An Introduction to Valuation

A philosophical basis for Valuation

Valuationisoftennotahelpfultoolindeterminingwhentosell
hypergrowthstocks,HenryBlodget,MerrillLynchEquity
ResearchAnalystinJanuary2000,inareportonInternetCapital
Group,whichwastradingat$174then.

Therehavealwaysbeeninvestorsinfinancialmarketswhohave
arguedthatmarketpricesaredeterminedbytheperceptions(and
misperceptions)ofbuyersandsellers,andnotbyanythingasprosaic
ascashflowsorearnings.
Perceptionsmatter,buttheycannotbeallthematter.
Assetpricescannotbejustifiedbymerelyusingthebiggerfool
theory.

Misconceptions about Valuation

Myth1:Avaluationisanobjectivesearchfortruevalue
Truth1.1:Allvaluationsarebiased.Theonlyquestionsarehowmuchandin
whichdirection.
Truth1.2:Thedirectionandmagnitudeofthebiasinyourvaluationis
directlyproportionaltowhopaysyouandhowmuchyouarepaid.

Myth2.:Agoodvaluationprovidesapreciseestimateofvalue
Truth2.1:Therearenoprecisevaluations
Truth2.2:Thepayofftovaluationisgreatestwhenvaluationisleastprecise.

Myth3:.Themorequantitativeamodel,thebetterthevaluation
Truth3.1:Onesunderstandingofavaluationmodelisinverselyproportional
tothenumberofinputsrequiredforthemodel.
Truth3.2:Simplervaluationmodelsdomuchbetterthancomplexones.

I.

Value first, Valuation to follow

Sources of Bias

Wedontchoosecompaniesrandomlytovalue:

Theinformationweuseisalwayscoloredbythebiasesofthoseproviding
theinformation:
Annualreportsandotherdataprovidedbythefirmrepresentmanagements
spinonevents
Independentreportsonthecompany(byanalysts,journalists)willbeaffected
bytheirbiases.
Ifthestockistraded,themarketpriceitselfbecomesasourceofbias.

Institutionalfactorscanaddtothebiasbyskewingrecommendationsin
onedirectionortheother.

Reward/punishmentmechanismsmaybetiltedtowardsfindingassetstobe
underorovervalued.

Manifestations of Bias

Inputstothevaluation:Ourassumptionsaboutmargins,returnson
capital,growthandriskareinfluencedbyourbiases.

Postvaluationtinkering:Themostobviousmanifestationofbias
Postvaluationtinkering
occursafterwefinishthevaluationwhenweaddpremiums(synergy,
control)andassessdiscounts(illiquidity)forvariousfactors.Ifweare
biasedtowardshighervalues,wetendtousepremiums;ifbiased
towardslowervalues,wediscount.

Qualitativefactors:Whenwerunoutofallotherchoices,wetendto
explainawaythedifferencebetweenthepricewearepayingandthe
valueobtainedbygivingitaname(strategicconsiderations)

What to do about bias

Reduce institutional pressures: Institutions that want honest sellside equity

research should protect their equity research analysts who issue sell
recommendationsoncompanies,notonlyfromiratecompaniesbutalsofrom
theirownsalespeopleandportfoliomanagers.

Delinkvaluationsfromreward/punishment:Anyvaluationprocesswherethe
reward or punishment is conditioned on the outcome of the valuation will
resultinbiasedvaluations.

No precommitments: Decision makers should avoid taking strong public

positionsonthevalueofafirmbeforethevaluationiscomplete.

SelfAwareness: The best antidote to bias is awareness. An analyst who is

awareofthebiasesheorshebringstothevaluationprocesscaneitheractively
trytoconfrontthesebiaseswhenmakinginputchoicesoropentheprocessup
tomoreobjectivepointsofviewaboutacompanysfuture.

II. It is only an estimate:

Sources of Uncertainty

Estimation Uncertainty: Even if our information sources are impeccable, we

have to convert raw information into inputs and use these inputs in models.
Anymistakesormisassessmentsthatwemakeateitherstageofthisprocess
willcauseestimationerror.

