ValuationSim
ValuationSim is a business simulation designed to be used in
finance courses when corporate valuation is an important component. It
simulates the business development division of a company making acquisitions
over multiple periods using an assigned budget. Students in teams of two or
three perform DCF-based intrinsic valuations using data and assumptions
provided at the beginning of each round and then deciding what acquisitions to
make. The goal in each round is to have the lowest valuation errors and to
generate the highest portfolio return from the acquired firms after the first
year.
The simulation employs the scaffolding instructional method, where
learning unfolds incrementally through structured steps. Initially, the data
and assumptions provided are few and simple in the first rounds, progressively
increasing in both quantity and complexity as the simulation advances. At a
certain point, an element of risk is introduced. This method allows
participants to gradually enhance their analytical and decision-making skills,
starting with basic valuation techniques and progressing to more refined
methods by the conclusion of the simulation.
In each round, participants also receive instructions and a
tutorial. They are required to conduct their valuations using MS Excel or
Google Sheets, but uploading their files to the web is optional. If so, these
files are downloadable by the instructor, but there is no required grading on his
or her part. The simulation system assesses performance based on submitted intrinsic
valuations and acquisition decisions rather than using the contents in the spreadsheet
files. Once the simulation administrator processes the round, performance
reports are made available on the web for viewing and download for both
students and instructor.
Performance reports for each team after each round provide
information on valuation errors and annual returns of the acquired firms after
one year including the correct valuations in an Excel file. The annual return
is calculated as the difference between the acquisition price and its correct valuation,
augmented by the return after one year determined using the cost of capital and
its intrinsic valuation.
General feedback on common errors, how to reduce them or how to
improve valuations is also provided. The score assigned to each team gives the
same weights to valuation errors and annual returns, but this can be adjusted
at the request of the instructor. At the end of the simulation, team scores are
compared and proportional scores are allocated accordingly.
The simulation is administered on www.asdsim.com.
Advantages of a
Valuation Simulation
Students are required to
use FCFE, FCFF and the comparables methods of valuation in a sequential mode. Learning
is reinforced by applying valuation models and techniques for many firms and for
multiple rounds. The simulation also improves students' skills in financial
modeling using MS Excel or Google Sheets.
The repetitive nature of
doing valuations reinforces the learning of the following subjects:
1.
How terminal value is
calculated using the next year FCF and not the stable or long-term growth rate
of sales (which is a common mistake).
2. The differences between FCFF and FCFE models and
the information required to model them.
3. How to calculate WACC and cost of equity.
4. When to use cost of equity or WACC as the
discount rate.
5.
By using many times, the
words required return, discount rate, cost of capital, cost of equity and WACC,
students learn the similarities and differences between these concepts.
Students also:
1.
Improve their ability to
identify errors in spreadsheet modeling. Identification of valuation errors
becomes easier when comparing their intrinsic valuations with other team’s
valuations.
2. Become more conscious about the role of
valuation errors after observing its impact on their acquisition decisions.
3. Navigate the decision to acquire when facing
similar company valuations with different risks.
4.
The publication of team
scores (which is done without mentioning student names) fosters a competitive
environment, serving as an incentive for improved performance and,
consequently, enhanced learning.
Similar to other educational simulations, due to
its engaging nature, participants may not be fully aware that they are
learning. The repetitive nature of the tasks they perform becomes valuable,
especially if they need to recall how to conduct corporate valuations in the
future.
For many students, calculating Free Cash Flow
(FCF) and its present value using the spreadsheet may become second nature
because of the repetitive task of performing valuation. This is particularly
relevant today, as some educational research suggests that students quickly or
easily forget what they learn in class.
Recommended Decision Schedule
Intrinsic valuation and buy/no buy decisions are
made each week with a budget of 200 million dollars. Each round simulates one year,
with each round conducted weekly. Instructions, a tutorial and data is provided
before each round. Everything is web based.
The strategy is to go from the simple to the
complex, with 'simple' meaning enough data to do valuation, like Free Cash
Flows (FCFs) and a discount rate in the first rounds and income statement and
balance sheets in the last rounds.
Providing students with limited information and
assumptions prevents them from feeling overwhelmed. This approach also ensures
that the time they dedicate to analysis and decision-making is shorter, thereby
avoiding the steep learning curve that is common in business simulations.
Round One. FCF-Based Valuation
Students perform equity valuation using
information consisting of given FCFs available to shareholders, growth rates,
and a discount rate. Six firms are valued
and considered for acquisition.
While it may seem straightforward, students
still face challenges because the lifespans and growth rates of the Free Cash
Flows (FCFs) vary.
Round Two. Value Drivers-Based Valuation
Instead of being given FCFs students need to calculate them. They still perform
equity valuation (FCFE) based on information consisting of value drivers: profit
margins, assets requirements, a discount rate and sales growth. The cost of
capital is given. This type of valuation gives the same result as DCF standard
equity valuation in which more FCFs need to be estimated.
Round Three. Accounting-Based Valuation
Value
drivers to be used in calculating the FCFs need to be derived from historical
income statements and balance sheets. FCFE is still used. The cost of capital
is given. Valuation and buy/no buy decisions are made for four firms, lowering
the time spent as compensation for the added complexity of the valuation
process.
Round Four. Accounting-Based Valuation (continued).
To improve valuation accuracy, regression analysis is used to
identify fixed and variable costs, and fixed and variable assets to sales using
the financial statements provided.
FCFE is still used, but this time the cost of
capital needs to be estimated using the CAPM model providing a beta for each
firm. Given the element of risk introduced by using beta, the market return is
also is given. Returns for each firm after one year will be based on these
betas.
Round Five. Accounting-Based Valuation (continued).
Alongside the calculation of Free Cash Flow to Equity (FCFE)
valuation, it is necessary to perform Free Cash Flow to the Firm (FCFF)
valuations. The estimation of Weighted Average Cost of Capital (WACC) is also
required. Beta for each firm is provided. No fixed and variable costs and fixed
and variable assets need to be identified. An element of uncertainty is
introduced in the form of uncertainty in the market return provided.
Round Six. Accounting-Based Valuation (continued).
In addition to FCFE and FCFF valuation, the comparables method is required. For each firm being valued, metrics on five comparable firms are provided.
The estimation of Weighted Average Cost of
Capital (WACC) is necessary, with Beta provided for each firm. There is no need
to identify both fixed and variable costs as well as fixed and variable assets.
The market return is uncertain.
The
decision schedule recommended above is subject to adjustment upon the
instructor's request.
