Monthly Archives: November 2019

Some comments on Aswath Damodaran’s Aramco post

I suspect that many readers of this blog also follow the blog of Aswath Damodaran, and if they don’t, I would recommend doing so. Damodaran is a Professor of Finance at the Stern School of Business and he often posts how he would approach valuing high-profile stocks such as Tesla or Uber. It’s very unlikely I would ever be interested in investing one of those companies, but his valuation methodology is pretty solid and his posts are educational. I think having a good grasp on the fundamentals of valuing a company is very important, even when most of the time you revert to simple back of the napkin valuations using a P/E multiple (which I do).

However, I disagree strongly with his approach in his latest post about how to incorporate truncation risk in the valuation of Aramco. To quickly recap Damodaran point of view, a DCF valuation is only suitable for going concerns because you assume cash flows are continuing long-term and potentially indefinitely. Because of that you can’t properly model survival risk where a company might cease to exist after a certain point in time. In the case of Amerco it could be a possible regime change at some point in time to fundamentally change the value of the business going forward. But it’s also very relevant in startups that have a high probability of not making it past the first few years. His suggested solution is to value the company as a going concern in one scenario, value it with a regime change in a second scenario, put some probabilities on the two scenarios and call it a day.

Aramco equity valuation model incorporating regime change risk, source: Aswath Damodaran

I think there are two problems with his post:

  1. This approach doesn’t work well because it doesn’t fit reality
  2. A DCF is perfectly capable of incorporating truncation risk

The reason that this methodology is flawed is because it doesn’t incorporate the timing of the potential event. It matters a whole lot if the regime change is in the next year, or if it happens in 30 years time. So what does a 20% probability mean? Is that a 20% probability of regime change happening this year? the next 5 years? the next 50 years? And because that question isn’t answered, you also can’t really do a equity valuation in the regime change scenario. What he is doing I think is just taking the going concern equity valuation, and reducing it by 50% in the regime change scenario to account for higher taxes and royalties. That implicitly assumes that the regime change will happen on day one, which is of course highly unlikely and unrealistic.

A better model would be to assume that there is a small probability of a regime change every single year. That sounds complicated, but luckily, that’s exactly what we can model in a DCF by increasing the discount rate. If you would for example assume a 1% probability that there is a regime change in a given year you can simply increase your discount rate by 1%. It’s that easy! A one percent chance for 10 years in a row would imply a probability of regime change of 9.56% during that period and 39.5% during a 50 year period.

Note that by increasing the discount rate by one percent in case of a regime change we are assuming that the residual value is zero. If you think there is a 1% probability with 50% residual value we should increase the discount rate by just 0.5%. And a second small note, if you want to do things mathematically correct, you can’t simply add probabilities. In the example below you can see how that becomes especially relevant when probabilities become large.

If you want you can also easily change the model to customize probabilities of failure for each time period. Perhaps you have the view that there is in the next five years a higher chance of regime change, followed by a period of lower probabilities. But it’s probably more useful when thinking about a startup. The probability of failure is presumably very high in the first few years while lower in subsequent year.

Let’s imagine a project that will costs 10 million to start and 10 million more at the end of the first two years, and will produce 100 million at the end of year 3 and 4. In the first two years there is a 25% probability of failure. We could (and should!) model that as following:

Hypothetical cash flow model with high risk of failure in first two years

Note that the discount rate is calculated by taking: (1 + "equity risk") / (1 - "truncation risk") - 1 and the NPV factor is the factor of the previous year multiplied by 1 / (1 + "discount rate") of the current year. That way you carry a risk of total failure that you introduced in the early years forward for the calculations of the NPV of later years1.

The great thing about this model is that it matches actual reality. If you have a failure in the first year you don’t have to put more cash in the project, that’s why the net present value of the cash outlays at the end of year one and two are severely discounted. And of course, the same is true about the payoff in year 3 and 4 because there is a high probability that the project will never get to that point. If you would want to model this using Damodaran’s approach you would be in big trouble, because one single failure scenario can’t easily account for the fact that failure can occur at different times, and that the impact on the net present value depends on the timing.