RealUncertainty:

Firmspecific Uncertainty: The path that we envision for a firm can prove to be
hopelesslywrong.Thefirmmaydomuchbetterormuchworsethanweexpectedit
to perform, and the resulting earnings and cash flows will be very different from
ourestimates.
MacroeconomicUncertainty:Evenifafirmevolvesexactlythewayweexpectedit
to, the macro economic environment can change in unpredictable ways. Interest
rates can go up or down and the economy can do much better or worse than
expected.Thesemacroeconomicchangeswillaffectvalue.

Responses of Uncertainty:
The healthy ones..

Better Valuation Models: Building better valuation models that use more of the
information that is available at the time of thevaluation is one way of attacking
theuncertaintyproblem.Eventhebestconstructedmodelsmayreduceestimation
uncertainty but they cannot reduce or eliminate the very real uncertainties
associatedwiththefuture.

ValuationRanges:Afewanalystsrecognizethatthevaluethattheyobtainfora
business is an estimate and try to quantify a range on the estimate. Some use
simulations and others derive expected, bestcase and worstcase estimates of
value.

Probabilistic Statements: Some analysts couch their valuations in probabilistic

terms to reflect the uncertainty that they feel. Thus, an analyst who estimates a
valueof $30 for astockwhichis tradingat$25willstate that thereis a60or
70% probability that the stock is under valued rather than make the categorical
statementthatitisundervalued.

Responses to uncertainty:
Unhealthy ones..

Passing the buck: Some analysts try to pass on responsibility for the
estimates by using other peoples numbers in the valuation. If the
valuation turns out to be right, they can claim credit for it, and if it
turns out wrong, they can blame others (management, other analysts,
accountants)forleadingthemdownthegardenpath.

Givinguponfundamentals:Asignificantnumberofanalystsgiveup,
especially on fullfledged valuation models, unable to confront
uncertainty and deal with it. All too often, they fall back on more
simplisticwaysofvaluingcompanies(multiplesandcomparables,for
example) that do not requireexplicit assumptions aboutthefuture. A
fewdecidethatvaluationitselfispointlessandresorttoreadingcharts
andgaugingmarketperception.

What to do about uncertainty..

Youcanreduceestimationuncertaintybutyoucannotdomuchabout
realuncertainty(otherthantreatitasriskandbuilditintoyour
discountrates)

Ingeneral,analystsshouldtrytofocusonmakingtheirbestestimates
offirmspecificinformationhowlongwillthefirmbeableto
maintainhighgrowth?Howfastwillearningsgrowduringthat
period?Whattypeofexcessreturnswillthefirmearn?andsteer
awayfrombringingintheirviewsonmacroeconomicvariables.

III. Is bigger better?

Sources of Complexity

Thetoolsaremoreaccessible:Computersandcalculatorshave
becomefarmorepowerfulandaccessibleinthelastfewdecades.
Withtechnologyasourally,tasksthatwouldhavetakenusdaysin
theprecomputerdayscanbeaccomplishedinminutes.

Thereismoreinformationforustoworkwith:Ontheotherside,
informationisbothmoreplentiful,andeasiertoaccessanduse.We
candownloaddetailedhistoricaldataonthousandsofcompaniesand
usethemasweseefit.

Cost of complexity

Information Overload: More information does not always lead to better

valuations. In fact, analysts can become overwhelmed when faced with
vast amounts of conflicting information and this can lead to poor input
choices.Theproblemisexacerbatedbythefactthatanalystsoftenoperate
undertimepressurewhenvaluingcompanies.

Black Box Syndrome: The models become so complicated that the

analystsusingthemnolongerunderstandtheirinnerworkings.Theyfeed
inputsintothemodelsblackboxandtheboxspitsoutavalue.Ineffect,
therefrainfromanalystsbecomesThemodelvaluedthecompanyat$30
ashareratherthanWevaluedthecompanyat$30ashare.

