on incremental
similar economic parameters. In the case of investment that exceed its cost of capital. Economic
bonds, for example, the coupon rate (or cash theory suggests that competitive forces will drive
flow) is contractually set, as is the maturity. returns down to the cost of capital over time (and
The bond price is set so that the expected perhaps below it for a period). Said differently,
return of the security is commensurate with if a company earns above-market required returns,
its perceived risk. The same is true for most it will attract competitors that will accept lower
commercial real estate transactions.5 At the returns, eventually driving industry returns lower.
end of the day, the process of investing The notion of CAP has been around for
returns to the analysis of cash flow, risk, some time; nonetheless, not much attention has
and time horizon. Since these drivers are not been paid to it in the valuation literature. The
contractually set for equity securities, they are concept of CAP was formalized by Miller &
by definition expectations and, in most cases, Modigliani ( 1961 ) through their seminal
dynamic. work on valuation. The M&M equation can be
Remarkably, in spite of CAP’s importance summarized as follows:
in the analytical process-which we will attempt NOPAT + I(R-WACC)CAP (1)
to demonstrate below-it remains one of the Value=
WACC (WACC) (1+WACC)
most neglected components of valuation. This
where
lack of focus appears attributable to two main
NOPAT = net operating profit after tax
factors. First, the vast majority of market
WACC = weighted average cost of capital
participants attempt to understand valuation
I = annualized new investment in
and subsequent stock price changes using
working and fixed capital
an accounting-based formula, which generally
R = rate of return on invested capital
defines value as a price/earnings multiple
CAP = competitive advantage period
times earnings. Thus, CAP is rarely explicitly
addressed, even though most empirical Rearranged, the formula reads:
(value)(WACC-NOPAT)(1+WACC) (2)
)5bcihghUbX]b[]`ìghfUh]cbcZh\]gkUgh\Y%--%gU`Y CAP=
cZh\Y9ad]fYGhUhY6i]`X]b[ Uf[iUV`mcbYcZh\Yacgh
I(R-WACC)
ZUacigVi]`X]b[g]bh\Ykcf`X"FYU`YghUhYYldYfhgdY[[YX These formulas have some shortcomings that
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H < 9 7 5 B 5 8 = 5 B = B G H = H I H 9 C : 7 < 5 F H 9 F 9 8 6 I G = B 9 G G J 5 @ I 5 H C F G
BUSINESS VALUATION DIGEST 3
Figure 1. Theoretical Decay in Excess Returns in a rapidly changing sector (e.g., technology)
are unlikely to be valued as generously as
Returns high returns in a more prosaic industry (e.g.,
beverages). The final driver is barriers to
entry. High barriers to entry-or in some
businesses, “lock-in” and increasing returns
CAP are central to appreciating the sustainability
WACC of high returns on invested capital.
Time Note that CAPs are set at the margin by

* shaded area = value creation self-interested, motivated, and informed
investors. That is, if an implied CAP is “too
Figure 2. How the Market Works short” (too long) for the shares of a given
company, astute investors will purchase (sell)
Returns those shares in an attempt to generate excess
returns. Accordingly, changes in CAP are a
critical driver in valuation. Experience shows
that CAPs are rarely static and are usually in
CAP the process of expanding or shrinking.7
WACC Graphically, CAP can be represented by
Time the accompanying two figures. In Figure 1,
* shaded area = value creation the Y axis represents expected return spread
(return on invested capital less the cost of
demonstrate, with clarity, how CAP can be concep- capital) while the X axis is time. As time
tualized in the valuation process. goes on, competitive forces drive returns to
A company’s CAP is determined by a a level equal to the cost of capital. The
multitude of factors, both internal and external. shaded area under the curve, therefore, is
On a company-specific basis, considerations such what the market is trying to determine, and
as industry structure, the company’s competitive is the basis for P/E ratios, cash flow multiples,
position within that industry, and management and various rate of return measures. Figure
strategies define the length of CAP. The structured I presents the theoretical decay in excess
competitive analysis framework set out by Michael returns as competitors are drawn into the
Porter (1980) can be particularly useful in this industry. Figure 2, on the other hand, is
assessment. Important external factors include how we believe the market actually works.
government regulations and antitrust policies. CAP Although value creation may occur beyond
can also reflect investor psychology through implied the CAP, as shown in this figure, risk-
optimism/pessimism regarding a firm’s prospects. averse investors are only willing to go so far
We believe that the key determinants of into the future. This notion has implications
CAP can be largely captured by a handful of that will be explored below. A careful
drivers. The first is a company’s current return look at these figures also reveals that they
on invested capital. Generally speaking, higher capture the three traditional components of
ROIC businesses within an industry are the best a discounted-cash-flow model. The first is
positioned competitively (reflecting scale economies, a “prestrategy,” or “steady-state”8 value-the
entry barriers, and management execution). As worth of the company if no value is created.
a result, it is often costlier and/or more time This point is represented by the intersection
consuming for competitors to wrest competitive of the X and Y axes. The second component
advantage away from high-return companies.
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UbbiUàYYh]b[cZg\UfY\c`XYfg"
is the value created by the company’s reasonable.11

pursued strategy, represented by the shaded Our discussion so far has dwelled on those
area. Finally, there is the terminal value, companies that generate returns above the cost of
which often, but not always, assumes no capital, a universe which represents roughly one-
further value creation. The terminal value is third of Corporate America (another one-third
where the CAP line intersects the X axis. are estimated to be value-neutral with the last third
From a practical standpoint, we find that value-destroying).12 Two points are noteworthy
the discounted-cash-flow analysis done by about value-neutral and value-destroying companies.
most analysts and strategic planners has a First, the CAP for a value-neutral company is of
forecast period, or CAP, that is too short, little consequence, since returns are assumed to be
and a terminal value that incorporates too equal to the cost of capital (i.e., the second part of
much of the overall value. As a result, the the M&M formula has little or no value). Applying
calculation of value becomes highly sensitive such performance to either Figure 1 or Figure 2
to the implicit growth assumptions beyond would show little area under the curve, thus having
the forecast horizon that are imbedded in the a minimal impact on value. Second, value-destroying
terminal value. For example, it is not unusual companies are often tricky to model, because many
for 75% or more of a company’s value to be of them appear to have an “imbedded option” for
attributable to a terminal value. In contrast, a better performance. That is, the market is willing
DCF model incorporating CAP usually has a to pay more for these companies than one would
longer forecast horizon, all growth assump- otherwise expect due to the possibility that the
tions are explicitly stated, and the terminal company will restructure, and hence generate better
value is usually a modest contributor to returns in the future.13
overall value.
In a theoretical sense, the allocation of
II. How Long are CAPs and How
intrinsic value among the components is not Should They be Determined?
important; in real life, valuations vary widely The CAP for the US stock market, as a whole, is
as a result of different CAPs and methods estimated to be between 10 and 15 years. However,
employed to calculate terminal value.9 To within that aggregate, individual company CAPs can
paraphrase John Maynard Keynes, we would vary from zero to two years to over 20 years. As a
rather be vaguely right than precisely wrong. general rule, companies with low multiples tend to
We often hear that it is completely have shorter CAPs (interestingly, these low multiples
unreasonable to forecast beyond two or are accompanied by above-market-average earnings
three years, because “anything beyond that growth in some industries). Alternatively, companies
is guessing”.10 This logic misses the point, with high multiples typically have long CAPs. For
which is that the market often does impound example, companies like Microsoft and Coca-Cola
cash flows beyond the near term. have CAPs well in excess of 20 years, demon-
Accordingly, an analyst must gain an strating their perceived market dominance, the
understanding of why cash flows are sustainability of high returns, and the market’s
recognized for so long and whether or not willingness to take the long view. If a substantial
those cash flow expectations are percentage of the value of a company can be
attributed to cash flows beyond a few years, it is
6GYYFUddUdcfh%-,*UbXA]``YfUbXAcX][`]Ub]%-*%" difficult to argue persuasively that the market is
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short-term oriented. In turn, it follows that the
%%5ZUjcf]hYUbU`c[mWcaYgZfcah\Y[UaYg\ck ¹BUaY forecast periods used in most valuation models are
h\UhHibY"ºCbYgY[aYbhkUgWU``YX6]X!U!BchY ]bk\]W\ not long enough.
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As we will argue below, it may be more to help translate the market expectations
important for the investor to try to quantify CAP impounded in a share price into value drivers
than to pass judgment on its correctness. As that are easy to understand and assess. The
noted earlier, the components of value are all value of any asset can be expressed with a
expectational, and therefore must be considered limited number of variables-in particular, cash
relative to one another and against the expectations flow, risk, and CAP. As such, the analyst
for the business overall. can hold constant one of the three main
There are a number of ways to estimate CAP, drivers and consider what the security price
but one of the most useful methods was is implying about the other two. For example,
developed by Rappaport (1986). We have chosen consider the shares of the Kellogg Company.
to borrow and slightly alter Rappaport’s name for (See Table 1 for scenarios.) With share prices
the technique_market-implied_duration-and call it at about $70 and a weighted average cost
market-implied CAP (MICAP). Determination of the of capital of 11%, the market is impounding
MICAP has a few steps. First, the analyst needs a roughly 10% cash flow growth15 for about
proxy for unbiased market expectations as the key 15 years. If the analyst lowers his or her
input into a discounted cash flow model (we use projection of CAP to 10 years, the cash-flow-
long-term estimates). Since, by definition, there is growth rate would have to rise just to equal
no value creation assumed after CAP, the model the current share price. Similarly, if the CAP
uses a perpetuity assumption (NOPATCAP/WACC) were deemed to be 20 years, the implied
for the terminal value. Next, the length of the cash-flow-growth rate would decline to a rate
forecast horizon is stretched as many years as under 10%.
necessary to achieve the current stock price. This By breaking cash flow down into its
period is the company’s MICAP. essential drivers_ including sales, margins,
Scrutiny of the MICAP-determination capital needs, and taxes-this technique can
process would correctly identify it as a circular help analysts translate intuitive assessments
exercise. That is, if a stock price increases without about a business into an economically correct,
changes in cash flow expectations and/or risk, the multidimensional framework. Rappaport uses
MICAP will necessarily expand. However, this in no an analogy of a high jumper. The analyst
way weakens CAP’s value as an analytical tool, as has a feeling for the future performance
the next section will explain. In fact, we believe of the company-how “high” the business can
this tight link with valuation highlights the power of jump-and using CAP in the analysis can help
including CAP as a key tool in the analytic toolbag. determine how “high” the bar is set. If the
anticipated performance of the business is
We believe that MICAPs can be key to the
greater (worse) than the implied performance,
analytic process. For instance, a calculated MICAP
the stock is a buy (sell).
can be compared to previous MICAPs for the
same company, an average MICAP for the industry A second important concept is that if the
(if possible and appropriate), and the company’s CAP for a value-creating company remains
historical cash-on-cash return on invested capital. constant, an investor can expect to generate
We have done this analysis for the packaged-food excess returns over time.16 Note that a
industry over the past few years and have constant CAP is contrary to economic
consistently derived industry MICAPs in the range theory, but it may be achieved through
of 14-16 years.14 outstanding management (i.e., resource
allocation, acquisitions). To illustrate this
III. How Can CAP be Used for point, refer to Figure 3. Imagine going from
Security Analysis? %)7Ug\Z`ck]gXYZ]bYXUgbYhcdYfUh]b[dfcZ]hUZhYfhUlYg
BCD5Ha]big]bjYghaYbhZcfZihifY[fckh\= cfZfYY
The first use for CAP in security analysis is WUg\Z`ck"
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%(GYYAUiVcigg]b%--'"
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Table 1. Relation of FCF, WACC, and CAP for Kellogg

