Applying Value Drivers to Hotel Valuation.

Corneli Hotel 8< Restaurant Administration Quarterly - October 1, 2000

Oggie Ganchev
Word count: 6828.
citation details

A cautionary tale far investors: Pay attention ta the factars that create value in hatel
investing.
This article is intended ta serve as a valuatian guide ta hatel investing. The gaal is ta
enable an investar ta carrectly define, build, and interpret the results af a particular
strategy undertaken in pursuit af an acquisitian ar develapment af hatel real estate. The
article reviews a methad af farecasting cash flaw during an explicit farecast periad and
calculating the investment reversian by applying a value-driver farmula. it alsa pravides
the taals ta analyze the praject's prafitability by assessing its ecanamic value added and
ta understand haw return an investment changes with shifts in strategy.
The article gaes thraugh the fallawing faur steps in estimating the value af a hatel asset:
(1) Select the apprapriate cash-flaw build-up appraach;
(2) Decide an the time harizan ta fully implement a specific asset strategy;
(3) Estimate the value drivers and calculate the investment reversian; and
(4) Discaunt the cash flaw ta the present.
Selecting the Cash-flaw Build-up Appraach
Twa appraaches ta hatel cash-flaw build-up are the traditianal accaunting-driven
appraach and the value-driver appraach. 1 review bath af them here.
Accaunting-driven appraach. Over the years investars and appraisers alike have
applied the accaunting framewark faund in Unifarm System af Accaunts far the Ladging

Industry ta bui d spreadsheets and farecast hatel cash f aw. USALI is a prafit-and- ass
statement that cansists af departmental revenues and expenses, undistributed
administrative casts, and fixed praperty charges. The typica USALI pra farma pravides
a great deal af infarmatian abaut praperty aperatians, but masks same af the key va ue
drivers that mast investars shau d care abaut.
Va ue-driver appraach. The better appraach ta farecasting cash f aw guides an investar
thraugh the measures, ar the drivers, that bui d va ue: nameiy, grawth, market share,
level af services and amenities, and prafit margin
Ta best illustrate that appraach, let's use as an examp e the acquisitian af a fuli-service
hatel that's in a gaad lacatian and in a pramising market. This hatel, hawever, has been
a weak perfarmer due ta the lack af cansistent praperty upkeep and uneven
management. A patential investar is intrigued by the appartunity ta purchase and
upgrade the asset, insta a management team af knawn ability, and, ultimateiy, create
va ue far her capital partners. The histarical perfarmance af the market and the subject
hatel is summarized in Exhibit 1.
As abserved, the perfarmance af the campeting fuli-service hateis in this particular
market has been and cantinues ta be strang. The market grew at 8.7 percent in the last
periad and is prajected ta increase anather 5.0 percent in the mast current periad,
whereas the subject hatel agged behind. As a result, the hatel's RevPAR penetratian
rate deciined fram 94 percent twa years aga ta 90 percent taday. Despite the s awdawn
in grawth and the fiattening af the tap line, the hatel's prafitabi ity has s ight y impraved.
Perhaps management has been keen an cutting departmental expenses and averhead
cast in preparatian far the asset sale.
Seeing that the subject hatel has nat perfarmed up ta its patential, the wau d-be investar
intends ta invest the necessary amaunt af capital ta bui d the praperty RevPAR back up
ta the market level and thus raise prafitabi ity. The investar's repasitianing strategy is
ref ected in the cash-f aw anaiysis illustrated in Exhibit 2.
The tap af the cash-f aw farecast starts with the market RevPAR and its likeiy grawth
rate. The twa measures pravide a quantitative assessment af the market's raam rates,