Big versus Small Assumptions: Complex models often generate

voluminous and detailed output and it becomes very difficult to separate
thebigassumptionsfromthesmallassumptions.

The principle of parsimony

Thebasicprinciple:Whenvaluinganasset,wewanttousethe
simplestmodelwecangetawaywith.

Dontgolookingfortroubleandestimateinputsthatyoudonothave
to.Youcanmanglesimpleassetsusingcomplicatedvaluationmodels.

Allinonevaluationmodelsthattrytovalueallcompanies,by
definition,willbefarmorecomplicatedthantheyneedtobe,since
theyhavetobebuiltforthemorecomplexcompanythatyouwillrun
into.

Approaches to Valuation

Discountedcashflowvaluation,relatesthevalueofanassettoits
intrinsiccharacteristics;itscapacitytogeneratecashflows,andtherisk
inthecashflows.Initsmostcommonform,intrinsicvalueiscomputed
withadiscountedcashflowvaluation,withthevalueofanassetbeing
thepresentvalueofexpectedfuturecashflowsonthatasset.

Relativevaluation,estimatesthevalueofanassetbylookingatthe
pricingof'comparable'assetsrelativetoacommonvariablelike
earnings,cashflows,bookvalueorsales.

Contingentclaimvaluation,usesoptionpricingmodelstomeasurethe
valueofassetsthatshareoptioncharacteristics.

Basis for all valuation approaches

Theuseofvaluationmodelsininvestmentdecisions(i.e.,indecisions
onwhichassetsareundervaluedandwhichareovervalued)arebased
upon
aperceptionthatmarketsareinefficientandmakemistakesinassessing
value
anassumptionabouthowandwhentheseinefficiencieswillgetcorrected

Inanefficientmarket,themarketpriceisthebestestimateofvalue.
Thepurposeofanyvaluationmodelisthenthejustificationofthis
value.

Discounted Cash Flow Valuation

Whatisit:Indiscountedcashflowvaluation,thevalueofanassetisthe
presentvalueoftheexpectedcashflowsontheasset.

PhilosophicalBasis:Everyassethasanintrinsicvaluethatcanbe
estimated,baseduponitscharacteristicsintermsofcashflows,growthand
risk.

InformationNeeded:Tousediscountedcashflowvaluation,youneed
toestimatethelifeoftheasset
toestimatethecashflowsduringthelifeoftheasset
toestimatethediscountratetoapplytothesecashflowstogetpresentvalue

MarketInefficiency:Marketsareassumedtomakemistakesinpricing
assetsacrosstime,andareassumedtocorrectthemselvesovertime,asnew
informationcomesoutaboutassets.

Discounted Cashflow Valuation: Basis for

Approach
CF1
CF2
CF3
CF4
CFn
Valueofasset =

.....
1
2
3
4
(1 + r) (1 + r)
(1 + r)
(1 + r)
(1 + r) n

whereCFtistheexpectedcashflowinperiodt,risthediscountrateappropriate
giventheriskinessofthecashflowandnisthelifeoftheasset.
Proposition1:Foranassettohavevalue,theexpectedcashflowshavetobe
positivesometimeoverthelifeoftheasset.
Proposition2:Assetsthatgeneratecashflowsearlyintheirlifewillbeworth
morethanassetsthatgeneratecashflowslater;thelattermayhowever
havegreatergrowthandhighercashflowstocompensate.

a. Going Concern versus Liquidation Valuation

Inliquidationvaluation,wevalue
onlyinvestmentsalreadymade

Figure 1.1: A Simple View of a Firm

Assets

Liabilities

Assets in Place
Existing Investments
Generate cashflows today

Investments already
made

Debt

Growth Assets
Expected Value that will be
created by future investments

Investments yet to
be made

Equity

Borrowed money

Owners funds

Whenvaluingagoingconcern,wevalueboth
assetsinplaceandgrowthassets

b. Equity Valuation versus Firm Valuation

FirmValuation:Valuetheentirebusiness
Assets
ExistingInvestments
Generatecashflowstoday
Includeslonglived(fixed)and
shortlived(working
capital)assets
ExpectedValuethatwillbe
createdbyfutureinvestments

