Case study question: How do you value a toll road
Got this question a while back and still trying to figure out how to best answer. The question was "You have the chance to buy a toll road- ask any questions necessary to come to a value".
I tried to assess competition, profits, growth, etc. But how do you actually value it based on these numbers? By discounting projected cash flows back? Any insights would be appreciated.
In a way you could consider a toll road a utility couldn't you? Maybe check out utility valuation metrics?
I would think discounting cash flows, but also analyzing the risks involved - could an alternate highway be built 10 years down the road? How will car-pooling affect your revenue? What if oil skyrockets? Legislative risks? High-speed rail line could be built, etc. Are you allowed to change the tolls, or do you need approval from somebody? Could the revenue stream be optimized - analyze demand elasticity and availability of substitutes. Look at comparable transactions obviously - maybe there is a risk you are not including that throws valuation off.
How to actually price - built a matrix of probabilities of oil skyrocketing, alternative highways being built, etc and corresponding impact to the income. Come up with expected value of annual revenues, and some idea of volatility, and discount slightly for this volatility. Don't assume events are independent - oil skyrocketing will increase impact of car-pooling, decrease probability of another road being built, increase probability of high-speed rail system. Also think about the beta of a toll road - could have diversification benefits for a fund. Project maintenance costs (based on traffic, which is based on price of road, etc), etc. Liquidity issues? Could this road all of a sudden be worth 0 at some point in the future, if it becomes more expensive to maintain than the revenue you can collect ($300 oil)?
If I had to eye-ball it, I would think annual income growing at 2%, discount rate of maybe 9%, price as perpetuity so P/E = 14, then discount maybe 20-30% for risk factors stated above. This is assuming income is optimized as it is - if not, assume optimization takes place (sweet spot of price vs demand) and use that as baseline income.
Actually sounds like a fun thing to price.
Dr. Joe- thanks for your input. This is similar to what I was thinking.
How did you come to your discount rate assumptions if I may ask? I also was thinking of pricing it as a perpetuity. And what would you discount 20-30%? Thanks for all your insight.
If it is a simple on the spot kind of valuation: - for a toll road the main uncertainty is the revenue. Costs (O&M, G&A, financing etc.) are more or less certain - how to project the revenue. You can be very sophisticated in real life, and still not get to an accurate figure, given the number of variables. Take a long enough horizon (say 40-50 years for which the usual concessions are) and you need to have two assumptions for the revenue (a) traffic growth rate (fair to assume it will grow at the same rate as GDP?), and (b) toll growth rate (it is tricky because the traffic growth may or may not be dependent on the toll rate growth. However, I would think it is fair to assume that this is linked to the inflation rate) - and voila, you have the revenue. Increase normal O&M by the inflation rate, account for any capex (say after every 5 years there is a major maintenance) and account for the interest and principal repayments (I would think the starting debt to equity may be 80:20, and debt tenor may be c. 20 years or higher; interest rate is market and interest dependent but a 6% all in will be a fair assumption over the life of the loan - after all this, you have the cash flows to equity, which you can discount by the required rate of return (say 10%)
As I said, the proper way to price would be via expected value of income per year, out 30 years, route.
The quick-and-dirty method is to take current net income, assume income grows by 2% and 9% is discount rate, and then scale down by 20-30% adjustment for risk to come up with P/E of 10-11.
Discount rate might be a bit high and I don't really have a good justification. As I said, gut feeling. But I think a PE of 10 or so makes sense since there are no growth prospects for a road, assuming it is properly optimized...
You would definetly NOT add a DLOM of 20-30% for a infrastructure investment. The sensitivity of traffic flows should be built into the model as worst case, base case, and best case so you can clearly illustrate the impact of traffic on your valuation. You want to justify how you would get to your traffic rate per day (kinda like a brain teaser question). And then use a WACC becuase typically this kind of low risk, high cash flow, project will be funded with a lot of debt. Growth in pepretuity would be your best bet for a terminal value with an extremely low growth number (2% like Dr. Joe said).
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