Estimated FCF Equity Value Per
Scenario Growth Estimated WACC CAP (Years) Share
5%$ %%%) +$
62%$%% %$ +$
70%$%% &$ +$
GcifWY.7fYX]hGi]ggY:]fgh6cghcb7cfdcfUh]cb
year 0 to year 1. As the length of CAP the two companies. Without CAP, we believe that
remains unchanged, a year of value creation it would be difficult to explain the differences in
is added, and the past year of value creation valuation between the companies. Accounting-based
is lopped off. As the investor purchased the valuation techniques are not helpful in resolving
shares expecting above-cost-of-capital returns these disparities.
for the implied period, the additional year of
value creation represents a “bonus,” or excess IV. Value Versus Growth Investing
returns. It appears that Warren Buffett has CAP’s Importance
used this concept for years in his investment In his 1992 letter to shareholders, Warren
process. He buys businesses with “high returns Buffett suggests that differentiating between growth
on capital” (returns in excess of the cost and value investing is “fuzzy thinking.”18 Buffett
of capital) that have “deep and wide moats” points out that stocks with low price-to-book ratios,
(sustainable CAPs) and holds them “forever” low P/E ratios, or high dividend yields are not
(hoping that the CAPs stay constant). Although necessarily good values while stocks with high
this technique seems fairly straightforward, valuations are not necessarily bad values.19 We
finding businesses with enduring CAPs is not concur with Buffett’s dismissal of the growth-
simple.17 Witness IBM. Although the company versus-value debate and believe the inclusion of
is reemerging as a formidable competitor, the CAP in the dialogue helps explain the seeming
company’s CAP shortened dramatically in the success of some investors, irrespective of their
early 1990s as the result of changes within stated approach. Said differently, the techniques
the industry and several management missteps. employed by most successful money managers-no
Once considered impenetrable, the company matter how they are characterized collapse into a
came to be viewed as a weakened giant, and its
MICAP shortened as a consequence.
Finally, understanding the concept of CAP Figure 3. CAP Remaining Constant Over Time
helps reconcile relationships that appear Shaded area=excess returns
counterintuitive when viewed through the Returns
accounting-based lens. For example, a relatively
slow-growth, high-return company in a stable
industry may well command a higher valuation
(i.e., higher P/E, price/book value, etc.) than
a fast-growing, high-return company in a WACC
rapidly changing industry. While part of such 0 1
a multiple discrepancy could be explained by
different risk profiles, we believe that the
%,GYY6Yf_g\]fY<Uh\UkUm%--'"
MICAPs would also be justifiably different for %-5gU[i]XYhcXYhYfa]b]b[jUìY 6iZZYhhfYZYfghcH\YH\Ycfm
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%+GYYG\Ud]fc%--&" ZcfaU`]nYgh\Y]XYUh\Uhh\YjUìYcZUVig]bYgg]gh\YdfYgYbhjUìY
cZ]hgZihifYWUg\Z`ckg"
model that is rooted in the drivers of cash flow, proved to be only about three years, as
risk, and CAP. the company’s actual results far exceeded
The essence of growth investing, it appears, is to expectations.
purchase stocks of companies with high returns and We calculate that Microsoft’s current
stable (or expanding) CAPs. We would note that implied CAP is 17-20 years. If the company
CAP is unlikely to expand if the rate of return still had an implied CAP of eight to ten
on incremental investment is declining sharply or is years, the current market value would be
below the cost of capital. Value investing, on the roughly $33 billion. Therefore, we argue
other hand, appears to either seek out those value- that two thirds of the company’s current
creating companies that have particularly short CAPs valuation is the result of an expansion in its
for reasons that can be identified as transitory, or implied CAP. Without the concept of CAP,
to identify businesses with improving returns, and we believe that most of Microsoft’s massive
hence potential for widening CAPs. Investing that value creation cannot be explained.
focuses solely on statistically cheap companies often Intel is also an impressive company.
leaves portfolio managers with a number of value- During calendar 1996, the stock increased
neutral or value-destroying companies that show little approximately 135% as investor expectations
potential to improve their performance. for the company’s growth and profitability
increased dramatically. Interestingly, once
V. Can CAP Work for Growth again we think that CAP played a critical
Companies? role in the company’s reevaluation. In May
It is generally accepted that discounted-cash- 1996, Intel announced that it would not
flow analysis, and therefore the use of CAP, is lower pricing in the fall of 1996 as it had in
not helpful in valuing fast-growing companies, such each of the prior years. This announcement
as technology businesses. These companies, it is proved to be a watershed event as it implied
asserted, are “earnings driven.” We will argue that in that-as the result of lower production costs
fact earnings-driven companies are implicitly valued and economies of scale-earnings and returns
by the market based on cash flow projections, and on invested capital (ROIC) would expand.
that CAP is a very important consideration in the From the time of this announcement to the
analysis of these businesses. end of the year, the stock doubled.
Microsoft has been one of the most successful Again, we ask the question: How can a
companies in Corporate America over the past ten stock with such a large capitalization (roughly
years. The company has grown sales from under $120 billion at year-end) better than double
$200 million in fiscal 1986 (the year it went public) in one year? We estimate that Intel’s MICAP
to $8.7 billion in the most recent fiscal year. The was roughly five years at the beginning of
company has created a phenomenal amount of 1996, but expanded to about nine years
shareholder value in the process. When the company by the end of the year. Expectations of
went public on March 13, 1986, it had a market net operating profit after tax (NOPAT)
capitalization of $519 million. The company’s market increased during the year as a result of
value was approximately $100 billion at year-end the strategic change in pricing strategy, but
1996. Microsoft created roughly $ 100 billion in we calculate that 65% of the increase in
shareholder value over a decade. market capitalization-$45 billion-was related
How is this possible? We argue that approximately to a lengthening in the implied CAP. Once
two-thirds of the increase in shareholder value again, the dramatic change in market value
was the result of a dramatic lengthening of cannot be explained without CAP.
the company’s implied CAP. We calculate that We have also used CAP as a heuristic in
Microsoft’s CAP was eight to ten years the our analysis. An example is the
day it went public-using then-prevailing consensus semiconductor
estimates. Interestingly, the actual CAP at the time industry in late 1995. At the time, the
Table 2. Variation in Food-Industry the X Factor

CAPs, 1982-1989 In an effort to demonstrate how changing
7cadUbm %-,&75D %-,-75D CAPs can affect stock prices-and explain the X
7UadVY``Gcid ( &$U factor-we studied a handful of companies within
the packaged food industry in the September
7D7=bh¼` %$ %)
1982 to August 1989 period. As our goal was
<">"<Y]bn ) %' to identify approximate CAPs in each period, we
<Yfg\Ym * &$ used Value Line long-term forecasts as a proxy
?Y``c[[ %, %- for consensus cash flows and used then current
risk-free rates, betas, and equity-risk premiums to
5jYfU[Y ,"* %+"(
estimate expectations for the cost of capital. These
UH\]gbiaVYfkUgUWhiU``m\][\Yf Ugh\YZ]fakUgh\Y drivers, when considered next to the stock price,
giV^YWhcZhU_YcjYffiacfg"KYbcfaU`]nYXh\YYgh]aUhY allowed for an estimate of CAP. As we accounted
Zcfh\]gYlWYfW]gY"
GcifWY.JUìY@]bY ?]XXYfDYUVcXm UbXUih\cfYgh]aUhYg" for changes in perceived growth rates and actual
interest rates in each period, extraordinary changes
sector had produced excellent appreciation for in the share values could be largely attributable to
three years. Expectations about the future of CAP.
the industry were generally upbeat. However, Table 2 summarizes our findings. The prevailing
there was growing evidence that significant CAP for this group roughly doubled in the seven-
new capacity would begin to come onstream year period (the food-group stock index out-
during the second half of 1996, negatively performed the S&P 500 index during those years),
affecting the profitability of the industry and implying that the industry had become better
causing the industry ROIC to fall. These competitively positioned. In fact, most of the
concerns notwithstanding, industry capacity at companies in the group streamlined their business
the time remained constrained, allowing the portfolios, cut costs, increased vital marketing
leading vendors to post impressive financial spending, and increased their cash flows sharply.
results. Further, an active market for corporate control
However, the leading semiconductor stocks in the sector forced managements to focus on
were beset with peculiar behavior. The shareholder value improvement.
companies reported record earnings-easily We suspect that a similar expansion in CAPs_
beating consensus expectations-but their stocks albeit less dramatic-occurred in the broader market,
failed to rise. In fact, the stocks started to allowing for shareholder returns to outstrip both
show considerable weakness (some dropped historical averages and those that could be justified
as much as 50% in the ensuing three to based on changes in cash flows and interest rates
six months) in the face of the impressive alone. In fact, the business-friendly environment
financial performance. How could this have that prevailed through much of the 1980s and
happened? As earnings estimates continued to the growing pressure on managements to create
rise, a valuation based solely on price/earnings shareholder value or run the risk of losing the
multiples was clearly of no help. entire company_may have been enough of a
We assert that the MICAPs shortened driver itself to create this sentiment of increased
because of concerns surrounding the impen- competitiveness and enhanced confidence.
ding capacity additions. Future expectations for
ROICs were effectively being cut by investors,
even as short term earnings forecasts were
rising. Once again, CAP proved to be a critical
component in the valuation process.
VI. Lengthening CAP Could Explain
References
VII. Summary 6Yf_g\]fY<Uh\UkUm %--' %--&5bbiU`FYdcfh %("
Although CAP has unassailable importance 7cdYÙbX H" H"?c``Yf UbX>"Aiff]b %--% JUìUh]cb.
in valuation, it is a subject that has not been AYUgif]b[UbXAUbU[]b[h\YJUìYcZ7cadUb]Yg BYk
Mcf_ BM >c\bK]`YmGcbg"
explicitly addressed in finance textbooks in a way
commensurate with its importance. Further, many @ckYbghY]b F" %--% ¹;c`XaUbGhiXmcZGhcW_F]gY]b
,CgDcgYgU6][F]XX`Y ºKU``GhfYYh>cifbU`>ibY* 7%"
analysts and strategic planners that adhere to a
DCF framework reduce the model’s validity by using AUiVcigg]b A">" %--' ¹DUW_U[YX:ccX=bXighfm º7fYX]h
Gi]ggY:]fgh6cghcb7cfdcfUh]cb9ei]hmFYgYUfW\AUm%-"
explicit forecast periods that do not reflect CAP.
A]``Yf A"UbX:"AcX][`]Ub] %-*% ¹8]j]XYbXDc`]Wm
We believe that CAP can play an important role in ;fckh\ UbXh\YJUìUh]cbcZG\UfYg º>cifbU`cZ6ig]bYgg
linking valuation theory and practice. CWhcVYf (%%!(''"
A]`àUb ;">" %--% ¹H\YgY7cadUb]Yg5XXJUìYZcf

G\UfY\c`XYfg º7cfdcfUhY:]bUbWYCWhcVYf&- %(!&'"
C¼6mfbY G":" %--* ¹9J5UbXAUf_YhJUìY º>cifbU`cZ

5dd`]YX7cfdcfUhY:]bUbWYGdf]b[ %%*!%&)"
DcfhYf A"9" %-,$ 7cadYh]h]jYGhfUhY[mHYW\b]eiYgZcf

