The perils of rule of thumb in valuation

The Perils
of Rule of
Thumb in
Valuation
Farmantra S.L.
Saurabh Mishra

The perils of rule of thumb in Valuation
DISCLAIMER: This document is not an offering for any investments and it is only for informational purposes. Farmantra was neither
retained nor it had any commercial relationships with any clients or service providers mentioned in this document. You should do
your own due-diligence before using any fundamentals or arguments mentioned in this document for your own analysis.
Background
One of our clients XYZ1
had a product ready to be commercialized and he had already out licensed to 3-4
companies in Europe and Latin America. He was in the process of negotiation with various companies
for out licensing his product. He wanted to know the value of his product and in order to get the
valuation; he used the services of a reputed consulting company, ABCD2
based in Europe.
We studied the report in detail and analyzed the assumptions used by them in the valuation report. It
was no surprise to us that they have used the rule of thumb at many places such as discount rates. The
intention to develop the report is to show that despite the valuation being so subjective, there are no
places for rule of thumb in valuation. For example - If one of the big pharmaceutical companies such as
GSK used a discount rate of 29% to value its product in a particular therapeutic area, should you also use
the same discount rate to value your product? If the company’s hurdle rate is 15%, should you use it to
value the company’s projects? The risks, growth and cash flows are different for different projects, and
hence the hurdle rate or the discount rate should be different for different projects. It is true that
experience has value, however, in the fast changing dynamics of the business where every other day,
business models change, the same parameters cannot be used to value. Put simply, we argue that the
rule of thumb or ‘gut feeling’ might have some value in those markets where the financial markets are
not developed, but not in developed markets.
Can anyone be 100% perfect on Valuation?
When we value an asset, we predict the future cash flows. We are actually trying to predict the future,
so there could be 100% chances that one’s prediction could go wrong. However, a real valuation expert
should not claim that he can do a 100% correct valuation but rather – how less wrong he could be while
predicting the future.
Summary of the ABCD report on the product valuation of XYZ
The ABCD report on the valuation of XYZ PRODUCT assumes the following:
 Risk adjusted NPV method used based on the probability of signing an agreement with the
distributor
 Discount rates of 25% : No explanation is provided why the discount rate of 25% is used
1
The client names are withheld for confidentiality
2
ABCD – A consulting company in Europe. They focus on valuations in life sciences

 Sensitivity analysis that assumes the range of discount rate from 23% to 28%
Our Analysis
We argue on the assumptions and methodology used for the following reasons:
 Risk adjusted NPV :
In biotech industry, the word ‘risk adjusted’ cash flows is widely used. ABCD assumes that the
risks of cash flows are dependent on the probability of signing an agreement with the
distributor. Does that imply that the signed agreements provide guaranteed cash flows? If yes,
there are several implications.
We discuss below the factors and flaws in the model:
o Risk adjusted is actually the expected cash flows: Does the adjustment of risks by
calculating the probabilities of signing the agreement provide guaranteed cash flows? If
not, then the cash flows are not risk adjusted, they are expected cash flows. To see
why, we provide a simple example. You have two options to invest in the project. The
first option provides you a guaranteed return on $85 M on the project. The second
option states that you will receive $100 M with 80% probability and $25M with 20% of
probability. The expected values of both outcomes are $85 M but the risk averse
investor will choose the first one as the returns are guaranteed.
o Double counting of risk: If the risk is already adjusted in cash flows leading to
guaranteed cash flows, then the cash flows should be discounted at risk free rate and
not any other discount rates. However, if ABCD assumes that the “risk adjusted NPV” is
not tantamount to certainty equivalent cash flows, care needs to be taken to not double
count the risk by reducing the cash flows by taking probabilities of success and also
increasing the discount rate.
 Discount rate: We argue that discount rate at 25% is too high to value the XYZ product. Besides
the high discount rate, the project cannot be discounted at a single discount rate. The flaws are
as follows:
o Each project has a different discount rate: XYZ has out licensed the product to different
companies in different countries. The risk associated with each cash flow is different and
hence each set of cash flows should be discounted at different discount rates and not
the same discount rates. So, we need to consider each project as a separate investment
and factor in individual cash flows, returns and discount rates for each project.

o Whose discount rate? XYZ has out licensed the product to a company X. The risks of the
cash flows will be dependent on the risks of the company X and not on the risks of XYZ.
For example- XYZ has already out licensed XYZ product to a company PQR that will
launch the products in two European countries. XYZ’s cash flows is now dependent on
the risks of PQR and hence the discount rate used should be the discount rate of
Investments of PQR in this project and not that of XYZ. For further explanation, please
check the Appendix 1
o Country Risk premiums: If XYZ out licenses to a company that launches the products in
emerging markets such as Pakistan or Columbia, a separate country risk premiums will
be added in determining the discount rate. For example- In case of Pakistan one needs
to add 9%3
country risk premium over and above the risk premium of developed market
(AAA listed country). Assuming that the project is only equity funded, the discount rate
in Euros for a project executed by a public Pakistani company4
would be close to: 1.525
+
1.086
*(5.74%7
+9%) = 17.43 %. Hence the discount rate would vary a lot depending on
which country the product is launched.
o Beta: The Beta captures market risks – the risks that cannot be diversified. However, if
the Licensee is a private company, the XYZ’s product could have firm specific risks too
that cannot be diversified assuming that the investors at private firm are not diversified.
The Beta should capture total risks and not just market risks. This will again vary if the
company is public or private
o Conclusion: We conclude that a single discount rate of 25% should not be used by the
consulting company ABCD. We believe that this is fundamentally incorrect for the
reasons mentioned above. For a summary of the explanation, please check Appendix 2
 The Sensitivity Analysis: The objective of Sensitivity analysis is to understand the variables that
could impact the outcome of the value of a project/product. These variables could be any of the
following:
3
Aswath Damodaran Website
4
Assuming the hypothetical company is located in Pakistan, draws all its revenues from Pakistan and is a stable
company
5
German 10yr bond rate : http://www.tradingeconomics.com/country-list/government-bond-10y
6
Industry average beta for a drug company assuming the Pakistani company is stable: Aswath Damodaran website
7
Implied equity risk premium: http://pages.stern.nyu.edu/~adamodar/