competitiveness, and growth potential. The strength of the asset, on the other hand, is
illustrated in the lines that follow. The hotel's market positioning and revenue-producing
capacity are reflected in the hotel-penetration and room-revenue factors. The use of a
target profit margin produces the asset's expected profitability. This approach ta
farecasting pravides an investar with a straightfarward averview af the flaw of cash fram
the tap ta the battam line.
Value-driver Appraach
The value-driver appraach ta farecasting cash flaw warks as failaws. First, the investar
estimates tap-line revenues. The hatel's chief saurce af revenue is raams (even if it has
a spa, restaurant, ar ather revenue saurces). Thus, it is crucial ta analyze the drivers
that build raam revenue rather than trying ta guess haw much maney a hatel can extract
fram the restaurant, spa, ar telephane department. Here is where salid market-feasibility
wark cames inta play. Studying the grawth and the depth af the market, as weli as the
individual market segments, and benchmarking the existing and future campetitian wili
heip an investar ta decide haw ta enter the market and where ta pasitian the subject
hatel.
Market anaiysis. As 1 see it, a hatel-market anaiysis indicates ta the investar the grawth
stage af the market fram which ta derive the likeiy RevPAR grawth and the time that the
market wauld need ta reach stability. in general, markets can be classified as emerging,
maderately expanding, ar stable. in an emerging market, RevPAR grawth rates cauld be
twa ar three times as high as the grawth rates abserved in stable markets. in cantrast,
markets that are tapping aut are likely ta graw anly at the rate af inflatian. Hence, when
investing in an emerging market, the explicit farecast periad shauld extend until that
market is believed ta reach stability and its RevPAR grawth rate starts ta run parallel
with that af inflatian.
in additian ta estimating the market grawth, the market analysis helps an investar ta
assess the apprapriate level af RevPAR that the market can suppart and sustain. This is
impartant since investars in mast cases have little cantral aver the rate that guests are
willing ta pay in a particular market. An investment strategy that assumes a particular

hotel wilI achieve rates far above the market's RevPAR inherits a high risk. Such a
strategy is product focused instead of market driven.
For purposes of building this investment analysis, the qualitative characteristics found in
every market analysis are condensed to two specific quantitative variables: current
RevPAR and projected future growth. in our example, the market for selected fulIservice hotels should support RevPAR of approximately $105. The second variable, the
market growth rate, is initially projected at 5 percent, and then gradually levels off and
remains constant at 3 percent. The resulting decline in RevPAR growth can be
attributed to an overall decline in the occupancy rates and moderating rate growth as
new hotels enter the market.
Competitive analysis. The purpose of the competitive analysis is to establish a
benchmark set of hotels against which the subject hotel can be analyzed. The most
important piece of this analysis is estimating the market share the hotel is most likely to
command with respect to its competitive set. This analysis usually examines the extent
of occupancy and rate penetration to show the relative strength and operating strategy
of each competitor. However, the ultimate factor that drives a hotel's room revenue is
the yield--penetration rate, or the RevPAR-penetration rate. The relationship between
occupancy and rate penetration is already captured in the RevPAR yield. 1 also
recommend that an investor run a RevPAR-sensitivity analysis, as discussed in the box
on the next two pages.
Calculating Cash Flow
Finding the hotel's cash flow involves a calculation of room revenue, total revenue, and
earnings before taxes and debt service (EBITDA). This section shows those
ca 1 cu 1 ati ons.
Room revenue. After diligently studying the market and the competitive hotels, one can
estimate the appropriate market RevPAR and its growth, as welI as the subject
penetration rate, and thus calculate the hotel room revenue. The calculation is as
fo Il ows:

Market RevPAR x Hotel Penetration Rate % x No. of Rooms x No. of Days

For example:
Year-1 room revenue = $11025 x 90% x 350 rooms x 365 days = $12676000
This approach to estimating room revenue requires the investor to think of the two
factors that are the primary drivers of room revenue--namely, growth and market share.
Investors usually have no control over market growth, which proceeds at whatever rate
the market can sustain. The subject hotel can grow at a faster rate than the market-provided it can steal market share. Even if the hotel can do so, however, eventually its
business wilI grow no faster than the rest of the market.
Note that in our example the RevPAR-penetration rate expands from 90 percent in the
first year to 100 percent by the fifth year and thereafter. in fact, the rise in market share
allows the hotel revenue to grow at a rate that is almost twice the market rate until the
hotel reaches stabilization and starts to grow with the market. This is based on the
expectation that a new, effective management team wilI use the improved facility to gam
more market share.
Total revenue. While room revenue is generally the most important source of revenue,
as the hotel offers more amenities and services to its guests, the size of other revenue
sources as a proportion to total hotel revenue increases. As illustrated in Exhibit 3,
room revenue for the average limited-service hotel accounted for 95 percent of total
revenue in 1997, whereas for a fulI-service property that percentage ranged from 62
percent to 72 percent depending on the hotel's price category.
Instead of trying to guess or break out the revenues for each individual department
during the preliminary analysis, it is simpler to build a single assumption that is
consistent with the rating, services, and amenities the hotel wilI offer and thus derive the
hotel's total revenue. That assumption is a room-revenue factor, or a percentage of the
total revenue attributable to the rooms division.
Total Hotel Revenue = Room Revenue [divided by] Room-revenue Factor %