Liabilities

AssetsinPlace

Debt

GrowthAssets

Equity

FixedClaimoncashflows
LittleorNoroleinmanagement
FixedMaturity
TaxDeductible

ResidualClaimoncashflows
SignificantRoleinmanagement
PerpetualLives

Equityvaluation:Valuejustthe
equityclaiminthebusiness

Equity Valuation

Figure5.5:Equity Valuation
Assets
Cashflowsconsideredare
cashflowsfromassets,
afterdebtpaymentsand
aftermakingreinvestments
neededforfuturegrowth

AssetsinPlace

GrowthAssets

Liabilities
Debt

Equity

Discountratereflectsonlythe
costofraisingequityfinancing

Presentvalueisvalueofjusttheequityclaimsonthefirm

Firm Valuation

Figure5.6:FirmValuation
Assets
Cashflowsconsideredare
cashflowsfromassets,
priortoanydebtpayments
butafterfirmhas
reinvestedtocreategrowth
assets

AssetsinPlace

GrowthAssets

Liabilities
Debt

Equity

Discountratereflectsthecost
ofraisingbothdebtandequity
financing,inproportiontotheir
use

Presentvalueisvalueoftheentirefirm,andreflectsthevalueof
allclaimsonthefirm.

c. Three pathways to DCF value

ClassicDCFvaluation:Discountcashflows(tofirmorequity)backatthe
appropriatediscountrate(costofcapitalorequity).Thepresentvalueofthe
cashflowsisthevalueofequityorthefirm.Theeffectsofdebtfinancing
arebuilteitherintothecashflows(withequityvaluation)orintothecostof
capital(withfirmvaluation)

AdjustedPresentValueapproach:Valuethefirmasifitwereallequity
fundedandaddthefinancialeffectsofdebttothisvalue.
Valueofbusiness=Valueofbusinesswith100%equityfinancing+Presentvalue
ofExpectedTaxBenefitsofDebtExpectedBankruptcyCosts

ExcessReturnsapproach:Thevaluecanbewrittenasthesumofcapital
investedandthepresentvalueofexcessreturns:
Valueofbusiness=CapitalInvestedtoday+Presentvalueofexcessreturncash
flowsfrombothexistingandfutureprojects

Advantages of DCF Valuation

SinceDCFvaluation,doneright,isbaseduponanassetsfundamentals,
itshouldbelessexposedtomarketmoodsandperceptions.

Ifgoodinvestorsbuybusinesses,ratherthanstocks(theWarrenBuffet
adage),discountedcashflowvaluationistherightwaytothinkabout
whatyouaregettingwhenyoubuyanasset.

DCFvaluationforcesyoutothinkabouttheunderlyingcharacteristicsof
thefirm,andunderstanditsbusiness.Ifnothingelse,itbringsyouface
tofacewiththeassumptionsyouaremakingwhenyoupayagivenprice
foranasset.

When DCF Valuation works best

Thisapproachiseasiesttouseforassets(firms)whose
cashflowsarecurrentlypositiveand
canbeestimatedwithsomereliabilityforfutureperiods,and
whereaproxyforriskthatcanbeusedtoobtaindiscountratesisavailable.

Ormeans,attheriskofstatingtheobvious,thisapproachisdesignedfor
useforassets(firms)thatderivetheirvaluefromtheircapacitytogenerate
cashflowsinthefuture.
Itworksbestforinvestorswhoeither
havealongtimehorizon,allowingthemarkettimetocorrectitsvaluation
mistakesandforpricetoreverttotruevalueor
arecapableofprovidingthecatalystneededtomovepricetovalue,aswould
bethecaseifyouwereanactivistinvestororapotentialacquirerofthewhole
firm
Arenoteasilyswayedoraffectedbymarketmovementstatarecontrarytotheir
valueviews