Concluding remarks

Let me know in the comments if you found this post useful, otherwise I will be back to posting the occasional merger with a contingent value right ;). And of course, perhaps you want to point out that I’m completely wrong. It’s totally possible that I don’t know things better than someone who is a professor of Finance.


No intention to ever initiate a position in Aramco

1. A previous version of this post was using the wrong formula to calculate the discount factor and the combined discount rate. Thanks to a reader in the comments this has now been corrected.

A last minute merger arbitrage in Celgene

Today is the expected closing day of the merger between Celgene (NASDAQ:CELG) and Bristol-Myers Squibb (NYSE:BMY). All regulatory approvals have been received so there is basically nothing anymore that could derail this deal. Bristol-Myers is acquiring the company for one share of stock, a $50 cash payment and a CVR that will pay an additional $9 dollar if, and only if, three treatments that are in development receive FDA approval. With CELG trading at $107.80 at the moment of writing and BMY trading at $55.70 investors can buy the CVR for $2.10.

A hint that this might be on the cheap side can be found in this SEC filing made by Bristol-Myers in May earlier this year where the company puts an estimated fair value of $3.83 on the CVR. They don’t provide an break down how they arrived at this value, only this:

The preliminary estimate of the fair value of the CVRs was determined by applying a probability weighting to the potential $9.00 per share payment reflecting the probability of achieving all three necessary approvals. The probability-weighted value was then discounted to present value using a credit risk-adjusted discount rate.

Since that time all three treatments have progressed as planned, so presumably if they would redo this valuation today it would be higher. The three approvals that they need to get are:

  • Ozanimod (by December 31, 2020)
  • Liso-cel (JCAR017) (by December 31, 2020)
  • Ide-cel (bb2121) (by March 31, 2021)

These deadlines seem to be tight, and the combined probability of three events happening is obviously quite a bit lower than the probability of individual events, so there is reason not to be too enthusiastic about the CVR. But these treatments are all in a very developed stage of development, and the base rates of success of going from Phase III to approval or from NDA/BLA to approval are quite high. Celgene gave the following update with regards to above treatments when the company announced their results for the third quarter:

I’m not a medical expert, but given that base rates for success at this point are pretty high I think you could even make a case that the $3.83 valuation made by Bristol-Myers is somewhat conservative. These are all events that should be in the range of 75%-85% or something like that and taking very crudely 75%^3*$9 gives us a value of $3.80. This ignores that time value of money, but given that the deadlines are all relatively soon I think that doesn’t matter too much.

Because the deal will close very soon and I think that right now the CVR is probably attractively priced I bought a significant amount of CELG with a corresponding short position in BMY.


Author is long CELG, short BMY

Sanofi CVRs litigation settlement agreement arbitrage

When Sanofi (NASDAQ:SNY) acquired Genzyme back in 2011 it issued tradable contingent value rights (NASDAQ:GCVRZ) that would payout when meeting certain regulatory and sale milestones. Despite high initial expectations none of the milestones were met, and at some point it looked extremely likely that the CVRs would expire worthless. However, some CVR holders went to court arguing that Sanofi didn’t fulfill their obligations under the agreement. Apparently their argument had some merit (I never followed these CVRs that closely to be honest), and yesterday Sanofi announced that they would settle and pay a total of $315 million.

Sanofi logoThe trustee estimates that this would translate into approximately $0.88/CVR after paying all fees, but is unable to provide an exact number at this time. With the rights trading at $0.84 yesterday I couldn’t resist picking up a couple of them since this implies a spread of 4.8% which I think it quite generous for something that should be more or less a done deal. They will need to get court approval for the settlement, but I don’t think there is much that can go wrong nor should it take that much time. It’s a very straightforward situation at this point, and combined with a decent spread I think it makes a good bet.