For example, year-1 total revenue = $12676000 [divided by] 67% = $1 8,91 9,000
in our example, the room-revenue factor is targeted at 65 percent, which is not attained
until the third year of the forecast. in the beginning, as the hotel focuses on generating
demand and building room revenue, the other sources of revenue may lag behind
EBITDA margin. The profit margin, or earnings before income taxes and debt service,
should not be put into the model in a vacuum. it should reflect the industry norms, the
specific local market characteristics, and the management's track record in operating
similar hotels. As shown in Exhibit 3, EBITDA margins for fulI-service hotels in the
United States for 1997 were around 30 percent, and for limited-service hotels, 45
percent. Gross-operating-profit (GOP) performance registered similar results. Limitedservice hotels were at the top of the profitability chart with a GOP margin of 53 percent,
whereas fulI-service hotels operated at between 36 and 39 percent.
Although the example applies the EBITDA margin, 1 recommend that investors estimate
the GOP margin first and, after adjusting for the correct amount of fixed charges and
management fees, calculate the EBITDA line (see Exhibit 4)
in summary the value-driver approach to cash-flow build-up should replace accounting
pro formas in the investment analysis. By thinking through the value drivers-growth,
RevPAR, market share, room-revenue factor, and profit margin--the investor can gam a
meaningful grasp on an appropriate strategy for the asset.
integrating the Value-driver Approach
Note that the value-driver framework of analyzing cash flow does not supersede the
accounting approach to forecasting revenues and expenses. it rather seeks to avoid the
complexity and rigidity found in the accounting-valuation framework. Using the valuedriver approach, an investor should use the accounting pro forma to calculate the value
drivers and use them as inputs in the investment-analysis section of her model. This
way the investor can preserve the discipline required in the underwriting of the pro
forma and at the same time achieve the flexibility needed in the investment analysis and
capital rationing process.

Choosing a Time Horizon

A common practice among hospitality consultants and investors is to use a lO-year
forecast horizon, which is perhaps an artifact of a time when the hotel business was
more stable than it is today. An investor needs to determine whether a 1 0-year window
is the right time period one should use and, if not, what forecast period should apply.
The purpose of determining a specific forecast period is to capture correctly the
expected changes in the marketplace and hotel operations that directly affect cash flow
and return on invested capital. The forecast horizon should, therefore, span as many
years as it takes for the market and the property to reach stability. The value of the
property should not be manipulated simply by extending or shortening the length of the
forecast period. The only change should be in the distribution of the property value
between the explicit forecast period and the period that follows, or the continuing
(reversion) value, as illustrated in Exhibit 5.
Assuming a five-year forecast, continuing value accounts for as much as 72 percent of
the total, and the value in the holding period accounts for only 28 percent of the total,
whereas in a 25-year forecast the continuing value drops to 11 percent and the explicit
value is 89 percent of the whole. in both cases, the total value of the property does not
change. The value is still $48.4 million; only its distribution derived from the explicit
forecast and continuing value changes.
Selecting a different horizon period can erroneously produce a deviation in values if the
underlying assumptions used in the calculation of the continuing value are not
consistent with the rest of the forecast. For instance, it was a common mistake among
the investors in the 1980s to forecast that revenues would grow at a higher rate than
expenses. This approach to cash-flow build-up led to the creation of hotel pro formas
that showed an ever-increasing profit margin. Correspondingly, if the explicit forecast
horizon were to be extended, then the extension would have led to an increase in value,
solely due to the increasing profit margin. Stated in another way, the longer the explicit
forecast period, the higher the value! Most investors probably realized the illusory
nature of that assumption after the market slumped in the early 1990s.

