Stock Option Valuation Insights Thought Leadership The Economic Analysis of Real Option Value Robert P. Schweihs The discounted cash flow method does not always completely capture the uncertainty of the future financial performance of a business, business ownership interest, or security that is the subject of a valuation analysis. In those instances, when the valuation purpose should take into consideration the owner/operator’s ability to influence the future financial performance of the subject investment, then real option valuation (ROV) theory is a powerful analytical tool. ROV analysis is often used by corporate acquirers—and by other investors— who are more interested in the question “what is this investment worth to me?” than they are in the question “what is the market value of this investment?” NTRODUCTION be justified by the intrinsic valuation of the subject I investment. These investors are admired (particu- The current market price of a publicly traded secu- larly if they are successful) as risk takers who invest rity may be inconsistent with the net present value perhaps on a “hunch.” cash-flow-based intrinsic valuation of that security’s This discussion considers how ROV theory may price. That is, the intrinsic valuation of the security explain some of that intuition. This discussion con- (based on a discounted cash flow valuation analysis) siders how investment risk takers can better handle may simply not support the apparently excessive uncertainty when they have the right—but not the public stock price of that security. obligation—to take some action in the future. In such instances, some market analysts have argued that the generally accepted economic theory of business valuation and security analysis is flawed. Such market analysts would observe that the price DISCUSSION OF REAL OPTION at which a security changes hands is the best indica- VALUE THEORY tor of its market value. ROV theory applies option pricing theory more So, when an Internet services company goes broadly than does the typical application of finan- public at a stock price that cannot be reasonably cial option valuation (i.e., in the valuation of public explained by the present value of its expected future company or private company stock options, war- cash flow, the question arises: what is wrong with rants, grants, or rights). ROV theory is often used as generally accepted business valuation and security an investment strategic tool. analysis pricing theory? Buyers of businesses or business ownership Real option value (ROV) theory is a management interests (including equity securities) may use ROV (or investor) strategic planning tool that may be theory to justify their acquisition/investment pric- used to explain the “unreasonable” or “irrational” ing (or “overpricing”) decisions. pricing that is observed in certain situations in the The objective of this discussion is to introduce capital markets. ROV theory and to proffer ROV theory as a pos- There have always been situations where inves- sible explanation for certain capital market pricing tors have made investments at prices that cannot phenomena. www .willamette .com INSIGHTS • AUTUMN 2016 3 When acquisition/investment prices cannot be NVESTMENT ALUE VERSUS AIR rationally explained, it is not the generally accepted I V F business valuation theory or approaches that should MARKET VALUE be challenged. The concept that is really under chal- The various forms of the efficient market hypothesis lenge is the definition of economic value. Investors essentially assume the following: who pay a price greater than intrinsic value—that 1. All appropriate information is available to is, the price that is can rationally be justified by the investors. present value of expected future cash flow—may be paying what valuation analysts define as “invest- 2. Investors use that information when mak- ment value” rather than “fair market value.” ing their investment pricing decisions. That is, an “irrational” price may include com- ponents of the value that are brought to the subject The price that an investor pays for any security investment by the particular investor/buyer. investment incorporates the security holder’s right ROV theory has obvious implications to the valu- to (1) invest, (2) wait, or (3) divest. ation analyst or the transactional financial adviser: These are the “reactive” attributes of most 1. when using empirical transactional pricing financial instruments, including both publicly trad- evidence as a guideline indicator of invest- ed company and privately held company stock ment fair market value, options. 2. when advising buyers/investors in the devel- However, ROV theory also involves “proactive” opment of potential acquisition candidates, attributes of stock options, with which the security and holder actually takes action to increase the value of the option itself. 