o Equity risk premiums: Based on the countries where the products are launched in the
future, equity risk premiums could vary
o Length of high growth period: Notwithstanding the fact that XYZ has a patent for the
product, it does not stop the competitors to come with another product using a
different pathway. Hence, the length of high growth period8
could vary depending on
how many years XYZ’s product could sustain competitive advantage
o Return on Capital: In order for the project to grow, the project should earn excess
returns i.e. the investment in XYZ product should earn high enough return on capital.
The return on capital could vary for each project
o Reinvestment rate: The companies would need to reinvest in order to sell the product
and the reinvestment in different countries would be different
o Beta: Based on the way the project is executed by a company, the beta that captures
market risks will vary over time
o Other factors based on the project
Conclusion: The sensitivity analysis done by the consulting company ABCD by varying the
discount rates does not really indicate the outcome of the value of the product. It just tells how
the value would vary if you change the discount rates. The question is – Can you control those
parameters. These sensitivity analysis makes more sense when you can control those variables
that would impact value. For example – You could argue that one of the factors that could
impact the value would be the operating expenses. Can you control the operating expenses? Of
course, yes.
To see how, we did the sensitivity analysis of Almirall S.A based on the valuation done by us in
March 20139
.
Illustration:
In order to do sensitivity analysis on Almirall, we assumed that we are uncertain on the
following variables:
8
Length of high growth period: Any company can grow more than the rate of the economy for a finite life. This will
depend on various factors such as the competitive advantage and barriers to entry. If the company is
9
http://farmantra.com/valuation-analysis/

 Growth rate: Although the fundamentals denoted that the growth rate would hover around
1.7% -1.9%, we believed that it could vary a lot depending on the success of new products that
would allow Almirall to earn excess returns. Hence we used a uniform distribution and put the
range from 1.7% to 6%
 Risk Premium: Based on where Almirall operates and draws its revenues, the weighted average
risk premium is 8%. We assumed that it could vary in the future as Almirall’s revenue from
emerging markets has started increasing. So, depending on from which countries Almirall draws
maximum revenue, the risk premiums could change. We used normal distribution for risk
premium
 Return on capital: We assumed that the return on capital could vary based on the success of the
new products and the range of ROC could be between 5.19% and 10%. Hence we used uniform
distribution
 Reinvestment rate: The growth rate depends on how much one reinvests in the firm. Hence we
decided to use normal distribution as Almirall has been reinvesting at an average rate of 30%.
The results on the simulation are as follows:
The graph below demonstrates the probability that Almirall’s Valuation would be more than 883.2 M
Euros
There is a 70.48% chance that the value of Almirall could be more than 883.4M Euros

Variables that drive valuation are as follows10
:
The sensitivity chart demonstrates that the risk premium has the highest impact and Almirall should
control the risk premium. This could be done by assessing if product launch in riskier markets make
sense or not. The riskier markets demand high risk premiums. The next factor that contributes is the
growth rate. Higher the growth rate, higher the valuation of Almirall11
. The reinvestment rate is the next
important variable. As described in the valuation report12
, higher reinvestment rate would lower the
valuation of Almirall as Almirall is not able to earn excess returns. Please note the Almirall example is
taken from the valuation report done in 2013 and has no relation as of today. The example is taken just
for demonstration purposes.
10
D19 = Risk premium; D15 = growth rate; D24 =Reinvestment rate and D23 = Return on capital
11
Provided the return on capital is more than the cost of capital
12
http://farmantra.com/valuation-analysis/

Conclusion: If the distribution regarding the variables is well understood, the simulation gives a better
picture of the variables that could affect the valuation and these variables could be monitored and
controlled.
The sensitivity analysis of XYZ’s product should also be done on similar grounds. It is important to
understand the variables that could impact the value of XYZ’s product. Those variables should be used
as an assumption in crystal ball software to understand the forecast. If done correctly, this provides a
real picture of the sensitivity analysis and the companies would be cautious and alert on controlling
those variables in order to maximize returns and increase value.

APPENDIX
1. http://www.farmantra.com/Blog-desc.aspx?ID=14
2. http://www.farmantra.com/Blog-desc.aspx?ID=25
3. The Sensitivity Analysis of Almirall has been done only for illustration purposes

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