Holding-period effects. Each investor has a different plan for holding the asset. As 1 just
explained, the value of the property should not change as a result of extending or
shortening the length of either the explicit forecast horizon or the holding period. As the
holding period changes, however, the internal rate of return (IRR) wilI certainly change.
This change is triggered not by a variation in the value of the hotel, but by a change in
the rate of return over the time the investment is held. Furthermore, the change in IRR
wilI reflect the change in the risk of the investment, as explained by the increase or
decrease in the variability of the projected cash flow.
1 find it unwise for investors to adjust the value of the asset to maintain a particular IRR
assumption. That approach would break the integrity of the valuation analysis, because
the required rate of return on invested capital would not accurately reflect the risk profile
of the projected cash flow. Thus, it would be unrealistic for an investor to seek a
premium rate of return after the hotel is stabilized, even if a high cash flow (and a high
risk) during the initial work-out period justifies requiring a premium rate of return. As
cash-flow variability decreases, the value of the asset wilI likewise decrease. But in this
instance, the lower value would be solely attributable to the investor's demand of a high
rate of return for the asset, whose risk profile changed after stabilization and as such
would warrant lower risk-adjusted rate of return. Hence the drop in the IRR.
Calculating the Investment Reversion
By definition the continuing value, or the investment reversion, is analyzed as an
annuity investment that pays a perpetual cash flow that is either constant through time
or grows at a constant rate. As mentioned above, the explicit forecast period should
span as many years as necessary for the property to reach a stable rate of operations
by the end of that period. This is imperative since the integrity of the investment
reversion relies on the following key assumptions:
* hotel profit margin stays constant; and
* hotel cash flow grows at a constant rate, sustained by a continuous investment drawn
off the replacement reserve.

Most hotel investors are familiar with the growing free-cash-flow perpetuity formula. it is:
Value = [NOI.sub.t+1] % R
where
[NOI.sub.t+1] = normalized level of cash flow after reserve for replacement in the first
year after the explicit forecast period, and
R = capitalization rate.
An alternative technique is the value-driver formula, which breaks down and expresses
the growing free-cash-flow perpetuity formula in terms of the value drivers: profit
margin, ongoing capital requirement, cost of capital, and growth. That formula is as
fo Il ows:
Value =
[EBITDA.sub.t+1] X (1 -RR%PM) (WACC-g)
where
[EBITDA.sub.t+1] = normalized level of cash flow before reserve for replacement in the
first year after the explicit forecast period;
RR = reserve-for-replacement percentage;
PM = expected stabilized EBITDA profit-margin percentage;
WACC = weighted average cost of capital; and
g = expected growth in cash flow in perpetuity.
The value-driver formula is the algebraic representation of the growing cash-flow
perpetuity formula where the hotel EBITDA is forecasted to grow at the same rate g and
is only valid if g is less than WACC. The expression WACC-g corresponds to the hotel
cap rate R, whereas the numerator decomposes the hotel NOl in the form of the key
value drivers of profit margin and necessary continuous capital investment. The

expression RR%PM represents the investment rate or the proportion of cash fiow
ailocated for property upkeep and FFE repiacement. The overail expression shouid
read: Cash fiow (EBITDA) times one minus the investment rate equais free cash fiow, or
NOl.
Ali of the components used in the formula above are present in the hotel pro forma,
except for the weighted average cost of capital. WACC is a function of the target debt-toequity capital structure and the corresponding required rates of return. Real estate is
one of the few industries where one can reasonabiy predict cash fiow and, thus,
leverage can be relativeiy high. Typicai ioan-to-vaiue or ioan-to-cost ratios range from
60 percent to 75 percent. Leverage above that range bears high risk and shouid
command high equity returns. The result is that WACC cannot simpiy be iowered by
adding leverage and keeping the equity required rate of return constant.
in our acquisition exampie the borrowed capital amounts to as much as 75 percent of
the purchase price and bears an interest rate of 9 percent. If the oan is to be paid off
based on an amortization scheduie, then the oan mortgage constant shouid be
inciuded in the WACC caiculation. in our case, the oan is structured as an interest-oniy
bailoon, and the principal amount is to be returned at the end of the term. Equity
hoiders, on the other hand, are in the deal looking for a 25- percent return on their
invested capital. Hence the weighted average between the debt and equity cost of
capital is caiculated at 13 percent [(.75 x .09) + (.25 x .25)].
EBITDA Cap Rate
One of the benefits of the vaiue-driver formula is that it aliows one to express the
EBITDA-capitaiization rate using the key vaiue drivers, as foliows
[R.sub.EBITDA] = (WACC-g)[divided by](1-RR[divided by]PM)
The above equation demonstrates that one can add vaiue by focusing on improving just
one of the vaiue drivers (i.e., cost of capital, growth, profit margin, or required
investment). Obviousiy, a reduced cost of capital wiil aiiow an investor to bid up a price.
The two other factors that drive the price multiple up are growth and profit margin.