5bU`mn]b[=bXighf]YgUbX7cadYh]hcfg BYkMcf_ BM :fYY
DfYgg"
FUddUdcfh 5" %--& ¹7:CgUbXGhfUhY[]ghg.:cf[]b[U

7caacb:fUaYkcf_ º<UfjUfX6ig]bYggFYj]YkAUm#
>ibY ,(!-&"
FUddUdcfh 5" %-,* 7fYUh]b[G\UfY\c`XYfJUìY BYk

Mcf_ BM :fYYDfYgg"
G\Ud]fc 5" %--& ¹7cfdcfUhYGhfUhY[mUbXh\Y7Ud]hU`

6iX[Yh]b[8YW]g]cb º]bH\YBYk7cfdcfUhY:]bUbWY.
K\YfYH\YcfmAYYhgDfUWh]WY 8"<"7\Yk >f" 9X" BYk
Mcf_ BM AW;fUk!<]`` +)!,-"
GhYkUfh=== ;"6" %--% H\YEiYghZcfJUìY BYkMcf_ BM

<UfdYf!7c``]bg &,-!&-,"
K][acfY 6"5" %--% ¹<ck7UbKY9ldÙ]bh\Y;fckh\

cZh\YGhD)$$]bh\Y%-,$g3º;c`XaUbGUW\g=bhYfbU`
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K]``]Uag >"6" %-', H\YH\YcfmcZ=bjYghaYbhJUìY

7UaVf]X[Y A5<UfjUfX6ig]bYggGW\cc`DfYgg"
Michael Mauboussin is a Managing Director and Equity Product

Manager at Credit Suisse First Boston Corporation and is an
Adjunct Professor at Columbia Business School. Paul Johnson is a
Managing Director and Technology Industry Analyst at Robertson
Stephens & Company and is an Adjunct Professor at Columbia
Business School.
Reprinted with the permission of The Journal of The Financial

Management Association International - Volume 26, Number 2,
Summer 1997.
BY JAMES L. (BUTCH) WILLIAMS, CPA, CVA, CBA

Valuing Automobile
Dealerships Overview
The valuation issues associated with are negotiated directly with one another. This is an
automobile dealerships, in many respects, extremely competitive industry requiring continuous
mirror those of most corporations. However, attention to management of resources. Accordingly,
the automobile dealership industry also the selling dealer is well advised to obtain an
possesses several unique characteristics accurate determination of worth before placing the
requiring specialized knowledge by the dealership or franchise in line for sale.
valuation professional. With terminology that
4) Divorce
distinguishes this industry from others, an
Individual state laws impact how most dealerships
abundance of performance and forecasted
are valued in divorce situations, but the valuation
data, and a strong reliance on the national
professional is frequently called upon to educate
and local economies, valuing automobile
the court on the unique ownership and operational
dealerships requires a thorough examination
issues confronting the dealership owner.
of the dealership by a valuator knowledg-
eable in the industry. 5) Litigation
Areas of litigation vary widely. Most litigation
What are the Major Reasons matters requiring the utilization of a valuation
for Valuation? professional involve shareholder disputes.
While automobile dealerships can be Accordingly, fair value and fair market value
valued for almost any reason, my 20+ years opinions are utilized to resolve these matters of
of experience with the industry has revealed dissent.
the following purposes for valuation: In addition, valuations are also utilized in
1) Dealer Succession disputes with manufacturers, usually in the form of
lost profits computations.
Because the automobile dealer is the
franchise owner, the various manufacturers 6) Income Tax Elections
(General Motors [“GM”], Ford, Chrysler, As mentioned earlier, the valuation professional
Toyota, Nissan, Mercedes, etc.) imposed is often utilized by the seller or purchaser in
stringent requirements regarding succession establishing value prior to a dealership transaction.
ownership. Valuation of the dealership for In addition, the valuation professional is often
estate and gifting purposes is very common, called upon to establish values for purposes of
and it provides unique issues to the valuation asset allocation in the transaction.
professional.
2) Merger and Acquisition Understanding the Industry

Most dealerships (and franchises) are Fortunately for the practitioner, the automobile
transacted directly between existing dealers. industry is one of the largest industries in the
Accordingly, valuations are utilized for due world, and a tremendous amount of information is
diligence purposes to help ensure that a fair available.
price is derived for the entity. While a detailed description of the automobile
3) Sale of Dealership or Franchise dealership is not practical in this article, the major
publications and resources are listed in the
As mentioned previously, most
Appendix to this article. However, a brief
transactions involving dealerships and
overview of the unique attributes of an automobile
franchises occur between existing dealers and
dealership is useful.
Multiple Businesses in One Larger dealerships may have separate

departments (or separate companies) for
Possibly, one of the most misunderstood and least
Lease and Rental sales, and they may also
appreciated aspects of the automobile dealership
have a Buy-Here, Pay-Here lot targeting
is the complexity of the business. While most
lower value used vehicle sales.
companies involve one or two line(s) of business(es),
the automobile dealership is composed of at The complexity of managing these varied
least five businesses in one company. The typical functions requires a skilled handling of
dealership is divided into several departments, but personnel, physical facilities, inventory
in the case of the automobile dealership, these control, and money management.
departments include very separate and distinct Relationships with the manufacturer and key
management requirements. vendors are also very important to the
success of the dealership.
Closest in similarity are the New Vehicle
Department and the Used Vehicle Department,
Dealership Accounting
although the methods for acquiring and
merchandising these two types of vehicles varies Unlike most industries, the automobile
dramatically. In recent years, margins on new dealership industry is fairly standardized in
vehicles have significantly decreased, and the its accounting. As part of the franchise
contribution to the gross profit of the dealership agreement, the dealer agrees to utilize and
has increasingly declined. Used vehicles, on the report to the manufacturer under that
other hand, have in recent years increased in gross manufacturer’s standard accounting system.
profit. In providing such, the manufacturer can
more accurately measure performance in
The Parts Department includes both retail and
comparing a particular dealership with its
wholesale activities, and it can represent a sizable
peers. Each dealership is provided with
investment of resources by the dealership. Proper
a Standardized Accounting Manual which
coordination of this department with the Service
describes how each type of dealership
Department can have a large effect on dealership
transaction is to be reported. Therefore,
profitability. As “front end” (vehicle sales) gross
with very few exceptions, most dealerships
profits have declined in recent years, the “back
within a particular manufacturing family
end” (parts and service) operations have become
(GM, Ford, etc.) will have substantially
increasingly more important.
identical reporting of financial information.
The Finance and Insurance (“F & I”) Department Understandably, this comparability provides a
of the dealership is the operation requiring the significant tool to the valuation professional.
least overhead and producing the largest gross
While automobile dealership accounting
profit, yet curiously is often the area of the
substantially follows generally accepted
dealership receiving the least attention. Directly
accounting principles (“GAAP”), it does
impacted by demographics and the product lines
possess several unique features of which
of the dealership, the F & I income can be very
the valuation professional should be aware.
significant.
A few of the more prominent, unique
In addition to the five departments prevalent accounting features are:
in almost every dealership, many dealerships will
also have a Body Shop Department. While this 1. LIFO Inventory Method
department is often linked with the Service An often employed method of inventory
Department, the Body Shop Department is also valuation in the automobile industry is the
reliant on its own unique factors. The relationship last-in, first-out (“LIFO”) method. LIFO is
with the various insurance companies is critical adopted to reflect the matching of revenue
to the success of this department, and a major and expense, and it can result in substantial
investment in equipment is also required. income tax savings for the dealership. Due
to the significant investment in inventories by
the dealership, this method (depending on tremendous number (generally several thousand)
the number of years it has been utilized) can of parts in a dealership’s inventory, the ability
reflect a dramatic reduction in the net assets to properly match this historical prices with the
of the entity. physical inventory on hand is virtually impossible.
The reporting of the LIFO Reserve Accordingly, the dealership will generally update
(a value often exceeding $1 million) is its parts pricing computer tape with the most recent
usually found in one of two places on the pricing on a periodic (usually quarterly or semi-
dealership’s balance sheet. One method of annually) basis. Therefore, the physical inventory
presentation reports the reserve as a contra- on hand is valued at the most recent prices.
asset account reducing the inventory (which As a result, a dealership which possesses a
can include one or all of the following: new large amount of old or obsolete parts could have
vehicles, used vehicles, parts) in the Current inventory that is reflected on the financial records
Assets section. at amounts exceeding their fair market value. As a
Another method of presentation is to result, when dealer-
record the entire reserve in the Equity ships are transacted, it is not uncommon to
Section of the balance sheet. This method see a reduction in value of 15-50% in the
is often utilized by the dealer preferring to reported book value of the parts inventory.
show the dealership assets not reduced by
4. Departmental Reporting
the reserve, in order to not appear out of
trust with the financial institutions financing As mentioned previously, most manufacturers
the vehicles. provide for departmental detail in the standardized
accounting model. Therefore, the valuation
2. Liability for Chargebacks professional can assess the performance of the
Chargebacks consist of amounts charged dealership as a whole, as well as departmentally.
by the finance and insurance vendors back A dealership’s performance by department, when
to the dealership for contracts terminating viewed in relation to economic and demographic
prior to maturity. The dealership earns conditions, can provide the valuation professional
commissions from the vendors on these with significant information in determining the
contracts at the time of sale, and it is entity’s value.
charged for any loss of income to the vendor
5. Dealer Reserve Accounts
when the customer prematurely ends the
contract. Related to the finance and insurance function of
the dealership, most financial institutions will
Depending on the level of paper
require the dealership to maintain reserves to offset
(outstanding finance and insurance contracts)
potential charge backs. These reserves are generally
associated with the dealership, the
reductions of dealership commissions and are often
outstanding contingent liability could be
not reflected on the financial records of the
significant. For example, if a dealership
company.
has $20 million of outstanding paper and
has a historical chargeback rate of 1.5%, While these amounts are generally not material
a contingent liability of $300,000 could be in nature, they are a result of individually
associated with the value of the entity. negotiated arrangements between the dealer and
the financial institutions.
3. Recording of Parts Prices
In addition to financial institution reserves,
Financial reporting of an entity’s assets is
generally reflected by the historical purchase dealerships will often establish reserves to offset
future losses. Examples of these include reserves
price of these assets. As assets are sold, for
they are removed from inventory at those losses on used vehicles and demonstration units.
historical prices. However, due to the
Industry Statistics • CSI - Customer Satisfaction Index, a

measurement of polled data obtained by
As noted previously, the automobile industry is
the manufacturer to evaluate the customer
one of the largest industries worldwide. Industry
service performance of the dealership.
data is both voluminous and accessible, and the
valuation professional is able to obtain accurate, • Demo - a vehicle typically driven by sales
contemporaneous information from a variety of personnel of the dealership which is
services. A number of these resources are recorded always available for demonstration
in the Appendix to this article . purposes to dealership customers.
• F & I - finance and insurance.
The dealership also has a large amount of
industry statistics provided directly to it by • Factory - another name for the franchisor
the manufacturer. (example, Ford, Toyota, etc.).
Dealership performance data, usually expressed • Fixed operations - another name for the
in relation to other dealerships within the zone, is non vehicle sales operations (parts, service,
attainable by the valuation professional from the and body shop) of the dealership.
dealer. In addition, the dealer may be a member of • Floor plan - financial institution financing
a dealer “Twenty Group”, a facilitated organization of vehicle inventory, with each floor plan
of dealerships (usually similar in franchises and note secured by a vehicle.
size) designed to share operational information and • Front end - another name for the vehicle
ideas. Furthermore, the following industry statistical sales (new and used) operations of the
information is available in the Automotive News dealership.
1997 Market Data Book, related to:
• Holdback - an amount held by the
1) United States Sales History and Forecast manufacturer, that is later remitted to the
2) U. S. Car Sales History dealership, that is in addition to a new
3) U. S. Truck Sales History vehicle’s purchase price.
4) 1996 Top 15 Makes by Region in U.S. • Rebates - inventory-related compensation