Disadvantages of DCF valuation

Sinceitisanattempttoestimateintrinsicvalue,itrequiresfarmoreinputs
andinformationthanothervaluationapproaches

Theseinputsandinformationarenotonlynoisy(anddifficulttoestimate),
butcanbemanipulatedbythesavvyanalysttoprovidetheconclusionheor
shewants.Thequalityoftheanalystthenbecomesafunctionofhowwellhe
orshecanhidethemanipulation

Inanintrinsicvaluationmodel,thereisnoguaranteethatanythingwill
emergeasunderorovervalued.Thus,itispossibleinaDCFvaluation
model,tofindeverystockinamarkettobeovervalued.Thiscanbea
problemfor
equityresearchanalysts,whosejobitistofollowsectorsandmake
recommendationsonthemostunderandovervaluedstocksinthatsector
equityportfoliomanagers,whohavetobefully(orclosetofully)investedin
equities

Relative Valuation

Whatisit?:Thevalueofanyassetcanbeestimatedbylookingathowthe
marketpricessimilarorcomparableassets.

PhilosophicalBasis:Theintrinsicvalueofanassetisimpossible(orcloseto
impossible)toestimate.Thevalueofanassetiswhateverthemarketis
willingtopayforit(baseduponitscharacteristics)

InformationNeeded:Todoarelativevaluation,youneed
anidenticalasset,oragroupofcomparableorsimilarassets
astandardizedmeasureofvalue(inequity,thisisobtainedbydividingtheprice
byacommonvariable,suchasearningsorbookvalue)
andiftheassetsarenotperfectlycomparable,variablestocontrolforthe
differences

MarketInefficiency:Pricingerrorsmadeacrosssimilarorcomparableassets
areeasiertospot,easiertoexploitandaremuchmorequicklycorrected.

Choices with multiples

EquityorFirm:Multiplescanbescaledtojustequityvalue(market
pricepershare,marketcapitalization),tofirmvalue(debtplusequity)or
tothevalueofoperatingassets(debtplusequityminuscash)

Scalingvariable:Themarketvaluecanbescaledto
Earnings:Thechoicescanrangefromequityearnings(EPS,NetIncome)to
operatingincome(EBITorEBITDA).
BookValue:Thechoicescanincludebookvalueofequityorbookvalueof
capital(debtplusequity)
Revenues

Current,TrailingorForwardValues:Thevaluesusedforthescaling
variablecanbefromthelastfinancialyear(current),thelastfour
quarters(trailing)orsomefutureperiod(forward).

Choosing the Comparable firms

Identicalfirm(s):Trytofindone,twoorafewcompaniesthatlook
verysimilartothefirmthatyouarevaluing.Ineffect,youarelooking
foratwinfirmthatistradedbythemarket.

Sector:Afarmorecommonchoiceistoconsiderallfirmsinthe
sectorthatthefirmoperatesintobecomparablefirms.

Valuationbasedcomparables:Firmsthatlooklikeyourfirminterms
ofcashflow,growthandriskcharacteristics.

Making the comparison

Direct comparison: In this approach, analysts try to find one or two companies that
lookalmostexactlylikethecompanytheyaretryingtovalueandestimatethevalue
baseduponhowthesesimilarcompaniesarepriced.

Peer Group Average: In the second, analysts compare how their company is priced
(using a multiple) with how the peer group is priced (using the average for that
multiple).Implicitinthisapproachistheassumptionthatwhilecompaniesmayvary
widely across a sector, the average for the sector is representative for a typical
company.

Peer group average adjusted for differences: Recognizing that there can be wide
differences between the company being valued and other companies in the
comparable firm group, analysts sometimes try to control for differences between
companies.Inmanycases,thecontrolissubjective:acompanywithhigherexpected
growththantheindustrywilltradeatahighermultipleofearningsthantheindustry
averagebuthowmuchhigherisleftunspecified.Inafewcases,analystsexplicitlytry
to control for differences between companies by either adjusting the multiple being
usedorbyusingstatisticaltechniques.