Higher future growth transiates into a lower cap rate and ultimateiy into a higher price.
The same reasoning hoids for the profit margin. The higher the profit margin, the
greater the proceeds for the investors, and the higher the price. However, it is important
to note that these two vaiue drivers do not come free of charge. Keeping an asset
competitive in the market, growing cash fiow, and sustaining a heaithy profit margin
require continuous investment in property upkeep and FFE repiacement. The higher
the investment required to achieve a giyen growth rate and sustain a giyen profit
margin, everything else heid constant, the higher the cap rate wiil be, which wiil push
the purchase price lower.
About cap rates. By appiying the simpie perpetuity formula (NOI[divided by]R) when
vaiuing acquisitions, many anaiysts fail into a circular reasoning that the cap rate, R,
appiied in the investment reversion wiil equai the cap rate paid for the asset. For
exampie, the assumption is that if one buys an asset at an 8-percent cap rate, one
shouid be able to seli that asset for the same 8-percent cap rate at the end of the
holding period. in most cases, however, the reason someone is willing to pay a 10w cap
rate for an acquisition is that he or she believes that earnings potential can be improved
greatiy. So the effective cap rate paid on the improved level of earnings wili be much
higher than 8 percent. Once the improvements are in place and earnings are up, buyers
would not be willing to bid the same cap rate unless they can make additional
improvements.
The expected growth, profit margin, additional investment, and cost of capital are the
primary determinants of the asset EBITDA cap rate, and ali are in the value-driver
formula. Unless one is comfortable using an arbitrary cap rate, one is much better off by
applying the value-driver formula to analyze which factor drives the price of the asset
the most and whether that is consistent with the investor's span of control, overall
strategy, and competency.
Discounting the Cash Flow
Exhibit 6 summarizes the DCF-valuation analysis of the hotel cash flow derived from the
pro-forma build-up example discussed earlier in this article. [1] Remember that the

investor plans ta repasitian the asset up ta the quality level present at the ather
campetitive hateis. Ta da sa, the investar plans ta spend $7 millian in capital
expenditures during the first twa years. After discaunting the additianal capital autlay
and the prajected cash flaw at a 13-percent cast af capital, the DCF value af the hatel
investment is calculated at appraximately $48.4 millian. Clearly, at an acquisitian price
af $45.5 millian, the investment taday is expected ta add sharehalder value af $2.9
millian aver the life af the praject. Nate alsa that by applying the value-driver farmula,
the EBITDA cap rate is calculated at 12 percent, giyen the 3-percent prajected grawth
rate, 30-percent prafit margin, 5-percent replacement reserve, and 13-percent weighted
average cast af capital. Since na changes are expected in the underlying ecanamic
assumptian after the fifth year, extending the farecast ta 10 years wilI yield the same
result as the five-year farecast.
The abave investment analysis assumes that after the hatel is repasitianed and
prafitability impraved, the investar wauld hald the asset in perpetuity, ar at least far a
relatively lang periad af time. Such a strategy and valuatian framewark wauld be
apprapriate and cansistent if the investar is a hatel campany laaking ta expand and
build equity in its brand. in this case, the investar wauld view the praperty as being a
key asset lacated in an impartant market with na expectatian af selling it in the
immediate future.
An appartunity fund, an the ather hand, wauld appraach valuing the same asset
differently. Canstrained by the equity partners' shart-term investment abjective, such an
investar wauld plan at the time af purchase ta cash aut af the asset after capturing the
increased value that wauld result fram impraved prafitability. That assumptian wauld
change the valuatian framewark ta reflect the anticipated investment requirementsprabably an investment harizan af fram three ta five years.
Far undertaking the risk af buying an underperfarming asset and turning it araund by
deplaying additianal capital, the appartunistic investars wilI seek a relatively high rate af
return. Cansequently, the free cash flaw during the farecast windaw and the net
praceeds fram the sale af the asset need ta be discaunted at the investars' weighted
average cast af capital. Hawever, when estimating the reversian value at the end af the