received from the manufacturer.
5) Financial Data - Average Dealership Profile
• SSI - Service Satisfaction Index
6) 1996 J. D. Power and Associates Surveys
• Water - a term used to indicate inventory
7) Dealer Census Data Publicly Held Dealer Groups
(usually parts and used vehicles) cost
carried on the financial statements in
Industry Terminology
excess of true value.
The automobile industry, similar to other
• DOC - Daily Operating Control Report -
industries, possesses its own unique terminology. In
an internally produced summary report,
determining the valuation of the dealership, the
prepared for management, which details
valuation professional will often be confronted with
daily and month to-date sales, gross
this terminology. The following is a brief listing
profit, and expense information by
of several terms that are often encountered in the
department.
automobile dealership environment:
• Dueling - a practice of maintaining more
• Back end - another name for fixed operations
than one new vehicle franchise at one
(parts, service, and body shop) of the dealership.
common physical facility (example, Toyota
• Blue sky - another name for the goodwill of the and Mazda).
dealership.
• Chargebacks - the unearned portion of finance
income which is repaid to the financial
institution when customers prematurely Key Risk Areas
pay their loans. In every engagement, the valuation
professional is confronted with the need The factories are currently in a process
to assess the key risk areas impacting of realignment of these franchises, and many
the subject company. Automobile dealerships franchises are changing hands. Often, the
provide several unique risk areas distinct manufacturer is leading this realignment (GM has
from the normal business valuation subject. channeling teams throughout the country devoted
Among those risk areas unique to automobile to this task) and is occasionally subsidizing this
dealerships are the following: process by offering varying levels of financial
assistance.
1. Environmental Issues
In recent years, environmental issues have 4. Viability of Location
become more important. By the nature of the Another factory initiative, also designed to
operations in most automobile dealerships, the strengthen the dealer distribution network, involves
contingent liabilities can be, and often are, the viability of the dealership location. As area
significant. Underground tanks, underground demographics change, the manufacturer is looking
lifts, chemical contamination, and leakage to have their dealerships located in the most
are but a few of the issues impacting the desirable areas for sales of their products.
dealership. In valuing a dealership, the viability of the
In dealership transactions involving real dealership in a particular location can dramatically
estate, Phase I and Phase II (if warranted) impact value. A dealership with a location no
environmental impact studies are usually longer deemed by the factory as being viable would
conducted. Costs to replace tanks and lifts, provide several obstacles to both a potential seller
along with related business interruption, can or purchaser, ultimately impacting the dealership’s
be significant. value.
2. Franchise Agreement Terms 5. Factory Relationship

The automobile industry is a franchise As indicated previously, the relationship with
industry, and the terms and conditions the factory is extremely important. In addition
of the franchise agreements can greatly to the alignment, location, and ownership issues
impact value. Most agreements contain highly mentioned above, the factory relationship can
restrictive language involving transferability also greatly impact the dealership’s ability to be
of the franchise, with factory approval profitable. An example of this is the CSI and
being required in most instances. Accordingly, SSI programs of several manufacturers. In many
transferability of the franchise is severely instances, the performance of the dealership in
restricted. CSI and SSI directly impacts their ability to obtain
inventory. Vehicle allocations are often tied to CSI
3. Franchise Alignment
and SSI performance, as well as to historical sales
During the past decade, and especially performance (“turn and earn” inventory programs
in the last two years, the issues of relate performance to inventory provided by the
franchise alignment in accordance with the factory).
manufacturers’ directives have increased in
A dealership is also at the whim of the factory,
importance. GM’s Project 2000 and similar
and its decisions regarding various programs.
initiatives by virtually every manufacturer,
For example, the factory’s rebate programs and
have impacted dealerships and the vehicle
financing terms can greatly influence a dealership’s
lines they own. In an attempt to strengthen
performance and profitability.
the dealer distribution network, the
manufacturers have recommended desirable Which Assets are Purchased/Sold
alignments of product lines (e.g., Buick, Directly?
Pontiac, and GMC trucks aligned together, as In most dealership transactions, the assets
well as Chevrolet with Oldsmobile or Cadillac).
6. Litigation Issues level, the industry has reacted significantly

In recent years, the automobile dealer has to such historic events as rising or declining
become an increasingly larger target for litigation. interest rates, the Gulf War, etc. Locally, the
Dealerships are being faced with larger incidents closing or opening of a major plant, a strike,
of class action law suits as well as ever increasing or a similar economic event could greatly
damage claims resulting from their customers. A impact a dealership’s performance.
thorough evaluation of historical litigation claims, as 8. Regulatory Issues
well as contemporaneous pending and threatened
Periodically, certain regulatory issues can
litigation, is essential.
impact the value of a dealership. For
7. Economic Issues example, the imposition of the luxury tax
Because of its high reliance on consumer and the proposed 1995 tariff against Japan
spending, the automobile industry is very much at significantly impacted the value of many
risk with respect to economic trends. On a national dealerships.
Understanding How Dealerships are

Purchased and Sold
best interests). However, the price paid for
Which Assets are Purchased/Sold
the parts is often negotiated and can range
Directly? somewhere between a price of all parts at
In most dealership transactions, the assets their current prices (as would be recorded
negotiated directly between the purchaser and seller on the dealership’s financial statements) to
are the following: a price equivalent to only those parts that
1) Vehicles are returnable to the manufacturer (generally
2) Parts non-obsolete parts boxed in their original
containers and packaging).
3) Fixed Assets
Fixed assets are usually the last tangible
4) Blue Sky
assets to be negotiated, and their ultimate
price is negotiated extensively by the parties.
How Are These Assets Purchased/
The fixed assets have usually been depreciated
Sold? by accelerated depreciation methods and
New vehicles are generally purchased at their oftentimes contain fully depreciated items,
FIFO cost from the manufacturer, with adjustments such as parts bins, furniture, and office
for holdback and advertising charges, and are taken equipment. Accordingly, the seller almost
subject to the related floor plan (or an appropriate always believes that the fixed assets are worth
substitution). Adjustments to new vehicles are also more than the book value, while the purchaser
made for demo units. looks at the assets as used and worth less than
Used vehicles are subject to full negotiation their book value.
between the parties and are often not purchased at Blue Sky is a term used in automobile
all, leaving the seller with the responsibility of selling dealerships, and it is another name for the
the used vehicles to customers or to wholesalers. dealership’s goodwill. This intangible asset
Any related financing is also paid off as the vehicles generally consists of the value attributable to a
are sold. combination of the dealership’s:
Parts are valued, oftentimes by taking a physical a) Earnings capacity
inventory at the time of sale, and it is usually paid
b) Reputation
equally by both parties (since it is in each of their
c) Franchises the lowering of the capital gains tax, as well as

d) Location the increase in acquisitions by public companies,
it is fair to assume that more dealerships will be
e) Demographics
transacted through stock deals.
f) Other factors
Two major factors influence the prices paid in
To quantify this Blue Sky, the industry a stock transaction: the LIFO reserve, and the built-
generally looks to the expected pre-tax, pre- in gains income taxes to be “inherited” by the
LIFO earnings of the dealership. Obviously, purchaser. In arriving at the adjusted book value
the most recent performance of the of the dealership, the LIFO reserve, in addition
dealership is given the greatest consideration, to any adjustments to reflect the fair market
but oftentimes the average (usually weighted) value of the underlying assets (for example, an
of the past two or three years is used, with adjustment to reflect the appraised value of real
the ultimate goal being to determine the most estate owned by the dealership), are added to the
reasonable level of earnings of the dealership. book value. Similarly, any downward adjustments
Once the earning’s stream is identified, a (such as uncollectible receivables, “water” in the
multiple of these earnings is applied, and it inventories, unrecorded reserves for chargebacks
is reflective of the other factors listed above. and litigation) are also made to decrease the book
The multiple tends to fall between 1 and 3 value.
times the earnings, with recent trends falling Related income taxes associated with these
between 1.5 and 2 times earnings (higher increases and decreases to the book value are
for more profitable lines, more desirable also given strong consideration. Depending on the
locations, etc.). intentions of the parties, particularly the purchaser,
Thus, a dealership’s assets are generally the negotiated adjustment for income taxes ranges
sold at their adjusted book value, plus Blue between 0 - 40% of net adjustments.
Sky represented by the equivalent of 1.5 - 2 The Blue Sky consideration in a stock transaction
times the pre-tax, pre-LIFO earnings. is often not incorporated into the stock price paid;
but rather, it is negotiated separately through non-
What About Stock Purchases/ compete, consulting, or rental agreements. This is
Sales? done primarily because of income tax reasons, since
While stock purchases and sales are the purchaser desires to maximize the deductibility
relatively rare, they occasionally occur. With of the purchased assets, including goodwill.
Methods for Valuing Dealerships

