Harvard Business Review
A Better Tool for Valuing Operations
NORMAN R. AUGUSTINE
RESHAPING AN INDUSTRY: LOCKHEED MARTIN’S SURVIVAL STORY WHY (AND HOW) TO TAKE A PLANT TOUR
MARCO IANSITI AND JONATHAN WEST
TECHNOLOGY INTEGRATION: TURNING GREAT RESEARCH INTO GREAT PRODUCTSRP
MAY-JUNE 1997 Reprint Number
97304 97301 DAVID M. UPTON AND STEPHEN E. MACADAM STEPHEN GOLDSMITH VIJAY VISHWANATH AND JONATHAN MARK TIMOTHY A. LUEHRMAN 97310 YOUR BRAND’S BEST STRATEGY
CAN BUSINESS REALLY DO BUSINESS WITH GOVERNMENT?
WHAT’S IT WORTH? A GENERAL MANAGER’S GUIDE TO VALUATION
TIMOTHY A. LUEHRMAN
MANAGER’S TOOL KIT USING APV: ABETTER TOOL FOR VALUING OPERATIONS HBR CASE STUDY THE INFORMATION TECHNOLOGY SYSTEM THAT COULDN’T DELIVER
JEFFREY E. GARTEN
WORLD VIEW TROUBLES AHEAD IN EMERGING MARKETS HBR CLASSIC THE PARABLE OF THE SADHU BOOKS IN REVIEW HOW DO ECONOMIES GROW?
BOWEN H. MCCOY
BRUCE R. SCOTT
97303 97311 97305 97306 97308 97302 97307 97309
M A N A G E R ’ ST O O L
K I T
If you learned valuation techniques more than a few years ago, chances are you are due for a refresher course. You were certainly taught that the best practice for valuing operating assets – that is, an existing business, factory, product line, or market position – was to use a discounted-cash-flow (DCF) methodology. That is still true. But the particular versionof DCF that has been accepted as the standard over the past 20 years – using the weightedaverage cost of capital (WACC) as the discount rate – is now obsolete. True, business schools and textbooks continue to teach the WACC approach. But that’s because it’s out there as the standard, not because it performs best. Today those same schools and texts also present alternative methodologies. Onealternative, called adjusted present value (APV), is especially versatile and reliable, and will replace WACC as the DCF methodology of choice among generalists. (See “What’s It Worth? A General Manager’s Guide to Valuation,” in this issue of HBR.) For managers with businesses to run, the question of which valuation method to use has always come
HARVARD BUSINESS REVIEW
by Timothy A. Luehrman
downto a pragmatic comparison of alternatives. What might you use instead of WACC? Just like WACC, APV is designed to value operations, or assets-in-place; that is, any existing asset that will generate future cash flows. This is the most basic and common type of valuation problem that managers face. Why choose APV over WACC? For one reason, APV always works when WACC does, and sometimes when WACCdoesn’t, because it requires fewer restrictive assumptions. For another, APV is less prone to serious errors than WACC. But most important, general managers will find that APV’s power lies in the added managerially relevant information it can provide. APV can help managers analyze not only how much an asset is worth but also where the value comes from. All discounted-cash-flow methodologies involveforecasting future cash flows and then discounting them to their present value at a rate that reflects their riskiness. But the
Copyright © 1997 by the President and Fellows of Harvard College. All rights reserved.
methodologies differ in the details of their execution, most particularly in how they account for the value created or destroyed by financialmaneuvers, as opposed to operations. APV’s approach is to analyze financial maneuvers separately and then add their value to that of the business. (See the exhibit “APV: The Fundamental Idea.”) WACC’s approach is to adjust the discount rate (the cost of capital) to reflect financial enhancements. Analysts apply the adjusted discount rate directly to the business cash flows; WACC is supposed to handle...