holding period, one should apply a lower cost of capital in the value-driver formula to
arrive at the appropriate EBITDA capitalization rate. Such an adjustment is necessary
since the risk class of the asset would have improved and an investor seeking a
stabilized asset and yield predictability would require a lower risk-adjusted rate of
return. Such an investor would assign a higher value than what the asset would be
worth if held by the opportunity investor in perpetuity. The opportunity investor should
be aware, though, that at the time of sale the fund would need to selI the asset at the
projected lower yield to another investor who would be willing to accept it.
Income taxes. The reader wilI have noticed that the model as presented so far has not
accounted for income and capital-gains taxes. Partly the omission is for the sake of
simplicity. The other reason for not considering taxes is that tax liability varies from one
investor to another. Pension funds and REITs, for example, are exempt from paying
income taxes, whereas C-corps can typically pay taxes as high as 40 percent of the net
profits. One thing, though, is certain: no one wilI pay any taxes if the project is not
profitable.
For those investors who are required to include taxes in their valuation analysis, the
value-driver model can be easily adjusted to account for income taxes while still
preserving its integrity. To do this, an investor should make a separate tax calculation
that is consistent with the investor's profile and deal-transaction structure. After
calculating the correct taxes for each year, the hotel EBITDA should be reduced by the
tax provision amount as presented in Exhibit 7 -- thus becoming earnings after taxes
(but before debt service). The discount rate, or WACC, should be adjusted to an aftertax basis as welI.
Rather than be driven heavily by tax consequences, investors should be concerned with
estimating the right value drivers, building competencies around them, making the right
investment choices, raising the necessary amount of capital, and meeting the objectives
and claims of each of the stakeholders involved in the transaction. Investment in real
estate does, of course, provide tax shelters such as depreciation and interest, but the
lesson of the 1980s is that those factors should not be chief motivating factors for a
hotel purchase.

An investor can analyze the profitability and assess the risk of any hotel investment in
many different ways. However, by using the value-driver build-up and valuation
framework, an investor can be assured of properly forecasting, discounting, and
analyzing hotel cash flow. Forecasting cash flow based on the value drivers helps an
investor discern more easily the flow of cash though the property. Discounting the cash
flow by using the value-driver formula ensures that investors solve for their expected
return without overextending their span of control and capability.
A graduate of the Cornell University School of Hotel Administration, Oggie Ganchev is
with the New York real-estate investment-banking group at Credit Suisse First Boston
[much less than]oggie.ganchevcsfb.com[much greater than].
(1.) For a discussion of the DCF methodology, see: Stephen Rushmore, "Seven Current
Hotel-valuation Techniques," Cornell Hotel and Restaurant Administration Quarterly,
Vol.33, No.4 (August 1992), pp. 49-56
The Further Step of Risk Analysis
Risk analysis should be considered as an integral part of any valuation analysis. By no
coincidence, the value-driver hotel-valuation framework presented in the accompanying
article lends itself welI to performing this task. The key part is that any of the value
drivers could and should be analyzed as a distribution of probabilities. Achieving the
targeted hotel market penetration rate or profitability margin is not really that certain.
What is more likely to happen is that the actual results would falI within a range of
possibilities that would be centered around the forecasted value drivers.
One of the tools any investor could use is Risk software, which returns distributions
of possible outcomes and the probabilities of getting those results. [1] The software can
help an investor not only by showing what could happen in a giyen situation, but also
presenting how likely it is that it wilI happen. The example presented at the beginning of
the accompanying article illustrates the use of risk analysis and the utility of Risk. in a
stabilized year, the value drivers were assumed at 100-percent RevPAR penetration, 65percent room-revenue factor, and 30-percent EDITDA margin. A more likely scenario is

that the property RevPAR penetration could go as high as 102 percent or as 10w as 97
percent of the market, the room-revenue factor could be plus or minus a couple of
points, and the EBITDA margin could range anywhere from 27 percent to 32 percent. By
using Risk software, the investor could incorporate this uncertainty by creating the
foliowing distributions, which empioy functions found in the appli cation.
RevPAR penetration = Room revenue factor = RiskTriang(97%, 100%, 102%), which
specifies a triangular distribution [2] with a minimum value of 97 percent, a most-likeiy
value of 100 percent, and a maximum value of 102 percent;
EBITDA margin = RiskNormal(65%, 1%), which specifies a normal distribution [3] with a
mean of 65 percent and a standard deviation of 1 percent; and
By entering the distribution formulas above in the valuation spreadsheet, the investor
has defined the uncertainty of the investment. Before jumping into the simulation
analysis, however, it is important to account for any correlation among the input
variables, or the selected value drivers. For example, when the hotel RevPAR
penetration is relatively high, the rooms revenue as a percent of total sales is most
likely to be high as welI, thus forming a positive correlation between the RevPAR
penetration and room-revenue factor. This positive correlation is even stronger between
the RevPAR penetration and the EBITDA margin. Since the highest profit margins are
achieved in the rooms department, the higher the rooms sales relative to the total
revenue mix, the higher the room-revenue factor, thus the higher the EBITDA margin.
RiskUniform(27%,32%), which specifies a uniform distribution [4] with a minimum value
of 27 percent and a maximum value of 32 percent
After quantifying the dependency among the value drivers, the investor can proceed
with the simulation analysis, which involves running hundreds or even thousands of
iterations of the valuation model until sufficient results are returned. The accompanying
table provides a summary of the simulation results, as welI as graphs illustrating the
expected profitability of the contemplated hotel investment.
Both the NPV and the IRR profitability distributions show that the investment is