Does the Purpose Matter? sold for an amount equivalent to the adjusted net
assets of the dealership, plus Blue Sky. Blue Sky is
Absolutely! Returning to some of the the
equivalent to a multiple (between 1 - 3 times) of
major reasons for valuation listed earlier in
pre-tax, pre-LIFO earnings.
the article:
Similarly, another asset method of valuing a
1) Purchases and Sales dealership involves an excess earnings method.
In situations involving the purchase and Similar to the net adjusted assets method, the excess
sale of a dealership, it is important to earnings method values the goodwill (intangible
understand how dealerships are bought and assets) based on earnings in excess of an
sold. In an earlier section of this presentation, industry return on the net adjusted assets of
the elements of the traditional asset purchase the dealership. Since the dealership employs a
were described. Generally, the dealership is significant investment in inventories and capital
assets, this method is a useful way to determine is obtained from the dealers themselves, as
value. However, care should be given to the specific well as brokers and professionals assisting
rates of return assigned to the tangible assets of the them.
dealership, since different dealerships have different Limited information for transactions
asset mixes. involving dealerships is available from market
An income approach in valuing a dealership data bases, but the size of the transactions are
poses a particularly difficult challenge because the generally small and vary widely in their terms
earnings can vary so dramatically. As has been and prices.
previously discussed, most dealerships have a value
2) Divorce and Litigation
of at least their net adjusted book value. A
strict capitalization of earnings or a discounting Applicable state laws generally define the
of future earnings/cash flows may not adequately standard of value, with most valuations
reflect all of the elements of value in an automobile using either fair value or fair market
dealership. Accordingly, the development of a value. Asset based and market methods are
proper capitalization rate provides an additional generally utilized, and the major factor of
challenge to the valuation professional. contention between the parties then becomes
the applicability of discounts. Once again, the
As in valuing any business, the choice of
courts generally determine which discounts
an appropriate earnings stream, indicative of
are appropriate in the valuation process
the dealership’s expected performance, is very
and whether the premise of value is either
important. Earnings of the smaller dealerships tend
liquidation or going concern.
to approximate cash flows, and the challenge in
this volatile industry is to arrive at a conclusion of How Does the Emergence of
representative earnings.
Publicly Traded Companies Impact
Historical performance is extremely important, Value in Automobile Dealerships?
but the days of the automotive industry being
Without question, the emergence of
on a predictable, five-year economic cycle are
publicly traded companies owning automobile
long past. Historical performance, coupled with
dealerships is the single most significant
the many, varied economic, industry, and other
development in the past few months. In
factors mentioned in this presentation, determines
the used vehicle market, CarMax and Auto
the ultimate conclusion of the earnings stream
Nation made early splashes in the industry,
upon which the valuation professional can base an
followed by United Auto Group and Cross-
opinion. In addition, this is an industry where
Continent Auto Retailers in the new vehicle
forecasted earnings are oftentimes available, availing
market. Quickly behind them were Lithia
to the valuation analyst an ability to compute a
Motors, followed by the most dominant
value based on various discounted future income
current participant, Republic Industries.
approaches.
Hardly a week goes by without news of a
Market methods, including guideline publicly
large dealer group being acquired by one of
traded companies and market data bases, provide
the publicly traded companies or news of a
some measure of comparability for the valuation
new publicly traded automobile dealer group
professional. A discussion on publicly traded
being formed. The multiples of earnings paid
companies follows later in this presentation.
for these acquisitions have been considerably
While market data is helpful, the availability higher than those traditionally transacted in
of comparable sales is extremely limited. As the industry, and this has produced an
previously mentioned, the majority of transactions impact on asking prices for most dealerships
of automobile dealerships occur between dealers, currently on the market. However, many of
and very little public information is available. these dealerships are not being sold, and it is
Accordingly, most information related to these sales important to view the facts and circumstances
currently in the industry to determine the trends in stock prices (declining prices in response
reason. to disappointing profits). Absurdly high prices are
The rush to go public has been fast still being paid by these companies as they seek to
and furious, with many groups vying for increase their profitability by acquiring earnings.
advantage in the stock market. The public’s Should the prices being paid by the publicly
infatuation with the initial offerings has been traded companies be considered? Most definitely!
very high, particularly with the addition Should they be utilized? Only in very unique
of Wayne Huizenga into the market. The situations, and even then, with some adjustments.
acquisitions of dealer groups have been
largely strategic ones, with the purchasers Common Normalization
seeking to obtain certain geographic locations, Adjustments
market diversity, and franchise diversity. When valuing controlling interests in automobile
Predominately purchased are larger dealer dealerships, several normalization adjustments are
groups and larger individual dealerships, with generally applicable. Many of these mirror those
an emphasis on earnings and franchises. adjustments prevalent in valuing most closely-held
For example, Republic has sought to companies, and include the following:
purchase large groups and dealerships in 1) Dealer and family member compensation - as
its bid to challenge the franchise limitations with most closely-held companies, these
currently imposed by both Toyota and can vary greatly from industry standards.
Honda. As mentioned earlier, the acquisitions 2) Rent - since many dealerships rent their
are strategic ones and are aimed at certain facilities from the dealer (or related parties), the
dealerships and dealer groups. rent factor should be reviewed.
Do these acquisitions reflect the current 3) LIFO - this method of accounting is generally
market values of dealerships? In larger utilized for the income tax level derived, and it
dealerships and dealership groups, they has a financial statement impact on both
certainly should be considered in the ultimate earnings and the balance sheet.
determination of value. However, in most
4) Adjustments for water in receivables and
dealerships with annual sales under $75
inventories.
million, the applicability of these publicly
traded companies’ transactions have very 5) Real estate and fixed asset values.
limited use. 6) Dealer perks - a thorough inquiry is
However, the excitement generated by required to uncover many of these which
these transactions has, most assuredly, raised can include demo units for family
the expectation levels of most dealers offering members, etc.; investment vehicles
their dealerships for sale. In addition to the (vintage antiques), motor homes, boats,
publicly traded transactions, another factor etc.; club memberships; and a host
influencing the sales prices of dealerships of personal expenses paid by the
is the emerging participation by the factory dealership.
in aligning franchises in desired locations. 7) Assets and liabilities not included on the books
These “Additional” funds are resulting in - dealer reserves, contingent liabilities
higher asking prices from selling dealers, but (chargebacks, litigation), etc.
limited increases have been in prices paid for By utilizing the comparative industry data
dealerships. that is readily available, inquiries can be
While the economy is solid, skepticism made about variations by the dealerships;
in the industry is fairly high. The ultimate and appropriate adjustments can be made.
impact by the publicly traded companies is
still undecided, especially in lieu of the recent
BUSINESS VALUATION DIGEST &
19
SUMMARY
While many of the traditional approaches to
valuing automobile dealerships apply, it is vital
that the valuation professional fully understand the
intricacies of the industry. An understanding of the
industry under “normal” conditions is a difficult
task; however, the current changes bombarding the
automotive business make it especially challenging
to accurately value a dealership. Daily events impact
value, and the valuation professional is required to
expand existing appraisal knowledge to encompass a
vast amount of constantly changing information.
This article is based on a paper by James L. (Butch)

Williams, CPA, CVA, CBA, “Valuing Automobile
Dealerships” presented to the 16th Annual Advanced
Business Valuation Conference held at the Sheraton
Palace hotel San Francisco, California on October 23,
1997.
Mr. James L. Williams, CPA, CVA, CBA, is

with Williams, Taylor & Associates of Birmingham,
Alabama.
Appendix A
Resources and References
GENERAL NACVA Wilshire 5000 Listing of Company Sales
Prices, NACVA, 1245 East Brickyard Road, Suite
Uniform Standards of Professional
110, Salt Lake City, Utah 84106
Appraisal Practice, 1995, The Appraisal
Data for Market Comparison, The Institute of
Foundation, 1029 Vermont Avenue, NW,
Business Appraisers, Inc., Post Office Box 1447,
Suite 900, Washington, D. C. 20005, (202)
Boynton Beach, Florida 33425
347-7722. A copy of the complete standards
is available for $25 from the Appraisal Standard Federal Tax Reports, IRS Valuation
Foundation. Guide for Income, Estate and Gift Taxes,
Valuation Training for Appeals Officers, Extra
Valuing a Business: The Analysis and
Edition Valuation 81 number 4, January 28, 1994
Appraisal of Closely Held Companies, 3rd
edition, by Shannon P. Pratt (Burr Ridge, Standard and Poor’s Register of Corporation,
III.: Irwin Professional Publishing 1996). Directors, and Executives, Standard and Poor’s
Corporation, 25 Broadway, New York, NY 10004
Valuing Small Businesses and Professional
Practices, 3rd edition, by Shannon P. The Value Line Investment Survey, Arnold
Pratt, with Robert F. Reilly and Robert P. Bernhard and Company, 711 Third Avenue, New
Schweihs (Burr Ridge, III.: Irwin Professional York, NY 10017
Publishing 1997). Standard and Poor’s Corporate and Government
Handbook of Business Valuation, Thomas Bond Yield Index, Standard and Poor’s
L. West and Jeffery D. Jones, editors (New Corporation, 25 Broadway, New York, NY 10004
York: John Wiley & Sons, 1992). Autos - Auto Parts, Current Analysis, December
Introduction to the Valuation of Businesses 14, 1995, Volume 163, No. 50, Sec. 1, Standard &
and Professional Practices, Shannon P. Pratt Poor=s Industry Surveys, 25 Broadway, New York,
and Robert F. Reilly (American Institute of NY 10004.
Certified Public Accountants CEA program
materials, 1995). PERIODICALS
Basic Business Appraisal, Raymond C. Miles Automotive Executive, a monthly publication of
(New York: John Wiley & Sons, 1984). NADA
Standard Industrial Classification (SIC) Services Corporation, a wholly-owned subsidiary of
Manual, (Washington, D.C.: Executive Office NADA,
of the President, Office of Management and 8400 Westpark Drive; McLean, Virginia 22102;
Budget, 1987). (703) 821-7150.
Handbook of Small Business Valuation Formulas Automotive News, a weekly publication of Crain
and Rules of Thumb, 3rd edition, by Glenn M. Communications, Inc., 1400 Woodbridge; Detroit,
Desmond (Camden, Maine: Valuation Press, Michigan 48207-3187; (800) 678-9595.
1994). Black Book, a weekly publication of National Auto
Financial Studies of the Small Business, (Winter Research, Post Office Box 758; Gainesville, Florida
Haven, Fla.: Financial Research Associates, 30503.
annual). Car Dealer Insider, a weekly publication of United
Annual Statement Studies, Robert Morris Communications Group, 11300 Rockville Pike -
Associates, 1600 Suite 2300, Philadelphia, PA Suite 1100; Rockville, Maryland 20852-3030;
19103-7398 (800) 929-4824 x247.
NADA Official Used Car Guide, a weekly Prospect Avenue; Mt. Prospect, Illinois
guide published by NADA, 8400 Westpark Drive; 60056.
McLean, Virginia 22102. Economic Indicators: The Motor Vehicle’s
Standard & Poor’s Industry Surveys - Autos & Role in the U.S. Economy, published
Auto Parts, weekly publication by Standard & by the American Automobile Manufacturing
Poor’s, a division of McGraw-Hill Companies, 25 Association, 1401 H Street, N.W. - Suite 900;
Broadway; New York, New York 20004. Washington, D.C. 20005; (202) 326-5500.
Ward’s Dealer Business, a monthly publication Guide to Dealerships, Don E. Ray, Stephen
of Ward Communications, a division of Intertec D. Holton, Marilyn Patterson and Marilyn
Publishing Corporation, 9800 Metcalf; Overland Z. Rutledge, published by Practitioners
Park, Kansas 66212-2978; (800) 441-0294. Publishing Company, Inc.; Fort Worth, Texas
(1996).
Periodicals (usually monthly or bi-monthly)
The Power Report, published by J. D. Power
from the applicable state automobile dealership
associations.
PUBLICATIONS,
MANUALS AND
GUIDES
A Dealer Guide to Valuing an Automobile
Dealership, David A. Duryee, an NADA
Management Guide, published by the National
Automobile Dealers Association, 8400 Westpark
Drive; McLean, Virginia 22102 (1995).
Auto Dealership Engagement Manual,
Tony L. Argiz, Marc S. Dickler and Don M. Pallais,
an AICPA Integrated Practice System manual,
published by the American Institute of Certified
Public Accountants, Harborside Financial Center,
201 Plaza Three; Jersey City, New Jersey
07311-3881 (1995).
Automobile Dealership Accounting, Jacob Cohen
and Carl Woodward, a continuing professional
education course (#735145), published by the
American Society of Certified Public Accountants,
1211 Avenue of the Americas; New York, New
York 10036-8775 (1996).
Bureau of Economic Analysis, published by the
U.S. Department of Commerce, 14th Street, N.W.;
Washington, D.C. 20230.
DeFilipps’’ Dealer Tax Watch, a quarterly
publication of Willard J. DeFilipps, CPA, P.C.,
317 West Prospect Avenue; Mt. Prospect, Illinois
60056.
DeFilipps’ LIFO Lookout, a quarterly publication
of Willard J. DeFilipps, CPA, P.C., 317 West
BY M. ARMSTRONG, Ph.D., AND A. GALLI., Ph.D. A]bYfU`9Wcbca]Wg

