Business Valuation - Option Pricing Approaches

Option Pricing Approaches

As above, in certain cases equity may be valued by applying the techniques and frameworks developed for financial options, via a real options framework. For general discussion as to context see Valuing flexibility under Corporate finance; for detail as to applicability and other considerations see further under Real options valuation.

In general, equity may be viewed as a call option on the firm, and this allows for the valuation of troubled firms which may otherwise be difficult to analyse; see Distressed securities. Here, since the principle of limited liability protects equity investors, shareholders would choose not to repay the firm’s debt where the value of the firm (as perceived) is less than the value of the outstanding debt; see bond valuation. Of course, where firm value is greater than debt value, the shareholders would choose to repay (i.e. exercise their option) and not to liquidate. Thus analogous to out the money options which nevertheless have value, equity will (may) have value even if the value of the firm falls (well) below the face value of the outstanding debt - and this value can (should) be determined using the appropriate option valuation technique. (A further application of this principle is the analysis of agency problems; see Contract design under Principal–agent problem.)

Certain business situations, and the parent firms in those cases, are also logically analysed under an options framework; see "Applications" under the Real options valuation references. Just as a financial option gives its owner the right, but not the obligation, to buy or sell a security at a given price, companies that make strategic investments have the right, but not the obligation, to exploit opportunities in the future. Thus, for companies facing uncertainty of this type, the stock price may (should) be seen as the sum of the value of existing businesses (i.e. the discounted cash flow value) plus any real option value. Equity valuations here, may (should) thus proceed likewise. Compare PVGO.

A common application is to natural resource investments. Here, the underlying asset is the resource itself; the value of the asset is a function of both quantity of resource available, and the price of the commodity in question. The value of the resource is then the difference between the value of the asset and the cost associated with developing the resource. Where positive ("in the money") management will undertake the development, and will not do so otherwise, and a resource project is thus effectively a call option. A resource firm may (should) therefore also be analysed using the options approach. Specifically, the value of the firm comprises the value of already active projects determined via DCF valuation (or other standard techniques) and undeveloped reserves as analysed using the real options framework. See Mineral economics.

Product patents may also be valued as options, and the value of firms holding these patents - typically firms in the bio-science, technology, and pharmaceutical sectors – can (should) similarly be viewed as the sum of the value of products in place and the portfolio of patents yet to be deployed. As regards the option analysis, since the patent provides the firm with the right to develop the product, it will do so only if the present value of the expected cash flows from the product, exceeds the cost of development, and the patent rights thus correspond to a call option. See Patent valuation under Economics and patents. Similar analysis may be applied to options on films (or other works of intellectual property) and the valuation of Film studios.