3. when pricing and structuring proposed acquisition/investment transactions. With regard to virtually any investment decision, investors have the following choices: 1. Invest now ROV theory also has obvious implications to the valuation, transactional fairness, and other invest- 2. Take preliminary steps to invest later ment analysis of: 3. Divest now 1. merger and acquisition transaction pricing; 4. Take preliminary steps to divest later 2. initial public offering pricing; 5. Do nothing 3. capital budget investment decision making; 4. capital market investment decision making; Each investment choice creates a set of eco- and nomic payoffs linked to further choices at a later 5. lost profit analysis and other economic time. This is the premise behind the proposition damages analysis related to securities fraud, that all management investment, financing, and lack of public disclosure, expropriations dividend decisions can be analyzed in terms of and condemnations, and other securities- option pricing. related litigation claims. As one may expect, the Black-Scholes option pricing model is where ROV theory conceptually begins. Table 1 Consideration of the Black- Financial Option Pricing Models versus ROV Analyses Scholes option pricing Parallels in the Component Economic Variables model helps to explain these otherwise inexplica- Black-Scholes Option Pricing Model Real Option Valuation Analysis ble “irrational” investment Economic Variables Economic Variables pricing decisions. Time to expiration Time to expiration There are direct paral- lels in the economic vari- Risk-free interest rate Risk-free interest rate ables of ROV theory and Exercise price Present value of fixed costs the six economic variables encompassed in the Black- Stock price Present value of expected cash flow Scholes option pricing for- Uncertainty of stock price movements Uncertainty of expected cash flow mula. These economic vari- able parallels are presented Dividends Value lost during decision period in Table 1. 4 INSIGHTS • AUTUMN 2016 www .willamette .com ROV theorists refer to this phenomenon as “flex- As a comparison, the holder of the financial ibility value.” This is where the “investment value” option is not in a position to influence the value of standard of value—versus the “fair market value” the security that underlies the subject option. standard of value—appears to come into play in In addition, apparently “irrational” acquisition ROV theory. prices may be explained by the application of ROV Investment value is often defined as “the value to theory. For example, these irrational prices may a particular investor based on individual investment relate to investments that are made in social media requirements and expectations.”1 companies at a significant premium over what the ROV theory seems to fit certain situations that expected net present value of future cash flow would are characterized by: indicate. 1. high levels of investment research and Corporate acquirers often expect that post- acquisition economic synergies will develop. Such 2. high levels of investment development, expected post-acquisition synergies help to ratio- manufacturing, and/or marketing. nalize the significant price premium that is paid over the expected net present value of the target For example, an investor may pay today’s “irra- company’s cash flow. tional” price for the investment—and then the Some of the recent social media company initial option buyer may use his/her influence to improve public offerings (IPOs) indicate that enough inves- the economic value of the subject investment. tors share this expected synergy explanation that this investment value may have become market value. If and when the economic benefits of the FINANCIAL OPTIONS VERSUS REAL expected synergies are not realized, these investors will presumably divest (probably selling at a more OPTIONS rational price than they bought it at). For example, as of the Tuesday, August 16, 2016, the stock market closing price of Facebook common stock was priced at $123.30. The publicly traded EAL PTION ALUE LEXIBILITY option (but not the obligation) to buy one share of R O V “F Facebook common stock before January 20, 2017, VALUE” for $110.00 per share was priced at $17.50. ROV theory encompasses both expected net present In this case, the investor of the financial option value plus “flexibility value”—the change in expect- on that day would receive a payoff of $13.30. ed net present value over the option’s life. However, that investor, having spent $17.50 on the The application of expected net present value option, would be “out of pocket” a total of $4.20. sensitivity analysis—with the best-case, worst-case, That $4.20 is the amount of the premium price and most-likely-case scenarios—does not incor- charged for the right to wait to exercise the stock porate the variance across different scenarios. purchase option—if and when the Facebook share Generally accepted sensitivity analysis procedures price increases. recognize the uncertainty with regard to economic “Real options” are not traded on organized stock outcome exists. However, such procedures do not market exchanges the way that financial options capture the “flexibility value” inherent in the situ- are. Real options are more analogous to a “valuation ation. premise.” The “flexibility value” is something that com- pany management can capture.