Option pricing: A new approach
to valuing mining projects
& Associates, 30401 Agoura Road; Agoura for valuing the mineral rights to deep-level gold
Hills, California 91301; (818) 889-6330. resources (see Box 1).
ABSTRACT This paper presents the main features of options,
Option pricing is used in finance for valuing reviews the mathematical models currently available
options to buy (or sell) shares at some future date for pricing them, and describes how these models
because it provides a convenient framework for have been adapted for mineral project valuation. At
quantifying values subject to uncertainty. As one of present, most published applications limit themselves
the main sources of uncertainty in mining is the to studying the added value derived from the mine
price (sales) of the metal, this approach can also be management’s options to stop/start/delay mining.
used for valuing mining projects. In reality, mining companies have a much wider
range of more subtle options at their disposal. In
The first part of this paper reviews options
the authors’ opinion, option pricing provides an
and option pricing; the second part presents the
interesting framework for valuing projects, but the
approach developed by Brennan and Schwartz
way in which applications are currently developing
(1985) for using option pricing to value natural
does not reflect industry practice. So this promising
resources. Several applications of this methodology
methodology needs to be adapted to allow for other
have been published; these are described. From
types of management options, and more realistic
a mining point of view, the assumptions made
ones at that.
by Brennan and Schwartz are too simplistic. The
weaknesses are discussed with a view to improving This paper does not present any new material;
an apparently promising new way of assessing the it attempts to provide a critical view of what
value of projects. currently exists, and of what is needed in the
future. In selecting books and papers to include in
Introduction the reference list, the authors have tried to stick
The collapse of the British merchant to those that are readily available, for example by
banking group, Barings, has highlighted the avoiding unpublished working papers.
risks that can be incurred by speculators The Standard Way of Valuing Projects:
and arbitragers in the futures and options DCF and NPV
markets. But this negative attention on futures
Before describing what options are, a few words
and options should not make us forget
should be said about other approaches to valuing
their positive aspects. They can provide
projects. The best known is undoubtedly discounted
producers and consumers of metals with more
cashflow analysis. Smith (1995) provided a thorough
predictable sales prices. The introduction
review of this. He stressed that the tricky point is
of the new traded average price options,
the selection of an appropriate discount rate, and
TAPOS, by the London Metal Exchange in
noted that although texts go into detail on the
January 1997 is a response to this need.
calculation of the corporate cost of capital, little is
Equally important, the theory that the finance
said in the literature about how to evaluate this key
industry has developed for valuing options
parameter for mining projects.
provides an interesting framework for valuing
mineral projects as well. While this paper Two recent books on option pricing compare the
was being revised, the South African gold two methods for valuing mineral projects. Copeland
mining house, JCI, announced that it was et al. (1990) argue that “a company that has the option
using a methodology based on option pricing to shut down and restart operations or to abandon them is
23
Box 1: JCI’s methodology for valuing

mineral rights • JCI then looks for specific gold call
The South African mining company, JCI, options at prices above the target price. Their
has recently developed a methodology for intrinsic value would be equivalent to the
valuing its deep-level mineral rights for gold expected NPV of the planned mine.
that is uneconomic given today’s gold price This approach is based on equating the NPV
and technology. Their approach which is of the planned mines to the equivalent option
detailed in the October 25 issue of Mining premiums. As Mining Journal points out,
Journal, is based on option pricing, but does If the full value of the mineral rights is the
not use models such as Black and Scholes option premiums received by writing the
(1973). Instead, it takes the empirical values equivalent gold calls, then it follows that the
option premiums are the only economic value
available in the metal markets. According to received by JCI. At any gold price higher than
Mining Journal, the steps involved in the new the target price, the additional economic value
approach are: of the planned mines will merely serve to offset
• the selected properties must be under the cost of servicing the call options.
JCI’s effective control so that it can decide Mining Journal then goes through an example
the timing of the investment; where the target price is $450/oz, and considers
• the geological model must be well how JCI would react if the price turned out to
understood; be $460/oz. The Journal stresses the sensitive point
• mine plans are drawn up at various in JCI’s analysis: being able to find suitable out-
cutoff grades in order to construct of-the money options (i.e. options at prices way
cashflow models; above current prices). The report concludes on a
• a target gold price is chosen that positive note:
would make the mine economically The beauty of this technique is that it puts
attractive; market value to the probability of the gold price
rising, and therefore fits in with the market
valuation of listed investments. Moreover, in
more flexible and therefore more valuable than the same two or three times as large as I. Hence the simple
company without these options”. DCF is not capable NPV rule is not just wrong; it is often very wrong.
of assessing this value whereas option pricing can. These quotes show that there is a growing
They claim that this increased flexibility may add interest in the use of option pricing for
30% to 40 % to a company’s NPV. valuing uncertain investments such as mines
In their book “Investment under Un- and oil fields. But in order to understand this
certainty”, Dixit and Pindynck (1994) use an new approach, one needs to know the basics
example of investing in a “widget” factory to about options and option pricing.
highlight the value of waiting until additional
information becomes available before making What Are Options ?
an irreversible investment (such as a mine). Those who are unfamiliar with options,
Box 2 presents this example, rewritten in at first find the vocabulary daunting. So it
terms of investing in a mining project. On is important to start out by defining the
page 136, they put their point clearly: terms used. Basically, there are two types of
The simple NPV rule is to invest as long as the options: “calls” (options to buy shares) and
›
value of the project V I, the cost of the investment, but “puts” (option to sell shares).
as McDonald and Siegel (1986) demonstrated, this is • A call option is a contract giving its owner
incorrect. Because the future values of V are unknown, the right to buy a fixed number
there is an opportunity cost to invest today. Hence the of a common stock at a
optimal investment rule is to invest when V is at least as fixed price at any time on or
large as a critical value V* that exceeds I. As we will see, before a given date.
for reasonable parameter values, this critical value may be • Conversely, a put option is a contract giving
7YbhfYXY;YcghUh]gh]eiY ')fiYGh!<cbcfY ++'$):cbhU]bYV`YUi :fUbWY
H < 9
< 9 7 5 B
5 B 5
5 8
8 == 5
5 B
B = B G
B G H
H == H
H I
I H
H 9
9 C ::
C 7 < 5
< 5 F
F H
H 9
9 F
F 9
9 8
8 6 I G
I G == B
B 9
9 G
G G
G J 5 @
5 @ I
I 5
5 H
H C
C F
F G
G
Box 2: An example of the value of waiting before investing

The Big Bonanza mining company is trying to decide whether to open up a new gold deposit. The
investment
is irreversible because there is no way for the company to recover its expenditure. (This assumes a zero salvage
value for equipment, etc). To simplify the discussion, suppose that the mine can be built instantaneously at a cost
of $4 million and will produce 1000 oz of gold per year forever, at zero operating cost. The current price of gold
is $400 per oz but next year the price will change. Next year’s price could depend, for example, on the results
of an election or on the success of some new metallurgical process for extracting gold. There is a 50% chance of
the price rising to $450 and an equal chance of dropping to $350. From then on the price remains constant. At a
price of $350 the project would lose money. (Note that the expected price is still $400 since 0.5 x 450 + 0.5 x 350
= 400) The discount rate is 10%. Is this a good project?
Time 0 Time 1 Time 2
P1 = 450 P2 = 450
P0 = 400
P1 = 350 P2 = 350
It is not difficult to calculate oo
the NPV of this investment. Remember that the expected future price
is $400. So if the project starts this year its NPV is
NPV = – 4,000,000 + 1,000 3 O
400
1.1n
= – 4,000,000 + 4,400,000 = 400,000

The project NPV is positive so it would seem that we should go ahead. This conclusion is correct if the
startup cannot be delayed. But suppose that the company could delay its decision for one year. In that case,
the decision is not optimal because the calculation given above ignores the opportunity cost of investing now,
rather than waiting to see whether the price rises or falls. If the company waits one year, then they will know
whether the long-term price is $450/oz or $350/oz. The project would not go ahead at the lower price. There
will be no expenditure and no revenue in year 0. In year 1, the 4 million is spent only if the price rises to
$450, which happens with probability 0.5.oo
So the new NPV is just
NPV = 0.5
[ – 4,000,0001.1 + 1,000
1
3 4501.1n]
= 431,000
If the company waits one year, the project’s NPV today is $431,000 compared to $400,000 if they
invest immediately. Clearly it is better to wait.
its owner the right to sell a fixed number of time in a more complicated way. These path
of a common stock at a fixed price at any dependent or exotic options include:
time on or before a given date. • Asian options which depend on the average
The act of carrying out this transaction is price of the asset over time;
called exercising the option; the price cited in • barrier options which come into effect or
the contract is called the exercise or strike price become worthless if the price hits a
and the date is referred to as the expiry or predetermined barrier; and
maturity date. In the case of European options, • look back options which depend on the
the transaction can be made only at this date; minimum or maximum price of
otherwise (for so called American options) the the asset.
right can be exercised at any time up to
or including this date. The terms “European” Who buys options?
and “American” no longer apply to different The easiest way to see how useful options can be
regions; both types of options are traded on is via a few examples. Here are cited two given in
either side of the Atlantic. the paper Les options ou les jeux de la finance et du
In addition to European and American hasard by Carrance and Pages (1988). Consider the
options, there are other types of options that case of the finance director of a French company
depend on the asset’s value over a period which does a lot of business with the United
States. Any variation in the exchange rate between in practice it can happen. Or, more accurately,
the franc and the dollar could leave this company it occurs for short periods of time until
with problems. So the director purchases a certain buying and selling sets the prices back into
number of USD/FFR options, thereby guaranteeing equilibrium. Now, let us address
getting at least a fixed number of French francs the question of what the equilibrium price
when the sales payments are completed. He is should be.
prepared to pay the premium to have this security.
Pricing the Premium
It is a sort of insurance policy for a risk-averse
An option buyer is clearly getting a good
company.
deal. He has the right, but not the obligation,
Now consider the financial director who is
to buy/sell the stocks at a specified price.
convinced that the dollar will rise sharply against the
He will exercise the option if the price at
franc over the next few months. If the exercise price
the stock exchange is better than the exercise
is low enough to be attractive (say 5 FFR = $1),
price specified in the contract, thereby making
he purchases put options to sell French francs a profit. Otherwise, he can go out and buy/sell
against dollars (say 5000 FFR = 1000 USD). He may what he wants on the open market. Conse-
even be prepared to borrow to do so. Let us see quently, the writer of the option contract will
what happens at the expiry date. If the exchange require a cash payment for providing this
rate at this date is much higher than the exercise flexibility to the option buyer. But how much
price (say it goes to 10 FFR = $1) he exercises his should this premium be? This is the essence
option to sell the FFR, and receives 1000 USD which of option pricing.
he immediately changes back into 10,000 French
The simplest way to understand what
francs on the open market. So he gains 5000 FFR
these premiums represent is by comparing
less the premium. If the exchange rate is not as high
them to insurance premiums. Take car
as had been hoped, then only the premium is lost. In
insurance as an example. The insurance
this case, the finance director is not trying to hedge
company works out the expected loss (the
against eventual fluctuations in the exchange rate.
value of the possible damage multiplied by
He is speculating to gain a profit.
the corresponding probability). Similarly, the
In addition to these two groups of people, there value of the option premium is the expected
is a third type, the “arbitragers”. These traders see value of the share, if it exceeds the strike
a slight difference between the prices for two types price. Basically, this comes back to modelling
of options, say the corresponding puts and calls, the chances of the share price going above
and cash in on it quickly, thus making a riskless various levels.
profit. In theory one should not be able to make a
Put-call Parity
riskless profit in a properly functioning market, but
Intuitively, we sense that there must be a
Box 3: Put-call parity the expiry date, not before) which then the call will be worthless,
Intuitively we sense that there pay no cash dividends during the but the put will be worth K-S.
must be a relationship between five life of the option. Suppose that >
Conversely if S K, the put is
critical variables: the following transactions are made worthless but the call will be worth
S = the market price of the stock simultaneously on a particular stock S-K. In either case you own one
C = the value of a call on that stock and its options with strike price K. share worth S and you owe K. So
(i.e. the premium) We construct a fictive portfolio as the future cashflow is certain to be
P = the value of a put on that stock follows. Write 1 call, buy 1 put, buy zero. That is,
K = the strike price 1 share and borrow Ke–rt, where t C – P – S + Ke–rt = 0
r = the instantaneous interest rate is the time left to expiry. After a
This is called the put-call
on a risk free loan (e.g. U.S. period of time (t) this will amount to
parity. Similar relationships can be
government bonds). K (principal + interest). The cost of
derived for more complicated cases,
The simplest case to consider this now is: C – P – S + Ke–rt. On
for example, if dividends are paid.
is that of European options (i.e. the expiry date, if the share price is
where action can be taken only on less than the exercise price (S K), <
relationship between five critical variables: the where dS is an incremental price change, dt is a
market price of the stock, S; the value, C, of a time increment, M and S are the local trend and
call on that stock (i.e. its premium); the value, the standard deviation, respectively, and dw is an
P, of a put on the same stock; the strike price, increment from a brownian motion (i.e. these are
K, and the instantaneous interest rate, r, on normally distributed). In finance S is called the
a risk free loan (e.g. US government bonds). volatility. The value of a call (C) is calculated as the
It can be shown that when the market is in expected value of S(t); the value of a put (P) is then
equilibrium, obtained from this and the put call parity.
C – P – S + Ke–rt = 0 When reading about the Black and Scholes