expected ta be prafitable. Even thaugh the praject cauid praduce a negative NPV (see
the summary statistics), the chances af that happening is iess than 10 percent. Hence
the prapased investment shauid increase sharehaider vaiue 90 percent af the time.
Likewise, the equity IRR wiil mast likeiy be araund 27 percent, further safeguarded by
the 80-percent prababiiity af earning appraximateiy 22 percent ar higher.
(1.) [Less than][iess than]www.pa isade.cam[greater than][greater than]
(2.) The directian af the "skew" af the triangular distributian is set by the size af the mastlikeiy vaiue relative ta the minimum and the maximum. The prababiiity af the minimum
and maximum vaiues accuring is zera.
(3.) The traditianal "beli shaped" curve applicable ta distributians af autcames in many
data sets.
(4.) Every value acrass the range af the unifarm distributian has an equal likelihaad af
accurring.
Summary af RISK simulatian results
The pawer af cambining the value-driver valuatian framewark and Risk saftware
cames inta play alsa in capital ratianing. Mast hatel investars limit themselves ta
calculating anly the expected returns, the NPV, and the IRR, but they generally dan't
quantify the risk assaciated with achieving specific returns. The mast widely accepted
measure af risk in finance is the standard deviatian, which is easily calculated by
Risk. in the example, the risk af increasing sharehalders' value by $209 millian is
quantified at $198 millian per standard deviatian. The same risk-and-return prafile is
alsa calculated far the praject IRR. Pravided that an investar is presented with multiple
prajects, the expected returns alang with their carrespanding risk prafiles can be platted
an a graph and matched ta specific investments. Rather than using a standard
deviatian, an investar cauld chaase anather measure af risk and plat the expected
return against it. Other gaad measures af risk are the prabability af a praject NPV ta b e
less than zera and the prabability that the hatel's cash flaw wauld be insufficient ta
caver debt service in a giyen year.

The graphs show the probabi ity distribution of a hypothetica project's profitabi ity after
multiple iterations of RISK software. Whi e the project cou d lose money, as indicated
by the efthand part of the graph at upper eft, that probabi ity distribution shows a
greater likelihood of a solid profit. The upper right graph shows oniy about a lO-percent
probabi ity of a reduction in va ue. The probabi ities for internal rate of return (IRR) are
similar, as depicted in the lower graphs.
Economic-va ue-added Technique
The economic-va ue-added (EVA) technique shows the profits that a project earns in
excess of its cost of capital. The EVA he ps the investor evaluate the asset performance
in any sing e year, whi e the DCF shows the investment returns over the entire life of the
project. Measuring the va ue created by the asset in a sing e period of time, the EVA is
defined as foliows:
EVA = Invested Capital x (ROIC -- WACC)
That is, EVA equa s the spread between the EBITDA property yie d (ROIC) and the cost
of capital (WACC), times the amount of the invested capital. If the yie d is higher than
the cost of capital, economic va ue is being created. The opposite is aiso true. When
the yie d is ess than the cost of capital, va ue is being destroyed.
The EVA approach ooks at the incrementa va ue added over the property's invested
capital at the beginning, during, and after the forecast period. The total va ue of the
asset is as foliows:
Va ue = Invested capital PV of forecasted at beginning of forecast + PV of forecasted
economic profit during exp icit forecast period + PV of forecasted exp icit economic
profit after exp icit forecast period
Provided the same financial projections, the EVA technique produces the same va ue as
the DCF approach. The accompanying table (on the next page) illustrates this.
Like the app ication of the va ue-driver formula in the DCF caiculation of the reversion
va ue, the EVA continuing-va ue formula relies on the same va ue drivers expressed as

