Option Valuation
This blog deals with why assets with option characteristics
should be viewed distinctly in corporate valuation process.
Assets are generally valued using conventional valuation
models such as book value, stock and debt, DCF etc. However, for some assets conventional
valuation models may not be appropriate because these assets possess option
characteristics and derive their value from it. Assets of pharma, oil producing,
and gold mining companies possess such characteristics.
For example, a pharma company may be awaiting patent
approval from Food and Drug Administration (FDA) for vaccine that can cure cancer
disease. The valuation of the company changes depending upon the
approval/rejection of the patent. If it successfully obtains approval its
valuation would increases drastically, if not, it remains stable or decreases.
For such companies it is preferable to use option valuation method.
In option valuation method the asset is treated as an option contract.
Why an asset is
treated as an option contract?
An option contract is a contingent claim wherein the payoff
is made only under certain contingency. In the above example, the contingency
is obtaining necessary approval from FDA.
The payoffs on call and put options depends upon the value
of the underlying asset. The payoff happens when the value of the underlying
asset:
·
exceeds a pre-specified value for a call option
·
fall below pre-specified value for a put option
An option variables include strike price, current market
price, payoff, and time to expiration.
·
In an asset, investment outlay or cost is
considered as strike price, patent life as time to expiration, market price as
current value and payoff as future cash flows. If the value exceeds a
pre-specified level, the asset is worth the difference, if not, it is worth
nothing.
Option premium and
DCF valuation model
Discounted cash flow, one of the popular methods in
corporate valuation, understate the value of assets with option
characteristics. DCF method is modelled on a set of expected cash flows and it
does not fully consider changes when faced with real time situations.
For example, oil producing companies may decide to reduce
the output of oil supply if the oil price is not at sustainable level (this
happened when the oil price went below $30 per barrel in 2015).
By adjusting the output these firms can preserve or protect
their valuation. This adjustment is valued in terms of option premium. If DCF
model is used option premium so derived is added to DCF value.
