5 Potential valuation approaches

5.1 We have noted in Section 2 that the actual market for renewal of the spectrum rights has certain key attributes that differentiate it from the market that is normally inferred by the term “market value” and is assumed when undertaking a market value calculation. We also concluded that we cannot ignore these differentiating attributes.

5.2 In this section we review the available valuation methodologies. In the following section we assess the methodologies and define the preferred methodology. In the last section we consider the adjustments to the preferred approach to reflect the actual market attributes. Available Approaches

5.3 There are generally two broad approaches to determining the price of the spectrum (other than actually holding a sale of spectrum):

• Applying recent, relevant and observable benchmarks; or
• Assessing a value on the basis of other data and assumptions.

5.4 A combination of one or more specific methodologies could be used. However, none of the approaches can be expected to provide a “magic bullet” that can simply produce a market value for the spectrum rights. In the discussion that follows we dismiss most of the approaches fairly rapidly, but they are provided for completeness. Benchmarking

5.5 Benchmarks for the value of spectrum could be obtained from a number of sources, including: • Auction and tender prices for 2G spectrum; or • Secondary market transactions.

5.6 Overseas and New Zealand benchmarks would be considered. Options for use of these benchmarks would include:

• Identification of a trend in prices that could be applied to the current renewal process;
• As the starting point in a Covec-style price-setting formula; or
• As inputs to a simulated auction. Assessed Values

5.7 Assessment of the value of spectrum to the holder can be approached in one of two ways:

• Earnings: the future cash flows that are made possible by holding the spectrum.
• Avoided Costs or Deprival: where alternatives to spectrum are possible (i.e. through reconfiguration of the physical network), the costs that would be required to maintain a given level of service for a given reduction in spectrum holding. Earnings Valuation

5.8 It is a fundamental principle of asset valuation that an investor acting to maximise profits will value an asset based on the present value of future cash flows that the asset will generate for its owner. The cash flow to the owner can arise from either using the asset or trading it, but in the long term, value will be a function of cash flow from utilisation.

5.9 In this context, an earnings valuation of spectrum rights, that is a valuation based on the ability of the asset to generate future cash flow, will be the most theoretically robust valuation approach.

5.10 An earnings valuation would involve valuing the business of a generic and hypothetical New Zealand cellular operator, and extracting from such a valuation the value of the spectrum rights. Options under this approach are:

• A simplified earnings approach. This involves developing a proxy for net cash flow. This is used to forecast future cash flows that are discounted to a present value. This would represent the value for the business.
• The Covec formula approach. Similar in approach, but with a proxy for growth in cash flow applied to the original auction price.
• Disaggregating market capitalisation: Attempting to split the evidenced value of a business (derived from its market capitalisation) into its component parts, so as to identify the value of the spectrum, as distinct from any other parts.
• Full earnings valuation. A full discounted cash flow analysis, involving development of detailed financial projections and an assessment of risk. Avoided Costs or Deprival

5.11 Deprival value is a cost-based valuation approach that answers the following question: “What is the least cost system or bundle of assets needed to provide customers with the existing level and quality of services?”

5.12 In New Zealand deprival value has been modified and used as optimised deprival value (“ODV”) in the utility sector for valuing infrastructure assets with sole supply characteristics. Typically, it has been used to value entire networks.

5.13 There are three important concepts within the ODV approach:

• Modern equivalent assets: costs should be based on modern assets with service potential equivalent to and (at least as, if not more) efficient as the existing assets.
• Optimisation: assets should be configured in the most efficient way possible. Any over design, excess capacity or inefficient configuration of assets should not be costed.
• The value based on a modern equivalent, optimised system should not exceed the present value of the future cash flows that can be generated from utilising the assets. This normally relates to a situation where revenue for some part of the system is constrained, for example by a more cost effective alternative technology.

5.14 ODV is based on the premise that competition in a market will ensure that prices will not exceed the amount needed to cover efficient operating costs and provide a return of and return on capital invested in an optimally configured system of modern equivalent, efficient assets. Assuming no barriers to entry, prices for services will be set by the operator with the most efficient costs (operating and capital). ODV is an approach to quantifying efficient capital costs.

5.15 This approach could be applied to valuing spectrum rights, by addressing the following: “If an operator was deprived of incremental spectrum rights, what incremental costs would be incurred to replicate the existing level and quantity of services using the remaining spectrum rights? These costs are “avoided” by owning the incremental spectrum rights and so, in this context represent the value of an amount of incremental spectrum. That is, the incumbent should be prepared to pay up to the value of the incremental costs to avoid being deprived of its spectrum rights, so long as the incremental costs are less that the present value of the free cash flows generated from the spectrum services.”

5.16 This would be similar in concept to the full ODV but is applied at the margin of the efficient network. (Note this might not be at the limit of the package of spectrum on offer.) It is also similar to the Administered Incentive Pricing or AIP, also known as the Smith-NERA approach, as used in the UK, although the Smith-NERA approach also incorporates the effects of identifying marginal costs that would result if an additional spectrum right was made available to a right holder.

5.17 The incremental ODV involves calculation of the difference in network roll-out and operational costs arising through deprival of a given quantity of spectrum. The question being addressed in the incremental ODV is what incremental costs would the operator incur to maintain the quantity and quality of services to its customers if it were deprived of spectrum rights at the margin? For example, if the operator was deprived of some spectrum, what additional costs (operating and capital) would it have to incur to continue services to its customers?

5.18 A network operator faces a trade-off between spectrum and network configuration. A reduction in available spectrum could be compensated for by an expansion in the capacity of the network (via additional cell sites, for instance) to maintain a given level of service.

5.19 Spectrum and network configuration (perhaps most simply thought of as the number of cell sites) are thus considered inputs which may be substituted for each other to maintain a given service level. The network reconfiguration required to substitute for a marginal decrease in spectrum (for a given level of service) depends on the technical rate of substitution of these two inputs (i.e. the rate at which the two inputs may be substituted for each other while maintaining a set level of output). In practice the value of the technical rate of substitution is likely to predominantly be an engineering question.

5.20 Clearly cell sites cannot be substituted for spectrum entirely. A minimum quantity of spectrum is needed in order to establish a network for a given area and coverage. Additional blocks of spectrum have value in that they enable movement toward a less efficient (in terms of spectrum use) and less costly network; however, the value of these marginal units of spectrum decreases as the quantity of spectrum held increases.

5.21 The value to the spectrum holder in terms of the network costs avoided is illustrated below. The minimum quantity of spectrum required to establish a network, N*, has value V*. The value of additional spectrum holdings declines according to the network substitution possibilities. Conceivably, each marginal unit may yield additional network substitution (and hence cost avoidance) possibilities. It is more likely, however, that substitutions of spectrum for cell sites will only be possible once a spectrum block of a certain size has been obtained. This would give rise to the stepwise changes in marginal spectrum value shown below.

Figure 3 Hypothetical Demand Curve

5.22 There are a number of important issues that would have to be resolved in applying the incremental ODV approach:

• Over what period is system utilisation and available capacity measured?
• What assumptions are made about system technology? For example, should the calculations be based on a modern equivalent, optimally configured system?
• Should an economic value cap be applied? Combination of Methods

5.23 Generally, any attempt to value a business or asset would use more than one methodology. Typically, a core methodology is used, which is crosschecked with the results of other methodologies. The same consideration would be prudent in the case of valuing spectrum rights.