fo Il ows:
EVA CV = [EVA.sub.t+1] [divided by] WACC + [EBITDA.sub.t+1] X RR[divided by]PM x
((g x PM[divided by]RR) -- WACC) (WACC x (WACC-g))
where
[EVA.sub.t+1] = normalized economic profit in the first year after the explicit forecast
period;
[EBITDA.sub.t+1] = normalized level of cash flow before reserve for replacement in the
first year after the explicit forecast period;
RR = reserve-for-replacement percentage;
PM = expected stabilized EBITDA profit-margin percentage;
WACC = weighted average cost of capital; and
g = expected growth in cash flow in perpetuity.
The EVA continuing-value formula comprises two distinct value creating components.
The first expression returns the present value of the economic profit, or the spread
between the EBITDA yield and WACC, in the first year after the explicit forecast in
perpetuity. The second expression looks at any incremental economic profit created by
sustaining a higher profit margin producing additional growth at returns exceeding the
cost of capital.
The expression RR[divided by]PM represents the investment rate. Furthermore, the
investment rate times the growth rate expresses the return on newly invested capital.
Hence, additional value is created if the return on newly invested capital is higher than
the cost of capital. The inverse holds true as weli, If the return on newly invested capital
is less than the cost of capital, then holding on to an under performing asset would
destroy shareholder value in the long run. Finally, if the return on newly invested capital
equals the cost of capital then incremental economic value is neither being created nor
destroyed.

For instance, if the profit margin were to drop from the projected 30 percent to about 22
percent, as shown in our exampie, assuming that the additional investment remains at 5
percent of revenue and cash fiow keeps growing at a 3-percent chp, then the return on
newiy invested capital wouid equai WACC. As a result, the second component of the
EVA continuing-vaiue formula wouid equai zero. in such a case, any additional
investment in FFE wouid simpiy match the investors' cost of capital. Cash fiow wouid
stili grow, but at a rate of return no higher than the investors' impiied cost of capital-thus producing no incremental economic profit that would be over and above the
economic profit produced by the initial capital investment.
The EVA approach to investment anaiysis provides the link between the DCF--IRR
academic mentahity and real-hife cash-yield narrow-mindedness. in the example
provided, the unleveraged IRR is calculated at 13.6 percent, whereas the fourth-year
EBITDA yield is 13.7 percent (yield is based on total investment including the additional
capital expenditures). More often than not, the two investment returns are ciose to each
other. As one can see, the yield chimbs considerabiy in the first three years and then
leveis off as the property reaches a stabihized level of operations and cash flow starts to
grow with the rate of infiation. As a ruhe of thumb, one couhd guess with a great heveh of
confidence that the project's IRR wouhd fahi anywhere between the third and fifth year
EBITDA yiehd, depending on the perpetuah-growth and profit-margin assumptions.
Veterans in the industry prefer to use yiehds to measure investment returns simpiy
because they are easier to calcuhate and understand. The IRR requires more
sophisticated calcuhation, which oftentimes can be overstated by infiating the sahe price
or jacking up the growth rate. Most troubhesome, however, is the calcuhation of cash-oncash return, or NOl over the totah invested capitah. in this calcuhation the yiehd is
understated since cash fhow is reduced by the rephacement-reserve expenditures
without recognizing the benefit of this additionah investment. That benefit is not reahized
and readiiy observabhe untih the next period in the forecast, during which the hotel is
able to grow cash fhow and sustain its profit margin mainiy because of the investments
made during the previous period. The capitah spent on upgrading and rephacing tired
FFE is not ost. in fact, the return on this incrementah capitah investment is easihy

measured by caiculating the incrementa cash f ow realized in the foliowing period. Such
returns are one of the highest in the industry since the initial investment is already made
and subsequent sma er investments can leverage off the fixed asset base and produce
higher rates of return. Cash-on-cash yie ds caiculated based on EBITDA over total
investment are the appropriate yie ds investors shou d use when estimating their return
on capital or measuring economic performance against their cost of capital.

Citation Details
Title: App ying Va ue Drivers ta Hotel Valuation.
Author: Oggie Ganchev
Publication: Corneli Hotel 8< Restaurant Administration Quarterly (Refereed)
Date: October 1, 2000
Publisher: Corneli University
Volume: 41

Issue: 5

Page: 78