model, it is important to realize that different
This is called the put-call parity. See Box 3
people use different names to describe the
for a proof. If this relation did not hold, it
underlying stochastic process. It is variously called
would be possible to make money at no risk.
a “lognormal random walk”, a “geometric brownian
The concept that one should not be able to
motion”, or occasionally a “gauss-wiener”, or a
make money at no risk in a properly balanced
“wiener-levy process”.
market is vital to the whole of option pricing.
To describe this, financiers say that there are As a brownian motion is not differentiable in
no possibilities of arbitrage. In short, there are the usual sense, care must be taken in handling it.
no free lunches. A special theorem, called “Ito’s lemma”, has to be
used. No further detail will be given here on the
In addition to the “no arbitrage” argument,
Black and Scholes model, but those who would like
the proof requires the construction of a
more information can consult the original paper or
fictive portfolio. These are the basics in
the annex at the end of chapter 3 in Figlewski et
option pricing and are used by Brennan and
al. (1990). More mathematical presentations can be
Schwartz (1985) in their seminal paper on
found in Wilmott et al. (1993) and Dixit and
evaluating natural resources. Although the
Pindyck (1994). Cox and Rubinstein (1985) give an
put/call parity gives a relation between the
interesting demonstration of the result, first for the
values of puts and calls, it does not provide
discrete case then generalizing it to the continuous
a valuation for either. More assumptions on
one.
the underlying stochastic process are required.
The best known model for this is the one Black and Scholes’ model has two clear
proposed by Black and Scholes (1973). advantages: first, it gives an explicit formula for
the value of the options (i.e. the premium to
Black and Scholes’ Model for pay) and second, it turns out to be a good
approximation to reality (see the Appendix for
Pricing Options
an example). But no mathematical model could
In 1973, Black and Scholes published their
reproduce all the complexity of the option market.
theory on how to price options. Two months
Many others have been developed to overcome
later, in 1973, Merton independently produced
apparent weaknesses in Black & Scholes’. These
similar work. Both used stochastic partial
models are reviewed in the Appendix. In the next
differential equations (PDEs) to model the
section, the use of option pricing to value mineral
evolution of stock prices. Using the same
projects is discussed.
notation as above let S(t) be the share price at
time t. Black and Scholes split the proportional Applying Option Pricing to Mining
price increase into two components, a local (Brennan and Schwartz, 1985)
trend that acts over time and a special type of
In financial transactions, the buyer has the
random component. Their stochastic PDE is
option to buy (or sell) shares, metal or the
dS like. Similarly, in running a mine, the
= M dt + S dw
management has a certain number of options
S
available to it. For example, taking a rather unfavourable commodity

extreme view of the situation, the management prices.
has the option to stop mining or mothball the Orebody Assumptions
operation, options which they could exercise if the
In setting up their model, Brennan and
metal price dropped low enough for a long enough
Schwartz (1985) made four assumptions to
time. On the optimistic side, a company with a
make the mathematics tractable. These are:
promising new deposit would opt to start mining
• the interest rates are constant;
if the price was sufficiently attractive relative to
• all costs are known;
costs.
• the ore is perfectly homogeneous; and
Brennan and Schwartz (1985) developed a • the quantities of ore are known.
methodology for valuing mineral projects by valuing
From a mining point of view, the
management’s options to start mining/stop mining/
last three hypotheses are untenable. With
mothball the operation. They used Black and
very rare exceptions, orebodies are always
Scholes (1973) to model the spot price of the
heterogeneous. This is why so much care and
commodity, and following the standard option
attention is required in reserve evaluation and
pricing procedure, they developed a fictive portfolio
in choosing the cutoff grade. So it seems that
for the value of the mine, that is long in the
some work is required to make this side of
commodity and short in futures contracts on the
the model more realistic.
same commodity. Using the no-arbitrage argument,
the instantaneous rate of return had to be equal to Stop-Start Mining
the riskless rate of rate. That is, they followed a Few mining operations can actually be
classical option pricing approach, which predictably stopped and started to follow commodity
led to a set of PDEs with appropriate boundary price fluctuations. The exceptions to this
conditions. These can be solved either explicitly would include low cost dredging operations
or numerically to give the limiting values of (e.g. tin in southeast Asia and gold in Alaska
the commodity price at which the company which traditionally stops in winter anyway).
should change over from mining to “care and Low cost quarries and mines extracting
maintenance”, and then to permanent closure (as industrial minerals are another case (e.g.
prices decrease) and vice versa. They illustrated talc mines in the Pyrenees Mountains in
these ideas via a case study on a hypothetical France). But capital intensive open pits and
copper mine. most underground mines are not flexible
Following directly in Brennan and Schwartz’s in stopping and starting operations. Putting
footsteps, Palm, et al. (1986) presented an example it differently the costs of stopping and
where option pricing was used to value a high cost starting are very high. Care would be needed
copper mine. A good case study, but no new ideas to work out the real costs of these in
are developed in the paper. order to incorporate them into Brennan and
Schwartz’s approach.
Comments on Brennan and
Major problems are encountered with a
Schwartz’s (1985) Approach to stop/start policy. Labour relations become
Mine Valuation more difficult. It is not easy to recruit
While Brennan and Schwartz’s (1985) approach qualified staff quickly, particularly if they
is extremely interesting, its usefulness in practice is know that they can be put out at any time.
limited by two factors: If operations are suspended for a long time,
1. The underlying assumptions about the orebody regulators may require costly site reclamation
are unrealistic; and work, making it virtually impossible to start
up again. Likewise, environmental permits
2. few mining operations can actually be stopped
may no longer be valid. Some operations
and started at will, just because of
(platinum mines and leaching processes) have
long lead times before any saleable metal is a type of Monte Carlo simulation which is computer
actually produced. Mines with long-term sales intensive.
contracts must fulfill these obligations even if So the question can be asked whether the
they would prefer not to. Similarly during the problem could be formulated in terms of PDEs and
payback period, operations cannot be stopped solved numerically as Brennan and Schwartz did.
because of repayments to the lenders. Even
Explicit Solutions
if a mine is losing money, most banks prefer
that it keep operating as long as it honours As Brennan and Schwartz’s PDEs tend to
its interest payments schedule, rather than to be complicated, they recommend solving them
repossess it and try to sell it. numerically. An analytical solution is given only in
the simple case where the the quantity of metal Q
What Options are Available is infinite. Galli and Armstrong (1996) show that
to Management? closed form solutions exist for other cases; first
A mining company has two critical business when the mine cannot close down, and second when
processes: (1) increasing its resources/reserves permanent closure is allowed. That is, it is possible
and (2) utilizing them. In order to increase to express the mine’s value as a function of the
its stocks, a mining company can acquire initial spot price and the initial metal quantity. Geo-
reserves from another company, explore for statistical conditional simulations could be used
additional reserves on an existing property or to probabilize the initial metal Q (i.e. to get a
conduct grass roots exploration to discover histogram of initial Qs). Then deconditioning on
new orebodies. On the reserve utilization side, Q would give the expected value of the mine
a company can certainly start, suspend or stop depending only on the initial price. This opens up
its operations. This description of business the possibilities of studying project values. If no
structure explains why Brennan and Schwartz analytical solution can be found, sensitivity studies
chose to model management options as a have to be carried out by simulating many cases
stop/start business. But in fact, management (possible initial values) and solving each numerically,
also has a considerable range of flexibility which is computationally heavy.
while operating, for example, by varying the
rate of production. Other Books and Papers
Cutoff Grade Flexibility Valuation: measuring and managing the value of
companies, by Copeland, Koller and Murrin
Another major source of flexibility comes
from varying the cutoff grade. Increasing the Copeland et al. (1990) present option pricing
cutoff grade raises the average grade of ore studies carried out as part of their consulting work
produced but shortens the mine’s life. Lane for McKinsey & Co. In studies on oil extraction and
(1988) developed a method for choosing the on mineral lease development, their clients had the
optimal economic cutoff grade, which has option to defer opening or expansion (i.e. going
since become the industry standard. Mardones from closed to open in Brennan and Schwartz’s
(1993) has combined this with contingent terms). Another example is on an operating mine
claims theory (a technique related to option (supposedly producing kryptonite) that could stop
pricing) in order to value a copper project and start depending on the spot metal price which
comprising mining, leaching and was, according to the authors, highly volatile. To
electrowinning processes. Each time the sum up, these applications only take account of
copper price changes unexpectedly, the new stop/start/
optimum cutoff is determined. This approach mothball/ defer options.
differs from the one proposed by Brennan Investment Under Uncertainty, by Dixit and Pindyck
and Schwartz because it is sequential. It is The paper by Brennan and Schwartz (1985) is
rather mathematical and is quite concise, which
makes parts of it difficult to read. The book and Schwartz (1989) discuss the valuation of
by Dixit and Pindyck (1994) covers much of the long-term oil-linked assets. Berck and Johns
same material but as it has been designed for (1989) present an application to fish stock
graduate students, it is simpler to follow. Chapters assessment. Fish is another natural resource
3 and 4 are devoted to presenting the background that is subject to uncertainty. Stensland
mathematics that is needed, first stochastic processes and Tjostheim (1989) treat the problem
and Ito’s Lemma, and then dynamic optimization. of optimal decision making when applied
The authors use an example of investing in to oil production. But as the conference
a widget factory to highlight the weaknesses of was primarily addressed to the mathematical
the classical DCF analysis and then to show the finance community, the papers tend to be
optionlike nature of an investment opportunity. rather theoretical.
Three chapters are spent developing the theory
of real options. In chapter 5 they treat the Conclusions
case of irreversible investments; chapters 6 and 7 The term option pricing refers to a method
extend this to the cases where the project can be for valuing stock options and other derivative
suspended temporarily or abandoned permanently. securities. It is almost universally accepted
Several case studies are presented in the final in the world of finance. In its usual form
chapter. One concerns how to value undeveloped which is due to Black and Scholes (1973), a
offshore oilfields. Another investigates the problem lognormal random walk is used to describe
of sulphur dioxide reduction in the electricity the behaviour of the spot price; a fictive
generation industry. The Clean Air Act calls portfolio is set up to mimic reality and
for reductions in SO2 emissions from power the no-arbitrage argument is then invoked
stations. Utility companies can invest in expensive to equate the return on the portfolio to
“scrubbers” which fix the sulphur chemically or they the riskless rate of return. This leads to a
can buy tradeable “allowances” that allow them to set of partial differential equations that have
pollute. The problems arise because the cost of the to be solved under appropriate boundary
allowances is unknown. conditions. Sometimes the solution can be
Tang and Elbrond (1996) use Dixit and written explicitly in closed form; at other
Pindyck’s theory to obtain an optimal investment times, numerical methods are required.
rule for a mining project requiring sequential The first part of this paper reviews the
investment. The case study considered involves a classical Black and Scholes (1973) model for
gold mine with geological reserves of 3.5 million option pricing. some of the more recent
tons at a grade of 0.2 oz/ton and having an output developments are sketched in the appendix.
of 1600 tons/ day. As they chose to use a lognormal The second half of the paper is devoted to
model, the value of the project cannot go negative its application for valuing mineral properties.
which is unrealistic because mines have been known In 1985 Brennan and Schwartz produced
to make losses. the seminal paper in this field. Their
Oslo Conference on Stochastic Models approach models the mine managements
and Option Pricing options to shut operations down, temporarily
or permanently, if the commodity price drops
In August 1989, the University of Oslo organized
low enough for long enough. Similarly, the
a conference on stochastic models and option values
owner of a new project has the option to
which was attended by economists, finance theorists,
open it and start production or to delay
mathematicians and statisticians. Both Brennan and
production.
Schwartz were present. Brennan presented a paper
on the price of convenience and commodity This approach has several limitations. The
valuation, which helps clarify the concept of only management options considered are of
convenience yield used in the 1985 paper. Gibson a stop/start nature. In fact decision-makers
have a wider range of options open to S

