Real options perspective of security analysis

Abstract

The recent misvaluations of high-tech growth stocks (i.e., the Internet stocks' boom and bust) have highlighted the difficulty of valuing dynamic companies whose cash flows and future growth are uncertain. Companies with no foreseeable profits might enjoy significant valuations based on investors' perceptions (or misperceptions) of their growth potential. This chapter presents a relatively "new" valuation methodology based on option pricing theory that practitioners can apply in valuing companies. This chapter has the following objectives: • Bring out an analogy between financial options and real options • Highlight the different types of real options • Introduce valuation of real options • Highlight the application of real options valuation in security analysis The recent misvaluations of high-tech growth stocks (i.e., the Internet stocks' boom and bust) have highlighted the difficulty of valuing dynamic companies whose cash flows and future growth are uncertain. Companies with no foreseeable profits might enjoy significant valuations based on investors' perceptions (or misperceptions) of their growth potential. Amazon.com, for instance, was valued at over $ 40b in 2000, though the company was not expected to make profits for few more years. Although this was a classic case of oversimplification of demand estimation (analysts were pointing out that even if Amazon captures 1% of the worldwide market for online book sales, it would be one of the largest companies), there is evidence to prove that stock markets value valuable growth options held by companies. The estimated value of growth option for some well-knownAmerican companies is presented in Exhibit 12.1 (Kester 1984). As can be seen from the exhibit, up to 80% of Motorola's market value in 1984 came from future growth opportunities.1 While discounted cash flow (DCF) is appropriate for valuing existing operations with rather predictable cash flows, Real Options Valuation is emerging as the most effective way to quantify the additional value of growth opportunities that may, to many investors, appear somewhat nebulous. Real Options Security Analysis can be useful in identifying companies whose growth potential is not properly priced in by the market and which are mispriced relative to comparable stocks (with comparable quality of management) in the same industry or sector.Mutual funds or hedge funds could find such a tool particularly valuable in their security selection and portfolio management activities. © 2009 Springer-Verlag Berlin Heidelberg.