Valuing a high-tech growth company: the case of EchoStar Communications Corporation

Abstract

This article uses real options to value a high-tech company with significant growth option potential. The case of EchoStar Communications Corporation is used as an illustration. The company's growth opportunities are modeled and valued as a portfolio of growth options, namely options to expand its pay television, equipment, and internet services. Expansion of the main business can occur geographically (in the USA, internationally, and through partnerships) or through cross-selling of new products and services to its customer base. The internet business can expand via switching to digital subscriber line and through partnerships. The underlying asset (business) for the expansion options is the ‘base’ discounted cash flow (DCF), after removing the constant growth rate in the terminal-value DCF assumption. The options-based estimate of present value of growth opportunities (PVGO) value substitutes for the terminal growth DCF estimate. We show that our options-based portfolio PVGO provides a better estimate of the firm's growth prospects than the terminal growth DCF assumption.

Keywords:

• general
• capital budgeting
• stock valuation
• contingent pricing pricing

Notes

We value EchoStar as of 9 October 2004. The company was publicly traded on NASDAQ under the symbol ‘DISH’.

See, for example, Business Week (1999) and International Herald Tribune (1999).

Excerpts from Mr Ergen's interview with analysts on 9 August 2004 (http://articles.boston.com/2004-08-16/business/29204415_1_offering-local-channels-satellite-tv-digital-cable).

Global GT LP v. Golden Telecom, Inc., C.A. No. 3698-VCS (Del. Ch. April 23, 2010); Maric Capital Master Fund, Ltd. v. Plato Learning, Inc., C.A. No. 5402-VCS (Del. Ch. May 13, 2010).

ROV has also been used for valuing public projects and investments. For example, Kitabatake (2002) conducted an ex ante evaluation of a large-scale road construction project in the Minami Alps forest estimating the market value of the underlying project and its volatility using historical data from similar projects. This involves identifying related market-evaluated goods and services.

Coy (1999) explained how Enron capitalized on electricity price volatility by building less-efficient but flexible power plants. The plants were left idle during periods of low or moderate electricity prices and were put into operation only when electricity prices peaked or went sufficiently high. The ‘peak’ power plants were seen as options to be switched on only when prices went up. Enron was not obliged to commit itself to investing at any point in time but did so at peak periods when clearly profitable.

See, for example, Financial Management special issue on Real Options (Autumn 1993); The Engineering Economist special issues on Real Options (2002, 2005); Review of Financial Economics special issue on Real Options (vol. 13, nos. 3–4, 2005); Multinational Finance Journal special issues on Real Options (vol. 14, nos. 1–2 and nos. 3–4, 2010); European Journal of Finance special issue on Real Options (forthcoming, 2011).

Information about EchoStar was collected by the authors as of the time of valuation in October 2004 (and is valid as of that date) through various sources: Bloomberg, CnnMoney, EchoStar.com, Financial Times, GoogleFinance, Reuters, SEC, ThomsonOneAnalytics, Yahoo!Finance, and several analyst reports on the company.

The long-term growth estimates were obtained based on averages of analyst reports on the TV, equipment, and internet sectors. Beta estimates were obtained as industry-weighted averages for these sectors based on most recent 30 monthly returns of each company in the sector using the capital asset pricing model (CAPM). Betas were ‘adjusted’ by taking 2/3 of the actual beta as betas tend toward 1 over time (see Brealey, Myers, and Allen 2011). Divisional RP were derived from these beta estimates assuming a market RP of 5.5%. WACC data were based on analyst reports. Debt/firm value ratio was estimated at 29.7% and the 10-year risk-free (US Treasury bond) interest rate was estimated at 4.2%.

Porter's ‘five forces’ are a framework for industry analysis and business strategy developed by Porter (1979, 1980). These forces are as follows: new market entrants, substitute products (including technology change), suppliers, the power of buyers/customers, and existing competitive rivalry. Porter (2008) discusses common misunderstandings, providing practical guidance for users of the framework, and its implications for strategy today.

In 2002 (March to September), there was a sharp drop in stock prices on stock exchanges across the USA, Canada, Asia, and Europe. This downturn was characterized as the ‘internet bubble’ bursting as a number of internet companies (e.g. Webvan, Exodus Communications, and Pets.com) went bankrupt, while others (Amazon.com, e-Bay, and Yahoo!) lost substantial value. An outbreak of accounting scandals (Enron, Arthur Andersen, Adelphia, and WorldCom) expedited the fall as numerous firms were forced to restate earnings and investor confidence suffered.

Base DCF or NPV₀=V ₀−I ₀; therefore, billion, where billion.

For further discussion on these trade-offs and the advantages of ROV versus DCF see Dixit and Pindyck (1995).

These results were presented at the 10th Annual International Conference on Real Options at Columbia University, New York, in June 2006. The confirmation of the validity of our valuation was revealed in the marketplace subsequently.

January 2008 marked the most important event in EchoStar's life. DISH Network business was demerged from the equipment, technology, and infrastructure side of the business creating two separate companies: DISH Network Corporation, consisting mainly of the DISH Network business, and EchoStar Broadcasting Corporation, which retained ownership of the technology side including the satellites, Sling Media, and the set-top box development arm. Dish Network Corporation, the larger of the two companies, focuses on programming, service, and marketing of satellite TV, while EchoStar Corporation runs a majority of the satellites and other signal infrastructure. DISH Network Corporation's and EchoStar Broadcasting Corporation's common stocks are now publicly traded on NASDAQ under the symbols ‘DISH’ and ‘SATS’, respectively.