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Chapter 9. Valuation of Companies > The Real Options Method

The Real Options Method

Introduction

The main methods used by managers and investors to analyze projects and companies—the DCF method and the residual income method—are based on the discounting of forecasted cash flows from existing and projected project baskets of the company. In practice, when the company examines the feasibility of projects, it analyzes the net present value of each project (or, in the case of a company valuation, the value derived from the models in comparison to the price of the company) and invests in the projects which demonstrate a positive present value. Using an excessively high interest rate in the discounting process results in many projects being mistakenly seen as uneconomical. In addition, the projection of cash flows from projects (or a company) is exposed to mistakes in the projection, which again may cause many projects to be rejected although they may create positive value. Furthermore, in many cases, when the analysts use the traditional projection methods, they do not give due consideration to the effect of the examined project on other projects (synergies) or to the fact that such projects could affect the company's growth possibilities even if they do not directly affect the growth of the company.

The basic assumption in models based on discounted cash flows (or residual income) is that the level of such cash flows is uncertain. Therefore, the discount rate is determined in a manner which “indemnifies” the investor for the risk entailed, from his perspective, by such uncertainty. The problem with this method is that it does not relate to the possibilities which are opened to the managers after the investment, namely, to the changes in the system of possible investments and sources of revenue, which become clearer after a certain period of time. The company and its investors always face different options, and the most basic among them is the option which most investors in the company benefit from: the possibility of investing based on the company's development. In other words, investors could decide to discontinue the financing the company if they are not pleased with the interim results. This is an example of what is called real options.


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