Advantages of Relative Valuation

InSyncwiththemarket:Relativevaluationismuchmorelikelytoreflect
marketperceptionsandmoodsthandiscountedcashflowvaluation.Thiscan
beanadvantagewhenitisimportantthatthepricereflecttheseperceptions
asisthecasewhen
theobjectiveistosellasecurityatthatpricetoday(asinthecaseofanIPO)
investingonmomentumbasedstrategies

Withrelativevaluation,therewillalwaysbeasignificantproportionof
securitiesthatareundervaluedandovervalued.Sinceportfoliomanagers
arejudgedbaseduponhowtheyperformonarelativebasis(tothemarket
andothermoneymanagers),relativevaluationismoretailoredtotheirneeds
Relativevaluationgenerallyrequireslessexplicitinformationthan
discountedcashflowvaluation(especiallywhenmultiplesareusedas
screens)
Inrelativevaluationyouareplayingtheincrementalgamewhereyouhope
tomakemoneybygettingthenextincrement(earningsreport,newsstory
etc.)right

Disadvantages of Relative Valuation

Aportfoliothatiscomposedofstockswhichareundervaluedona
relativebasismaystillbeovervalued,eveniftheanalystsjudgmentsare
right.Itisjustlessovervaluedthanothersecuritiesinthemarket.

Relativevaluationisbuiltontheassumptionthatmarketsarecorrectin
theaggregate,butmakemistakesonindividualsecurities.Tothedegree
thatmarketscanbeoverorundervaluedintheaggregate,relative
valuationwillfail

Relativevaluationmayrequirelessinformationinthewayinwhichmost
analystsandportfoliomanagersuseit.However,thisisbecauseimplicit
assumptionsaremadeaboutothervariables(thatwouldhavebeen
requiredinadiscountedcashflowvaluation).Totheextentthatthese
implicitassumptionsarewrongtherelativevaluationwillalsobewrong.

When relative valuation works best..

Thisapproachiseasiesttousewhen
therearealargenumberofassetscomparabletotheonebeingvalued
theseassetsarepricedinamarket
thereexistssomecommonvariablethatcanbeusedtostandardizethe
price

Thisapproachtendstoworkbestforinvestors
whohaverelativelyshorttimehorizons
arejudgedbaseduponarelativebenchmark(themarket,otherportfolio
managersfollowingthesameinvestmentstyleetc.)
cantakeactionsthatcantakeadvantageoftherelativemispricing;for
instance,ahedgefundcanbuytheundervaluedandselltheovervalued
assets

Asset Based Valuation: A Detour

Incontrasttovaluingabusinessasagoingconcern(basedoncashflows)or
bylookingathowotherbusinessesthatlookitarepriced(relativevaluation),
yousometimesmayvalueabusinessbyvaluingitsassets.
Assetbasedvaluationmaybeinthecontextof
Liquidationvaluation,whereyouarevaluingtheassetsforsale
Accountingvaluation,whereyouarevaluingindividualassetsforaccounting
reasons(fairvalueorgoodwillestimation)
Sumofthepartsvaluationtoeitherseeifacompanyischeapasaninvestmentor
agoodtargetforacquisition/restructuring

Tovaluetheindividualassets,though,youhavetoeitheruseexpectedcash
flows(intrinsicvaluation)orbaseitonthepricingofsimilarassets(relative
valuation)
Assetbasedvaluationiseasiesttodowhenassetsareseparableandhave
standaloneearnings/cashflows

What approach would work for you?

Asaninvestor,givenyourinvestmentphilosophy,time
horizonandbeliefsaboutmarkets(thatyouwillbe
investingin),whichoftheapproachestovaluationwould
youchoose?
DiscountedCashFlowValuation
RelativeValuation
Neither.Ibelievethatmarketsareefficient.