them such as varying the cutoff grade in where dS is an incremental price change, dt is
response to perceived long-term price trends. a time increment, M and S are the local trend
A more serious criticism of their approach is and the standard deviation, respectively, and dw is
that it assumes that the orebody is perfectly an increment from a brownian movement. These
homogeneous and of known quantity. Recent increments are normally distributed. But as a
work by the authors shows that it is possible brownian movement is not differentiable in the
to overcome this. usual sense, care must be taken in handling it. A
Having mentioned these limitations, the special theorem called Ito’s lemma has to be used.
strong point of Brennan and Schwartz’s Without going into the mathematics in detail, a few
approach is that they have succeeded in important results can, nevertheless, be deduced from
setting up a set of partial differential the formula. Rewriting Black and Scholes equation
equations which can be solved either as:
explicitly or numerically to obtain the
d(log S) = Mdt + S dw
threshold commodity prices for which it is
optimal to mothball or abandon an operation shows that S must be lognormally distributed.
if it is running, or to open it if it is not Going further, after removing the trend the
operational. Their equations also give the variogram of log S has to be linear. Many
optimal extraction rate in tonnes per annum. different models for the spot price could be
envisaged. The advantage of Black and
Practical applications of Brennan and
Scholes is that it gives an explicit formula for
Schwartz’s model are starting to be published.
the value of the options (i.e. the premium to
The book by Dixit and Pindyck (1994) has
pay).
made option pricing much more accessible to
potential users and has provided additional How Well Does the Black and Scholes
case studies. One major gold mining Model Work in Practice?
company, JCI, is now using option pricing No mathematical model could reproduce all the
for valuing its deep gold reserves. Taken complexity of the option market but as a first
together, these confirm that option pricing is approximation the Black and Scholes model works
a promising approach to valuing mineral quite well. One way to illustrate this is to calculate
properties (and oil reservoirs). the variogram of the log of the share price (after
having removed the local trend) and see to what
Acknowledgment extent it is linear. Figure 1 shows the log of the
Many thanks to Professor Michael Brennan (weekly) price of a particular mining share over
for his constructive comments during the a 10-year period; Figure 2 shows the same values
preparation of the manuscript and to after the trend has been removed. Figures 3 and
Normand Champigny for his encouragement 4 present the variograms up to 50 weeks and 150
to tackle this topic. weeks, respectively. Although the first one is nearly
linear (it is only slightly curved), the second clearly
is not. This indicates that in this case, the Black
Appendix C : Black and Scholes
and Scholes model may be acceptable for shorter
Model for Pricing Options time periods, but not over longer ones.
Black and Scholes (1973) split the
Having shown that the variogram is
proportional increase in the spot price S(t)
approximately linear for time periods up to one
into components, a local time-dependent trend
year, the next test of Black and Scholes’ model
and a random component:
is to check the normality of the increments of
dS the logs. To do this, the increments of the logs
__ = M dt + Sdw were calculated over periods of one week, then five
and ten weeks. Figures 5a, 5b and 5c. Comparing

the experimental histograms to the histogram of
a normal distribution with the same mean and
variance, three things are seen: first, the tails of
the experimental distribution are fatter, its central
portion is more peaked and its shoulders are lower.
This shows that the experimental increments are
not normally distributed. Statisticians describe this
deviation from normality as “leptokurtosis” (because
the discrepancy shows up in the fourth order
moments). This is not just an artefact of this
particular data set; it has been found in many
studies.
The discovery of leptokurtosis led to a flurry of
academic activity, though practicians continue to use
Black and Scholes, “tweaking” the parameter values
when necessary. New models and improved versions
of Black and Scholes were proposed and tested.
These will be summarized in the next paragraph.
The aim in presenting these new developments is
to sketch the main lines of current research rather
than to provide an indepth literature review. For
our purposes these new developments mean that
one is not limited to only the standard lognormal
random walk if one wants to use option pricing.
It could, if need be, be replaced by other models
that are better suited to the particular type of
application in question but the resulting system of
equations would be much more difficult to solve.
Improvements on the Basic Black and

Scholes Model
The standard Black and Scholes model is
based on three underlying assumptions about the
behaviour of the logs of the price:
1. strict stationarity of the increments, for
each lag;
2. independence; (log S(t+T) - log S(t) is
independent of log S(u) for all u
b t.); and
3. normality of the increments.
The second hypothesis means that the price is

markovian (i.e. the future price depends only on
the present value not earlier ones). This
assumption based on efficient markets is standard
in finance. Relaxing one or more of these
assumptions leads to the development of a
to capital markets. More rigorous approaches can be

found, for example, in Flandrin et al. (1991).
As early as the 1960s, Mandelbrot (1963) and
Fama (1965) had investigated the use of stable
distributions initially developed by Levy (1937), for
modelling stock market prices. It is, of course,
possible to combine fractionary brownian motion
with stable distributions (see Peters, 1991, p.
105-130) for finance applications or Maejima (1983)
for early theoretical work on this.
ARCH Models
These models were first developed by Engle
(1982) and Bolleslev (1986, 1987). They are a
natural extension of the autoregressive models used
in time series. A comprehensive review of the
ARCH family of models is given in volume 52
of the Journal of Economics (1992). The editors’
introduction and the leading article (Bollerslev et
al., 1992) are particularly relevant. Two papers,
Day and Lewis (1992) and Engle and Mustafa
(1992) specifically relate ARCH models to option
new model. As leptokurtosis has been
pricing. The paper by Pesaran and Robinson
reported by many authors, it could be
(1993) presents a study on the volatility of the
interesting to consider alternatives to the
sterling-deutschemark exchange rate before and
normal distribution. Proposals include a
after the introduction of the European exchange
special class of stable distributions called
rate mechanism, in which these models with a t
intermediate stable paretian (ISP)
distribution were found to give a good fit.
distributions, the Student t distribution, the
normal—Poisson distribution, the power Jump-Diffusion Models
exponential distribution, etc. Looking at the logarithms of the price increments
When choosing the type of stochastic shown in Figure 1, the presence of a few very
process to use, three broad groups can be large jumps, sometimes upward and downward are
distinguished: noticed. These cause the fat tails in the distribution
and the leptokurtosis. As they seem to occur at
1. fractal brownian motion;
random time intervals, it is natural to model the
2. autoregressive models (e.g. ARCH and price increments as being the combination of a
GARCH); lognormal random walk (which obeys the diffusion
and PDE) together with occasional large jumps. The
standard way of generating random time intervals
3. jump-diffusion models.
is by a Poisson process. Hence the jump-diffusion
Fractal Brownian Motion and Stable processes.
Distributions. It is not the authors’ aim to make value
Allowing the increments to be correlated judgments for or against any of these particular
rather independently gives rise to several new models. Time will tell which are most appropriate
models including fractionary (or fractal as for different types of applications. All that
it is usually called) brownian motion. Peters the authors want to demonstrate here is the
(1991, p. 45-103) gives a very readable but existence of a wide range of models that can be
not necessarily rigorous account of fractals, incorporated, with greater or lesser difficulty, into
fractal brownian motion and their application the standard option framework.
COX, J., ROSS, S., and RUBINSTEIN, M., 1979.

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Competitive Advantage Period: The Neglected Value Driver

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Competitive Advantage Period: The Neglected Value Driver

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VOLUME 4

BY MICHAEL MAUBOUSSIN AND PAUL JOHNSON

IN THIS Competitive Advantage Period: The

In 1991, a Goldman Sachs limited problem. However, to understand the

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Table 1. Relation of FCF, WACC, and CAP for Kellogg

Table 2. Variation in Food-Industry the X Factor

VI. Lengthening CAP Could Explain

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Michael Mauboussin is a Managing Director and Equity Product

Reprinted with the permission of The Journal of The Financial

BY JAMES L. (BUTCH) WILLIAMS, CPA, CVA, CBA

2) Merger and Acquisition Understanding the Industry

Multiple Businesses in One Larger dealerships may have separate

Industry Statistics • CSI - Customer Satisfaction Index, a

4) 1996 Top 15 Makes by Region in U.S. • Rebates - inventory-related compensation

2. Franchise Agreement Terms 5. Factory Relationship

6. Litigation Issues level, the industry has reacted significantly

Understanding How Dealerships are

c) Franchises the lowering of the capital gains tax, as well as

Methods for Valuing Dealerships

This article is based on a paper by James L. (Butch)

Mr. James L. Williams, CPA, CVA, CBA, is

BY M. ARMSTRONG, Ph.D., AND A. GALLI., Ph.D. A]bYfU`9Wcbca]Wg

Box 1: JCI’s methodology for valuing

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Box 2: An example of the value of waiting before investing

= – 4,000,000 + 4,400,000 = 400,000

C – P – S + Ke–rt = 0 When reading about the Black and Scholes

available to it. For example, taking a rather unfavourable commodity

have a wider range of options open to S

and ten weeks. Figures 5a, 5b and 5c. Comparing

Improvements on the Basic Black and

The second hypothesis means that the price is

to capital markets. More rigorous approaches can be

COX, J., ROSS, S., and RUBINSTEIN, M., 1979.

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