Contingent Claim (Option) Valuation

Optionshaveseveralfeatures
Theyderivetheirvaluefromanunderlyingasset,whichhasvalue
Thepayoffonacall(put)optionoccursonlyifthevalueofthe
underlyingassetisgreater(lesser)thananexercisepricethatis
specifiedatthetimetheoptioniscreated.Ifthiscontingencydoes
notoccur,theoptionisworthless.
Theyhaveafixedlife

Anysecuritythatsharesthesefeaturescanbevaluedasan
option.

Option Payoff Diagrams

Strike Price

Value of Asset
Put Option

Call Option

Direct Examples of Options

Listedoptions,whichareoptionsontradedassets,thatareissuedby,
listedonandtradedonanoptionexchange.

Warrants,whicharecalloptionsontradedstocks,thatareissuedbythe
company.Theproceedsfromthewarrantissuegotothecompany,and
thewarrantsareoftentradedonthemarket.

ContingentValueRights,whichareputoptionsontradedstocks,that
arealsoissuedbythefirm.TheproceedsfromtheCVRissuealsogoto
thecompany

ScoresandLEAPs,arelongtermcalloptionsontradedstocks,which
aretradedontheexchanges.

Indirect Examples of Options

Equityinadeeplytroubledfirmafirmwithnegativeearningsandhigh
leveragecanbeviewedasanoptiontoliquidatethatisheldbythe
stockholdersofthefirm.Viewedassuch,itisacalloptionontheassetsof
thefirm.

Thereservesownedbynaturalresourcefirmscanbeviewedascalloptions
ontheunderlyingresource,sincethefirmcandecidewhetherandhowmuch
oftheresourcetoextractfromthereserve,

Thepatentownedbyafirmoranexclusivelicenseissuedtoafirmcanbe
viewedasanoptionontheunderlyingproduct(project).Thefirmownsthis
optionforthedurationofthepatent.

Therightspossessedbyafirmtoexpandanexistinginvestmentintonew
marketsornewproducts.

Advantages of Using Option Pricing Models

Optionpricingmodelsallowustovalueassetsthatweotherwise
wouldnotbeabletovalue.Forinstance,equityindeeplytroubled
firmsandthestockofasmall,biotechnologyfirm(withnorevenues
andprofits)aredifficulttovalueusingdiscountedcashflow
approachesorwithmultiples.Theycanbevaluedusingoption
pricing.

Optionpricingmodelsprovideusfreshinsightsintothedriversof
value.Incaseswhereanassetisderivingitvaluefromitsoption
characteristics,forinstance,moreriskorvariabilitycanincreasevalue
ratherthandecreaseit.

Disadvantages of Option Pricing Models

Whenrealoptions(whichincludesthenaturalresourceoptionsandthe
productpatents)arevalued,manyoftheinputsfortheoptionpricing
modelaredifficulttoobtain.Forinstance,projectsdonottradeandthus
gettingacurrentvalueforaprojectoravariancemaybeadauntingtask.

Theoptionpricingmodelsderivetheirvaluefromanunderlyingasset.
Thus,todooptionpricing,youfirstneedtovaluetheassets.Itistherefore
anapproachthatisanaddendumtoanothervaluationapproach.

Finally,thereisthedangerofdoublecountingassets.Thus,ananalyst
whousesahighergrowthrateindiscountedcashflowvaluationfora
pharmaceuticalfirmbecauseithasvaluablepatentswouldbedouble
countingthepatentsifhevaluesthepatentsasoptionsandaddsthemon
tohisdiscountedcashflowvalue.

In Summary

Whiletherearehundredsofvaluationmodelsandmetricsaround,
thereareonlythreevaluationapproaches:
Intrinsicvaluation(usually,butnotalwaysaDCFvaluation)
RelativeValuation
ContingentClaimValuation

Thethreeapproachescanyielddifferentestimatesofvalueforthe
sameassetatthesamepointintime

Totrulygraspvaluationyouhavetobeabletounderstandanduseall
threeapproaches.Thereisatimeandaplaceforeachapproach,and
knowingwhentouseeachoneisakeypartofmasteringvaluation